January's dreadful German unemployment figure is the most politically significant euro event since the Dublin summit. Chancellor Kohl was always seen to be more powerful from abroad than he was in reality at home. He is now seen as a chancellor with a great plan for European integration and no strategy for German economic rejuvenation.
Kohl's decline won't stop the euro happening on time, but it has reduced its chances a little. More important, there will be economic and political effects for the Dm. Stand by for perverse financial market reactions. A few months ago anything that increased the chances of Emu postponement would have caused the Dm to strengthen and the fortunes of Europe's high-deficit, high-debt Southern Comfort Countries to fall. Not so now.
The Dm will stay weak because the Bundesbank will cut interest rates to boost the economy. This crisis is about German weakness, not strength. That's why the German-Italian summit last month went so swimmingly for Italy's prime minister Romano Prodi, and why Kohl had to declare glumly that, without further measures, Germany wouldn't qualify for Emu .
The reason the Dm will suffer is two-fold. First, rising unemployment will hit the German budget deficit (0.3% point increase alone for the cost of last month's 500,000 extra unemployed) and depress demand (another 0.2% points on the deficit). Second, the weakening of Kohl leaves a vacuum on the German and European political stage, and financial markets abhor a vacuum.
Persistent trend
January's seasonally-adjusted unemployment rise of 160,000 was mainly the result of German fiscal and corporate restructuring. Banish from your head any idea that the increase was due to Jack Frost. Only 30% (156,000) of the 500,000 headline rise was due to cold-weather layoffs in the construction sector, and most of that was in eastern Germany where state subsidies are ending. The remaining 70% was due to restructuring in services and industry. That trend is here to stay. You cannot pay people $33 an hour to screw wheels onto VWs and stay competitive in a global economy.
Without new measures, I expect Germany's budget deficit to hit 3.8% this year, well over the Maastricht limit. France will be no worse. Spain could do better. And Belgium certainly will. That will make financial markets worry that Emu won't happen on time, or that, if Emu does happen, it will be a fudged matrimony of economic weaklings. That's hardly a recipe for a strong euro.
I expect the Germans will cut more fiscal fat to get their deficit down. But the issue of how is going to set the German cabinet members at each other's throats and the coalition partners too. Which brings us to Herr Kohl.
Kohl will fight hard for his political life, but he's clearly on the slide. The most likely alternative to Kohl running again in October 1998 is that in spring next year he names Wolfgang Schauble as his Kanzlerkandidat. Then Kohl and Schauble campaign jointly in the election and win. That would mean no change in Emu policy. Even if one of the younger and now more critical CDU leaders, like Christian Wolff, replaces Kohl, there would be little change in Emu policy.
Where things would change is if Social Democrat premier for Lower Saxony Gerhard Schroeder were to become SPD candidate for chancellor instead of Oskar Lafontaine at the party's spring 1998 conference. He's already made some Emu-doubting noises. If Schroeder became leader, he might adopt an anti-Emu platform to win the October election.
But Schroeder would have a tough job uniting the SPD on an anti-Emu ticket. If anything, the SPD is even more pro-European integration than the CDU and CSU. And come spring 1998, the Emu goose will already have been cooked.
The difference this time from the last Emu crisis is that, far from driving up the Dm, renewed political and economic uncertainty about Emu is more likely to drive it down, as capital exits into the Swiss and US currencies.
I've just returned from Italy, and I stick to my view that Italy will not make it into Emu in the first wave. Publicly, the government of Romano Prodi states that it is determined to meet the Maastricht criteria for Emu participation in 1999. But chancellor Kohl is equally determined to ensure that Italy does not join in the first round, in order to provide credibility for a strong euro and win the continued support of the Bundesbank, if not for his doubting electorate.
With Kohl in political trouble, Prodi was able to dismiss doubts about Italy's first-wave membership at the recent summit. But economic reality still suggests that Italy will be excluded, although with a deal that puts it into monetary union shortly after 1999.
The Italian budget overshot badly last year. The deficit finally came in at L138 trillion, or 7.3% of GDP. That means that this year's government targets start at about L24 trillion more than originally forecast. So, even on the government's assumptions of growth and inflation, an extra fiscal package of about L20 trillion will be needed this year to hit the government's PSBR target of a L62 trillion, or 3.1% of GDP.
The Italians were recently helped by the European Commission, when Eurostat spirited away L6 trillion or 0.3% of GDP of the forecast 1997 deficit by allowing interest payments on zero coupon bonds to be accounted for at maturity (thus is Europe's destiny measured out in coffee spoons!).
The government plans to find the extra L14 trillion through a supplementary budget to be combined with a tough 1998 budget (to be announced in the summer), to convince financial markets and the European Commission that Italy will sustain its fiscal austerity.
But it will be all to no avail, because Italy's budget target of L62 trillion is unrealistic. The government assumes 2% GDP growth this year. I expect only 0.5% to 0.8%, despite the recent signs that the economy may be bottoming out. The European solidarity tax, coming in May, will wipe 4% off disposable income. That's exactly the amount wages and salaries are expected to increase this year. As most of that increase is a one-off adjustment for past excessive inflation, it may be saved rather than spent. Household revenue from government bonds, which probably makes up 30% to 40% of disposable income, will fall along with interest rates. That's one of the perverse effects of lower interest rates in a country with a high savings rate and significant household financial assets. Exports, which only grew 0.7% last year, are unlikely to accelerate this year if European growth remains weak, and the effect of past devaluations has waned.