The stability pact — R.I.P., 2003

The Economist has the latest on the death of the European “stability and growth pact,” which was made in order to harmonize the business cycles of European economies for the creation of the Euro (for my previous takes on this, click here and here). The good parts version:

Never has a straitjacket seemed so loose-fitting. The euro area’s “stability and growth pact” was supposed to stop irresponsible member states running excessive budget deficits, defined as 3% of GDP or more. Chief among the restraints was the threat of large fines if member governments breached the 3% limit for three years in a row. For some time now, no one has seriously believed those restraints would hold. In the early hours of Tuesday November 25th, the euro’s fiscal straitjacket finally came apart at the seams. The pact’s fate was sealed in a meeting of the euro area’s 12 finance ministers. They chewed over the sorry fiscal record of the euro’s two largest members, France and Germany. Both governments ran deficits of more than 3% of GDP last year and will do so again this year. Both expect to breach the limit for the third time in 2004 (see chart). Earlier this year the European Commission, which polices the pact, agreed to give both countries an extra year, until 2005, to bring their deficits back into line. But it also instructed them to revisit their budget plans for 2004 and make extra cuts. France was asked to cut its underlying, cyclically adjusted deficit by a full 1% of GDP, Germany by 0.8%. Both resisted. Under the pact’s rules, the commission’s prescriptions have no force until formally endorsed in a vote by the euro area’s finance ministers, known as the “eurogroup”. And the votes were simply not there. Instead, the eurogroup agreed on a set of proposals of its own. France will cut its structural deficit by 0.8% of GDP next year, Germany by 0.6%. In 2005, both will bring their deficits below 3%. Nothing will enforce or guarantee this agreement except France and Germany’s word.

Now, as has been pointed out in several places, the economic logic undergirding the stability and growth pact were not necessarily rational, so it’s demise can be seen as a good thing. However, the combination of no fiscal rules and a unified monetary policy creates massive free rider problems, as the story goes on to observe:

They worry that governments are more likely to run deficits in a monetary union: governments can enjoy the full stimulus of a fiscal expansion, while the unwelcome side-effects (higher inflation or interest rates) are divvied up among all the members. Similar concerns are voiced by smaller members: if the Austrian government borrows too much, its impact on euro-area interest rates is negligible; but if France, Germany or Italy overborrow, borrowing costs rise for everyone.

Meanwhile, some of the European Union’s incoming members are not sanguine about the current state of the EU (link via Josh Cohen):

Czech President Vaclav Klaus said Europeans are living in a “dream world” of welfare and long vacations and have yet to realize “they are not moving toward some sort of nirvana.” The Czech Republic is a candidate for European Union membership, but Mr. Klaus, who was elected president in February, made clear in an interview his distaste for the organization.

Klaus is probably a bit of an outlier in terms of Eastern European opinion. Still, it’s gonna be fun to see him tangle with the EU. UPDATE: Atrios makes some cogent points on this topic, and on the premature rumors of the death of Keynesian macroeconomics. His key point:

The truth is the S&G Pact does need to go, though the proximate cause of its death shouldn’t have been this kind of “crisis,” but rather a sober reassessment.