The Stability and Growth Pact was designed to enforce fiscal discipline amongst member states of European Monetary Union. Key provisions are limits to the budget deficit at 3% of GDP and medium-term balanced budgets. As currently stated, the member countries have committed themselves to achieve balanced budgets by 2004. The European Commission is now waking up to reality and acknowledging that several member countries are not going to make it. In fact, even the 3% of GDP deficit limit is likely to be breached in the coming year. The culprits? Portugal, Italy, France and Germany. With the three largest Euroland economies being in breach, the Stability Pact is looking very wobbly indeed.

By tinkering with the timetable the European Commission hopes to defuse the situation and save the Pact in some form. The Pact is important because each member state can set its own fiscal policy. Absent such a Pact there is a serious risk of a free-rider problem developing in that one country could have its budget deficit balloon while others suffer through fiscal discipline. This would be an unstable situation; bond yields would rise, affect all member states, and the incentive for maintaining fiscal stability would be weakened. After all, if bond yields are higher because of other countries' fiscal irresponsiblity, why not run a higher budget deficit yourself?

Now with the adverse economic conditions prevailing in Europe, the Pact will be broken. Government expenditure is up, revenue is down. To an extent having a counter-cyclical fiscal policy is a good thing, as long as it does not run up structural deficits. But this stabilization is unavailable to countries that go into a downturn with their budgets already in deficit under the current Pact. So something will have to give.

Depending on the amount of realism that prevails, the process could become very messy indeed. The European Central Bank is going to fight it tooth and nail, and there will be a trilateral showdown between governments, the ECB and the European Commission. Within the governments' camp, some will side with the ECB. Others will welcome a relaxation of the rules. The more rancorous and chaotic it gets, the higher bond yields will rise, and the further the euro will fall.

Europe is taking the next steps with the experiment of the single currency, spread among 11 countries with different economic and fiscal policies. This is one of the fault lines that had been apparent for some time. The euro is not popular with its users, and now we will see whether it can stand the strain.