A High-Stakes Game of Brinksmanship
With the United States reeling from the terrorist attacks and Japan mired in a decade-long slump, Europe was supposed to steer the global economy through the storm. Instead it is stalling, too - held back, economists say, by a high-stakes game of brinksmanship among European policymakers.
While U.S. leaders slash borrowing costs and seek to spend tens of billions of dollars to try to rev up their economy, Europe is paralyzed, constrained on the one hand by a stubborn central bank and on the other by budgetary restrictions that have been called a corset, a straitjacket - even a medieval torture chamber.
Instead of taking action, European policymakers are pointing fingers at each other. Finance ministers, some of them with an eye on pending elections, accuse the European Central Bank of damaging the economy by cutting interest rates too slowly.
The charge only seems to strengthen the central bankers' resolve. As the ECB steadfastly pursues its tight-money policies, it also lobs challenges back at its accusers. From his bully pulpit, the ECB president, Wim Duisenberg, tirelessly advocates fiscal rigor by national governments and insists that they deregulate European labor markets and slim down their welfare states.
"Fundamentally, they are playing a game of chicken," said David Smith, a chief economist at Williams de Broe in London. "It is a dangerous game to play."
By airing their dirty laundry, European policymakers are damping confidence in the region's economy - and the timing could hardly be worse. Not only do the United States, Japan and Germany face a simultaneous recession, but in two months the 12 members of the European single currency bloc are preparing to embark on their most ambitious experiment in unity: the introduction of euro notes and coins.
"We need to be more adult," acknowledged Didier Reynders, the Belgian finance minister and a frequent critic of the ECB, in an interview this week.
It was not supposed to be this way. When they first designed the framework for European monetary union, policymakers aimed at economic strength based on a system of democratic and transparent governance. But, pushed by conservative German policymakers still fearful of the 1920s hyperinflation that gave rise to the Third Reich, they were so wary of some of their neighbors' spendthrift ways that they put particular emphasis on the need for fiscal and monetary discipline to preserve price stability.
Those good intentions served Europe well during the economic upturn of the late 1990s. But they are intensifying the pain during the present downturn. Ironically, while many of Europe's smaller economies are thriving, Germany, the biggest, is suffering the most. And its weakness now threatens the others. "There is frustration after such a collapse in growth this year and then to have your hands tied," a German government official said.
European finance ministers are prevented from pumping billions of dollars into their economies by a cornerstone of monetary union, the Stability and Growth Pact, which requires them to keep budget deficits at less than 3 percent of gross domestic product.
While that requirement has tightened Europe's notoriously loose purse strings - in the early 1990s some countries' budget deficits ran as high as 10 percent of GDP - it now rules out a large Keynesian stimulus.
"It is a fair-weather concept," said Gustav Horn, the chief economist of the German Economics Institute in Berlin, one of the country's leading policy groups. "Now that the economy is weakening across the board, it is becoming a big problem."
The problem was compounded by insufficient fiscal discipline during the relatively fat years of the late 1990s. While the United States built up a budget surplus, giving it a rainy day fund that can now be tapped, only a few smaller members of the euro zone did the same. "It is only with a surplus in our budget that we can react to a slowdown," said Mr. Reynders, who also serves as the current chairman of the so-called Eurogroup of finance ministers.
There have been minor efforts to pump up individual European economies, and economists predict that there will be others before most governments' budgets are finalized in mid-December. Mostly, however, these involve chipping away at the edges of the growth and stability pact without violating its fundamental precepts.
"There's a lot of window dressing," said Kevin Gaynor, an economist at UBS Warburg in London. "It's pretty tiny compared with what's going on in the States."
There is little doubt that the stability pact will stand, but analysts say there is room to fudge. Under the pact, if governments breach the 3 percent deficit limit, they can be fined a sum equivalent to up to 0.5 percent of their country's GDP. But the decision to impose a fine is not automatic; it is subject to a lengthy political approval process involving the European Commission and the member states.
A country is exempted from the 3 percent limit only in the extreme scenario of a 0.75 percent decline in annual economic growth. So far, no penalties have ever been assessed. The pact has worked mainly through peer pressure.
"The penalties are designed not to be used," said Iain Begg, a professor of international economics at Southbank University in London. "It's a bit like MAD," he said, referring to the Cold War doctrine of "mutually assured destruction."
According to some German officials, efforts are under way, supported by some finance ministers, to find a more accommodating "interpretation" of the deficit requirements. They hope to reach agreement on a face-saving measure to soften the criteria when finance ministers hold their regular monthly meeting in early December.
Mr. Reynders said there was a "technical" discussion on "methods of calculation" for the deficits. "Later on, it will be possible to pay more attention to growth, but for now we must concentrate on consolidation," he said.
While governments could find some ways around the limitations of the stability pact, analysts say a lot of the talk is bluster aimed at the monetary policymakers at the European Central Bank. Compared with the Fed, the ECB has looked relatively complacent as economic forecasts have been downgraded across the world. It has cut its key interest rate this year, but at 3.75 percent it remains far higher than the 2.5 percent benchmark in the United States.
Each time the ECB has stood firm on rates it has come under a storm of criticism from European politicians. It has even surprised one of its own architects, the former Bundesbank president, Karl-Otto Poehl. "The European Central Bank should have lowered interest rates more resolutely months ago," Mr. Poehl said in an interview this week in the German magazine Der Spiegel. "It evidently incorrectly perceived the economic situation."
Most analysts agree that there is plenty of room for the bank to reduce interest rates, and they say that the ECB probably will do so at its next meeting, on Nov. 8. Inflation is falling rapidly and looks set easily to fall under the bank's 2 percent target next year.
"But comments by finance ministers should be watched closely, since jawboning could yet lead to another delay in action," said Julian Callow, European economist at Credit Suisse First Boston.
Indeed, Mr. Duisenberg sometimes seems to take pleasure in keeping European finance ministers in line. At a news conference in August he recounted a phone call he received from Finance Minister Hans Eichel of Germany while the ECB president was on vacation in the south of France, in which the German finance minister explained that he had been misquoted in media reports suggesting that he was looking at ways of altering the stability pact.
"I was very pleased, when driving in the neighborhood of Avignon in France, I received a phone call from Mr. Eichel, who told me that he had been misinterpreted, misquoted in the press the previous day and that there was no intention on the part of the German government to bring the Stability and Growth Pact under discussion and he wanted to assure me on this."
Mr. Eichel's backpedalling underscores the sensitivity surrounding the stability pact. As a cornerstone of the monetary union, finance ministers shy away from publicly criticizing it in fear of raising questions about the entire euro project. But their silence also prevents serious debate about the pact's complicated role in the region's economies.
The ECB's stubborn approach on rates wins praise from some analysts, who say it demonstrates the young bank's independence as the all-important introduction to euro notes and bills looms in January.
But having stalled on rates for so long, the ECB has also undercut its own power to stimulate the economy. A rate cut now would have less effect in Europe, anyway, than it would the United States, analysts say, in part because much more of the European economy is controlled by the state while in the United States the financial markets play a large role in the economy. With less activity in private hands in Europe, moving market interest rates down a notch would do relatively little to stimulate economic activity directly.
"Alan Greenspan is in a much stronger position because if he presses a button marked 'cut interest rates,' he has years of experience in knowing what the reaction will be," Mr. Begg of Southbank University said.
Similarly, a big fiscal move - spending billions of euros on new infrastructure projects, for instance, or cutting taxes aggressively - could backfire. Japan has done just that over the last decade, lavishing trillions of yen in a futile effort to restart the economy after the bursting of the stock market bubble. Economists say it would be folly for Europe, having finally controlled its addiction to tax-and-spend policies, to breach the stability pact now.
Other analysts say they are bemused that the United States, having long preached the gospel of market economics, limited government involvement and fiscal restraint, is now proposing a big package of spending increases. Ambitious new stimulus plans are now undergoing sharp political debate in the U.S. Congress.
At times of crisis, however, it is another American economic virtue - pragmatism - that is perhaps most important. Even the appearance of swift and decisive action can increase confidence in the financial markets and consumers. By contrast, the European cacophony on economic matters leaves them confused and concerned. That is why the dollar, despite a slide this week caused by weak U.S. economic data, remains roughly where it was on Sept. 11 against the euro.
"If investors do not believe that the captain of the ship knows how to read the charts, they will sail on another vessel," wrote Carl Weinberg, chief economist at High Frequency Economics, in a recent market commentary. "If this is what a loss of credibility is, then the ECB has created it."
Many analysts say the real problem with Europe's economies is not the fundamentals - given the stream of bad news coming out of the United States this week and out of Japan for nearly a decade, Europe still looks relatively healthy. But Europe should be performing much better. The current debate over monetary and fiscal policy, these analysts say, obscures a flagging commitment to a shakeup of Europe's rigid employment market.
"It's a smoke screen to hide the fact that as long as they have highly regulated labor markets and high taxes on jobs, they are going to have stagnant economies," said Mr. Smith at Williams de Broe. "The real issue is, how are you going to get people off their velvet sofas."
Mr. Duisenberg exhorts governments to press ahead with such "structural reforms" in virtually every speech and appearance he makes.
Of the major euro zone countries, France has gone the furthest, introducing some flexibility measures along with a 35-hour workweek. It has reduced employers' contributions to the social security fund, a measure that created 106,000 jobs between 1997 and 1999, according to one study. But France still clings to many labor regulations that make it hard for employers to hire and fire workers, leaving it far from an American-style labor market.
In Germany, while Chancellor Gerhard Schroeder has supported a move to introduce flexible working conditions at the automaker Volkswagen, he has also allowed other measures that make the labor market more rigid. His Social Democratic Party has approved a law that lowers the limit on temporary work to 10 weeks from 12, and another that increases the power of workers' councils. Italy, meanwhile, has made few changes, though Silvio Berlusconi, the new prime minister, has promised a law on workplace flexibility.
As European economies slow down, unemployment is increasing again after several years of modest declines. That worries policymakers, particularly in Germany and France, where elections loom next year. Mr. Schroeder promised to bring German joblessness down to 3.5 million by next year - a goal that now seems impossible.
Broad make-work projects to combat unemployment have been ruled out because the three biggest economies in the euro zone - Germany, France and Italy, accounting for over 70 percent of the region's economic output - have little room to maneuver under the growth and stability pact. They will be able to increase spending under so-called automatic stabilizers in their social programs - increased unemployment benefits and the like.
The closest thing to a real fiscal stimulus is a plan to create 30,000 jobs in France. Paris has also proposed a tax-rebate program for low-income earners, and there is speculation that the government will consider moving up corporate tax breaks scheduled for 2003.
But compared with the possible U.S. fiscal spending spree, it is not much. Nor does France have very much room next year, when some economists see its deficit rising to well above 2 percent of gross domestic product.
Italy, under Mr. Berlusconi, actually appears to be going the other way. Under current proposals, tax cuts for companies and households would be postponed, and a scheduled increase in pension payments would be delayed.
The country in the best situation under the stability pact is Ireland, which has a budget surplus - but it accounts for only 1.4 percent of euro-zone output. And although Ireland could increase spending if it wanted, it hardly needs to do so: It has managed to sustain healthy growth.
In the worst shape is Germany. After the terror attacks, Berlin came up with a 3 billion Deutsche mark crisis program to support its police and military. Although it justified the measures as a response to a national emergency, it had no way to pay for them without new consumption tax increases - a move that think-tank economists say is like poison to the economy as it slides into a possible recession. A tax reduction that took effect early this year appears only to have delayed an inevitable slippage into recession.
Now Germany has the biggest budget deficit and the slowest growth of any euro zone country. The ECB's austerity policies and the stability pact were the price - insisted on by former Chancellor Helmut Kohl - that Europe had to pay for German participation in monetary union. Now Germany is paying the price and, perhaps, dragging down the rest of Europe with it.