The EU needs a flexible pact

The decision of EU finance ministers in February 2002 to ignore a Commission proposal to warn Germany and Portugal over the level of their budget deficits has jeopardised the credibility of the Stability and Growth Pact. But Ecofin's inaction does not mean, as some have suggested, that the Pact has been fatally undermined. Indeed, the dispute could provide a much-needed opportunity to refine the workings of this key institutional feature of economic and monetary union.

The political sensitivities that drove European finance ministers to reject the Commission's proposal are easy to understand. For the German government, which faces an election in September, the Commission's stance was an unwelcome criticism of its economic management record. Other major euro-zone countries such as Italy, France and Spain were prepared to support the German position, aware that they could be in the dock in the future. Only a number of smaller EU countries - including Belgium, the Netherlands and Austria - objected. These countries claimed that Germany was being accorded a special status as a large country.

However, these short-term political factors conceal a more fundamental philosophical debate about the structuring of the Pact. Several EU governments, led by France but with strong backing from the UK, have long claimed that the Pact is too mechanistic and fiscally restrictive. They argue that the Pact as it currently stands fails to take fully into accord other important budgetary factors such as government investment, overall debt levels and the position of the economic cycle.

Even those who support a rigid interpretation of the Pact accept it possesses flaws. The 3 per cent deficit figure, which triggers punitive action, is arbitrary. Wim Duisenberg, ECB President, admitted, as much when he told the European Parliament in January that what should really be assessed is the 'underlying' budget performance rather than a nominal measure of the deficit. The real divide seems to be between those such as the Commission and the ECB, which was to uphold the existing Pact rigorously, and those member-states, which want to adopt a more 'flexible' approach.

However, there is a danger that unless EU finance ministers quickly establish the parameters of this more flexible approach, the Stability Pact could become a byword for political opportunism. The finance ministers should consider introducing a number of straightforward reforms to clarify their future approach to budget scrutiny.

A relatively simple change, and one that the EU has already agreed to introduce for its Broad Economic Policy Guidelines, would be to state clearly that the primary focus of the Stability Pact is the structural - or cyclically adjusted - measure of the budget deficit. A structural measure of the deficit has the benefit of being less vulnerable to the whims of the economic cycle. This should ensure that governments are not penalised for minor breaches of the 3 per cent ceiling when the underlying budgetary position is improving.

Secondly, finance ministers should make more explicit how they intend to treat investment expenditure and overall debt levels. The Stability Pact already contains reference to the need to consider these factors, as well as the nominal budget deficit. However, there is no indication as to how debt and investment should be treated in the Stability Pact process. The Commission has narrowly interpreted the Pact's provision that governments must achieve a 'balanced budget' over the medium term, precluding any room for borrowing in order to finance investment.

The EU should therefore consider adopting a variation on the 'golden rule' for public finances employed by Gordon Brown in the UK. This rule states that over the course of the economic cycle, current revenues should match current expenditure. Furthermore, borrowing for investment should be permitted, provided overall government debt levels remain at a 'stable and prudent level' - currently defined as around 40 per cent of GDP. This would enable governments with a strong underlying budgetary position to borrow for investment purposes, without breaching the terms of the Pact.

Both these sensible refinements of the Stability Pact would enjoy widespread support in the financial markets. As the suggested changes would only reinterpret the existing Pact, they require simply the assent of Ecofin and the Commission, rather than a full-scale treaty change.