Economic sense and political sensibilities over the euro

One of the great failures of economics as a profession has been its inability to convince the world that economists really understand more about economics than everyone else. We all accept that doctors know more about medicine than politicians. We all accept that accountants know more about accountancy. But when 155 German economists attack the view of the German political establishment about the economic weaknesses behind European monetary union and call for it to be delayed, the chances are they will not be believed.

This is a pity because the arguments outlined by the 155 in letters to the Financial Times and the Frankfurter Allgemeine Zeitung ought to carry the same authority as a similar warning by doctors or accountants. They are not against the currency as such, but they believe the big European countries have not yet achieved a sufficiently stable economic state for a new currency safely to be introduced. Accordingly, they call for an "orderly postponement" for a couple of years.

It is just possible that they will be successful. The last time a similar action took place in Germany, in 1969 when 50 economists called for the German mark to be floated, they succeeded: the mark was indeed floated when the fixed exchange rate system collapsed. The UK precedent, however, is less propitious: when 364 economists warned of disaster in 1981 after the then chancellor, Geoffrey Howe, had tightened policy in the middle of a recession. That budget is now generally regarded as laying the basis for Britain's economic recovery during the 1980s.

What the German economists' letter has done is to show that a large part of the professional establishment in Germany is deeply concerned about the technical weaknesses of the plan for economic and monetary union (EMU) at this time. By coincidence, yesterday there was yet another survey showing that ordinary Germans were deeply concerned too. A poll commissioned by Abbey National revealed only 29 per cent of Germans were in favour, compared with 32 per cent here.

It will be at least a few weeks before we know whether these German fears are translated into political action, for at the moment the political establishment remains firmly in favour. What has become completely clear, though, is that whether or when there is to be a euro will be a German decision.

Until that letter was published the financial markets had become convinced that a broad, 11-member, euro would start on time. The various investment banks have been working overtime to chart its likely future. Two pieces of work in the last few days, one by JP Morgan, the other by PaineWebber, deserve a wider audience.

The Morgan paper focuses on the euro-area economy, that is, the economy of the 11 prospective members. The key point here is that demand is turning up and accordingly the next few months would see a more favourable economic backcloth.

The general picture is shown in the left-hand graph, which shows what has actually been happening to the euro area's gross domestic product (GDP) and the prediction of it from business surveys in the key countries. In addition, export order books have been rising since the spring of 1996, and with them consumer and industrial confidence. Credit growth is strong and, outside Germany, unemployment is falling. As yet there has been no recovery in consumer spending, but if the confidence indicators are any guide this should happen soon.

It is even possible that what has so far been a jobless recovery will turn into a job-creating one. If that happens then the most powerful practical argument against EMU, that it will add to European unemployment, will be pushed back a little.

So the practical reality is that if the Morgan team is right the overall economic background in the euro area will tend to improve rather than deteriorate. What are the implications of this for euro interest rates?

PaineWebber operates on the politically sensitive but probably correct assumption that the policies determining the euro's interest rates will be similar to those that have determined the mark's. It has produced the chart on the right, which shows short-term and long-term rates for the mark until 1999 and the euro thereafter.

It reckons the run-up to the millennium will see quite strong growth, with unemployment stabilising and extra demand coming from both from added investment and pre-millennial euphoria. Interest rates will be too loose for many European countries, including Italy, Spain, Ireland and the Netherlands, which will further add to the sense of elation. Eventually, interest rates will have to be tightened and the euro repo rate (the equivalent of the present German repo rate) will rise to 5 per cent in the year 2000.

The result will be monetary overkill, for this rise will hit the European economy just as it heads into the post-millennial slump. What then? Will the slump come in time to break up the whole project, for remember the individual currencies will still exist even though they have been locked together? Well, PaineWebber makes the wise comment that if the project has the support of the German government, the Bundesbank will use all its weight to support it too. So if the thing is to break apart, EMU itself will not the weakest link in the chain: politics or society will crack first.

The difficulty in assessing what will happen to the plan for the euro is working out to what extent each new bit of information changes one's "call". The economic case for delay is overwhelming, as those 155 German economists argue. But for a while political will can override economic forces. Political will held together the Bretton Woods fixed exchange rate system for about five years after it had become evident that the system might not survive. So the 155 letter, notwithstanding the force of its arguments, is not important in economic terms - merely in political. Does it shift the debate in Germany enough to change the politician's minds?

Of itself, probably not. But it may have a snowball effect, particularly if the assessment for the euro-group economy outlined above proves overly cheerful and the Continent does not get decent growth this year.