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The slowdown in economic growth and rising unemployment in the euro area, with major economies slipping into recession, have revealed serious faultlines in the stability and growth pact governing the euro area's macroeconomic policies. The pact dictates that budget deficits must not exceed 3% of GDP, with a requirement budgets are in balance or surplus on average. Countries that do not adhere to these limits are threatened with fines. It should come as no surprise that slowdown pushes up deficits and has taken some countries over the 3% limit, notably in Germany and France.

For now, penalties for countries exceeding the limit have not been imposed and countries are given up to four years to meet the budget deficit requirements. Although there has been some bending of them, the rules remain in place. Indeed, the European Central Bank and members of the commission are demanding strict adherence to the rules of the pact in future. They are supported by the small countries of the eurozone, which complain that it is unfair for them to have to adhere to the pact while its main architects, Germany and France, do not.

The ECB and some governments view the zone's slowdown as the result of structural factors—labour market rigidities above all—and the failure to tackle burgeoning budget deficits. The rigidities, though, have been around for a long time: during the 50s and 60s, when many European economies were booming, especially Germany's "economic miracle" of the 70s. It is adherence to the pact's rules to limit budget deficits, which thereby can require tax rises and expenditure cuts in the face of recession, that has promoted the present slowdown.

This has not been helped by the ECB's inability to take action to stimulate the zone's economies. The recession has raised severe questions about the appropriateness of the institutional and policy arrangements governing the single currency and their ability to deal with unemployment, recession and inflation.

The limit on budget deficits and the overall balanced budget requirement are severe, running counter to the experience of the past six decades, not allowing public capital investment to be funded by borrowing and more severe than necessary to maintain the 60% public debt to GDP ratio.

Seeking to enforce the requirements of the pact imposes a substantial deflationary thrust and calls for flexibility in the pact's terms do not deal with the underlying problem. It is often argued the budget position of each country has to be restrained because of externalities, or spillover effects. These sometimes take the form of a government's spending putting upward pressure on interest rates and raising the cost of borrowing for others. This may then spill over into other countries and may cause the ECB to raise rates to dampen inflation.

Without accepting that expenditure would necessarily have these effects, we would say the expansion of private sector spending could be expected to have similar effects to those resulting from public spending. Fluctuations in the overall level of expenditure come into play mostly because of fluctuations in private expenditure. The logic of imposing limits on public expenditure would also apply to the private sector. Perhaps there should be limits on private sector deficit or on the trade account.

The pact threatens to become an "instability and no growth pact", with the thrust of fiscal and monetary policies pushing the eurozone economies in a deflationary direction, with Germany, Italy, and the Netherlands now in recession.

No wonder the EC president, Romano Prodi, complains that current pact arrangements are "rigid" and "stupid", and it would not be an exaggeration to suggest they have also become a standing joke.

France and Germany's justification for violating the fiscal rules is that the pact has delivered too much stability and not enough growth. Changes at this juncture in global economic development are very pressing. The falling dollar provides an opportunity for expansion. For, without strong growth outside the US, the economic imbalances may undermine the rest of the world's prospects.

The euro countries should take a lead. What is needed is a fundamental change so a truly effective pact emerges. Coordination of monetary and fiscal policies is paramount but requires monetary authorities to enter into agreements with fiscal authorities and a removal of limits on national deficits. And those deficits should be used to ensure high levels of activity within the euro area.