Rising Deficits in Europe Give
Euro Its Toughest Challenge Yet

The euro -- the most prominent sign of European integration -- is facing its most severe test.

Simmering tensions over the Continent's common currency and its rules have flared into a full-blown fight between member countries. The rules require individual countries to keep down budget deficits, potentially forcing cuts in generous social welfare programs and other government spending in some of Europe's biggest countries. The brewing controversy over the nearly five-year-old euro is revealing centuries-old fault lines and raising questions about Europe's resolve to become a united economic and political power.

By Christopher Rhoads in Stockholm and G. Thomas Sims in Stresa, Italy

In the past week, France made it clear it would look after its own interests first, with French Prime Minister Jean-Pierre Raffarin dismissing the rules underpinning Europe's currency as obscure "accounting equations." The European Central Bank warned that unless France and Germany limit their surging budget deficits, as European Union rules require, the credibility of the euro could be damaged. The Netherlands threatened to sue the European Commission -- the EU's budget watchdog -- to make sure it requires the big countries to follow the rules they themselves wrote.

In Sweden Sunday, voters soundly rejected the euro and kept the krona, despite a wave of last-minute sympathy following the stabbing death of the nation's popular and pro-euro foreign minister, Anna Lindh. Among the reasons for the defeat: Fears that adhering to EU budget rules would force Sweden to slash its generous cradle-to-grave social welfare system. (See article¹.)

RELATED NEWS • Swedish Voters Reject Adopting the Euro2   • Estonians Vote to Join the EU3

The EU's 15 finance ministers fretted over the developments this past weekend during closed-door meetings in Stresa, Italy. If France and Germany say no to complying with the currency's rules, "Who can you trust in the future development of Europe?" said Nout Wellink, governor of the Dutch central bank, in an interview.

The infighting has consequences that go well beyond Europe. To sustain the nascent, U.S.-led global recovery, the world desperately needs other big engines of growth to kick in. With Japan mired in a long-term slump, a strong European economy, the world's second largest, is the next most likely candidate. But the euro's rules in some ways make jump-starting the European economy trickier. By requiring member nations to keep their budget deficits low, the rules remove a common tool for economic stimulus -- big government spending.

Recently, the euro has been gaining strength against the dollar amid worries about terrorism and the rising U.S. current account deficit, a broad measure of trade and investment. That too has taken a toll on European growth rates, since it makes EU exports more expensive abroad. The euro-area economy this year is expected to grow by just 0.5%, according to a consensus of economists, while estimates for the U.S. are being revised above 3%.

Politically, a strong consensus behind the euro project is crucial to the Continent's goal of playing a major role on the global stage. Spats over the currency could slow member nations' drive to act and speak with one voice in issues such as fostering global peace and dealing with terrorism.

No one expects any country to stop using the euro. Member countries often gripe about damage to national interests before hammering out some sort of compromise, and the project has made major strides. The currency became a physical reality last year in 12 countries, as 305 million people handed in their marks, lire, francs and other national currencies for the common one. Europe is on the brink of adopting its own constitution. And measured against the EU founders' original goal -- to avoid another European war -- the overall project of integration has been a resounding success.

Europe is in the midst of not only binding the old western European powers closer together but extending deep into the former Soviet empire. Next year, 10 Eastern Europe countries will join the EU, from Estonia on the Baltic Sea to tiny Cyprus, just 60 miles from Syria. Negotiations will begin soon on whether to allow in Turkey, a Muslim country with more citizens than France.

But the current standoff threatens to derail, or at least delay, expansion of the currency itself. The rejection by Sweden may push back plans to hold another vote in neighboring Denmark, which already rejected the euro once, possibly until 2006. In June, the British government decided to delay a euro vote, likely until at least 2006, reflecting the low standing of the euro in the eyes of Britons.

The setting for the latest contretemps was Stresa, a Northern Italian town that benefited from an earlier attempt at European integration. In the early 1800s, Napoleon Bonaparte ordered a road built through what was then a quaint fishing village, which ultimately turned the village into a resort for the rich.

At the center of the dispute is the so-called Stability and Growth Pact, which was designed in 1997 to ensure currency stability and low interest rates. It requires countries using the euro to limit their government budget deficit to 3% of the nation's gross domestic product. Germany worried that historically profligate countries such as Italy would run up high deficits. That in turn could trigger Europe-wide inflation that would force the European Central Bank to raise interest rates.

Last week, French Budget Minister Alain Lambert disclosed that France's budget would remain above the 3% limit until 2006. That would mean France would break the budget rules for four consecutive years. Germany is projected to break the rules for a third year in a row next year. France expects a budget deficit of 4% this year; Germany's is projected to be 3.8%.

In a closed-door meeting Friday afternoon in Stresa, Pedro Solbes, the EU's economic affairs commissioner, said he asked France to cut next year's budget deficit by more than 0.5% of GDP. French Finance Minister Francis Mer said at the meeting that France was committed to meeting the commission's rule, but he refused to give any specific figures for next year. After the meeting, Mr. Solbes said he was "not reassured" by France's response.

Both Germany and France are lobbying the commission to invoke a clause allowing for "special" circumstances to avoid paying fines for violating the deficit rule. The fines are potentially as much as 0.5% of GDP -- or about $7.8 billion for France and more than $11 billion for Germany. What makes their positions even harder to accept by the smaller member countries -- many of which have cut spending to balance their budgets -- is that Germany and France were the countries that initially demanded budget discipline.

France said that in the coming days it will begin to make public some elements of the budget. In early October, it is required to show the commission that it is taking corrective action.

Europe was moving gradually toward economic integration when the fall of the Berlin Wall in 1989 suddenly forced a reconsideration of its place in the wider world. European Commission President Jacques Delors, a Frenchman, and others, pushed through a treaty in 1991 that was the blueprint for introducing the common currency. "Delors was obsessed with the idea that Europe had to integrate faster or the EU would find itself behind Japan and the U.S.," says Ulf Jonsson, a professor of economic history at Stockholm University. "It was about Europe's place in the global economic system."

Throughout the 1990s, to prepare for a common currency, candidate countries slashed debt to below 60% of GDP and lowered their deficits to under 3%. Before the process began, several had deficits above 10%. National central banks brought their interest rates close enough together to make possible a single monetary policy. In 1999, that policy was placed in the hands of the European Central Bank and the euro was introduced as a common currency for international payments, with the member currencies pegged to it at set rates.

In the past, countries could voice their support for Europe, while not having to worry too much about it impinging on national concerns and issues. That's harder in the wake of the economic slump. France, for example, wants to bail out important companies, such as ailing engineering giant Alstom SA, and run up the deficit to help the economy. That could send a dangerous message to countries such as Poland and Hungary, which are set to join the EU early next year.

For EU members who haven't signed on to the common currency, the euro area's weak economic performance can make that a tough call. EU membership is largely a political designation. In theory, non-euro members in the EU are urged to stick to the spending rules too, but because their actions don't have economic ramifications on currency union, they are largely left to do as they want.

In Sweden, the country's tradition of neutrality made the question particularly controversial. Swedes worried that adopting the euro would undermine their generous social-welfare state, believing that euro membership would mean they'd have to become more competitive and cut taxes. They feared that would make their welfare payments unaffordable. The euro's appeal as a peace project means little in a country that hasn't been to war in nearly 200 years.

What's more, Sweden feels more culturally in tune with America, its largest single trading partner. American television shows, such as "Late Show With David Letterman," appear nightly on Swedish TV, undubbed. "We are reluctant Europeans," says Mr. Jonsson, the history professor. "We fear a supra-national EU structure."

When it voted to join the EU in 1994, the country was in the throes of a financial crisis, which drove unemployment above 15%. At the time, joining the EU seemed like a good bet. Today, the Swedish economy is stronger, its budget is in surplus and unemployment is well below the EU rate.

"Germany and France have big problems," says Segnhild Hansen, chief executive officer of Svenska LantChips AB, a maker of potato chips outside of Stockholm. "Are we going to suffer for that?"

Write to Christopher Rhoads at christopher.rhoads@wsj.com⁷ and G. Thomas Sims at tom.sims@wsj.com⁸

Updated September 15, 2003 9:26 a.m.