The house of cards that Jacques built Larry Elliott Monday December 10, 2001 The Guardian The house that Jacques built is almost ready. In three weeks time, crisp euro notes and shiny euro coins will be replacing francs, marks, pesetas and all the other currencies of the nations that joined monetary union. As the last lick of paint is applied, there are wistful looks from this side of the channel. Tony Blair, we are told, would like to live in the house that Jacques Delors built. He feels he has rather outgrown his cosy little semi and wants to move into something bigger. Like any potential homebuyer, Tony knows that it is one thing hankering after a new pile, quite another being able to afford the asking price, however. The sums, in other words, have to add up. And that's where the difficulties begin. Although it has been more than a decade in the planning, the house that Jacques built already looks passé, the economic equivalent of a 1960s tower block. Back in 1988 when the Delors commission started laying the foundations for monetary union, it seemed natural that the central bank charged with setting interest rates should be based on the German Bundesbank. Germany was the most successful country in Europe and, together with Japan, seemed to have all the answers to the economic problems of the day. Even had this not been the case, the Bundesbank would still have been the template for the European Central Bank. Everyone knew that without Germany there would be no monetary union, and the German people needed reassurance that a single currency would not involve the dilution of their beloved mark. Doing things the German way meant not just setting up the ECB as a carbon copy of the Bundesbank, but creating an institution that would be even more dedicated to fighting inflation. Balanced budgets Nor was this the end of it. While the German government was happy enough about the arrangements for monetary policy, there was always the danger that some of the more profligate members of the club - Italy, for one - would play fast and loose with fiscal policy. There had to be a mechanism for preventing governments running large budget deficits as a way of mitigating the effects of a centrally controlled monetary policy. As such, Theo Waigel, the German finance minister at the time, came up with the idea of adding an extension to the house that Jacques built, called the Stability and Growth Pact. All countries would agree to balance budgets over the medium term, with fines threatened for those whose deficits exceeded 3% of GDP. Warnings that this would make recessions worse by preventing fiscal policy acting as a shock-absorber during economic downturns were ignored. There are those in Paris - and even Berlin - who now wish that the advice had been heeded, because Europe's macroeconomic framework no longer looks like the latest in swish design and the obsession with fighting a war that was over long ago is amplifying the effects of the global downturn. German bankruptcies are up nearly 20% in the past year, unemployment has been rising for the past 11 months and is forecast to rise above 4m over the winter. The German economy contracted in the second and third quarters of this year and - judging by Friday's dire figures for industrial output - will contract even more rapidly in the fourth. "We have particular concerns over Germany," said the City firm ABN Amro last week. "The ECB is explicitly setting monetary policy for the euro zone in aggregate. This means that interest rates will remain far too high for Germany. "In addition, the permanent fixing of the nominal exchange rates rules out the option of a sizeable depreciation of the mark and EMU also means there is limited scope for fiscal stimulus." ABN Amro believes that Germany could become the next Japan. In fact, the medium-term outlook could be even worse, since Japan at least has the ability to apply the remedies necessary for recovery. Germany does not. The one-size-fits-all policy means it is impossible to regulate the central heating system in the house that Jacques built; some rooms are too hot, some too cold. Germany is too cold. The ECB's obsession with inflation and its failure to be act pre-emptively means that it is keeping interest rates too high for too long. Inflation in the eurozone is 2.1%, above the ECB's ceiling, but pressures are abating fast. Prices have risen by an annualised 1.2% in the past six months, and with Europe's economy weakening, rates should be coming down fast. Delay means another grim year ahead. Faced with the consequences of a deflationary monetary policy, the sensible thing for Germany would be to ease fiscal policy, even though that would mean breaching the 3% limit set by the stability and growth pact. Not possible, said Didier Reynders, Belgium's finance minister last week. Rules are rules. The world has moved on. Inflation is no longer the only problem facing policy makers. Central banks that go in for monetary overkill end up by harming growth prospects and, in the end, damage their own credibility with the markets. Inflation targets need to be symmetrical so that deflation is treated as seriously as inflation. For fiscal policy, it makes sense to build some "give" into the system so that deficits are looked at over the course of the economic cycle and there is scope to borrow for investment. And this is where we come back to Britain and to a book launch last week. This was no ordinary book launch, being held at 11 Downing Street and hosted by the chancellor of the exchequer. Reforming Britain's Economic and Financial Policy (£50 hardback, £15.99 paperback) is never going to be a best seller, but it pulled in the cream of UK economic policy making from the Treasury and the Bank of England. Proud parents What was clear, both from the book and its launch, was that Gordon Brown and his advisers are remarkably proud of the framework they have established. They believe that the Bank of England is a better designed central bank than the ECB, and that the government's rules for fiscal policy avoid the pitfalls of the stability and growth pact. Treasury mandarins and the Bank of England's top officials share this view and there is little appetite in either institution to adopt a regime they consider inferior. In his foreword Brown says: "A sustained track record of stability is the best foundation upon which the government can deliver its wider goals of higher levels of growth and employment, and so deliver rising living standards and better public services." Brown thinks it is no accident that Britain is on course to be the fastest growing economy in the G7 both this year and next. Neither would deny the British economy still suffers from serious defects, but they argue that since the rebuilding of the UK's macro-economic structure from the foundations up means that it is now possible to give the shabby interior a makeover as well, with extra spending on health and education. All of which helps explain why the chancellor is serious about the five economic tests and is no particular hurry to move into the house that Jacques built. With its deflationary monetary policy and anti-Keynesian fiscal policy it has the appearance of a folly put up by a right-wing eccentric. [EMAIL PROTECTED]
