Finance ministers' attack on stability pact was a major blow for ECB, writes Denis Staunton

If the exchange rate were the measure of a currency's success, 2003 would go down as a year of triumph for the euro, which rose dramatically against almost all other currencies. This is particularly true in relation to the dollar, which lost 30 per cent of its value against the euro between January and December.

The European Central Bank (ECB) welcomed the euro's appreciation, despite the difficulties it created for euro-zone exporters, as a dampener on inflation and a welcome sign of the new currency's coming of age. If the soaring exchange rate was indeed good news, it was one of very few reasons for the euro's guardians to feel cheerful in a year that saw the destruction of the Stability and Growth Pact at the hands of France and Germany, Europe's biggest economies.

The pact had been under some pressure since the beginning of the decade, when it became clear that a 2002 deadline for all euro-zone countries to bring their budgets into surplus or close to balance could not be met. That deadline was subsequently extended to 2004 and later to 2006, although there is little chance of its fulfilment even then.

Meanwhile, it became clear that a number of countries were set to breach the pact's most important rule - that budget deficits should not exceed 3 per cent of GDP. Portugal was the first to break through 3 per cent, followed by France and Germany.

Both Portugal and Germany adopted a contrite approach at first, agreeing to implement recommendations from the Commission to reduce their deficits and affirming their commitment to the pact. The real problems started in 2002 when France's President Jacques Chirac campaigned for re-election on a platform of tax cuts and spending increases that could only increase his government's budget deficit.

The Economic and Monetary Affairs Commissioner, Mr Pedro Solbes, sought to hold the pact together by insisting that its procedures should be followed while offering the maximum possible latitude to the offending member-states. The Commission acknowledged that Germany could not afford to put up taxes or make radical spending cuts without wrecking the prospects of economic recovery and linked demands for deficit cuts in both France and Germany to growth expectations.

The dispute became a crisis in the autumn when the Commission sought to discipline both countries for running excessive deficits for more than three years in succession, invoking Article 104 (9) of the EU Treaty. This would have allowed the Commission to impose binding commitments on Paris and Berlin to take specific steps to cut their deficits; failure to comply could have triggered financial sanctions.

Germany's Chancellor Gerhard Schröder feared that such a procedure could prove embarrassing in the run up to federal elections in 2006, by which time he hopes Germany's economy will have started to flourish as tax cuts boost consumer confidence.

Paris and Berlin persuaded a majority of euro-zone finance ministers to oppose the Commission's proposal, suspending the pact's excessive deficit procedure in favour of a non-binding call for France and Germany to take action.

The ECB, under its new President, Mr Jean-Claude Trichet, condemned the finance ministers' decision, hinting that interest rates could rise if the member-state governments did not fulfil their commitments under the pact. The threat from Frankfurt lacked force, however, not least because the financial markets appeared to ignore the row over the pact and continued to push the euro upwards against the dollar.

Any rise in euro-zone interest rates would not only risk damaging Europe's fragile economic recovery but would reinforce the flight from the dollar, pushing the euro's exchange rate beyond acceptable limits.

The ECB may feel constrained from picking a fight with the member-states at present by the fact that the EU's draft constitutional treaty includes a number of proposals that could affect the central bank's independence. Before negotiations on the treaty stalled on December 13th, EU leaders appeared close to agreeing on a proposal that would allow them to sack members of the ECB's executive council, a move Mr Trichet and his colleagues are resisting.

2004 is likely to see a debate about reforming the Stability and Growth Pact that could lead to calls for the broadening of the ECB's mandate to include encouraging economic growth. At present, the sole purpose of the ECB's monetary policy is to maintain price stability, which is defined as keeping inflation below but close to 2 per cent.

As the dollar continues to fall, however and US authorities show little interest in halting the trend, the biggest challenge to the ECB and the euro-zone economy may come from the capricious nature of international financial markets rather than the EU's own rule-book.