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Last Updated: Thursday, 25 September, 2003, 13:45 GMT 14:45 UK
Q&A: What is the European stability pact?
The stability and growth pact is a key part of the agreement that led to the establishment of the euro, the currency used by 12 European countries. But why has the pact become so controversial?

What is the stability pact and why was it set up?

The stability and growth pact is an agreement to limit budget deficits in countries that are members of the eurozone.

When the eurozone was set up, it meant that control of interest rates passed from national governments to the European Central Bank (ECB), whose mandate was to keep inflation under control.

But the architects of European Monetary Union - especially Germany - feared that some countries would get round the tough monetary policy of the ECB by increasing government spending and running large budget deficits.

So they insisted that countries agree to limit their budget deficits to no more than 3% of their total economy.

So who is in breach of the deficit rules now?

Ironically, it is the biggest and most influential members of the eurozone - France and Germany - who have been breaking the very rules they insisted on.

The recession in Germany and France has meant that the income received from taxes by their governments has declined, while their high unemployment has meant greater spending on benefits.

In order to help boost their economies, both governments have decided to cut taxes, defying the European Commission.

They both claim that they are aiming to reduce their budget deficits to below 3% - but not yet.

Many of the smaller eurozone countries, which have introduced sharp budget cuts to keep their own deficits in line, are furious.

Who enforces the rules?

The rules of the stability pact are enforced by the European Commission.

Its directorate of economic and financial policy decides whether a country has breached the stability pact, and recommends measures to correct the problem.

If persistent breaches occur, it can recommend fines - which in theory can be a large proportion of government revenue - to the council of European finance ministers.

But in practice, it has been difficult if not impossible to get these elected politicians to agree on such large fines which would further damage that country's economy.

So effectively enforcement must rely on the public shaming of countries that breach the rules, and an acceptance that those rules make sense.

Should the stability and growth pact rules be relaxed anyway?

Many observers, including the UK Chancellor, Gordon Brown, argue that the stability pact is too rigid.

Countries should be allowed to run larger deficits if there is a major recession, and money borrowed for productive investment in infrastructure projects like roads and schools should also be allowed.

Fears about the effect of the stability pact rules on Sweden's welfare state was a key element in the decision by its electorate to reject membership of the euro.

But some economists say that the eurozone does need a rule to control fiscal irresponsibility - otherwise some countries could "free ride" and gain the benefits of membership in the euro currency zone without having to pay the costs.

And they argue that, given the difficulty of enforcing any rule without a functioning European-level government, a simple, rough-and-ready rule is better than none.

What is likely to happen?

There may be some modifications of the pact - something the European Commission has already foreshadowed.

Those changes might involve a different way of measuring the budget deficit, to take into account the economic cycle (i.e. a country being in recession).

But in order to enforce such changes, there would need to be more cooperation among eurozone governments about their fiscal policies - something that could prove politically controversial.

Some fear the end result would be harmonisation of tax rates across Europe, potentially damaging the competitiveness of individual member states' economies.

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