France and Germany break the rules

The EU fiscal rules, that is. Each country using the euro is supposed to maintain a budget deficit of less than three percent of gdp. Earlier this week France and Germany announced that they had no real intention of meeting the target, here is the full story. What are the implications of this?

1. The euro hit an all-time high against the dollar, clearly the markets were not rattled and largely expected this outcome or some version thereof.

2. Many of the smaller countries in the EU are upset, most of all Netherlands, Austria, Finland and Spain, all of which went through painful fiscal restructuring themselves. It appears there are two sets of EU rules, one for France and Germany, one for everyone else.

3. France in essence has given up on its dream to provide significant leadership for the other EU countries, and can no longer expect to lead by example. Otherwise France and Germany will suffer no real penalties from this.

4. France and Germany have shown that they simply will not make significant spending cuts, no matter what.

5. France and Germany were right not to raise taxes to meet the targets.

6. The three percent rule is effectively dead. The rule was a bad idea in the first place. Rules based on strict targets, with trigger penalties kicking in at a predetermined level, are likely to fail in democracies (remember the Gramm-Rudman Act, first it was to control deficits, then spending, ha-ha?). The boundary lines are arbitrary, and if they start to matter the penalties are seen as arbitrary and unfair by voters. So no penalty is accepted and then the targets fall apart.

7. The old written rule mandating three percent will not be revised. The new system in practice will likely take the form of loose ranges, with penalties of moral suasion applied by other EU members.

8. The real question is what will happen when one of the smaller nations thumbs its nose at France and Germany someday, over some EU agreement, and then claims exemption from the relevant penalties. Until then, stay tuned…