TCS Daily


Central Bank Blues

By Constantin Gurdgiev - November 29, 2005 12:00 AM

It's an iron law of conflicted Third World countries that anything you do can get you shot at - including nothing. But whether it's tax harmonization or the Bolkestein-Frankenstein Services Directive the law seems, in its own way, to work for European politics as well. Last Friday, in its first real act, the European Central Bank (ECB) risked being shot at by announcing that it is ready "to moderately augment the present level of [interest] rates" when it meets on December 1.

This is no surprise to most analysts and economists. Rising oil prices, expanding money supply, easing of terms of trade pressure caused by the US dollar, growing credit and rising house prices all point to an increased risk of medium-term inflation. Yet, throughout the year interest rates have remained at 2 percent - a level set in 2003. This is despite the fact that inflation reached 2.5 percent in September 2005.

While the ECB is unlikely to increase the rate by more than a modest quarter of one per cent - to 2.25 percent - the Bank's comments have caused fingers in a few member states to edge towards the nearest weapon.

There are three reasons for this. First, even a modest tightening of liquidity could place strain on an already-anemic Eurozone. Even though recent U.S. experience suggests that the sensitivity of output and employment growth to changes in monetary policy is lower than it was in the 1970s and 1980s, such a trend is yet to be confirmed in the Eurozone. The second reason is that a modest interest rate increase in December could, as long as energy prices and fiscal spending remain high, pave the way for further increases in 2006. Lastly, higher interest rates and the Eurozone's Stability and Growth Pact will reduce individual countries' ability to finance escalating fiscal deficits through borrowing. A few of their governments will be taking the only action possible - aimed at the ECB.

Of course the best medicine for the Eurozone is structural reform. But there is little appetite in Europe for anything other than Keynesian big-government solutions. Certainly there is no appetite whatsoever for an approach to job creation based on entrepreneurship, lower taxes and reduced government spending.

The inability of the member states to reform is probably one of the major drivers behind the ECB's announcement. By forcing monetary tightening, ECB President Jean-Claude Trichet is putting pressure on Eurozone countries to change course. Unless they wish to see their government debt downgraded to junk status, Germany, France, Italy and Spain must now consider cuts in government spending. In October, the ECB issued a stern warning to Eurozone members with high fiscal deficits, stating that it might not accept their governments' bonds as collateral if their credit ratings were to diminish.

Although the ECB decided to keep interest rates unchanged at its most recent November 3 meeting, it stressed the need for states to speed up structural reforms.

As opponents of monetary tightening suggest, real GDP continued to grow at an extremely moderate pace - expanding some 0.6 percent in the third quarter. Labor market improvements over recent months were modest at best. Unemployment averages 8.6 percent. At the same time, public confidence in the new currency has slipped. For example, only 38 percent of the new member states' citizens believe that joining the Eurozone would benefit them.

According to the European Commission's November 17 report, the Eurozone economy is expected to reach a low this year, accelerating in 2006 and 2007. The Commission forecasts that GDP growth in the Eurozone will drop to 1.3 percent this year from 2.1 percent in 2004, rising to 1.9 percent in 2006 and 2.1 percent in 2007. Germany is expected to grow by a meager 0.8 percent, Italy by 0.2 percent, Portugal 0.4 percent and the Netherlands 0.5 percent. The Eurozone unemployment rate is expected to fall from 8.6 percent this year to 8.1 percent in 2007.

Many analysts believe even these dismal forecasts to be rosy - if oil price pressure continues, the likely outcome for 2007 will be 1.6 percent growth in GDP and an 8.5 percent unemployment rate. There is even more disagreement with Commission's assumptions on inflation reaching 2.3 percent in 2005, 2.2 percent in 2006 and 1.8 percent in 2007. Although the Eurozone's consumers have not shown increased confidence, recent trade statistics show strong growth in imports, despite the falling Euro, while credit is still expanding.

The EU's money supply - watched closely by the ECB - has shown significant inflationary pressures. M3, the broad money supply measure, grew at an annual rate of 8.5 percent in September 2005 - the fastest in over two years. This growth is alarming since it does not match any fundamental changes in the Eurozone economy. Following the 9/11 attacks investors shifted out of emerging markets and moved into less risky assets, fueling a spike in liquidity. However, since 2004, the new liquidity supply came largely from high risk investments and growing credit demand. The latter factor is of serious concern to the ECB with Otmar Issing, the ECB's chief economist, warning on October 28 about housing price bubbles emerging in several Eurozone states.

Recent months saw growing insistence on behalf of the ECB officials on the need for structural economic reforms. Instead, the governments' resorted to fiscal expansions and deficit financing, combined with reliance on cheap credit under the low interest rates policy of the ECB to generate growth. The fact that the latest intention to change the interest rate was pre-announced by the ECB, shows Central Bank's dissatisfaction with the member states indefinite delays of structural reforms.

The most immediate candidate for this pressure is Germany where the coalition government of Angela Merkel has completely reversed Merkel's pre-election promises of reforms and is planning to raise taxes on income and consumption in order to balance the budget.

In addition to serving potential political strategy, the ECB announcement may be geared toward gradually increasing the value of the Euro by making euro-denominated assets more attractive through higher interest rates, replacing inefficient domestic liquidity with, hopefully, more efficient foreign investment. If by mid-2006 the Eurozone recovery begins to falter again, a speculative attack on the currency will be virtually unavoidable, further exacerbating pressures for reforms.

Overall, it appears that the ECB has decided to make the first move in the battle between the monetary authority and the member states. In doing so, it may be risking being shut down by political pressures from Eurozone's capitals. Yet, with some inflationary pressures rising and the economic recovery remaining weak after the years of historically low cost of capital, the ECB hardly has an option to remain static.

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