Market Directions

Will the European Monetary Union countries return to the budgetarydiscipline of the Stability and Growth Pact? Can they bring theirfuture national finances into line with the treaty limits on deficitsand debt?

The Former Stability and Growth Pact

Will the European Monetary Union countries return to the budgetary discipline of the Stability and Growth Pact? Can they bring their future national finances into line with the treaty limits on deficits and debt?

The 1997 Stability and Growth pact was based on the Maastricht Treaty and was the operational precursor to the euro launch in 1999. It will now join the Kellogg-Briand Pact, the Locarno Treaties and other international agreements that have attempted to control the natural inclinations of governments and failed. But unlike those anti-war and disarmament treaties from the 1920s, whose goals disappeared along with the treaties in the conflicts and wars that followed, the Stability and Growth Pact will disappear but its chief goal and the great achievement of European unity, the euro, will live on.

The pact was a German sponsored addition to the Maastricht Treaty that set up the euro. It set a yearly deficit limit of 3% percent of GDP and an overall national debt limit of 60% of GDP for all countries adopting the euro. Its purpose was to enforce the fiscal discipline of the convergence criteria which set monetary and financial parameters for joining the euro.

The pact was designed to rein in the perennial deficit spenders of Southern Europe. It was to be reassurance to the Germans who were giving up the stability of the Deutsche Mark for the euro and an image makeover for the Italians, Greeks and other profligates; it was a complete success. For a few years the spenders pretended that the euro had disciplined their public finances as it eliminated the recourse to competitive currency devaluation. The pact helped establish the credibility of the ECB as a worthy inheritor of the sound money German Bundesbank and gave the euro a credible beginning and a decade of strong valuation.

In short order the euro was established, accepted and valued by the world’s financial markets. It was the most successful introduction of a currency and central bank in history. The euro is a competitor to the dollar and yen in world markets and a growing competitor in reserve status to the dollar. The ECB is the world’s second central bank and holder of the best inflation reputation. All of these are at least partially due to the rigorous criteria of the Stability and Growth Pact.

But the pact has been another victim of the financial crisis and recession. Almost every member of the European Monetary Union (EMU) had a 2009 budget deficit above the 3% percent limit and all are expected to be over the limit in 2010. But that has not stopped the lectures from the central euro duo of Germany and France.

“No government, no state can expect any special treatment”. “Some governments, one in particular, has very difficult decisions to take”. Jean Claude Trichet, the president of the European Central Bank said in his stern in his warning to the Greek government. German Chancellor Angela Merkel noted that Greece’s fiscal woes could hurt the euro.

The budget woes in Greece, Portugal, Spain and Ireland are not the only consideration weighing on the euro. European economic growth is moribund. The German Finance Minister expects GDP to be flat in the fourth quarter after 0.4% expansion in the second quarter and 0.7% in the third. EMU growth was 0.4% in the third quarter and is not expected to be very different in the fourth. ECB interest rate policy is stationary and there will not be a fast withdrawal of the crisis liquidity from European money markets. In all of these factors, except perhaps GDP growth, the euro is no worse off than its two major competitors the dollar and the yen; only the United States is likely to have a stronger recovery in the fourth quarter.

German and French government deficits are moderate compared to those of Greece, Portugal, Ireland and Spain. But the ability of the two central members of the EMU to enforce the 3% deficit limit or even to lead by example is very limited.

This is not the first breech of the deficit limit by Germany or France. The German deficit was over the limit for four consecutive years in the first half of the last decade. And the French ignored the limit when it suited their interests. The German deficit in 2009 was 3.2% and will likely be over 5.0% in 2010. This is of course nowhere near the level of Greece whose 2009 deficit was 12.7% of GDP, or Spain’s at 11.8%.

But despite brave talk by the European Commission, national and ECB officials, it is the Greek government that holds the whip hand. It is the Athenian politicians who must cut their budget and answer to their voters. If the Greek government is unable or unwilling to meet the demands of Germany, France and the European Commission what then? If the Greek voters remove the current government for doing what the Northern Europeans want, what happens? Will Greece default on its sovereign debt? No. Will they leave or be forced out of the euro? No. Will the Greek Government then make some very public efforts to bring down their deficit levels? Yes. Will the Greeks be able to stabilize their deficit under the 3% limit anytime in the next generation? Very problematical. What exactly can the French and Germans do if the Greeks, Spanish and Portuguese do not cooperate?

The truth is that in a democratic system foreign governments have little recourse to enforce international agreements on unwilling countries that can bear the consequences of their actions.

So what will and will not be the results of the EMU deficit and debt crisis?

The euro will not be abandoned; sovereign debt will not be repudiated; profligate governments will not suddenly develop budget discipline. But the Stability and Growth Pact, specifically the 3% deficit and 60% debt limits, will fade into history. The primary purpose of the pact was the adoption and introduction of the euro; the pact has served its purpose well. Publicly European and ECB officials will continue to praise the pact and demand adherence. But the schedules for compliance to the 3% limit will stretch into the next decade. Privately they will admit the game is up.

The most successful central bank of the past decade will now fall to earth. The ECB has been able to make disciplined monetary policy because the Stability and Growth Pact has limited the inflationary tendencies of the EMU governments. That restriction is now gone; the euro can only suffer in consequence.