A timely acceleration of European economic growth and a setback for the German opposition in local elections have lifted Helmut Kohl?s hopes of seeing economic and monetary union begin on time in 1999. On the other hand, much could still go wrong on the road to the euro. The recent rise in German interest rates and the fall of the Italian government of Romano Prodi place significant hurdles ahead of the "wide" Emu that the financial markets have been assuming will start in 1999.
The German interest rate rise was the first in more than five years. The Bundesbank demonstrated that its frequent warnings over accelerating inflation were not mere bluff, and sent a clear signal that participation in Emu will be limited to countries that have substantially converged with Germany. This condition implicitly rules out Italy, gripped as it is by political wrangling over a Maastricht-induced austerity programme for 1998. The signal will not be liked by the French government, which has always favoured a wider Emu. The alternative?an enlarged Deutschmark bloc?would not give France the geopolitical parity with Germany that it has long desired.
The chances of Emu starting on time have certainly risen since the early summer, when miscalculations in Bonn and Paris made it seem as if France and Germany were campaigning to scupper it. However, the Bundesbank?s action on interest rates and the problems facing Italy mean that, by my calculation, there is still only a 60 per cent chance of Emu going ahead as scheduled.
For Tony Blair?s government, preparing to take over the EU presidency in the first half of next year?the crucial period of Emu decision-making?the stakes are finely balanced. Blair will want to give some signal of a warmer attitude to Emu both out of political conviction and in order to maximise Britain?s leverage during its EU presidency. But he will also want to take into account the many uncertainties that still surround the project and the opinion polls indicating that more than 60 per cent of the British electorate are opposed to a single currency.
Whether or not Emu will be a success remains, as ever, mired in doubt. A project designed to make the economic environment more predictable has, perhaps unavoidably, become a powerful source of continent-wide uncertainty.
Kohl?s last laugh?
Kohl?s hopes of a fifth term after elections in September 1998 looked slim a few months ago. But presiding confidently over his party?s annual conference in Leipzig in mid-October, he once again looked like a possible winner. Unless he makes serious errors over Emu decision-making next spring, the euro is unlikely to play a big role in the September 1998 election. Like all German elections, the outcome will be decided by the state of the economy and the electorate?s assessment of prevailing policies on social security and law and order. An expected dip in German unemployment next year and renewed divisions in the opposition Social Democrats (SPD) are likely to help Kohl. The recent failure to push through a badly needed reform of the tax system may count as much against the SPD, which blocked it, as against the government.
Arguments for postponing monetary union have been advanced by Kohl?s domestic rivals and, more quietly, by the Bundesbank, but have made no headway with the French and German governments. France?s ruling socialists, united by the desire to retain power and credibility in the delicate cohabitation with President Chirac, have kept up their deft handling of 1998 budget plans. The main doubts centre no longer on Germany or France, but on Italy.
After Prodi?s resignation, the odds are lengthening on Italy?s ability to enact suf-ficient public sector reforms to guarantee inclusion in the first wave of Emu. One possible outcome of the current dispute?early elections?would delay work on the 1998 budget and associated welfare reforms. Another option would be the formation of a technocratic government of both left and right to push through the necessary decisions in time for qualification, when the decision is taken next spring. But such a government might not offer the guarantee of sustainable economic progress that Germany is demanding from countries participating in Emu.
In Germany itself, the well publicised Emu scepticism of Kohl?s rivals will not go away?but is starting to look like shadow-boxing. Kurt Biedenkopf and Edmund Stoiber, the conservative premiers of Saxony and Bavaria, who have argued in favour of postponing Emu, may be doing Kohl a favour. Since two thirds of the German electorate oppose replacement of the Deutschmark by the euro, a debate on postponement led by conservative heavyweights helps to convince floating voters that the government is taking Emu qualms seriously.
For the same reason, the statement on 3rd September by Bundesbank president Tietmeyer that the "roof would not fall in" if Emu were postponed is a help rather than a hindrance to Kohl. By maintaining maximum rigour, the Bundesbank has reinforced its position as the supreme arbiter on monetary union. If the central bank eventually comes out in support of a 1999 start-up, this will defuse a large part of the political opposition which Kohl might otherwise fear.
Sensing a weakening of Emu resistance, the chancellor has instructed his Christian Democratic Union cohorts to take the offensive on the issue. The document on monetary union issued in September by Kohl?s parliamentary lieutenant Wolfgang Sch?uble is far better argued than previous party statements on the issue. (It also avoided the political mistake made in the CDU?s much-remembered paper of September 1994.)
Kohl calculates that if European leaders make an uncontested decision to go ahead next spring, he could even make Emu a vote-winner. The electoral aspiration for change after 15 Kohl years is offset by the desire for a tried and trusted hand to complete the Emu adventure. Additionally, a go-for-Emu spurt will focus attention on SPD divisions. Gerhard Schr?der, the only SPD leader with a real chance of beating Kohl, has suffered from the resignation of his ally Henning Voscherau, head of the Hamburg city government, after the party?s disappointing result in the recent state election there. And Schr?der?s scepticism about Emu?based on the argument that it only makes sense if it includes Italy and Spain and is accompanied by higher growth?has been toned down in recent weeks. In his 12-point economic policy statement issued earlier this month?stressing Blair-style "modernisation" and market reforms?Schr?der backs Emu provided that the convergence criteria are fulfilled and that it leads to an EU-wide "employment offensive."
the financial arithmetic
The financial markets? surprising confidence in Emu was apparently vindicated by the decision of EU finance ministers on 13th September in Mondorf, Luxembourg, to fix participants? bilateral conversion rates in May 1998. This move is intended to lower incentives for foreign exchange speculation during the run-up to the conversion of Emu currencies into the euro in January 1999.
Many observers interpreted the Mondorf plan as confirmation that Emu would go ahead with broad participation. However, by speeding up the timetable for convergence, the Mondorf decision in fact increases the likelihood of a narrow initial Emu. Despite the convergence of long-term Italian in- terest rates, short-term lira rates are still more than 3 percentage points above those of the Deutschmark. The Mondorf move increases pressure on the Bank of Italy to lower short-term rates while the Bundesbank continues its moderate tightening in the coming few months.
For Italian participation in Emu to be credible, the markets need to feel confident that both Germany and Italy can live with short-term interest rates in the region of 4 per cent to 4.5 per cent after May 1998. If there is any doubt about the sustainability of this position, markets will test the poli-ticians? desire for a wide Emu by buying Deutschmarks and selling lire. The steps taken in Mondorf could lead to Emu starting de facto seven months earlier than planned. However, the decision also increases the danger of an attack on soft currencies by the financial markets.
the franco-german dance
One longstanding problem?discord between Bonn and Paris on political control of the European central bank (ECB)?now looks rather less serious as a result of concessions by France?s Socialist government. Contrary to indications when Lionel Jospin took power, France has decided in recent bilateral encounters with Bonn not to make a high-profile case for a gouvernement ?conomique to supervise the functioning of the ECB.
Similarly, Paris now tacitly accepts that the president of the ECB will be Wim Duisenberg, the former Dutch central bank chief who took over the presidency of the European Monetary Institute (the ECB?s forerunner) on 1st July. Jospin has thus backed away from pressing for a French- man at the helm of the ECB?a line that was vigorously pursued by Chirac and the former government of Alain Jupp?. Jospin appears to have been persuaded by Duisenberg?s Dutch Labour party credentials, his know-ledge of French language and culture (including frequent holidays in Provence) and?last but not least?the stern pro-Duisenberg campaign of the Bundesbank and the Bonn government.
The diminishing differences between Bonn and Paris reflect wise leadership in France. The Jospin government has learnt the lessons of futile French attempts to overplay its hand in monetary bargaining with Germany. However, not all sources of Franco-German tension have been eliminated. Already French critics have argued that by giving up previous policy positions, Jospin is attaching greater priority to furthering Kohl?s re-election chances than to pursuing France?s national interests.
The quid pro quo of France?s softer line on the ECB has been Germany?s willingness to stop demanding that France fulfils precisely the Maastricht deficit targets for 1997. But any setback for French economic growth for 1998 will heighten the risk of Emu derailment. And the chances of a successful anti-Emu lawsuit at the German constitutional court will rise if next May?s decisions?on who will qualify for the first wave?fall short of a "strict and narrow" interpretation of the convergence criteria.
On the other hand a "narrow" Emu could attract a blocking move from another German institution?the Bundesrat, the upper house where the states are represented. The SPD has a majority in the Bundesrat and if Italy is excluded from Emu, Schr?der might be able to persuade enough SPD states to refuse to ratify Emu next spring (with the possible support of two conservative states: Biedenkopf?s Saxony and Stoiber?s Bavaria).
new risks for old
The sales pitch for Emu rests on the hope that it will equip Europe for a new period of economic expansion and employment. But the intended result of Emu?higher growth?is also the condition for it to go ahead at all. Unless the EU returns to a 3 per cent growth path in 1998?for the first time in many years?there is still a strong possibility that monetary union either will not start on time or will break down during the 1999-2002 transition period. Speculation during the three year cohabitation between the euro and national currencies could trigger destabilising movements out of "weak" currencies and into "strong" ones.
The International Monetary Fund, otherwise a cheerleader for Emu, has predicted that slow European labour market reform could undermine the euro by keeping unemployment high. As long as national currencies continue to exist up to 2002, the legal and political basis for an irrevocable monetary union will be imperfect and thus vulnerable. Any political upset, or even an accentuation of regional EU divergences, would increase the risk of a break-up.
Emu?s success depends on financial market operators banishing all doubts about the system?s long-term viability. Unless these doubts disappear permanently, markets will demand a risk premium during the transitional period on those currency instruments that continue to be denominated in "softer" currencies. At the very least, such doubts would cause commercial banks to demand a "spread" premium for converting "softer" currencies into "harder" national currencies and the euro. The existence of these spreads at a retail and wholesale level would subvert the aim of Emu.
Incomplete political union in Europe represents another problem. Kohl and the Bundesbank supported political union in 1991-92 as a sine qua non for monetary union. But as German public opinion has grown less Europhile, the German government has dropped its insistence that such steps are necessary before a single currency. Bonn now argues that political union will become both more necessary and more feasible after monetary union is in place.
But the absence of political union could influence the chances of anti-Emu action at the constitutional court. The German professors intending to lodge a lawsuit next year argue that the institutional development of the EU since 1991 has been insufficient to guarantee that Emu will become a "stability community" which will uphold the security of the currency. Lawyers advising the group say they are confident that the court will at least accept that the planned submission is legally valid. Such an outcome could force an injunction that would delay Emu beyond January 1999 even if, eventually, the court were to find against the plaintiffs.
The possibilities of post-1999 currency speculation, obstruction at the constitutional court or rejection by the Bundesrat, demonstrate that the risks of Emu have shifted rather than disappeared. The impetus behind Kohl?s dash for Emu-by-1999 is the fear, explicit or implicit, that delay would scupper the momentum and thus automatically break up present currency relationships. This argument, however, suggests little faith in the economic convergence that supposedly underpins the entire Emu process.
If politicians are right to believe that the main reason for the present stability of European currencies is the plan for Emu, then postponing the project would be disruptive. If, on the other hand, convergence depends on more fundamental factors than the political drive towards Emu, a delayed start would not be an irretrievable setback. In the next 18 months, as Europe?s experiment in monetary engineering develops, we may discover which of these views is correct.
