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EU Proposes Looser Deficit Limits

New Rules Would Exempt
Countries on 16 Grounds;
Bowing to France, Germany
By JOHN MILLER and G. THOMAS SIMS
Staff Reporters of THE WALL STREET JOURNAL
March 8, 2005

BRUSSELS -- The European Union unveiled a broad proposal to loosen budget rules for its 12 euro-zone countries, in a compromise that some economists warn could raise interest rates and eventually harm the stability of the euro, the world's second-most used currency after the dollar.

Jean-Claude Juncker, who holds the EU's rotating presidency, proposed the rules, which would allow a country to be exempted from the budget-deficit cap for any of 16 reasons. The cap, equal to 3% of a nation's gross domestic product, was imposed when the euro was launched six years ago to glue together the fiscal policies of otherwise sovereign nations.

Mr. Juncker, who also is Luxembourg's prime minister, earlier this year promised to strengthen Europe's budget rules, which also would apply to 10 new EU members planning to join the currency over the next decade. He brushed aside suggestions from Germany and France -- two of Europe's biggest overspenders -- for a number of loopholes to allow larger deficits without facing penalties, so they can spend more-freely to boost their sagging economies. He declared that German Chancellor Gerhard Schroeder, who was agitating for looser rules, "is not in charge of the European economy."

But after a month of bilateral meetings with leaders across Europe, Mr. Juncker proposed a long series of mitigating factors to be considered in enforcing the rules, raising questions over whether they could be enforced at all. According to a draft copy that finance ministers were debating last night, the factors include how well a country reduces its debt and pares spending in good economic times, whether it is making progress reforming its pension obligations, whether it suffers from negative exchange-rate developments, and whether it is increasing research and development spending. Many were considerations sought by France and Germany.

In an addition that appears to specifically benefit Germany, which took on the economic problems of unifying with East Germany 15 years ago, they also include "change in the perimeter of general government." And instead of the only exemption that now exists -- a 2% shrinkage in GDP -- they would take into account any "negative GDP growth," such as the 0.2% drop Germany experienced last quarter.

The proposal also requires smaller deficits in good economic times to promote spending discipline. But if adopted in this form, analysts say, the plan will give big EU countries more power to spend as they please in bad times without fear of serious challenge from the European Commission. "It leaves the judgment to the leaders of large countries, who have the political weight," said Lorenzo Codogno, an economist for the Bank of America in London. Germany and France will be under "zero pressure" to cut their deficits in the short term, predicted Daniel Gros, director of the Center for European Policy Studies, a Brussels think tank.

The Juncker proposal also comes as opposition by France and Germany has scuttled the commission's plan to jump-start growth by integrating Europe's market for service industries, casting renewed doubt on the ability of Brussels to shape a common European economic policy.

Credit-rating agency Standard & Poor's said yesterday that a weaker pact and budget deficits could trigger debt downgrades for individual euro-zone countries, resulting in higher debt-servicing fees that could further cut into economic growth. It also warned that the European Central Bank might have to lift interest rates to offset the looser fiscal policy.

The ECB has repeatedly opposed moves to loosen the pact. "The credibility of the excessive deficit procedure needs to be fully preserved," ECB President Jean-Claude Trichet told journalists last week. "This is not only fundamental for macroeconomic stability and cohesion in the euro area, but also for confidence and growth prospects."

Opinions from the euro-zone's finance ministers about Mr. Juncker's proposal were sharply divided, with small countries -- in particular the Netherlands and Austria -- taking a hard line against watering down the rules that many economists consider a key to underpinning the euro. Dutch spokesman William Lelieveldt said his boss, Finance Minister Gerrit Zalm, wouldn't give up his fight for strict rules.

The pact has been in a shambles since Germany and France -- which insisted on the strict limits in the first place -- avoided any penalty last fall for persistently breaking the 3% rule. In total, half of the euro-zone countries are breaking or have broken the pact -- partly because of a long economic slump over past years, partly because they didn't cut spending. That has raised pressure to overhaul the rules.

Mr. Schroeder and French President Jacques Chirac met in Germany yesterday to coordinate their approach to the summit and re-emphasized their commitment to looser rules. "We want [the pact] to be applied more flexibly so that we are able to give a boost to our economies," Mr. Chirac told reporters. Mr. Schroeder is scheduled to meet Mr. Juncker today in Luxembourg.

Meetings continue today in Brussels. Failure among finance ministers to find common ground risks a political free-for-all at an EU-wide summit of heads of state and government in two weeks, when leaders had hoped to sign off on the new rules. Most EU finance ministers discount the latest proposal as shaky economics, said a top-ranking EU official. But the official added: "This is no longer about sound economics, it's political horse-trading."

Write to John Miller at john.miller@dowjones.com1 and G. Thomas Sims at tom.sims@wsj.com2