European Union members approved the Growth and Stability Pact in 1997 as part of the Maastricht Treaty process. The pact's purpose was to support the fledgling euro and to keep fiscal miscreants in line. The accord was drawn up at the insistence of Germany (and the Bundesbank, the model for the European Central Bank) in order to whip into line those countries thought to be fiscally irresponsible. The pact's tight fiscal rules helped underpin the creation of the euro. Governments were told to balance their budgets in the medium term - a feat achieved so far by 11 of the 15 members - and were forbidden to run a deficit of more than 3 percent of gross domestic product. The pact was born during a period of strong growth but is growing up in a period of faltering growth, and the soaring welfare costs and falling tax revenues that go with it.

Some history
At issue from the start was how to maintain the stability of a single currency that countries use for their separate economic policy. Germany, which in the 80s had a thriving economy and a sound budget, did not want to be dragged down by chronic debtors like Italy. If one wants a common currency, fiscal policies must harmonize somehow. The countries finally agreed at Maastricht to set out strict requirements that members had to meet before they could be admitted to the euro club. Among the requirements, they must balance their budgets by 2004 and they cannot run deficits of more than 3 percent of gross domestic product.

Those rules were enshrined in the Stability and Growth Pact, which is administered by the European Commission. Countries that fail to heed the rules are supposed to be disciplined with warning letters, and then with fines equal to 0.5 percent of gross domestic product. Monetary policy was given to the European Central Bank (ECB), which regulates the money supply and whose primary goal is to keep inflation in check.

In its early days, the pact seemed the perfect antidote for decades of profligate government spending. When Italy got under the deficit ceiling, the event was hailed as an example of how the European Union could bring out the best in its members. The pact provided a cover for leaders to cut spending for the "greater good of Europe". Today, 7 of the 12 euro countries are running surpluses, and those countries that have complied with the rules understandably oppose changing the rules.

So what's the problem?
The pact was created when European economies were basking in 2-plus percent annual GDP growth and falling unemployment amid the global economic boom of the late 90s. The current slowdown has exposed the fault-lines between Germany, France and Italy on one side, and smaller countries on the other side that have stuck to the pact. Critics have derided the accord for its emphasis on stability rather than growth. France and Germany now criticize the pact as too inflexible in times of economic weakness. According to Keynesian theory, governments should boost public spending when the economy falters.

The rules that were designed to spread fiscal discipline across the European Union no longer produce the same fear they once did. It is not just Italy or Portugal - traditionally Europe's more wayward members in terms of budgetary discipline - that are clamoring for reform. Most governments agree that in these times of low inflation and sluggish growth, the pact's strict rules are simply inappropriate.

Over the past few months, the rules have been bent to allow Germany, Portugal, France and Italy more time to balance their budgets. Germany and Portugal have been given more leeway because of worsening public finances and poor economic growth. But France and Italy have laid down blatant challenges to the pact, demanding more time so they can implement tax cuts promised in election campaigns.

There are many, like some European finance ministers, who believe a loosening is vital for coping with the downturn. Furthermore, few believe the euro has been put at risk by the exceptions made for Germany, France, Italy and Portugal, although they are watchful of how the pact might be reformed in future. But a more flexible pact, one more in tune with the cyclical needs of member economies, might not be a bad outcome. The problem is how to make it more flexible without creating a free-for-all of irresponsible government spending.

Bottom Line
The pact was supposed to work by deterrence alone. The possibility of punishment was so terrible that the threat alone would be enough to ensure compliance. It failed. France has brushed aside threats and EU finance ministers proved merciful when meting out punishment to Germany and Italy.

The Stability and Growth Pact was viewed as a tool to make eurozone fiscal policy sustainable. By forcing governments to keep their budget deficits below 3 percent of GDP, the pact would limit the ratio of public debt to GDP to less than 60 percent. As recently as last week, the ECB stressed the pact's indispensability for monetary union but stopped short of warning against efforts to modify it.

The euro's effect on Europe is hard to measure, in part because notes and coins have circulated for only 10 months and because the global downturn has swamped other economic indicators. But Europeans of all stripes say the euro has already helped by eliminating foreign exchange uncertainties and by making it easier to compare prices across borders. Inflation, the old curse of Europe, is a distant memory. Some argue that the monetary union's greatest achievement is that it imposed order on Europe's once-volatile economies. Guardians of the stability pact say this order would be lost if the rules are not enforced.

Coda
Members of the eurogroup of finance ministers (Ecofin) are meeting this week to discuss, among other things, the beleaguered pact. Finance ministers from France and Italy emphasized the need to make the pact more "flexible", while smaller states, such as Belgium and the Netherlands, are infuriated by the impression that there is one rule for big countries and another for small ones. They ended their meeting Monday night stressing that there would be no change to the way the pact is implemented despite a Franco-German initiative to adapt it. However, the Commission head called for an "intelligent" application of the pact and for a strengthened Commission role in monitoring it. The increasingly grim economic situation makes such an approach all the more necessary.

Anne D. Picker, International Economist, Econoday