Last look before EU leap

Date: 24/07/1997

THE chaos that was the Amsterdam summit did economic and monetary union a favour.

Prime ministers looked into the future and it frightened some of them. The warnings sounded so often before that without the Holy Grail of EMU floating ahead of them, member states would focus forever on what divided rather than united them, suddenly carried weight.

Perhaps all summits would be like this, they suggested tremulously.

The French Socialist government, which had seemed lukewarm about the German version of the single currency - lots of rules which have to be obeyed and not even a soupçon of inflation - is now keener.

The audit of France's public finances published this week revealed that Prime Minister Lionel Jospin's predecessors had been economical with the truth.

The revelation that, without further measures, the budget deficit would be worth between 3.5&percent; and 3.7&percent; of gross domestic product this year provided him with just the fig-leaf he needed to retreat from his campaign promises at lightening speed.

Jospin and his Finance Minister Dominique Strauss-Kahn have no intention of ending their political careers by trying to hit the EMU entry target level of 3.0&percent; of GDP, but they are going to have a stab at approaching it.

Casting an envious eye across the English Channel at their nominally Socialist colleagues in London, they have even discovered a 'pain-free' tax - one levied on companies rather than people.

Egged on by a sense of diplomatic obligation to German Chancellor Helmut Kohl, the French government is prepared to get the 1997 deficit on the right side of 3.5&percent; of GDP and push through new tax increases or spending cuts to meet the 3.0&percent; target a year later.

Kohl has so far kept quiet, but he must be happier with this than the alternative: the total destruction of everything he has worked for and defeat for his party in the October 1998 elections.

The French government's approach has even received the tacit approval of Economics Commissioner Yves-Thibault de Silguy, who is talking much less these days about 3.0&percent; and much more about the Maastricht Treaty's requirement for “sustainable convergence”.

While a deficit of 3.5&percent; of GDP and above would have little chance of meeting EMU's entry rules, 3.3&percent; and falling might well sneak in, he hints.

It is a fascinating aspect of the history of EMU since the Maastricht summit six years ago that the nature of the debate changes so frequently and so entirely.

It is hard to keep up. Utter despondency can turn to wild romance within the space of a week as German unemployment figures recede from the headlines in favour of 'stability pact' negotiations. And with only ten months to go until the final short list of EMU members is drafted, the process has now entered a novel phase.

In the past, we have seen massive flows of investment capital out of the deutschemark because EMU was going ahead, and then watched it ebb back as political bickering or bad figures seemed to threaten the project.

But the feeling now is totally different. The financial markets have decided that the euro will come, and will come on time on 1 January 1999. However, they have convinced themselves that politics will override economic considerations and the euro will be - in the words of former UK Foreign Minister Douglas Hurd - “weak and flabby”.

Fearing Europe after 1998, pension and insurance funds as well as company treasuries are shifting out of marks and mark-denominated stocks and bonds and looking for safe havens. This means traditional homes like the US dollar and the Swiss franc but also, much to the chagrin of the UK government, sterling.

The logic of the markets is, as so often, impeccable and wrong-headed. Since the left took the reins in Paris, the idea has gained ground that the French have become more uncooperative and less willing to do whatever Kohl and the Bundesbank require.

The French will get into EMU with a bloated budget deficit and they will invite all their southern cousins from Portugal to Italy in with them.

Once safely inside, they will all go on public-spending sprees, establish political control over the European Central Bank (ECB), stoke up their public debt and then encourage inflation to erode this away. As a result, the euro will be 'weak' - or so the theory goes.

But this will not happen. Just because France will be allowed into EMU with a 3.5&percent;-of-GDP deficit does not open the doors to the Italians. The French have a long track record of very low inflation and long-term interest rates, currency stability, a budget deficit edging lower and public debt well below the 60&percent;-of-GDP target rate.

The Italian government, while it has managed a fantastic turnaround in the public finances, has no such history. Inflation may be heading for 2.5&percent; this year, but it was 5&percent; two years ago and public debt is worth 124&percent; of GDP and is hardly falling. The budget deficit may hit 3&percent; of GDP this year, but this will be down from 6.7&percent; last year and achieved in large part by smoke and mirrors.

Secondly, spending sprees are a thing of the past and, if they happen, they will be severely punished by the stability pact. For all their bluster, French politicians cannot get their hands on the ECB. The powers of the bank are watertight and enshrined in the treaty (which is more than can be said for the Bundesbank) and only a unanimously agreed treaty revision can change them.

Thirdly, does anybody really think that the French, Italian, Spanish and Portuguese central bankers sitting on the central council of the ECB are going to vote constantly for lower interest rates simply so that they can erode their governments' debt?

All of these governors have suffered vilification from their governments over the past three years for failing to cut rates fast enough. Why would they start in Frankfurt?

Finally, what does a 'weak' euro mean? Weak against what? The dollar, the yen, sterling? If EMU does go ahead against a background of lax fiscal policy, the new ECB will simply offset this by keeping short-term interest rates higher than necessary for longer than necessary so as to establish its yearned-for credibility in the financial markets.

As US economist Fred Bergsten pointed out in European Voice recently, the ECB would emulate the US Federal Reserve under 'Reaganomics' and the Bundesbank after German reunification. Massive public-sector borrowing and the threat it posed to inflation would be met by a spectacular rise in interest rates and a huge appreciation of the euro.

Far from being flabby, the euro would be a paragon of strength - a currency bulging with credible muscles.

Much more likely than all of this is that monetary union will begin on 1 January 1999 with Germany, France, Belgium, Luxembourg, the Netherlands, Austria, Finland and maybe Ireland. Italy and the Iberians will be asked to wait a year or two. The UK, Denmark and Sweden will sit outside and think about it.

Massive portfolio shifts, plus the ECB's credibility, will ensure that the euro rises against the dollar, while the stability pact and a desire to make the thing work will keep spending under wraps for a few years.

After that, the EU's failure to encourage labour mobility over the years will start to make itself felt. Unless governments start taking serious measures to introduce cross-border markets in pensions, insurance, social security and healthcare, and stamp out ridiculous residence laws, Europe may end up looking back with envy to the days when only 18 million of its citizens were unemployed.