Europe's Money MessBill Javetski
Helmut Schlesinger, iron man of international money, was battered and bruised. At a Sept. 14 press conference in Frankfurt, the visibly weary Bundesbank president showed the strain of three days of negotiating Germany's first interest-rate cuts in five years.
But the real slugfest was just getting started. Just a day after the Bundesbank's rate cuts, Schlesinger let it be known that only a broad realignment of European currencies against the mighty German mark would stabilize Europe's wobbly monetary system. Almost instantly, European currency markets exploded. The first casualty may well be a single European currency. "European monetary union?" asks Nicholas P. Sargen, managing director of Prudential Life Insurance's Global Fixed Income Advisers unit. "Give me a break."
In the end, the sea change in Europe's historic quest for economic integration took just two days to play out. At first, the markets leapt in euphoria over the Bundesbank's deal to trade a 7% devaluation of the Italian lira for the German central bank's half-point cut in its discount rate and quarter-point reduction in the Lombard rate, which sets a floor for European money-market rates.
DUMPING POUNDS. But then, Schlesinger amateurishly suggested to a German newspaper on Sept. 15 that the accord didn't go far enough toward resolving the crisis in Europe's currency markets. Traders attacked the British pound, Italian lira, and other weak currencies with a vengeance, dumping them for marks.
Soon, the pressure became too much for central bankers in London and Rome to bear. Britain and Italy simply pulled their currencies out of the European Community's system of managed exchange rates, opting to let the currencies trade freely rather than defend them by snapping them up in the open market.
Amid the chaos, EC finance ministers rushed off to a midnight meeting in Brussels. On the agenda: whether to shut down Europe's foreign-exchange markets until the Sept. 20 French referendum on the Maastricht Treaty on European monetary and political union.
For all the hubbub, the inevitable realignment of European currencies now may offer the sagging global economy some new support. After years in which economic growth and job creation have stagnated as monetary policy among Washington, Frankfurt, and Tokyo has drifted out of sync (chart), the Bundesbank's mere return to the rate-cutting fold, linked with Japan's recent package of $86 billion in fiscal stimulus, is bound to have a positive impact. "We're at the beginning of a downward cycle of German interest rates, and that has got to be welcome everywhere," says George Magnus, an international economist at London's S.G. Warburg Group. Indeed, market watchers figure the Bundesbank may have to cut at least an additional half to full point off rates to keep more currency trouble from breaking out. The result? "A major improvement in European growth prospects," says C. Fred Bergsten of the Institute for International Economics in Washington, D.C.
Europe's currency crisis should accelerate a trend back to more realistic exchange rates. John Williamson of the Institute for International Economics feels a readjustment of 12% for the pound and 15% for the lira against the mark would stabilize markets and bring more pressure to cut rates on the Bundesbank.
What's more, thanks to the Bundesbank's cuts, the dollar on Sept. 16 skyrocketed to 1.50 against the mark, from a low of 1.39 on Sept. 2. That gives the Federal Reserve room to spur the U.S. economy with more rate cuts without risking a currency crisis of its own. When the dollar was low, "You had to consider the risk that a rate cut might cause some destabilization of the dollar," says one senior Fed official. "Now some of that risk goes away."
Europe's political outlook is far cloudier. After months of agonizing over whether French voters would say oui or non to monetary union and to a common foreign and defense policy, the shock in Europe's currency markets made the referendum seem eerily irrelevant. The reason: If two of Europe's largest economies already were too weak to keep up with the Maastricht march toward tough anti-inflation economic policies, more difficult tasks--such as the establishment of a single European central bank modeled on the Bundesbank--seemed unachievable.
Just what went wrong with Maastricht? In the end, it was the EC architects' insistence on a combination of tough economic criteria to enter a monetary union and a tight timetable of reaching it this decade. Complicating the process was a lack of consensus on how to make a transition to a single currency and European central bank. "There has just never been a meeting of minds within Europe on a monetary system," laments Richard Reid, economist at UBS Phillips & Drew in Frankfurt. "Instead, the politicians and central bankers stood around in a circle with guns pointed at each other's heads."
ITS OWN VICTIM. The Bundesbank forced the matter to a head. After years of exporting its high interest rates--needed to counter unification-driven budget deficits--to the rest of Europe, the Bundesbank suddenly found itself a victim of its own anti-inflation strategy. In one recent week, the bank's interventions to prop up the lira forced it to create more marks than it would normally pump out in a year. Schlesinger admits: "We were in a position in which we no longer saw ourselves as able to execute our monetary policy."
The shock waves will keep spreading across Europe for weeks. Currencies such as the Spanish peseta and the French franc could come under continued pressure, especially if French voters deal Maastricht the coup de grace. And politicians from British Prime Minister John Major to Spain's Felipe Gonzalez have invested enormous political capital in sidling up to an integrated Europe. They'll have to keep on their feet at a time when they're already battling sluggish economies: EC economic growth this year is coming in at an anemic 1.25%.
The shock will also bring enormous pressure to bear on the government of German Chancellor Helmut Kohl. He must now put together a deficit-reduction package to control the runaway German unification budget that prompted the Bundesbank to keep such a tight rein on credit. Germany presents "the oddest economic picture I've seen in my lifetime," says former German Chancellor Helmut Schmidt. "The villain in the currency crisis is the German government. And the Bundesbank is to be blamed for trying to counter a rather ridiculous fiscal stance."
Perhaps the biggest losers are the EC's architects of unity. Then again, with the European single market at least moving ahead on time for its debut on Jan. 1, Europeans may have something to look forward to: an economic union driven more by market forces and less by Brussels abstractions.