The euro’s recent rise against the dollar disguises deepening strains in the fiscal foundations of the single European currency that argue for a rethink of the rules governing the finances of participating nations.
The single currency, widely attacked as unworkable before its launch in 1999 and derided by financial markets as it plummeted by a third against the dollar in its first two years, has rebounded by as much as 8% in the last three months.
But its revival, to a recent peak of $1.10 from an all-time low of 82 cents, stems from the weakness of the dollar amid increasing concerns about faltering U.S. economic growth, plunging stock prices, and renewed doubts about the U.S. government’s commitment to its longstanding strong-dollar policy. Market jitters about the war in Iraq have also undermined the U.S. currency.
The euro’s rebound certainly isn’t because of any improvement in the economic prospects of eurozone countries. Germany, the largest economy of the 12 sharing the single currency, reported just 0.5% growth in gross domestic product for 2002 while France, the second-largest, recorded an anemic 1.7%.
Amid near-recessionary conditions and rising unemployment – France’s jobless rate was 9.1% in December and Germany’s 10.3% in January – both nations have exceeded the eurozone’s budget deficit limit of 3% of GDP, raising questions about the viability of the fiscal rules, embodied in the Stability and Growth Pact, at a time of economic hardship.
In France’s case, the deficit rules have put it on a collision course with the European Commission, which enforces the fiscal pact, and have tested the country’s willingness to override its domestic political agenda in favor of the pan-European rules. France is finding out that when it is limited in its ability to manage its own economy, the sharing of sovereignty that underlies the euro project is a painful experience.
“The European authorities are going to have to weigh the impact of fiscal stability versus growth,” said Ashraf Laidi, chief currency analyst at MG Financial Group in New York. “The politicians don’t care because they have a short-term view. If they have to choose between the electorate and the European Central Bank or the Commission, they will choose the electorate every time.”
That problem is multiplied by the number of sovereign nations using the euro, which is set to expand to 22 in coming years as central European and Baltic states such as Hungary and Estonia join the European Union.
According to Franklin Allen, professor of finance and economics at Wharton, “There are a lot of problems stored up in the fact that there is no one political authority.” A solution to that, he added, might be for member nations to cede more sovereignty to the European administration so that it has the authority to act on fiscal crises in a way that benefits the whole euro area.
For example, if a German bank collapsed, a Commission with enhanced powers – including, perhaps, direct taxation – could ensure that creditors throughout the eurozone were paid rather than just those in Germany, helping to contain the economic fallout of such an event. “The central authority could make that decision based on the needs of the whole area,” Allen said.
A more likely prospect, however, is a redesign of the Stability and Growth Pact, whose deficit rules have proved too restrictive during the economic downturn, Allen argued. He advocates modifying the Pact so there is a greater emphasis on a country’s accumulated debt and less on annual deficits.
A new-look Pact might, for example, allow a country with a debt-to-GDP ratio of 50% to run a deficit of up to 5%, a number that would diminish as debt rose. Such a change would allow Germany, for example, to run a higher deficit than at present while Italy, with debt of more than 100% of GDP, would have to keep its annual deficit under tighter control.
Changes like these would probably result in a stronger euro, Allen predicted, because the system would be more sustainable and hence more credible to the financial markets. The current arrangements, by contrast, are “unrealistically restrictive,” he said.
France: No Austerity Policy Here
French Finance Minister Francis Mer announced on March 6 that his country’s deficit for 2002 would be an over-the-limit 3.1% of gross domestic product, rising to 3.4% this year. Less than two weeks later, he slashed the government’s growth forecast for this year to 1.3% from the previous prediction of 2.5%.
But France won’t be raising taxes or cutting spending to bring the deficit down, Prime Minister Jean-Pierre Raffarin said last month. “I won’t conduct a policy of austerity. When growth is uncertain you do not lower spending more than necessary – that would depress the economic climate even further.”
In Germany, weakening growth depressed tax revenues last year, domestic demand was lower than projected, and health-care spending exceeded projections. The result was a budget deficit of 3.75% of GDP in 2002. That’s projected to decline to 2.75% this year although the Commission warned in January that its assumption of 1.5% GDP growth for 2003 may not be achieved, increasing the risk of another year over the deficit limit. Germany’s accumulated debt also slightly exceeded the Stability Pact’s limit of 60% of GDP, and is expected to rise to 61.5% this year.
Germany was rebuked by the Commission for failing to “live up to its commitment” to the 3% rule, and urged to reform its labor market and social welfare systems as well as reduce the regulatory burden on the economy.
Only a 1.4% increase in net exports staved off recession in Germany last year; domestic demand fell by 1.1%. While the rise in the euro makes it easier for the European Central Bank to cut interest rates, the risks to German growth increase as its exports become more expensive to overseas buyers. The German economy, the Commission said, remains “highly vulnerable to external shocks.”
The Commission has the power to impose fines for euro members who break the rules on deficits and debt. But in France’s case the Commission has given it a year to put its house in order, signaling to other countries that there may be more fiscal room for maneuver than the Pact would indicate.
The Pact does allow for “exceptional and temporary” deficits that exceed the limit if the Commission judges that they result from an unusual event – such as a war – that is outside the control of the member state. The Commission will also waive sanctions if a deficit results from a “severe” economic downturn involving a fall of at least 2% in annual GDP.
But the fiscal rules are still too rigid, some analysts say. “We call it the ‘growth and stupidity pact,’” said Bob Sinche, head of global currency strategy at Citigroup in New York. “When there is talk of deflation in global markets, the last thing you need is to restrict the flexibility of policymakers.”
The U.S., by contrast, is demonstrating a flexible fiscal stance by running a budget deficit that the administration projects to rise to a peak of $307 billion, or 2.7% of GDP, by 2004 as the result of tax cuts and increases in spending on military needs and homeland security.
Many observers see France’s defiance of the Commission as a “rational policy response,” to an economic downturn, Sinche said, and so it comes as no surprise. The effect of the French decision on financial markets was also lessened by the overwhelming focus on preparations for war with Iraq. “It was pretty shocking but people were too busy watching CNN for [France’s position] to have much impact,” said Laidi of MG Financial.
An answer to the continuing fiscal strains could be to modify the pact so that it puts more emphasis on maintaining sustainable debt levels and less on the short-term balancing of budgets. The lower the debt level, the less need there is to reduce annual deficits.
In Search of Flexibility
Policymakers may also consider raising the 3% deficit limit, especially if economic growth remains sluggish or non-existent. “The idea that the world will come to an end if the deficit rises to 3.25% is silly,” said Richard Marston, a Wharton finance professor. “If it turns out that this (economic slowdown) continues, they may have to rethink the pact.”
In the search for a more flexible approach to economic management in Europe, monetary policy, too, has come under the microscope. The European Central Bank, modeled on the German Bundesbank, has been widely criticized for its rigid adherence to an anti-inflation doctrine at a time when deflation appears to be the greater danger.
The ECB’s benchmark refinancing rate, currently at 2.5%, is double that of the U.S. fed funds rate which is at its lowest since 1961. Since October 2000, the ECB has cut rates by a total of 2.25 percentage points, compared with the Fed’s massive 5.25 percentage-point reduction since May of that year.
In zealously following a policy of price stability, the ECB is not only obeying the letter of the Maastricht Treaty that established the legal basis for the euro, but also deliberately establishing its own credibility in the early years of its existence, according to Marston.
As a new institution, the ECB has had to maintain a rigorous stance on inflation despite the economic downturn that argued for lower rates, Marston added. The Federal Reserve, with its proven leadership and successful anti-inflationary record, could afford to cut rates aggressively to stimulate the economy in 2001 and 2002. But the ECB would have lost whatever confidence it has generated in its short life if it had followed the Fed’s example.
“It’s unfortunate that they have had to follow this policy at a time of economic downturn,” said Marston. “But if I was on their board I would have voted with them.”
The ECB is also constrained by the need to set a single interest rate that will cover higher-growth euro members such as Ireland and Spain as well as the less-vigorous Germany and France.
In response to the criticism, the ECB is undergoing what it calls a “stock-taking” of its approach to monetary policy. But few analysts see any significant change resulting from the exercise whose results are expected to be published in May.
“The ECB is modeled on the Bundesbank and the Dutch central bank and they have always taken a much longer perspective on monetary policy,” pointed out John McCarthy, director of foreign exchange at ING Barings in New York. “They take a much more formulaic approach to price stability (than the Federal Reserve). I don’t see any real change.”
So any increase in the flexibility of European economic policymaking is likely to fall on the Stability Pact. “It might be best to admit that (the Pact) was not workable,” said McCarthy. “There are times when it’s OK to run budget deficits.”
