Tuesday, November 19, 2002

Should Britain's Euro Decision Be A Political One?

Well Elisabeth Guigou, former minister in the Jospin government, and deputy in the current French parliament thinks it should. She argues her case in today's Financial Times:

Times are changing. Much like any other old couple, the French and the Germans seem to have understood that divorce would be too difficult to cope with. The prospect of enlargement and the considerable achievements of the convention on institutional reform are providing the EU with fresh impetus. In such a context, can Britain reasonably refuse to join the eurozone?

Of course, economic considerations must be taken into account. Britain needs to judge whether joining the single currency would benefit its economy and financial status, and the welfare of its people. As I read the various British contributions to the debate, I am surprised that they are unable to provide a clear answer to the most crucial question of all: where does the UK's economic interest lie?................Since economists do not agree, and because the opinion of business circles fluctuates along with the economic situation in the eurozone, it would seem that economic arguments in themselves are inconclusive.

In my view, political arguments should weigh heavily when the time comes for a final decision. Britain's answer to the euro question will be seen as the most important test of whether the country believes its destiny lies within the EU. The choice belongs to the British people. But they should be aware that an eventual refusal to join would considerably and lastingly diminish British influence in Europe. On the other hand, were the UK to become part of the eurozone its authority would be strengthened, both in the EU and in the wider world.
Source: Financial Times

Guigou's argument seems to be that that since the economic arguments appear to be inconclusive, the better decision strategy would be a political one. This really reveals quite clearly what the whole problem is with how we think about the Euro, and how decisions have been arrived at. The central idea is that political fiat can over-ride economic imperatives. But take a glance across the planet - to Japan, or another glance to the other side - to Argentina. Do we not have clear examples of how political over-rides on economic processes do not always end happily.

Gordon Brown is about to present his famed five economic assessments - sustainable convergence between Britain and the eurozone; sufficient flexibility within the eurozone; the effect on investment; the impact on financial services; and the effect on employment. Before deciding whether or not the economic arguments might be compelling would it not be interesting to await the results of this assessment. Does Britain not have the opportunity to wait and see whether this 'experiment' in political economics works before jumping in feet first. Should some consideration not be given to the current conflict between the ECB and the Commission (conveniently enough not mentioned by Guigou). Instead she simply asserts that "on the cost side, the loss of independence in setting interest rates appears to be the most important issue. Can one size fit all?" Indeed the interest rate situation seems to be a telling situtaion at present, with Duisenberg unable to take a good decision because there is no 'good' decision available (see my blog here). As for sustainable convergence between the UK and the Eurozone, the Eurozone itself appears to be experiencing divergence big-time (to steal an expression) right now, with Germany slumping towards deflation while Spain spirals its inflation upwards. I wish someone would explain to me how this can work.

Now interest rates may be an important issue, but they are surely not the only one. How about the affect of the inability to control the currency value on the balance of payments, or the homogeneity of the economic infrastructure and labour force? Unfortunately, instead of investigating whether or not the sum total of the associated economic problems means that the benefits of Euro membership are now as clear as they appeared to be, she simply informs us: that "an assessment-based approach underestimates the dynamic character of European economic integration." I am afraid Elizabeth that you do not convince.

Sunday, November 17, 2002

Pros and Cons of Euro Entry

In this timely piece, Morgan Stanley's Fatih Yilmaz and Stephen Jen do some options call accounting on the pluses and minuses for EMU participation on the part of the UK and Sweden. They rightly conclude that, seeing what we are seeing, the value attached to waiting just went up, dramatically. As they point out both the UK and Sweden are already members of the EU, and, in that capacity, enjoy all the trade benefits that are afforded to all EU members. In addition the benefits of joining the EMU should be distinguished from those of being EU members. On the plus side, the key benefits of joining the EMU seem to be: firstly, a reduction in the transaction costs of trading with and investing in the other EMU member countries fall, the cost of raising capital should also decline towards that of the rest of Euroland, secondly, in theory, "monomoney" in Euroland should enhance price (and wage) transparency, which in turn should lead to greater competition in the product market and the labour market (it's important to note the 'in theory part here, since at present it might seem that this transparency, absent labour market flexibility, is leading to a naive inflationary coupling effect in the Southern zone of Europe). Thirdly, any potential adverse effects of exchange rate uncertainty on trade and investment would disappear. These benefits appear extremely thin when we start to look at the associated costs:

Joining the EMU comes with its costs. First, there is the issue of abandoning monetary independence. The use of domestic monetary policy and exchange rate adjustments for the purpose of national demand management will be lost. The size of the cost of forsaking monetary independence depends on two factors: As the effectiveness of monetary policy for adjusting the macroeconomic imbalances increases, and as the asymmetry of the responses of the member countries to economic shocks intensifies, the associated costs will be larger. Second, the Maastricht treaty imposes tight fiscal policy restrictions to fulfil several convergence criteria. With negligible large-scale regional transfers, the loss of fiscal autonomy can also have adverse impacts on demand management and economic stabilisation. Third, factor mobility and price (wage) flexibility, the vital mechanisms for adjustments in a monetary union when monetary and fiscal constraints are binding, are severely restricted in Europe. Fourth, attempts to achieve one-size-fits type Europe-wide policies can themselves generate political conflicts within Europe.
Source: Morgan Stanley Global Economic Forum

Let me just run this again. You get to save some currency uncertainty costs, and possibly to borrow money a bit cheaper (mid-term this remains to be seen). In exchange you lose all control over fiscal and monetary policy, have to operate permanently in sub-optimal conditions (this follows from the fiscal/monetary point, look for eg at Germany right now) and face a lot of political in-fighting to boot. Seems like no-contest to me. Of course one mistake (there have been many I'm afraid) always was to create the category of EU member, non-EMU participant. But now it's too late I guess.

Despite the fact that central banking decisions are meant to be shielded from political pressures, the governing council of the ECB is inevitably coming under growing pressure, simply because the introduction of the Euro was a political, not an economic, decision, and the complexities of making it operational are not widely understood.

Many commentators criticise the bank suggesting that it is not sufficiently responsive to public opinion.(Obviously Duisenbergs obscurantism doesn't help here). In fact the opposite situation really would be a problem. Look at the difference between fiscal and monetary policy in the EU. Fiscal decisions are taken by politicians who are far more tied to public pressures and votes - ie they make decisions with a very short-term time horizon. What happens. You get to be on the 3% deficit ceiling before the problems even start, then when things get tough you cry foul, there is no flexibility (a la Prodi).

Duisenberg faces three tough problems. One is credibility - his, that of the bank, and that of the Euro. Two is really being able to measure consequences, as he says in the press release, uncertainty about the future is very high right now, and even if it weren't the capacity of the central bank to predict changes in inflation and unemployment is nowhere near as extensive as is popularly imagined. Three is the fact that the EU economies are far from homogenous.

If we start from the idea that what matters are real, not nominal interest rates. Then since Germany has 1% inflation (and dropping), the ECB rate of 3.25%represents a real rate of 2% - far two high. Spain, on the other hand, has an inflation rate of 3.5%, thus the real rate in Spain is -0.25%, ludicrously low for a country with a chronic inflation problem.

The present rate is bad for both countries. So what do you do, raise or lower, take your pick? Obviously depending on whether you're German or Spanish you may take a different view. And if you are Irish or Italian, or Dutch or French. Why, oh why, you may well ask, did anybody dream up the idea of the Euro in the first place? DW-World is of course German:

As the ECB keeps interest rates constant, Germany’s new economic Super Minster has renewed calls for the European Central Bank to help its flagging economy by cutting interest rates. Germany’s Minister for Economy and Labor, Wolfgang Clement, made an indirect call on Friday to the European Central Bank (ECB) to lower its interest rates after the bank decided to keep monetary policy constant for the 12th month in a row. Speaking at a forum of the Rationalization and Innovations Center for the German economy on Friday, Clement implied that the responsibility for German economic growth was not solely that of the German government and that the ECB should help by lowering interest rates in the eurozone. "In order to have a consistent policy for growth and employment [in Germany], others have to do their homework, too," Clement told attendees at the forum in Berlin. "The tariff policy or European monetary policy is part of that," he added.

Speaking to journalists in Berlin, the head of the Federation of German Trade Associations Michael Sommer joined the chorus of calls by German trade unions to put life back into Germany’s flagging economy. "How long will politicians in Europe stand by and watch while the ECB pursues an interest rate policy that does nothing for job creation?" Sommer asked. A cut would be good news for Germany, which has admitted it will exceed the 3 percent budget deficit allowed under the Growth and Stability Pact rules. Currently the country’s economic growth is crawling at some 0.3 percent. With unemployment figures at the four million mark and experts predicting no end in sight to Germany’s economic malaise, calls to change eurozone monetary policy are likely to grow louder every day.
Source: DW-WORLD.de

Of course a cut would be good news for a lot of hard-pressed German companies. But what if the price is sending Spain, Greece and Portugal, via an inflation straight jacket, down the road, recently trodden by Argentina, of stagflation and suffocation? Will the need to cut then have been so obvious?

At a press conference yesterday Wim Duisenberg explained the decision of the governing council of the ECB as follows:

We have reviewed monetary, financial and economic developments and updated our assessment in the light of the information available. In view of the high uncertainty on future growth, and its implication for medium-term inflationary developments, the Governing Council has discussed extensively the arguments for and against a cut in the key ECB interest rates. The view has prevailed to keep interest rates unchanged. However, the Governing Council will monitor closely the downside risks to economic growth in the euro area.

However, for the time being, the main scenario for the euro area remains that economic growth is expected to return to rates close to potential in the course of 2003. In fact, this expectation is consistent with all forecasts published by international organisations. Private forecasters, on the whole, also seem to share the same view. Moreover, financial markets have shown signs of stabilisation in recent weeks following a period of considerable turbulence. The expectation of an improvement in economic activity in the euro area is contingent on a recovery of growth in private consumption, supported by a reduction in actual and perceived inflation rates. This expectation is also based on a projected gradual recovery of the world economy and export growth which, together with the low level of interest rates, should help to strengthen investment.

Nevertheless, the uncertainty surrounding this scenario remains high. It is therefore very difficult, at this juncture, to predict the timing and strength of the economic upswing, both in the euro area and globally. Regarding fiscal policies in the euro area, may I expressly refer you to the Governing Council's statement of Thursday, 24 October on the Stability and Growth Pact. There is a strong consensus within the Governing Council that the principle of budgetary discipline enshrined in the Treaty and the Stability and Growth Pact are indispensable for Economic and Monetary Union and that the Stability and Growth Pact has been successful in promoting sound public finances and fiscal convergence, as well as in supporting the return to price stability. Moreover, the Pact is in the interest of the Member States.

May I also again urge governments to implement decisively the structural reform agenda, both within the area of fiscal expenditures and revenues and in labour and product markets. Such action is needed to enhance potential output growth over the medium term. At the same time, the prompt implementation of structural reforms would contribute towards strengthening confidence in the euro area and thereby support economic growth in the short term
Source: Press Release ECB

Now Duisenberg may have many hidden abilities, but one of them certainly isn't communicative capacity. His press conference responses are pretty revealing. [Question]: Mr. Duisenberg, I have never heard you say before in this forum that the ECB has discussed the arguments for and against cutting or raising rates. Are you going to start doing this more regularly in the future in your opening statements?..........[Duisenberg:] I do not know yet what we will say in the future. That depends on the circumstances in the future, but it is true that you have never heard me say that before. You have heard it for the first time today. What I will do in the future is up to the future.............. [Question] So, this may not be a permanent change in the way in which the ECB communicates?...... [Duisenberg] Not a permanent change. But, you are right, it is a change......[Question] if the ECB were to continue to stick strictly to its two pillar mandate and monetary rules such as the "Taylor rule", is it not the case that the ECB should, in fact, perhaps raise rates very soon, given the high rates of M3, ample liquidity, high core inflation prices, high service prices and the threat of higher oil prices?.........[Duisenberg] That is a very hypothetical question. If we were to stick to rules like the "Taylor rule", what would you do then? Well, we do not stick to rules like the "Taylor rule", so I prefer not to speculate........ [Question] I was wondering whether the public debate on the Stability and Growth Pact had any impact on the decision-making process this morning?.....[Duisenberg] Well, you would have to be a psychiatrist, because what you are actually asking is: to what extent did it have an impact on the minds of the individual members of the Governing Council. Certainly, it is a factor we perceive. But then let me say that the utterances and the discussions about the Stability and Growth Pact are very much a thing, I believe, of the past–, of the very recent past....................

Yes, I think, I've finally got it. The word is obscurantist. Like his fellow countryman Barcelona FC manager Louis Van Gaal, Duisenberg is clearly not comfortable in front of the cameras. I sympathise, but then I wouldn't take the job of Head of the ECB. One of the key characteristics of a good central banker is a capacity to handle and present information. In fact it is a virtue for a central banker that he keeps people guessing, the problem is, as others have noted, Duisenberg keeps us guessing because we have difficulty understanding what he is trying to say, and little sympathy with the way he says it. One source that is definitely not normally obscurantist or guarded in its comments is the Economist:

On November 6th, America’s Federal Reserve caught nearly everybody off guard by cutting interest rates by half a percentage point—twice the cut expected, bringing rates down to 1.25%, the lowest level since 1961. On the following day, the European Central Bank (ECB)—in charge of monetary policy for the 12 countries of the euro area, which share a currency and interest rates—left rates unchanged at 3.25%.

The ECB did consider making a cut. At a press conference after its decision, the ECB’s president, Wim Duisenberg, said the question had been discussed “intensively” at the meeting. He also expressed concern at the poor growth outlook for the euro area as a whole. In the end, though, said Mr Duisenberg, “the view prevailed that it would be wise to leave interest rates unchanged.” He also noted that the ECB does not think it is for monetary policy to stimulate economic growth.On the face of it the ECB’s stance is hard to understand. Partly it reflects the ECB’s single-minded focus on inflation—which is, after all, what its mandate requires. The bank has set its inflation target at 2% or less, and for a good part of the past two years, inflation in the euro area has been bumping up against, or even exceeding, that target. Inflation picked up in October, following a sharp rise in the money supply, which the ECB uses as a guide for future inflation. Critics reckon the ECB would do better to have a symmetrical inflation target, much like the Bank of England has: Britain’s central bank has to keep inflation within one percentage point either side of a central target, currently 2.5%. This more flexible approach would give the ECB more scope to cut rates when there was, as now, widespread concern about economic weakness.

A closer look at what the ECB has done, as opposed to what it has said, suggests it has, in practice, been ready to react to weak growth and to tolerate some overshooting of its inflation target. Behind Mr Duisenberg’s comment about the limitations of monetary policy lies real concern about the failure of many euro-area economies, and above all Germany, to tackle urgent structural reforms. The German labour market is much too rigid, making it expensive to hire workers and difficult to fire them. Mr Duisenberg and at least some of his colleagues (no details of ECB discussions are ever released) are worried that an interest-rate cut used as a substitute for, instead of an accompaniment to, economic reform will bring little long-term benefit. That is probably correct. In the short term, though, an increasing number of economists now think the ECB should do what it can to stimulate growth and reduce the impact of the current economic and political uncertainty.
Source: The Economist


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.

Saturday, November 16, 2002


The recent remarks by EU Commission President Romano Prodi about the stability pact continues to make waves. Yesterday he staunchly defended his description of the stability and growth pact as "stupid", claiming he was only saying in public what others were saying in private. When questioned by the European parliament on the topic he explained that in his opinion the euro's tough fiscal rules could not be rigidly applied when the world was on the brink of deflation. No apart from the fact that someone in authority in the EU is prepared to publicly admit deflation might be a problem, the overall impact of this 'gaff' is decidedly negative.

"What a tragedy it would be if, in winning the battle for stability, we lost the trust and backing of our citizens," he said. Although some of Mr Prodi's colleagues privately admit that his use of the word "stupid" last week was misjudged, the Commission chief claimed that he was striking a blow for a more open political debate in Europe. "The public mistrusts us and the institutions precisely because they suspect that only minor matters are aired in public and the truly important decisions are taken behind closed doors."

"Europe's citizens must be sure that the system is in safe hands - hands that are capable of giving consistent guidance to the system, both in quiet periods and, even more so, in times of difficulty and crisis." Mr Prodi's comments last week stunned EU finance ministries and infuriated many smaller countries, which claimed he was discrediting the pact in an attempt to make life easier for big countries such as France, Italy and Germany, which all have budget problems. "We see a Commission bending over to help the big countries, but when we had the same problems they held a gun to our head," said one EU ambassador from a smaller member state.

Despite Mr Prodi's defiance yesterday, even his closest aides admit use of the word "stupid" to describe the stability pact detracted from his basic message: that the pact needs reform and Brussels needs more power to enforce it. "He has an Italian political style, where you can throw up ideas for debate," said one of Mr Prodi's aides. "Perhaps a European setting is not the right place to do it."
Source: Financial Times

What exactly is the point of the stability and growth pact?. Well ever heard of Enron anyone? The principal Euro group countries, and especially Germany, Spain and Italy, all have enormous off-balance sheet undeclared liabilities: they're called unfunded pension and health care claims with rapidly ageing populations and imploding dependency ratios.

The stability pact was an attempt not to get into more debt before things really started to get tricky. Ever heard of rosy cash-flow massaging (think of all those dot-com venture capitalist plans). Well take a look at the growth numbers projected by these same countries for this decade, and look at the realities. The big danger in all this "stupid pact" talk is that ECB policy becomes a political toy. Of course changing the objectives from price stability towards growth oriented policy sounds nice (as if we weren't all trying to achieve growth already), the problem is when you get to read the fine print.

Sure, Germany needs more budgetary flexibility to be able to tackle the growing deflation dangers, but then there is the problem of inflation in Greece, Portugal, Spain, Ireland and Holland. I don't know whether a quick band-aid fix exists for all this, somehow I doubt it. But simple demogogic talk about 'stupid' pacts is easy and dangerous.
Perhaps the real problem is that the Euro decision was a political and not an economic one in the first place.

The decision to allow France, Germany and Italy until 2006 to comply with their balanced budget commitments has not please some of the EU smaller partners who have already made great efforts to comply. Of course each case is different, Italy, for example, appears to be making a standing joke of the whole process, while both France and Germany can muster case specific arguments in their favour. Additionally the condition of the world economy is arguably significantly different - much worse - from when the pact was originally agreed, and thus flexible, rather than 'letter of the law' interpretations are probably the order of the day. The bottom line, however, is that it is precisely this need for flexibility, and country specific measures according to contingency, that places the question mark over the Euro process itself. The stubborness of the ECB on the interest rates question places another. And in the end the good-order countries have a right to feel cheated, not to mention the consequences of all this where a Euro membership vote is looming.

Anger erupted across Europe yesterday over plans to allow France, Germany and Italy an extra two years to balance their budgets, in one of the most serious rows since the launch of the euro. Some smaller EU countries, which have already taken painful measures to eliminate their deficits, are upset over proposals to give the euro's three biggest economies until 2006 to do the same. They claimed the European Commission plan showed there was one rule for the big countries and another for the rest, and that it damaged the budgetary discipline underpinning the euro. Although markets have so far reacted calmly, many think the euro could be damaged if respect for the budgetary rules in the EU's stability and growth pact breaks down.

Yesterday France published its budget for 2003, with tax-cutting plans that clearly break its commitment to achieve a balanced budget in 2004. Italy's budget next Monday is also expected to signal a postponement in the target date for scrapping its deficit. Although both countries are suffering from sluggish growth, many EU members think Paris and Rome are flouting the stability pact by pushing through election pledges to cut taxes.
Source: Financial Times