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And what Alice found there

Europe's road to a single currency was mapped out in the Maastricht treaty. Or so you supposed. Germany says that one or two details still need sorting out

THE criteria for entry into Europe's monetary union have a looking-glass quality: try for years to reach them and the goal recedes; do nothing and you're almost there. Like Alice, voters are baffled onlookers. And for European politicians, no image seems more appropriate than the White Rabbit. Like that flustered courtier, Helmut Kohl, Jacques Chirac and others are looking at their watches and muttering "Oh dear! Oh dear! I shall be too late!" as they scamper towards Wonderland. The cause of their nervousness is the timetable for EMU laid down in the Maastricht treaty.
     The treaty's biggest loophole--a provision that allowed the start of EMU to be postponed from 1997 until 1999--has already been exploited. The treaty now obliges all countries that meet the convergence criteria to lock their exchange rates irrevocably on the first day of 1999, in preparation for the adoption of a common currency, the euro, in 2002. Only Britain and Denmark are not bound by the plan. For the rest, the formal position is that the big decisions have already been taken. All that remains is to tie up some loose ends and let next year's figures on the convergence indicators take their course.
     To which Alice retorted, "Stuff and nonsense!" More than you might think, given the timing, the nature of Europe's proposed monetary union remains far from clear. Its character--supposing it goes ahead at all--will be decided not just by the design laid down in the treaty, but also by the various fudges that governments will undertake between now and 1999.
     Perhaps the most important adjustment will provoke fierce debate at the meeting of Europe's leaders which begins in Dublin on December 13th. Germany has decided that countries taking part in EMU must be placed under a permanent obligation--through a "stability pact"--to keep budget deficits low.
     In doing this, it is stretching the terms of the Maastricht treaty. The convergence criteria specify that countries with budget deficits of more than 3% of GDP will be ineligible for membership of EMU--unless the deficit is (a) "close" to the target and (b) either moving in the right direction or only "temporarily" too high. The treaty also obliges all governments to avoid "excessive deficits". As with the 3% threshold, this notion is defined flexibly. The drafters of the treaty foresaw a long and tortuous procedure before sanctions are applied to violators--persistent and egregious violators, it was assumed. The treaty justified these provisions by the need not to control deficits minutely, but to avoid "gross errors" in budgetary policy.
     It was never envisaged that EMU members would be under a strict obligation to keep their deficits always (or nearly always) below 3% of GDP, or that violators would face semi-automatic and massive fines. But that is what Germany has proposed. (As Alice told the king: "That's not a regular rule: you invented it just now." "It's the oldest rule in the book," said the king. "Then it ought to be number one," said Alice.") If a rule like the stability pact were adopted at Dublin or thereafter, it would affect Europe's monetary union profoundly.

Curiouser and curiouser
According to the German formula (which is opposed by other countries, notably France), governments failing to keep their budget deficits below 3% of GDP would have to place "a deposit" with the European authorities. If the excess borrowing continued, the funds would be forfeit. Fines might be calculated at the rate of 0.2% of GDP plus another 0.1% for every percentage point by which the deficit exceeded 3% of GDP. A deficit of 6% of GDP would attract the maximum fine of 0.5% of GDP--an enormous sum.
     To be confident of hardly ever violating the 3%-of-GDP limit, governments would need to run budget surpluses during "normal" times, leaving room for borrowing to rise during recessions. In this way, the "automatic stabilisers" of fiscal policy would be allowed some scope to work.
     Otherwise, it would be not a stability pact but a deepen-your-recession pact. Suppose a country with a deficit of 2% of GDP (small by contemporary European standards) began moving into recession. To prevent the deficit rising above the ceiling, the government would need to cut spending and raise taxes--worsening the slowdown and putting further upward pressure on borrowing. In thinking about the scale of the needed fiscal adjustment, recall that when Britain moved from boom to recession at the end of the 1980s, the public sector's financial balance deteriorated by ten percentage points of GDP: from a surplus of 3% of GDP to a deficit of 7%.
     If the government failed to hold borrowing at less than 3% of GDP, it would then have to pay a big fine-in-waiting to the European authorities. It could hardly be allowed to meet this impost by borrowing. If the rules allowed such a manoeuvre, they would be saying, in effect: borrowing to pay unemployment benefit is not allowed, but borrowing to pay the fine for borrowing to pay unemployment benefit is. This seems preposterous, even by EU standards. So the government would have to cut spending and raise taxes once more--all in the midst of a recession, by command of the European Union. If that is not enough to bring anti-Brussels protest on to the streets, what is?
     The great peculiarity of the debate about the stability pact is that, so far, few if any advocates of closer political integration have recognised the danger that it poses to their vision of Europe's harmonious and ever closer union. This apparent complacency may reflect the conviction that, in practice, the rules would have to be waived. That seems to be what the French want: a flexible version of the pact. Many precedents for such flexibility have been set (more on the convergence criteria shortly). Even so, it seems odd to "strengthen" monetary union by writing rules that are acceptable only because no one expects them to be enforced.
     Supporters of a stability pact reply that, if credible, it would deter governments from making a fiscal mess in the first place. Moreover, they say, there is a clear need for such a pact. In part, this is a matter of politics. German voters need to be convinced that the euro will be as strong as the D-mark they are about to surrender; otherwise they might simply reject EMU. A stability pact, by calling for better-than-German standards of public finance, offers reassurance that the euro will be solid.
     A pact also seems to be needed for economic reasons. The argument goes as follows: once EMU begins, governments will find it easier to borrow more. At present a would-be heavy borrower--Italy, say--is limited by the size of its domestic capital market. If the Italian government wants to borrow more than this market is able to supply, it must borrow in a foreign currency, which exposes the government to exchange-rate risk. But with EMU in place, Italy's "domestic" capital market is suddenly much bigger: EMU-wide, in fact. The government can borrow far more than before without taking on any exchange-rate risk.
     Supporters of a stability pact claim that special arrangements will be needed to prevent this increased capacity to borrow leading to all sorts of dangers. When Italy seizes its borrowing chance, they say, the cost will be shared with its EMU partners. The increase in Italy's borrowing will force interest rates higher across the union. In effect, it is argued that without a pact, the other countries will end up subsidising Italy to borrow too much. Finally, if all this were not enough, there is also the question of default-risk. The markets may calculate that EMU provides an implicit guarantee of its members' debts. If so, any risk premium on Italian debt will disappear, again encouraging the government to borrow more. And if this overborrowing does lead Italy to default, the other governments may indeed end up bailing it out. A stability pact may seem a plausible response to these dangers--and none too onerous, you might think, given that it appears to call for no more than good fiscal practice.

Beware the Jabberwock, my son
Quite how onerous it proves to be depends on the details, which await the outcome of negotiations at the summit, or later. What can be said now is that Germany's first proposal went far beyond what most governments would regard as sound fiscal practice. It would appear not only to leave less scope for the operation of automatic stabilisers than nearly all economists would regard as wise; it would also leave less than the most fiscally conservative governments (including Germany's) have adopted in practice. To tie governments' hands as tightly as that seems downright dangerous--especially considering that, with currencies and interest rates locked together, fiscal policy under EMU will have to carry more of the burden of cushioning recessions than it does now.
     What of the argument that some fiscal rules, even if less strict than the ones Germany would like, will be needed to check the greater temptation to borrow too much? This is less convincing than it seems at first sight. It is true that the advent of a euro capital market would make it possible for countries to borrow at lower exchange-rate risk. But this privilege comes at a heavy price: that of abandoning control of your monetary printing-press.
     In a many-currency Europe, currency risk goes hand in hand with the opportunity to reduce the real burden of debt by raising inflation: these are two sides of the same coin. In principle, one cannot say which effect of EMU would be greater--the effect of less exchange-rate risk (tending to raise borrowing) or the effect of denying governments inflation as a way to service their debts (tending to reduce it). In practice, the latter may well dominate.
     Suppose, however, that some governments did borrow more. Would this force interest rates higher in other EMU countries, as advocates of the stability pact say? The effect, if any, would be small. The world's capital markets are increasingly integrated, forming a single pool. The euro capital market would be part of it. Higher borrowing by one or more European countries would therefore raise euro interest rates only (or almost only) to the extent that it raised world interest rates. And that would not be much: Europe's economies are too small to have much effect on the global demand for capital.
     What if a country overborrowed so much that the markets feared it might default? Again, there is little danger that its EMU partners would suffer as a result--provided they had made it clear to the markets that there would be no bail-out. In that case, the default-risk premium would be loaded exclusively on to the debt of the over-borrower; there would be no free-riding. But the no-bail-out promise is essential. The Maastricht treaty explicitly forbids governments or the European central bank to come to a defaulter's rescue. If the markets doubt this promise, the default-risk premium may be spread more widely. And if governments themselves doubt it, they may be tempted to borrow more adventurously.
     But having granted this, how much does the stability pact really help? Its advocates, notably Germany, are undermining the treaty's no-bail-out rule by suggesting there is a fiscal problem that needs solution at a European level, instead of by insisting that each country's fiscal stance is a matter for it and it alone. By doing that, they are adding to the moral hazard that the treaty was at pains to eliminate. Indeed, the outcome may be worse than this. Suppose governments and markets view the pact as a sign that, in extremis, there will indeed be a bail-out; suppose also that the markets think that the pact is either too weak to be any use or too strong to be enforceable. This would be the worst of all worlds: maximum incentive to cheat, minimum protection if anybody does.

Will you join the dance?
The merits of the stability pact may be dubious (at best), but Germany's determination to write new rules for the conduct of governments once EMU begins is easy to understand. Its problem is that the convergence criteria will not, as it might once have hoped, divide the candidates for EMU neatly into solid citizens on one side and troublemakers on the other. If anybody needs reminding, the criteria are to be tested on figures for 1997, available in the spring of 1998, and are as follows:

  • Inflation: no more than one and a half percentage points higher than the average of the three best-performing states;
  • Long-term interest rates: no more than two points above the same benchmark;
  • Budget deficit: 3% of GDP or less;
  • Public debt: no more than 60% of GDP;
  • Exchange rate: observe the "normal margins" of the exchange-rate mechanism (ERM) for two years.
         Next year, only Luxembourg will comply with all these criteria, on the strictest definition. For that reason, the criteria will be loosely applied. The need for fudge-room was anticipated in the treaty--and there is plenty. (The European Commission's attitude to the criteria is rather like Humpty Dumpty's to language: "When I use a word, it means just what I choose it to mean, neither more nor less.")
         The public-debt criterion, for instance, may be deemed met if "the ratio is sufficiently diminishing". "Sufficient for what?" you may ask. Sufficient to let you in, obviously. The budget criterion will also let you through, provided your deficit "comes close" to the threshold. Since 1993, the ERM bands have been widened to plus-or-minus 15%, so nobody is sure what "normal margins" means. Britain says this criterion is defunct (a view that would protect its option to join EMU in 1999). To be on the safe side, Italy and Finland resolved to enter the ERM this year, aiming to clock up two years inside before the start of 1999.
         On top of this, there is scope for all manner of accounting fiddles. The European Commission is supposed to stop such jiggery-pokery, but it rarely meets a scam it doesn't like. Of the multiple dodges so far submitted to it by France, Spain, Belgium and Italy (to name just four), it has blocked only one, a Belgian wheeze. In September it ruled in favour of the biggest and most patently bogus manoeuvre yet. France Télécom plans to pay the French government a sum equal to roughly 0.5% of GDP to take on its pension liabilities. This purports to reduce the budget deficit in 1997; plainly, it does nothing whatever to improve the French public finances. Somehow, the commission thought this was all right.
         Given flexibility of that sort, the convergence criteria could let in almost everybody; only Greece seems beyond the pale. Barring accidents, therefore, the list of members to be drawn up in April 1998 (when Britain, by the way, will have the presidency) will be a matter of ticklish diplomatic negotiation, not disinterested statistical scrutiny.
         The treaty says that the commission and the European Monetary Institute (forerunner of the new central bank) will report on whether the criteria have been met, and the commission will recommend countries for admission. Finally, heads of government will, by qualified-majority vote, make the choice. The scope for tactical voting-- for instance, Spain and Italy seeking to block France's entry unless they are let in too--promises some fine entertainment. ("Everybody has won, and all must have prizes.") Then, the decisions may be subject to challenge in the courts. Recall that Germany's constitutional court almost blocked ratification of the Maastricht treaty. The scrum of 1998 will make the Maastricht process look like a model of judicial propriety. At the end of it, Germany could have some monetary partners it would rather be without.

    Sentence first--verdict afterwards
    Germany's doubts about its future partners may be understandable: in economic terms, the country has more to lose from monetary union than any other. Yet those doubts conspire to make a successful EMU much harder to achieve. The stability pact, one expression of those doubts, could easily misfire, turning popular opinion against the whole idea. But that is not the only way in which German anxieties could undermine the great German vision.
         Even if all goes well until EMU's participants are chosen in 1998, Europe's single-currency design will still be acutely vulnerable between then and 2002. According to the Maastricht timetable, exchange rates will be locked at the start of 1999. Exactly how they will be locked poses something of a dilemma. If the authorities leave the fixing of rates until the last moment, speculation may cause a lot of exchange-rate turbulence in the very months or weeks before EMU starts. If instead the rates were announced in advance, as some propose, everything would depend on the credibility of Europe's monetary authorities. If they retain the markets' confidence, speculation could help pin exchange rates at the preannounced levels; if not, the preannounced parities might be attacked just as the old ERM was--with similar results.
         The problems will continue, and perhaps worsen, once exchange rates have been fixed "irrevocably", at whatever parities, at the start of 1999. The plan proposes that national currencies will then stay in circulation for another three years, until the euro replaces them in 2002. Surely, you might think, this cannot be tenable: denied even the flexibility of the old ERM (in which currencies were allowed some freedom to move), this system will surely yield to speculative attack. Europe's planners say it will not. By this point, Europe's new central bank, the ECB, will have taken command of monetary policy: national central banks will be acting on its instructions. This, it is argued, makes all the difference.
         Suppose that the French start swapping their francs for D-marks. The ECB will simply order more D-marks, and fewer francs, to be issued. The crucial thing is that it would be willing, and perceived to be willing, to do this without limit--that is, until the entire stock of francs had been converted into D-marks. This prompts an obvious question: would Germany and its Bundesbank go along with this? Or do they regard the period between 1999 and 2002 as a last chance to change their minds about the whole idea? Any suspicion of the latter could give markets the incentive they need to test the system to destruction. As with the ERM, the expectation of a change of parities--and, with that, the end of this plan for monetary union-- would become self-fulfilling.
         Is the stability-pact zeal of the German government a sign of steely confidence that EMU will happen, and be done well? Or is it a sign of second thoughts, an intimation that things are not turning out as Mr Kohl hoped? He himself may not yet know the answer--but a lot depends on it. As the Red Queen warned Alice: "When you've once said a thing, that fixes it, and you must take the consequences."

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