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Last Updated: Friday, 5 December, 2003, 08:17 GMT
How to save the EU stability pact

By Steve Schifferes
BBC News Online economics reporter

Following the collapse of the European stability pact, which was supposed to enforce budget limits for eurozone countries, economists are now looking for new measures to ensure fiscal stability in Europe.

Euro banknotes
Some say the eurozone's Stability Pact is outdated
The twelve countries in the eurozone - including France, Italy, and Germany - have pooled their currencies and now have interest rates set by a single central bank, the Frankfurt-based European Central Bank (ECB).

But they were also supposed to coordinate their fiscal policies, keeping budget deficits below 3% of GDP, in order to ensure that rising government debt did not undermine the ECB's attempt to control inflation.

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Last month the eurozone's two largest economies, France and Germany, defied those limits and blocked European finance ministers from imposing large fines on their economies, on the grounds that they were still deep in recession.

German and French finance ministers - and the UK Chancellor Gordon Brown - have argued that the stability pact rules are too rigid and must be applied with more flexibility if they are to be effective.

New role, fewer rules

Now a leading research organisation, the Centre for Economic Policy Research, argues that the strict rules of the stability pact should be scrapped entirely and replaced with an independent review body which would have the sole right to judge whether countries were going too far into the red.

The new "sustainability council" would be appointed by the European Parliament, and like the UK's Monetary Policy Committee, they would be independent experts appointed for a fixed term, and accountable and open in their deliberations.

It would look at total public debt as well as the yearly deficit, and have the power to interpret the rules flexibly in different countries.

In the last resort, the sustainability council - rather than the European Commission - would be the body that would recommend fines and public criticism for countries who are spending too much.

Challenge of flexibility

The challenge for managing the eurozone's finances, according to Ed Balls, the chief economic advisor to Chancellor Gordon Brown, is to combine rules which are strict enough to be credible with financial markets, while retaining enough flexibility to adopt to changing economic conditions.

EU flags
Future EU members will find the stability pact hard-going
Mr Balls is highly sceptical of the stability pact, which he said has sometimes given the impression that "it is whatever (European finance) ministers agree it says."

But Mr Balls, who chaired the meeting launching the new proposals, also appeared to be concerned that a proposed council of experts might not have the authority to curb the fiscal excesses of some European countries.

He pointedly asked whether some countries in Europe had deliberately run large budget deficits regardless of their commitments to adhere to the Stability Pact.

The author of the report, Andrew Hughes Hallett, pointed out that the fiscal rules like the 3% budget limit had been much easier to enforce in the run-up to the launch of the euro, when countries who exceeded the target would have been excluded from membership altogether.

And he said that, in his view, a number of countries had been steadily increasing their government spending once inside the eurozone.

Why have rules?

Professor Hallett said that the stability pact was flawed for several reasons.

It lacked a clear goal, it was too rigid, and there was no credible body to enforce it.

He also pointed out that the fixed budget deficit rules acted in the wrong direction during economic downturns, when the "automatic stabilisers" (such as increased spending on unemployment benefits) would stabilise the economy but destabilise the budget.

And Professor Hallett argued that the current stability pact also might work against "structural reforms" like more flexible labour markets that many economists see as essential to make Europe more prosperous.

That is because the short-term cost of those reforms would also push countries like Germany over the budget limits, despite their longer-term benefits.

No Golden Rule

But designing a set of rules that would fit all the countries in the eurozone was very difficult, he said.

That is partly because the small countries in the eurozone are growing quite fast, while the larger countries are lagging behind and accumulating bigger budget deficits.

The implicit assumption in the Maastricht Treaty rules was that on average, countries would grow by 5% per year, and thus a 3% deficit would be sustainable as long as total public debt stayed at or below 60% of GDP.

Although the stability pact has proved deeply flawed, many economists believe that eurozone countries need to stick to some agreed limits on budget deficits in order to help control inflation

Otherwise, countries would be tempted to over-borrow to counter the effects of monetary policy, eventually lowering their credit rating.

Stability and Growth in Europe: Towards a Better Pact, by Antonio Fatas, Jurgen von Hagen, Andrew Hughes Hallett, Rolf Strauch, and Anne Sibert, is published by the Centre for Economic Policy Research.

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