Sunday, November 17, 2002


Without specifically referring to Romano Prodi as 'stupid' the ECB issued a press release last Friday which might as well have done so:

The principle of budgetary discipline enshrined in the Treaty and the Stability and Growth Pact are indispensable for Economic and Monetary Union (EMU)
EMU, with a single monetary policy and 12 governments responsible for budgetary policies, needs a fiscal institutional framework. The framework must be simple and enforceable and ensure that fiscal policies in Member States are sound and sustainable. Such a framework of fiscal policies fosters sustainable growth and employment, is conducive to economic stability and is a necessary complement of a monetary policy geared to price stability.........

The main commitment of Member States under the Stability and Growth Pact is that the fiscal policies should result in medium-term budgetary positions which are "close to balance or in surplus". This, in conjunction with the Maastricht Treaty obligation to avoid excessive deficits and to apply appropriate implementation procedures, secures the sustainability of public finances and provides scope for dealing with the expected fiscal challenges caused by population ageing. Moreover, and contrary to the claims of its critics, the Stability and Growth Pact also provides sufficient flexibility after "close to balance or in surplus" positions have been reached, as automatic stabilisers can then operate fully. Problems have arisen not because the rules are inflexible, but as a result of some countries' unwillingness to honour their commitment to respect the rules. The results of fiscal policy in several countries are very disappointing. In this context it is important to recall that the main reason why countries are in budgetary difficulties at present is because they have not used the situation of higher growth to substantially improve their fiscal position.
Source: ECB Press Release

In saying "contrary to the claims of its critics, the Stability and Growth Pact also provides sufficient flexibility", the ECB doesn't directly mention Prodi, but they might as well have done so. This means the two leading institutions of the Euro zone have effectively gone to war with each other. As Morgan Stanley's Eric Chaney has it:

The debate on fiscal policy in EMU-land has suddenly jumped several degrees on the Richter scale. A lapidary communiqué from the European Central Bank created a sensation on trading floors and government circles. In short, the ECB entered the fray with a strict interpretation of the Stability and Growth Pact (SGP) that leaves little ambiguity on its intention: the ECB is throwing its full weight toward avoid a watering down of the EMU code of good conduct.

The explanation given in yesterday's communiqué will sound rhetorical and hollow to most readers: "By ensuring sustainable public finances and by providing enough flexibility for the full operation of automatic stabilisers in periods of economic weakness as well as strength, the SGP also has a favourable effect on macroeconomic stability. This facilitates achieving price stability and fosters confidence in the euro area's economic prospects." Reading between the lines, I understand that fiscal stability is crucial for the ECB because its opposite might eventually imply its own extinction. In plain English, fiscal instability -- read spiraling government debt -- might lead to a serious political crisis and, in the end, a break-up of the EMU. Hence, it makes sense that central bankers do their best to secure a strong initial bargaining position.
Source: Morgan Stanley Global Economic Forum

The situation of having the two leading institutions of the Euro zone at loggerheads is a new development for financial architecture theory to chew on, it is also, for a Spanish resident like me, rather preoccupying.

Paul Krugman has recently raised the question of using backward induction points (which I don't claim to fully understand) as a means of analysing current strategy options for key players. Well, one possible scenario could look like this:

Firstly, think about the impact of this rather chaotic situation on an already Euro-skeptic British public. The balance of pro's and con's of the Euro just took a dramatic hit in favour of the latter. (Many commentators try to be positive by emphasising the teething troubles line, but others may be surprised that so-many problems are arising so-quickly). Then look at the impact of the entry of ten new members into the EU, and the consequent impact on agricultural policy and structural fund distribution. The first idea which comes to mind is that these new members will not be entering the Euro any time soon. The problems of coordinating the existing members are just too big. So we've got a two tier Europe, a customs union and a core currency union block (I suspect that this was always Margaret Thatcher's spanner-in-the-works strategy). Then think about the budgetary impact of the new entrants, Spain, Portugal and Greece will all be net losers, less aid/more contributions and more competition from low-wage, currency flexible customs union states. Add to this the inflationary tendencies of the latter three, and the fact that if they were not in the Euro and the UK was, then interest rates could come down and help Germany with its difficult situation since the average inflation would then be well below the 2% target (nice thought that the UK being able for once to help Germany).

Bottom line: medium term the three above mentioned countries (suffering from a mixed metaphor of 'cost push'/'demand pull') could well as we say in Spanish 'salir disparados' from the Euro group. Oh, what a mess, and why didn't anyone think of this sooner! Of course this is just one scenario. But it is a real possibility, and if the financial community finally get round to projecting forwards and then calculating backwards to factor it in, then the chances of it happening shoot up significantly.

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