Analysis: 'Stupidity pact' crumbles as euro's foundation stone

The fiscal rules underpinning the single currency have been publically called into question and face being re-written

For the first time in its brief life, the impenetrable rulebook underpinning the European single currency has a nickname, and it is not one that will please its architects.

Damned by the European Commission president, Romano Prodi, as "stupid", the credibility of the euro's foundation stone – the so-called stability and growth pact – could hardly be lower this week. In Brussels it is now being called the "stupidity pact".

Whether Mr Prodi meant to say what he did in the French daily Le Monde, and whether he was wise to do so, remains open to question. But many people accept Mr Prodi's explanation that he has merely said in public what others whisper in private.

Less than three years after the launch of the euro, and less than 10 months after the introduction of notes and coins, the rules surrounding the currency are in tatters.

Faced with the chill winds of an economic downturn, the stability and growth pact has proved about as much use as a string vest. The ceilings it lays down have been breached by one country, Portugal, and are about to be broken by the eurozone's biggest economy, Germany. Meanwhile, France has thumbed its nose at the pact, defying both moral and political pressure to fall in line with its objectives, and Italy is giving cause for concern.

The rulebook's failings have been both economic and political, and significant reform in both areas is now inevitable.

Conceived in the run-up to the launch of the single currency, the stability pact was a German-inspired creation, the baby of the then German finance minister, Theo Waigel. With its strong deutschmark and record of low inflation, Germany's financial community signed up to the euro only reluctantly. The quid pro quo was a set of rules that would ensure Germany's economic might was not undermined by Italy's profligacy. Public spending, inflation and interest rates would be kept low.

The pact has two central features. First, members of the euro must move their public finances into surplus or close to balance in the medium term. Second, there is a budget deficit ceiling of 3 per cent of gross domestic product. If broken consistently this can expose nations to hefty fines. The economic plans of member states, including those outside the euro, are subject to the European Commission's scrutiny. All countries must agree a set of broad economic policy guidelines.

The first sign of trouble arrived last year when Ireland's pre-election tax-cutting budget was deemed by Brussels to be a threat to an economy in danger of overheating. But the real test came with the economic slowdown that has left the continent's big economies in stagnant growth.

In June, the Portuguese government admitted that its 2001 deficit had breached the ceiling, eventually owning up to a figure of 4.1 per cent. Last week, Germany said it would probably exceed 3 per cent (speculation is that it might be as high as 3.7 per cent).

In September, the European Commission decided to retreat in the face of the inevitable, giving France, Germany and Italy an extra two years to meet their target of getting public finances close to a balance.

If that was sensible economics it was contentious politics because it infuriated Spain, the Netherlands and most small member states which are already close to balance. Why, they asked, should we make sacrifices only to see the big countries indulged?

While the economics behind the pact have been found wanting, its political weakness has also become apparent. Discipline is imposed by a combination of peer group pressure and rulings from the European Commission.

But the authorities in Brussels have found themselves increasingly impotent. Under the current rules, nations that risk breaching the 3 per cent deficit limit should be given an "early warning". Yet the European Commission can only recommend such a rebuke to finance ministers who approve it.

When, in January this year, Germany faced such a threat, it lobbied other member states to prevent the warning being issued. Earlier this month, France defied the unanimous criticism of all 11 other eurozone finance ministers by announcing it was in no hurry to start reducing its deficit. All of which has left the pact exposed to an extraordinary barrage of criticism from large and small countries.

The French government has waged a war of attrition against the pact, demanding the right to boost growth and job creation in tougher economic climate. Britain's Chancellor, Gordon Brown, has criticised the pact, arguing that it does not distinguish sufficiently between current spending and investment in infrastructure.

Pascal Lamy, one of France's European Commissioners, described the rules as "medieval" and suggested that the UK's regime was preferable. Then came Mr Prodi's famous blunt words to Le Monde: "I know very well that the stability pact is stupid like all rigid decisions."

So if the rulebook – the very thing that was supposed to sustain public confidence in the euro – has been torn up, where does this leave the euro? One of the most surprising elements of the row is how little it has damaged the currency, with the foreign exchange markets appearing to view the debate as part of the evolution of a young currency.

As Chris Huhne, the economic spokesman for the Liberal group in the European Parliament, puts it: "So far, the markets have not reacted badly. They would probably react worse if they thought the stability pact was going to be applied in a crude way." The lack of action in the markets should buy time for reform which is now vital.

Mr Prodi's aides argue that his comments were deliberately timed to influence an inquiry into the future of Europe which is being chaired by the former French president, Valéry Giscard d'Estaing.

The pact faces even more challenges because its economic policy framework will have to apply to the 10 new countries that plan to join the EU in 2004 (even though they will not be inside the euro for several years). These are much more varied economies than those of the current 15 nations.

The Commission wants a greater role in co-ordination of economic policy and the power, for example, to issue early warnings to countries without having to get the approval of finance ministers. That will end some of the political weakness of the current system.

It also wants to have more flexibility in interpreting the rules. The European Commissioner for economic and monetary affairs, Pedro Solbes, is sympathetic to pleas from nations with low debt (such as the UK) who want to run deficits for several years. He also wants to take account of the investment in infrastructure, although officials are wary about exempting some areas of spending from the calculation of deficits, fearing this will offer too many loopholes.

In short, we are likely to see the emergence of a new code which would keep the main elements of the pact, including the 3 per cent deficit ceiling, but give more latitude for economies to adapt to changing economic circumstances.

There is a consensus that the revised pact should force nations to cut deficits when times are good, allowing them more leeway during recessions. Most policy-makers also want to encourage investment in infrastructure rather than current expenditure.

None of this makes things simple for Tony Blair as he contemplates bringing Britain into the euro. On the one hand, such turbulence and uncertainty may complicate the prospects of a referendum on British membership. But on the other, it is likely to bring about the very changes demanded by Mr Brown to smooth Britain's entry into the single currency.

THE DEMISE OF THE STABILITY PACT

February 2002

EU finance ministers block the European Commission's attempts to use the stability and growth pact to rap Germany's knuckles with an "early warning" over its rising budget deficit.

June 2002

France says it will take until 2004 to balance its budget with a growth rate of 3 per cent a year.

July 2002

Commission criticises Italian accounting system.

Portugal becomes the first country to break the rule limiting national deficits to 3 per cent of GDP.

August 2002

Italian cabinet ministers call for a weakening of the rules of the stability pact. Giuliano Urbani, the culture minister, says the EU should be stimulating growth not demanding cuts.

September 2002

Commission admits that Germany, France, Italy and Portugal will not make the grade by 2004 and gives the four countries until 2006 to achieve balanced budgets.

October 2002

France defiantly refuses to cut its deficit in 2003, putting domestic concerns above the common good of the eurozone.

Germany admits it has breached the 3 per cent deficit limit in 2002.

Romano Prodi, the Commission president, tells Le Monde the stability pact is "stupid".