You and your friends are having regular games nights. Every week, you meet to play Monopoly. And almost every week, one of your friends cheats. They manipulate the dice. They deliberately take the wrong card from the Community Chest. Some players even steal from the bank.
As the weeks pass, even the hitherto honest players lose respect for the rules. And so, they begin cheating as well. As the game progresses, it becomes almost lawless. A little cheating is now accepted, if not expected. At least as long as players don’t make it too obvious.
After a long time of playing this way, you and your friends face a dilemma. Is it time to return to the proper rules? Or would it be better to acknowledge that the rules will never be enforced properly? Maybe you should negotiate with the worst offenders about how much dishonesty they are allowed?
This is roughly what is happening in the Eurozone right now. The countries that use the Euro currency need to decide, not about Monopoly rules, but about the rules associated with the Euro.
It is not as if there are no such rules. It is just that these rules have never been enforced.
Many countries, most notably Germany, the Netherlands and Austria, were sceptical when the Euro was introduced. Many of their citizens feared they would be exchanging their stable currencies for something much weaker.
In response to such concerns, the Maastricht Treaty and later the EU’s Growth and Stability Pact, created a set of rules to govern the finances of Euro member states. Their budget deficits could not exceed three percent of economic output. Public debt should not exceed 60 percent of GDP. The inflation rate should not be higher than 1.5 percent in the three states with the lowest inflation rate.
There were supposed to be substantial fines for breaking these rules. The penalty for countries exceeding the 60 percent debt limit would be 5 percent of the extra debt, up to half a percent of GDP.
On paper, all of this seemed cogent. The problem was that, in practice, no-one ever played by these rules.
The first test of the Eurozone’s fiscal rules came in 2002 and 2003 when both France and Germany breached the deficit limit. However, the EU’s finance ministers did not dare to punish these two economic heavyweights. In any case, they knew their own countries might be next.
With that, the precedent was set. From then on, there would always be good reasons to turn a blind eye to rule breaches. When history threw up severe crises, like the Global Financial Crisis, Covid-19 or Russia’s attack on Ukraine, that made justifying the breaches even easier.
As a result of the pandemic, the EU suspended the Growth and Stability Pact in 2020. It is not scheduled to come back into force until 2024.
One has to put it this bluntly: the whole edifice of the Eurozone’s Growth and Stability Pact has not only become obsolete. It has become a farce.
Public finances in many European countries have deteriorated so much that a return to the Maastricht conditions is unrealistic.
France’s debt is not going to fall below 60 percent of GDP (it currently stands at 112 percent). Italy would be happy with a budget deficit of 3 percent (it will have a deficit of about 5 percent this year). And Greece, despite its relatively successful consolidation path, is still sitting on public debt three times greater than the EU’s ceiling.
So, what should the Eurozone do?
The EU Commission is caught in a Catch-22 situation. It could accept that its old rules will never be met, let alone enforced.
However, that would send a terrible signal to the financial markets. It would also dissuade member states from consolidating their public finances.
The alternative is a return to the old Growth and Stability Pact rules. But these are so far from reality that markets would not take such an announcement seriously. Governments in Europe certainly would not, either.
And then there is an additional political complication for the EU Commission. Germany and the Netherlands have very different incentives than, say, Italy and Greece. But all countries need to agree to the new rules. Good luck with that.
In these circumstances, the EU does what it always does: it reaches a flawed compromise.
The three percent deficit and 60 percent debt limit rules remain, in principle. There will be no sanctions, however, if a country can convince the Commission that its debt development will be managed prudently and the Commission agrees to that.
It is a typical EU compromise. On the one hand, the Commission offers more flexibility to heavily indebted countries, allowing them to get their finances in order over extended periods of time without fear of punishment.
On the other hand, the Commission threatens to punish countries that deviate from previously agreed paths of fiscal consolidation. With the EU’s track record, however, one might remain sceptical whether such penalties would ever be enforced.
It is not even clear how strict the EU Commission would be in future negotiations of debt reduction paths.
If, for example, the French government presented an unambitious fiscal programme to Brussels, how likely is Paris to be rebuffed? If past experiences are anything to go by, France would not have much to fear.
The situation will remain unsatisfactory. To make the Eurozone more stable, it would be desirable to have stricter and enforceable rules. But because it is so unstable, no such rules can ever be introduced. And every new rule will automatically be tainted because of the EU’s history of never enforcing anything.
You would not run a games night with your friends like that. And if you did, chances are at least some of your friends would leave and spend their nights with someone else or on their own.
That is the risk the Eurozone runs, too.