Europe's Destabilizing Stability Pact

Europe's Growth and Stability Pact is under threat as never before. Even European Commission President Romano Prodi now calls it "stupid." In many ways, he may not be wrong.

Last summer, as soon as it became clear that Germany's mounting budget deficit might exceed the Stability Pact's ceiling, Chancellor Schröeder postponed a tax cut he had already announced rather than cut public spending. The French government, unwilling to cut its swollen public sector, is now thumbing its nose at the Stability Pact and its enforcers in the European Commission, saying that it has "different priorities" than those required by the pact. The question now is whether or not the Stability Pact can long survive the antagonism of the EU's two biggest economies.

The Stability Pact emerged after a long period (part of the 1970s, all of the 1980s, and a good portion of the 1990s) during which many European countries lost control of their fiscal balances. The Stability Pact initially sought to force countries that wished to join European Monetary Union to bring their budgets closer into balance and to slash excess debt. Now, however, its built-in flaws are being revealed.

The biggest problem concerns the fact that the Stability Pact focuses on a country's budget deficit, rather than on the component parts of government budgets: taxes and public spending. Europe's fiscal problems have their roots in governments that are too big and that require, in order to pay for their bloated size, levels of taxation which grossly interfere with the incentives individuals need to work harder, invest more, and run entrepreneurial risks. Setting a limit on a country's overall budget deficit - as the Stability Pact does - cannot correct this distortion.