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European stability pact compromise

Short-term solution to long-term problems

Published: Nov. 25 2003, 12:45 GMT

In the short to medium term, the compromise will stimulate demand and foster growth in the Euro area, but longer term it will postpone solutions to the serious structural problems that Euro area countries are facing.

The stability pact demands a budget deficit no larger than 3 percent of GDP. France and Germany have been running deficits over the 3-percent threshold for three consecutive years. In this warm and fuzzy compromise, the finance ministers permitted a continuation of the present situation on the condition of German budget cuts of 0.60 percent of GDP next year and 0.50 percent in 2005. For France the cuts should be 0.77 and 0.50 percent. Even these moderate budget cuts require a considerably stronger growth for Germany and France to meet the requirements of the stability pact.

The stability pact was designed during ‘perfect times’ – i.e. high growth, balanced budgets, and falling unemployment. Now, with growth lagging behind and budget deficits growing, the last thing the financial markets need is a contracting fiscal policy to curtail demand.

Accordingly, due to the present low growth economic environment in Euroland, the recent political compromise seems to be interpreted by the financial markets as a probate remedy to foster an economic upswing. This morning German bunds sold off and both the French CAC40 and the German DAX reacted with moderate gains on the news.

With the tax stimulus package in Germany and the fiscal stimulus in France, the overall economic activity will likely pick up on the short term. The problem is, that deficit spending and a lack of financial discipline do not constitute a solution to the problem of an inflexible European economy.

The low growth in the Euro zone is the result of “Euro-sclerosis” – i.e. outspoken government intervention, high workers compensation, too many public employees and high taxes that have caused high unit labour costs and a shift of productive resources from the private sector to an unproductive public sector. These problems are especially present in France and Germany, whose political leaderships have stubbornly refused to deal properly with them.

Debt issuing to finance these inefficient economic structures is a short-term solution to a long-term problem.