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October 23, 2002

The Imminent And Welcome Death Of The Euroland's Stability And Growth Pact
by William Thomson

As if to prove the old saw that if you gave typewriters to an infinite number of monkeys sooner or later one would come up with the works of Shakespeare, last week the intellectually-challenged European Commission President declared Euroland's Stalinist sounding Stability and Growth Pact (SGP) 'stupid'.

Hooray, truer words were never spoken! The Stability and Growth Pact, like the Holy Roman Empire, provides neither stability nor growth. In today's circumstances, it is a recipe for a pro-cyclical cutting of expenditures and tax increases in a deflationary, recessionary environment. A dumber policy had never been invented since Winston Churchill placed Britain back on the gold standard in 1926 at pre-World War I exchange rates.

The SGP was a German invention designed to sell the loss of the Deutschemark to the German people. It was designed to show them that Europe would be governed by sensible fiscal rules and there would be no widespread inflation. Monetary authority would be the competence of the European Central Bank, operating much like the old Bundesbank with strict rules on inflation. On fiscal policy, there would be no freeloading by the profligate Italians and others. Deficits would be constrained to 3 percent of the budget deficit and national debt to 60 percent of GDP. Violators would be subject to first peer pressure and then swingeing fines of potentially billions of dollars.

Unfortunately, the great minds that designed this monstrosity showed all the flexibility and vision of generals fighting the last great war against inflation. They failed to understand the rise of China and the opportunities for comparative advantage presented by deregulation and globalisation.  In fairness, they probably also underestimated the incompetence and pusillanimity of successive European governments (especially German governments) in restructuring and reforming their over-regulated, uncompetitive economies.

As their economies have receded from slow growth to recession, deficits have grown in the main European economies, but like priests of an outdated religion ministers have propounded their mantras about the inviolability of the SGP until very recently. A relatively poor country like Portugal was threatened with severe penalties unless it reduced its deficit from 4 to 3 percent and it complied. Ireland, which was running a budget surplus, was told it was growing too fast and should increase taxes. It declined.

However, only now are the big European economies being threatened. M. Mer, the French Finance Minister, when faced with orders from his Euroland peers to increase taxes and cut expenditures to reduce his deficit below 3 percent, gave them an elegant middle finger and informed them that France would do what France needed to do. Germany and Italy are also out of compliance and desperately need faster growth.

Europe needs a combination of policy shifts to get it moving again. Somewhat looser monetary policy is one essential element. Germany is now following Japan into active deflation, which means it real interest rates are far too onerous. Unless corrected soon the stability of its dangerously exposed and concentrated banking system will be further threatened. There are already fears about the future of Commerzbank, its third largest bank, because of bad loans and derivatives. Bad loans will mushroom rapidly in a deflationary environment.

Aggressive supply side tax cutting would also help. What are not needed are endless bailouts of zombie engineering companies whose day has long since passed. But most of all, a political willingness to restructure the labour market and the welfare system would reap dividends. There is not long till the population time bomb hits Germany. Instead of making itself an attractive locale for investment and welcoming immigrants it puts its head in the sand and does the opposite. As the supposed engine of growth this is depressing news.

The recent re-election of Chancellor Schroder probably means that a German crisis will come sooner than if we had had more of Stoiber 'muddle-along but nothing drastic actions'. The sooner a German crisis comes, the sooner remedial action can be taken and the less damage will be done. The world cannot afford another Japan amongst its three largest economies. Especially, when the US economy faces its own substantial problems.

The best hope now is that the SGP will either die a quick death or more likely be given a facelift that will not stand in the way of preventing a meltdown in Europe.

The good, no great news, is that there is very little likelihood of a referendum in the UK on joining the Euro and, if there were, absolutely no hope that it would pass. Europe is not, and probably never will be, the optimal currency zone that is required to make its economies prosper. The British, at least the man on the Clapham omnibus, if not the commentators of the left, understand this.

If it ain't broke don't fix it, applies to the UK. As for the SGP: it is broke, so scrap it!

William R. Thomson
Chairman of Private Capital Ltd.

William Thomson, Chairman of Private Capital Ltd., an advisory company in Hong Kong. He is also a senior adviser to Franklin Templeton in Hong Kong and Axiom Alternative Funds in London.

Mr. Thomson is not a registered advisor and does not give investment advice. His comments are an expression of opinion only and should not be construed in any manner whatsoever as recommendations to buy or sell a stock, option, future, bond, commodity or any other financial instrument at any time. While he believes his statements to be true, they always depend on the reliability of his own credible sources. Of course, we recommend that you consult with a qualified investment advisor, one licensed by appropriate regulatory agencies in your legal jurisdiction, before making any investment decisions, and barring that, we encourage you confirm the facts on your own before making important investment commitments.

Copyright © 2001-2009 William R. Thomson

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