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Tuesday, March 25, 2003

The Future of EMU

Even while the war rages around us in all its bloody reality, it is still important to try to take stock of some of its likely economic consequences as and when they become a little clearer. Today it is the turn of Morgan Stanley's Joachim Fels to start to ask some of the pertinent questions. Whatever the final outcome it is clear that the post-Iraq war EU will look somewhat different to the pre-war one. In the first place everything is happening against the backdrop of an important structural change: the entry of ten new members into the community. In and of itself this will produce changes, and some of the possible lines of evolution of those changes are already discernable. Firstly there will be a political re-alignment. Those with long enough memories cannot fail to remember that one of the main backers of the EU enlargement process was in fact Mrs Thatcher. The then British prime minister, in my opinion, took this view for two reasons. Firstly in an attempt to make any move towards European political union (and the creation of a Euro super state) much less likely, and secondly to break the back of the Franco-German axis by creating the possibility for new political alignments.

Regardless of whether one considers this a good or bad thing, it is impossible for the thoughtful observer of the European scene today not to have the feeling that Mrs Thatcher was the most prescient of the then politicians. The enlargement seems now destined to take place without the political reforms which were widely regarded as being indispensible (not tackling the veto situation, as we have just seen in the UN case, might be considered as something of a 'lethal dose'). At the same time Jaques Chirac's recent outburst against the new Eastern members should not be regarded as anecdotal, but rather as an indication of what may well be to come. If, from the time of De Gaulle, rough and ready anti-Americanism has been the handmaiden of French foreign and domestic economic policy, with the EU as a political structure being merely an extension of this policy by other means, then this bubble has now, suddenly, burst. The political divisions which have emerged around the Iraq war only serve to underline this new reality. Perhaps the only really surprising thing, and I, like almost everyone else here in Spain, am having great difficulty in interpreting this, is the political stance of the present Spanish government.

Europe really is divided into four components: a South (Greece, Portugal, Italy and Spain), a North (UK, Sweden, Finland, Denmark, Holland (?), Ireland (?)), an East (principally the so-called 'transition' economies, and in particular Poland, Hungary, and the Czech Republic), and a central component around the Franco-German axis (France, Germany, Belgium, Luxemburg, Austria). In my view the weakest of these components is the southern group, and this is the component with the most to lose if Joachim Fels is right and the growing political rivalry spills over into increased economic competition. This is especially true for one reason not mentioned by Fels: the principle competitors of the Mediterranean four will be the Eastern group, and these, since they do not belong to the euro group, will have far greater room to manouevre in the newly competitive environment. They are also, if Fels is right in predicting widening yield spreads, the most at risk from negative public debt liabilities given their demographics and lack of adequate pension preparation.

On the other hand the likelihood of UK euro participation seems to have faded considerably, and this may have its own impact on the other principle axis of economic and political competition, the North/Central one. Here, among other factors which should be taken into account, are the different levels of penetration of the English language, and internet take-up and participation rates, both of which could in some ways be seen as proxies for capacities to realise available externalities in the so-called knowledge-based economy.

All-in-all, Not a pretty picture I feel. Perhaps the most ominous of Fels' forecasts: that market participants need to begin to factor-in an EMU break-up probability assessment. As Fels says, this seems extremely unlikely. But the mere fact that he even mentions it, and the fact that the markets may begin to recognise it as a conceivable possibility, this fact in itself means that it is just that little bit more possible today than it was yesterday.

The rift that has emerged within Europe between those countries backing the military intervention in Iraq and those opposing it has made one thing crystal-clear. The idea of an ever-closer political union culminating in the United States of Europe will remain a pipe dream for a very long time, especially now that the European Union (EU) looks set to expand towards Central and Eastern Europe with ten new, self-confident members scheduled to join next year. These developments have some important economic and market ramifications. Markets will have to get used to the notion that national governments will increasingly pull in different directions on important foreign or domestic (economic and non-economic) policy issues. In short, the country factor will loom large for investors, the risk of a break-up of the EU and/or EMU, while small, will be non-negligible, and the ECB could be pressured into producing higher inflation. However, a diverse and diverging EU that moves at different speeds in different policy areas may actually produce better economic outcomes than a monolithic United States of Europe governed by a single government in Brussels ever could. In my view, economic and political diversity, combined with a huge single market for goods, services, capital and people, provides for a healthy competition of national or regional entities for mobile resources. The result would be a less regulated, more dynamic and faster-growing European economy............

Make no mistake: the current and potential future divisions within Europe will make national governments, parliaments and voters less and less likely to cede more sovereignty to Brussels. This has important consequences for the EU Convention, the assembly led by Valerie Giscard d'Estaing which is currently seeking to draft a European constitution to be finalised next year. European federalists will deplore the fact that Europe seems unable to build a political union that can speak with one voice and match the status of the United States. In my view, however, this has been an unrealistic and unworkable vision all along, especially for an enlarged EU comprising 25 or more members....... I rather try to see the positive side of Europe's disunity.....
Yes, this kind of competition may look messy or even chaotic at times, some countries may run in the wrong direction for a while, and internal disagreements and even institutional crises will ebb and flow. However, as long as the common market for goods, services, capital and people rules, this kind of competition should produce better economic outcomes than a single government for the whole union, which would be far detached from its diverse citizens in 25 or more member states. Countries that pursue the right tax, welfare and labour market policies in this set-up will be rewarded with capital inflows, stronger growth and lower unemployment and can serve as a role model for others who are doing less well. Eventually, the process of "dynamic benchmarking" will lift the boat for all members willing and able to play the game and should result in a less regulated and stronger-growing European economy.

Growing divisions on budgetary policy and a possible slow death of the Stability and Growth Pact could lead to a significant widening of government bond yield spreads between the more and the less virtuous countries. Partly, this would reflect the actual fiscal policy divergences and partly it would reflect the fact that a financial bail-out for a member state that runs into serious fiscal difficulties will be less likely in a dis-united Europe. Second, in this changed environment, markets will have to attach a higher probability to a break-up of EMU and/or the EU at some future date. While I believe that the economic benefits from participating in both are sufficiently large to make such an event unlikely, we simply cannot neglect the possibility of fraction and secession. Everything else being equal, this suggests a higher risk premium on European financial assets and the euro. Third, a disunited Europe won't make the ECB’s job any easier. As the ECB has no policy instrument to address economic divergence between the euro participants, a growing divergence of budgetary and general economic policies would likely lead to increased political pressures for an easier monetary policy to grease the wheels. Whether the independent ECB would cave in to such pressures is uncertain. Yet, history shows that even the most independent central banks are not immune to the political environment in which they operate.
Source: Morgan Stanley Global Economic Forum

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