Can Europe Muster the Fiscal Discipline Investors Want to See?

Europe, whose common currency, the euro, has lost ground almost from the moment it was launched in January, is facing a stiff test of its fiscal discipline these days. And critics say it got the first answer wrong.

Faced with the inevitable--one of the European Union’s 11 euro nations, Italy, is unable to meet its financial targets because of poor economic growth--the EU agreed last week to let the Italians increase their budget deficit.

The implication that European officials are caving in on their pledges of fiscal discipline was all investors needed to hear: The euro tumbled anew, hitting an all-time low of $1.0399 on Friday before recovering to $1.0454 in European trading on Monday.

It’s hardly been a catastrophic decline from the euro’s perch at $1.17 on Jan. 4. The major world currencies, including the dollar and yen, have had their share of reversals in the ‘90s. But in a region where support for the euro has been tenuous all along, it is raising eyebrows.

In Britain, the biggest non-euro economy, a research group said Monday that the euro’s travails are undercutting chances that Britain will adopt the new currency. The likelihood is now about 30% to 40%, down from about 70% to 80% two years ago, said the Center for Economics and Business Research in London.

“It’s a major disappointment to global investors,” said David M. Jones, chief economist at the Aubrey G. Lanston investment firm in New York. “I think the feeling was that the euro would be headed higher . . . but so far it’s been a flop.”

In part, the euro has been undermined by forces no bureaucrat can control. European economies, including the German powerhouse, continue to suffer from the downturn in Asia, a slump that the United States, with its huge domestic market and increasingly productive corporate sector, managed to fend off.

Six major German research institutes in April cut their forecast for growth in 1999 to 1.7%, Germany’s lowest level since 1996, as recessions in Asia, Latin America and Russia--which together account for almost a fifth of exports--reduced overall sales of German products abroad.

Although recent improvements in Asia’s economies are expected to boost German exports, a report released Monday shows that new orders to the German plant and machinery industry actually fell 4% in April from a year ago.

The economy of Europe’s 11-nation single-currency zone will probably grow just 2% this year, several research groups predicted Monday, before it gains steam next year to post a 2.8% gain.

By comparison, the U.S. economy grew at a robust 4.1% annualized rate during the first three months of 1999, according to newly revised government figures.

The trans-Atlantic difference in growth prospects has led to different interest-rate policies--higher rates in the U.S., reflecting fears of inflation, and lower rates in Europe, reflecting fears of recession. Higher rates, though unwelcome to consumers and many industries, nonetheless prop up currency values by luring investors.

In the U.S., for example, 10-year Treasury notes pay an interest rate about 1.6 percentage points higher than their European counterparts, a much higher-than-usual gap.

Indeed, interest rates are so low in Europe--the European Central Bank on April 8 reduced its benchmark interest rate to 2.5% from 3%--that there isn’t much room to lower rates further should the region’s economy need more stimulus.

“For much of the year, U.S. growth has surprised people on the upside, and for much of the year, Europe’s growth has surprised people on the downside,” pointed out Michael J. Hartnett, senior international economist at the Merrill Lynch investment firm in New York. “Until those trends reverse, the euro falls.”

As some see it, war in Yugoslavia has become an increasingly serious economic matter for all of Europe, in ways that may not be obvious to outsiders. In Germany, for example, the NATO effort has weakened Chancellor Gerhard Schroeder, who faces opposition from the left in his bid to make labor markets more efficient in a nation that has been plagued by stubborn high unemployment.

“Now that you have Schroeder in a real battle with his own coalition over Kosovo, it’s depleting his political capital,” lamented David D. Hale, chief global economist with Zurich Group in Chicago.

Last week, skeptics of the euro thought their worst fears were realized when European Union officials allowed Italy to increase its budget deficit to 2.4% of its gross domestic product from the old level of 2%.

The action did not violate the 3% cap that the EU has imposed, but the official endorsement of the backsliding from the EU troubled investors. The resulting plunge in the euro has observers fretting that it will slip below the $1 mark.

Questions about financial discipline in Europe reach far beyond Italy’s budget deficit. Left-winger Oskar Lafontaine’s brief, stormy tenure as Germany’s finance minister earlier this year spread unease that lingers in financial circles, which have counted on Germany to maintain its traditional role as a bulwark against inflation.

Officials of the European Central Bank, meanwhile, have so frequently declared their determination to maintain a sound euro that they risk a loss of credibility. The bank’s policymakers have limited leverage over the national politicians who still set budget policy--and who tend to be susceptible to voters’ demands for big spending programs to combat unemployment.

“Loose lips, loose fiscal policy and loose monetary policies are pushing the euro lower against the dollar,” said Joseph P. Quinlan, senior international economist at the Morgan Stanley, Dean Witter investment firm in New York.

The potential for a ground war in Kosovo, Quinlan added, “is icing on the cake.”

These concerns are not all new. Long before the euro made its debut in January, skeptics doubted whether European countries accustomed to costly social programs could muster the fiscal discipline to win the respect of unsympathetic financial markets.

Also crucial to investor confidence was whether the crazy-quilt organizational structure of Euroland--in which a relatively weak central bank must share power with a Europe-wide bureaucracy and national politicians--would somehow be able to set forth a coherent economic policy for the continent.

Investors remain unconvinced: “You’ve got Larry and you’ve got Alan in the United States,” noted Hartnett, referring to U.S. Treasury Secretary nominee Lawrence H. Summers and Federal Reserve Board Chairman Alan Greenspan. “In Europe, it’s unclear who’s running economic policy.”

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Euro Slide

Weakness in the European economy has put the euro on a downward path against the U.S. dollar. Weekly closes in New York, euro in dollars, since Jan. 1:

Jan. 1: $1.17

Friday: $1.042

Source: Bloomberg News