France opens its arms to Waigel's tough plan

'Whenever it comes, EMU now seems certain to involve much tougher controls over budgetary policy than any British government, certainly any Tory government, could accept.'

On a visit last week to some of America's largest international investors, I was struck by two strong themes about the European economy that kept on cropping up. First, US equity investors are quite fearful that a new contraction may be hitting Europe. This reportedly started in mid-year, has intensified in the current quarter, and now applies as much in the UK as it does on the Continent.

Second, most Americans blame these developments on attempts by certain economies to tighten fiscal or monetary policy in order to prepare for monetary union (EMU). This line has been strengthened by recent calls from Germany for new and permanent fiscal controls to be put in place after EMU - an area that was left opaque by the Maastricht Treaty. Proposals for these new budget controls have gone surprisingly unnoticed so far in the UK. But they will certainly prove explosive when the anti-EMU camp begins to focus on them - not least because they are seemingly being imposed by a side agreement between Germany and France, with virtually no reference so far to the rest of the European Union.

Let us start with the talk of "recession". There can no longer be much doubt that European activity has weakened markedly in recent months, particularly in the manufacturing sector. Much of this seems to be due to a rather belated, but now quite sharp, downward adjustment in stock levels, and there are no signs this is abating. Figures out last week showed the biggest monthly drop in EU order books this year, with a further build- up in unwanted stock levels.

There were huge drops in order books in both France and Germany last month, and the UK now seems to be getting sucked into this Europe-wide phenomenon. Price inflation pressures in the manufacturing sectors throughout Europe are dropping precipitously. Even if we are only seeing a temporary inventory correction that will blow over next year, it certainly should, and almost certainly will, force a co-ordinated cut in European interest rates fairly soon.

It is far from clear, though, that this setback in activity should be blamed mainly on the EMU process. The accusation here is that attempts to comply with the budgetary targets in the Maastricht Treaty are leading to contractionary fiscal policies in the EU, while attempts to stabilise currencies against the German mark are leading to contractionary interest rate policies as well. But in most EU countries, including Italy and the UK, this argument does not seem to stand up. Fiscal corrections would have been necessary in many countries after 1992, regardless of the Maastricht criteria, and monetary policy outside the core exchange rate mechanism has been completely uncorrelated with that inside it. Furthermore, the drop in output growth this year has been a world-wide phenomenon, not one confined to the EU.

But one country where the EMU argument does stand up is France. Until last month, the Chirac/Juppe administration had been making unconvincing attempts to tighten budgetary policy, while also appearing equivocal at times about its commitment to exchange rate stability. As a result of the confused message this sent to the markets, the risk premium on French interest rates rose significantly, adding to the dangerous contractionary forces already on the loose in the economy. In short, France was getting the worst of all worlds.

Clearly this could not go on. The watershed came in a summit last month between Chancellor Kohl and President Chirac that has resulted in a new resolve from both sides to give the EMU project a gigantic new push. Since then, the Germans (who have their own reasons, connected to the competitiveness of German industry, for wanting to shore up the French franc) have returned to their previous posture of full and unbending support for the French.

And, following the Juppe government's budget proposals, finalised last week, the fiscal stance in France will be decisively tightened by around 1 per cent of GDP in both 1996 and 1997. This will allow the budget deficit to come down to the Maastricht limit (3 per cent of GDP), assuming that real GDP growth is around 2.5-3 per cent per annum in the next two years.Furthermore, it should allow real interest rates in France to fall precipitously, especially if the Bundesbank helps by simultaneously cutting rates.

So the French and Germans seem to have renewed their determination to get to full EMU by 1999. The main threat to this resolve would be a recession in Europe next year, since this would throw the French budget plans into renewed disarray. In the context of much lower GDP growth, France would need to introduce even tougher budget measures to hit the Maastricht targets, and that would almost certainly be too much to ask. In fact, should a recession intervene, the EMU project would get postponed for at least a couple of years. So the only assured route to EMU in 1999 is the route of economic growth, and that requires lower interest rates soon.

But whenever it comes, EMU now seems certain to involve much tougher controls over budgetary policy than any British government, certainly any Tory government, could accept. In order to placate the German electorate, the Finance Minister, Theo Waigel, has proposed a new "stability pact" that all full members of EMU would be required to sign. This pact would set a budget deficit target of 1 per cent of GDP for all countries, with an upper limit of 3 per cent of GDP for the budget deficit during recessions.

Countries that exceed the limit would be fined 0.25 per cent of their GDP for every 1 per cent of GDP by which they miss the limit, and this would be recoverable only if the budget excess were eliminated within two years. If the UK were already a member of such a pact, we would now be preparing to pay Brussels a fine of pounds 2bn for this year's budget overshoot - a figure that would certainly get the attention of Bill Cash, among others.

Actually, the principle of a supra-national agreement to limit budget deficits is a very good one. Because of spill-over effects, one country's budget deficit is another's rise in the global real interest rate. But the Waigel proposal looks much too restrictive. The 1 per cent central target for the budget deficit is much lower than the figure required to stabilise the public debt/GDP ratio in the EMU bloc (2.5 per cent would be enough to do that), and it would require yet another fiscal retrenchment in the early years of EMU.

Furthermore, since individual members of the EMU could no longer respond to recessions by reducing interest rates in their own economies, they might want to ease the fiscal stance by more than they have typically done in the past. Yet, as the graph shows, the 3 per cent Waigel limit on budget deficits would have been triggered by at least one of the likely core EMU members in virtually every year in the past 20. Fines would be an everyday event under the Waigel plan.

Nevertheless, the French have welcomed the Waigel proposal with the alacrity of a foreign legionnaire receiving his first Gauloise after a year lost in the desert. This only goes to show how keen the Chirac government now is to get the EMU deal done.