The EU Debt Crisis Why Europe's Avoidance of Automatic Penalties Is a Mistake

Germany and France have reached agreement on the future of European Union debt penalties. Economists are horrified, and say that Chancellor Merkel and President Sarkozy haven't learned a thing.

German Chancellor Angela Merkel and French President Nicolas Sarkozy: "Obviously not learned a thing."

German Chancellor Angela Merkel and French President Nicolas Sarkozy: "Obviously not learned a thing."

By in Frankfurt

One of the cardinal rules of politics is that whenever a suboptimal decision is made, it should be praised all the more. True to this motto, on Tuesday senior Finance Ministry official Steffen Kampeter described the latest compromise as a "great success."

The reason for the jubilation: Chancellor Angela Merkel and French President Nicolas Sarkozy had announced the previous evening an agreement to deal with and penalize nations that break European Union rules regulating national budget deficits. It is an agreement that paves the way for a reform of the much criticized EU Stability Pact, which EU finance ministers had been brooding over at the same time in Luxembourg. "Without a functioning German-French axis there wouldn't have been an agreement yesterday," said Kampeter.

Experts are more critical of the proposed agreement. "Politicians have obviously not learned a thing from the crisis," Klaus Zimmermann, head of the German Institute for Economic Research, told SPIEGEL ONLINE. The new rules only made "marginal steps forward."

Experts say the only success that can be claimed is that any agreement at all was reached on debt regulations within Europe's common currency zone. For a long time a consensus could only be reached on one point: that a debt crisis like the one in Greece -- which for a time seemed to threaten the entire euro zone -- must be avoided in the future. This was to be achieved with the help of a new improved stability pact. Now, though, opinions are divided over what reforms are necessary.

Only one thing seemed clear: things couldn't go on as before. The so-called Maastricht criteria -- which euro zone member states and those aspiring to the common currency must adhere to -- proved themselves largely ineffective within the first years they were in use. According to the criteria, countries must keep their annual budget deficits below 3 percent of GDP and public debt cannot be more than 60 percent of GDP.

Automatic Penalties?

Many observers blame the failure of member states to stick to these criteria on an ineffective punishment mechanism. Up to now, if a country accumulated too much debt, sanctions had to be decided upon by the European Council of Ministers. It's a complex process. In practice, this meant that member states running up large budget deficits had little to fear, even if they crossed the debt limit year after year.

As a result, some countries went ahead and accumulated debts without restraint -- like Greece. Once the country was on the brink of collapse, many things suddenly became clear: EU stability regulations had to be fundamentally changed. Germany, for example, began calling for automatic penalties for those who had breached EU debt limit regulations.

But other EU countries put on the brakes. Despite all the existing problems, France wanted politicians to remain in the driver's seat. In other words, it wanted penalties for offending member states to be decided on a case-by-case basis.

Proposed Reforms
The finance ministers of the 27 EU states have agreed on more stringent supervision of budget deficits intended to prevent Greek-style debt crises and threats to the euro. A political declaration is to follow the new legislation.
New Early Warning System
An early warning system will be installed to detect national economic imbalances in time to prevent a crisis. The real estate bubbles in Ireland and Spain went on a long time without reaping consequences at the EU level. Penalties can also be issued, but only for countries within the euro zone.
Debt Supervision
European debt supervisors will also be paying much more attention to the gross government debt of member states, which will not be allowed to exceed 60% of GDP. A country that has reduced its debt ratio below the three percent threshold may, for example, remain in deficit proceedings if the total amount of debt remains too high.
Penalties have to be passed by a two-thirds majority of EU finance ministers. But the process of trying to impose new sanctions could be affected by the "reverse majority" rule. In practice this would mean that any recommendations of the European Commission to impose sanctions on a member state could be contested if rejected by a qualified majority of finance ministers. This will place a constraint on the veto rights of member states. The European Stability Pact already laid down financial penalties that in practice have never been imposed.
Euro countries with deficit problems may be called on to put down a "deposit" in Brussels. The European Commission had proposed 0.2 percent of economic output as an amount - the proposed sum of the sanctions, however, was not mentioned by the ministers. Diplomats reported that the 0.2 percent figure was received "without outcry." The deposit can be converted into a penalty in the course of deficit proceedings against a member state.
European countries entering deficit proceedings in the future will have six months to "put the house in order" -- that is bring their budgets back on track. If the state fails to do so within this time frame it will face penalties.
Amending Treaties
Germany and France are insisting that the EU looks at altering EU treaties during a second round of reforms to financial regulations. Among other things, the aim will be to create a lasting mechanism to prevent states going bankrupt.
Given the disparity of the two positions -- and the need for both sides to save face now that an agreement has been reached -- it should come as little surprise that the politicians involved have engaged in a bit of verbal acrobatics. Sarkozy, for example, announced on Monday that penalties are to be imposed "more automatically" in the future.

Jörg Krämer, chief economist at Germany's Commerzbank, isn't so sure. "In essence, it will still be a political procedure in the future," he told SPIEGEL ONLINE. The problems inherent in Maastricht from the very beginning won't be resolved, he said.

Even the chief economist of the European Central Bank, Jürgen Stark, criticized the Franco-German compromise. "If these reports are confirmed, the findings of the working group will fall far short of the Commission's proposals on this point, which foresaw that sanctions on states who break the deficit rules would be more automatic," Stark told the German newspaper Die Welt. The central banker called on European governments to take more decisive action. "European politics has to draw some clear and tough conclusions from the budget crisis," he added.

A Realistic Chancellor

Still, the punishments that are to be available in the future sound quite harsh on paper. A worst case scenario foresees the suspension of voting rights for persistent flouters of deficit rules. Other penalties involve states being forced to park money with the EU which could later be converted into a fine, should they not turn around their profligate ways. This penalty could only be vetoed by a majority of the EU's Council of Ministers. At other stages of the proceedings, the Council of Ministers would be able to impose penalties with a qualified majority.

For economist Krämer and many of his colleagues, another aspect is more important. Under the new proposals, the initial decision to open deficit proceedings in the first place would remain with the individual member states. The effect will thus be limited: "A club based on consensus like the European Union will be reluctant to chastise its individual member states," said Krämer.

Has Merkel had the wool pulled over her eyes? It could be that she was just being realistic. Many experts think radical reform of deficit regulations wouldn't have been possible anyway. That's simply because all member states, and probably all their parliaments, would have had to agree to an alteration to the Stability Pact treaty, points out Stefan Homburg, a professor at Leibniz University in Hanover. He thinks it is "completely unimaginable" that a heavily indebted country like Greece would voluntarily submit to such rules.

From this perspective, Merkel has only dispensed with the impossible -- but has still managed to force a concession from Sarkozy in another area. In addition to tightening the Stability Pact, the chancellor had another issue close to her heart when she met her French colleague: German demands for insolvency regulations for faltering euro-zone states.

Not Enough to Turn Things Around

Current statements are not at all explicit on the subject, but both France and Germany say the Lisbon Treaty must be changed to allow "the establishment of a robust crisis management framework." This should also include an "appropriate level of involvement from private creditors."

Is this a first step towards an orderly debt restructuring procedure? German Institute for Economic Research head Zimmermann, for his part, is hoping just that. Even if the Stability Pact does work better than expected in the future, despite all the criticism, it won't be able to prevent debt crises. Spain and Ireland have weathered the quakes in the financial markets fairly well -- and are still at high risk. There must be a mechanism to allow countries to restructure their debt, Zimmermann believes. "If an orderly debt-restructuring procedure for states also falls through, then the US can celebrate," he says. "That would mean the stability of the euro is under threat."

Krämer has a similar view. He thinks that, since the decision to bail out Greece and the launch of a rescue package for other states, the euro zone has been on the path to becoming a "transfer union" in which stable states have to pay for the weaker ones. The proposals now on the table to reform the Stability Pact, he says, aren't enough "to turn things around."


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