Europe, the euro and sterling

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The euroland economy stinks of stagflation. Its politicians are faltering on reform amid electoral paranoia, and the threat to jobs from the global slowdown. That means, combined with the European Central Bank's confused interest-rate policy, that the outlook for capital flows into mainland Europe remains poor. I reckon that will continue to undermine the euro. The place to be in Europe is the UK, where I expect sterling will hold firm, despite the risk of possible early entry into the single-currency system.

With parliamentary elections taking place in half of Europe's states over the next 18 months, the focus is on meeting social obligations rather than economic reform. The tone is set by France, which has both presidential and parliamentary votes to cope with. The Jospin government has made it clear that it will do nothing to undermine its popularity (for which, read: prejudice the chances of the prime minister acceding to the presidency!). The practical consequence is a raft of new measures designed to protect French workers' rights in the face of the global slowdown.

But it's not just France that has pulled the plug on structural reform for the time being. Germany has offered Paris its full support in blocking accelerated electricity market deregulation, while watering down its own pension reform. Spain and Italy have made a stance against a rapid EU enlargement that could threaten their access to EU structural funds.

Now the new Italian government has announced that its budget deficit will be closer to 2% of GDP than 1% and that it might not be able to meet its commitment to reduce public sector debt to 100% of GDP by next year, as promised to other EU finance ministers. Fiscal profligacy will make it just that much more difficult for the ECB to get interest rates down in Europe.

Everybody knows that pursuing EU enlargement without wide-ranging reform risks institutional breakdown. And yet Berlin's latest proposals to create a more accountable, democratic and federalist structure for the European Commission, parliament and council have been firmly rejected in Paris.

Euroland needs this kind of stalemate like a hole in the head. Growth is slowing fast. Nowhere is this clearer than in Germany where the business climate indicator has fallen precipitously since last autumn. It's a worryingly reliable indicator for German and pan-European real GDP growth prospects. German unemployment is now rising in both the east and west, which will undermine already fragile consumer confidence.

Germany is the largest economy in euroland, accounting for a third of its output. So it's big enough to influence growth in the rest of the region, particularly now the one-off monetary union dividend - of low German interest rates for all - is beginning to recede. Indeed, the early warning signs on regional growth prospects are there for all to see.

Unfortunately, the ECB doesn't share this view. While the US Fed, the Bank of Japan and the Bank of England have all reduced the cost of capital sharply, the ECB stands defiant with a paltry 25 basis point cut. Of course, its position is not indefensible. Headline in-flation at 2.9% and rising is well above its medium-term target of 2% and headline M3 money supply growth has also been growing faster than the reference rate of 4.5%.

The ECB, too, is quick to point out that its mandate is very different from its peers. While most central banks have a built-in focus on growth, the ECB maintains a rigid focus on price stability, taking little account of immediate economic growth prospects. But as a result, it risks being smothered by its own logic. ECB president Wim Duisenberg insists that public confidence in the euro will improve if the ECB fulfils its obligation to control inflation. In the (very) long term that may well be right. But right now, keeping interest rates high is undermining European growth as well as confidence in the relative merits of investing in euroland.

If it wants to become part of the solution rather than part of the problem, the ECB should start focusing on the outlook for inflation.

Last year's big rise in euro-denominated energy prices will "automatically" fall out of the inflation equation during the remainder of this year. And that will bring the headline rate down towards the core rate, which remains below 2% and has probably peaked. As the prompt action of the US Federal Reserve and the Bank of England illustrates, such an approach pays quick dividends.

The Bank of England's willingness to cut rates promptly in response to the global slowdown is already limiting the downside. While the UK manufacturing sector is undeniably weak, exports are drying up and foot and mouth looks set to knock around 0.25% off the GDP growth rate in 2001, all is not lost. A resurgent consumer - accounting for over 60% of GDP - will likely save the day.

Superior growth prospects are one reason why I expect sterling to stay firm against the euro.

Another is the sustained foreign capital inflow into the UK (in contrast to the euroland experience). And a third is the growing probability that the UK will stay out of EMU for the foreseeable future.

Euroland's investment/GDP ratio has been falling steadily for the best part of a decade. And outflows of foreign direct investment and portfolio capital have become an albatross round the euro's increasingly scrawny neck. Indeed, the ECB's intransigence risks driving the euro back down towards historical lows, pushing up imported prices - and the region as a whole into a stagflationary mire.

For the euro to trend stronger, two things need to happen. Europe has to commit itself to reform and shrink government. And, as currencies are seen as an extension of central bank chiefs' persona, Duisenberg has to be fired. No one doubts he is an honest, well-meaning man, but, as ECB head, he is a Labrador dog in a china shop.

The landslide victory for Tony Blair's Labour party in the UK may seem to have changed the landscape for sterling. But has it? The big problem is that up to 70% of British voters are against joining the euro. Blair knows this so he may want to postpone the euro referendum for as long as possible. Worst of all, the euro looks such a miserable currency at the moment, that it's hardly a good time to make a case for joining it.

Anyway, I reckon the UK will stay out of the euro because the population will not be persuaded to vote for it. First, it makes no economic sense. It would involve a liberalised, market-driven economy retrograding to join a club of political control freaks running relatively unreformed economies. Second, it runs against the sense of Britishness of the voters who will not be swayed by elitist economic arguments.

Suppose I'm wrong and the UK does join the euro. UK equities would be the major beneficiary from sterling depreciation and a one-off interest-rate cut before entry. But the long-term effects on the UK economy, and thus equities, will be much worse inside the eurozone than out of it.