Leaning on the money men

Central bankers across Europe are under pressure to toe a line drawn by new political masters, writes Stephen Castle

WHEN European finance ministers met last month, in a drab concrete block in Luxemburg, Theo Waigel, Germany's veteran disciple of sound money, made his swansong appearance after his party's rejection by the German electorate.

But few around the table seemed to grasp the scale of the moment, and Mr Waigel got just one farewell gift - a bottle of Scotch from Gordon Brown, the Chancellor of the Exchequer.

One month on, the change of regime has become impossible to ignore. Mr Waigel's more flamboyant successor, Oskar Lafontaine, has led Europe's leftward shift in economic thinking, appealing openly for lower interest rates and plunging Germany into a bitter row over the independence of its central bank.

The call for cheaper borrowing has been echoed by a host of European politicians, and augmented by demands for a new, neo-Keynesian spending package to boost job creation.

On the eve of the birth of the euro, politicians have begun to challenge the Continent's powerful central bankers. Suddenly the main planks of Europe's single currency, with its strong, independent central bank (the so-called "son of Bundesbank") and its "Stability and Growth Pact" with punishments for nations which run up big deficits, seems to be in question.

In Germany the shift is clear. The Bundesbank has enjoyed hallowed status as the guiding influence behind the country's long-term financial success, based on low inflation and steady growth. Accustomed to independence, it resented any hint of intervention from politicians, but rarely had cause to. Despite occasional tensions, Helmut Kohl's Christian Democrat government accepted such a status quo and Mr Waigel never commented on interest rate movements.

Two weeks ago, the new German Defence Secretary, Rudolf Scharping, was the first to call for a "dialogue" with central bankers to convince them to reduce rates. At a summit in Austria, the Italian and Portuguese prime ministers joined in. Newly installed in a more powerful finance ministry, Mr Lafontaine added his voice. Since then, five European countries, including Britain, have cut the cost of borrowing.

In addition there were hints from the European Commission that countries launching big investment projects may be allowed to breach tough limits laid down for the single currency under the Stability and Growth Pact.

But last week marked the beginning of a counter-offensive from central bankers, mindful that Mr Lafontaine's real target is the European Central Bank, which will control euro-zone rates from January.

Jean-Claude Trichet, governor of the Bank of France and future vice president of the ECB, argued: "Any suggestion that central banks were on the way to losing their independence would affect savers' confidence, both in Europe and worldwide, and as a result rates would have to go up."

On Thursday, German rates remained unchanged at 3.3 per cent, despite an appearance by Mr Lafontaine at the Bundesbank policy-making committee. Indeed, the Finance Secretary's pressure was probably counter-productive, economically if not politically. Dr Rolf Schneider, head of macro research at Dresdener Bank in Frankfurt, said: "The fact that Mr Lafontaine has asked, in such a situation, means that we cannot expect the Bundesbank to reduce rates.

"We expect the ECB will start with a rate of 3.3 per cent which is still an easing of monetary policy because rates throughout the zone average 3.5 per cent and that figure was 3.7 per cent a few weeks ago."

Allies of Wim Duisenberg, the president of the ECB, argue that interest rates in core EU countries are low, and that reducing them would not automatically create jobs (extremely low Japanese rates have not prevented stagnation, they point out). As one source put it: "Lafontaine is on a learning curve. The idea that you just reduce interest rates and create jobs is unrealistic. It doesn't work like this."

Whatever Mr Lafontaine thinks of this, Mr Duisenberg is set to enjoy a considerable degree of independence, because his position is protected by international treaty.

So why has this row erupted with such ferocity, and what does it mean for the nascent euro? The change of governments in Germany and Italy leave just two of the 15 European capitals in the hands of conservatives. The leftward shift has coincided with the global economic downturn, producing a series of questions about how the new currency should work.

All this is happening as the euro-11 nations manage the transition of responsibility from their national central banks to the ECB, putting the relationship between bankers and politicians into the spotlight.

Meanwhile Europe is conducting a philosophical debate about how a currency designed on a Bundesbank model, with the control of inflation in mind, should adapt to a situation where the danger is one of recession.

Politicians favour looser policy, bankers want to stick with what they know: sound money.

The Maastricht Treaty appears to bolster the position of the bankers, because it states that the ECB's primary responsibility is to maintain price stability.

But latest figures from the European Commission show that inflation in the euro-zone fell from 1.4 per cent in July to 1.2 per cent in August and 1 per cent in September. In other words, the target of price stability has already been achieved. Which prompts the new left consensus to argue that it is time to focus on other, secondary treaty objectives, such as supporting the general economic policies of the EU.

With the current ECB looking less than likely to comply, Europe's politicians face an acute challenge. As one source put it: "The fear, among Europe's politicians, is that if they don't get their act together, the only serious actor on the European stage will be the ECB."

Hence Mr Lafontaine's stand, which is likely to lead to two different developments. He may seek to apply pressure on the ECB through the head of the Bundesbank, who will have a big influence over ECB decisions. The current Bundesbank president, Hans Tietmeyer, is due to retire next August, giving the new German government an opportunity to choose a replacement of a more Keynesian flavour.

The second option is to co-ordinate economic policy more closely at a political level through the euro-11 committee. Already ministers can do so via broad economic policy guidelines and these could be tightened, laying down targets for each country on a range of economic criteria. Along these lines, a paper being drawn up by the European Commission is expected to propose greater co-ordination of economic policy than Europe has ever known.

And that may mean the battle between bankers and politicians is only just beginning.

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