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                                                                                COVER STORIES, Page 41

THE ECONOMY

On Each Other's Nerves


Europe's currency rumpus and economic slump have got the
Community's fractious partners . . .

By ADAM ZAGORIN/BRUSSELS -- With reporting by Daniel Benjamin/
Berlin, William Mader/London and John Moody/Rome


    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 Euro pean 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.