http://www.opinionjournal.com/extra/?id=110004425 CONTINENTAL DIVIDE Humpty Dumpty's European Adventure France and Germany shatter the EU. BY MELVYN KRAUSS Saturday, December 13, 2003 12:01 a.m. The current French-German axis is proving a nightmare for European unity. Not only has it fractured Europe over its foreign policy; it has split Europe's big countries from its small ones by demanding special status for French and German budgetary deficits. The key question underlying Europe's now-defunct Growth and Stability Pact--that budget deficits for all countries using the euro be kept under a 3%-of-GDP limit--always has been "whether the big countries would be willing to sacrifice any measure of national sovereignty for the European good" as one senior European Central Bank official put it. After Europe's finance ministers refused to punish France and Germany last month for their excessive deficits, he has his answer. Trust has been decimated. Anger overflows. The small countries feel tricked. Should European integration falter, the consequences for the United States as well as Europe could be dramatic. How long will the smaller countries continue to sacrifice for the European good when they have been told, in effect, to go to the back of the bus and be grateful for the ride? Little Portugal had to endure sanctions and strict budget cutting when its deficit ran over the 3% limit two years ago--a painful process that no doubt exacerbated the country's recession. The Netherlands has chosen to run a tight budget even though its economy has been in a deep slump. Second-class citizenship for the smaller countries means that the consequences from the demise of the stability pact won't be limited to the fiscal arena. Expect spillover effects from disgruntled smaller countries across a wide spectrum of EU activities and initiatives, not least on agreeing to a new EU constitutional treaty. And its effect on monetary union will be devastating. Presumably, no one wants a monetary union that bloats the welfare state and is an engine of inflation. But this is exactly where European Monetary Union is heading. One reason the stability pact is not popular in social democratic Europe is that it has hamstrung welfare state spending. Now that the curbs on spending are off, welfare-state interest groups can be expected to make up for lost time and prior restraint. Supply-side critics of the stability pact take note: Public expenditure will likely go up, rather than taxes down. The image of Europe's social democratic politicians, chafing at the bit to cut taxes but thwarted by the stability pact from doing so, always had an aura of the absurd about it. The markets also are wrong over the impact of the stability pact's demise. Using defunct Keynesian logic, the market believes that increased budget deficits will boost economic growth and be good for the euro. It is inconceivable, however, that bloating the welfare state and stoking inflation will prove salutary either for Europe's fledgling currency or its economy. "We've come to reform the stability pact--not bury it": That's the big lie being spread by Europe's big-country politicians and their Keynesian co-conspirators in the universities and media. Don't buy it! Europe's politicians lack discipline. Unwilling to follow the alleged rigid budget rules when they proved inconvenient. EU rules are made for the other guy to follow in Jacques Chirac's France and Gerhard Schroeder's Germany. It's worth remembering why there was a stability pact in the first place. When monetary union is pursued without a common fiscal policy, there is temptation for individual member states to inflate their fiscal deficits to bolster their own economy. Then the cost of budgetary profligacy is passed on to others in the union because the European Central Bank must raise interest rates to combat inflationary pressures resulting from the increase in deficit spending. This is beggar-my-neighbor policy, pure and simple. The stability pact was designed to preclude or limit this possibility. The deficit cap prevents individual members from running up budget deficits and "free-riding" on their fellow members. Of course, fixing the budget cap at 3% of GDP was, to a certain extent, arbitrary. That was unavoidable. But whatever the level chosen, the pact would have worked had the members been willing to cut public expenditure in good times to finance the inevitable budget deficits when business went south. The discipline--or lack thereof--of Europe's politicians to follow the rules was the reason the pact failed. It is doubtful that the European Central Bank's Governing Council will raise interest rates to punish politicians for their misdeeds. But abandoning the fiscal rules will increase interest rates at the long end of the yield curve as inflationary expectations increase in the marketplace. Thus, the demise of the stability pact can be expected to steepen the yield curve--which will tend to slow down the economy. Who said the stability pact was anti-growth? By liberating themselves from the burdens of the pact, Europe's politicians also seek to weaken the independence of the ECB, which is a thorn in their sides. It is too worried about inflation, too concerned with fiscal deficits, too vocal about structural reform or lack thereof, and altogether too critical of politicians. ECB president Jean-Claude Trichet--a known hawk on inflation--will prove at least as tough as his stubborn Dutch predecessor, Wim Duisenberg. But the testing is a sign of the times. And the EU is fractured along so many fault lines that the day of centrifugal reckoning appears lurking around every corner. A Mother Goose rhyme comes to mind: Humpty Dumpty sat on a wall Humpty Dumpty had a great fall All the king's horses and all the king's men Couldn't put Humpty Dumpty together again Jacques and Gerhard have given poor old Humpty one good push. Mr. Krauss is a senior fellow at the Hoover Institution. Copyright © 2003 Dow Jones & Company, Inc. All Rights Reserved.