Lafontaine warns of EMU deflation in row with ECB

The German Finance Minister, Mr Oskar Lafontaine, warned yesterday that Europe could fall victim to deflation if the European Central Bank (ECB) does not cut interest rates to stimulate economic growth.

Outlining his budget plans for 1999 in the Bundestag, the lower house of parliament in Germany, Mr Lafontaine painted a gloomy picture of Germany's economic outlook and said that monetary policy should now be used to boost output.

"At the moment there is no danger of inflation. In addition, real producer prices are falling," he said.

If no action is taken soon, deflationary dangers will predominate." Mr Lafontaine's remarks will irk the president of the ECB, Mr Wim Duisenberg, who believes that such political pressure for rate cuts is to blame for the recent slide in the value of the euro.

The currency has fallen by almost 8 per cent against the US dollar since its introduction on January 1st.

The ECB insists that, although inflation is not a threat at present, there is no deflationary pressure in the euro zone and that the economic climate can improve without a cut in interest rates.

The German government expects the economy to grow by 2 per cent this year but most economists dismiss this figure as too optimistic.

Mr Lafontaine told the Bundestag that unemployment could fall by up to 200,000 by the end of the year but that a cut in interest rates could provide a crucial stimulus to growth.

"There is a need to act. Monetary policy is not growth-neutral. The interest rate mechanism can be used, in a stable economic environment, to give growth impulses," he said.

As Mr Lafontaine spoke, senior German officials were warning of "a European crisis" leading to a collapse in the value of the euro if talks on the Agenda 2000 reform package fail.

The chancellor, Mr Gerhard Schroder, is expected to spell out the consequences of failure when EU leaders meet in Bonn on Friday to discuss the reforms of farming subsidies and EU financing.

"If there is no solution, we will see a depreciation of the euro on the markets. The markets will think European leaders cannot get their act together," said one official.

The official warned that a further weakening of the euro could lead to higher interest rates and bigger debts for European countries.

A leading economics professor yesterday blamed the German government for the euro's fall on the money markets and warned that the ECB may be forced to put up interest rates.

Prof Wilhelm Hankel said that Mr Lafontaine's attempt to politicise the euro as an instrument to reduce unemployment meant that Germany had abandoned its traditional policy of currency stability.