The Finance Vigilantes Are Closing In

Depending on whom you talked to, the European aftermath of Mexico's peso crisis was either a triumph or a disaster. At their monthly meeting in Brussels on Jan. 16, Europe's finance ministers congratulated themselves on how well their currency markets had weathered the storm. French Economy Minister Edmond Alphandery even said optimistically that the European Union could achieve monetary unity on schedule by 1997.

Meanwhile, in London, Swiss Bank Corp.'s head of global foreign exchange thought just the opposite. After watching the financial markets hammer Spain, Italy, and Sweden--calming down only when the U.S. announced it would bail out Mexico--Andy Siciliano saw worse to come for the EU. "Bringing together Europe's disparate economies will never happen," he said.

Indeed, the recent bond and currency turmoil seems to prove that the financial vigilantes are closing in on Europe's economic weaklings. Traders are piling into the mark and fleeing weaker currencies--in effect, voting against high levels of public debt and stagnant fiscal policies in Europe's more profligate nations. Says Peter Praet, chief economist at Generale de Banque in Brussels: "What the market is telling European governments, and what is not being understood, is that it wants the welfare state reformed."

As investors continue to favor the most solvent and reform-minded countries, the threads that hold together the EU's crowning achievement--its single market--could begin to unravel. Over time, chronic currency and bond weakness could even split Europe into two ranks of countries: those that adapt to and thrive in an open global economy, and those whose balance sheets classify them with the emerging markets.

Already, investors are demanding fat risk premiums from countries whose policies continue to foster inflationary spending. Long-term money in Italy or Spain costs almost 500 basis points more than it does in Germany--nearing the 600-point spread between Mexican government bonds and U.S. Treasuries.

CHOKE OFF. The gap between European haves and have-nots is likely to get even wider soon. With Germany's economic recovery further along than its neighbors', most analysts believe the Bundesbank will raise interest rates by midyear to keep inflation at bay. That will put pressure on the other EU nations to keep up. But raising rates in countries that are only now emerging from recession could choke eff growth prematurely--and pump up the deficits of Spain, Italy, and Belgium even further.

Italy may be the most dramatic example of a country pushed to the brink by market turmoil. A crisis of political confidence drove the lira to a historic low against the German mark before the naming of an emergency technocrat government on Jan. 16 calmed the markets down. Now, Acting Prime Minister Lamberto Dini is in a race against time to overhaul Italy's costly state pension scheme and rein in the 1995 budget deficit. Although trade unions and the business community applaud his agenda, former Prime Minister Silvio Berlusconi could make it tough for Dini to push debt-busting measures through Parliament before another election is called.

Other European governments, from Lisbon to Helsinki, are scrambling to improve their budget numbers before investors punish them further. In early January, Sweden unveiled a four-year budget program intended to cut $15 billion, or 7% of gross domestic product, from annual state outlays to stabilize state debt. In Spain, the scandal-wracked government of Prime Minister Felipe Gonzlez on Jan. 13 approved a belt-tightening budget package intended to cut $1.1 billion in spending.

HITTING TAXPAYERS. But such steps fall far short of the spending cuts the markets are demanding. Bo Engstrom, Stockholm analyst for James Capel & Co., thinks that Swedish bonds and the krona will get pummeled again as the minority government tries to push the package through Parliament. And while Ford Espaa Managing Director Alain Batty calls the Spanish government's plan "important," he worries that it "won't change the overall environment," which he characterizes as "a lack of confidence" in governments around southern Europe.

If governments try hitting taxpayers again to finance their spending, they could derail the consumer phase of what has so far been an export-led recovery. And slower growth could get dangerous. Lehman Brothers Inc. analyst Keld Holm estimates that if the EU's GDP growth averages 2% per year for the remainder of this decade, its budget deficit will actually be 10% higher in 2000 than it is today. As a result, he says, "it won't take a recession but only the signs of a slowdown" for markets to push up the risk premium for much of Europe in what he predicts could be a "nightmare scenario" of lower revenues, higher debt, and rising interest rates in some of the weaker EU members.

At that point, European governments will have no choice but to reach for an old-fashioned remedy--inflating their currencies--to reduce their debt burden. That might kill once and for all the idea of a broad monetary union in Europe. Between the two versions of reality offered by Europe's politicians and the global capital markets, there's no doubt where the odds lie.

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