Stability Pact to face even tougher questions next year

European governments are likely to ignore the rules rather than see businesses go bang and unemployment rise, writes Denis Staunton, European Correspondent.

It began with the most ambitious and successful currency changeover in the history of money but as 2002 ends, Europe's monetary authorities are plagued by self-doubt and anxiety about the future.

The President of the European Commission, Mr Romano Prodi, has described the Stability and Growth Pact that underpins the euro as "stupid" and the European Central Bank (ECB) is questioning the very basis on which it sets interest rates.

Economic growth in the euro zone fell to 0.3 per cent in the third quarter of 2002 and the prospects for the near future are gloomy.

The economies of Germany, France and Italy, which account between them for most of the euro-zone's output, are in the doldrums. And a number of euro-zone countries, including Germany, are already breaking through the Stability and Growth Pact's limit of 3 per cent of GDP on budget deficits.

The successful launch of euro notes and coins gave a badly needed boost to the confidence and authority of the ECB but as the year wore on, the central bankers in Frankfurt faced growing criticism for their failure to do anything to revive Europe's weakening economy.

By the end of the year, many Europeans were even falling out of love with their new currency, especially in Germany where the euro was blamed for higher prices in some shops and restaurants.

The ECB argues that, even before this month's cut to 2.75 per cent, euro-zone interest rates are at a historically low level. The central bankers maintain that cutting rates further would do little to boost economic growth because Europe's economic problems are not caused by a lack of liquidity. They blame international economic uncertainty, high oil prices and Europe's lack of structural reform for the euro zone's poor growth performance.

The ECB is constitutionally obliged to maintain price stability in the euro zone and it has set an inflation target of less than 2 per cent annually. Its monetary policy rests on two "pillars" - money supply growth and a consumer price index.

The two-pillar strategy has long been controversial, not least because the ECB has appeared to ignore its own target of keeping money supply growth below 4.5 per cent each year. The central bankers ignored a recent surge in money supply growth, for example, and pressed ahead with December's interest rate cut of 0.5 per cent. The reason for the surge was that weakness on the stock market meant that more people were selling shares for cash.

Many analysts believe the ECB's inflation target is too tight and euro-zone inflation has remained stubbornly above 2 per cent since the euro was launched. The ECB has signalled that it is rethinking its policy and hinted that it could abandon its money supply target and introduce a more flexible inflation target - perhaps a range between 1.5 and 3 per cent.

Such reforms could enhance the transparency of ECB decision-making but they are unlikely to have much direct impact on economic growth in the euro zone. Reforming the Stability and Growth Pact could, however, help euro-zone governments to boost their economies.

The 3 per cent limit on budget deficits means that Germany, for example, cannot cut taxes or boost public spending in an effort to revive economic growth.

The consequences of a German recession on the rest of the euro zone could be calamitous but instead of helping Berlin out of its difficulties, the Commission is obliged by the pact to institute disciplinary procedures to force spending back into line.

EU finance ministers have already all but abandoned the pact's demand that all euro-zone countries should bring their budgets close to balance by 2004.

And the Commission has proposed a more flexible interpretation of the rules to allow governments that have maintained fiscal discipline to borrow for infrastructural improvements during a downturn.

If the economy picks up in 2003, calls for a more thorough overhaul of the pact could recede. But if growth remains sluggish, governments are likely to ignore the rules rather than watch businesses go bankrupt and unemployment rise.

As the Convention on the Future of Europe discusses proposals to give EU institutions more control over economic policy, the faults within the present system are weakening the arguments of those who want more integration.

One issue that is refusing to go away at the Convention, however, is the one the Government dislikes most - tax harmonisation. Few governments want to harmonise all tax rates but most favour some harmonisation of corporate taxation.

They argue that low corporate tax rates, such as Ireland's, distorts the internal market and hinders the establishment of common European social standards.

Britain and Ireland are determined to veto any proposal to abolish the need for unanimity in all EU decisions concerning taxation.

But mindful of the disadvantages of taking a consistently defensive approach to the issue, the Government is preparing in the New Year to make a positive case for retaining tax competition between EU member-states.