Does Europe need a new Stability Pact?

What is the Stability and Growth Pact? It was part of the rules governing the creation of the euro. It forbids any member state from running a fiscal deficit of more than 3% of GDP in any one year. The aim was to stop countries borrowing too much. Usually, when countries borrow too much, inflation rises and they are penalised with higher interest rates and falling exchange rates. The danger was that, in a monetary union without rules, some countries would borrow too much, driving up rates across the eurozone.

Whose idea was the Pact?

The Germans. The idea was put forward in the mid-1990s by German finance minister, Theo Waigel, as a way of selling economic and monetary union to a sceptical German electorate. Many Germans were unwilling to put at risk their hard-won financial stability by pooling their economic fortunes with countries such as Italy that had a record of financial instability. Indeed, the purpose of the Stability Pact was to keep Italy and other southern European countries out of monetary union.

Why has the Pact now been suspended?

Because Germany and France are running budget deficits this year in excess of 3% of GDP. Under the terms of the Pact, this would be permissible only if a member state had suffered a fall in GDP of 0.75% or more in a single year. But this is not the case with Germany and France: their problem is that they have suffered several years of sluggish growth, weak tax revenues, rising unemployment and higher social spending. Germany's budget deficit is likely to rise to 4% of GDP and beyond, the biggest it has been in 30 years. The European Commission demanded France and Germany make significant cuts in their spending or face fines under the "excessive deficit procedure". But France and Germany refused to make the cuts demanded. Instead, they called upon member states to suspend the Pact.

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How have the markets reacted?

The markets took the collapse of the Pact in their stride. The euro this week even rose to new highs against the dollar. The Pact's demise had been expected and was even welcomed. No economists thought it wise to cut government spending to the extent required by the European Commission at a time when the eurozone economy is struggling, while imposing fines would have made a difficult situation worse. "The Stability Pact needed to be killed off," Robert Lind of ABN Amro told the Financial Times. "It should have been done years ago. The only shame is it that is has taken so long to get here." Even the President of the European Commission had recently called the Pact "stupid". Many economists argued that higher borrowing was needed to boost demand in the eurozone. They argued that the real villains were not the French and German governments, but the European Central Bank for keeping eurozone interest rates too high during the downturn.

So who is complaining?

Smaller eurozone members, including Austria, Finland, the Netherlands and Spain, were opposed to the suspension of the Pact. Many have been forced to introduce painful austerity measures to comply with the Pact. The Portuguese were forced to introduce drastic budget cuts to comply with the terms of the Pact, thereby throwing their economy into recession. These smaller countries resented being forced to comply with rules that bigger countries just ignored. There is also a risk that the failure of the Pact will undermine the commitment of central and eastern European accession states to economic reform. The Czech Republic, Hungary and Poland are all grappling with fiscal deficits of up to 8% of GDP. And they are all trying to introduce austerity programmes to their voters in an attempt to meet eurozone convergence criteria.

So is the Pact now dead?

No. In fact, much of the Pact is due to be incorporated into the new European constitution. The present draft of the treaty will reaffirm the rules and procedures of the Pact, including the 3% rule and the excessive deficit procedure of fines for countries that breach the Pact. Almost everybody agrees that these rules are too rigid and a new, more flexible, framework is needed. The problem is that to change the rules of the Pact would require unanimity, which would be almost impossible to achieve. Moreover, redrafting the new constitution would put paid to any hopes of finalising the treaty later this month. Francis Mer, the French finance minister, has proposed that the constitution be adopted in its current form, but that member states agree to change the stability Pact later. But the fear is that, in the interim, the eurozone will be left with a fiscal free-for-all.

What will replace the Pact?

A monetary union comprising very different economies must have some binding mechanism for co-ordinating policy, since a voluntary co-operation between EU members on economic policy that lacks an enforcement mechanism is unlikely to last long. The UK Government wants a solution similar to Gordon Brown's "golden rule", in which there are no fixed annual limits on borrowing, but individual governments promise to balance their budgets over the course of an economic cycle. But this is unlikely to be acceptable, since it is impossible to say when an economic cycle begins and ends. The truth of the matter, says Stephen King, managing director of economics at HSBC, is that "in a monetary union, the only sensible long-term solution is a federal fiscal authority". But nobody wants to admit that yet.