The euro comes of age

A dozen years after the Delors Committee produced a plan for Economic and Monetary Union, the euro finally becomes a reality for 300 million Europeans this January. The technical difficulties of introducing notes and coins will ensure a nervous few weeks for euro-zone businesses and policy-makers alike. Yet a much bigger challenge now hangs over the embryonic currency. For as Europe suffers a sharp economic downturn, the decision-making system in the euro-zone will come under increasing scrutiny.

Even before the events of September 11th, the euro-zone economy was slowing. Germany entered a recession midway through 2001. Since September 11th, consumer and business confidence across the euro-zone has plummeted even further. The European Commission now estimates that euro-zone GDP will increase by just 1.3 per cent in 2002, compared with a previous forecast of 2.9 per cent.

If the economic downturn is prolonged, doubts about the ECB's mandate, which is narrowly focused on beating inflation, are likely to resurface. Euro-zone governments have been careful not to criticise the ECB in public, not wishing to undermine confidence in the new currency during the vital changeover period to notes and coins. Nevertheless, tensions between the ECB and the Euro Group, the informal forum for euro-zone finance ministers, are never far from the surface. At the Ghent European Council in October, one part of the draft conclusions specifically called for the ECB to cut interest rates, though this was watered down in the final text.

The subject of reforming the ECB is likely to move up the agenda anyway in 2002, as the debate on the EU's institutions post-enlargement develops. If the perception grows that the ECB has not cut rates swiftly enough to head off a full-scale recession, some governments, including probably France, are likely to begin a concerted campaign to strip the Bank of its sole right to set the inflation target.

For its part, the Euro Group faces a double challenge. First, it will need to help the ECB maintain public confidence in the euro during the changeover period. Its track record in presenting a coherent and united approach to economic policy is not strong. If individual finance ministers upset the markets or undermine consumer confidence in the coming months, the debates over whether the Euro Group should become a formal institution, and whether it needs some sort of 'High Representative' to lead it, will intensify.

Second, a sharp economic downturn is likely to prove the first serious test of the euro-zone governments' commitment to budget discipline. EU leaders have already made clear that the Stability and Growth Pact will not be amended to give governments more flexibility in coping with the downturn - though they did recognise that budget deficits may need to rise modestly in the short run. The pact prescribes the actions that the Council of finance ministers may take against governments which breach the Maastricht treaty's 3 per cent budget deficit limit, including the possibility of fines. Ironically, Germany - which was instrumental in establishing the pact's strict rules -is likely to run a deficit perilously close to this ceiling. The European Commission estimates the German budget deficit will total 2.7 per of cent of GDP in 2002.

EU governments have given themselves greater fiscal flexibility by revising the system under which they agree every year to 'Broad Economic Policy Guidelines'. Unlike the Stability and Growth Pact rules, these guidelines are not formally binding. They provide a more detailed annual analysis of the governments' efforts to bring their budgets into balance, and also cover a wide range of structural economic policies.

The EU has begun to revise this system so that targets are no longer based on a straight measure of budget deficits -which are vulnerable to the whims of the economic cycle - but rather on the structural, or underlying, budgetary position. Once this new principle becomes established in the Broad Economic Policy Guidelines, it should then be extended to ensure that any breach of the Stability and Growth Pact rules is also examined in structural terms.

Reform on these lines would not unsettle the financial markets, which already accept that the existing rules are untenable. Rather it would suggest that Europe's leaders are prepared to allow the euro-zone system to evolve. Only then will the single currency finally come of age.