By Jan Strupczewski
BRUSSELS, Nov 18 (Reuters) - The European Union is likely to quietly let the economy take precedence over its rules on budget discipline as countries seek to avoid recession, but the result will likely be higher borrowing costs for the budget offenders.
After the G20 summit last weekend top EU officials have called for coordinated fiscal action in the 27-nation bloc to quickly stimulate domestic demand and complement the positive effects of global central bank interest rate cuts.
But not every EU country has room for tax cuts or extra government spending under the bloc's budget rules, the Stability and Growth Pact, which sets the limit on budget deficits at 3 percent of gross domestic product.
A source at the Eurogroup, the monthly meeting of euro zone finance ministers, said the key thing was to think what was best for the economy.
"We can think what we would do if we did not have these rules to observe, what makes sense, and then reassure everybody that once the situation is better we will also improve our behaviour," the source said.
The Pact, which underpins the euro, was revised in 2005 to give those who breach the 3 percent limit more time to get back in line, after France and Germany put up a fight against an escalation of disciplinary steps against their excessive gaps.
Since the revision, budget positions in many euro zone countries, notably Germany, improved substantially, mainly thanks to fast economic growth, but also some reforms.
Germany, the Netherlands, Austria or the Nordic countries now have low deficits or surpluses and plenty of room for tax cuts or more spending. But others, like France, Britain, Ireland, Italy, Greece or Portugal -- don't. [ID:nBFA000792]
STIMULUS AT A COST
While the markets are likely to accept rising deficits as necessary in the circumstances, it will come at a price.
"EU finance ministers may turn a slightly blind eye to the higher deficits for some time," said Juergen Michels, economist at Citigroup.
"The market would see this as a reasonable thing, but countries like Italy or Greece have been punished by the markets for loose fiscal policy so when a country goes for more fiscal easing, they have to have in mind that this is bearing costs," Michels said.
Because only concerted fiscal action is likely to kick start the economy, economists say, the EU needs everybody on board and will seek to exploit the new flexibility of the rules without giving them up altogether.
The Pact says that in exceptional circumstances like the current crisis, countries breaching the 3 percent limit can get two, instead of the normal one year, to correct the shortfall.
This would mean that if the French deficit turns out to be above 3 percent in 2008 as expected, this would be confirmed only in 2009 and the correction deadline could be set for 2011.
For those who break the limit only in 2009, when the euro zone is likely to be in recession, the deadline could be 2012.
More time can be bought if a country implements structural reforms or if the difficult situation persists or becomes worse.
The European Commission, which is the guardian of EU laws, would still start disciplinary steps against the offending countries, because that is EU law. But the EU executive has suggested correction deadlines could be long and the disciplinary steps might not be escalated towards fines.
"We want to make full use of the flexibility instruments that the Pact offers us," Economic and Monetary Affairs Commissioner Joaquin Almunia has said.
"We don't want to ignore the Pact but it's a matter of applying the pact at a time when the fiscal and budget policy to support demand is absolutely vital," he said.
RISKY MOVE
But euro zone officials worry that if deficit offenders are treated leniently, it would be interpreted as a sign that the rules have no teeth and market borrowing costs would rise.
"People are afraid that if they show any kind of flexibility with respect to the rules, the markets and the media would perceive it very negatively," the Eurogroup source said.
But the alternative is a prolonged recession so it is better to get all countries to use the fiscal stimulus now and make sure the deficits are slashed once the crisis is over.
"There needs to be a very strong political commitment...that in the short run maybe the situation is so serious that we can allow all countries, regardless of what they have done in the past, to raise deficits, but once the crisis is over, you would very quickly go back down," the source said.
The influential Bruegel think tank proposed a way to solve the problem by making countries without budgetary room start reforms to improve budget sustainability by September 2009.
If the reforms are not in place by that time, the country could face accelerated disciplinary budget steps with a 2010 correction deadline, Bruegel suggested.
The 27-nation bloc has roughly four weeks to come up with a solution which would be approved by a EU leaders summit in mid-December and for the measures to kick in 2009.
(Reporting by Jan Strupczewski, editing by Toby Chopra)