The collapse of the Growth and Stability Pact highlights the economic challenges facing Europe. If it hadn’t been for the fast-falling dollar, there would have been little to cheer as the euro celebrated its fifth birthday earlier this month. Sudip Roy reports

As early birthday surprises go, it was hardly the most welcome. The decision by EU finance ministers not to punish France and Germany for breaking the rules of the Growth and Stability Pact in November was not the most auspicious way for the euro to begin celebrating its fifth birthday.

Europe’s single currency managed to shrug off the setback – it hit a new high against the fast-falling dollar shortly afterwards – and entered its sixth year in relatively good health.

But the decision not to enforce treaty law against France and Germany has left a bitter taste. And although no one seriously doubts the long-term viability of the euro, the in- cident has brought sharp focus to some key questions.

Is this the end of the Growth and Stability Pact? If so, what, if anything will replace it? Will the divisions precipitated by the crisis deepen – especially between those countries such as Spain and the Netherlands that wanted to enforce the treaty – and the two culprits?

What will this mean for Europe’s emerging nations that are about to join the EU? Will they be less disciplined in their fiscal policies? Will they be given the same flexibility if they break budgetary rules in the future?

Almost everyone is agreed that the pact in its current form is dead – something that is welcomed by most economists who saw it as straitjacket on European fiscal policy.

Its critics claim the pact failed to take into consideration other important economic indicators such as inflation. Nor, they say, did it take into account the impact of the economic cycle on a country’s finances.

These were the arguments put forward by France and Germany as part of their defence as to why they had violated the EU’s budget deficit limit of 3% of GDP for the third year running.

The worry, however, is that the collapse of the pact may undermine eurozone growth and set dangerous precedents. Timothy Ash, an economist at Bear Stearns, argued in a letter to the Financial Times that dissolution of the pact could lead to eurozone economies adopting a less disciplined fiscal policy.

Already the European Central Bank – with its new president, former Banque de France governor Jean-Claude Trichet, at the helm – has begun to make hawkish noises about raising interest rates.

If that happens, most economists believe Europe’s chances of generating long-term growth will be diminished. Far from freeing Europe’s finance ministers, the demise of the pact could lead to a dangerous policy vacuum with nothing to keep spending habits in line.

“The concern is that the latest fiscal adjustment will be the thin end of the wedge,” Ash wrote. “The Rubicon has been crossed. Further transgressions become that much easier in the future.”

That is why Europe’s policy-makers are desperately trying to come up with an alternative. The problem is finding a suitable one that suits all countries.

German finance minister Hans Eichel said in the aftermath of the pact’s collapse that he was open to discussing changes to it, but that he wanted any new arrangement to focus on a wider range of indicators than just the deficit.

“Economic policy is too complex to be boiled down to just one criterion,” said Eichel in an interview with newspaper Welt am Sonntag.

“The inflation target is very important. And if other countries have persistently higher inflation rates, we must look more closely at what to do about that.”

Of even more immediate concern than the economic issues are the political divisions opening in Europe because of the Franco-German stand. Countries outside of the big three (the UK, Germany and France) are no longer willing to sit subserviently on the sidelines; rather they are becoming more belligerent in their insistence for a level playing field.

As Gerrit Zalm, the Dutch finance minister, said: “Everything is now going to be more difficult. After what has happened, many countries are not going to put themselves in the hands of the big states.”

These divisions – between the big and small countries – were further sharpened at the Brussels summit in December when Spain and Poland refused to agree to a EU voting system that would have seen their powers weakened under a new constitution.

With France and Germany threatening to exact revenge by cutting their contributions to the EU budget, some observers are concerned about the EU’s long-term future.

Poland’s foreign minister, Wlodzimierz Cimoszewicz, fears the Union turning into an organization dominated by France and Germany. These splits have come at the worst possible time, given that the EU is to grow by 10 new members in May. The argument between Germany and Poland over voting rights is threatening to undermine the accession process.

Moreover the collapse of the Stability Pact will make it harder for the EU’s new members to garner support for domestic economic reforms.

“There is a real problem now that when you come up with plans to cut your deficit, people turn round and say ‘that is not what is happening in western Europe,’” says former Polish finance minister Grzegorz Kolodko.

Reform in central and eastern Europe is essential though. Ash at Bear Stearns says the core central European economies – Poland, Hungary, and the Czech Republic – are “grappling with bloated fiscal deficits [5-8% of GDP], mounting public sector indebtedness and, in the case of Hungary, a marked widening in the current account deficit [7-8% of GDP last year].”

He adds: “All three governments are trying to put policy back on track and meet the Maastricht convergence criteria for membership of the euro by selling austerity programmes to sceptical populations,” he adds.

“The fact that existing members of the eurozone appear willing to adjust the rules when it suits them hardly sends out the right messages.”

Ash concludes: “The impression is that the Maastricht criteria are an initiation test for entrants to an exclusive club. Once you are in, you can break the rules if you serve as members of the disciplinary committee. This is unlikely to carry much weight among the populations of central Europe who are seeing social, welfare, healthcare and education programmes slashed.”

French finance minister Francis Mer – speaking at a conference in Paris organized by Euromoney Institutional Investor following the collapse of the Stability Pact – denied that smaller countries would be treated differently.

“It’s not a question of size or political power in the EU, it’s a question of how to reach the target the best way,” he said, addressing France’s failure to meet the fiscal deficit target.

He added: “All economies [in the EU] are interdependent. It’s important for all that the large countries take measures without affecting present growth.”

Mer reiterated that France is committed to a tighter control of its public finances and that the deficit will fall below 3% of GDP by 2005 and will be wiped out by 2007. “I’m well aware of the long-term issues we must face up to. Escapism is not an issue,” said Mer.

European leaders will hope that the recent squabbles will prove to be nothing more than a difficult phase. But, as French president Jacques Chirac says: “Europe’s history is one of a series of crises overcome. We progress from crisis to crisis.”