DURING the cold war, the doctrine of mutually assured destruction helped keep the peace. Responsible behaviour was ensured by the threat of unthinkable consequences. The designers of the euro have created their own nuclear option to ensure responsible behaviour by the 12 members of the European Union that have adopted the single currency. Under the terms of a “stability and growth pact”, any government in the euro-zone that runs a fiscal deficit of more than 3% of GDP is liable to be fined up to 0.5% of its GDP. Potentially, the fines could run into billions of euros. It is hard to believe that any European government, particularly one already struggling to balance the books, could survive the humiliation of such a fine. But that is precisely the point. The idea is that, faced with such a choice, all governments would follow the path of fiscal righteousness.
On January 30th, just weeks after the successful launch of euro notes and coins, the European Commission issued its first warning to a euro-zone country that it was in danger of crossing the 3% threshold. The warning was to Germany, the euro-area's largest economy and, ironically, the country that had insisted on the stability and growth pact in the first place. The Germans wanted the pact to ensure that their country's post-war tradition of sound money would not be imperilled by a currency union with countries like Italy, which had a reputation for weak currencies, inflation and fiscal irresponsibility. But a big economic dip at home means that it is the Germans themselves who now have the biggest deficit. The commission is predicting that Germany will run a deficit of 2.7% of GDP this year.
Commission officials are at pains to play down the warning. They say there are three degrees of EU comment. The first and mildest is simply to note that a deficit is approaching the dangerous 3% mark, but not to criticise government policy. The second is to note a problem, and to point the finger at government policy. The third is when a country actually breaks 3%, prompting a complicated fining procedure. Germany, say EU officials, has had a warning only of the first sort. By contrast, Portugal, though its projected deficit of 1.8% is lower than Germany's, has received a more severe second-degree warning, because its government is deemed to have irresponsibly stoked up its economy.
But the commission's extreme tact only sharpens sensitivities all round. For it is distinctly possible that when the EU governments' finance ministers meet in council on February 12th they will reject the commission's recommendation that Germany should be formally warned. If that were to happen, the whole stability pact would begin to unravel. Pedro Solbes, the commissioner in charge of economic and monetary affairs, declares that “the pact's credibility is at stake.”
The possibility of the council squashing the commission has been increased by Germany's objection to the commission's recommendation that it should get an early warning. If Germany and Portugal abstain in the council and just one other big country fails to back the commission, then no formal warning will be given. Bizarrely, that big country could be Britain, which, though not even inside the euro-zone, still has a right to vote on issues such as this one. The British fear that, if they ever joined the euro, the pact might hinder plans to put extra cash into public services.
A senior commission official says that if the Council of Ministers does not let the commission warn Germany, “that will be the end of the stability and growth pact”. So the council may well back the commission this time. But the threat of fines is already posing politically awkward choices in Germany. The chancellor, Gerhard Schröder, can no longer go on a pre-election spending splurge to massage down the country's stubbornly high unemployment figures, though there are respectable arguments for boosting the economy even if that did widen the deficit, particularly as membership of the euro club means that Germany can no longer give itself a stimulus by cutting interest rates.
The stability pact is also causing tension between Germany's federal government and its 16 Länder, or states, which have caused more of the deficit's increase. “The Länder are still behaving as if the euro did not exist,” fumes a federal official.
But the biggest danger is still that Germany may break the 3% deficit limit later this year. Senior commission people believe it may happen. The commission's forecast of a deficit of 2.7% this year is based on an assumption that Germany's economy grows by 0.75%, which may well prove optimistic. The Economist's poll of forecasters puts this year's growth at 0.6%. Last year the German government predicted a deficit of 1.5% but the actual figure was 2.6%. Clearly, a similar underestimation this year would smash the 3% limit and present the EU with a nasty dilemma.
European diplomats whisper that of course it is inconceivable that any country would ever really be subjected to the sort of fines laid out in the stability pact. No matter that it is now part of European law and that the European Central Bank has insisted on its enforcement; nor that the get-out clauses written into the pact are tightly defined and that Germany seems unlikely to qualify for them. Somehow a way would have to be found to get Germany off the hook.
Would that matter? Some economists think that the pact was always a stupid idea: the sooner Europe is shot of it the better. Without it, argue critics, the markets would simply mark down the debts of profligate countries without damaging the euro's fortunes as a whole. But the pact's backers say it is essential to enforce fiscal rigour and to prevent countries running irresponsibly wide deficits that would push up interest rates across the euro-zone. They also argue that a long-term mechanism for ensuring fiscal responsibility is needed, since government debt and unfunded pension liabilities are large. They fear that abandoning the pact would hurt the euro's credibility in the eyes of the markets.
That credibility is already pretty low. This week the euro once again slid against the dollar and is threatening to hit its lowest point ever. But nobody knows for sure how the currency markets would react were the pact to be diluted or even scrapped. Like everybody else, the markets are still trying to puzzle out what to make of this new transnational currency—and what is needed to make it work.
Copyright © 2002 The Economist Newspaper and The Economist Group. All rights reserved.