ECB should link budget deficit level to interest rate policy

The stability pact is being increasingly ignored, writes Marc Coleman, Economics Editor

The cartoon has graced a million seaside postcards: a clutch of chubby middle-aged men standing on a beach on a gloriously sunny day, their bald foreheads shielded from the sun by neatly knotted handkerchiefs.

Spotting an attractive girl in a bikini walking by, they decide to impress, thrusting out chests and pulling in stomachs. The girl glances at them, smiles and then walks past them.

After that, the sad charade comes to an end. Chests deflate and bellies sag.

This is exactly what has happened to budgetary positions and to the so-called Stability and Growth Pact. In 1996 EU leaders agreed in Dublin to the pact, which formalised the tests of fitness for EU members to enter EMU, including a limit on the size of budget deficits.

As well as meeting other criteria, countries joining EMU were told to keep their budget deficits below 3 per cent of Gross Domestic Product (GDP). EU leaders set 1997 as the year in which the test would be applied - to remarkable effect. Bad budgetary positions were quickly corrected.

Among the 12 current member states of the euro zone, the average budget deficit/GDP ratio fell from 4.6 per cent in 1996 to 2.6 per cent in 1997. The ECB and EU Commission smiled and the euro was born.

But thereafter governments went back to their bad old ways. For a while no-one noticed as Europe's economies grew in the first years of EMU.

But soon the truth became apparent and the average euro-zone deficit rose from 0.9 per cent of GDP in 2000 to 2.8 in 2003, with France ,Germany and Portugal breaching the 3 per cent limit in 2002 and 2003.

The Portuguese, responsibly, tried to tackle their deficit. But, with elections looming, Jacques Chirac and Gerhard Schröder faced a choice. Either they could abide by the pact and forgo spending increases and tax cuts or ignore the pact and appeal to voters. Politicians being politicians, they did the latter.

They had realised something very simple. After 1997, the stability pact ceased to have teeth because the euro was up and running. What sanctions are available to punish breaches are controlled by EU leaders themselves.

Last March, EU leaders renewed their commitment to the pact but, as noted by the European Central Bank (ECB) in its latest monthly bulletin, the pact is being increasingly ignored.

There is a solution, however, and it is one that lies in the hands of the ECB. The ECB should now formally add the average euro-zone budget deficit to the indicators it uses to decide monetary policy.

If that deficit goes above 3 per cent, it should consider raising interest rates.

This would give EU leaders pause for thought and, hopefully, slim the fiscal waistlines of certain countries.