The Euro Zone: There Go The Brakes

The decision to scrap strict spending limits may get growth going again. But it could also trigger bigger deficits

The euro is setting record highs daily against the dollar and is up 13.7% so far this year. Europe's manufacturers posted a third month of expansion in November. And business confidence in the euro zone is at its highest since the summer of 2001. These all sound like reasons to celebrate. But European financial officials are unseasonably glum. Even as the Continent's economy revs up, one of the pillars that supports Europe's monetary union is looking distinctly shaky.

A maneuver to skirt government spending limits enshrined in the European Union's Stability & Growth Pact has unleashed a wave of recrimination that is souring relations among nations and threatening to damage the euro zone's new financial clout. It may even complicate the drafting of a new EU constitution member states were hoping to wrap up by mid-December. "It's obvious this decision will have consequences," says Spanish Prime Minister José María Aznar. "How could it not?"

The stability pact was effectively shredded on Nov. 25 at an acrimonious European finance ministers' meeting in Brussels. There, nine of the EU's 15 finance ministers agreed to ignore a recommendation by the European Commission to impose sanctions on Germany and France for failing to reduce their budget deficits, which are way above the pact's 3% ceiling. As a result, tensions between the nine naysayers and two of the EU's main institutions -- the European Central Bank and the EC -- are at an all-time high. On Dec. 1, ECB President Jean-Claude Trichet warned that failure "to respect the rules and procedures foreseen in the pact risks undermining the credibility of... public finances across the euro area."

Some ministers asserted the vote was a triumph of sanity, pointing out that the consensus in the EU is that the inflexible deficit limit had the euro zone economy in a stranglehold. French and German officials argue that overzealous fiscal prudence could snuff out a budding recovery. Says German Finance Minister Hans Eichel: "It would be unthinkable to raise taxes to cut the deficit when the economy is just starting to recover."


Still, the damage may be lasting. That's because the move away from strict spending limits calls into question EU members' commitment to collective action and consensus. Increased government spending may have a positive short-term impact -- that's one reason the euro has held its value. But despite pledges by France and Germany that they will balance their budgets when their economies strengthen, critics fear their decision to ignore the pact now will only lead to mounting deficits later, as well as higher inflation and greater borrowing costs that ultimately choke off growth. In short, critics say, it could mean a return to the undisciplined days of a decade ago, before many governments had to curb runaway spending to qualify for the euro. "A lack of fiscal policy discipline will lead to higher government bond yields and lower growth in the medium term," says Thomas Mayer, chief European economist at Deutsche Bank in London.

That's why the Netherlands, Spain, Austria, and others don't buy the French and German argument that the stability pact as originally conceived is something Europe can do without. "If they'd run up surpluses and made structural reforms when their economies were growing, they wouldn't have gotten into this mess," says a senior Austrian finance official. "They acted as if the rules didn't apply to them." Austria's chancellor, Wolfgang Schüssel, called the decision to gut the stability pact "a sin."

The consequences of this rift may soon be felt. Speculation is rife that ECB head Trichet, a deficit hawk, may raise rates earlier than expected to temper inflationary effects of any excessive fiscal stimulus. A day after the pact was suspended, the ECB warned of "serious dangers" ahead and said it would "staunchly" guard against inflation. "The ECB has left no doubt that it will need to follow a tighter monetary policy than otherwise if fiscal policy discipline is endangered," says Deutsche's Mayer.

The question now is how to make the pact more workable. Some say a new agreement should be created that combines short-run flexibility with more effective surveillance. "Though the pact was faulty in its narrow focus on annual deficits, it is important that, after the flagrant breach by Germany and France, the euro area is not left without protection against irresponsible fiscal policies," says Jürgen von Hagen, director of the Center for European Integration Studies in Bonn. Others propose that the 3% deficit limit be replaced with rules allowing countries with lower national debts -- such as Germany -- to run up bigger short-term deficits. Under this plan, countries such as Italy, which have a bigger national debt, would be given less flexibility. For his part, Eichel wants the reformed pact to take account of inflation rates. He points out that low-inflation Germany is burdened with higher real interest rates than its partners in monetary union. French Finance Minister Francis Mer, however, says any decision on a revised pact should be left until 2005, when the European economy is expected to be growing more strongly.

While the EU can't turn back the clock, economists say that even without spending limits, Germany and France can do much to shore up faith in their ability to contain debt levels. How so? Germany's Federal Audit Office, which inspects the government's books, recently issued a report describing what its president, Dieter Engels, calls "major cases of mismanagement." For instance, Germany could have saved up to $6 billion in 2002 by cutting subsidies to public projects such as a troubled electronic highway toll system. And the government could generate additional revenue by collecting more of the tax money owed to it by, among others, brothels, which have failed to collect taxes due from their employees. Critics of Germany say belt-tightening alone would not have been enough to bring the deficit below 3% of GDP, but it might have pushed it down from the 4.2% expected this year -- possibly enough to stave off the crisis.


France is equally guilty of profligate spending, critics say. Jacques Marseille, an economic historian at La Sorbonne, estimates that France could easily save more than $100 billion, about 10% of its annual budget. His 2002 book, The Big Waste, brims with examples. For instance, it notes that an audit showed that the government agency overseeing professional training programs bought 5,445 computers, even though it employed only 2,872 people.

While the debate rages, the markets so far have taken the pact's suspension in stride. But financial specialists warn of trouble if governments now throw budgetary discipline to the winds. Moritz Kraemer, a credit analyst at rating agency Standard & Poor's, says that sovereign credit ratings could be cut, borrowing costs could rise, and the spreads between the bonds of different EU countries -- which have been narrowing since the launch of the euro in 1999 -- could widen. To forestall these consequences, Europe will have to show in the months ahead that it has fiscal discipline, stability pact or no.

By David Fairlamb in Frankfurt with Carol Matlack in Paris

— With assistance by Carol Matlack

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