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Will Europe’s Sinners Save Themselves?

When German officials pushed in the 1990’s for the Stability and Growth Pact as a prerequisite for giving up the Deutschmark, they did not anticipate that Germany would be the first country to violate the pact. While the pact says that a government cannot borrow more than 3% of its GDP, Germany’s public-finance deficit reached 3.7% of GDP and more from 2002 to 2004.

There have been more sinners, though. France also violated the pact’s fiscal criterion in these three years. Portugal did so in 2001 and the Netherlands in 2003. Greece cheated by manipulating its statistics: while the reported deficits were below the limit, the country had to admit that the true deficit from 2000 to 2004 was 4.3% on average and never below 3.7%.

Other countries have been more successful due to fortunate circumstances. Italy, for example, not only benefited from its government’s creative accounting, but also from the fact the euro led to interest-rate convergence in Europe. Long-term interest rates for Italian government bonds declined from about 12% to about 4% in the ten years from 1994-95 to 2004-05. With the Italian debt/GDP ratio currently at roughly 106%, lower borrowing costs reduced the public debt ratio by more than eight percentage points.

Indeed, other things being equal, had the interest rate not declined, Italy would have had a public-finance deficit of 11% of GDP in 2004 rather than the reported 3%, and its debt/GDP ratio would, of course, have been much higher. It was the euro, not the Italian government, that helped Italy satisfy the Stability and Growth Pact. But now Italy seems to have run into trouble again and also wants to weaken the pact.