We might not have to delay the start of EMU

The financial markets have recently started to lose confidence that European Monetary Union will start on time in 1999. At the very least, this seems premature.

While the markets have been fretting about the huge jump in unemployment in Germany, a wodge of other evidence suggests that the central European economies are at last picking up as export orders rise in response to weakening currencies. This is far more important for the chances of hitting the start date than any off-stage noises which are emanating from politicians at the moment.

Goldman Sachs' latest forecasts show GDP growth in France and Germany reaching 2 to 2.5 per cent this year. On existing fiscal policies, this would produce budget deficit outturns of 3.4 per cent of GDP in both countries in 1997. While these outcomes would be higher than the 3 per cent permitted under a strict reading of the Maastricht convergence criteria, it seems unlikely that the entire project would fall, or be reviewed, on such a small divergence on just one of the convergence criteria. Either extra measures would be taken in France and Germany to push the deficits below 3 per cent of GDP, or the EU would choose to focus on forecasts for the outturn in 1998, or some other method would be found to fudge the outturn.

Admittedly, any such fudges would make it difficult to exclude countries such as Italy (if necessary), while including Germany and France, and these problems have certainly not yet been solved. But in the European Union, an old maxim states that where there is a political will, there is usually a political way.

That would probably prove to be the case if the French and German budget deficits were fairly close to 3 per cent of GDP this year, despite the recent protestations of Chancellor Kohl (and many others in Germany) about the need to observe the convergence criteria to the letter.

Different circumstances would, however, arise if GDP growth this year falls substantially short of the 2 to 2.5 per cent central forecast. For example, if GDP growth drops by 1 per cent this year compared with the central projection, then the budget deficits for France and Germany would rise to around 4 per cent of GDP this year, and would stay at 3.5 per cent of GDP in 1998.

This higher path for the budget deficit would almost certainly lead to a postponement of the EMU project, since in the circumstances of continuing recession it would not be possible to introduce significant further restrictive measures to hit the Maastricht targets.

Furthermore, as a recent study by Martin Brookes of Goldman Sachs points out, it is now too late to reverse this situation by easing monetary policy, since the scale of the required action appears implausible, and the time lags involved are now too long.

For example, using simulations on macroeconomic models, a combination of a 100 basis point reduction in German and French short-term interest rates, and a 4 per cent decline in the trade-weighted exchange rate in those countries, would be required to offset a shortfall of 1 per cent in the growth rates. But such an easing in monetary policy would need to happen immediately in order to have any effect on the outcome for GDP and budget deficits this year.

It is much more likely that an easing would not actually come until later this year, which would be too late to impact demand sufficiently in 1997, so budget deficits would significantly exceed target.

What does all this imply for a possible postponement of the EMU start date? If it rapidly becomes clear that GDP growth is on course to hit 2 per cent or more this year, then neither the financial markets nor the governments of key EU countries are likely to contemplate seriously a postponement. However, if it becomes clear that the growth rate is remaining at or below last year's outturn of 1.3 per cent for France and Germany, then governments could start to contemplate the need for a delay. Or they could be forced to do so by market chaos.

The question of whether it is possible to delay the start date in an orderly fashion would then arise. This is much more difficult that it may seem. Remember that Maastricht was intended to put in place an automatic glide-path to monetary union, with an absolutely final date of 1 January 1999 for the start of the project.

Hence, the drafters of the Treaty did not include any specific provision for any delay beyond that date. However, there are two possible escape routes which could be used to keep the Maastricht super-structure in place, without needing to draft a completely new Treaty, with all of the national ratification problems which would inevitably be involved.

The first concerns Article 109J4, under which the Council of Ministers is empowered to set a date for the start of EMU, assuming that the launch has not already happened on 1 January 1997.

It is clear that the drafters of the Treaty intended this provision to allow flexibility to set a start date in 1997 or 1998, failing which 1 January 1999 would automatically become the effective start date.

However, this is not specifically stated in the Treaty, so there is a loophole under which the Council might be able to set a later start date (such as 1 January 2001) and still claim that the provisions of the Treaty have been respected.

Although lawyers for the European Commission, and most member states, do not appear to believe that such a procedure would necessarily be legal, this loophole could nevertheless be adopted for overriding political reasons in extreme circumstances. But it would mean that member states would have to agree during 1997 to a new specific start date, and that may not be easy.

An alternative, perhaps preferable, procedure would simply be to allow the 1 January 1999 start date to be maintained, but for no members to be admitted to the monetary union from the start.

Although this may seem absurd, it would in fact be quite practical, and it would enable future members to join the non-existent monetary union at some point in the future, when convergence criteria had been achieved. Under this procedure, the precise start date for a meaningful EMU would not be fixed in advance, and nor would the initial members be determined until later. Countries would simply opt in to the EMU super-structure when they were able to do so.

This alternative would appear to have the advantage of great flexibility. But the disadvantage of this approach is that it might lack both political and financial market credibility.

Certainly, it would be difficult to persuade electorates and markets to take seriously an empty monetary union for an undefined period, especially since the previously sacrosanct start date of 1 January 1999 would have been ditched.

It must be very debatable whether EU politicians could overcome these problems and make any delay credible to the financial markets. Fortunately for them, the recent behaviour of the foreign exchanges makes it less and less likely that this will become necessary. Ironically, after all the fuss the Germans have made about the need to create a strong European currency, it is the weakness of the German mark that may yet make EMU feasible in 1999.