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October 27, 2002

Europe Strains to Put Laggards Back in Line


FRANKFURT -- Leave it to Portugal, the little country known for its fearless explorers, to test the boundaries of Europe's monetary union. In July, the Portuguese government became the first member to breach the ceiling on budget deficits allowed by the European Union.

It has been downhill ever since for the bureaucrats in Brussels who administer the rules for the 12 countries in Europe's monetary union. Germany said it, too, was likely to violate the deficit limit this year, while France flatly rejected an order from the European Commission to pare its deficit.

Nearly four years after the establishment of the euro, Europe's grand experiment in a monetary union is fraying badly — the victim of its own rigidity, an unforgiving global downturn and national politicians who still put the interests of their own countries before those of a united Europe.

Even Romano Prodi, the outspoken former Italian prime minister who heads the European Commission, has lost faith. He recently dismissed the Stability and Growth Pact, the agreement among European countries that underpins the monetary union, with a single word: "stupid."

Mr. Prodi's comment, made in Le Monde, the French newspaper, was the verbal equivalent of a hand grenade, igniting a debate that had been smoldering in corporate boardrooms and finance ministries across Europe. How it is resolved could help determine the long-term stability of the euro — to which Europe has, for better or worse, lashed its fortunes.

"It's clear that fiscal policy in Euroland is in disarray, and it was refreshing to hear Prodi say it," said David Walton, the chief European economist at Goldman, Sachs and a sharp critic of the rules.

Mr. Walton and others say the stability pact imposes a straitjacket on Europe, forcing countries to adopt austerity budgets just when they should be greasing their economies with more spending, not less. Its zeal to impose uniformity on a diverse territory of 300 million people, the critics say, is the definition of stupid.

Defenders of the pact are predictably steamed. "It was my proposal, and I am a little astonished," said Theo Waigel, who as finance minister of Germany under former Chancellor Helmut Kohl pushed the idea of requiring members of the currency union to meet budget targets.

"Mr. Prodi participated in the process at the time," Mr. Waigel said in an interview from his home in Bavaria. "He must ask himself, `Was I participating in a stupid process?' "

Among many current European leaders, however, there was a quiet satisfaction in Mr. Prodi's outburst. He said what many of them felt and, in so doing, took some of the heat off of them and their swelling budgets.

Jorge Sampaio, the president of Portugal, said he was chagrined that his country had been the first to transgress the pact. But he said in an interview that Portugal's troubles — a sluggish economy and a soaring budget deficit — demonstrated that Europe must rethink the rules.

"The pact was thought and discussed and approved at a moment of economic growth," Mr. Sampaio said. "Now we are in a situation of economic near-stagnation. What on earth are we going to do when we need to invest?"

Nobody has an easy answer to that question, and it has left Europe in a limbo that only a policy wonk could love.

The debate over how to run Europe's monetary union has eclipsed the smooth rollout of the euro itself. Thirteen billion euro notes and 56 billion coins began circulating here on Jan. 1, replacing marks and francs. Despite sporadic cavils about price gouging in the wake of the changeover, most Europeans have slipped into their new currency like an old jacket. The simplicity of a single currency is genuinely appreciated by people on this increasingly borderless continent.

After a lackluster debut in world markets, the euro also began flexing its muscles. In July, it reached parity with the dollar — a reflection of fears about the American economy and a possible war in Iraq, but also a symbol of the euro's rising credibility.

Mr. Prodi's comments knocked a few cents off the euro relative to the dollar. It was hardly a rout, but perhaps an early warning that Europe's messy state finances could undermine the currency.

"It's not that we're going back to the deficits we had before," said Daniel Gros, the director of the Center for European Policy Studies, a research institute in Brussels. "But we're probably going back to being less disciplined. This will mean a slightly weaker euro."

Still, Mr. Gros, who helped draft a landmark study on the euro in 1991, bitterly criticized Mr. Prodi's remarks. "It was calculated to do the maximum damage," he said. "It was just ineptness."

To understand why this debate is so fierce, recall how hard it was for Germany, France and other European nations to agree to forsake their own currencies in favor of the euro. The crisp euro notes and nickel-and-gold coins are the product of three decades of grinding negotiation.

At issue from the start was how to maintain the stability of a single currency when the countries that use it make their own economic policy. Germany, which in the 1980's had a thriving economy and a sound budget, did not want to be dragged down by chronic debtors like Italy.

"If you want a common currency, you must in a certain way harmonize your fiscal policies," said Daniel Cohn-Bendit, a onetime student radical who represents France in the European Parliament.

In the end, the countries agreed, in the Maastricht Treaty of 1993, to set out strict requirements that members had to meet before they could be admitted to the euro club. Among them, they must balance their budgets by 2004, and they cannot run deficits of more than 3 percent of gross domestic product.

Those rules were enshrined in the Stability and Growth Pact, which is administered by the European Commission. Countries that fail to heed the rules are supposed to be disciplined with warning letters, and then with fines equal to 0.5 percent of gross domestic product.

Monetary policy, meanwhile, was handed over to a European central bank, based in Frankfurt, which regulates the supply of the euro with the cardinal goal of keeping Europe's inflation in check.

In its early days, the pact seemed the perfect antidote for decades of profligate spending by governments. When Italy, under Prime Minister Prodi, got under the deficit ceiling, the event was hailed as an example of how the European Union could bring out the best in its members.

"There is a case to be made that they could never have done it individually," said Robert M. Solow, an economist and Nobel laureate at the Massachusetts Institute of Technology. "The pact was a cover for leaders to say, "We're going to cut spending. The reason we're doing it is not because we're bad people, but because we have to. It's for the greater good of Europe.' "

Today, 7 of the 12 euro countries are running surpluses, while Spain's budget is near balance. Not surprisingly, those countries oppose changing rules with which they have complied.

The trouble is, Europe's biggest economies, Germany and France, continue to spend heavily on welfare benefits and other programs that pile up debt. And the pressure is rising on all European countries to spend more on pensions and health care as their populations age. Such concerns were scarcely noticed during the boom years of the 1990's.

In 2001, however, the bottom dropped out of Europe's economy, and deficits suddenly loomed large. Germany and France have struggled to cut spending but have not taken the kind of scalpel to their budgets that would push them comfortably below the 3 percent threshold.

Officials had hoped a quick rebound would paper over their problems. But as the downturn has stretched into this year, and likely into 2003, the numbers have become harder to square.

The European Commission estimates the euro zone as a whole will grow at less than 1 percent this year. Germany, its largest member, will be stagnant; some pessimists predict a double-dip recession.

After insisting that Germany's deficit in 2002 would slip under the 3 percent limit, Finance Minister Hans Eichel now acknowledges that it will be over. Economists are expecting 3.5 percent — better than the 4.1 percent reported by Portugal for 2001, but still a clear miss.

Mr. Eichel has pledged to push the deficit back below 3 percent in 2003, and that won him a pat on the back from the European Union's commissioner for economic and monetary affairs, Pedro Solbes. Mr. Solbes said last week that Brussels would not fine Germany if it put its house in order next year.

To Mr. Solow and other critics, Germany owes no apology. They say a pragmatic government in a downturn should use fiscal policy to jump-start its private sector. Indeed, some say Germany's fealty to the pact — driven by the fact that it was one of its architects — has hindered its policy.

"The stability pact can force countries into a perverse fiscal policy," Mr. Solow said. "It forces governments to treat a contracting economy with measures that cause it to contract further."

Under pressure from its members, the commission has already relaxed part of the pact, pushing back the deadline for balanced budgets for Germany, France, Italy and Portugal to 2006 from 2004. In return, it demanded that they whittle down their deficits by 0.5 percent a year, starting in 2003.

France refused, telling Brussels, in effect, to mind its own business. Its finance minister, Francis Mer, said the directive conflicted with his government's plans to revive the French economy. France's defiance has led the commission to consider issuing Paris a formal letter of reprimand.

Critics say that Brussels had better stock up on stationery. Italy is also likely to breach the deficit ceiling. Only creative accounting, they say, may make it appear that its deficit is less than 3 percent of its output. "Italy is cleverly hiding what they are doing by pushing it below the line," Mr. Gros said.

With a scofflaw in Rome, a mutiny in Paris and a pair of admitted perpetrators in Berlin and Lisbon, what's the European Union to do?

Critics say that pushing back the deadline for balanced budgets by two years is not enough. Some say the focus on eliminating deficits is unnecessary, citing the futile effort to pass a balanced-budget amendment in the United States.

Mr. Walton of Goldman, Sachs said the commission should look at the underlying debt of countries, not their annual deficits. In the case of France, public debt amounts to 57 percent of gross domestic product, near the 60 percent level widely acknowledged as sustainable.

France could run a deficit of 2.5 percent of its gross domestic product and still keep its debt at manageable levels, Mr. Walton said. The government expects to have a shortfall of 2.6 percent in 2002.

The distinction between deficit and debt becomes more crucial with the expected entrance of Poland and other Central and Eastern European countries into the union. Collectively, the deficits of those countries are above the limit. But their debt levels are lower than those of most Western European countries.

Forcing the new entrants to cut government spending to meet the requirements of the stability pact could hamper them from making desperately needed public investments, according to Mr. Walton.

Other economists suggest factoring out cyclical elements like a recession from the deficit numbers. Countries like Germany would be allowed to overshoot the limit, as long as they pledge to put their books in order as soon as their economies recover. In practice, this is already happening.

Mr. Solbes, the commissioner for monetary affairs, declined a request for an interview. But his spokesman, Gerassimos Thomas, said, "We should, and will, continue to apply a flexible interpretation of the pact."

Flexibility, however, is in the eye of the beholder. Some wonder if the current pleas for understanding by officials in Berlin, Paris and Lisbon could be misused later to justify a return to old habits.

"It is a very small way between good and evil," said Rolf E. Breuer, the chairman of the supervisory board of Deutsche Bank. "You can use the same argument as an excuse for a spending policy which is totally out of range."

Mr. Waigel, the former German finance minister, said that for the pact to work, countries must address structural flaws in their economies. In Germany, the high cost of production and the rigidity of the labor market are crucial factors behind the country's dismal performance.

Mr. Waigel faulted Germany's recently re-elected chancellor, Gerhard Schröder, for not tackling these problems when times were good. Now, with near-zero growth and unemployment near 10 percent, Mr. Schröder has fewer options and would face an even more resistant public.

Few Europeans call for the most radical course: scrapping the stability pact altogether. There is a general recognition that too much has been invested in it and that the smaller countries would probably revolt.

Mr. Solow, however, doubts that killing the pact would make much difference. Italy, he said, is unlikely to lapse into chronic deficits, if only because it would drive up the cost of government bonds. Also, Italy and its neighbors have an overriding interest in guarding the euro's stability.

The euro's effect on Europe is hard to measure, in part because the notes and coins have circulated for only 10 months and because the global downturn has swamped other economic indicators.

But Europeans of all stripes say the euro, which has traded as a "virtual currency" since 1999, has already helped Europe by eliminating foreign-exchange uncertainties and by making it easier to compare prices across borders. Inflation, the old curse of Europe, is a distant memory.

Some argue that the monetary union's greatest achievement is that it imposed order on Europe's once-volatile economies. Guardians of the stability pact say this order will be lost if the rules are not enforced.

In Portugal, the government has embarked on a draconian cost-cutting program to get back into the good graces of Brussels. President Sampaio said the process would be painful, but he does not doubt it is necessary.

"We have to live with it," he said. "We can't have this permanent institutional fight in an increasingly unified Europe." 

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