Germany's ploy to keep Italy out now threatens the EMU project

`It beggars belief that a single currency should be desirable for a country with a budget deficit of 2.9 per cent of GDP in 1997 but wholly impossible for one with a budget deficit of, say, 3.5 per cent of GDP'

The whole EMU process is now being endangered by one particular problem which has been created as a result of an intricate game involving Germany, France and Italy. It concerns the interpretation of the Maastricht convergence criteria on budget sustainability, with particular reference to the 3 per cent limit for budget deficits. When the Maastricht Treaty was agreed, member states were perfectly aware that a monetary union could only work satisfactorily if there was tough control over budget deficits.

One of the convergence criteria contained in the treaty requires that government financial positions should be "sustainable", which is subsequently defined to mean that members of the monetary union "shall avoid excessive government deficits".

The treaty does not define an excessive deficit in an unambiguous manner. The Commission is given the responsibility of monitoring the budgetary situation with a view to identifying "gross errors" in individual countries. One of the criteria in this regard is whether the ratio of the planned or actual government deficit exceeds 3 per cent of GDP, "unless either the ratio has declined substantially and continuously ... or the excess is only exceptional and temporary". The Commission's report shall also "take into account whether the government deficit exceeds government investment expenditure, and all other relevant factors including the medium- term economic and budgetary position of the member state".

It is obvious from this description that the drafters of the treaty never intended anything so narrow as to suggest that the 3 per cent limit for the budget deficit should be an absolute requirement, and certainly not that it should be applied to any given year. The creation of a single currency is undoubtedly the most important economic step in the history of Europe, and it really beggars belief that the EU should argue that this is desirable for a country with a budget deficit of 2.9 per cent of GDP in 1997, but wholly impossible for a country with a budget deficit of, say, 3.5 per cent of GDP. What really matters on this front is whether the political process in the country concerned is able to deliver a disciplined budget out-turn, not just in one year, but for the indefinite future.

The drafters of the treaty realised this with complete clarity, which is the reason they left so many deliberate loop-holes in the definition of excessive deficits. Yet we now find ourselves in a position where the German finance minister, Theo Waigel, is arguing "3 per cent means 3 per cent", which suggests only those countries which can reduce their deficits below the magic number in 1997 should be admitted to the first round of EMU. Why has he adopted this position?

Almost certainly it is because this was thought to be the best way of excluding Italy from the 1999 start date for the single currency, while admitting those countries which the Germans believe have demonstrated their ability to stick with the discipline required for an indefinite period. When the Germans first adopted the 3 per cent formula, Italy seemed to have no chance of hitting this objective, but all the countries inside the Franco-German core of the system did. The 3 per cent budget target was therefore a convenient way of differentiating between those countries that the Germans wanted to include in the single currency, and those which they believed were unsuitable and unacceptable to the German electorate.

This was all very well until quite recently, but the problem now is that several countries that were supposed to have no trouble qualifying by hitting the 3 per cent limit are finding that they may not be able to do so, and this even includes Germany itself. It most certainly includes France, despite some creative accounting designed to cut the deficit.

Furthermore, the markets are becoming increasingly concerned that the German and French deficits will exceed 3 per cent of GDP this year, which means that market confidence in the 1999 start date could disintegrate at any time. A ploy originally designed to provide a convenient means of excluding Italy from the first round is now beginning to threaten the participation of the core countries themselves.

This problem seems likely to come to a head during May, when the German government, in conjunction with independent economic forecasters, will publish an updated official projection for the 1997 budget deficit. This forecast update has become a focus of the international financial community, especially the key hedge funds. If the new projection exceeds 3 per cent of GDP by a significant margin, which seems quite possible, it will not be possible to continue with the present German line without threatening the entire process.

Some observers think that Chancellor Kohl will simply shrug his shoulders if this happens, and say the following: "We can no longer be sure that Germany will hit the budget criteria - we will have to wait and see." But this would leave the 1999 start date a hostage to the whims of the financial markets throughout the rest of the year, which is surely much too dangerous. Instead, it seems a great deal better to adopt the last resort of politicians - tell the truth. Assuming they still wish to maintain the 1999 start date, this would involve Germany and France saying: "We can no longer be sure of hitting the 3 per cent budget limits in 1997. But this would be for good reasons which were written into the Maastricht Treaty for precisely the present circumstances, in which slow GDP growth is making it temporarily difficult to keep budgets under control. We are both confident that our budgetary positions are sustainable in the long run, which is the prime requirement of the treaty. But we are not yet convinced that this is true of some other countries, who have not achieved overall convergence for long enough to merit inclusion in the first round."

If the 1999 start date is to remain viable, it will be necessary at some point to make an adult statement of this kind. This would differentiate between countries on the grounds of an overall long-term assessment of the ability of their political systems to maintain disciplined economic policies indefinitely, and would give up the nonsense of pretending that the outcome for the budget in a single year is a satisfactory indicator of this key requirement.

Clearly, such a statement would not be welcomed in Italy, where the Prodi government has been making remarkable and brave efforts to hit the 3 per cent budget limit for this year. The Prodi administration has been a shining beacon compared to some of its predecessors, and it deserves to be given every possible encouragement from abroad. The prospect of early entry into a second round of EMU should be offered to it. But the fact of the matter is that Germany does not believe that first-round entry for Italy is politically acceptable to the German electorate, and is not wholly convinced that Romano Prodi or his successors can maintain the present budgetary momentum indefinitely. More time is needed to persuade them of this.

The bottom line is that the present German formula of "3 per cent means 3 per cent" is now threatening the entire EMU project. If they intend this to be the case, then so be it. If not, then the sooner they change it the better.

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