European Affairs

Winter 2003

 

In the News
The EU Needs Stronger Economic Policy Coordination
By Philippe Lemaître

 

Romano Prodi, President of the European Commission, caused quite a hullabaloo by describing the European Union's Stability and Growth Pact as "stupid," because it was too rigid, in an interview with the French daily Le Monde in October.

He was speaking about the agreement that lays the basis for economic policy coordination among the 15 EU member states, and more specifically for the twelve of them that comprise the euro zone. Mr. Prodi is more of a politician than a technocrat, and it was as a politician that he was reacting to a steadily deteriorating situation, over which the European Union was progressively losing control.

His sudden outburst was at first criticized by those who wrongly feared that he was trying to make things easier for the four countries with the slackest budgetary policies - Germany, France, Italy and Portugal. But it quickly became clear that Mr. Prodi had made an inspired comment that had a salutary galvanizing effect on public opinion.

Mr. Prodi's message was simple: the smooth functioning of economic and monetary union and the credibility of the euro will be endangered if the EU countries do not take the corrective action necessitated by their unsatisfactory experiences over the past four years, since the single currency was introduced in January 1999.

Mr. Prodi wants to reform the pact in order to have a "more intelligent instrument," and thus a more efficient one, at his disposal. But, in a part of his October speech that has too often been neglected, he also indicated that he wants to give more authority to the institutions primarily responsible for managing EU macroeconomic policy, and particularly to the Commission, which he heads.

The battle is far from won, but debate on the issue is at least now under way in the press, in national parliaments and above all within the Convention on the Future of Europe, apparently with a good chance of success. The Convention's mission is to reflect on the future of Europe, and possibly to propose a European constitution to the 25 nations that will make up an enlarged European Union (the current 15 members plus the ten that are due to join on May 1, 2004).

The dictates of necessity are such that the Convention, and the subsequent Intergovernmental Conference, could make the most significant progress in the construction of Europe in the field of macro-economic governance, rather than in external policy, where progress could be difficult in view of the differing views and circumstances of the member states.

The introduction of the euro was not easy. One must bear its history and the nature of the 1990s in mind, if one is to understand the rudimentary, brutal character of the Stability Pact, which stipulates that budget deficits may in no circumstances breach the taboo threshold of three percent of gross domestic product, on pain of financial penalties which, let it be said in passing, are themselves one of the pact's most controversial elements.

The main aim of the Treaty of Maastricht, agreed in December 1991, was to move in stages to economic and monetary union and the single currency. To that end, the Treaty obliged member states progressively to align their economic policies and performances, and, at the end of the process, meet mandatory targets for inflation rates, budget deficits, public debt, interest rates and exchange rate stability, in order to qualify for participation in the single currency.

Governments engaged in a tough battle to put their economies on a sound footing, and to meet the famous "Maastricht criteria," which were often criticized for the sacrifices they imposed in terms of growth and employment.

As late as 1996 or 1997, few government or private experts thought that countries such as Italy or Spain could achieve these goals. In Germany and the Netherlands sarcastic comments were made about Mediterranean countries that were supposedly incapable of exercising economic and budgetary discipline.

When it became clear that the challenge would be met, and that the euro zone was likely to extend beyond the traditional club of "virtuous" countries (Germany and the Benelux countries, with France generously included), Germany got worried.

The Germans were rightly proud of the Bundesbank and the monetary stability that it had maintained throughout its existence. They fretted that even if their congenitally lax southern partners managed to meet the requirements for euro zone entry, they would not be able to sustain economic discipline over the longer term.

It was thus to guard against unpleasant surprises, and to reassure a German public worried about abandoning the deutsche mark - the symbol of Germany's post-War economic and political renaissance - that Theo Waigel, the then Christian Democrat Minister of Finance, imposed the budgetary stability pact on the other member states. At the time, the pact was regarded less as a real economic policy instrument than as a rough and ready guarantee against potential misbehavior.

In the mind of its supporters, the pact was not so much a means of ensuring the efficient coordination of budgetary policies; it was a way of altering mentalities by establishing a solemn ban on budget deficits exceeding the three percent limit. The pact's advocates hoped that the mere existence of the ban would suffice to deter escapades that could upset the newly acquired, and thus still fragile "culture of stability."

Before its formal adoption by EU leaders in Amsterdam in 1997, the pact was renamed the Stability and Growth Pact, at French request. The idea was to suggest that the pact was meant not just to impose financial discipline, but also to promote economic growth - even though no changes were made in its fundamental provisions. In brief, rather than an economic policy measure, the pact looked like an expression of mistrust, which in large part explains its inadequacies.

During the years that followed the introduction of the euro, experience has shown that this mistrust was not totally unfounded, even if the most serious failings did not necessarily occur where they were expected. The stability culture imposed by the move to economic and monetary union was not challenged. But several governments realized that voters were weary of austerity for Europe's sake, and took big liberties with their pledges to coordinate budgetary policies.

There are two other instruments for coordinating EU macro-economic policy, in addition to the stability pact. The first is the adoption by the Council each year of broad economic policy guidelines, following a recommendation from the Commission; the second, the stability programs developed by each member state on the basis of there guidelines.

Current rules provide for the Council, again acting on a Commission recommendation, to put pressure on countries that fail to respect these undertakings by giving them "early warnings." If a country exceeds the three percent limit on budget deficits, it may trigger a procedure designed to penalize "excessive deficits," under which the offending country may be required to pay substantial fines.

The economic policies of all 15 EU member states are coordinated and monitored in the EU Council of Finance Ministers; policies of the 12 members of the single currency receive particular attention in the Eurogroup, an informal gathering of Finance Ministers from the euro zone countries.

Simply put, these procedures have not worked well. From the beginning they were not flexible enough to react quickly to unexpected short-term economic developments; in addition, several member states have not played by the rules of the game. In 1999 and 2000, when the economy was growing strongly, the four recalcitrant countries already cited, France, Germany, Italy and Portugal, failed to keep commitments made under their own stability programs.

They did not take advantage of this period of high tax revenues to make serious reductions in their budget deficits and give themselves a margin of maneuver in the event of a sudden drop in economic activity. Others, such as the Benelux countries, Britain, Spain and the Nordic countries, behaved more wisely.

The European economy changed for the worse in 2001, on the heels of the telecommunications and hi-tech crisis in the United States. It quickly became evident that the more spendthrift member states would not manage to balance their budgets in 2004, the target adopted by all 15 EU member states. There followed a period of confusion, which showed that the system needed to be reformed and reinforced. The Ministers of Finance accordingly rejected a perfectly legitimate bid by the Commission to issue an "early warning" to Germany.

A few weeks later, Pedro Solbes, the Commissioner for Economic and Monetary Affairs, tried to make the best of a bad job by proposing that the deadline for balanced budgets be postponed to 2006, with a requirement that the four countries running behind schedule start making efforts to meet the target in 2003.

The countries that had exercised better discipline over their finances protested that such indulgence would cost them dearly, since it might encourage the European Central Bank to delay lowering interest rates. France, Germany, Italy and Portugal, however, applauded the suggestion. France nonetheless casually dismissed the prospect of reducing its deficit in 2003, thus signaling that it would not be willing to balance its budget until 2007.

For a moment, France seemed to be challenging, if not the overall need for budgetary policy coordination, at the least the requirement that governments accept a minimum of constraints, which comes to much the same thing. When other countries reacted negatively to this approach, Francis Mer, the French Minister of Finance, adopted a more conciliatory tone.

These different episodes, however, caused considerable commotion, and suggested that the policy needed to be clearly and strongly restated at European level. That seemed all the more necessary since at the same time the European Convention working group on economic governance, chaired by Klaus HÀnsch, a German member of the European Parliament, was unable to agree on reforms to the system. Against this background, Mr. Prodi's interview undoubtedly gave rise to new thinking, both within the governments and in the Convention.

In December, the Commission proposed that the stability pact be confirmed and strengthened. It said that inflation and public debt should be monitored as well as budget deficits, and that greater account should be taken of short-term economic developments. It asked the member states to strengthen the Commission's right to take initiatives in guiding budgetary policy and to tighten the monitoring procedures so as to give the Commission more influence.

In parallel, the 15 member states seem to agree on the need to strengthen the Eurogroup and its external representation, particularly in the Group of Seven, although they have not yet decided how to do so. Such a move would be a logical consequence of the expected admission of ten new members into the European Union on May 1, 2004, after which there will be a big increase in the number of EU countries that are not yet members of the euro.

As decisions can only be taken by the full EU Council of Ministers, it might then in some cases be possible for the non-euro countries to block measures informally agreed by the 12 euro member countries in the Eurogroup. That would be an unhealthy development. On all these points, there will be a lively debate between now and the summer, but the member states, sensing the danger of past errors, seem ready to go in the direction suggested by Brussels.

Philippe Lemaître is the Brussels correspondent of European Affairs, and a member of an advisory committee appointed by the government of France to lead the debate on the future of Europe. Now retired, Mr. Lemaitre was for 35 years the EU and NATO correspondent of the French daily Le Monde.