The New York Times

July 4, 2003

Europe's Deficit Cap Becomes Rule Often Broken


FRANKFURT, July 3 — While Germans are seething over the damage done to European unity by the intemperate remarks by Prime Minister Silvio Berlusconi of Italy at the European Parliament this week, the bigger threat to unity may come from Germany and its red-ink-stained finances.

By announcing that it would move up a sweeping tax cut to recharge its economy, Germany is almost certain to violate a treaty-imposed ceiling on budget deficits for a third consecutive year.

Germany's decision was far less provocative than Mr. Berlusconi's words, likening a German member of the European Parliament to the leader of a Nazi concentration camp. (He apologized today.) But it may have broader long-term ramifications, according to economists and political experts here.

A chronic violation of the rules by Germany — which has Europe's biggest economy and insisted its neighbors cap their deficits as a precondition of adopting a single European currency — could effectively vitiate the agreement, known as the Stability and Growth Pact.

France this year will also breach the deficit ceiling, which is set at 3 percent of gross domestic product, while Italy and Portugal are skirting the edge. All told, countries representing 71 percent of the total economic output of the euro zone no longer comply with its fiscal rules.

"The pact has basically been put on ice until the Germans and the French get their act together," said Daniel Gros, the director of the Center for European Policy Studies, a research institute in Brussels. Once Europe's torpid economies recover, the pact, Mr. Gros predicts, "will rise like a Phoenix from the ashes."

Other experts are not so sure. Now that Germany and France have established a pattern of violating the rules with relative impunity, they say, the tendency will be for other countries to do the same.

Portugal, which first violated the cap in 2001, used harsh spending cuts to bring its deficit to below 3 percent of gross domestic product last year. In part, it was acting to head off the possibility of sanctions, including heavy fines, that could be imposed by the European Commission.

This year, Portugal's deficit is likely to bounce back above 3 percent. And nobody is talking about sanctions.

"With the big countries more or less flouting the pact, small countries may view Portugal as an isolated example," said Holger Schmieding, a European economist at Bank of America in London.

The problem, Mr. Schmieding and other experts said, is timing. The stability pact imposes strict fiscal constraints on governments at the very moment their economies need stimulation. To adhere scrupulously to it would require them to impose austere budgets that could bring on a recession.

One of the last-ditch mechanisms to stimulate the European economy — further interest rate cuts — was taken off the table today by the European Central Bank's president, Wim Duisenberg.

"The bank has done its part to create the conditions for economic growth," he told European Union lawmakers today. "Governments can no longer hide behind the E.C.B. to cover their failures to enact structural reforms." Among other measures, he urged the European governments to cut their budget deficits.

In Germany, which is arguably already in a recession, the government decided it could no longer afford such a policy. The tax cut brought forward by Chancellor Gerhard Schröder comes on top of another cut, which together, will reduce income tax here by about 20 billion euros ($22.8 billion).

Economists said the tax relief would provide a much-needed, if modest, incentive to consumers and small businesses to start spending. A lack of consumption has been one of the main weaknesses in Germany's economy.

Mr. Schröder insists the government will offset the lost tax revenue through cuts in subsidies and the sale of stakes in state-owned companies. But he acknowledges that the government will also increase its borrowing. The extent of that borrowing will be closely watched in Brussels.

Germany's deficit projections depend on its economy rebounding next year. If it does not — and many economists see no signs of a recovery — Germany could overshoot the 3 percent limit by a wide margin.

Publicly, Chancellor Schröder and his cabinet ministers still promise to adhere to the pact. But increasingly, the government's policy is being driven by the need for growth rather than meeting deficit targets.

"Last year, they were trying to be good citizens," said David Mackie, the chief European economist at J. P. Morgan Chase in London. "This year, they've been quietly ignoring the pact."

Germany, at least, pays lip service to the rules. When pressed by Brussels, France bluntly declared that it would not reduce its deficit to below 3 percent this year because it was not in its interest. Prime Minister Jean-Pierre Raffarin's government is also pushing tax cuts to lift its sluggish economy.

"We are still in a Europe where budgetary policy and political decisions are under national control," said the finance minister, Francis Mer.

Despite the fact that the stability pact is now largely disregarded, few people in Europe seriously favor shelving it — or even radically reforming it. The issue has scarcely come up in the debate over a new European constitution.

In part, that is because changing a provision of the Maastricht Treaty would be a mammoth undertaking; in part, it is because officials recognize the pact can still be used as a tool to head off profligate behavior.

"The 3 percent number exerts pressure on governments," said Thomas Mayer, the chief European economist at Deutsche Bank. "The E.U. should keep insisting that Germany finance its tax cuts with spending cuts. At the last minute, it could grudgingly accept some borrowing."

That, more or less, has been the approach of the European Union's commissioner for monetary affairs, Pedro Solbes. After meeting with Mr. Schröder in Berlin on Monday, Mr. Solbes endorsed the tax cuts, so long as they do not prevent Germany from reducing its deficit.

"We have a government which is making every effort to behave fiscally responsibly," said a spokesman for Mr. Solbes, Gerassimos Thomas. "At this stage, there's very little we can do."

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