It'll Be A Bumpy Ride For Europe's Central Bank
The brouhaha is over, and European Monetary Institute President Wim Duisenberg is no doubt steeling himself for his new job as president of the European Central Bank (ECB). Under a controversial compromise forged by France and Germany at a summit of European heads of state on May 4, Duisenberg, who is Dutch, will split his eight-year term with Bank of France Governor Jean-Claude Trichet. The deal sparked fears that the ECB could fall hostage to politics when it takes over the job of setting interest rates from national central banks on July 1. "The real danger for European Monetary Union is nationalism," worries Cesar Molinas, co-chief of research at Merrill Lynch & Co. in London.
But Europe's new monetary watchdog faces challenges even more complex than managing Continental politics. The launch of Europe's single currency--the euro--next January is an unprecedented event: Never before has a major international currency been issued that wasn't backed by gold or silver. Moreover, no group of countries or regions has tried to issue a currency without formal political unity.
In fact, as a policy problem, the euro presents a great unknown. With a single currency and central bank but separate tax and budget authorities, EMU members will be neither federalist states nor entirely sovereign nations. The euro region lacks stabilizers that right economic imbalances in the U.S.--job migration and reallocation of tax revenues, for instance. Instead, countries will adjust fiscal policy to compensate for their loss of currency and interest-rate moves as economic levers. That fiscal autonomy is likely to put them regularly at loggerheads with the ECB.
For the bank, disciplining 11 countries with one interest rate will inevitably mean sacrificing individual economies on the altar of a stable euro. Already, euro-watchers are predicting that Duisenberg and his new board of governors will make an early show of strength by raising short-term interest rates as early as July. In part, that would be a preemptive strike against the inflationary surge of liquidity that will result when Europe's financial markets convert to euros in January, 1999. From Duisenberg to Bundesbank chief economist Otmar Issing to Finnish central banker Sirkka Hamalainen, the board members are known as inflation hawks. But the ECB is sure to have to steer through uncharted waters. Scenarios such as recession in one country, an asset bubble in another, or external economic shocks will test its mettle.
Above all, the ECB's mandate is to hold down inflation for the entire EMU. The trouble is that, while the prospect of union has already brought European interest rates and currency values into line, individual economies remain very different. If one country goes into a growth spurt or falls into recession, the bank must ignore its plight and continue setting policy based on regional averages. Until Europe has a single government as well as a single currency, any divergence in economic performance sets the stage for political strife. "This will be a much tougher job even than running the U.S. Fed," says Thomas Mayer, an economist at Goldman, Sachs & Co. in Frankfurt.
PULP FACT. If one country suffers an economic shock that doesn't affect others, the job gets even harder. Finland's economy, for example, remains dependent on world demand for pulp and paper, a cyclical industry. Although the country is growing at nearly 6%, it has historically suffered from extreme economic volatility. A slump in the paper market could throw the Finns into recession while the rest of Europe hums. Since Finland accounts for just 1.5% of the euro zone's total gross domestic product, the ECB couldn't lower rates just to help the Finns.
Finland's only recourse would be to boost spending. In its last downturn--in 1991-92--its budget deficit soared to 12% of GDP. But under the EMU's Stability & Growth Pact, members risk penalties if their deficits exceed 3%. The ECB would face huge pressure to look the other way while Finland spent its way back to economic health. "It's likely we'll have some kind of political crisis if a big negative shock happens in a small country," says Patrick Artus, chief economist at CDC Marches in Paris.
Because politicians, not the central bank, are responsible for enforcing the stability pact, many economists think it will be more honored in the breach than the observance. And there is leeway for a little deficit spending by one country in case of recession. "The pact will bark, but it won't bite," says David Mackie of J.P. Morgan & Co. in London. The finance ministers who will decide whether to punish a country--especially a large one such as France--will wield enormous discretion. The capital markets, meanwhile, may impose less discipline on individual countries than they did before the EMU. A high-deficit country will continue to pay a premium for its debt, but a smaller one than before. That's because investors don't believe a member nation will be allowed to default. Although the Maastricht Treaty forbids bailouts between member nations, most observers think that rich nations will jump in to buy the poorer ones' depreciated bonds. The availability of such helping hands could make fiscal discipline even tougher to sustain.
But the greatest political upheaval may lie in Europe's next downturn. That could happen just about when Trichet is due to take the reins from Duisenberg, in 2002. Merrill Lynch's Molinas worries that the French will react the way they normally do to economic pain--by throwing out the government. "They will elect a right-wing government that may be very nationalistic and have few European concerns," he frets. Pressure from his countrymen could push Trichet into adopting a looser monetary policy for Europe, even if other ECB governors oppose it.
HARD-LINE. Not all experts share the suspicion that Trichet would cave in to demands from Paris. "Do we really believe a Frenchman can't fight inflation?" asks Alexander Schrader of Bayerische Vereinsbank in Munich. Schrader thinks Duisenberg's agreement to hand over the ECB's reins to Trichet halfway through his term was a political solution, not a sign that France wants to divert the ECB from its purpose.
Indeed, the public perception of hard-line Germans and inflation-tolerant French may be obsolete. Artus notes that, while in theory the Bundesbank focuses obsessively on inflation, in practice it has been pragmatic in setting German interest rates. To help Germany recover from its last recession, it relaxed policy even though the money supply was growing at 10% a year.
After the hue and cry that followed the Brussels summit, all eyes are on the bank to act tough. For now, Europe's growing economy will let Duisenberg make his mark as a German-style inflation monitor. The bank's trial by fire will come if one EMU economy falls out of step, or when Europe's cycle begins its inevitable descent.