Europe is facing a Catch-22 over interest rates

SO HERE it is: the first real test of monetary union. Should the European Central Bank raise interest rates? The decision is finely balanced. On the one hand, recorded inflation in Euroland's core economy is still so low that (allowing for quality improvements) prices are probably falling. Growth is still slow; budgets are being tightened. On the other, dark warnings from ECB members and officials have created a strong expectation that they will increase rates this week, and markets hate to be misled. That dread word "credibility" is flashing over the ECB's head.

One source of these warnings has been a modest acceleration in Euroland's money growth. But the monetary aggregates of a currency union less than two years old are rather less reliable an omen than a chicken's entrails. Another is wages; but there are no real signs of trouble yet from a round that has barely begun. The weakest excuse of all is concern about fiscal policy, when it is abundantly clear this is now being tightened. Germany is leading the way, which will make it much crabbier about other governments that do not do likewise, so in Euroland as a whole the budget deficit may be little more than half the Maastricht limit next year. No case to answer there. The real source of the dilemma is the sharp difference between the core and the periphery of Euroland.

Inflation in Germany is still only 0.8 per cent. Unemployment is over 10 per cent. Growth is (at last) under way, but by this summer had only reached an unexciting 1 per cent. The best that could be said is that Germany might simply shrug off a small rise in interest rates; and that is not much of an excuse for monetary policy-makers.

But if Europe has a cool core, it has some warm edges. Using their own, independent, monetary tools, aspirants for membership of the single currency squeezed their inflation rates within the narrow range of 1.5 percentage points of each other that was a condition for entry. At the end of 1997, indeed, there was less than a percentage point between them. Once subject to a single interest rate, the range was bound to widen again. Ireland, for example, has been clearly overheating, with property prices soaring - only its ability to suck back its diaspora of migrant workers has stopped the labour market exploding too. Mere teething troubles? Well, maybe: but such inflation differentials can persist for quite a time.

Ireland, however, is so small that Goldman Sachs calculates it would take an extra 11 percentage points on its inflation to raise Euroland's inflation rate by 0.1 per cent. No one could expect the ECB to run its monetary policy to suit such a small outlying region. Spain, however, is a rather different matter; one of the four big Euroland economies, whose weight in European affairs has been increasing. Inflation there is 2.5 per cent, significantly above the ECB's long-term ceiling for "price stability" of 2 per cent. So Spain wants monetary policy tightened.

In theory, Spain could motor along for years with an inflation rate above the Euroland average. Some extra inflation is the tolerable by-product of catching up with richer economies. Wages rise with productivity in the fastest-growing sectors, and this spills over into higher wages and prices in sectors where productivity does not rise so fast. But Spain needs a high growth rate, with its huge margin of human over-capacity.

Although unemployment has been falling fast, Spaniards say this is partly a side effect of monetary union. Many in the thriving black economy have been emerging, fearful that the euro would render their pesetas under the mattress worthless. In any event, recorded unemployment is still over 18 per cent.

In practice, however, Spain is displaying some classic symptoms of excess demand, and those who took such pride in getting its inflation rate down under the Maastricht wire are worried. But it is not the ECB's job to control the cost of living in Ireland or even Spain, merely to protect the spending power of the euro (a little more labour flexibility in Spain would help, but a looming election delays reform). The over all Euroland inflation rate is still only 1.2 per cent. Most forecasters expect it to rise next year, but their average forecast is still well below the 2 per cent mark.

This dilemma has, of course, lessons for Britain. Our inflation rate is very close to the Euroland average - above Germany's 0.8 per cent but below Spain's 2.5 per cent. However, it is not hard to imagine what the housing market in the South-east of England would be like today if we had Euroland interest rates. Even the CBI's remarkable enthusiasm for joining the euro must be dimmed by the lack of interest-rate convergence. And by convergence, we must understand a parallel track, not just a crossing point between two economies on different cycles. With the United Kingdom so out of sync with the core of Euroland, it is simply very hard to imagine that happening on the Government's supposed timetable for entry.

Of course the balance of monetary union would change if Euroland gained more easily-heated economies like the British (another is on its way: the Euro 11 are going to find it hard to refuse Greece in 2001). An intriguing article in the new Economic Journal concludes that monetary unions have a tendency to over-expand, if all members have equal weight in the decision. Equally, monetary policy may tend to be too tight if the ECB gives equal weight to the needs of all members - exactly the opposite bias to that feared by the Germans before entry.

"More symmetry" is clearly going to be the tune sung by the British government, though whether as a condition for entry or an excuse for not doing so is still an open question. It is certainly needed in the stability pact for fiscal policy. As presently designed, this one-height-fits-all budget ceiling can require economies in recession to tighten, while booming economies are free to ease, thus encouraging members of the union to diverge. Symmetry would help in monetary policy, too.

But why should we care, anyway? If Euroland's interest rates remain consistently higher than needed by its core economies, in theory at least that would make it more compatible with our economy. More to the point, this distortion may in fact suit the political preferences of existing members, since Germany traditionally cares more about inflation than the periphery countries do, and might consider a "symmetrical" target of 2 per cent far too high.

Meanwhile, if higher rates cause the euro to strengthen, that is good news for British exporters. However, if the result is to choke off recovery in the region that now needs to take on leadership from an overstretched United States, the consequences for the world economy look the poorer. And Euroland looks a duller country.