Dose of realism crucial for EMU

Date: 12/12/1996

ALEXANDRE Lamfalussy specialises in being a party-pooper. It is, after all, in every central banker's job description. As their representative and spokesman, the president of the European Monetary Institute is required to reassert the importance of economic reality every time he hears the sirens of political expediency.

Lamfalussy's latest pooping target is the fickle international investor. Since the summer, the expectations of the financial markets have undergone a transformation; from arch sceptics, they are now utterly certain that European economic and monetary union will kick off in less than 800 days.

“Somehow, the financial markets have got themselves into that belief, but they swing from one extreme to another. Two years ago, they thought it was absolutely hopeless. While I am reasonably confident that it will happen, it is not 100&percent; sure,” says Lamfalussy, speaking in his 35th-floor office with its panoramic view of Frankfurt.

The man who has headed the precursor to a European Central Bank (ECB) since its inception nearly three years ago is suspicious of the kind of certainty which has narrowed the difference between the long-term interest rates of the EMU front runners to such an extent that they are treated as almost interchangeable.

Many investors have got it into their heads that politics will take precedence over economics when the EMU membership short-list is agreed in March 1998.

They believe that countries which are considered essential to get the single currency under way (ie France) will not be shown the door simply because their budget deficits surpass the now famous target of 3&percent; of national income.

“That is precisely why I am not 100&percent; certain, because I think we must be absolutely sure that the monetary union starts on a viable basis,” says Lamfalussy. “This means that you cannot disregard a serious assessment of genuine and sustainable convergence.”

Just 15 months from now, a Union summit will decide which countries should be allowed to form a single currency bloc on the basis of assessments of economic performance in 1997 - one drawn up by the European Commission and the other by the EMI.

If anybody thinks the EMI will do a rubber-stamping job, they had better think again. Lamfalussy, who will have retired nine months earlier in July 1997 to make way for Nederlandsche Bank President Wim Duisenberg, serves notice that the central bankers will scrutinise the figures rigorously.

The Maastricht Treaty rules make it clear that, during 1997, budget deficits should be reduced to 3&percent; of gross domestic product or less, unless an overshoot is caused by undefined “exceptional” and “temporary” factors, and that public debt should be heading towards 60&percent; of GDP. But this is not everything.

“The treaty also insists on sustainability,” says Lamfalussy. “This is a qualitative judgement and therefore, when we sit down and look at the real-life 1997 figures, we will first have to ask whether an exception is acceptable and for what reason, and secondly ask: even if the figures are good for 1997, will this last?

“Even setting aside political considerations, it is not intuitively evident what conclusions we would come to. My recommendation is to stay on the safe side. The single most important factor in making sure that EMU starts off well is to make a good choice of countries.”

To judge this, the EMI will look at the published budget for 1998. “Good figures for 1998 budgets are no substitute for bad actual figures in 1997, but they can confirm the sustainability of good figures.”

Lamfalussy is scrupulously careful not to name names, but the message is clear: the bookkeeping tricks performed by the French and Italian governments to get their deficits conveniently below 3&percent; in 1997 will not necessarily do them any good when the crunch comes.

“We will have to look behind the 1997 figures and ask how they were achieved,” he warns. “Clearly, if a country has achieved good results because it is beginning to tackle some of its most substantial problems then that is alright, but if it has achieved those figures in a way that does not seem to be sustainable and fails to attack the core of its problems, that is not good.”

Countries using one-off measures to window-dress their 1997 data should be warned. “If it is a one-off measure which has no future, then we will have to be tough,” says Lamfalussy. “We will have no choice because the sustainability criterion will not have been respected.”

It is the very readiness of this fledgling institution to throw its weight around that has already started to worry the politicians.

When it came up with its design for a new exchange rate system to bind those outside the euro-zone to those inside, the EMI council - made up of all the EU's central bank governors plus Lamfalussy - suggested that those 'outs' which wanted narrow bands should negotiate with the ECB.

This, in the view of several finance ministries, was a flagrant attempt to wrest away powers specifically assigned to them by the Maastricht Treaty.

To look at it more generously, the EMI has certainly managed in its short life to bring swift solutions to problems - such as the new European Monetary System or drafting a blueprint for the transition to the single currency - which would certainly have bedevilled ministers for years.

This ability to act quickly is in the very nature of the EMI, says its president. “Once you have an institution with staff and a tightly working council, it helps. But, more fundamentally, you must remember that central bankers have been working together for a very long time. Before the EMI, the committee of central bank governors had been meeting for 25 years. These people have been relatively stable in their jobs so ensuring continuity,” he points out.

“The result of that is that in many respects we have had a convergence already in central banking philosophy and strategies, and even in practices. We have seen a convergence not only in the techniques of policy, but also in the general philosophy oriented towards price stability. Once you have this sort of consensus, it is relatively easy to be efficient because you do not have to question basic principles every single time there is a difference of opinion.”

Should politicians be scared of this emerging Frankfurt powerhouse?

“I do not believe they should fear that,” says Lamfalussy, who maintains there is a simple way for politicians to redress any power imbalance.

“There is clearly a need for strengthening the E, or economic, leg of EMU. The M leg has been well spelled-out in the treaty, but the E leg needs strengthening - not to control the central bank which the ministers will not do - but so that they can become a credible partenaire de dialogue. This means cooperation between governments in the shaping of macro-economic policy. What we need is a good policy mix.”

Lamfalussy believes the 'stability pact' designed to impose budgetary discipline in a monetary union suggested by the German government goes some way towards addressing this problem, but does not go far enough.

Even once these tough rules have been agreed, it will be possible for a large country to swing from a budget surplus of 2&percent; of GDP to a deficit of 3&percent; without facing the approbrium of fellow pact members.

“That is a 5&percent; shift in GDP! This is something which is bound to have an impact on interest rates and affect the others. The stability pact is there to prevent major slippages and it needs to be there but, within the pact, you still need to have an ex ante coordination of policies,” he insists.

As he heads for retirement in July, Lamfalussy might be just the right man to explain to governments just how they should deal with what promises to be the world's most powerful central bank.