The Wall Street Journal

November 15, 2002


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 EU Founding Nations Trail in Expansion2
 ECB Holds Rates Steady But Hints at Cuts to Come3

Single EU Economy Is Distant
As Nations' Growth Rates Differ


BERLIN -- The sharpest economic downturn in a decade has revealed just how far away Europe is from forging a single economic bloc, causing headaches for financial officials on how to respond, economists say.

The bigger, core countries of the euro area, particularly Germany, are stumbling. Inflation is falling as demand dries up. On the periphery, however, such as in Spain and Ireland, growth and inflation are holding up. Overall, inflation for the euro-zone is 2.2%, above the European Central Bank's inflation target. Since its mandate is to maintain price stability, the central bank can justify sitting pat.

What's the ECB likely to do? Cut rates.

The slowing pace of economic activity reflects the "significant degree of uncertainty that has been building up over recent months," the central bank said in its monthly report Thursday. This follows similarly dovish remarks from ECB President Wim Duisenburg last week, leading most economists to expect a rate cut as early as the central bank's next meeting on Dec. 5.

The rules of the fledgling single currency are clearly strained, economists said. Some, such as the beleaguered Stability and Growth Pact, are likely to be changed, as the differences in the 12 national economies are laid bare.

The ECB is "in charge of managing monetary policy for an economy that exists only on paper," wrote Kevin Gaynor, an economist with UBS Warburg. Mr. Gaynor added, "It has become increasingly clear that real economic convergence is some way off."

Predictably, those varying economic conditions have led to a dispersion in the fiscal health of the euro member countries. The budget deficits of Germany, France and Italy, which together account for 70% of euro-area economic output, are near or above the 3% limit of gross domestic product, the maximum they agreed on as a condition for joining the euro. Germany, the author of the fiscal rules enshrined in the Stability and Growth Pact, is reckoning with a budget deficit this year of 3.8% of GDP, according to the European Commission's latest forecasts.

With the exception of Portugal, the budgets of the smaller countries are in good shape, balanced or close to it. Efforts by the big countries to loosen the fiscal rules -- France is simply ignoring them -- have prompted outrage from the smaller countries.

To be sure, varying growth rates within the euro zone are to be expected, as the economies of less-developed countries, such as Portugal, Spain and Greece, catch up to the richer ones of Germany and France. For example, in 1995, the GDP per capita (a common measure of standard of living) in Spain was just 71% of that of Germany, according to Eurostat. As of last year, Spain had closed the gap to 79%. To make up that ground, the country had to have a higher rate of growth, and consequently, higher inflation, than that of Germany.

"Spanish inflation needs to run higher than Germany inflation," said Darren Williams, economist in the London office of Schroder Salomon Smith Barney. Spain "has lagged, and this is part of making up the difference."

The problem is the pain this causes Germany, as the ECB sticks to its inflation target, he said. Germany's low inflation rate means that its real interest rate -- the nominal euro-area interest rate of 3.25% minus its 1% rate of inflation -- is much higher than that for high inflation countries like Spain or Greece, whose real interest rates are close to zero. As long as prices in the euro area don't converge, countries with lower inflation will continue to suffer, compared with the higher-inflation countries.

Write to Christopher Rhoads at christopher.rhoads@wsj.com1

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Updated November 15, 2002

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