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Europeans Weigh Prodi's Effect on Markets

The European Commission president-designate has sent the euro tumbling with his talk of things fiscal.

Gone are the days when the market could write off Romano Prodi, the president-designate of the European Commission, the executive body of the European Union, as a voluble Italian intellectual holding court in Brussels.

Last week, Prodi asserted Italy could be ejected from the eurozone if it didn't keep costs down -- a remark that caused the single currency to fall close to its historic low against the dollar.

The 59-year-old former Italian prime minister is a heady thinker with ambitious plans for the EU and the commission, which is responsible for initiating many of the union's policies. He will almost certainly make bold and controversial pronouncements in the future, which could send shock waves through the region's markets.

Prodi's effect will likely make Europe a trickier place to invest as his plans for deeper integration of the EU could divide member countries and even set some against him. And eyebrows will certainly be raised at some of the economic policies he appears to favor.

Prodi was appointed acting head of the commission in March by EU leaders after a corruption scandal prompted the resignation of all 20 commissioners, including President

Jacques Santer

. Prodi and his team, which he is currently choosing, formally take over from the Santer administration at the beginning of next year.

His comments last week on Italy and the euro shed light on the biases of his economic thinking. They are also problematic.

Speaking at a conference of the Italian chemical industry on June 21, he said, "We have had very low inflation, only 2%, but other European competitors have had 1%. If our costs diverge and we continue on this road, we will fail to remain in the euro."

First, Prodi's numbers are off. Italian annual inflation, measured using an EU-harmonized inflation index designed to best compare member countries, is only 1.5%, against an EU average of 1.1%. Italy's inflation is better than six other countries in the EU, including the Netherlands and Spain.

It's also unclear why Prodi felt himself to be in a position to lecture Italian businesspeople, some of whom are the most dynamic in Europe. Corporate earnings estimates from

I/B/E/S

show Italian-listed companies to be by far the most profitable in the EU over the 1995-1998 period, with earnings growing at an annual average of just under 50% a year, vs. 13% for the region as a whole.

Rather than inflation, Italy's problems will likely come from its public finances, which are in a poor state when compared with the rest of the EU.

Italy's general government debt is equivalent to 119% of GDP, the highest in the EU. And the country recently announced that it was resetting its fiscal deficit target to 2.4% of GDP, from the originally agreed-upon 2%.

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During his spell as prime minister for two-and-a-bit years from April 1998, Prodi tried hard to improve Italy's fiscal position to make sure that the country qualified for inclusion in the single currency. On the whole, Prodi made progress but did so the easy way: by increasing government revenue.

According to an

Organization for Economic Cooperation and Development

study, Prodi's administration increased taxes and pushed government receipts up to a record 48% of GDP in 1997, which can only have added to the Italian costs he now decries.

Consequently, investors should wonder how serious Prodi is about reducing taxes in the EU, an aim he stated in a May speech to the

European Parliament

. It's hard to see how lower taxes can be introduced at a time when several countries in Europe are close to exceeding the 3%-of-GDP fiscal-deficit limit stated in the Maastricht criteria.

In fact, there are clues that Prodi aims to press for a special euro tax for the EU when the time is right. In another speech, this one to the European Parliament in April, he said: "There needs to be greater coordination to permit fiscal policies ... to arrive at the genuine harmonization of national economic systems."

The problem is that it's impossible to identify a European government that has the financial wherewithal, let alone the political will, to cut back national spending so it can send more money to Brussels. That means extra money for EU fiscal coordination would have to come from extra taxes, something even the most pro-Europe governments would refuse except in a crisis scenario.

However, current opposition to fiscal coordination isn't likely to deter Prodi, who, like many other committed federalists, believes the EU is like a bicycle: It has to keep moving forward to keep from falling over.

The Amsterdam Treaty, ratified in May, gave the president of the commission considerably more power. Prodi, for instance, has far more say over the appointment of commissioners than his predecessors did, and he will no doubt try to exploit this to wrest more power away from member governments.

In addition, some commentators expect Prodi will exploit the weaknesses in several EU countries' economies to get more fiscal coordination. If a country in the eurozone got into serious economic trouble, better-off nations, particularly Germany or France, would probably spend considerable sums to keep the country in the single currency. For example, if investors started dumping Italian bonds on the back of fears about the country's debt levels, other EU countries would probably step in and buy the debt.

"The end result is that you have a new treaty that institutes an economic government for the EU," says Bernard Connolly, chief economist at

AIG International

.

Is Prodi secretly hoping for a euro crisis?