Monday, March 21, 2005

Maastricht for thee but not for me 

The finance ministers of the European Union have agreed to let France and Germany off the hook for missing its limits for budget deficits under the rules that created the euro. The rules, created back in 1990 under the Maastricht Treaty and then better codified in the Stability and Growth Pact in 1997 (SGP) which led to many divisions in Europe ever since, called for Germany and France to face sanctions for violating the 3% limit on budget deficits. Back in January, Gerhard Schroeder told the EU to butt out of its affairs:
The stability pact will work better if intervention by European institutions in the budgetary sovereignty of national parliaments is only permitted under very limited conditions.
This has been going on for awhile. The pact virtually ended last year when this communique from the EU to Germany and France was greeted with virtual hostility from Schroeder and Jacque Chirac. The EU Council, which is a political organization, would not accept the report in November 2003 from the European Commission on the violations of the SGP by Germany and France. It led to a lawsuit which the EC won in part, and subsequently a paper was written that would have allowed for some more flexibility in how the EC enforces the SGP.

The European Central Bank is now caught in a bind. While they can express concern over the busting of the deficit limits, they have little ability to do more than hope the EU leaders tomorrow night tell their finance ministers to go back and try again. That's unlikely. The finance ministers signaled by their vote a lack of political will to enforce the SGP which holds European monetary union together. The ECB is now caught with either a declining euro and rising inflation in Euroland or will react with higher interest rates to hold inflation and the euro in check. The latter would also have the effect of offsetting any expansionary effects of the tax cuts or spending hikes Germany and France wish to use to boost their lagging economies. The latter course would be suicide for the ECB: it cannot win a conflict with the EU Council. As Captain Ed notes, the bond markets are already betting on inflation and a declining euro.

The impact is also on countries in eastern and central Europe seeking accession to the EU. Oxford Analytica noted last month that it's unlikely that loosening the SGP for the big fish of Europe will help those other fish hoping to jump into the Euro pond. This is likely to be the biggest problem facing countries seeking accession, and France and Germany have bascially told the joiners that they don't have to play by the same rules. The other impact now will be the effect of any decline in the exchange rate on the costs of joining Euroland.

UPDATE: Reader Brian Ferguson notes this post from my friend John Palmer, in which Ferguson is quoted as saying:
I think this is what's known in macroeconomic theory as a time-inconsistency, precommitment problem. Which in general parlance means that a committment from a politician is not worth the paper it's written on.

Yup. And I agree with John that this could signal the bottom on dollar devaluation.