This is going to hurt us more than it hurts you, Germany

Now that they're in the dungeon, the eurozone countries are taking a look at the bondage services on offer

It might be a little difficult to imagine Pedro Solbes, the European Monetary Affairs Commissioner, in a Miss Whiplash outfit but that's metaphorically the costume he chose to wear last week. Wednesday saw Mr Solbes taking a number of countries down to his Brussels dungeon. "Thwack!" went Mr Solbes' whip as the European Commission admonished Germany for its overly optimistic budgetary projections. "Ouch!" screamed Italy as Mr Solbes gave Rome's unrealistic deficit plans a spanking. "Have mercy!" cried France as the Commission over-estimated the Parisian appetite for discipline.

The masochistic tendencies of countries within the euro were, perhaps, never properly revealed when they signed up to the Growth and Stability Pact. Back then, no one quite expected the eurozone economy – Germany in particular – to perform quite so badly. Perhaps more importantly, countries in the late 1990s were so focused on joining the eurozone club that they forgot to look in detail at the membership rules. Joining the club required them, among other things, to reduce their budget deficits to below 3 per cent of GDP. For government borrowing, that was all that mattered: once through the front door, there was no way in which a country could subsequently have its membership rescinded.

Countries hoped that, once in the club, countless economic pleasures would present themselves. But, as the front door closed, it became increasingly clear that countries were in a club rather different from their expectations. Finance ministers were hoping that, with growth picking up on the back of euro benefits and a smattering of new-technology magic, budget deficits would continue to fall. But, as we now know, the eurozone never really enjoyed a sustained period of decent growth. Just as the euro got going, so the new technology bubble burst.

Companies in Europe were left awash with debt. Growth slowed, government revenues came in lower than expected and budget deficits began to widen. Suddenly, countries were bumping into fiscal constraints at precisely the wrong part of the economic cycle. In an ideal world, a few choice tax cuts or spending increases would seem to be dish of the day. Instead, the door to the club's dungeon opened up and there, at the threshold, stood Mr Solbes, beckoning the members downstairs to a new life of discipline. Traditional deficit debauchery became a distant, hazy, memory.

Now that they're in the dungeon, the eurozone countries are taking a hard look at their fate. Germany has already opted for the rack. The fiscal screws are being twisted and Berlin is promising to tighten fiscal policy to the tune of 1 per cent of GDP in 2003. Other countries have chosen more modest tortures, with Italy, for example, tightening fiscal policy to the tune of only 0.25 per cent of GDP through the course of 2003.

But can these countries cope? A simple health check would seem to be a sensible first step before submission to punishment but it seems as though the Brussels dungeon hasn't taken health issues too seriously. Unless the masochistic country is showing signs of near-fatal illness, submission to a thrashing is inevitable.

Specifically, economies need to be in a state of total collapse before the rules contained within the Stability Pact can be lifted. The threat of fines for a fiscally recalcitrant country, for example, is taken away only if GDP contracts by 2 per cent or more in any one calendar year. Germany may be in a bad way but it's certainly not facing difficulties on this kind of terminal scale as yet. If GDP falls by between 0.75 per cent and 2 per cent, the country is allowed to ask its peers for respite and, to be realistic, there's a good chance of a sympathetic hearing. If, however, the economy shrinks by less than 0.75 per cent or grows at a snail's pace, punishment will be required. A severe telling off comes first but, if this is ignored, there is a transparent path towards monetary fines.

Think about Germany in this context. Germany's GDP was virtually unchanged in 2002 relative to 2001. By the end of last year, GDP probably started to contract again. This poor performance pushed the budget deficit up to an estimated 3.8 per cent of GDP in 2002, hence Germany's appearance in the Brussels dungeon.

The 1 per cent of GDP fiscal tightening that Germany is planning for this year should – according to Berlin – reduce the budget deficit to 2.8 per cent. But this is based on the rather optimistic assumption that growth will rebound to about 1.5 per cent in 2003. The signs are, however, that this number is simply too high – a point conceded by Berlin on Friday. If, instead, the economy does no better this year relative to 2002, the deficit is more likely to come in at about 4 per cent of GDP, assuming that Germany meets all its fiscal promises (which, in any case, are likely to be undermined by public sector wage increases).

Under these circumstances, Miss Whiplash will have a field day. A deficit of 4 per cent of GDP would require even more fiscal tightening in 2004 than is likely to be delivered through 2003. And, unless the world economy suddenly improves – unlikely given last Friday's terrible US payrolls – or the euro collapses, this will leave Germany teetering on the brink of recession on a semi-permanent basis. Germans will then face the twin threats of unemployment and banking failure, potentially undermining the social fabric of the country. Bizarrely, Germany will have to go through a lot more pain to keep Miss Whiplash happy.

Is this sustainable? Can Germany persistently suffer at the hands – and whips – of the rubber suits in Brussels? I think not. There are two obvious ways out of the present conundrum. The first is for Brussels and for the other European finance ministers simply to let Germany off the hook. Mr Solbes is already showing signs of hanging up his whip, suggesting that Germany will not be asked to go through additional fiscal torture if growth disappoints in 2003. The second is for Germany to bite the bullet and allow itself to be fined. Under the rules of the Stability Pact, those countries that are persistent fiscal sinners can be fined up to 0.5 per cent of GDP. Germany could be forced to tighten fiscal policy by more than this to meet the 3 per cent of GDP target in 2004. Far easier, then, to pay the fine and avoid the pain.

Either of these could mark the death knell for the Stability Pact. If Brussels can forgive Germany, then other countries will also be expected to be treated more favourably. If Germany decides to accept a permanent fine of 0.5 per cent of GDP, it can then have a budget deficit as big as it likes. Having sampled the dubious pleasures of the Brussels dungeon, eurozone countries will soon be running back up the stairs, slamming the dungeon door shut and making their fiscal escape. They will then join with America in a new world of bumper budget deficits.

Stephen King is managing director of economics at HSBC.

stephen.king@hsbcib.com