Robert Chote: The euro-creature

Europe's economies are recovering but, Robert Chote argues, they are diverging too much to ensure Emu gets off to a smooth start
The European economy is pulling out of the doldrums. Growth is set to reach 2.5 per cent this year and to rise further in 1998. That is good news as far as it goes. But the average masks big differences in performance: the Continent's biggest economies remain sluggish, while some of the smaller ones are in danger of overheating.

Those differences could pose serious problems in the early years of Europe's economic and monetary union. Europe's proposed single currency, rather like an economist's version of Frankenstein's monster, is starting to look like an attempt to create new life out of old body parts. In less than 15 months the creature will be unveiled. Europe will then find out if it is destined to be a force for good or, like its fictional counterpart, its creators' nemesis.

But, in a novel twist on the old story, the creature is showing signs of life even before work on it has finished. Some of the single currency's benefits have manifested themselves already: Europe is enjoying stable exchange rates and low inflation. So too have some of its costs: interest rates are converging at a time when Europe's economies are at different stages of growth and recovery, and hence there remains a need for different rates in different countries. The body parts do not fit together as well as Frankenstein might wish.

As a precondition for the creation of a stable euro, the Maastricht Treaty laid great emphasis on the need for national inflation rates and budget deficits to converge at low levels. This is what has happened. Look at the 11 European countries that are plausible participants in monetary union from the outset. The International Monetary Fund predicts that their inflation rates this year will vary from a low of 1.1 per cent in France to a "high" of 2.3 per cent in the Netherlands. As recently as 1990 the gap between highest and lowest would have been almost 10 times as large.

But this convergence masks stubborn differences in underlying economic conditions, both in structural rates of unemployment and cyclical levels of economic activity. Those differences raise the question of whether Europe is really ready for a "one size fits all" policy.

Formally speaking, the participants in monetary union should not be committed to a common interest rate until the single currency comes into being on January 1 1999. But interest rate convergence has been accelerated by the recent meeting of European finance ministers in Luxembourg. They decided that the bilateral exchange rates at which first-wave participants in monetary union will be locked together should be announced next May when the "ins" and "outs" are named.

As long as the investors remain confident that monetary union is going ahead - and that the proposed bilateral rates will not be changed during the rest of 1998 - futures markets will reflect the fact that currencies will be locked together from January 1 1999. Forward interest rates should also be identical from that day, for January 1 1999 onwards, barring any small variations that reflect perceptions of default risk in each country.

But it will still be possible for interest rates to differ from one country to another - central banks can still influence the rates through money-market operations, as they do now. But with long-term exchange and interest rates as good as eliminated by the May announcement, spot exchange rates should adjust automatically so there is no incentive for investors to move into another euro-area currency to take advantage of higher interest rates.

Europe's central bankers are well aware of this. They also know that short-term interest rates affect economic activity and inflation because of their impact on longer-term rates as well. So from May, when longer-term rates will be determined by conditions in the putative euro-area as a whole, the weapon of domestic monetary policy will survive only in a drastically weakened form.

This suggests that national policymakers might as well forswear domestic activism right away and opt to manage the transition to a single interest rate in co-ordinated fashion. This should help minimise investors' uncertainty. "After May, monetary policy is likely to be explicitly co-ordinated, and even before May it is likely to be seen as semi-co-ordinated," argues Gavyn Davies, chief economist at Goldman Sachs in London. As one leading European central banker points out, there will be plenty of opportunity for central bank governors and presidents to meet informally in the run-up to May and beyond.

The Bundesbank will play a central role in this process. Its senior officials accept publicly that in coming months they will have to set monetary policy with reference to the needs of the euro-area as a whole rather than Germany alone.

Goldman Sachs expects the German repo rate to rise from its current 3 per cent to 3.4 per cent by the end of this year and 4 per cent next May. Most analysts expect rates in the would-be euro area to converge at around 4.5 per cent, not far from their current weighted average.

This implies big shifts. Look at the starting points. At the end of last week Germany, France, Finland and the Netherlands all had three-month interbank interest rates of less than 3.5 per cent. But Spain, Italy, Ireland and Portugal had rates of between 5 per cent and 7 per cent. In other words, rates would rise for the first group and fall in the latter, accelerating an existing trend.

Would such movements suit differing national circumstances? "Only in two countries - the Netherlands and Italy - would a rapid convergence of short-term interest rates be justified on domestic fundamentals," argues Richard Reid, chief European economist with UBS in London. "In Germany and France it would exacerbate the problems being faced by weak domestic economies, while in Ireland, Portugal and Spain it would cause a build-up of inflationary pressures."

Cyclical differences within the European economy can be illustrated by looking at the extent to which output of goods and services in each country exceeds or falls short of the "potential" level that economists assume to be consistent with stable inflation - the so-called output gap.

In its most recent forecast, the Organisation for Economic Co-operation and Development predicted that output would be more than 2 per cent below potential this year in France, Italy, Spain, Belgium and Luxembourg. Germany, Austria and Portugal would be more than 1 per cent below potential, Finland would be 0.4 per cent below potential, while Ireland and the Netherlands would be slightly above potential.

Growth rates also vary markedly from country to country. Spain may have a relatively large output gap, but accelerating domestic demand means it is on course for uncomfortably strong annual growth of about 4.5 per cent. As in several other European countries, buoyant exports have prompted stronger domestic investment, job creation and rising consumer confidence. In the Netherlands, pre-election tax cuts are set to add further fuel to already strong consumer spending.

"The Netherlands and Spain are set to grow much faster than the euro-area as a whole," argues David Mackie at J.P. Morgan. "With no room to tighten monetary policy, they should be tightening fiscal policy in the year ahead. Yet in the Netherlands fiscal policy will provide an outright stimulus to demand next year, while in Spain it will be broadly neutral."

With several exceptions, Europe's smaller economies have outperformed its larger ones for some time. Domestic demand in France, Italy and Germany has risen by less than 1 per cent a year on average over the past five years. The IMF blames this "exceptional sluggishness" on timid interest rate cutting, reluctance to tackle labour market rigidities and over-reliance on tax increases to reduce government borrowing.

But prospects for the big economies do look brighter. "Output in both Germany and France is projected to rise by 2.75 per cent in 1998 - growth that would narrow output gaps, though only modestly, for the first time since 1994," the IMF said last month.

Exports remain the mainstay of recovery in Germany, with high unemployment and weak disposable income growth suggesting that the second quarter spurt in consumer spending is probably unsustainable. Hopes that the pace of economic expansion in France will accelerate through the rest of the year were buoyed by last month's upbeat Insee survey of manufacturing prospects. Consumer confidence in France has picked up sharply since the general election, but needs stronger employment growth to underpin it.

Differences in domestic economic conditions suggest that several countries will find convergence to a single euro-area interest rate uncomfortable. Inflexible labour markets and unresponsive fiscal policies mean that these differences are likely to persist for some time within the monetary union, producing painful shifts in competitiveness.

This was always going to be the case. Very few economists would describe the broad monetary union that looks set to emerge in Europe as an "optimal" currency area. It lacks the flexibility and mechanisms for fiscal redistribution that have helped other large currency areas. In coming months Europeans may, like Dr Frankenstein, realise that, because of the way they have designed their creature, it will be harder to control than they ever imagined.


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