Wednesday, August 15, 2007

Sarkozy wants the reins of economic power

Sarkozy has tried to make eurozone economic policy more reform friendly – i.e. extend deficits beyond stability pact limits and reduce euro interest rates. He has succeeded in the first objective but not (yet) succeeded with the second.

The ECB is bound by its incorporating treaty to target inflation only. This means that it has no remit to adjust rates to reduce unemployment or stimulate growth. The US fed has a looser remit and it has explicitly included growth and unemployment as part of its rational for setting interest rates. The low dollar policy is designed to be growth friendly.

Sarkozy has pointed to the essential benefits of a looser monetary policy to absorb the painful impact of substantial structural reforms i.e. extending the working week, reducing employment protections etc. This pressure valve is now seen by many as being fundamental to the growth actually achieved from the structural reforms in Britain.

A tight monetary policy at a time of comprehensive labour market reform resulted in the record unemployment of the late Callaghan and early Thatcher era in Britain. Conversely the liberation of the pound from the ERM, and the subsequent cut in interest rates was the trigger for the longest sustained growth cycle in British history.

Sarkozy understandably wants to skip the pain of early Thatcherism by loosening both the monetary and fiscal corset imposed by the EMU. Nor is this uniquely a problem for right of centre reformers. Oskar Lafontain found (to his great cost) that a socialist policy also required a looser monetary framework and that this was impossible to achieve under EMU. "Political control" of monetary policy was deemed to be anathema to the founders of EMU.

The electorates of Europe can vote for any policy they like as long as it is ECB policy. European electorates cannot however change ECB policy - it is set in stone by treaty and designed to be independent of electoral interference.

So the elephant in the room neither mentioned by Sarkozy or others is that the Eurozone is not merely a sub optimal currency area but without a Euro fiscal policy (Euro taxes and borrowing) the eurozone is not even a viable currency area in the long term. Hans Tietermayer said of EMU that absent a European central tax and borrowing capability the single currency was "a house without a roof".

The stability pact was tacked on to cover this gap so that countries could not recklessly import inflation to the whole Eurozone by increasing their domestic deficit in the knowledge that the inflationary consequences would be everyone’s problem and not just theirs. This pact has been serially violated by the bigger Eurozone economies notably Germany, France, Italy and the Netherlands. As Sarkozy has again demonstrated it no longer even serves as anything more than an aspiration.

As Sarko points out these annual borrowing targets are not realistic at national level but they are still essential for the survival of the Euro. To repeat - the Euro cannot bridge the asymmetric impact of 18 untethered fiscal policies. The pact no longer has teeth and has swiftly loosened its targets so that chronic instability threatens the Euro itself as Eurozone economies diverge. This is no laughing matter.

So an ostensibly left of centre government in Germany under Schroeder had to fire Lafontain and implement labour law reforms and cut taxes in order to boost German growth. An ostensibly right of centre government in France will be unable to enact labour reforms because the dead weight of ECB policy will rob those reforms of effectiveness and make them politically impossible.

Sarkozy will now have no option but to cut taxes and to follow Germany in "the race to the bottom" via "fiscal dumping" which we are always being told by our European masters is such a "bad thing". This will further blow out the French deficit and increase the breach of the now pointless stability pact.
As inflation is fed into the system by reckless debt on the part of large economies Euro interest rates will rise and likely so will the exchange rate thus prompting a further spate of fiscal irresponsibility as the one legged man of Eurozone economic policy is trapped in ever tightening circles.

So glad we're still out....

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