French demands would not mean a weaker euro

Click to follow
In the financial markets, the latest battle between Germany and France on the nature of the single currency is commonly portrayed as a battle between good and evil. On the side of good, we have the traditional German approach to macro-economic policy - strict adherence to budgetary discipline, a central bank made bullet-proof against political interference, and a corporatist pay-setting mechanism which generally delivers sensible wage increases.

On the side of evil, we have, if not exactly the French approach, then the traditional Mediterranean approach - high public borrowing, central banks which are subservient to their political masters, and a chaotic labour market which generates strikes and inflationary pay awards. Or, to put it more simply, it is argued that Germany stands for a strong euro, and the new French government stands for a weak euro.

It remains to be seen how much truth there is in this caricature. Admittedly, while the Jospin government may have its heart in the right place, it does not seem to have its head in the right place. Its domestic programme, which is based on the creation of 700,000 extra jobs in the public sector, the stimulus of demand through higher wages, and the curtailment of the working week in order to ration out scarce jobs, is scarcely the height of economic modernity. If implemented in anything like this form, it would undoubtedly be a disaster, and a very rapid disaster at that.

Yet the overwhelming impression of France's new ministers is one of unpreparedness for office, of an administration that made rash promises during its election campaign because it expected to lose. There has been a lot of talk of Tony Jospin and Lionel Blair, but it is hard to see why. Not least in their degree of pre-planning for office, the two new leaders in Britain and France have less in common than chalk and cheese. The view in Whitehall is that the Jospin government has yet to come to a definitive view on exactly what concessions to demand from the Germans on the single currency, and probably will not do so in time for the Amsterdam Summit this week. Instead, we may get a mixture of shadow boxing and suck-it-and-see from the French, with the real bargaining being left until later.

How much can, or should, the Germans be willing to concede to the French during the summer? When thinking about this, it is important to realise that much of the conventional wisdom on the weak euro/strong euro debate is just arrant nonsense. Here are a few key points to recognise.

First, which nation in the EU has been most eager in the last year or two to devalue its currency in the foreign exchange markets? It is not the Italians, the Spanish or the French, all of whom are reasonably content with the competitiveness of their exchange rates. No, the nation which has been desperately trying to devalue its currency is none other than Germany. Indeed the main reason being put forward by Chancellor Kohl for launching the euro in 1999 is that there would otherwise be a disastrous rise in the mark on the foreign exchanges. In other words, the Germans are interested in the euro because they want a weak currency, not a strong one.

Of course, this should be placed in context. One reason why the Germans have been so keen on devaluing their currency in the past two years is that the mark became substantially over-valued in the previous three years, under the impact of the sharply over-restrictive monetary policy being followed by the Bundesbank at that time. Nevertheless, according to Goldman Sachs calculations, the mark has more than fully eliminated this earlier over-valuation, and is now trading about 10 per cent below its long-term fair value in real terms. Despite this, the federal government in Germany is perfectly happy to push the mark still lower, thus proving that for the time being they have become proponents of a weak currency. I mention this simply because there may be times in the future when it will make perfect sense for Europe to think similarly to the way that Germany is thinking today.

Next there are the changes being demanded by the French on the Stability Pact. These are also described as if they will "weaken" the euro. But again this is just rubbish. There is no sign whatever that the French are asking for any concessions on the key points in the pact - ie the aim to balance the budget over the medium term, and the system of fines which will kick in if budget deficits exceed the limit of 3 per cent of GDP. If they are asking for concessions on these topics, they should be sent packing.

But what they are actually requesting is an improved system whereby the members of the euro can co-ordinate their fiscal policies sensibly, a necessary improvement to ensure that the overall fiscal policy of the EU is not just a serendipitous composition of what the individual member states happen to be doing. The need for this is clearly foreshadowed in articles 102 and 103 of the Maastricht Treaty, and Jacques Delors has suggested that it may be enough simply to append these clauses to the Stability Pact itself. If the French would be content with this, then it should certainly be acceptable to the Germans.

In any case, even if the French were asking for concessions to the key points of the pact, this would not result in a weak euro. If the fiscal policy of the EU is less restrictive than intended under the terms of the pact, this will inevitably induce the European Central Bank (ECB) to raise interest rates more than they would otherwise have done, a move which would result in a stronger euro, not a weaker one. Amendments to the key elements of the pact should be rejected on the justified grounds that they would lead to bad fiscal policy, not on the cock-eyed grounds that they would lead to a weaker currency, which is the reverse of the truth.

All this assumes that nothing is done fundamentally to alter the independence of the ECB from political interference. Again, the French seem very ready to accept the basic principles here, though they do want a co-ordinated system under which member states can develop a "political counter-weight" to the board of the ECB. This smacks a bit of looming political interference, but as long as the statutes and objectives of the ECB are left untouched, then this should not be a problem. And, as any central banker should be aware, in the long run it is a poisoned chalice to attempt to set monetary policy in a political vacuum. A coherent system for making the ECB accountable to the political process is essential for its durability in a democracy, and this basic point was not properly considered by the drafters of the Maastricht Treaty.

The strong euro/weak euro dichotomy is therefore much more complex than is often realised in the financial markets. The domestic objectives of the new French government look a little alarming, but some of their demands on the single currency might actually make sense.