0

The Ghost of the Stability Pact

Murdered when France and Germany refused to abide by its rules, the Stability Pact's ghost is haunting Europe, particularly the postcommunist countries that join the European Union in May. By breaking the Pact's ban on fiscal deficits exceeding 3% of GDP, France and Germany undermined this limit as a key criterion for determining whether countries are ready for eurozone membership. Would denial of admission to the eurozone because a country fails to fulfil rules that current members spurn really be legitimate?

The convergence criterion on exchange rates is in similar disarray. Countries must remain within the European exchange rate mechanism (ERM II) for two years in order to ensure the "right" exchange rate when they adopt the euro. Germany satisfied the criterion with ease during 1996-8, though by most measures the Deutschemark was 20% overvalued compared to the franc and other eurozone currencies. This damaged Germany's economy, and continues to be a drag on growth in the whole eurozone.

The European Commission spent the last three years trying to tighten the exchange rate criterion, which would make it an insurmountable obstacle for eurozone candidates. Although the criterion requires only that countries remain within the ERM's normal fluctuation band - 15% on either side of a central parity - the Commission says that it will base recommendations concerning candidate countries' admission on whether their exchange rates remain within a 2.25% band.

The final two criteria - inflation and interest rates - are also a mess. A eurozone candidate's inflation must not be more than 1.5 percentage points above the average of the three best performing EU states for one year. But the three countries that prospective members can be compared to may be outside the eurozone. Indeed, in September 2003, the three "reference" countries would have been Lithuania, Poland, and the Czech Republic, were they already members of the EU (they join in May).