Edward Hugh on the European Central Bank

He writes:

A Fistful of Euros: Crisis Looming At The ECB?: A right royal row is brewing at the ECB. Basically the old guard theorists of the "one size fits all" monetary policy are being challenged by more pragmatic observers of day to day realities. For the moments it is the politicians who are making the running (but there are plenty of competent economists in Germany and Italy who are ready to back them up), and yesterday the OECD joined the fray....

[Y]ou have the theorist of the old guard over at the ECB Otmar Issing: "European Central Bank chief economist Otmar Issing said euro zone growth differentials have to be addressed by national economic policies rather than by the ECB's interest rate policy." In fact Issing is really digging in. He provocatively gave this One Size Fits All speech on 20 May. His conclusions were as follows: "Let me conclude with a citation. On the eve of the changeover, I wrote a commentary on diversity and monetary policy in the euro area. To the question whether a single one-size monetary policy could fit all parties involved -- be they national entities, social partners or economic actors -- my answer was: 'One size must fit all'. The political decision on the creation of EMU had resolved all discussions on whether monetary union should precede or follow political unity and the fulfilment of the criteria for an optimum currency area. Today, in light of the evidence gathered so far in the euro area, I am more confident in saying: 'One size does fit all!'"

p>Obviously you have to ask whether Issing in now losing his grip on reality.... As the FT notes: "The ECB has insisted that a rate cut would be harmful and was not supported by sensible economists. Jean-Claude Trichet, the ECB president, told the European Parliament on Monday: 'The last time we met, we were absolutely convinced that we would not improve the situation [with a rate cut] but that we would hamper Europe if we would go in the direction that is suggested by some.' But now that the OECD, a bastion of orthodox economic thought, has flatly contradicted the ECB's position, Mr Trichet will find it more difficult in future to reject out of hand a discussion of lower rates."...

Just to give us a measure of who is and who isn't considered a "sensible economist", one might look at today%'s statement from Hans-Werner Sinn, President of Germany's prestigious Ifo index: he is reported as telling CNBC that: "the ECB has done a good last year in keeping interest rates stable, but we have a different situation now and the ECB should cut interest rates." This situation is not without its comic aspect: Sinn means sense, ie he is the real, true to life, sensible economist.

Comments

[Ginger Yellow]

I'm no economist, but it seems to me that the ECB's pathological aversion to inflation has played a large part in Europe's current difficulties. Apart from maybe Ireland and Spain, there's been hardly any inflationary pressure in the Eurozone, while the other countries have been stagnating in no small part thanks to high borrowing costs (relative to the US/Japan) and a rising currency. So for those with more knowledge on the matter, why shouldn't the ECB (have) cut rates by at least 0.5%?

[anne]

Nicely done, Edward.
And agreed, Ginger.

Sluggish European growth is a factor in threatening a French vote in a few days against the European Constitution, the same growth problem has threatened Germany's government in fairly modest labor reforms and led to a difficult call for early elections. Though European market adjustment to interest rate changes is not as effecient as in America, because work does not move as readily region to region, interest rates have been too high.

[anne]

Frankly, though I am listening carefully to all sorts of arguments, I am concerned about short term American interest rates rising too much. I just can not quite understand what a long term Treasury rate of 4.02% represents for our economy. There is little issue of 10 year Treasury notes, there is central bank demand for dollar securities and after all the dollar is strengthening against the Euro, but why are long term interest rates so low?

[guillaume]

If I remember well, prior to the introduction of the Euro European countries (prominent amongst them were France and Italy) frequently complained that the BuBa's rigidity in monetary policy (and its fanatical defense of M3) was impacting all other countries in the ERM.
So that basically, even with no Euro, the actual freedom of action of non-German central bankers was extremely limited : for instance France could not lower interest rates, for fear of seeing the FF tank despite widely different macro economic needs in France and Germany. So does the Euro really change things ? I think not.

And in addition, I will have lived to see Germans bemoan the monetary fanaticism of... a French central banker !

[anne]

Italy is especially worrisome to me, for there is need for significant change in its dependence on a manufacturing employment base. This change is going to take significant investment in country and from the rest of Europe.

[Jesper]

The ECB is responsible for monetary policy for a group of countries rather than merely one country like the Fed, so it's understandable that the ECB has picked a policy target that's easy to evaluate. If the ECB had a whole set of policy tagets like the Fed there would be constant suspicion (probably justified, too) that some countries were more equal than others when the ECB chose what problems to focus on for the moment. With a single-minded inflation target, at least it is easy to see whether inflation is in line with the goal or not.

Having said that, the inflation target that the ECB does have (keeping inflation below 2 percent) would probably be on the low side even for an individual country, much less a whole group of countries. The current size is too small to fit anybody.

[Ginger Yellow]

Italy has a lot more problems than just manufacturing. It has a massively fragmented and geographically lopsided economy - some absurdly high proportion of businesses are family owned. It's bureaucracy puts Kafka to shame - it has four times as many laws as the EU average. It has a stupendously corrupt and incompetent prime minister/government. And it has a huge debt burden.

[anne]

Ginger:

I was worried already. The thought of a bureaucracy to put Kafka to shame is almost intriguing :)

[shah8]

One reason I would be hesitant to side with all the *sensible* politicians and economists is that lowering interest rates may not do any good.

Some people view the situation as that the US political and economic elite is trying to put a squeeze play on euro governmental institutions, namely to reduce the hardness of their currency to mask the weakness of the dollar. In other words, people here are trying to maintain or increase the flow of european savings into US assets, and the euro banking elite view this attitude and some of the actions resulting from it as a squeeze play and are resisting, no matter how politicians might scream to save export dependent jobs.

I do not know enough to say whether this is true. However, I *do* view US interest rates as being dangerously low, and if the Euro economic conditions are primarily related to the fact that *US* interest rates are too low, then I would agree with the Euro banking elite and keep the interest rates high. All lowering interest rates will do is allow the US to export inflation to Europe, with little compensation from increased economic activity.

[Maynard Handley]

It seems to me that what we have here is that the US is eating its seed corn (massive deficits, borrowing from China, low interest rates discouraging savings, burning up natural resources like no tomorrow) while Europe is, for the most part, running slower because they are not doing these things.
And sure, of course if you look no more than three months into the future this looks like a terrible deal for Europe. If they ramped up deficit spending, removed oil taxes, dropped interest rates, they could also turbo-charge their economies for a year or two. But if you look five or ten years into the future, is it this such a good idea? There appears to be a perfect storm of trouble headed for the US over the next ten years, from peak oil to China no longer needing to buy Treasuries to ever-weakening corporate pensions and the perennial health-care problem.

If you believe that none of these are real problems, that peak oil is fifty years away, that oil prices will climb smoothly and the economy will easily adjust, that China will never feel it owns too much US debt, that health-care will simmer making US people's lives miserable but having no other effects, then sure, Europe is making the wrong set of tradeoffs. But, as should be clear, I see Europe as making the more sensible choices here.

[derrida derider]

It's true, as Guillame says, that there is a limit to using currency adjustments to respond to shocks within countries that trade closely, and that therefore such countries have limits to what they can do with individual monetary policy. dsquared pointed out in another comments thread here that an Australian like me (in a small, very open economy) should be especially sensitive to these limits.

But in adopting a common currency for countries whose business cycles were never going to be in synch for a long time to come the Europeans substituted *limited* inter-country flexibility for *zero* flexibility. It was a really dumb thing to do, compounded by the rigidity of the Stability Pact and the absurdly low inflation target of the new ECB.

[anne]

What is driving the weaker European economies is still American imports, America is surely not the cause of European slowness of growth. American long term interest rates are low despite 8 increases in short term rates by the Federal Reserve, and surely our mix of interest rates is not prventing Europe from lowering short term rates. By growing below potential, Europe is not providing for the future nor preventing inflation but needlessly limiting living standards.