David Marsh

The currency with a hole in it

David Marsh sees the political case for joining the euro, but excessive spending has revealed the fundamental flaw - no one is really in charge

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The drama of the European single currency has had more than its fair share of theatrical twists and turns. The prize for the most spectacular transformation in the long-running Folies Maastricht must, however, be awarded to the quaintly named Stability and Growth Pact. This character entered Act 1 as a strutting hero, but now - several years into the plot - has been unmasked as the villain of the piece, destined shortly to be skewered behind an arras and then hauled off into oblivion. The Pact's demise may dampen the spirits of euro enthusiasts, but it creates a chance for Britain to obtain more influence on European policies while maintaining its position outside the euro.

The dumping of the Pact - designed to shore up the euro by setting limits on budget deficits and government borrowing - has been accomplished by no less a personage than Romano Prodi, the president of the European Commission, who last week said it was 'stupid'. Mr Prodi, who as Italian prime minister in the late 1990s was largely responsible for Italy's achievement of joining Economic and Monetary Union (EMU) in 1999, has a formidable reputation for emotional outbursts. As head of government he had a penchant for personally telephoning the Financial Times to complain about editorials berating Italy's economic policies. Now he has surpassed himself. With one blow against the economic rules underpinning the European currency project, Mr Prodi has maddened the monetarists, fortified the fiscal faint-hearts, and deepened doubts among all those (particularly in Britain) who had wondered whether the euro could ever prosper.

On one level, Mr Prodi, with his plea for 'intelligence' in interpreting the fiscal limits, is simply calling for common sense. Ever since the Pact was forged in 1997, two years before the euro's birth, many economists have argued that, during a time of slow economic growth such as that facing Europe today, rigid borrowing rules could risk turning downturn into depression. When economies falter, government borrowing automatically widens in response to lower taxation and higher spending on unemployment benefit. To reduce deficits under such circumstances by raising taxes or cutting spending, many economists argue, is economic and political suicide. The French government, which had already said it was not taking seriously the plan for the European Commission to impose large fines on countries borrowing more than 3 per cent of Gross Domestic Product, was the first to hail Mr Prodi's statement.

There is more to it than that, however. At a deeper level, the European Commission president's plain speaking has exposed an alarming hole in the heart of Europe's monetary arrangements. The Stability Pact (the word 'Growth' was added later to make it sound more attractive) was invented by the German government as a centrepiece of the new economic order. There were two reasons for the Pact. First, it was a political device to assure the German people that irresponsible fiscal policies from free-loading southern countries such as Italy would not subvert the new currency that was about to replace the deutschmark. With the fabled Bundesbank no longer in charge, the Germans were asked to believe that a pan-European spirit of economic rectitude would take over as the euro's guardian. Second, the Pact marked a step towards the greater degree of political union that many politicians and commentators - both euro supporters and sceptics - believe is necessary to safeguard the new currency. Now, however, the curtain protecting the euro from fiscal debilitation has been drawn aside - and, Wizard of Oz-like, the great sustaining force seems to be more scrawny than many had hoped or realised. An essential and dreadful truth at the centre of the Maastricht dilemma has been exposed for all to see. The centralised control of government borrowing necessary to secure the euro is increasingly unacceptable to European governments and electorates.

The new state of affairs is most visible in Berlin. The Germans, once diehard supporters of fiscal virtue, have given discreet but powerful backing to Mr Prodi's volte-face. Buffeted by unemployment of four million and led by Gerhard Schroeder, the re-elected Social Democrat Chancellor who has never been a friend of the euro, the Germans are no longer in any mood to impale themselves on the spikes of a hard currency. Mr Schroeder, who faces a deficit this year that will badly overshoot the 3 per cent limit, has paid lip service in public to the Stability Pact, but has long dropped hints that he wants it toned down. Mr Schroeder's new economic tsar, the hard-faced former journalist Wolfgang Clement (previously prime minister of the most populous state of North Rhine-Westphalia, just sworn in as minister for economics and employment) now wants growth