AS THE River Elbe burst its banks this month, the German government's budget deficit threatened to breach the limits of the euro area's “stability and growth pact”. The pact prohibits fiscal deficits above 3% of GDP. Except in severe recessions, they can attract a fine of up to 0.5% of GDP. Germany now has a deficit of 2.8%. This week, Gerhard Schröder, Germany's chancellor, delayed popular tax cuts in order to be able to dispense flood aid without violating the pact. With an election coming up, this is a political embarrassment. Portugal, which admits to a fiscal deficit in 2001 of over 4%, already faces the prospect of punishment. Conceivably, France and Italy may also test the limits of the pact before long.
A decade ago, the pact's architects, most of them German, feared that the euro's credibility might be undermined by fiscal laxity among its members. If a government's borrowing becomes unsustainable, its central bank might be forced to bail it out, inflating away the real value of its debts. Such bail-outs are expressly forbidden in the euro area, while the European Central Bank (ECB) enjoys a forbiddingly strong position relative to national-level fiscal authorities.
Prudent or not, the euro area's 12 finance ministers remain accountable for their fiscal choices. If they court insolvency, financial markets will apply a risk premium to the government's bonds, or refuse to lend to them altogether. Why should the European Commission try to police sovereign borrowing when the markets already do so? If anything, monetary union calls for granting more fiscal discretion to national governments, not less. Having ceded monetary policy to the centre, member nations have greater need of fiscal flexibility to cope with problems that afflict them at home.
Germany is a case in point. If it were still in a position to conduct its own monetary policy, interest rates would now almost certainly be lower. Meanwhile, a weak German economy probably needs precisely the kind of tax cuts that Mr Schröder was forced to shelve this week. In other words, the pact's “excessive deficit procedure” looms large at precisely the moment it will do most harm. Germany may yet escape fines, by invoking a special exemption for events beyond its control—observing the letter, if not the spirit of the pact.
The pact may be flawed, but the euro area still has fiscal problems which its members need to address. Between 1990 and 1996, the future euro-area members ran an average deficit of well over 4% of GDP. Stronger economic growth, along with the tough rules of the stability pact, have since forced that figure down, to 1.5% on average. But now that “Maastricht fatigue” may be setting in, those deficits may widen again. Euro-area government debt stands at 72% of GDP, a deal higher than the 60% figure the Maastricht treaty deemed sustainable. Many European governments face hefty pension liabilities in the near future. If Europeans are serious about putting their budgets in order, they will need to undertake long-term fiscal reforms. Is it better that they do so singly, as and when the pact forces them to, or together, as part of a collective effort?
Christopher Allsopp and David Vines of Oxford University, together with Warwick McKibbin of the Australian National University, argue against going it alone*. Budget cuts are never painless, but within a monetary union individual cuts can be excruciating. A country with an autonomous monetary policy can offset tighter fiscal policy by expanding credit and devaluing the exchange rate. But in a monetary union, where an individual country can no longer cut interest rates, nothing cushions the blow.
The authors asked what would happen if France were to cut its budget deficit unilaterally, by 2% of GDP. According to their simulation, French output would fall by more than 2%. Prices would fall a bit in France, but across the euro area as a whole they would barely change. So the ECB would have little cause to cut nominal interest rates. As a result, the real rate of interest—nominal rates adjusted for inflation—would actually rise in France. Output would eventually recover, but not before a recession of up to three years.
What if France agreed with the other member states to cut deficits together? Surely, a synchronised contraction would be even more damaging, as each country's recession spilled over into its neighbours' economies. Possibly, the authors acknowledge. Yet, while the ECB might not respond to a slowdown in one country, fiscal austerity in all 12 euro countries would probably force it to cut rates, so bolstering private spending even as government spending falls. A rate cut would also weaken the euro, boosting exports.
Investors might provide another cushion. Collectively, the euro area accounts for a big share of the demand for global savings. As they reduced their claims on these savings, Europe's governments would take pressure off the world's long-term real interest rates, boosting share prices and “crowding in” private-sector investment.
If fiscal reforms are undertaken jointly, the short-term sacrifices may be surprisingly light, and the long-term benefits may arrive surprisingly early. Such a happy outcome hangs upon pursuing reforms that are both credible and co-operative. It is a pity, then, that Europe's stability and growth pact, as it stands, is neither.
* “Fiscal Consolidation in Europe”, by Christopher Allsopp, Warwick McKibbin and David Vines, in “Fiscal Aspects of European Monetary Integration”, Cambridge University Press, 1999.
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