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Bonjour Trichet

It's a new day and a new hard line at the European Central Bank. Why Frankfurt needs its new deficit hawk.

Jacques Chirac spared nothing in his campaign to make Jean-Claude Trichet head of the European Central Bank. Back in 1998 the French president withheld his endorsement of Wim Duisenberg as the ECB's first president until the Dutchman agreed to make way for Trichet by stepping down midway through his eight-year term. And over the past year, Chirac promoted Trichet's candidacy even as the Banque de France governor was tried on (and acquitted of) charges that he helped cover up massive losses at Crédit Lyonnais in the early 1990s, when he oversaw the bank at the French Treasury.

So much for gratitude: After presiding over his first meeting of the central bank's governing council last month, Trichet proceeded to issue a stinging rebuke of the French government's budgetary policy, which is on track to violate the deficit limit for euro-zone countries for a third straight year in 2004. France, he warned, risks undermining the single currency and its economic rules unless it rapidly commits to substantial new deficit reductions next year -- something it has defiantly resisted.

"It is the overall credibility of the fiscal framework, and hence the prospects for economic growth in the euro area, that are at stake," Trichet said.

Trichet is anything but a soft touch. The new ECB president is just as staunch a defender of the central bank's existing policy orthodoxy as his predecessor, and equally determined to resist any political pressure. Trichet believes that the ECB's current 2 percent interest rate is plenty low enough to support economic activity without igniting inflationary pressures. And he is positively hawkish about the Stability and Growth Pact, considering it vital that governments respect the pact's limits on budget deficits to maintain confidence among business and consumers . In short, Trichet is not a dove eager to take risks for the sake of growth. He represents the status quo -- "a spirit of continuity," as he puts it -- at the head of the world's second-most-important central bank.

Trichet's hard line may disappoint critics who have been hoping for a more pro-growth stance from the central bank, but it won't surprise anyone familiar with his record. The former Banque de France governor cemented his reputation in the early to mid-'90s by defending the policy of pegging the franc to the deutsche mark instead of letting the currency slide to stimulate growth. For his uncompromising stance, he became known to his critics on the left and the right -- including at times Chirac -- as "the ayatollah of the franc fort," or strong franc.

But if Trichet is as much of a hawk as Duisenberg, he nonetheless brings a welcome change of style and stature to the ECB, inspiring hopes of a more enlightened and influential leadership. Whereas Duisenberg's bluntness often resulted in gaffes, Trichet is a skilled communicator who knows how to deliver carefully nuanced messages to financial markets. He is also a deft political operator whose words command close attention at the highest levels of government across the Continent. Duisenberg, by contrast, never enjoyed quite the same clout.

"The problem of the central bank today is that its influence on governments is too low,'' contends Marc-Antoine Autheman, head of international retail banking and private banking at Crédit Agricole Indosuez in Paris, who worked closely with Trichet at the French Finance Ministry in the early 1990s. "I think he can be more effective in influencing governments than his predecessor, whose views did not carry weight in France and Germany."

Trichet will need all his skills in the months ahead. The Stability and Growth Pact was stretched to the point of near-irrelevance late last month after France and Germany, which remain far in excess of its deficit limits, blocked a European Commission proposal that would have forced them to make deeper budget cuts or face the threat of multibillion-euro fines. By dealing a blow to fiscal restraint, the Franco-German move could prompt the ECB to adopt a tighter monetary policy. The euro's recent strength, meanwhile, has offset some of the ECB's interest rate cuts and threatens to strangle Europe's fragile economic recovery. And the stubborn persistence of inflation in the euro zone despite three years of economic stagnation could put pressure on the ECB to raise rates before economic growth is firmly established. How Trichet and his ECB colleagues handle these challenges will go a long way toward determining whether the European economy finally sustains a durable recovery.

As he showed at his first public appearance as president, in Frankfurt, Trichet will keep pressing governments to respect the stability pact deficit limits. But rather than threatening rate hikes if governments refuse, he's likely to offer a carrot -- something Duisenberg would never have done. Trichet suggested in a speech last month that rates could stay low for longer if budgets are reined in. He is a longtime critic of big government who believes that the key to growth in France and other European countries lies in making painful reforms of welfare systems and labor markets, not in deficit spending. "The government has a great interest in reducing public spending as a percentage of GDP," Trichet told Institutional Investor in an interview earlier this year. Says Jean-Paul Fitoussi, president of the Observatoire Français des Conjonctures Economiques, a Paris-based research institute: "Trichet has never liked public deficits. He is convinced that Europe's problems are structural."

In his first news conference as ECB president, Trichet indicated that the central bank was likely to hold interest rates steady at the current 2 percent level for some time. Although inflation in the 12-nation euro zone was sticky at 2.1 percent, slightly above the ECB's target, Trichet said he was "reasonably confident" that inflation would return to the target in the medium term. For many economists, that was a positive signal that the ECB would not be quick to raise rates at the first sign of recovery -- a potential concern since the Bank of England became the first major central bank to hike rates, with a quarter-point increase last month. "That was mildly encouraging," ING Financial Markets chief economist Mark Cliffe says of Trichet's comments.

Trichet takes over a central bank that despite a rocky start has enhanced its reputation among financial analysts. Part of the improvement reflects the performance of Duisenberg, who developed a more disciplined and consistent speaking voice toward the end of his term after rattling markets and inviting speculation against the euro with rash comments in his first few years.

Even more important was the ECB's newfound activism. Between December 2002 and this June, the bank cut its key short-term interest rate three times in response to the economic slowdown, leaving rates at an all-time low of 2 percent. In 2001 the bank had been much slower to cut rates than the Federal Reserve Board, a fact that many analysts believe aggravated the economic downturn in Europe. And in May the bank bowed to its critics by clarifying its monetary policy strategy. The new inflation target of below but close to 2 percent -- compared with a previously declared target of 0 to 2 percent -- suggested that the bank would be just as vigilant in avoiding the risk of deflation as it had been in preventing a resurgence of inflation.

"If Trichet continues the recent policy of Duisenberg, I would be satisfied, because Duisenberg reacted to the slowdown," says Gustav Horn, head of forecasting at DIW, an economic research institute in Berlin. "He reacted too late, but he reacted."

The critics haven't gone away entirely, however. Norbert Walter, chief economist at Deutsche Bank in Frankfurt, asserts that the ECB should trim rates to 1 percent, the same level as the Fed, because of the weakness of the European economy and the lack of inflationary pressure. The French, German and Italian economies, which represent more than two thirds of the euro zone's output, were all in recession in the first half of 2003, he notes. Inflation, meanwhile, has been exacerbated by increases in taxes and state-set prices as governments seek to reduce their deficits. France, for example, boosted cigarette prices by 20 percent with a big October tax hike, and Germany is raising insurance premiums and consumer co-payments to reform the state health care system. Such moves will contribute 0.4 percentage point to inflation in the euro zone this year and 0.5 point in 2004, Deutsche Bank estimates. "I suggest our real rate of interest is higher than it looks, because much of our inflation is not really inflation," Walter says.

Trichet's allegiance to the deficit limits in the Stability and Growth Pact also worries many analysts. No one doubts that Germany and France need to make serious budgetary reforms to reduce their deficits in the medium term, but making big cutbacks in the short run risks undermining the recovery. "I hope the ECB will try not only to combat inflation but also to stimulate activity," says Luxembourger Socialist Robert Goebbels, a member of the European Parliament. "It's obvious now that the problem in Europe the past couple of years is not inflation but recession. We have to have a macroeconomic policy in the European Union that is much more pragmatic. Look what the Americans are doing: They will end up this year with a fiscal deficit of 5 percent of GDP. I would not recommend that, but still they are trying to boost their economic growth, and at the moment, it looks like they are succeeding."

No one is expecting Trichet to chart a dramatically different course from Duisenberg on either interest rates or deficits. His record, like his rhetoric, indicates continuity. And even if he wanted to introduce change, his powers as president are tightly circumscribed. Unlike the Federal Reserve Board, which has traditionally been dominated by a strong chairman, the ECB is very much a collegial body. Trichet has only one vote among 18, and the ECB's six-member, Frankfurt-based executive board, which he leads, is outweighed on the policymaking governing council by the heads of the euro zone's 12 national central banks.

"I don't expect any important change, because we don't need any important change," Guy Quaden, governor of the National Bank of Belgium, tells II . "It is a collegiate body, and Trichet was a member from the start. Trichet has shared fully in the policy of the ECB."

Over time, however, Trichet is sure to make his influence felt. He is starting an eight-year term, which means he should outlast virtually all of his governing council colleagues as well as most of Europe's political leaders. He also is likely to oversee a significant expansion of the euro zone as new EU members from Eastern Europe apply to adopt the euro, beginning with Estonia and Lithuania as early as 2006.

TRICHET'S LONG CAREER HAS PRE pared him well to take over the reins at the central bank. The son of a university literature professor, Trichet tried his hand at poetry as a student , then earned a degree in mine engineering. He briefly worked in the mining industry in northern France before taking the more traditional French route to power, enrolling in the Ecole Nationale d'Administration, the school that grooms the French political and business elite. He graduated fifth in his class of 100 in 1971 and became an inspecteur des Finances at the Ministry of Finance, a position that put him on a fast track to the top of the civil service. He helped oversee France's state-run companies in the mid-1970s, when double-digit inflation was undermining the country's competitiveness. The experience convinced him of the need to move from dirigisme to a more liberal, market-based economy.

After a stint as an industrial policy adviser to then-president Valéry Giscard d'Estaing, Trichet returned to the Finance Ministry in 1981 as deputy head of the Treasury for bilateral affairs. He began to build a network of contacts across Europe and later served as head of international affairs and chairman of the Paris Club, a powerful committee of major sovereign lenders.

In 1986 he got his first taste of currency politics when he was tapped to become chief of staff for Edouard Balladur, Finance minister under the new, Gaullist prime minister, Jacques Chirac. At the time, France was struggling with slow growth and relatively high interest rates as a result of the about-face of president François Mitterrand, who had abandoned the high spending of his early years for the franc fort policy, based on a stable franc­deutsche mark peg. Chirac had won election by promising to liberalize the French economy, lift credit controls and privatize many state-run industries. He wanted easier monetary conditions to facilitate his economic reforms, so after taking office he ordered a quick devaluation, which Trichet negotiated with his German counterpart, Hans Tietmeyer. It didn't prove to be a panacea, however. With international capital flowing into the mark because of the dollar's weakness at the time, France had to seek a second devaluation less than a year later. The humiliation made Trichet a convert to the franc fort and persuaded him of the need for a single European currency.

Five years later Trichet would defend both of those ideas doggedly as director of the Treasury -- the most powerful civil servant in France. In September 1992 a currency crisis caused by high German interest rates forced Italy and the U.K. to abandon their pegs to the deutsche mark. After French voters came within a whisker of rejecting the Maastricht Treaty in a referendum, speculators focused their attacks on the franc. Trichet and Finance minister Michel Sapin negotiated furiously with their German counterparts to avert a franc devaluation, and after the intercession of Mitterrand and then­German chancellor Helmut Kohl, the two sides cut a deal. Both countries declared their political commitment to franc-mark parity and staged a coordinated interest rate move -- France raising rates to bolster the franc, Germany cutting rates to ease upward pressure on the mark.

Trichet maintained his defense of the franc fort, often in the face of strong political opposition, after he was appointed governor of the Banque de France in 1993. He wrote an open letter to Mitterrand in 1995 urging wage moderation for public sector workers, only to be rebuked by Chirac, who was running for president on a platform that promised to revive growth and questioned the franc fort policy. Chirac won, and in the following months, Trichet raised rates to defend the franc before the president finally committed himself to the franc fort as a step toward adopting the euro.

Trichet's steadfastness during the mid-'90s was decisive in maintaining French support for the euro, contends Crédit Agricole's Autheman. "The single most important thing about Jean-Claude Trichet is the length of his consistent stance. He has sustained his line, and he has never felt any doubt about his policy," Autheman says. "Whatever happened, he found a way to stay the course."

His success at defending his currency, in contrast to the failed efforts of British and Italian officials, burnished Trichet's reputation in international policymaking circles. Says Eric Chaney, a senior economist at Morgan Stanley and a former French Finance Ministry official, "Trichet is much closer to the Fed than Duisenberg was, because he won the battle of the French franc against George Soros," who at the time led speculators in attacking European currencies. "He got a lot of respect for that." Trichet also reassured German policymakers that France was a reliable partner for entering monetary union and that he himself was a worthy successor to Duisenberg. "He was the only guy the Germans would trust," Chaney says.

"He was very courageous, very brave in his own country," says the National Bank of Belgium's Quaden. "He demonstrated in the past that he was able to resist political pressures."

In addition to determination, Trichet also has exhibited a healthy streak of pragmatism throughout his career. In the early stage of the Maastricht Treaty negotiations, for example, he resisted German demands that the ECB be granted full independence from national governments. At the time, of course, Treasury director Trichet, not the Banque de France, controlled French interest rates. But when it became clear that Germany's demand was nonnegotiable, he converted to the cause of central bank independence. And when France granted policymaking independence to its central bank in 1994, Trichet used his powerful new position to defend the franc and argue for economic reforms.

"Trichet is essentially a very pragmatic person," says Charles Wyplosz, director of the International Center for Monetary and Banking Studies at the Graduate Institute of International Studies in Geneva. "He's a very astute politician. That's what got him there, not his knowledge of monetary policy. He will want to be in the ECB like Greenspan -- a very powerful chairman over a very powerful institution."

Trichet's influence will face an early test. Both France and Germany are on track to violate the stability pact's deficit limit of 3 percent of GDP for a third consecutive year in 2004. The European Commission wanted both countries to make deeper budget cuts next year and pledge to bring their deficits back under the limit in 2005. Crucially, the commission wanted to put real teeth in its request by launching a process that for the first time would lead to automatic fines of billions of euros if the two countries failed to comply.

French Finance Minister Francis Mer and his German counterpart, Hans Eichel, however, persuaded fellow ministers to reject the commission's proposal, arguing that deeper cuts would only weaken the economy and prove counterproductive. Trichet's riposte was immediate. Just a few hours after the ministers' decision, he convened an emergency teleconference of the ECB's governing council -- the first such meeting since the aftermath of the September 11 terrorist attacks -- which warned of "serious dangers" for the euro-zone economy as a result of the Franco-German move. All of which leaves euro-zone policymakers in a quandary: They can't enforce respect for the stability pact, but neither can they agree to an alternative policy of fiscal stimulus. Policy is deadlocked, the euro's rules lie in tatters, and the economy continues to limp along.

The stability pact fiasco "just shows that there are a lot of political risks in the EU," says Joachim Fels, euro-zone economist at Morgan Stanley in London. "Markets will have to price in the risk of a breakup of economic and monetary union in the future. It should lead to a higher risk premium on euro assets. It also adds to the risks of an earlier rate hike."

Trichet has no formal budgetary authority. The euro zone's unique feature -- flaw, some would say -- is that the single currency is not matched by a single budgetary policy. Trichet has a prominent bully pulpit in the ECB and attends the monthly meetings of the euro-zone finance ministers. Duisenberg used his appearances to plead the case for budgetary restraint, to no great effect. Can his successor do any better?

Trichet met twice with euro-zone ministers last month and urged France and Germany to respect the stability pact, contending that the commission's proposal already bent the rules "to the limit." But he stopped well short of threatening to raise interest rates over the issue. As Quaden of the Belgian central bank says, "We are not going to punish the euro zone because some countries are not fully respecting the rules of the game in the budget field." The ECB would hike rates only if deficit spending puts upward pressure on inflation, he adds.

Belgian Finance Minister Didier Reynders notes that Trichet has spent much of his career at the nexus of monetary and fiscal policy in France and has worked closely with Europe's central bankers and finance ministers for the past two decades. He sees the Frenchman as more open to dialogue with finance ministers than Duisenberg was.

Ironically, by undermining the stability pact, finance ministers may have increased Trichet's leverage, because they will need his credibility for whatever framework of fiscal discipline they adopt in the future. The situation presents "an opportunity for Trichet to bring the ECB into the heart of the fiscal debate rather than playing the role of an outsider shouting advice," contends Holger Fahrinkrug, an economist at UBS in Frankfurt. "What replaces the current structure could be an improvement."

Trichet sent a clear message to ministers in a speech in Frankfurt last month. He said that restraining spending to comply with the stability pact's deficit limits and making structural reforms of labor and welfare policies could have "positive spillover effects" on monetary policy. "Policies that contribute to lower current and future taxes, moderate labor cost increases and higher productivity in the euro area could allow monetary policy to maintain price stability by keeping rates relatively low as long as aggregate demand lags behind sup ply-side dynamics," he said. Compared with Duisenberg, who once notoriously rebuffed ministers by saying, "You might say, I hear, but I do not listen," Trichet's overture hinted at a Greenspan-like willingness to coordinate monetary and fiscal policy.

The renewed weakness of the dollar also poses a major challenge to Trichet's ECB. The euro dipped below $1.10 in early September as evidence of a strong U.S. economic recovery boosted demand for the dollar. But the euro subsequently rebounded by 10 percent, touching a record high of more than $1.19 in late November after the Group of Seven's call for market-based exchange rates at its Dubai meeting suggested that the Bush administration was abandoning its strong-dollar policy. The U.S.'s decision to slap import quotas on Chinese textiles last month put more pressure on the dollar. America's trade problems may lie mainly in Asia -- notably China -- but Europe stands to bear the brunt of any currency pain in the near term: The euro-dollar rate is the only major exchange rate set by market forces rather than by central bank intervention.

Germany's third-quarter growth figures underscored the risk of the dollar's weakness. GDP rose by 0.2 percent in the quarter -- the first growth after three quarters of recession -- but it was driven almost entirely by a 3.2 percent rise in exports. By contrast, German consumer spending and business investment declined. A further rise in the euro would hit the only source of growth in Germany and risk pushing much of the euro zone into recession. If the single currency stays at about $1.20 on a sustained basis, "it would begin to pose a number of problems for our economy and for the whole of Europe," cautions French Finance Minister Mer.

"We're not that far away from the ECB being in a position to respond with a rate cut" if the euro appreciates further, contends ING's Cliffe, who points out that the euro's strength was a factor in the central bank's half-point rate cut in June. Trichet himself has sent mixed signals about exchange rates. At his press conference last month, he declared ECB policy to be in favor of a "strong and stable euro," which he insisted would foster growth by helping to keep long-term interest rates low and strengthening consumers' purchasing power. But he also maintained that the G-7's Dubai statement was aimed at Asian currencies, which he said should appreciate over time against both the dollar and the euro.

Trichet's background suggests that he will be much more willing than Duisenberg to try to steer the euro's exchange rate. As head of the French Treasury in the mid- to late 1980s, he was intimately involved in drafting the Plaza and Louvre Accords, which sought to weaken and then to stabilize the dollar. He also comes out of a French policymaking establishment that has typically favored managing currencies rather than leaving them exposed to the whims of Anglo-Saxon speculators. "In his heart of hearts, Trichet's an interventionist," contends James O'Neill, head of global economic research at Goldman Sachs & Co. in London.

The difficulty for Trichet is that the euro's exchange rate is a matter of shared responsibility between the ECB and EU finance ministers, and as the recent tensions over the stability pact indicate, the central bank and finance ministers aren't exactly singing from the same hymnal. The ministers have often talked about the need to designate a point man -- a so-called Mr. Euro -- to represent the euro zone on currency matters and other international issues, but they've never been able to agree on who it should be. Whether Trichet can step into the role will be a key test of his influence. "Europe needs an exchange rate policy, and it needs a Mr. Euro," asserts Morgan Stanley's Chaney. "Trichet wants to be Mr. Euro."

The remaining challenge for Trichet will be the timing of interest rate hikes. Barring a relapse into recession or a drastic rise in the euro, most analysts believe that rates have bottomed for the cycle. Otmar Issing, the ECB's chief economist and a member of the executive board, buttressed that view last month by saying that with its rates at record lows, "there is nothing more monetary policy can do."

What happens if the economic recovery continues to gather steam? The European Commission predicts that growth in the euro zone will accelerate to a modest 1.8 percent rate next year from 0.4 percent in 2003, but some analysts contend that strong growth in the U.S. and Asia will fuel a faster recovery. Economists at Goldman Sachs have just boosted their forecast for euro-zone growth to 2.6 percent in 2004. ING's Cliffe forecasts that the ECB will wait until late next year to tighten policy, but futures rates in the European money market are pricing in a quarter-point rate hike by March.

"That's my worry now, that as soon as the European economy picks up next year, the ECB will be quick to raise rates," says the DIW's Horn. He asserts that the euro-zone economy has been running below potential for so long that it could sustain a 3 percent growth rate for an extended period without igniting inflation. He believes that Trichet should take a cue from Greenspan, who has helped foster the U.S. recovery by telling markets that the Fed could keep rates low for "a considerable period of time." A similar hint by Trichet would be "really welcome, just to stabilize expectations," Horn says. Such a dovish signal might seem out of character for a hard-liner like Trichet, but that's just the reason many economists hold out hope. "He could do that because he has a reputation as being a very hawkish guy," says Horn. Europe's politicians, including Chirac, could hardly agree more.