Reform of stability and growth pact moves closer

Reform of the European stability and growth pact that seeks to stop countries racking up deficits moved a step closer yesterday after a panel of independent economists recommended a major shake-up.

The pact has been criticised for forcing countries in a severe economic downturn to cut spending and hike taxes to prevent their deficits exceeding a 3 per cent limit. A committee of experts appointed by Romano Prodi, the President of the European Commission, said the rules should be changed to give greater freedom to breach the limit.

Andre Sapir, the Belgian economics professor who chaired the seven-strong panel, said: "We say that we need even more than before to put growth as the number one priority."

The key recommendation was that the exceptional condition under which breach of the limit was allowed should be defined as simply a negative annual growth rate rather than the current rule of a 2 per cent fall in GDP.

France and Germany broke the ceiling last year and will stay above the limit in 2003 and possibly 2004 as well. Italy is expected to loosen its fiscal policy.

The report comes just days after France's President Chirac called for a temporary loosening of the pact. This was backed by John Snow, the US Treasury Secretary, who said this week that a review of the pact would be a "healthy thing".

The review will also please the UK Treasury, which has flagged up the pact as a barrier to British euro membership. Professor Sapir echoed a key British recommendation that countries with low debt, which would include the UK, should be given more flexibility on deficits.

Earlier this month Ed Balls, the chief economic adviser to the Treasury, said there should be greater flexibility for low-debt countries. "We would like to see the stability and growth pact taking more account of the economic cycle symmetrically in periods of both above and below-trend growth," he told an audience of City bankers.

Last month the Treasury suggested a rule based on the output gap - the difference between actual and potential growth - so that a country growing at, say, 1.5 per cent below trend would be allowed to breach the pact. Likewise very fast growth would force it to build up surpluses. A spokesman said yesterday: "We support any move towards a prudent interpretation of the pact that takes into account the cycle, sustainability and the role of public investment."

The document also received lukewarm reaction in the City, where economists hold out little hope of radical or rapid reform. Robert Prior, a European economist at HSBC, said there would be opposition from the majority of euro states that took tough action to comply with the pact.

He said he expected the issue would come to a head if the Commission decided to fine Germany, France and Italy, who would in turn use their combined votes to block the penalty. "It would become a farce that would force them to renegotiate properly although that might not come until 2005 at the earliest," he said. "The pact is effectively dead."