The threat of deflation in the world economy highlights serious flaws in the plans for the single currency. These are the consequence of insufficient reform on the economic side of Economic and Monetary Union.
The stability pact law - agreed as part of the move to EMU - means that the total budget deficit of the single currency member states cannot be increased much beyond 2 per cent of their GDPs.
Ordinarily, this would not be a problem. However, there are two situations where it would be. An ordinary recession in the European economy would probably be unnecessarily prolonged by the stability pact. The more unusual macro-economic event of deflation - or falling prices - could turn into an unending deflationary depression if the current fiscal and monetary laws in the European Union were not changed. Unfortunately, for the EU member states, the deep recessions in Asia, are threatening to turn a very low level of inflation into "deflation".
Further political and legal development of the economic side of EMU was always inevitable, because the stability pact that was agreed in Dublin in 1996 was clearly unbalanced on the side of fiscal and monetary rigour. The political-economic priority at the time was first to establish a sound European currency with even sounder characteristics than the deutschmark. Once this vital objective was achieved, the EU could return to the complementary task of developing economic union at its leisure. But the recent unexpected turn of events in the world economic cycle means a leisurely pace of change could prove disastrous for the European economy.
Deflation can be much more damaging than moderate inflation because it can cause an economic depression. Deflation makes it worthwhile for consumers and investors to postpone consumption and investment in anticipation of lower prices. If this effect were to occur across a substantial part of the EU economy, a deflationary depression could result. A negative contributory factor would be the falling export trend that is being experienced in Italy, Germany and Britain, and to a lesser extent in France. High taxes are inhibiting normal growth in consumer demand in a number of major states, most notably Germany and Italy.
Recent inflation data in Germany and France both show a noticeable decline to an annual rate of below 1 per cent. When account is taken of the upward bias in measuring consumer inflation, the true underlying inflation rate is already zero. There are also two structural downward effects on European inflation, which will take effect from 1999 and 2000. EMU will cause greater price transparency in Europe - making it easier for consumers to compare prices across national boundaries - and a tendency for prices of manufactured goods to fall to the lowest level in Europe and closer to (lower) levels elsewhere in the world. Second, another round of Common Agriculture Policy reform will begin in 2000 with accompanying falls in some food prices.
The stability pact will severely limit the response of policy, if the EU economy turns down. For example, at the urging of all the world's other economic powers, the Japanese introduced successive rounds of fiscal policy actions to stimulate their economy that have amounted to more than 2 per cent of GDP. These measures would have been illegal under the stability pact law in any member state participating in EMU. This is because the Japanese budget deficit forecast for 1998 was approximately 3 per cent of GDP even when allowance is made for the social security surplus.
The stability pact law says that no participating state in EMU may have a budget deficit exceeding 3 per cent of GDP, or plan for a budget deficit that exceeds 3 per cent. There is a conditional exemption clause if the member state is in deep recession.
The EU budget is tiny relative to the aggregate budgets of the 15 member states. There can be no scope for fiscal policy action through the Union budget, without a major structural change in the public finances of the Union and the member states. This is not possible in the short term because of the existing high level of taxation in most member states.
The stability pact was proposed by Germany as a means of enforcing the budgetary rules for EMU in the Maastricht Treaty. Neither the EMU chapter of the Maastricht Treaty itself, nor the stability pact allow for sufficient fiscal policy discretion for the EU over the long term to deal with all possible macro-economic eventualities - for instance deflation, an economic recession in Europe or a global economic crisis.
The rapidly changing trends in the world economy may well require the EU to make legal changes to allow for more fiscal policy discretion within it early next year. There are only two possibilities. First, the stability pact needs to be changed. Second, the EU could be allowed to borrow significant amounts of money in certain economic circumstances and use it to increase EU spending and thereby stimulate the European economy.
It is possible that the EU will be slow to respond to current economic trends because western Europe's statesmen and women may be suffering from reform fatigue after the Amsterdam Treaty. They are also shaping up for the mother of all European budget battles in March next year. Nevertheless, the question of whether the EU can itself respond satisfactorily to a world economic crisis may determine the long-term success of EMU and indeed of the Union itself.
Brendan Lynch is an economic consultant and was an adviser to the Labour Party leader, Mr Ruairi Quinn, when he was Minister for Finance.
