[A-List] EU stability & growth pact: ECB intransigence

["Michael Keaney" <michael.keaney@xxxxxx>]

Duisenberg should stop suffocating Europe
By Philipp Hildebrand
Financial Times: November 7 2002

In the autumn of 1998, amid the storm of the Asian crisis, Europe's central
bankers referred to Europe as an "island of stability". They were roundly
criticised by their US friends who felt that the world economy was enduring
its worst financial crisis for 50 years.

Four years on, the world economy is again under attack. This time it faces a
potentially lethal mixture of $8,000bn of destroyed equity wealth, a global
corporate governance crisis, worldwide excess capacity, disinflation,
sagging consumer confidence and the threat of war. The US Federal Reserve
has responded aggressively, cutting interest rates to the lowest level since
the 1950s. Meanwhile, the European Central Bank has stood by and watched.

Wim Duisenberg, ECB president, has declared that interest rates are
"appropriate" and insists he is right to "keep the powder dry". Under his
stewardship, the bank has manoeuvred itself into a dangerous corner, based
on five flawed arguments.

First, as a new institution, the ECB has convinced itself that the only way
to acquire credibility is to maintain an orthodox anti-inflation rhetoric
and monetary policy stance. Admittedly, the ECB is encouraged to do so by
the European Union's Maastricht treaty, which provides it with the most
restrictive monetary policy mandate in the world. Yet the notion that
credibility is inherently linked to monetary orthodoxy is misguided and
rests on a misunderstanding of how financial markets and the public accord
credibility.

The ECB could still learn from the Bundesbank. In 1995, Ottmar Issing, its
chief economist (now the ECB's), explained that "one of the secrets of the
success of the German policy of monetary targeting was that it often did not
feel bound by monetary orthodoxy as far as its technical details were
concerned". Financial markets and the public do not award credibility for
the blind pursuit of orthodoxy but for prudent, forward-looking policy.

Second, the ECB wrongly believes that by keeping monetary policy tight it
can ensure fiscal prudence and somehow force unwilling politicians to
embrace structural reform. The ECB should be applauded for criticising the
unwillingness of politicians in Germany and elsewhere to deal with labour
market rigidities. Equally, it is right to highlight the risks of returning
to fiscal profligacy, notwithstanding the details of a flawed stability
pact. But to use an exceptionally cautious monetary policy to encourage pro-
cyclical tax increases and force Germany to reform its labour markets is
akin to denying a dying heart patient his medicine until he goes on a diet.

Third, a number of ECB officials seem to have embraced the notion that
lowering interest rates would have no impact on the real economy even if it
could be justified by the inflation outlook. This argument is testimony to
the ECB's misunderstanding of the multiple channels by which modern
financial markets transmit monetary impulses. Furthermore, it is
inconsistent to argue that interest rate cuts have no effect while
maintaining that increases bring benefits by controlling inflation
expectations.

Fourth, price increases following the introduction of euro notes and coins
have become the latest justification for keeping interest rates unchanged.
To conclude - like Jean-Claude Trichet, governor of the Bank of France -
that such increases have triggered a structural increase in inflation
expectations, undermining consumer confidence, is misguided. Even a
perfunctory look at economic data shows that unemployment, not increased
inflation expectations, is undermining consumer confidence

Fifth, the ECB continues to struggle with its two-pillar monetary policy,
which sends confusing signals to the markets and to the public. Money growth
is consistently above the ECB's reference value, making it difficult for the
ECB to focus on the inflation outlook. While the two-pillar strategy was
understandable as a way for the ECB to inherit the credibility of the
Bundesbank, it has outlived its usefulness. By abandoning the vague
objective of a monetary "reference value" and instead targeting prices
directly, the ECB would clean up its framework, ease communication and
create room for lowering interest rates on the basis of its longer-term
inflation outlook.

It is time for the ECB to ease monetary policy decisively. Mr Duisenberg is
operating under a monetary model where inflation is the predominant economic
threat. This has led him to base his decisions on a set of flawed
assumptions. He must adapt his model now or the market will adapt it for
him, thus undermining his credibility and that of the institution over which
he presides. Presumably, that is precisely what he has been trying to avoid.

The writer is a managing director of Union Bancaire Privée