May 24 (Bloomberg) -- European finance ministers are proving reluctant to penalize each other for breaking the budget deficit rules that nations agreed to when they introduced the euro in 1999. Standard & Poor's should do the work for them by lowering the credit ratings of the worst sinners: Italy and Germany.

The rules say deficits may not be more than 3 percent of gross domestic product. Instead, the European Union expects half of the currency's 12 members, including Italy and Germany, to bust that limit this year. In theory, offenders face an official warning, followed by fines if they fail to get back on track.

Turkeys, however, don't vote in favor of Thanksgiving, and euro members realize that agreeing to sanction transgressors leaves them open to similar treatment. French Finance Minister Nicolas Sarkozy summed it up on May 11. ``The idea isn't to take a country in difficulties and hold its head under water,'' he told a European Union meeting in Brussels. ``Each of us has known, knows, or will know difficulties.''

So Konrad Reuss, the managing director at S&P who's responsible for the credit ratings of European governments, should drag Italy to the ducking stool and cut its long-term AA rating. He should follow up by kicking Germany out of the elite AAA club.

He already has a negative outlook tagged to Italy's grade, which is how rating companies signal to investors that a cut is likely. In February, Reuss said his view of Italy's creditworthiness will be ``resolved'' this year because ``the government has to show its hand'' on taxes and spending. Last year, Reuss said he would need to see ``a reversal of deficit trends for Germany to keep its rating.'' He didn't return phone calls requesting comment.

`Slow Train Crash'

``It's the long-term fiscal implication that S&P cannot ignore for these two countries,'' said Stuart Thomson, an economist at Sutherlands Ltd. in Edinburgh, Scotland, in an e- mailed response to questions. ``It's like watching a slow train crash -- ugly, but inevitable.''

The agreement on deficit limits was designed to buttress investor confidence in the euro by preventing individual governments from slashing taxes and boosting spending. A large dollop of fiscal homogeneity was deemed necessary for the European Central Bank's ``one-interest-rate-fits-all'' policy to work.

This month, the Paris-based Organization for Economic Cooperation and Development cut its 2004 Italian growth forecast to 0.9 percent, down from a 1.6 percent estimate made in November and lower than the Italian government's 1.2 percent prediction. Moreover, the OECD said the deficit will reach 3.1 percent of GDP this year and surge to 3.9 percent in 2005.

Ministers Waver

Because Italy is in clear breach of the deficit rules, finance ministers from the 25-nation European Union were supposed to decide at a meeting this month whether to issue an ``early warning'' to the nation. They chickened out, postponing the judgment until July.

So the decision, conveniently, won't happen until after Italy holds its local elections, alongside EU-wide elections to the European Parliament, in mid-June. That means Prime Minister Silvio Berlusconi can still flaunt vote-winning tax cuts worth 12.5 billion euros ($15 billion) to his electorate, and promise the EU he'll balance that with some spending cuts in the economic blueprint he's scheduled to deliver in late June.

Axel Weber, the recently installed Bundesbank president, called the decision by finance ministers ``an absolutely counter- productive development.'' Governments should be ``sticking to the treaties that were negotiated,'' he said.

At a May 12 reception at the central bank's Frankfurt headquarters to celebrate his inauguration, Weber also lambasted Germany. ``The current budget gap would be clearly smaller if the government had made more conservative tax estimates and shown more initiative in following its expenditure goals,'' he said.

Eichel's Deficits

In his audience was German Finance Minister Hans Eichel, who has said Germany may breach the deficit limit for a fourth consecutive year in 2005. Eichel expects a shortfall of 3.3 percent of GDP next year, the magazine Der Spiegel reported last week, citing unidentified Finance Ministry officials.

Since it was the Bundesbank that held feet to the fire and insisted on the so-called Stability and Growth Pact, there should be a certain sense of shame in seeing how far Germany has fallen below the standards it set.

The impact a rating cut would have on German borrowing costs was seen last August. Government figures showing the German economy slid into recession in the second quarter were followed by trader talk that a rating reduction was imminent. By the time S&P denied the speculation, the yield on the two-year German government note had jumped 8 basis points to 2.58 percent.

Moody's Investors Service, which shares the bulk of the duties for global credit ratings with S&P, also assigns its top Aaa rating to Germany, though it hasn't been threatening a cut.

German Reaction

The loss of AAA status would probably provoke howls of protest from German politicians who have already bemoaned the dominance of S&P and Moody's, both based in the U.S., on the world of credit ratings. In March 2003, German Chancellor Gerhard Schroeder called explicitly for Europe to construct its own rating service.

That might give S&P pause for thought, though it hopefully won't stop Reuss from doing his job -- acknowledging that Germany's economic performance doesn't justify the top rating.

``I think the first move will be to downgrade Italy,'' said Thomson at Sutherlands. Once that's done, ``S&P will give a thinly veiled warning to Germany, and determine the next move on the basis of the political reaction,'' he said.

And the timing of a German rating cut? Well, the government said last week it plans to sell bonds denominated in dollars next year as it tries to trim its debt costs. It would be fitting for the U.S. rating company to admonish Germany for its profligacy before it starts hawking those securities to U.S. investors.

To contact the writer of this column: Mark Gilbert in London magilbert@bloomberg.net.

Last Updated: May 24, 2004 01:00 EDT