November 5, 1998

Leftist Politics Complicate Job of Euro's Banker

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    FRANKFURT, Germany -- Wim Duisenberg will not acquire his full powers for another eight weeks, but he is already enduring his baptism by fire.

    As president of the new European Central Bank, Duisenberg is in charge of setting into operation Europe's single currency, the euro, on Jan. 4. But just when the historic project seemed set for a remarkably smooth start, the ground underneath him has shifted.

    Even as the new bank is preoccupied with projecting its hard-nosed credibility in world financial markets, Germany's new left-of-center government is badgering it almost daily to open up the monetary spigots and generate more jobs.

    Indeed, Duisenberg suddenly finds himself playing with a rule book developed by players who are not around anymore. After years of belt-tightening, a new raft of center-left governments are increasingly eager to lift spending and let their budget deficits nose upward once again.

    In a major ideological shift, Germany's new government, under Chancellor Gerhard Schroeder, now exhorts the bank almost daily to reduce interest rates and help stimulate growth.

    Germany's new finance minister, Oskar Lafontaine, passionately argues that the country's high unemployment stems directly from the austere monetary policies of the Bundesbank, which serves as the model for the European Central Bank.

    "Just look at America," Lafontaine said, referring to the Federal Reserve Board chairman. "Alan Greenspan has shown that you can simultaneously achieve inflation-free growth and growth in employment."

    And Christa Mueller, an influential government adviser who is married to Lafontaine, said: "The policies of the European Central Bank and the Bundesbank are not sacrosanct. They must be subjected to a certain control."

    To be sure, the new bank's independence and its duties are legally enshrined in the 1992 Maastricht Treaty, which laid the ground rules for the euro.

    But the political landscape has changed enormously since European leaders signed the treaty. Most countries now have left-of-center governments, and Germany's change in power eliminates the most formidable champion of hard-money policies.

    It was Germany, under then-Chancellor Helmut Kohl, that enshrined the new bank's political independence. It was Germany, often to the fury of France, that insisted the bank focus almost entirely on keeping prices stable rather than on promoting economic growth or jobs. And it was Germany that demanded harsh penalties for countries that run high budget deficits.

    Indeed, many European economists believe that the gospel of fiscal austerity is losing force. Under the Stability and Growth Pact signed last year by all 11 nations adopting the euro, countries that run high deficits or have mountains of acquired debt are subject to huge penalties.

    Yet countries like Italy, which has twice as much debt as the rules allow, are expected to increase government spending next year. Last month, Italian Prime Minister Romano Prodi was forced to step down, because he could not muster enough support for his proposed budget cuts.

    And Italy is not alone. "You're clearly seeing a shift left in European governments that is triggering a greater willingness to increase spending," said Kermit Schoenholtz, global economist for Salomon Smith Barney in London.

    "I think it is fair to say that the rules of the game have been changed already," said Friedrich Heinemann, senior economist for the Institute for European Economic Research in Mannheim. "Until now, an important element of the credibility of the Stability and Growth Pact was Germany's tough position. With Lafontaine now in the government, the pact has already lost some of its credibility."

    At a news conference on Tuesday, Duisenberg brushed aside demands for a policy change. "It's normal for the political side to give suggestions or opinions," he said, "but it would be abnormal if these suggestions were listened to."

    A towering man with a shock of white hair and piercing blue eyes, Duisenberg established his credentials as an anti-inflation hawk as president of the Dutch central bank. There he locked his own monetary policy to the Bundesbank's. He argues that the only real way to promote job creation is by deregulating the economy.

    Indeed, a growing number of experts believe that outspoken pressure from Lafontaine and other European leaders will merely force Duisenberg to adopt an even tougher line just to demonstrate his independence.

    "Lafontaine would do well to study the example of Bob Rubin, which is to know when to shut up," said Rudiger Dornbush, an economist at Massachusetts Institute of Technology, referring to U.S. Treasury Secretary Robert Rubin. "The European Central Bank has to show its independence, and if it is pushed, it will have to shove back extra hard."

    But there may be other pressures. Greenspan has already cut U.S. interest rates in the hope of pre-empting a severe downturn. That has put pressure on Europe and Duisenberg because it caused the dollar to sink in value against European currencies.

    That makes European exports more expensive in many foreign markets and is expected to severely dent European growth in 1999.

    Senior German advisers to Lafontaine have seized on the U.S. moves as a vindication of their own arguments.

    "The only question we have raised is whether there is maneuvering room for monetary policy to do something expansionary," said Heiner Flassbeck, Lafontaine's senior adviser on international economic issues. "This is exactly the question that Alan Greenspan has posed hundreds of times, and he has answered the question by reducing interest rates."

    Until January, the formal power of monetary policy will continue to lie with the 11 national central banks. But in practice, the countries are already following a common European policy -- and that policy is closely modeled on the Bundesbank.

    Indeed, the European Central Bank is governed by a board that includes the presidents of each country's national bank. Most decisions require a majority vote.

    As a result, Lafontaine and Schroeder have exchanged most of their barbs with officials at the Bundesbank. On Thursday, Lafontaine and Flassbeck plan to take their case directly to the Bundesbank's concrete fortress in Frankfurt, where members of the executive board will hold their monthly meeting.

    But economists say the issues in Europe are more complicated than those in the United States.

    Even without pressure from Germany, many countries were already reducing interest rates in preparation for the euro. Rates must be almost equal in all member countries, because every country will have the same risk of inflation and currency devaluation.

    As a result, countries with historically higher inflation have been systematically cutting rates for several months to bring them in line with those of Germany and France. Ireland, Spain, Italy and Portugal have all slashed their rates several times, and more cuts are expected before the end of the year.

    The Bundesbank's basic overnight interest rate, now at 3.3 percent, is already considerably lower than that of the United States. Many economists worry that cutting rates could lead some countries to overheat, igniting inflation.

    But amid increasing signs that European growth may slow to less than 2 percent next year, Schroeder has joined Lafontaine in putting pressure on both the Bundesbank and the European Central Bank.

    "It doesn't only have responsibility for monetary stability but also for economic growth in a sensible way," Schroeder said on Saturday, noting new government estimates that the German economy will expand only about 2.3 percent in 1999.

    "That's damn little, too little for a big offensive on the labor market that is supported solely by economic growth," Schroeder said.

    Lafontaine and other officials have also tweaked the central bankers for their secretiveness and their refusal to reveal the minutes of board meetings. Christian Noe, state secretary at the Finance Ministry, recently accused the Bundesbank -- and by extension, the European Central Bank -- of indulging in "predemocratic" behavior.

    "This isn't the Vatican we're talking about," said one government official, who insisted on anonymity. "No one is questioning the independence of the central bank. We're just raising questions of public interest."

    But Europe's central bankers have been far from amused. Jean-Claude Trichet, head of the Bank of France, warned bluntly that political leaders risked jeopardizing the euro's credibility.

    "Any suggestion that central banks were on the way to losing their independence would affect savers' confidence both in Europe and worldwide," Trichet said on Monday in Paris.

    Juergen Stark, the Bundesbank's deputy governor, said last weekend that he was already worried about growing budget deficits in Europe.

    "Excessive deficits are damaging," Stark said in a television interview. "The European Central Bank could be forced to react with interest-rate increases."

    Politics aside, a growing number of economists believe that Duisenberg will eventually be driven by economic pressure to reduce rates slightly -- to perhaps 3 percent.

    But that may not satisfy people like Lafontaine, and Duisenberg has made it clear he has no intention of deviating from his basic concern about price stability.

    "The leaders today are different from the ones that signed the Maastricht Treaty, but the fact remains that we still have the treaty," said Heinemann of the Institute for European Economic Research. "The fact that we have a new government in Germany doesn't change one letter in the treaty."

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