Germany: Putting the Stability Pact in Peril

German Finance Minister Hans Eichel wants to cut income taxes by $23 billion in 2004 to kick-start the economy. He is hoping that accelerating tax cuts scheduled for 2005, on top of reductions already slated for next year, will start a virtuous circle whereby tax cuts stimulate growth and create more revenues.

Despite widespread expectations that Germany will breach the Stability & Growth Pact for a second straight year in 2003, Eichel says the tax cuts won't threaten efforts to keep the 2004 budget deficit below the 3% of gross domestic product limit. First, the government says the 2% growth it forecasts for 2004 will lead to an increase in tax revenues. Second, the government plans to trim spending and privatize some government holdings.

But there's a problem with Eichel's line: Only the government thinks growth will reach 2% in 2004. The German Institute for Economic Research says even with tax cuts, growth won't top 1.6%, after a 0.1% decline this year. That would lead Germany to break the Stability Pact again next year.

A Yawning Budget Gap
If Germany heads for a third straight breach of the deficit rule, it would very likely be publicly castigated by the European Union. Germany could also be fined, possibly making the budget situation even tougher.

A more serious consequence would be a loss of credibility for the pact, ironically installed at Germany's behest. France and Italy could be tempted to follow Germany and let their deficits grow. Indeed, Germany's problems may widen the rift between large and small euro zone members since countries like Finland, Ireland, and Luxembourg maintain more or less balanced budgets or surpluses.

Foreign-exchange analysts warn the pact is necessary to provide the euro with a credible budgetary foundation. The analysts say a monetary union must be able to stop wayward government spending. If not, the creditworthiness of other countries in the union will be called into question, leading to a deterioration in the currency.

By David Fairlamb in Frankfurt

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