THE CURRENCY WITH A HOLE IN IT

David Marsh sees the political case for joining the euro, but

excessive spending has revealed the fundamental flaw — no one is really in charge

THE drama of the European single currency has had more than its fair share of theatrical twists and turns. The prize for the most spectacular transformation in the long-running Folies Maastricht must, however, be awarded to the quaintly named Stability and Growth Pact. This character entered Act 1 as a strutting hero, but now — several years into the plot — has been unmasked as the villain of the piece, destined shortly to be skewered behind an arras and then hauled off into oblivion. The Pact's demise may dampen the spirits of euro enthusiasts, but it creates a chance for Britain to obtain more influence on European policies while maintaining its position outside the euro.

The dumping of the Pact — designed to shore up the euro by setting limits on budget deficits and government borrowing — has been accomplished by no less a personage than Romano Prodi, the president of the European Commission, who last week said it was 'stupid'. Mr Prodi, who as Italian prime minister in the late 1990s was largely responsible for Italy's achievement of joining Economic and Monetary Union (EMU) in 1999, has a formidable reputation for emotional outbursts. As head of government he had a penchant for personally telephoning the Financial Times to complain about editorials berating Italy's economic policies. Now he has surpassed himself. With one blow against the economic rules underpinning the European currency project, Mr Prodi has maddened the monetarists, fortified the fiscal fainthearts, and deepened doubts among all those (particularly in Britain) who had wondered whether the euro could ever prosper.

On one level, Mr Prodi, with his plea for 'intelligence' in interpreting the fiscal limits, is simply calling for common sense. Ever since the Pact was forged in 1997, two years before the euro's birth, many economists have argued that, during a time of slow economic growth such as that facing Europe today, rigid borrowing rules could risk turning downturn into depression. When economies falter, government borrowing automatically widens in response to lower taxation and higher spending on unemployment benefit. To reduce deficits under such circumstances by raising taxes or cutting spending, many economists argue, is economic and political suicide. The French government, which had already said it was not taking seriously the plan for the European Commission to impose large fines on countries borrowing more than 3 per cent of Gross Domestic Product, was the first to hail Mr Prodi's statement.

There is more to it than that, however. At a deeper level, the European Commis sion president's plain speaking has exposed an alarming hole in the heart of Europe's monetary arrangements. The Stability Pact (the word 'Growth' was added later to make it sound more attractive) was invented by the German government as a centrepiece of the new economic order. There were two reasons for the Pact. First, it was a political device to assure the German people that irresponsible fiscal policies from free-loading southern countries such as Italy would not subvert the new currency that was about to replace the deutschmark. With the fabled Bundesbank no longer in charge, the Germans were asked to believe that a pan-European spirit of economic rectitude would take over as the euro's guardian. Second, the Pact marked a step towards the greater degree of political union that many politicians and commentators — both euro supporters and sceptics — believe is necessary to safeguard the new currency. Now, however, the curtain protecting the euro from fiscal debilitation has been drawn aside — and, Wizard of Oz-like, the great sustaining force seems to be more scrawny than many had hoped or realised. An essential and dreadful truth at the centre of the Maastricht dilemma has been exposed for all to see. The centralised control of government borrowing necessary to secure the euro is increasingly unacceptable to European governments and electorates.

The new state of affairs is most visible in Berlin. The Germans, once diehard supporters of fiscal virtue, have given discreet but powerful backing to Mr Prodi's volteface. Buffeted by unemployment of four million and led by Gerhard Schroeder, the re-elected Social Democrat Chancellor who has never been a friend of the euro, the Germans are no longer in any mood to impale themselves on the spikes of a hard currency. Mr Schroeder, who faces a deficit this year that will badly overshoot the 3 per cent limit, has paid lip service in public to the Stability Pact, but has long dropped hints that he wants it toned down. Mr Schroeder's new economic tsar, the hardfaced former journalist Wolfgang Clement (previously prime minister of the most populous state of North Rhine-Westphalia, just sworn in as minister for economics and employment) now wants growth iiber al/es. A go-for-growth stance in Berlin and Paris may risk a tussle with the remaining monetarists on the independent Frankfurt-based European Central Bank who set interest rates for the whole of the EMU area and are appalled by the Stability Pact's dismantling. But the pugnacious Mr Clement is willing to take them on. Government pressure is increasing on the ECB to cut interest rates fast — and there is little doubt that the ECB will soon do the politicians' bidding.

For long-standing observers of the euro saga such as myself, the latest shift confirms the deep flaws in the Maastricht arrangements. I have long been a sceptic over the economics of the euro. But 12 months ago I declared my support for

Britain joining after the next general election, principally to help shape a groundbreaking political rapprochement between Britain and Germany. My view was (and still is) that Britain should offer membership of EMU to engineer a fundamental understanding with Germany over the big issues at the heart of Europe's future: the relationship with Russia, eastern enlargement, and reforms in the functioning of the European Union. Agreement with the Germans on these questions, combined with a shift in Europe's power away from the postwar Franco-German axis, would, I reasoned, be ample compensation for the economic inconveniences of joining the euro. Put simply, Britain would trade German help in tranquillising Russia against the Bank of England's sovereignty over interest rates.

As a matter of fact, one half of the stratagem seems to be working. Britain has gained political influence over Germany in the last 12 months without having taken any concrete steps to join the euro. The travails over the Stability Pact underline the shakiness of the economic case for Britain participating in EMU. The British people will vote in a referendum in favour of the euro only if they see a healthy European economy aiding chances of growth, employment and investment in the UK. So the economic problems in the rest of Europe significantly lower the euro's electoral attractiveness. This is borne out by the opinion polls showing that a large majority of Britons still oppose the idea — and by the lack of punch of pro-euro groups such as the Britain in Europe lobbying organisation.

Germany's changed position over the Stability Pact mirrors the reversal in the country's own economic fortunes. Germany has been much slower than most industrial countries to recover from the shocks caused by the terrorist attacks of September 2001. The sluggish German economy, the structural imbalances inherited from German reunification, and — most recently and alarmingly — the dire state of the German banks are turning the entire euro area into a low-growth zone. In the aftermath of German reunification in 1990, the euro was designed (above all, by France and Italy) as a means of constraining Germany's supposed increase in economic power by replacing the deutschmark with a supranational currency. Yet France and Italy are now suffering through membership of a currency bloc that itself seems to be permanently enshrining chronically low German economic growth.

Many people have criticised the Maastricht plan as imposing a `one size fits all' interest rate on countries with different structural and cyclical economic positions. However, few thought that Germany would be the chief victim. Most observers during the 1990s believed that pan-European interest rates would sink to the habitually low levels prevailing in Germany, and this might cause inflation among higher-growth southern economies at the periphery of Europe. For a while, up to the creation of the euro in 1999, this set of affairs seemed to prevail. Now, however, reflecting the greater dynamism of the rest of the euro area relative to Germany, the interest rates set by the European Central Bank are appreciably above those that would be warranted by Germany's own low economic growth. If the Bundesbank were still in charge, German interest rates would be up to a percentage point lower than they are today — an important factor that continues to hold back German economic expansion.

All this explains the remarkable turnround in German rhetoric over the single currency during the last ten years. Just after the Maastricht summit in 1991 that set down the path to the euro, Theo Waigel, the then German finance minister, proclaimed breezily, 'Our stability policy has become the model and yardstick for the new Europe. We are exporting to Europe the essence of the D-Mark!' By contrast, an editorial last week in Germany's leading economic journal, Wirtschaftswoche, showed how far Germany has travelled away from triumphalism. 'Germany, the European Union's former locomotive, now has to be pulled along by the others. The ECB's monetary policy is far too restrictive for our country,' the magazine wrote. The largest economy in Europe has the slowest growth and is on the brink of deflation. We need lower interest rates and a weaker currency.'

In similar vein to Mr Waigel, Helmut Schmidt, the former German chancellor who was one of the country's greatest proponents of the euro, argued at the beginning of the 1990s that German banks and insurance companies would inevitably dominate the rest of Europe. In fact — partly as a result of high non-performing loans caused by the weakness of the German economy — German banks are now beset by significant structural weakness. The total stock-market capitalisation of Germany's four largest publicly quoted banks, now including the mighty Allianz insurance group, has shrunk to less than that of Britain's largest bank, HSBC. Even though it may be many years before Britain enters EMU, Germany's spectacular hoisting on its own petard over the Stability Pact creates an intriguing political opening for Tony Blair. The two Western countries with which postwar Germany has traditionally had a 'special relationship', France and the US, are both making heavy weather of their ties with Berlin, reflecting Mr Schroeder's opposition to American *adventurism' over Iraq and his more independent line on European affairs. This has given Blair a powerful position as an intermediary between Europe and the US — a role he is enjoying to the full.

As long as the European economy remains in a parlous state. Britain's nonmembership of the euro detracts not one jot from the influence it enjoys on the international stage. For the first time in living memory Britain is beating the French at their own game of laying down German trump cards on the table of European diplomacy. Mr Blair was the first foreign leader to telephone Mr Schroeder to congratulate him on German election night on 22 September. The re-elected Chancellor promptly invited himself to Downing Street two days afterwards — a significant break with the tradition that normally sees German leaders making their first post-election visit to Paris.

The Stability Pact uncertainties give Mr Blair an excuse to maintain the door halfopen and half-closed to euro membership for much longer than seemed possible even a year ago. Mr Schroeder has just added his support to Mr Blair's favourite notion of appointing a president of the EU Council (possibly from 2005 onwards it could be Mr Blair himself) to give Europe more political driving force. Unless he commits the improbable error of calling a euro referendum next summer and then losing it heavily, Mr Blair seems unlikely to suffer politically, either at home or abroad, from a postponement of Britain's aspirations to join EMU. Britain can continue to proclaim that it would dearly like to join, but is prevented from doing so by the inability of Germany and the rest of Europe to get their economic house in order. In the meantime, in the fields of European and foreign policy, Britain can quietly build up clout in Berlin and Brussels that would have been unthinkable in the heyday of the Franco-German alliance. As the Spectacle de Maastricht drones on, Britain may see the Stability Pact's unceremonious disappearance as an opportunity to move closer to Europe's centre-stage, The problem is that, as the essentially tragic nature of the Maastricht drama becomes clearer, this may not turn out to be a play in which anyone wants a starring role.

David Marsh is UK director of the German management consultancy Droege & Comp, and a deputy chairman of the German-British Forum.