Against the tide: The unstoppable Eurotrain?

For some time in this column, I have argued that European Monetary Union (emu) was unlikely to go ahead on schedule in 1999. There were two main reasons for my view. First, on the basis of the criteria set by the Maastricht Treaty, hardly any eu countries were likely to meet the convergence targets. Many would fail to meet either the budget deficit target of 3% of gdp by the end of 1997 or the debt-to-gdp target of 60%. Others would fail to meet the inflation and bond yield limits.

The other reason was that if the criteria were relaxed or flexibly interpreted by the European Commission in order to allow emu to get up and running, that would never be accepted by the German public who wish to protect the value of their Deutschmark savings. A monetary union that included member states like Italy and Spain, which could not meet the Maastricht criteria in time, would produce a very weak euro compared with the Deutschmark. So Chancellor Kohl would be forced to postpone emu rather than face the wrath of German savers.

But now it seems more likely than not that emu will go ahead on time in 1999. Why have I changed my view?

First, it’s still the case that key European governments will fail to reach the Maastricht targets next year. The European Commission appears to have quietly forgotten the debt-to-gdp criterion. High debtors like Italy (124% of gdp) or Belgium (130% of gdp) will be allowed to join as long as they are “making progress” in lowering the debt levels.

But, most important, it seems that financial markets and the Bundesbank are prepared to countenance France’s creative accounting trickery in its 1997 budget designed to meet the 3% of gdp deficit criterion. Without France, emu is not on. On any reasonable forecast, France’s budget deficit in 1996 was likely to overshoot the government target of 4%. But, by sleight of hand, the French government has come up with a package of one-off revenues in order to meet the target. It’s got fr37 billion from France Telecom in return for taking on the future pension liabilities of the state-owned utility. It also plans to raid the surpluses in the accounts of the Caisse des Dépôts and the unemployment benefit fund, as well as the special fund set up to pay down the huge debt built up on the social security account. Lo and behold, after doing all this, it can meet the 3% target in 1997.

I still think it will overshoot and end up around 3.5% of gdp. But that brings me to the second reason for a change of view. It seems that financial markets and the Bundesbank, and of course, Chancellor Kohl, are prepared to accept that France will get “close enough” to argue that emu can go ahead in 1999.

Climbing aboard

So the first wave will include Germany, France, Benelux, Netherlands and Austria, and possibly some peripheral countries like Finland, Portugal and Ireland. That will also give a big incentive for Spain and Italy to follow soon after.

Of course, there are still several slips ‘twixt cup and lip. First, the French trade unions could still have something to say about another austerity package, as they did last year. Second, slow growth in Europe next year could start to throw all the fine calculations of mice and men askew. France’s budget could overshoot badly by next summer. And third, the biggest irony of all could be that Germany may not make the Maastricht targets. Its debt-to-gdp ratio is right on 60% and appears to be on the rise. And the 1996 budget targets are already breached, which will mean that finance minister Theo Waigel will have to bring a deeply unpopular supplementary budget to get public finances back in line.

And of all the hurdles to come, the most immediate and critical to the markets’ acceptance of the inevitability of emu happening on time, will be the stability pact, which is to be ratified at the Dublin eu summit in December 1996. That’s because Germany needs a political tool to sell the idea of a European single currency that does not debase the Deutschmark for the world’s greatest savers.

All emu applicants have accepted the principle of a stability pact to limit future fiscal deficits below levels sanctioned by Maastricht. That may seem odd. Why would Italy, Spain and the uk sign up? The reason is that the Italians and Spaniards need emu and continued convergence of their interest rates with Germany, if rising interest rates are not to bankrupt them. The uk doesn’t give a damn, as it’s not going to be in emu anyway.

The stability pact would work like this. A 3% of gdp fiscal deficit is the maximum a emu member state would be allowed and only for a short period. The average permissible deficit over a cycle should be a maximum of 1% of gdp. Transgressors which go above the 3% level would get fined for the duration of their deficit overshoot. But how does this get enforced?

Germany wanted transgressors to be automatically penalized with a deposit or fine of 0.25% of gdp. But it has now accepted the idea of a progressive fine for countries breaching the budget-deficit criteria. These would amount to 0.25% of a country’s gdp following the discovery of the breach, and rise by 0.1% increments for every additional breach that exceeds 1% of gdp. In other words, a country that has a 3.1% budget deficit after emu is in place will pay a fine of 0.25% of its gdp, while a country which has a budget deficit of 4.1%, for instance, will be fined 0.35% of its gdp, and a country with a 5.1% budget deficit will forego 0.45% of its gdp in fines. Fines will be capped at a maximum of probably 0.5% of gdp. So a state running a 6% budget deficit will be fined the same amount as a country with, say, a 9.5% budget deficit.

But here’s the get-out. The system of fines will come into operation only after other measures are exhausted. In the first phase, offending governments will be warned and given the opportunity to correct their actions. When this fails, countries will be ordered to deposit interest-bearing certificates with the eu. Only when this fails to produce an improvement in the fiscal deficit, will fines be imposed. Informal calculations suggest that it will take at least two years after an individual state breaks through the 3% ceiling on its budget deficit before the question of fines arise.

Furthermore, future trends will be taken into account in a decision to impose fines. Thus, a government that breaches the conditions in one year but offers reliable projections that it will meet them in the next year will almost certainly get away with no fines at all.

Also, special exemptions will be granted in “exceptional” circumstances. The Germans want to restrict these to major natural calamities, when a country may need to spend more for reconstruction. Others continue to argue for a looser interpretation. Regardless of the outcome, the Germans have accepted that the concept itself can be interpreted, already a major concession.

Another concession against automatic fines is over who decides. Countries with excessive deficits will be brought to the attention of a “stability council” composed of the finance ministers of the euro member-countries and not the broader 15 member-state, economic and financial committee (proscribed by article 109c of the Maastricht treaty) or the Ecofin council of finance ministers.

Fatally flawed

Now, voting in this stability council is still being negotiated. But it is likely it will accord each emu member-country votes in accordance with its weighted gdp. Alternatively it may use the voting procedures laid down by the Maastricht treaty that give France and Germany equal votes. Either way, this is not ideal for France because Germany and its satellites would outvote it, but it’s the minimum the Germans are prepared to accept. And it gives France and Germany the biggest share of the votes together.

According to the German vision, unless the stability council majority votes against a fine, the fine is automatically imposed. France disagrees. Under the French proposal, an excessive-deficit country would first come up with its own plan to put its house in order. If the plan is accepted by a majority vote of the council of ministers, there will no fine. If the majority rejects the plan, a fine is imposed. Which version of the pact gets passed will ultimately depend on how a unanimous vote (qualified majority does not suffice) of prime ministers can be cobbled together at the Dublin Summit.

When it’s announced, the stability pact will be painted as looking pretty severe. But in reality, because sanctions will be imposed only after considerable delay by majority vote in the stability council, they will never be imposed. Germany will continue to allow France to bend rules in order to be a founder member of emu.

So the euro now looks much more likely to be born on time. Political mind has triumphed over economic common sense. The euro will be a weak currency compared with the dollar and the yen. And emu is fatally flawed. There will be huge pressures on the monetary union as it inflicts higher unemployment, lower investment and growth on the economically weaker emu members. That could eventually lead to an emu blow-up. But that’s a story for another day.

David Roche is president of Independent Strategy, a London based research firm.