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from the financial times
EMU: Raining on Europe's parade
One of the greatest monetary changes ever - Europe's single currency - will begin as the full effect of the emerging-market crisis becomes clear. Wolfgang MĀnchau considers the implications
Only a few weeks ago a senior European central banker said the launch of the single currency could not take place at a better time. Economic growth was picking up, he noted, unemployment was coming down, and there were few signs of inflation.
A few weeks and a financial crisis later, the opposite seems true. It now looks as if European economic and monetary union could hardly have been launched at aworse time. The fear of global recession, an unstable financial environment and a contagious spread of devaluations from Asia, to Russia and possibly to Latin America and central Europe have all combined to create disturbing dilemmas for European policymakers. In particular, the risk is growing that the new European Central Bank will get its monetary policy wrong when it assumes responsibility for the single currency next year.
If the governors of the ECB set interest rates too high, they will be criticised for forgetting the lesson of the 1930s depression, caused by the failure of central bankers to offset falling share prices with a looser monetary policy, sending a ripple effect of bank failures across the world.
But if the ECB's governors set interest rates too low, they will be criticised for failing to observe another historical lesson. In 1987 many of the world's central banks made the opposite mistake by overreacting to a stock market crash by cutting interest rates in the middle of an economic boom. The result was higher inflation which required a fierce monetary squeeze in the early 1990s. If the ECB opted for this particular mistake, it would risk breaching its constitutional duty to maintain price stability.
Finance ministers face equivalent risks with fiscal policy. The budgets of the 11 countries that will use the euro are constrained by a stability and growth pact, which calls for balanced budgets over the business cycle. But as signs grow of a world slowdown (or worse), politicians will confront the question: should they react by relaxing fiscal policy, and thereby risk breaching the pact? Or should they stick to the pact, set policy on autopilot, and hope everything works out?
The scope for mistakes is alarming and the stakes are huge. If there is a global slowdown, then Europe, which accounts for almost 30 per cent of world output, should be better placed to act as a locomotive for the world economy than Japan or the US, the other industrial superpowers. Japan is plunging deeper into recession. The US, which has so much of its wealth in the stock market, will be harder hit by a market correction than Europe. The Organisation for Economic Co-operation and Development estimates that a 20 per cent fall in share prices would reduce European gross domestic product by 0.2 per cent in the second year, but would cut the US's by 0.6 per cent. The corollary is that if Europe is perceived to have got its policy response wrong - if it retreats into its shell instead of being a locomotive - then the disappointment and opportunity cost will be all the greater.
Eurosceptics should not get too excited, though. Emu will not disintegrate or even be delayed because of a slump in world stock markets or because of the economic meltdown of Russia. On the contrary. A delay would only add to the uncertainty and would smack of panic.
Nor does the crisis mean that Emu is necessarily at greater risk of breaking up. The main threat to the currency union has always come from a so-called asymmetric shock - that is, one that affects different countries differently. The shocks of the past few weeks are not like that. It is true that a meltdown of the Russian economy would affect Germany more than France, but even so Russia makes up less than 2 per cent of German trade. Broadly, from the European point of view, shocks from Russia, Asia or on Wall Street, are all symmetrical -affecting the whole of the euro zone in the same way.
But all this is little consolation for Europe's policymakers. For them, the situation differs from the position in the early 1930s or late 1980s because of the great uncertainty over the immediate economic outlook. Policymakers are now confronting two sharply different possibilities, with very different policy implications.
The first outlook is the optimistic case. In its spring forecast, the European Commission forecast growth in the E-11 zone of 3.0 per cent this year, rising to 3.2 per cent in 1999. At these rates, the euro-zone would become the world's economic locomotive by the end of this year. It was this prospect of a strong rebound in growth that has attracted many international investors and much hot money into the euro-zone.
The other possibility is far more pessimistic. It is increasingly being shared by private-sector economists. The economic research team of Deutsche Bank in Frankfurt warns that the E-11 growth rate might not be 3.2 per cent in 1999 as the Commission had forecast, but only 2 to 2.5 per cent. Similarly, Gary Dugan of J.P. Morgan has cut his GDP growth prediction for 1999 from 2.9 per cent to 2.5 per cent and revised down his forecast for European corporate earnings growth next year from 12 per cent to 5 per cent.
The difference between the two forecasts is due in part to the wealth and investment effect of the recent fall in stock markets as consumers are less well-off and companies face a less attractive environment for raising cash for investments. But most of the difference is due to the knock-on effects of any global economic slowdown. Around 40 per cent of the world economy is either in recession or heading that way. It is difficult to imagine that the euro-zone can make itself immune from the world economy and remain a safe haven for any length of time.
The contrasting forecasts have different policy implications. If the euro-zone economy is growing at 3 per cent, as the European Commission suggested back in the spring, the current level of European interest rates would appear extremely low by historic standards, even taking into account the relatively benign outlook for inflation.
Under the Commission's forecast, the euro-zone economy would be well on its way towards the peak of the business cycle and interest rates should probably go up now, anticipating future capacity shortages, rising further next year.
The correct fiscal policy response, on these assumptions, would be to keep a tight rein on spending and seek to run balanced budgets. European officials have already expressed concern that European governments may have lost interest in keeping fiscal policy tight as soon as they met the Maastricht criteria for entry into the single currency. Adjustment fatigue is setting in everywhere.
Now consider the pessimistic forecast. The cycle is almost flat, and the economy is stuck at low growth rates. Deutsche Bank, for example, said this scenario suggests interest rates would remain at 3.3 per cent until the end of 1999. This would mark an unprecedented long time of extremely low rates.
The pessimistic outlook would be especially bad news for Europe's 17m unemployed. Unemployment in the euro-zone has slowly fallen from its peak of 11.7 per cent in June 1997 to 11.2 per cent in June this year.
With economic growth faltering, the trend decline in unemployment is unlikely to continue. Further reductions in unemployment would then require controversial fiscal and labour market reforms - cuts in effective minimum wages, cuts in non-wage labour costs, a more liberal legal environment for labour contracts and, of course, cuts in income tax rates. Many of Europe's governments had hoped the resurgent economy would take care of the unemployment problem, obviating the need for such reforms.
But neither structural reforms, nor an overhaul of the international financial system, will eradicate the policy dilemma for the ECB. There is no imminent need for policy action now, since Europe faces neither an imminent threat of inflation or of deflation. But the problems will set in next year, when the ECB takes over from national central banks. By that time, ECB directors must have made up their minds about where they think the European economy is headed.
Europe's central bankers are a cautious bunch. They are likely to remain more concerned about the devil they know - inflation - than they one they don't: deflation. That suggests they will not loosen policy much. If they are right, European growth will continue steady. But if they are wrong, economic problems could get much worse - and not only in Europe.
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