[A-List] EU stability & growth pact: Prodi speaks out

["Michael Keaney" <michael.keaney@xxxxxx>]

Prodi pulls down the house of cards

When Berlin and Paris fell over the rules they devised to protect the single
currency, someone had to call time

Larry Elliott, economics editor
Tuesday October 22, 2002
The Guardian

Romano Prodi, the president of European commission, who described Brussels's
fiscal rulebook as "stupid", stuck by his guns yesterday when he was called
before the European parliament to explain his comments in an interview with
the French newspaper Le Monde.

He was in no mood to retract. The pact for stability and growth, designed to
prevent the 12 eurozone states going on an inflationary borrowing spree,
should not be enforced "inflexibly and dogmatically" he said. "That is what
I called - and still call - stupid."

The truce holding the pact together collapsed last week when Mr Prodi
admitted that the rules were not working. For months it has been growing
clearer that the pact, which punishes countries with weak economies by
intensifying the deflationary pressures on them, was an emperor without
clothes.

Mr Prodi's interview came at the end of a month in which the big members of
the zone, Germany, Italy and France, have been at loggerheads not just with
the commission but with the smaller members. Countries such as Spain and
Belgium are furious that the powerhouse economies are trying to wriggle out
of the rules they themselves framed.

The endless sniping has harmed the credibility of the euro, which the pact
is supposed to enhance. Its value fell sharply last week as speculation that
the pact would collapse increased. A poll showed that 61% of Germans want
the mark back.

Three big questions therefore arise: why has the crisis happened? can the
pact be fixed? and what does it mean for Britain?

The answer to the first is that the pact is flawed. It was dreamed up by the
Germans in the mid-90s as the price of giving up the mark, the symbol of
their post-war strength. The finance minister, Theo Waigel, said the rules
were needed to prevent profligate governments (he meant Italy) undermining
the euro's credibility by spending and borrowing too much.

To do this the pact had two parts. First, governments were not allowed to
have budget deficits of more than 3% of GDP, under pain of fines, and
second, they would keep their budgets balanced or in surplus in the medium
term.

Blind spot

But the pact failed to recognise that some eurozone states might suffer
periods of slow growth that would put enormous pressure on their public
finances.

In bad economic times budget deficits rise automatically, even if
governments do nothing, because tax revenues fall and spending on welfare
benefits goes up. Trying to reduce deficits in those circumstances by
raising taxes or cutting spending simply removes spending power from the
economy and makes the problem worse.

This is the problem facing Germany, which admitted this week that this
year's budget deficit will breach the 3% limit. It has agreed to start
cutting the deficit next year, even though the prospects for the economy in
2003 are bleak.

But as the architects of the pact it was hard for the Germans to break rank
first. That honour fell to the French, whose finance minister, Francis Mer,
thumbed his nose at Brussels earlier this month by insisting that Paris had
priorities greater than cutting its deficit to meet the strict terms of the
pact.

That brought the crisis to a head. With the eurozone's biggest economy about
to burst the pact and its second biggest in open defiance, the writing was
on the wall. After months, if not years, of being denied, the shortcomings
of the pact were at last accepted. A couple of days before Mr Prodi's
outburst, the EU trade commissioner, Pascal Lamy, described the pact as
"mediaeval" and inferior to the fiscal regime operating in Britain.

This was merely a foretaste of what was to come. In his interview with Le
Monde, Mr Prodi said: "I know very well that the stability pact is stupid,
like all rigid decisions. If we want to adjust these, unanimity is needed
and it doesn't work.

"The Stability Pact is imperfect, it's true, because there is a need for a
more intelligent tool and more flexibility . . . [but] the idea of having
divergent economic policies is totally crazy. The stability pact is a means
of unity within the currency."

His remarks opened the floodgates. Hans Eichel, the German finance minister,
said: "The pact must be applied in a concrete reality. We must achieve the
target but not create additional economic problems. If this is what Prodi
meant, I agree."

Christa Randzio-Plath, the German Social Democrat who heads the European
parliament's economic and monetary affairs committees said: "The pact has
been administered so far with ridiculous rigidity, that has further weakened
countries with already weak growth, with a counterproductive impact on
employment.

"The stability pact also has to respect these other goals and react to
changes in the economy. It is an unhappy fact that the pact pays too little
attention to growth, which large economies are especially dependent on."

The question whether the pact can be reformed is trickier. In theory, the
answer is yes.

Gordon Brown has been insisting for years that the rest of Europe should
adopt his model, which like the stability pact has two main building blocks.
First, the government accepts that current spending on wages and day-to-day
running of the public services has to balance in the course of an economic
cycle but not in any one year. Second, he argues that it is perfectly
prudent to borrow money for long-term investment in infrastructure.

In practical terms it is not quite as easy as that. There is strong
resistance to changing the rules just because Germany and France have fallen
foul of them, not just from the finance ministries in smaller countries but
from the European central bank, whose president, Wim Duisenbeg, has made it
clear that he is opposed to any backsliding on the pact.

And he has the means to make his displeasure felt. The bank can keep
interest rates in the eurozone higher than they otherwise would be until the
renegades accept the need for fiscal discipline.

Finally, what does this mean for Britain? In the short term it further
lengthens the odds against a referendum on joining the zone during this
parliament. Turning round public opinion was always going to be a Herculean
task; with Europe's finance ministers at war with each other and the ECB, it
is more difficult still.

Earlier this year it was predicted that Tony Blair would begin pushing for
the euro in the autumn, seeing if he could soften up the voters for a 2003
poll. This has not happened. Mr Brown has insisted that there is no chance
of him cutting public spending or raising taxes simply to meet the
constraints of the pact. The squabbling in Europe's capitals seems to have
shaken the euro off the government's radar screen, for the time being at
least.

In the longer term the crisis in the pact may help the euro camp in Britain.
Should Europe come up with more sensible fiscal rules , it would help the
government sell the idea. But the chance of that happening soon is extremely
remote.