ECB refuses to play Keynesian ball

Date: 05/11/1998

Europe's left-wing governments will not have as much room for manoeuvre as they think. Tim Jones reports

IF THE rhetoric is to be taken at face value, we are entering a brave neo-Keynesian world.

A key policy prescription of British economist John Maynard Keynes - that governments can offset slow growth by spending money on public works and boosting overall demand - is back on politicians' lips. Apparently, the blind decade-long obsession with fighting inflation and cutting public spending has been washed away by a leftist tide.

“We are opening a new era,” crowed Rudolf Scharping, leader of the Party of European Socialists last week. “All the leaders of the left are convinced it is necessary to establish a policy of economic growth.”

The arrival of 'Red' Oskar Lafontaine at the German finance ministry has emboldened the European left. Faced with the crash of their Asian export markets and a collapse in the price of imported products from these wounded tigers, Socialists in Germany, France and Italy have dared to call for a cut in European interest rates and increased public spending.

Even European Central Bank President Wim Duisenberg, the former big-spending finance minister reborn as an orthodox monetarist, has taken this talk seriously and warned governments against engaging in “policy activism”. This is Duisenberg-speak for stimulating consumer and business demand for goods and services by pumping cash into the economy via tax cuts, state-sector wage hikes or investment in public works projects.

Some commentators suggest that all the ingredients exist for a titanic struggle between the forces of monetary orthodoxy and spendthrift lefties.

But the truth is that this tug of war between the ECB and left-wing governments makes for entertaining articles and even better newspaper cartoons, but bears as much resemblance to reality as Gerhard Schröder, Tony Blair and Lionel Jospin do to Willy Brandt, Clement Attlee or Léon Blum.

The stability and growth pact, which obliges euro-zone members to keep their budgets under tight control, will not be renegotiated since nobody except the French and Italian Communists wants this. This means that the wiggle room for these would-be Keynesians is limited.

Beneath the ceiling for his budget deficit ( 3&percent; of gross domestic product), Lafontaine has room to spend 6 billion ecu, the Dutch and Italians 4 billion apiece, and the Belgians 3 billion. As for the 'Keynesian' French, they have no room for manoeuvre, as the supplementary budget published this week showed only too clearly.

Internal Market Commissioner Mario Monti's suggestion that the pact should be interpreted to exclude some areas of investment spending from the deficit calculations is not new. Article 104c (3) of the Maastricht Treaty itself stresses that assessments of budgets should “take into account whether the government deficit exceeds the government investment expenditure”.

The recent informal EU summit at Pörtschach is supposed to have endorsed a new pro-growth policy among the Union's leftist ascendancy. In fact, all the heads of state and government did was “welcome” the progress made in “converging” their inflation rates, so making the conditions more propitious for lower interest rates - not quite the same thing. Even UK Premier Tony Blair's comment that the new “focus on jobs and growth is surely right” is hardly original or meaningful.

Italy's new Prime Minister Massimo D'Alema has taken up a proposal first made by his predecessor Romano Prodi in suggesting that the ECB's excess foreign currency reserves could be used as collateral for a new EU investment fund. Spending more on research into biotechnology and information systems may be a good idea in itself, but it will not offset economic slow-down.

The 'big idea' of French Prime Minister Lionel Jospin for a unquantified “European loan” to channel much-needed cash into some of the Union's biggest transport infrastructure projects has no chance of success.

The notion has been mooted twice before and has met with a resounding 'no' both times from governments which are already complaining about paying too much into the EU coffers.

In the current climate, it does not even make much sense. With long-term interest rates at historic lows - below 4.5&percent; - throughout the euro-zone, a European loan designed to reduce interest costs for infrastructure projects is less needed than ever.

Moreover, pumping money into transport investment sometime over the next five years would not begin to address today's problems.

A world economic slow-down is already under way. Many western countries, including the UK and the US, have seen their exports to Malaysia, South Korea and Thailand cut in half since the beginning of the year.

The London-based Centre for Economics and Business Research (CEBR) published a detailed study of the impending crisis last week and warned that the world economy could shrink by 2&percent; over the coming two years unless governments and central banks ease monetary and fiscal conditions.

The CEBR expects the Group of Seven leading industrialised nations to take reflationary measures by early next year, so preventing world recession but keeping economic growth capped at 1&percent; next year and in 2000.

Continental European countries probably have little to worry about. Most are already swinging into recovery after years of slow growth, and even the most pessimistic of forecasters expect the euro- zone to achieve 2&percent;-plus growth next year, although the UK will not be so lucky.

Nevertheless, most of them are worried. Most budgetary plans are based on faster growth rates than these and nobody wants their export markets to collapse. What they need, and they know it, is not tinkering with European loans or foreign exchange reserve funds, but interest rate cuts to reflate the world economy.

However, the people they have appointed to run the ECB are true believers in the idea that recessions and unemployment are caused by 'structural' distortions to the economy.

Jürgen Stark, the newly appointed vice-president of the Bundesbank, has been the most outspoken critic of the new-left rhetoric. The former top official at the German finance ministry, who escaped just before Red Oskar's car drew up outside, dismissed talk of demand boosts.

“The claim expressed in recent times that monetary policy should slacken to promote jobs is - just like calls for a more expansive fiscal policy - neither helpful nor appropriate,” he said. “Monetary policy cannot straighten what has been twisted by finance, social and labour market policies.”

Anticipating political pressure on the ECB, William McDonough, a voting member of the US Federal Reserve, last week told Duisenberg to show some “machismo”. What he meant was: keep interest rates higher than they need be.

Short-term interest rates in the 'core' of the euro-zone - Germany, France, the Netherlands, Belgium and Austria - are now 3.3&percent;. The ECB, after a pre-emptive verbal strike by Bundesbank president Hans Tietmeyer, has no inclination to ease them despite a steadily rising euro exchange rate and historically low inflation rates.

Some members of the Bundesbank's decision-making council, including Hans-Jürgen Krupp and Klaus-Dieter Kühbacher, believe that the euro's opening interest rates should be below Germany's. But they are a minority and, with the council's demise just two months away, it is Tietmeyer who, more than ever, calls the shots.

If rates are not cut, European economies slow down and budget deficits swell, the already fragile French affection for the new currency will be shattered. The Frankfurt-based ECB will have proved itself to be as obstinate and inflation-obsessed as sceptics such as Jean-Pierre Chevèment and Philippe Séguin had always warned.

The inevitable rise in the euro against the dollar and the pound will drive them crazy. “A cut in interest rates is essential in this area,” warned Jospin last week. “We must also be sure that the putting in place of the euro does not lead to an undervalued dollar.” It could prove to be the shortest romance in history.