A Test Of Euro's Mettle

Less than two months before Europe launches its new single currency, the euro, in a challenge to the US dollar, a noisy and potentially dangerous fight has broken out at the highest levels of European policymaking over how the new money should be managed.

On one side stands the continent's new generation of socialist political leaders - led by new German Finance Minister Oskar Lafontaine - who are demanding interest rate cuts, desperate for economic growth and jobs. Facing them down are central bankers - led by Wim Duisenberg, president of the European Central Bank - who are committed to defending the new currency against inflation.

At stake is the future of European monetary union.

"This is a perilous venture in an untested vessel," wrote London's Financial Times in an editorial yesterday. "How can the passengers feel confident if the officers are so visibly squabbling on the quarter deck?"

At the same time, the battle heralds future tensions.

The Socialists, who now hold or share power in 13 of the European Union's 15 member states, are in a position to reverse two decades of social and economic conservatism. But if they seek to do so, they will likely run up against the strict economic austerity rules that will govern the single currency.

Even before he took office last week, Mr. Lafontaine was demanding lower interest rates from the Bundesbank, the German central bank, and from the European Central Bank (ECB), which will launch the euro on Jan. 1 and oversee its operation.

A cut in rates, he argues, will stimulate the economic growth that is needed to create jobs; the battle against unemployment formed the centerpiece of the victorious Social Democratic Party's (SPD) election campaign.

Lafontaine failed to convince the Bundesbank council to lower interest rates at a meeting yesterday in Frankfurt, despite what a Finance Ministry spokesman called "an intense exchange of views."

Lafontaine's demands also reflect a consensus among European leaders that the greatest risk they face is no longer inflation but recession, and that urgent steps are needed to ward off that danger.

Meeting in Austria at the end of last month, European Union (EU) leaders agreed that growth is now their top priority. "Europe must accept the responsibility of facing up to the danger of a world recession," said Massimo D'Alema, the former Communist who took over as Italian prime minister two weeks ago. "The fight against inflation must not contribute to creating deflation."

The EU leaders also called for lower interest rates, although setting those rates will be the ECB's exclusive responsibility, and the new mood may unsettle markets.

"When you have a large and vocal consensus resorting to pressure, tactics that have not been seen before, it becomes worrisome," says J. Paul Horne, an analyst with Salomon Smith Barney in London.

They have met with a harsh response, however, from Mr. Duisenberg, who is intent on preserving his infant bank's independence. It is normal for politicians to offer their opinions on monetary policy, he said earlier this week, "but it would be abnormal for those suggestions to be listened to."

The 1992 Maastricht Treaty, which governs monetary union, gives the ECB absolute independence, modeled on the Bundesbank's status. But as a young and inexperienced institution, it could be vulnerable. "In the past, central banks were treated like sacred cows," says one German SPD economic adviser. "They are not sacred cows, they are just very good and important institutions among others."

Though the fight against inflation is the ECB's top priority, the adviser says, "when that battle is won, the bank should support European governments' general economic policy," which is geared toward creating jobs.

Lafontaine this week pointed to the US Federal Reserve as a model for European monetary policy. "Alan Greenspan has shown that both things are possible, inflation-free growth and employment growth," he told a German news magazine.

The Maastricht Treaty, however, sets price stability as the ECB's overriding goal, and also sets a 3 percent budget deficit ceiling on member countries. Fiscal discipline is enforced through a system of fines for violators. The treaty, in fact, is a shrine to economic orthodoxy, negotiated by leaders who are no longer in power, most notably former German Chancellor Helmut Kohl.

New, more interventionist-minded policymakers in power in Bonn and Paris seem at odds with the very principles on which Maastricht was built. Duisenberg, defending those principles from his office in Frankfurt, has been scolding governments that he fears will boost their spending beyond the 3 percent deficit rule next year, and insisting that only continued fiscal discipline and structural reform will create jobs.

This message is not to the taste of leaders who are focused on growth, many of whom won office precisely because of voter fatigue over the economic austerity measures that their predecessors imposed in order to meet Maastricht criteria. They are seeking to create jobs, not shed them, for example through a French-inspired scheme to finance public works through a Euro-loan.

The employment picture has brightened a bit in Germany. Figures released by the government yesterday show the jobless rate fell for a second straight month in October, from 10.3 percent to 10.1 percent.

Average European interest rates - now at 3.6 percent - are almost certain to come down by the end of the year, as the 11 countries launching the euro reduce their rates to converge with the German and French 3.3 percent by Jan. 1.

But in the longer term, "tensions will develop," according to Joachim Fels, an expert on monetary union with Morgan Stanley in London. "The Maastricht Treaty will act as an important constraint on [the new government's] aspirations and ambitions."