ECB and world-wide recession

[Sven R Larson <larson@xxxxxx>]

Hi everyone,

Today's Wall Street Journal Europe reports on the ECB and its stubborn
refusal to cut its leading interest rate. While all main indicators show
that most of Europe is now in a recession (latest figure: manufacturing
is down) the ECB still refuses to cut interest rates. This time, though,
the refusal is not spoken in sotto voce, but outlined with unusual
strength. Here's what WJS Europe quotes the bank to say:

--The ECB can't save the world even if it wanted to. The bank and Europe
cannot be the "white knight" of the world economy.
--According to the Maastricht treaty the ECB is constrained to inflation
policy, and cannot expand into employment boosting.
--Europe's economy is "set to" outpace the US economy in 2001 and that
means there's a risk inflation will rise. Hence the bank has to keep
interest rates up to curb the upcoming expansion.
--It's better for employment and growth that euro-zone governments slash
debt and thereby give themselves "more flexibility" in spending.
--Weak euro, recent wage raises and the oil price situation all point at
more inflation.

It's worth to keep in mind that the ECB maintained its interest rate
high in its first year of operation way past the point where a cut was
needed, only because the German finance minister publicly called upon
the bank to cut. This was Duisenberg's way of showing political
independence, but at the price of becoming weak on the markets. This
time the bank is in a similar situation, where external pressure makes
them all the more persistent. The Maastricht treaty does indeed ban
employment concern from the list of reasons why the bank should cut
rates, but all the bank has to do to circumvent the treaty's statutes is
to say it doesn't expect inflation to rise because of the rate cut. But
this doesn't happen, and it won't because Duisenberg wants to show he's
independent.

At the same time, I honestly don't think an ECB rate cut would make very
much of a difference. Not only is the bank a weakling in the eyes of
international investors, but its rate cuts are also to a large extent
inefficient in terms of boosting aggregate demand. If it helps
households by cutting debt service costs, then that's fine. But it won't
trigger any expansion in the private sector so long as euro-zone fiscal
policy is such a mess as it is. Some countries are pursuing expansionary
tax cuts, while others seem to go straight in the opposite direction.
(Italy under Berlusconi would add to the latter crowd.)

If the ECB does nothing it's a sign of weakness and will hurt the euro.
If it does something it's a sign of weakness (they will look like
they're caving in under political pressure) and the macroeconomic
effects will be untraceable. What troubles me here is that a weak ECB
might prevent the formation of a consistent fiscal policy in the
euro-zone. So the question is really how on earth we're going to make
the ECB strong - if that's at all possible. (Disbanding the ECB is
simply unthinkable for political reasons.)

/srl


--
Sven R Larson
PhD; Assistant professor of economics
Department of Social Sciences, Bldg. 22.2
Roskilde University
Pb 260
DK-4000 Roskilde, Denmark
Phone: (+45) 4674 2910