Helmut Schlesinger may hesitate before he tries to help Germany’s neighbors again. Until last week, the dour 68-year-old economist, who has been president of Germany’s central bank, the Bundesbank, since May, 1991, had steadily increased German interest rates in an effort to prevent the high costs of German unification from fuelling inflation in his country. But those rate increases had slowed economic growth in Germany and across the rest of Europe – and raised concerns about Germany’s increasing economic dominance within the 12-nation European Community (EC). Last week, just six days before a critical referendum in France on the Maastricht treaty on European union, Schlesinger bowed to political pressure from Germany’s trading partners and lowered the Bundesbank’s trend-setting Lombard rate by a quarter of a percentage point to 9.5 per cent. That move backfired spectacularly, and it sparked an international currency crisis that imperilled – rather than strengthened – the drive towards European economic integration. By week’s end, Britain and Italy had withdrawn from the European Monetary System (EMS), the EC’s exchange rate system, and British and German politicians were feuding openly over who was responsible for the crisis. Declared William Martin, chief economist of UBS Phillips & Drew, a leading London stockbrokerage firm: “It is possible that the whole system will implode.”
That clearly was not what Schlesinger and the rest of the Bundesbank’s 18-member council intended. By lowering interest rates, Schlesinger and his colleagues were trying to ease downward pressure on the British pound, the Italian lira and the beleaguered currencies of other EC countries, and to demonstrate Germany’s commitment to European economic union. But instead of easing the pressure on those currencies, the Bundesbank’s rate cut caused speculators to intensify their attacks on them. Attempts by European central banks to prop up the currencies and keep them within the targets of the EMS proved to be futile. That left Britain and Italy with no other option but to withdraw from the EMS. And once outside the EMS, the pound and lira drifted even further downwards. Many analysts said that the chaos in the money markets was a sign that European leaders still face a formidable task in trying to overcome deep-seated nationalist fears about the Maastricht blueprint for complete European economic union by 1999.
In Britain, the collapse of the pound sparked the most severe political crisis that John Major has faced since he succeeded Margaret Thatcher as Prime Minister two years ago. Thatcher was a resolute opponent of close economic links with Europe, but Major promised a change in direction. Last week, however, it appeared that he was going to have to pay a high political price for his support for closer links with the EC. Both Thatcher loyalists within Major’s Conservative party and opposition leaders called for his resignation and that of his finance minister, Chancellor of the Exchequer Norman Lamont, accusing them of “blatant inconsistency” after they withdrew Britain from the EMS.
Major and Lamont, in turn, blamed the Bundesbank for precipitating the crisis. They argued that the German central bank waited too long to reduce interest rates, ignoring the harsh impact that its high-interest-rate battle against inflation was having elsewhere in Europe. And Major said in a television interview that he would not return the pound to the EMS until the system is operated “in the interest of all the countries of Europe and not veered towards national interests in any individual country.” But German leaders were making no apologies for their actions. “I don’t think it’s fair to blame the Germans,” said German finance minister Theo Waigel. “Everyone would be well advised to put their own house in order.”
Before last week, high German interest rates had driven the mark up to historic highs on world money markets as international investors converted other currencies into Deutschmarks to take advantage of those high rates. That created problems for central bankers in Britain and other EC countries, who are required to maintain the value of their currencies close to that of the mark as part of the European Exchange Rate Mechanism (ERM).
The reaction in currency markets to the Bundesbank’s cut was swift and violent – and quickly overwhelmed the efforts of central bankers and finance ministers to quell the turmoil. The Bundesbank lowered its Lombard rate on Sept. 14. According to conventional freemarket economic theory, that action should have encouraged investors to shift money out of mark-denominated investments, slowing the upward momentum of the currency. But international investors and currency speculators, who have expressed pessimism about the long-term economic prospects of almost every European country except Germany, continued to dump pounds and lira and buy up marks.
At first, the Bank of England, the Bundesbank and other European central banks tried to reverse the trend directly by selling marks and buying up other currencies. But compared with the estimated $800 billion in foreign exchange traded every day on world money markets, even the combined foreign currency reserves of all of Europe’s central banks are tiny. “It’s pocket change,” said Michael Hart, vice-president of foreign currency bond trading with the Friedberg Mercantile Group in Toronto. He added: “Speculators aren’t afraid of central banks any more.”
Indeed, by midday on Sept. 16, the Bank of England abandoned its strategy of direct intervention and attempted to defend the pound by increasing its base interest rate, first to 12 per cent from 10 per cent and then, a few hours later, to 15 per cent. But speculators interpreted those measures as further signs of weakness and desperation, and continued to bet against the pound, along with the Italian lira, the Spanish peseta and other weak European currencies, driving them below minimum levels that the ERM requires. As a result, both Britain and Italy temporarily suspended their membership in the exchange rate system and the Bank of England reduced its interest rate back to 10 per cent.
Initially, many traders and economists predicted that the turmoil in Europe might provoke a jump in North American interest rates. The Canadian dollar dropped by more than half a cent in two days as speculators rushed to buy marks. But later in the week, North American dollars climbed relative to European currencies even though interest rates in Canada and the United States remained substantially lower than those in Europe. As a result, the Bank of Canada increased its trendsetting rate by only 0.2 percentage points to 5.34 per cent.
Meanwhile, finance ministers from all 12 EC countries convened in Brussels for an emergency overnight meeting on Sept. 16. Despite the failure of Britain, Italy and Spain to keep their currencies within the ERM targets, the ministers issued a joint statement re-affirming their “unanimous commitment to the European Monetary System as a key factor of economic stability and prosperity in Europe.”
But long-standing tensions among the member nations quickly resurfaced. The following day, the Bundesbank’s council met and announced that it would not lower German interest rates any further in an attempt to alleviate the crisis in foreign exchange markets. The Germans’ refusal to budge was the last straw for Lamont and Major, who began to complain publicly about the Bundesbank’s conduct. And until that conduct changed, they said, Britain would not return to the EMS. Said Lamont: “We want to be satisfied that German policy, which has produced many of the tensions within the exchange rate mechanism, is actually going to have some changes and be able to operate within a more stable environment.”
The war of words, in turn, provoked speculation among analysts about whether the EMS could continue to function without some of its major participants. Rainer Schroeder, for one, an international research analyst with Frankfurt-based Dresdner Bank AG, Germany’s second largest bank, said that the whole system would likely collapse if French voters rejected the Maastricht treaty. “Without France, the EMS doesn’t make much sense,” he said. For his part, German Chancellor Helmut Kohl disagreed. When asked whether the events of last week represented the end of the EMS, Kohl replied: “No, in no way.”
As French voters went to the polls on Sunday, finance ministers from around the world were scheduled to wrap up a weekend of concurrent meetings of the International Monetary Fund, the World Bank and the Group of Seven leading industrial nations, in Washington. There, U.S. officials joined their European counterparts in urging Germany to lower interest rates. Although he was careful not to single out Germany for blame in public, U.S. Treasury Secretary Nicholas Brady said that lower rates in Europe were necessary “if that continent is to return to growth.”
Last week’s splintering financial crisis was one of the most severe in the four-decade-old drive to integrate the continent’s economies. The European Community traces its origins back to the April, 1951, Treaty of Paris, which established the European Coal and Steel Community to create a common market for those commodities. According to Jean Monnet, the French political economist and diplomat who first proposed the plan after the Second World War, a new economic and political framework was needed if future Franco-German conflict was to be avoided. Even then, the ultimate objective was a United States of Europe.
When the limited measures covering coal and steel proved a success, the six founding countries, Belgium, France, Germany, Italy, Luxembourg and the Netherlands, expanded the agreement to cover their entire economies. In March, 1957, the Treaty of Rome established the European Economic Community, which was to remove all tariffs and quotas among member states by 1968. Other Western European countries eventually joined: the United Kingdom, Denmark and Ireland in 1973; Greece in 1981; and Spain and Portugal in 1986.
Despite the removal of tariffs, a complex web of non-tariff barriers continued to hamper trade among EC members. But French-born EC President Jacques Delors, among others, argued that further integration was the best way to revive the sagging EC economies. The result was the Single European Act of February, 1986, which called for greater economic and monetary union, although it did not spell out how to achieve it. More concretely, the act established the goal of a single market by the end of 1992. To ensure the free movement of people, goods, services and capital as of Jan. 1, 1993, EC officials headquartered in Brussels have issued more than 300 directives to harmonize standards. Everything from immigration control to the percentage of preservatives in sausages has been “Brusselized.”
In many ways, the Maastricht treaty, which the leaders of the 12 EC member countries signed last December, was the final step in the process begun in the 1950s. In providing for a single European currency and co-ordinated financial policies under one central bank sometime between 1997 and 1999, it outlines the mechanism of how the EC will achieve its long-stated goal of economic and monetary union.
But it has also proved to be one of the most contentious steps. In calling for joint foreign, defence, health and consumer protection policies, among others – in effect, political. union – the treaty abruptly collided with nationalistic fervor. Before that, citizens in EC countries often complained about the so-called “Eurocrats,” the EC’s 47,000-member civil service, or lobbied to maintain certain national idiosyncrasies. The Spanish, for their part, fought hard to keep the tilde accent on the letter “n” on the computer keyboard. But few outside the United Kingdom publicly questioned the basic goals of the EC.
That all changed in June, however, when the Maastricht treaty lost its first contest with public opinion. Danish voters rejected the treaty by the narrowest of margins, 50.7 per cent against compared with 49.3 per cent in favor, but it was enough to make many politicians and EC officials pause to consider whether they were out of step with their voters.
French President Francois Mitterrand, whose personal popularity and that of his ruling Socialist party have plummeted recently, had hoped to avoid a referendum. Under French law, Mitterrand had a choice of ratifying Maastricht by a three-fifths majority of a joint National Assembly and Senate session at the palace of Versailles, or by a referendum. Following the Danish voters’ rejection of the treaty, Mitterrand, one of its main architects, called for a referendum, gambling that a “yes” vote in France would put Maastricht back on track.
Since then, much of the debate in France has focused on a provision in the treaty that would allow foreigners to vote in local, but not national, elections. The issue is especially sensitive in France because local officials often play a part in national politics. Regional councillors, for one, form part of the electoral college that chooses the Senate. There was also widespread concern that French voters, unhappy with a slumping economy and rising unemployment, would vote “no” in the Maastricht referendum to punish Mitterrand. “There is no logical reason to vote against Maastricht,” said one EC representative, on condition of anonymity. “A |no’ vote is a vote from the gut.”
In Germany, domestic concerns are also influencing the debate over the country’s role in Europe. Since the fall of the Berlin Wall in November, 1989, Kohl’s Christian Democratic government has concentrated its efforts on German reunification. After the wall fell, Kohl promised nervous West Germans, many of them concerned that their prosperity would be sapped by the poverty of their previously Communist brethren, that his government would not raise taxes to cover such costs as welfare payments, subsidies, and environmental upgrading in the former East Germany. And in an important symbolic gesture, Kohl’s government converted East Germany’s near-worthless Ost Marks into Deutschmarks on a one-for-one basis.
The resulting cost required the German government to sell bonds to foreign and domestic investors to cover the massive shortfall. Germany’s deficit has grown to 4.5 per cent of its Gross Domestic Product (GDP) in 1992 from 2.5 per cent before 1989. That has fuelled inflation, forcing the Bundesbank to pursue a high-interest rate policy to contain a wage and price spiral. It also meant that Germany was out of step with many other countries, including the United Kingdom and France, which cut their bank and interest rates to fight recession. “It was not a very European position for the Bundesbank to take,” said the Dresdner Bank’s Schroeder. “But the Bundesbank’s position has always been that it is responsible for the Deutschmark, that it was not the central bank for all of Europe.”
Still, the U.K. government tried to blame the Bundesbank for the pound’s problems. “The discussion in the United Kingdom seems to concentrate on |the ugly German Bundesbank,'” said Schroeder. Indeed, as the conflict between the two countries escalated last week, British government spokesmen cited numerous instances where Bundesbank officials had openly speculated that European currencies would have to be realigned. Most recently, the German financial paper Handelsblatt quoted the Bundesbank’s Schlesinger as saying that other changes might have to occur in the wake of the lira’s devaluation. The U.K. officials interpreted that as encouraging the markets to bet against the pound – as indeed they did.
Many analysts, however, dismissed the attempt to paint the Germans as the villains. According to Richard Portes, director of the Centre for Economic Policy Research in London, the Bundesbank’s high-interest-rate policy was right for Germany, because of Kohl’s inflation-spurring refusal to raise taxes to pay for the costs of unifying Germany. As a result, the bank wanted a realignment of European currencies to take pressure off itself to lower rates. “The Bundesbank got exactly what it wanted,” Portes told Maclean’s. Still, he added, the whole affair underlines what everyone knew anyway: that the Bundesbank calls the shots in Europe’s financial world.
The British attempt to blame the Bundesbank for the pound’s woes, according to some analysts, was a way of trying to divert attention from what has been an enormous policy disaster for the British government. For months, Lamont said that he would never remove the pound from the ERM. Last week, however, he did just that – and, in effect, devalued the pound. At week’s end, it had floated down to 2.60 marks from 2.78 the week before.
The crisis was a huge setback for Major, who took the United Kingdom into the ERM in October, 1990, when he was then-Prime Minister Thatcher’s finance minister. It also provided fuel for the fire of the so-called “Euroskeptics” who remain opposed to further integration with Europe. Said William Cash, a Tory MP who is one of the leading Euroskeptics: “We are in a state of political shambles.”
The debate is likely to intensify both in Britain and on the continent as EC members contemplate taking the final steps towards complete economic union and a common currency. Germany’s reluctance to relent in its high-interest-rate battle against inflation last week, and Britain and Italy’s decision to withdraw from the ERM rather than align their policies with Germany’s, were perhaps the most dramatic examples to date of just how reluctant EC members are to take those final steps.
Still, economists point out that even if European union remains stalled at its current levels, the EC has already achieved a level of economic integration unparalleled among sovereign states anywhere else in the world. In preparation for the completion of the so-called 1992 plan, which will almost certainly go ahead, the EC has created an unprecedented single market. The trading zone created by the North American Free Trade Agreement (NAFTA) is larger, with 370 million potential consumers and $5.5 trillion in annual GDP, than the EC’s 342 million residents and $4.04-trillion GDP. But the EC has already reached a high level of standardization and harmonization among its member nations. Declared Brian Copeland, an economist who specializes in international trade at the Vancouver-based University of British Columbia: “Europe is taking economic integration further than we are even contemplating.”
Copeland added that the EC provides some important lessons for Canada, Mexico and the United States as they go forward with NAFTA. Even though NAFTA is primarily concerned with the free movement of goods and services among the three countries, the agreement will force its signatories to examine everything from agricultural policies and environmental issues to income distribution. Said Copeland: “If you start get ridding of trade barriers, these other things become more visible.”
But opening their domestic policies to increased foreign scrutiny is a risk that a growing number of European countries have been clamoring to take. Austria, Finland, Norway, Sweden and even staunchly neutral Switzerland have all applied to join the EC. Hungary and Poland, eager to rebuild their economies after 40 years of Communist rule, also wish to become members of the club.
Before last week’s economic crisis, the EC was prepared to admit new member nations as early as 1996. But as the current members grapple with the effects of the latest setback, that timetable could be pushed back for years. For the moment, economic policy-makers in those countries, like the Bundesbank’s Schlesinger, are concentrating on problems in their own backyard.