Commentary: How Europe Should Save the Stability Pact

What a role reversal. As Europe was preparing itself for the introduction of the euro little more than half a decade ago, German policymakers were so concerned that fiscally irresponsible countries like Ireland, Italy, and Greece would ruin the show that they forced all European Union members to sign a pledge limiting the size of deficit spending. The French -- as usual, more politically savvy than their German partners -- insisted that lip service also be paid to the idea of "growth," making the pact easier to sell at home.

Thus was born Europe's Growth & Stability Pact. But it has yielded neither growth nor stability for its German and French authors. Both countries are in recession, dragging down the rest of the Continent. And instead of delivering on their promised fiscal probity, Paris and Berlin admitted in late August that ballooning budget deficits this year will breach the pact's limit of 3% of gross domestic product for the second year running, as tax revenues fall far short of spending. France's projected 4% deficit for 2003 alone amounts to $66 billion. The French were even singled out for a special scolding by the European Commission on Sept. 2.

So much for stability. And what about those wastrel smaller countries? True, Italy's deficit of 2.5% of GDP is getting dangerously close to the 3% limit. But Ireland and Greece are keeping a tight lid on their deficits. Belgium -- once the laughingstock of financial Europe -- actually had a balanced budget last year. Finland even has a surplus.

The split between spendthrift France and Germany and the thrifty smaller states forces Europe into a painful dilemma. It's easy to argue that French and German violations mean the pact is worthless. A renunciation of the pact would at least give the French and Germans a free hand in using government spending to boost a nascent economic recovery.

But is it worth the cost? Such a piece of financial realpolitik would have severe repercussions in the effort to build a unified Europe. For starters, the smaller states would never believe the French or Germans again. "The pact is needed to ensure fiscal discipline," says Austin Hughes, chief economist at Dublin's IIB Bank. And without any pact to act as a brake, French and German deficits might get so big that their borrowing needs would drive interest rates up across Europe.

Then there's the issue of Greater Europe. With 10 new largely Eastern and Central European countries about to join the EU club, it's important that the biggest founding members obey the rules. Already, French and German backsliding is making it much more difficult for central bankers and politicians in accession countries to argue for badly needed budgetary restraint. The Polish government, for example, needs to cut a 7% budget deficit and quickly restructure its pension system. "It's now going to be harder to tighten things," says Krzysztof Rybinski, chief economist of Warsaw's Bank Przemyslowo-Handlowy.

What to do? Not even its fiercest critics suggest rewriting or abandoning the pact. Better a more flexible interpretation to allow countries to breach deficit ceilings temporarily without penalties. What is really needed is a new, public commitment to balance budgets in the medium term and even build a surplus. That's what Ireland and Finland did in their growth years of 2000 and 2001. Both have drawn on their surpluses during the downturn, avoiding the need for big deficits. It was the utter unwillingness of France and Germany to put away money during the fat years that leaves them so weakened now.

If Europe is to be more of an economic success story, its two most powerful economies must start acting more like fiscally responsible grown-ups. Abandoning the pact would not make that maturation any easier. In the U.S., when borrowing gets out of hand, Congress slaps down bills to limit the federal deficit. In Europe, the only recourse for putting its fiscal house in order is the Growth & Stability Pact, imperfect as it is.

By John Rossant

With David Fairlamb in Frankfurt

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