Fixing Europe's Stability Pact

Europe's Stability Pact - which underpins the euro by setting fixed constraints on the size of budget deficits for euro members - is in trouble. The European Union's leading country, Germany, failed to meet its commitments to its EU partners concerning its deficit. Furthermore, it used its political muscle to block the early warning about its deficit that the EU Commission had mandated by the terms of the Stability Pact.

Now France is making waves. The EU's reluctant number two country has served unofficial notice that it, too, does not plan to abide by its deficit-reduction promises. This comes one year after tiny Ireland received an official warning about its fiscal policies, even though Ireland's budget was in surplus, and mightily so.

So, four years after it was signed, the Stability Pact seems to be in shambles. Indeed, Europe is now rife with talk about junking it, as well as with discussions about how to fix it. Rightly so: the Pact is ill-conceived and its implementation ill-designed.

Not only is the Pact's fixed 3% limit for the ratio of budget deficit to GDP arbitrary, but it also ignores the fact that when an economy slows, deficits increase automatically. Recognizing this fact, the Pact's architects made things worse by adopting two misguided `solutions'. They introduced a safety clause allowing a country to suspend the deficit ceiling in case of serious recession, but they went on to define a serious recession in such a way as to make such a suspension implausible in practice.

Mindful that normal slowdowns could lead to a breach of the ceiling, they decreed that a normal deficit is a zero deficit. Accordingly, each year, every county is required to submit a budget that projects two years ahead which demonstrates how its budget will be balanced in that time.

Germany's commitment for 2002 was made in early 2001 when its economy was growing at a reasonable pace. The unanticipated slowdown made it impossible for Germany to meet the target. Finance Minister Hans Eichel decided, reasonably, not to worsen conditions by adopting a contractionary fiscal policy.

The Commission, seeking to project itself as the protector of the Pact, sought to issue a warning. But that decision had to be taken by real-life politicians, the Council of Finance Ministers. No one on the Council wanted to upset Germany, for all of them recognized that the same problem could one day confront them. No warning was issued.

France's case is different. During elections, politicians invariably make promises, including those of tax cuts. In a country with crushing rates of taxation, this is not only smart politics, but it is also good economics, provided spending is cut. But France is also a country where everyone enjoys some publicly-funded privilege, so cuts are a political "no-no." Thus France cannot meet the Pact's deficit target. The Commission expresses outrage, but France is skilled at challenging the EU's rules of common behavior. Political scheming is guaranteed.

Economists and cynics are not surprised. The Pact's objective - to enforce fiscal discipline in countries that share the same currency - is worthy. But having lost control of their national monetary policies, euro member countries retain only one macroeconomic instrument, fiscal policy. The challenge, therefore, is to combine long-run discipline with short-run flexibility.

Like promising to go on a diet just before a big party, this challenge is not easily met. The Stability Pact is too crude and technocratic: a 3% deficit target enforced by Brussels bureaucrats cannot bind real-life politicians. A solution must be found elsewhere.

Fortunately, we need not look far. Monetary policy faces a similar challenge. It needs to deliver price stability in the long run while being flexible enough in the short run to deal with business cycles. Over the last decade, monetary policy has been a true success story. Everywhere the recipe is roughly the same: delegate policy to a group of competent people - the central bank - by making them formally independent from political pressure and providing them with a clear, explicit mandate. Knowing that any slippage today will need to be dealt with tomorrow, they exercise their best judgment. This has been a spectacular improvement over the monetary rules of the past.

The same approach should work for fiscal policy. Some, of course, may fear a loss of democratic accountability. It is essential to realize that fiscal policy fulfills two very different tasks. The first task is structural and redistributive: it concerns the size of the budget and its detailed structure on both the spending and revenue sides. Decisions on such issues cannot be delegated; they must remain in the hands of elected governments and be subject to parliamentary approval and oversight.

The second task is macroeconomic: it is about setting the budget balance to deal with cyclical fluctuations. That task does not differ from monetary policy and can be delegated to an independent body.

So what Europe must to do is clear. Each country should regain full control of its fiscal policy but delegate its macroeconomic component, decisions about deficits or surpluses, to an independent Fiscal Policy Committee given the long-run mandate of stabilizing, or in some countries reducing, the size of the public debt. In order to guarantee the outcome, the statutes of such committees and their mandates ought to be agreed upon by all euro members. No more Brussels interference, no more arbitrary rules, no more political judgments-- just plain common sense.