In a superficial sense, the outcome depends on whether the convergence criteria in the Maastricht Treaty can be hit in 1997. The key criterion, though hedged with many qualifications, is the objective of cutting the budget deficits in participating countries to less than 3 per cent of GDP next year. If this and other criteria are achieved, then, in theory, the move to EMU in 1999 becomes automatic. This was, after all, the whole point of the Maastricht process. But in practice, the outcome will depend mainly on political will, especially on whether President Chirac continues to place EMU ahead of almost any other economic objective in the next two years. And the context in which he is working is being shaped not by elected politicians, but by the "independent" central bankers of Germany and France.
There have always been questions about the depth of President Chirac's personal commitment to EMU. Only a few weeks ago, there were murmurings from within the French government (and perhaps even from within the Elysee itself) that Jean Claude Trichet, the governor of the Bank of France, was pushing the economy towards disaster with his tough monetary policy, designed to ensure that the franc remained firm against the mark as a prelude to EMU. In Paris, the talk among economists has been of the risk of deflation - an outright fall in the price level - and a renewed collapse in the property market. Some economists have started to call for the kind of aggressive easing in monetary policy which hauled the US out of recession in 1991/92, and did the same for Japan in 1995/96.
But the central bankers coldly point out that interest rates in Germany and France are already close to post-War lows, and that no further action is needed to generate an economic recovery. If they are right, the two economies could generate enough growth next year to enable budget deficits to come in below 3 per cent of national income. If they prove wrong, and GDP growth stumbles along at 1 per cent or less, then EMU will have to be postponed or abandoned.
The stakes are therefore very high, and the rewards for getting monetary policy right are unusually large. But it is still hard to feel confident that overall monetary conditions have been eased enough. Admittedly, real short-term interest rates in Germany now stand at about 1.5 per cent, while in France they are around 2 per cent, the lowest level in a generation. But monetary conditions should not be measured by looking at short-term interest rates in isolation. It is the responsibility of central banks also to take into account the behaviour of the exchange rate and long- term interest rates. These are not directly within their control, but it is crucial to take account of their potential deflationary impact when setting the one variable that central bankers can control, the overnight interest rate.
One way of doing this is to try to derive a single index which takes account of the combined effect of the exchange rate, short-term interest rates and long-bond yields, with the weights attached to each of the variables being determined by their relative impact on economic growth. The graph shows the Goldman Sachs Monetary Conditions Indices (MCIs) for the US, Japan and the two main European economies over the period since 1987. When the indices are at 100, overall monetary conditions are at the level they have attained on average in the past decade, and upward movements in the graph represent easier money. The index is constructed such that a one-point move is equivalent to a combination of a one percentage point change in both short and long rates and a one percent move in the exchange rate.
Although it is dangerous to use these MCIs to make overly precise comparisons between the stance of monetary policy in different economies, the graph does illustrate a couple of important points. First, monetary conditions in Germany and France have eased very sharply in the past 18 months, with the overall MCI loosening by over 2 per cent. This has eliminated the inadvertent tightening in policy which occurred as bond yields and exchange rates rose during 1994. In the same way that the tightening in policy in 1994 caused, with the usual lags, the recession of 1995/96, the easing ought to be followed by an economic recovery in 1997.
Second, despite this easing, the stance of monetary policy in the two European countries is still only about average for the past decade. The very low level of short rates is offset by a firm exchange rate and high bond yields, so the central banks are not yet delivering an overall monetary stimulus which is aggressively easy. Certainly, the central bank stance in the EU today does not compare with the degree of monetary stimulus which succeeded in triggering the recoveries in the US and Japan earlier in this decade. And the central banks should also be taking into account the fact that fiscal policy is due to tighten by around 0.5-1 per cent of GDP in Germany and France next year, so that the work which is left for monetary policy is that much harder.
The bottom line of this analysis is that there has probably been sufficient recent change in the stance of monetary policy in the big two EU economies to get some response in terms of output growth in the next few quarters. In contrast to many forecasters, Goldman Sachs believes that the rebound in growth could prove slightly more robust in France than in Germany, because there is more scope for recovery in the building sector and in the level of inventories. The central case must therefore be a cautiously optimistic one.
But the central banks have certainly not yet erred on the side of safety in setting the absolute level of the MCIs. With the French economy still plagued by a weak property market and a banking sector still struggling to adjust to a collapse in balance sheet strength, it could turn out that it will need much more than average levels of the MCI to sustain the strong recovery which is so needed.
One consolation for the politicians is that if it all goes wrong they will know exactly whom to blame - the Bundesbank and the Bank of France.Reuse content