The Post-Maastricht Money Muddle


By David Fairlamb The European Central Bank is less than three years old, and the currency it's supposed to manage, the euro, won't be real money for six more months. Yet it's already clear that the Frankfurt-headquartered ECB, which sets monetary policy for the 12 nations of the euro zone, is in dire need of reform.

The electronic euro, which was launched amid much fanfare on January 1, 1999, has lost more than a quarter of its value since then, despite strenuous efforts by the EC to give it some traction. The euro zone economy, which the ECB predicted would expand upward of 3% both this year and next, will be lucky to muster growth of 2% this year many analysts now say.

Euro inflation hit 3.4% in May, way above the 2% level the ECB insists is consistent with price stability. Germany, the largest European economy, is hovering on the brink of recession. Should it go that way, the rest of the Continent would probably follow. "The ECB's worst nightmare is unfolding," says Paul Podolsky, chief foreign-exchange strategist for FleetBoston Financial Corp. "Prices are rising, while the economy is slowing, and the currency is falling."

DITHERING. Instead of taking drastic remedial action, the ECB is dithering. Despite the pace of the slowdown, the bank's 18-strong governing council has cut interest rates only once this year, on May 10, by a paltry 25 basis points. The ECB claims inflation has peaked, which should mean it has room to cut rates. And yet, at 4.5%, European interest rates are now well above the U.S. federal funds rate of 4%.

That's hard luck for manufacturers from Portugal to Finland, who say they need cheaper money to rekindle the economy. To make matters worse, council members consistently confuse the markets by sending out conflicting signals on the direction of the economy and interest rates. And no matter what he does, ECB President Wim Duisenberg just can't seem to stop making things worse.

Currency traders rushed to dump the euro on May 24 after Duisenberg said "the exchange rate of the euro is not a target" for the ECB. The currency hasn't recovered. "As a result, the ECB has no credibility with the markets," says David Abramson, European Investment Strategist at Montreal-based BCA.

Admittedly, the ECB is in a bind because of the constraints put on it by the Maastricht Treaty, the intergovernmental European Union compact that set up the bank. According to the treaty, the ECB's prime responsibility is to ensure price stability. So, it's difficult for the central bank to justify cutting interest rates when inflation is so high, even if it may have peaked. European pols, who are dragging their feet on structural reforms needed to get the economy growing faster, also hinder the bank.

OUTDATED APPROACH. Most of the ECB's problems are of its own making, however. Let's sort them out: For one, it's trying to use an outdated model when making monetary-policy decisions. It has a two-tier approach that takes both inflation and money supply into account when making rate decisions. That's just what Deutsche Bundesbank, the German central bank, used to do. It would make sense if the ECB told the markets just how much weight it gives to each variable. But it doesn't -- probably because it doesn't have any firm guidelines, let alone a strong idea.

The result is that the markets don't really know how the ECB reacts to different stimuli, which further reduces its credibility. As if that's not bad enough, the ECB also takes the old Bundesbank approach to the business cycle. Throughout the era of floating exchange rates, the German central bank used to tighten monetary policy as the economy expanded and relax it as the economy slowed. Its actions would always lag behind the economic cycle a little, so it would raise interest rates after the economy stopped growing in order to avoid a late burst of inflation.

But Germany was a much more open economy -- foreign trade accounted for around 40% of its gross domestic product -- than the euro zone, where exports and imports represent less than 20% of the economy. That means that the Bundesbank approach, which depended on the exchange rate of the German mark, has all the get-up-and-go in the new global economy of a snail on the garden walk.

NEW WORLD. In the old days, the German mark would strengthen as interest rates rose and weaken as they fell, thus affecting the level of "imported inflation." But the euro, which is a new currency with no track record, doesn't behave the way the mark did. And the ECB has nowhere near the credibility the Bundesbank used to enjoy.

Besides, the financial world has changed. Markets are now driven more by expectations of economic growth than they are by interest-rate differentials. And investors still assume that the U.S., despite the current deep slowdown there, will do better than Europe in the long term.

Meanwhile, the ECB's governing council of 18 is too big and unwieldy to ensure speedy and effective decision-making. It always gropes always for consensus, which means it can take a lot longer for it to act than the Federal Reserve Board, where Chairman Alan Greenspan is a far more dominant figure than the congenial but consensual Duisenberg will ever be.

AIMING TOO LOW. With the launch of the paper euro just months away and the euro trading within a whisker of its all-time lows, the ECB needs to rethink how it does things. First, it should reconsider its limits on letting inflation get above 2%. The politicians who hammered out Maastricht rightly left it up to the fiercely independent ECB to come to its own conclusion about what constitutes price stability.

The 2% the bank came up with is clearly too low in the current slowdown. The ECB should opt for a more flexible regime. It also needs to move away from the two-pillar strategy, which confuses just about everyone. Far better to focus on inflation -- assuming it opts for a more realistic definition of what constitutes price stability -- than on both price levels and money supply, which is difficult to measure accurately and to interpret. The ECB should also move away from the old Bundesbank approach to the economic cycle, where action trails economic twists and turns.

The governing council needs to be streamlined. As the euro zone expands to the East, the council's size -- already too big to be efficient -- will increase. Reduction will be difficult politically, as some smaller countries will lose their right to representation. But it has to be done if the ECB is to work efficiently.

MEDICINE NEEDED. Meanwhile, Duisenberg needs to become more like Greenspan and give the council some focus and direction. Consensus is all very well when most council members see eye-to-eye and decisions can be made quickly. But it can lead to paralysis in difficult times like these. And that's what seems to be happening in Frankfurt right now.

Just as the ECB needs to reform, the politicians have to do their bit. The only way of invigorating the euro zone economy is for pols to take their medicine -- deregulate European labor markets, privatize some social security and pension provisions, cut taxes further, and undertake other structural reforms that would make the economy more nimble.

Only then will the euro zone really start growing again. And only then will the euro recover and finally become the challenge to the dollar that many European politicians predicted it would. Fairlamb covers finance from BusinessWeek's Frankfurt bureau


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