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Ajay Jaiswal

The European Central Bank has been a cautious mover on the monetary policy. It has kept the interest rate high due to the threat of inflation from the monetary changeover. As the threat of inflation changes swiftly to deflationary threats in major economies, the high interest rates would stifle the fledgling economies.

ONE of the corner stones of European Union (EU) is economic amalgamation. Under the pact, member-countries give up control over monetary policy and also agree to rein in fiscal policy. European Central Bank (ECB) decides on the monetary policy for the region.

Member-countries have entered into a stability pact under which they have to keep their budget deficit under three per cent of their gross domestic product. This budget deficit ceiling is becoming a problem for the union, which is on the brink of recession. In earlier articles we had looked at the possibility of long period of stagnant global growth.

The US economy has certain imbalances which would warrant long period of low growth for them to unwind. How would European Union cope with the stagnant growth scenario? How do the member countries fight the deflation and recession if they cannot use an accommodative fiscal policy?

Germany remains one of the largest economies of the European Union. Germany has been under-performing over the last few years against most of the other members.

Over the past few years, German GDP has been growing at a rate of around 1.9 per cent. And now this rate is expected to drop down to 0.8 per cent.

Why is German economy reeling under pressures that are much stronger than other members of the European Union? One of the reasons is low private investment in the economy over the last few years. This investment over the past five years has been dropping by 0.7 per cent per annum.

In comparison, French investment in a similar period is around 5.7 per cent. Though Government investment in Germany remains buoyant, the overall investment drop has lead to slowdown.

Construction spending has fallen sharply after the boom in the post-unification period. Consumer spending also remains weak in Germany.

Export growth has prevented Germany from going into recession straight away.

Weak domestic demand has forced companies to look at export opportunities and become competitive. This has led to a squeeze on margins and has also resulted in companies becoming wary of making capital investment and hiring more workers.

Are the European Union countries suffering from fiscal and structural imbalances akin to that of US? Germany does not have a large current account deficit like US.

However, its budget deficit is now close to three per cent. In case Europe would like to spend its way out of this problem, it would hit against the deficit cap. Interest rates in EU still remain high.

The European Central Bank has been a cautious mover on the monetary policy. It has kept the interest rate high due to the threat of inflation from the monetary changeover. As the threat of inflation changes swiftly to deflationary threats in major economies, the high interest rates would stifle the fledgling economies.

Household debt has also risen in the EU countries and now poses a threat to consumer spending. Equity markets in Europe continue to melt down and result in negative wealth effect. Household debt in Germany has risen to around 74 per cent of the GDP in 2001 compared to 80 per cent in UK and 108 per cent in the US.

Most of the other countries in the Union do not have as high household debt. Germany also suffers with high unemployment. Strong trade unions in Germany have continued to drive good bargains in wage negotiations. This makes German wages relatively high and reduces growth in employment.

EU is also heading towards its first attempt of adding new members. Ireland goes to referendum on October 19 to vote on the Treaty of Nice. This treaty contains guidelines for enlarging the EU. There are ten countries that are likely to join the EU in 2004. A `no' vote from Ireland may delay the enlargement process.

In case European Union does not break the stability pact, the options available with the Governments' get limited.

These measures would include unconventional steps like intervening in the equity markets to limit the negative wealth effect. Governments may not be able to add liquidity by buying their own bonds, as this move may not be allowed by ECB.

Germany may be left with the only option of increasing productivity. This would involve long period of wage restraint and cut welfare benefits and employment taxes.

This may be a tough political call but seems like the only measures that Germany and other countries in the Union may be left to resort to.

In case the Union loosens the fiscal rules, it would invite the wrath of smaller countries which have been conforming to the rules and would become a litmus test of the Union.

(The author is Senior Manager, Corporate Treasury Sales - Southern India for HSBC. The views expressed herein are his own and not necessarily those of his employer.)

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