Schröder seals coalition with pact to defy Brussels

Gerhard Schröder, the German Chancellor, formed a new government yesterday and unveiled an agenda that could lead to new conflicts with the European Union.

Mr Schröder's Social Democrats and the Greens, re-elected last month on a wafer-thin majority, signed a coalition pact to increase borrowing in defiance of EU rules. They say they will also levy higher taxes and cut spending.

The 88-page agreement, reached after three weeks of talks, contained a plea to the EU to be "flexible" in interpreting the Stability Pact. This sets limits on budget deficits, which Germany is expected to breach as unemployment payments rise and tax revenues fall. The agreement calls on the European Central Bank, which sets interest rates for the eurozone, to follow a policy that "leads to more investment and therefore more growth".

At a ceremony to mark the formation of the government, Mr Schröder said: "The momentum for growth has deteriorated and the scope for public finances has narrowed as a result. The international situation is uncertain."

Joschka Fischer, the Foreign Minister, said: "We have decided we want more flexibility in the EU Stability Pact. We don't want to give the Pact up."

Mr Schröder has clashed with the European Commission several times this year over its application of monetary rules, which he says are damaging to German manufacturers.

He declared that the main goals for his second term were boosting employment and improving the sluggish economy. "We really need a thorough reform of the job market and we agreed that we want to and we intend to achieve this," he said.

Angela Merkel, the leader of the Christian Democrats, criticised the agreement. "Taxes are being raised everywhere," she said. "That raises the cost of employment and leads to a situation where there is less work and less growth."

Business leaders also complained that the plan would result in higher unemployment and stifle growth.

Mr Schröder has retained most of his principal ministers from his previous four-year term. Mr Fischer, Hans Eichel, the Finance Minister; Otto Schilly, the Interior Minister; and Peter Struck, the Defence Minister, remain in their posts.

New faces include Wolfgang Clement, premier of North Rhine-Westphalia, who has been appointed a "super minister" in charge of a merged economic and labour ministry.

Brigitte Zypries takes over the Justice Ministry from Herta Daeubler-Gmelin, who was dropped after being accused during the election campaign of comparing President George Bush to Hitler for threatening war to distract attention from domestic issues.

The Greens are in charge of ministries for the environment, consumer protection and foreign policy. They had hoped to be rewarded with another post for helping the coalition's survival with their strongest election showing, at 8.6 per cent.