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Gambling on the euro
Economist-ledare January 2-8 1999 - utdrag/excepts

Nobody can claim that EMU was forced upon Europe’s governments by force of events, still less by popular demand.

This is an initiative of extraordinary ambition, given that it is to be carried through despite quite shallow support in popular opinion. EMU is an elite project. Europe’s governments are saying: Our people may not be convinced of the euro’s benefits just yet, but once it is in place and they come to understand it, they will change their minds.

Europe’s leaders had better be right. Otherwise, when the system comes under strain, its political foundations may prove too weak to sustain it.

The next few years are, after all, transitional. National currencies will continue to circulate until the end of 2001, albeit at permanently fixed parities.

In the meantime, the European System of Central Banks undertakes to defend those parities. In principle this means that if, say, Italians decide to switch all their lire into D-marks, the supply of D-marks will be expanded without limit to accommodate them.

That danger aside, and for the moment considering EMU only in its economic aspect, two principal risks remain.

The first, which will be most acute during the project’s early years, is that economic policy in the euro area as a whole will be ill-judged, leading to a recession that discredits the whole venture.

The other, which will remain a threat into the medium term, is that the system will prove too inflexible to cope with local (in the jargon, “asymmetric”) economic shocks.

Independent to a fault

In designing EMU, the architects laid great emphasis both on the independence of the European Central Bank (ECB) and on the simplicity and severity of its anti-inflation objective. In statutory terms, at least, the ECB may well be the most independent, and most single-minded, central bank in the world.

America’s Federal Reserve, for instance, is required by law to take output and

employment into account alongside inflation, for which no numerical target is set. In addition, the Fed is accountable to Congress, which periodically questions its top officials and sometimes tries to influence their views. The restraint that Congress and the White House show in this regard is a matter of custom, reflecting the standing which the Fed has won for itself in financial markets over many years, and not a matter of law.

The position of the ECB is quite different. The Maastricht treaty allows for no clear accountability to any other arm of national or European government. In fact the treaty explicitly forbids the ECB and its decision-making bodies to “seek or take instructions from Community institutions or bodies, from any government of a member state or from any other body”. It also stipulates that the proceedings of the ECB council’s meetings will remain confidential.

If he chose, Wim Duisenberg, the first chief of the ECB, could nonetheless announce the outcome of its deliberations, together with a commentary and forecasts justifying it. Mr Duisenberg says he is not against this sort of openness. Time will tell. The point is, everything is left for the ECB to decide: this is independence with a vengeance.

As to aims, the treaty further stipulates that the ECB’s goal is “price stability”, leaving the bank to decide what that means. In many other countries with “independent” central banks—in Britain, for instance—the government sets a target for inflation and reserves the right to change it as circumstances, in its judgment, dictate. EMU has no such escape-clause.

Moreover, the bank is forbidden to balance the goal of price stability against other aims. The treaty directs the ECB to “support the general economic policies of the Community” but, crucially, it is to do this “without prejudice to the objective of price stability”.

The ECB has now defined “price stability” to mean inflation of less than 2% a year.

In modern times, no major economy has hit such a target consistently over a run of years.

America’s inflation rate has averaged 3.3% over the past ten years; Germany’s, despite the mighty Bundesbank, has averaged 2.8%. In short, a radically undemocratic institution has been charged to achieve, without compromise, an exceptionally demanding goal of virtually zero inflation.

Strong evidence suggests that central-bank independence is indeed a good idea: any given level of inflation can be achieved more cheaply, in terms of forgone output and employment, if firms and workers believe that monetary policy is free from undue political pressure. The danger is that EMU’s architects have gone too far. The European Union, with its weak parliament, is acknowledged in any case to have a “democratic deficit” at its centre; the

powers of the new central bank will make that deficit all the greater.

In economic terms, the danger is simply that the ECB will take its instructions literally—and will try to screw inflation down to nothing regardless of wider economic repercussions.

As it happens, the circumstances seem likely to prove favourable. Forecasters at the OECD expect that output in the euro zone will grow by 21/2% in the coming year, with inflation remaining at about its present 11/2%.

This assumes that short-term interest rates in the euro area will average 3% in 1999, their current level, a full percentage point lower than the average for 1998. All that would presumably suit the ECB pretty well. But more awkward eventualities cannot be ruled out.

One is that governments, after years of post-Maastricht squeezing and fudging of budget deficits, will ease fiscal policy too much (despite the rule forbidding it, of which more in a moment). That could put upward pressure on inflation and lead the ECB, with little headroom beneath its inflation target, to assert itself at once and raise interest rates (or delay cutting them).

An early conflict of this kind between loose fiscal policy and tight monetary policy would be an extremely discouraging start.

Another even more awkward possibility for monetary policy in EMU’s first year or two is that the OECD’s forecasts for output may prove too optimistic. This is not implausible.

The health of the world economy is far from robust. With Wall Street overvalued on every historical measure, the danger of sharp falls in global equity prices in 1999 needs to be taken seriously. That in turn might prompt a worse slowdown in demand than is allowed for in the OECD’s central-case forecasts. The question would then be whether the ECB would cut interest rates soon enough and far enough to avoid recession in Europe.

If the bank waited for inflation to fall before acting, that would be too late. Yet the bank might be reluctant to act more promptly, responding to forecasts of lower inflation rather than to out-turns, as it should, for fear of undermining its credibility with the markets.

Mr Duisenberg will prefer to err on the side of caution (that is, on the side of lower inflation and higher short-term unemployment) in any case; he will want to be judged by the euro zone’s inflation record, maintaining that unemployment is none of his concern. Adding to his desire to establish a tough reputation at the outset will be his memory of the fiasco surrounding his appointment. France wanted to appoint its own candidate to the job; the other

countries resisted. The absurd compromise that was settled upon allowed France to say that Mr Duisenberg will step down early in favour of its man, while Mr Duisenberg says that no such promise was made.

When Mr Duisenberg comes to be tested, the price of that squabble may well be higher interest rates and fewer jobs.

A shocking possibility

In principle, however, a recession that threatens the euro-11 as a group is not the most difficult scenario for the ECB. Once its reputation is established and any teething troubles overcome, a system-wide problem of that kind can be dealt with perfectly well by the system-wide response of a change in interest rates. Indeed, a single central bank is arguably better equipped to deal with such a case than would be 11 separate national banks, acting in an

unco-ordinated way. That is why, beyond the transitional period, the larger challenge for the new system will be to deal with fluctuations that are not system-wide.

The euro zone is not what economists call an “optimum currency area”—that is, it is not a region whose constituent parts are affected in broadly the same way by typical economic disturbances, or among whose constituent parts labour moves freely.

If it were, then no economic purpose would be served by retaining sub-European currencies. Admittedly, few if any national economies meet that ideal standard: regions within the United States often suffer asymmetric shocks because of local concentrations of particular industries, and although American labour migrates comparatively smoothly from one state to another, these shifts are by no means costless.

The point, though, is that the euro zone is very much further from being an optimum currency area than is the United States.

Disparities in relative prices (after allowing for exchange-rate fluctuations) are greater among the euro-11 than among American states; and the mobility of labour within Europe is, according to one study, only one-third of the mobility of labour within America.

Advocates of monetary union argue that the euro will itself narrow the gap, by encouraging closer economic integration. This is quite true. However, even with the euro, the barriers of culture and language are likely to remain stronger in Europe.

One perverse consequence of the euro may be that, precisely because it encourages closer integration, it will also promote greater local specialisation—increasing the chance of asymmetric shocks from that source.

In sum, for many years to come, persistent national divergences in growth and unemployment are likely to recur from time to time.

Europe’s governments all acknowledge that one way to reduce the costs of these divergences is to improve the supply-side flexibility of their economies.

The price of European over-regulation is a both a higher unemployment rate over time, and a greater susceptibility to a further upward ratcheting of this average or equilibrium rate of unemployment with each serious recession. The trouble is, governments have so far proved better at paying lip-service to the need for deregulation than they have at dealing with the problem. The recent shift to the left in European politics makes this remedy all the less likely to be adopted.

That leaves macroeconomic policy. When a country with its own currency suffers a recession, it is free to cut interest rates. This stimulates demand twice over: first by lowering the cost of credit, and second by causing the currency to depreciate (which spurs exports).

Countries in the euro zone will not have this option. Emigration cannot help much (as it would in the case of Michigan, say). And since Europe has only a tiny central budget, net assistance from faster-growing countries (in the form of bigger inflows of public spending and smaller outflows of taxes) will also play a far smaller part than the equivalent fiscal transactions in the United States.

All that remains is national fiscal policy. The recession-struck economy is still free to borrow on its own behalf, thus stimulating demand and speeding its recovery. Or it would be, except for EMU’s “Stability and Growth Pact”. This is a rule that governments agreed to at Germany’s insistence, requiring budget deficits to be held to 3% of GDP or less. Violators will be fined, subject to a vote of governments, unless output has fallen by 2% or more in the year in question.

Despite this purported flexibility, the regime (like the rules defining the ECB’s aims and freedoms) is exceptionally severe. Falls in output of 2% or more are extremely unusual; far smaller downturns would cause unemployment to rise quickly and be universally regarded as “recessions”.

And the restriction is too tight in another way: governments that tried to anticipate a downturn by relaxing fiscal policy early, thereby breaching the 3% limit before output fell by 2%, would also face fines.

The German doubts that led to the adoption of this procedure were exaggerated, albeit not entirely groundless. The concern was that chronic overborrowers would become even more fiscally irresponsible once they had adopted the euro, because they would no longer face the financial-market sanction of higher interest rates and (in the end) a depreciating currency.

Moreover, this overborrowing would henceforth be at least partly at the expense of Germany and the other euro countries, because they would bear some of the cost of default, if it came to that.

The fear is exaggerated because the Maastricht treaty rightly insists that the central bank cannot bail out national governments. Provided that promise is believed, and so long as the no-bail-out rule applies to other finance ministries as well as to the ECB, the markets would attach a risk premium (in the form of a higher interest rate) to borrowing by heavily indebted governments. That is as it should be—and no further discipline should be necessary.

As it is, the stability pact calls that promise into doubt, by making budgets a collective responsibility. Worse, in the meantime it rules out counter-cyclical fiscal policy of the sort that will often be necessary, and for which there is no longer any plausible national substitute.

The crucial question regarding the stability pact, therefore, is the same as for the ECB: given that the design is so bad, how might it work in practice?

Today, budget deficits in many euro economies (including the three biggest) stand at more than 2% of GDP (see table 3). If demand in Europe grows more slowly in 1999 than the forecasters expect, those deficits may rise. (In some cases they will tend to rise regardless, as assorted post-Maastricht fudges are unwound.)

Governments may soon be faced with the stability-pact requirement to raise taxes and/or cut public spending—even as their economies slide toward recession. Again, therefore, the hope must be that the rules will be bent, or scrapped. If this does not happen, and one or more countries encounter a downturn that the ECB cannot remedy by means of system-wide monetary policy, there are only two alternatives.

One is that the countries concerned endure a deeper and longer recession than they are used to, or is necessary. This plainly runs the risk of calling forth mounting protests against EMU itself.

The other is that the fiscal powers available to the centre—the money gathered and spent by Brussels—must be greatly enlarged. This would allow automatic fiscal stabilisers to work within Europe as they do within the United States of America. Many in Europe would regard this second alternative as desirable in any case, which (if the stability pact survives) makes it the more probable outcome. In any event, this seems likely to be the issue on which Europe’s political future turns.

Ever closer union

Judged strictly as an economic venture, EMU will be a success if, over the coming years, the participating countries benefit from closer integration (measured by growing trade and investment in the euro area), satisfactory growth, declining unemployment and low inflation. If the single-currency project had been better designed, the chances of achieving this would have been good. Closer economic integration seems assured in any case. A plan that created a properly directed, properly accountable central bank and provided for adequate freedom in national fiscal policy would have done as much as macroeconomic policy can do to take care of the rest. To be sure, that would still have left governments to carry a heavy burden of supply-side reform—without which Europe cannot expect to cut its unemployment to the

levels seen in America. Still, the outlook would have been promising.

As it is, the chances of success are no better than fair. The central bank will have to rise above its flawed design—winning the popular regard it will one day need both by explaining what it is up to, and by balancing the short-term demands of low inflation, on the one hand, and growth in output and employment, on the other, more intelligently than its statutes require. And governments will have to find a way to make fiscal policy respond far more flexibly to economic circumstances than the Maastricht rules allow.

Ideally this will be done by changing the rules—perhaps to require that budgets are balanced over the course of the economic cycle, but leaving them free to run further into deficit at times of slowing demand than the 3% of GDP allowed by the stability pact. Needless to say, in this case too, efforts to liberalise Europe’s markets for goods, services and labour far more determined than governments have made so far will also be required.

If EMU can overcome the flaws of its design and prove an economic success after all, Europe’s governments (and, preferably, their citizens as well) will be able to weigh the coming political choices on their merits.

If it fails in economic terms, those political choices may be severely constrained—and, as a result, far more divisive. Closer political integration built on the solid foundation of an EMU that worked would be one thing. The same course adopted in distress to save EMU from failure, or even outright collapse, would be an entirely different, and much more dangerous, enterprise.

More comments to the start (Euroland and Hans Tson Söderström)

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