EU Grapples With Deficit Caps

An important fiscal-discipline rule underlying the euro came under attack Wednesday, dividing Europe as it tries to emerge from the sharpest economic slump since the region unified under a common currency.

By Daniel Schwammenthal and William Echikson in Brussels and G. Thomas Sims in Frankfurt.

French Prime Minister Jean-Pierre Raffarin admitted that his country's budget deficit was worsening, hinting the nation might exceed for a third year in a row a European Union budget-deficit cap of 3% of a country's gross domestic product. The admission opened the door to a potential bitter fight over whether countries exceeding the limit, including France and Germany, would face massive fines -- a move that would lend credibility to Europe's fiscal rules but perhaps intensify the economic slowdown.

Mr. Raffarin, meeting with members of the European Commission in Brussels, said his priority is closing the yawning deficit by stimulating the economy, not cutting spending. "I told the commissioners that employment and growth are a priority," Mr. Raffarin told journalists. The comment follows an unconfirmed report in Wednesday's edition of Les Echos, the French business daily, that France would exceed the 3% cap next year. Mr. Raffarin refused to comment on the newspaper report.

Maximum 'Flexibility'

At a joint news conference Wednesday with Mr. Raffarin, European Commission President Romano Prodi warned that France must "respect" EU budget rules, though he did say the rules would be interpreted with maximum "flexibility."

Elsewhere, German Chancellor Gerhard Schroeder, in an interview in Wednesday's La Repubblica newspaper, called for "more flexibility" in the application of the rules -- known as the Stability and Growth Pact. Many analysts believe Germany also is likely to breach the 3% cap for the third straight year.

Together, the statements from Europe's two largest countries raise doubts about the euro zone's commitment to fiscal discipline.

To be sure, deficits are becoming a problem across the globe. In the U.S., the Congressional Budget Office this week estimated the budget will remain in the red for most of the next 10 years. In Europe, however, the problem is particularly acute because interest rates for the 12 nations that use the euro are set by the European Central Bank, but national governments still control spending-and-tax decisions. If some countries run large deficits while others practice restraint, the ECB would have trouble pinpointing an appropriate interest rate that would best serve the region.

Though seemingly arcane, the pact and its implications for the euro-zone economy are of global significance. The countries that use the euro have a combined population that is larger than that of the U.S., and their combined GDP well exceeds that of Japan.

Stuck in the middle is the European Commission, guardian of EU budget rules. It soon must decide whether to recommend spending cuts and eventual fines against France of as much as 0.5% of the country's GDP -- difficult moves both politically and economically. If the commission goes ahead, it risks escalating the already simmering spending crisis. If it doesn't, the commission could compromise its authority, possibly encouraging other governments to flout the rules.

Seeking Sanctions

Smaller countries with minimal deficits are particularly angry with France and Germany. Austrian Finance Minister Karl-Heinz Grasser, whose country is likely to post a deficit of 0.4% of GDP next year, has said "sanctions must be the consequence" if France violates the limit for a third year. But economists fear that fines would only aggravate Europe's economic woes. "If there's a push for spending cuts, it will be a real negative for the markets -- and the economy," predicts Lorenzo Codogno, an economist at Bank of America.

While both Germany and France face budget woes, they are approaching their problems differently. Mr. Schroeder is going ahead with tax cuts, but he also has embarked on the most ambitious welfare and health-care overhaul since World War II. In return, EU diplomats say, the commission could accept Germany's deficit as a temporary transgression. France also has started overhauling its welfare system, but it is being less ambitious. "Germany is attempting real reform, while France is fudging," said Nico Kleine, an economist at ABN Amro in Amsterdam.

Write to Daniel Schwammenthal at daniel.schwammenthal@dowjones.com¹, William Echikson at william.echikson@dowjones.com² and G. Thomas Sims at tom.sims@wsj.com³

Updated August 28, 2003