Europe's Currency

By ADAM ZAGORIN BRUSSELS

HURRICANE MAASTRICHT HIT EUrope a week earlier than expected, and with a roar that all but drowned out France's fateful vote on European integration. In its wake lay a twisted political and economic landscape that may never look quite the same again. Battered as never before in its 13-year history, the European monetary system will need extensive repairs if it is to serve as the cornerstone of some future monetary union. Britain, where a parliamentary vote in favor of the treaty on European unity had once been a foregone conclusion, emerged from the tempest in a shaken and vengeful mood, facing a political crisis. Europeans elsewhere were praying that what they experienced was the storm before the calm. But nobody was foreseeing that the good ship Europa would reach safe haven anytime soon.

Like many a natural catastrophe, Europe's monetary storm blew up with little warning, though the clouds had been darkening since June, when Denmark narrowly rejected the Maastricht treaty. Named for the Dutch city where it was signed last February, the pact provides for the eventual political union of the European Community, a common foreign and security policy, and most important, a single European currency by 1999.

On Monday, Sept. 14, Germany's central bank allowed a key interest rate to slip for the first time in five years, from 9.75% to 9.5%. The cut was hardly a generous one on a Continent desperate for cheaper credit and stronger growth, but it was enough to set off foreign-exchange traders already nervous about the upcoming French referendum on Maastricht.

The markets surmised that the German central bank really wanted a fundamental realignment in the exchange-rate mechanism that tied the E.C.'s 12 currencies together. Within 24 hours, traders drove the British pound below the minimum level agreed on by governments, and Prime Minister John Major was forced to take his currency out of the rate-setting mechanism. A hastily recalled Parliament will press him this week to reconsider the Community's goals, and a number of members will demand that at the very least he allow British voters a say on whether or not to ratify Maastricht.

The Italian lira found itself under attack too, even though Rome had tried to anticipate traders with a 7% devaluation at the beginning of the week. Italy quickly followed Britain out of the European Monetary System. Meanwhile, the Spanish peseta was devalued by 5%, and Sweden (not a member of the European Community, but exposed to its economic winds) raised its overnight interbank lending rate to a towering 500% in a desperate bid to support the % krona. As the Germans resisted pressure for a further cut in interest rates, the French, Danish and Irish currencies all found themselves struggling at the bottom of their permitted exchange rates, and the European monetary system experienced its worst week ever.

It is in the nature of free markets that they correct themselves if imbalances occur, so it was inevitable that the European system would eventually come under pressure, given the diverging performances of its member economies: while Germany and France are growing slowly, recession has hit Britain and Italy hard.

But much more happened in Europe last week than the reconfiguration of exchange rates. The storm's main casualty was not currencies that one day will rise again if managed properly but rather Europe's listing ship of state, which has been blown off its course toward political and economic union. "The markets held their own referendum a week early," said David Roche, chief European strategist with the U.S. investment bank Morgan Stanley International in London, "and voted no, a thousand times no."

The markets mirrored widespread anxiety over the future of the Continent that may not ease for months. "The last week has significantly lowered expectations that crucial elements of the Maastricht treaty can survive," said Susie Symes, director of the European Program at the Royal Institute of International Affairs in London. "However the French vote, progress toward economic and monetary union will now be a lot less automatic." One good reason is the clear lack of economic cohesion within the E.C., which does not bode well for Maastricht's ambitious agenda. But the problem is mainly political.

Despite the treaty their leaders signed in Maastricht, some citizens in the 12 member nations have come to have doubts about the pan-European projects and dreams that had beckoned so beguilingly in the aftermath of the cold war. The Danes spurned the Maastricht treaty because they feared an overcentralization of power in Brussels. Ireland did vote in favor of the treaty in June. France's President Francois Mitterrand, who did not have to call a national referendum, chose nonetheless to do so after the Danish vote in order to boost his own stature. He assumed the treaty would easily be approved by French voters; instead it became inextricably tied to his own unpopularity.

Money problems completed the process of disillusionment. For months, partners of Germany have been pressing that nation to reduce interest rates and allow the stalled European economy to gather some speed. The problem was that German unification was costing far more than Chancellor Helmut Kohl had anticipated -- and honoring a German version of the "read my lips" pledge, Kohl was paying the bills by borrowing money instead of hiking taxes. As a result, interest rates rose not only in Germany but also throughout the Continent. Supporters of European unity could claim that the closer union envisaged in the Maastricht treaty would give everyone else a greater say over Germany's actions, especially if a "Eurofed" came to replace the German Bundesbank as the main arbiter of Europe's monetary policy. "The only answer for avoiding these sorts of crises is to move on to a European central bank as fast as possible," said E.C. commissioner Sir Leon Brittan.

But as tempers mounted last week, the opponents of a more integrated Europe were making the most of the situation by pointing to German obtuseness as a taste of things to come. Recognizing the negative impact such perceptions could have on the looming French vote, Kohl paid an extraordinary, secret visit to the Bundesbank. Though all parties denied it, the move was widely interpreted as an attempt to exert political influence over an institution that jealously guards its independence. Kohl argued that Germany had to offer a gesture of goodwill to French voters and other Europeans ahead of the crucial referendum. Bundesbank president Helmut Schlesinger opposed such an action but finally agreed to back a rate cut of some kind.

WHATEVER THE BANK'S REAL intentions, its actions wreaked by far the most havoc in Britain. When sterling plummeted well below its permitted floor, Major called a series of emergency meetings with key Cabinet members. "This is bloody awful," he reportedly told them. "It's that damned Bundesbank." When dramatic increases in British interest rates failed to halt the slide, the government conceded defeat and ordered the "temporary suspension" of sterling from the fixed exchange-rate system.

This stunning reversal by Major left his government's economic policy and British politics in turmoil. He rejected all calls for the Chancellor of the Exchequer, Norman Lamont, to resign, and even among the government's critics there was a forlorn sense that the crisis had been beyond the ability of anyone in Britain to control. "It wouldn't matter if you put King Kong in the Treasury," complained Tory M.P. and Euro-skeptic Sir Teddy Taylor. "The ^ Germans control our economy."

More difficult to quantify was what the whole debacle had done to Britain's commitment to Europe and to the political prospects of its pro-E.C. Prime Minister. Britain's relations with Germany will ultimately be mended. Harder to repair, however, will be the damage done to Major's prestige both within his party and in the country at large. British Europhobes have seized on the crisis to demand that the country never return to the monetary system and that it get on with the job of reviving the British economy. Sir Alan Walters, onetime personal economic adviser to then Prime Minister Margaret Thatcher, quickly declared that the "government has made a howling mess of things."

That would apply equally in France, where two weeks ago Mitterrand found himself under the knife for prostate surgery and under the gun to cure his nation's political and economic malaise. But there were few takers for the argument advanced by Prime Minister Pierre Beregovoy that the Bundesbank's actions proved the willingness of the Germans to "put the interests of Europe ahead of their own."

In Italy fledgling Prime Minister Giuliano Amato informed a stunned parliament that despite the crippling economic woes of the country and its temporary withdrawal from the fixed-rate system, "we'll come out of this with our heads held high." The government said it hoped to rejoin the mechanism this week if conditions permitted, and it imposed a $72 billion austerity package of spending cuts and new taxes.

All hurricanes eventually blow themselves out, and the one that hit Europe's currency markets last week will do so as well. Even its victims will recover: battered as it was, the European monetary system will continue to limp ahead. Completion of the Community's single market at the end of this year with free movement of goods and capital will require the currency stability that fixed exchange rates have helped provide. If lower interest rates and higher economic growth can result from currency realignment, then some good could yet come of an ill wind. But tempests have a way of testing the soundness of structures, and Hurricane Maastricht has exposed just how unprepared the E.C. remains to go forward with monetary and political union. The good ship Europa is still afloat, but if it is to begin making headway again, it will need a crew that is prepared to work together -- and perhaps even a new chart.

CHART: NOT AVAILABLE

CREDIT: NO CREDIT

CAPTION: HOW THE EUROPEAN EXCHANGE RATE MECHANISM (ERM) WORKS

With reporting by Daniel Benjamin/Berlin, William Mader/London and John Moody/Rome