Good riddance to the instability pact We should all be grateful to France and Germany for giving us a chance to restore some sanity to European fiscal policy
Larry Elliott Thursday November 27, 2003 The Guardian Nobody does smug quite like the British, and the Treasury's smugometer had a high reading this week when Germany and France thumbed their noses at the European Commission over the failure of Berlin and Paris to abide by the terms of the stability and growth pact. Put simply, Brussels wanted to see tough action against the eurozone's two biggest members for refusing to bring their budget deficits under control. Germany and France told the commission to get lost, and had the power to block the disciplinary action. Cue one hissy fit from the eurozone's smaller countries, a perhaps terminal crisis for the pact and a murmur of "don't say we didn't warn you" from London. It's not the Whitehall way to rejoice openly at the pact's travails, but the message came across loud and clear all the same. It seems, one official said sweetly, that the pact now lacks credibility. With borrowing set to reach £30bn-plus in the UK this year, some reputable forecasters think Gordon Brown is in danger of breaking his own fiscal rules. If that happens, there will be lashings of schadenfreude in Brussels. However, Brown's criticisms of the pact are valid. Even on its own terms the pact has been a failure, since it has always lacked credibility and is now a laughing stock. It was an ill-conceived monetarist project that has added to Europe's considerable economic problems, and its effective demise shouldn't be mourned by anyone who cares about Europe's unemployed. The sooner it is dispatched to the knacker's yard, the better. First, a bit of history. The stability and growth pact was dreamed up by the Germans in the mid-90s as a means of ensuring that the European Central Bank (ECB) could be as tough on inflation as the Bundesbank. Interest rates were going to be set for all members of the eurozone by the ECB, but control of fiscal policy - taxes and spending - would be left in the hands of national governments. For the Germans that was a big problem. What if one country (Italy was the country in mind) tried to get round the anti-inflationary policy of the ECB by cutting taxes or increasing public spending? Rules were drawn up saying that if countries ran budget deficits of more than 3% of GDP they would be obliged to take remedial action or face fines. The basic premise of the pact was sound enough. It would have been impossible to launch the euro without some arrangement in place for individual members to run fiscal policy. The problem was that the mechanism chosen was deflationary, punished countries when they were already in trouble and was at least 20 years out of date. What it did was establish a system whereby countries were obliged to raise taxes or cut spending when slow growth pushed their budgets into deficit. In the short term, the victory of Germany and France this week was a humiliation for the commission. But the long-term outcome could be beneficial provided European policy-makers seize the moment. Britain was humiliated on black Wednesday when speculators blew the pound out of the exchange rate mechanism, yet it proved a blessing in disguise. The government was forced to stop wrecking the economy by sticking to a policy that was no longer working. Economic policy was rethought; since then neither the economy nor the Bank of England has looked back. Credibility has been gained, not lost. Would the same apply to the eurozone? Certainly. The markets don't believe it is credible for countries to immolate their economies simply to meet the pact's doctrinaire terms. These are deflationary not inflationary times; the pact is a throwback not just to mark one Thatcherism but to the early 1930s when governments thought the right response to the Great Depression was to aim for balanced budgets. It's as if Maynard Keynes had never lived. The smart move would be for the commission, the ECB and the member states to accept that the game is up and that they should start afresh. As Brown never ceases to tell them, Europe can buy a new fiscal policy off the peg from the Treasury any time it likes. Brown's model would allow countries to run deficits in bad times provided they ran surpluses in good times, and permit borrowing for investment just so long as debt levels were modest. The chances of this happening are, however, remote. More likely, a neutered form of the stability pact will remain in place, with fudge taking the place of reform. That would be a great shame, since the current imbroglio presents the best chance in years to bring European policy-making into the modern world. Does all this affect Britain's euro decision? You bet. The vacuum left at the heart of eurozone fiscal policy means a possible UK referendum on membership of the single currency recedes even further. The fact is, however, that it is some years off in any event. Reform of the way Europe makes economic policy would, in the long run, make it more likely that the government could secure a yes vote, particularly if the new arrangements looked kindly on government borrowing to repair Britain's crippled infrastructure. Certainly, it's hard to see reform turning round public opinion should Europe continue to deny the obvious: that the pact has long outlived its usefulness and should be scrapped. · Larry Elliott is the Guardian's economics editor [EMAIL PROTECTED]
