July 21, 2003
A Guide to Europe's Stability Pact
Amid a Weak Growth Rate, the Accord
Has Evolved Into a Policy Punching Bag
By CHIRSTOPHER RHOADS
and G. THOMAS SIMS
Europe's economy is showing only sparse signs of recovery and the region's governments are at loggerheads over what to do about it. Their punching bag: the Stability and Growth Pact, central to the functioning of a common currency among the 12 nations that use the euro. Most smaller countries want the pact's limits on budget deficits enforced. France and Germany want to be let off the hook for now. Here, a look at what the pact is and why the economic fortunes of Europe, and indeed the world, are tied to its fate.
What is the Stability and Growth Pact?
Adopted in 1997, it is one of the main foundations for the euro, Europe's common currency that hit the stage in 1999. Interest rates for the 12 nations that use the euro are set by the European Central Bank. But national governments still have control over spending and tax decisions, which is where the pact comes in. It requires each member to bring deficits near or in balance within a few years. It threatens hefty fines -- up to 0.5% of gross domestic product-against those whose budget deficit exceeds 3% of gross domestic product for three years in a row. Without it, some countries might be tempted to run large deficits, while others decide to cut theirs -- a fiscal mishmash that would make finding the appropriate monetary policy for the region all but impossible.
Why should people outside the euro zone care about the pact?
The countries that use the euro have a combined population that is larger than that of the U.S. and combined gross domestic product that well exceeds that of Japan. About $1 (88.56 European cents) of every $6 in U.S. exports goes to the euro zone. So the health of the global economy depends in part on Europe -- a point U.S. Treasury Secretary John Snow made last week on a European tour when he said, "It's in our interest to see Europe's economies perform better."
Why is there such a fuss over the pact now?
Quite simple: the economy. The euro-zone economy is in the third year of an economic slump, with growth expected to reach only 0.6% this year. The result: Tax revenues have fallen much more sharply than expected and spending has risen to pay for unemployment benefits and other social costs. Budget deficits, therefore, are soaring and in France and Germany are expected to exceed the pact's limits for a second year in a row this year -- and possibly next year, too. They say they want the flexibility to stimulate growth. Smaller countries say France and Germany didn't do enough in the boom times to bring down their deficits so should reap what they have sown, while the smaller countries in general have kept their budget houses in better order. "We went through hell and high water to comply," Irish Finance Minister Charlie McCreevy said last week.
What are the consequences for countries that have violated the rules?
Fines, though countenanced in the pact, are unlikely because the decision about whether to impose them is made by the countries themselves. And since France and Germany happen to be the two largest countries in the euro area, with the most political clout, they will likely convince the other countries to temporarily suspend the rules. That is ironic, because when the pact was negotiated, Germany wanted the fines to be implemented automatically when a country was in breach. France insisted the decision should be made by member countries, making it ultimately a political decision. Lucky for Germany.
Should the pact be changed? If so, how?
The tensions surrounding the pact have exposed what many economists believe are its flaws, and could lead to some substantial changes. Most agree that the biggest problem is the pact's focus on deficits, which are largely affected by changes in the economy, rather than on debt, often considered a more accurate gauge of a government's financial rectitude. Some form of change is likely -- at the very least a softening of the pact's terms until an economic recovery is firmly under way. "We cannot suspend or freeze the stability pact, but we can interpret it with a certain flexibility," Pedro Solbes, the European Union's commissioner for monetary and economic affairs, said Friday.
Should the pact be killed?
Even critics of the pact agree that fiscal-policy rules are essential for monetary union. And economists fear that the credibility of the euro would plummet if Europe abandoned the rules because they are being broken. Fiscal discipline also provides scope down the road for dealing with the expense of caring for an aging population -- a huge problem facing Europe. Abandoning the pact would set a bad precedent for the 10 Central and Eastern European countries lined up to join the EU next year, and soon after, the euro.
Is European integration at stake?
No, but the fight over the stability pact is testing it. Smaller countries will likely bend to the will of the larger ones with the deficit problems. But as the divisions over the Iraq war showed, their acquiescence could make them less amenable to following controversial decisions by France and Germany, the traditional leaders of the EU, in the future.
Updated July 21, 2003
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