In 1997, the countries of the European Union agreed to coordinate their fiscal policies. The agreement, which became known as the Stability Pact, established that the public sector deficits of the member-countries could not exceed 3% of their GDPs. Barely six years later, France and Germany have imposed checkmate on the balance of power. The two locomotives of Europe are showing clear signs of fatigue that are preventing them from complying with European requirements. But the problem goes beyond economic questions, and it has opened a debate about whether a fiscal framework that is so strict should be maintained.


According to the latest forecasts, in 2004 Germany will fail to observe the norms of the Stability Pact for the third consecutive year, recording a public sector deficit of 3.5%, according to a report produced by the six main economic forecasting institutes of that country. For its part, France also appears incapable of finding the path toward fiscal balance. In fact, the European Commission has given France a one year extension in order to try to adjust its deficit, which amounted to 3.1% in 2002. During this fiscal year it is expected to reach 4%, and 3.6% for calendar 2004.


To avoid these situations, the Stability Pact incorporated a series of sanctions against those countries that repeatedly fail to comply. But for the moment, Brussels prefers to keep the rod of punishment in hiding. Instead, it is giving an extension to offenders in the hope that they will correct their problems. Sara González Fernández, professor of international economics at the Complutense University of Madrid, explains that the sanctions vary with the degree of non-compliance with the Pact. “The first year of non-compliance brings a reprimand from Brussels. In the second year, they impose a penalty that can rise as high as 0.5% of the GDP of the country. That penalty is left as a deposit until the offender corrects its imbalance. Starting with the third year, offending countries expose themselves to losing their vote in the European Central Bank (ECB).”


When it comes to France and Germany, losing their voting rights regarding European monetary problems is an especially sensitive problem because those countries are the two main contributors of capital [to the ECB]. “The member states of the Union, with their contributions to the ECB, turn into a sort of shareholder in the entity,” notes González. “Germany is the largest shareholder with 24.5% of the capital; meanwhile France is the second-largest, with 16.33%. Temporarily taking away their voting rights means taking away the possibility that they could make pronouncements about European monetary policy.”


Internal Division

The extra time granted by the Commission has divided the countries of the European Union. The Netherlands and Austria head up the opposition to this alternative. They believe that all countries must respect the sanctions laid out in the Stability Pact. In fact, the Dutch are considering the possibility of taking the European Commission to the Court of the EU for not imposing the prescribed fines on France. But France and Germany are not alone in their attempts to make the conditions of the Pact more flexible. They are counting on the support of Italy and Portugal, two economies that have also racked up significant deficits. Together, those four countries expect to have a minority that is large enough to put a brake on any moves taken against France or Germany. 


This fracturing of EU member states has raised questions on several fronts about the survival of the Stability Pact. Does it make sense to maintain an agreement in which the main driving forces – that is to say, France and Germany – are not compliant? What is the point of maintaining a framework if the corrective measures that it lays out are not applied? Does Europe really need fiscal policies that are so strict?


Wim Duisenberg, the ex-president of the ECB, noted on the day of his retirement (last September 31) that “it would be a disaster for Europe, but the danger (of a failure of the Stability Pact) does exist.” It is a risk that Rafael Pampillón, professor at the Instituto de Empresa business school, feels like fighting for. “The Stability Pact enables the euro to be in balance and, as a result, it facilitates European competitiveness. It would be an extremely grave mistake to do away with this accord – although, unfortunately, that could be the case.”


Among experts, opinion is divided, nevertheless. Antonio Fatás, professor of economics at the INSEAD business school, believes that “without doubt, the Pact should be modified. I am in favor of restricting fiscal policy but not in the manner in which the Stability Pact does so. I would prefer an institution that is similar to the way central banks operate when they make monetary policy. It would decide on the broad outlines of fiscal policy without coming under the direct influence of political tensions associated with elections.”


For the moment, the European member states appear ready to defend the established framework. France has committed itself to presenting, by November 25, a series of measures that permit it to reduce its deficit. These will be directed at cutting its public spending and, above all, introducing structural improvements in the health field that allow it to cut public-sector medication bills.


For its part, Germany has announced a pension cut, with the goal of keeping non-salary costs from shooting up. Specifically, the proposal of Chancellor Gerhard Schroeder consists in not raising pensions in 2004, as well as in making retirees pay their entire share of disability insurance (1.87%) – not half of it, as had been the case. That way, a retiree with a pension of 1,000 euros [a month] would lose between 15 and 20 euros each month. Moreover, the German government wants to close the early retirement spigot so that the retirement age comes close to 65. Currently, the average retirement age for German workers is 60.


González, however, distrusts these measures. “Schroeder is taking measures to patch things up while, for France, it is becoming very hard to impose any improvements because labor unions will throw politicians out, the way it happened when they tried to toughen up the number of the years in contributions to national insurance.”


In her opinion, the problems that these countries are undergoing are a reflection of the crisis in the European socio-economic model. “We must accept that this is about models that are in crisis. They are unsustainable with criteria of stability and, moreover, they need reforms that are basic and inescapable, although they are different from the American model, where the State barely offers any social benefits.”  The improvements can be applied as much in an individual way – so that each country decides the changes that must be carried out – or in a joint manner. “It is always preferable if Europe lays down the main lines and then each state applies them to its own reality. That way, they can draw up lines for making improvements with less of a political burden,” adds González.


Fatás defends the notion that “given the impossibility of raising taxes in these economies, the only way to react is by controlling and cutting public expenditures. But that is always very difficult, and it takes a lot of time. There is no spending that is totally unnecessary, and there is always someone who gets hurt when public spending drops.” Moreover, any improvement “is going to take time and social pressure before it takes effect.”


Pending Improvements

When they approved the Stability Pact, notes Pampillón, “they considered that it was the best road for getting the Mediterranean countries to balance their accounts. Germany and France, in contrast, looked like they could achieve that without any special difficulties. But the opposite turned out to be the case, ultimately. Although it is clear that Portugal and Italy also have a deficit larger than 3%, other Mediterranean countries such as Spain and Greece are complying with this agreement.”


The secret of those states consists in having applied the correct policies at the time when they were enjoying an economic bonanza. “The privatizations, for example, were carried out at the peak of the stock market, allowing the public coffers to get fatter,” says Pampillón. “At the same time, they implemented policies for restraining public expenditures. In contrast, France and Germany showed their opposition to creating a European market for energy, transportation and telecommunication, which was proposed by José María Aznar, the Spanish president, during the Barcelona Summit. This opposition was a reflection of the fact that they continue to prefer protectionist policies and, therefore, control on the part of the State.”


Nevertheless, Fatás remembers that the arrival of Germany and France in the Monetary Union was a bit difficult. “The two economies began with deficits that were practically at the limit of what was permitted. In fact, France had a deficit that was slightly above 3% but it was allowed to enter in order to avoid tensions over a deviation that was so small. Moreover, after entering (in 1998), the two economies grew in a significant way and moved slowly away from being in the danger zone.” But peace didn’t last long. “In 2001, the two economies went into recession and slower growth, and that meant that their deficits worsened. Also, they are countries with very high taxes, and they are always being warned that they must lower them, which creates a situation in which there is not much room for maneuvering.  Fiscal revenues drop because economies don’t grow and governments begin to lower taxes in order to help them grow, which only leads to revenues drop even more,” adds Fatás.


In addition to reviving a stagnant model, the countries of the Community are facing a favoritism problem. The fact that the Commission has granted a one-year extension to France opens the door for the rest of the member countries to ask for the same flexibility if they wind up failing to comply with the 3% limit. Moreover, those countries that are shortly to join the euro zone, such as Hungary and Poland, can also ask for this favorable deal. “It is not certain if this is going to happen,” says Fatás. “It is possible that France and Germany will correct their deficits during the next two years, and all will be forgotten before Poland and Hungry have to do the same thing. But if France and Germany don’t correct their accounts, then the system will collapse because of a lack of credibility.”


Fatás emphasized that the true danger of the Pact is lack of credibility. Jean-Claude Trich, new president of the ECB, has declared himself a firm defender of this framework. He has asked every country to take whatever measures are necessary – including those of political scope – to reinforce confidence in the Euro zone. “It is impossible to deny that if the major powers don’t comply, the Pact will have failed,” says González. “But at this stage, there is no room for accepting failure to comply, or for considering whether the Stability Pact makes sense or does not.”