Wednesday, May 25, 2005

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.

"Wolfgang Clement, Germany's economics and labour minister, supported the OECD's conclusions about Europe, joining Italian ministers in urging the ECB to loosen monetary policy."

At the other end there is eg Erkki Liikanen:

"In an interview in today's Financial Times, Erkki Liikanen, governor of the Bank of Finland and a member of the ECB's governing council, reiterated the ECB's view that the next move in European rates would be up."

Or you 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!?"

Obviously you have to ask whether Issing in now losing his grip on reality. Can one size fit all is a legitimate question, one size must fit all is not an adequate response, and one size *does* fit all seems to reflect a distorted vision of reality to say the least. Clearly Issing has a lot personally at stake in the euro process, but obviously, as we can see from political life, inability to reform and address real life issues normally leads to even bigger changes later. My feeling is that it will not be long before heads will roll at the ECB.

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."

I don't know if I count as a sensible economist or not, but this situation has long been clear to me. Personally I welcome the prospect of a new broom sweeps clean over in Frankfurt. This problem has been obvious for a long time, and it is better to address it sooner rather than later.

Update : 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.

Tuesday, May 24, 2005

The Mysteries of Growth: France & Germany

The latest data on French household spending show that it rose rather faster than expected in April. This suggests that consumer spending is still supporting economic growth in sharp contrast with the pattern in Germany. In Germany the domestic economy actually *contracted* in the first quarter. True the German economy grew, but this was due exclusively to the export sector. So while the German domestic economy has been struggling France has been one of the eurozone's best performing economies, with consumer spending and a booming housing market supporting growth. The French consumer is, it seems, considerably more robust than the German one.

So the big question is why the difference? They are both economies which according to the criteria of the Lisbon agenda are badly in need of reform. My own view, almost inevitably, is that this might well have something to do with the differing demographies of the two countries. Fertility is much higher in France - at nearly replacement rate - and over the years France has had a lot more long term immigration. Surely other factors are important: but which ones are they? Any constructive suggestions anyone?

Saturday, May 21, 2005

The Euro And The Vote

The euro reached its lowest level against the dollar in seven months last week dropping from a valueof $1.311 a month ago to $1.255 on Friday. This was the lowest level since last October. Undoubtedly there are a confluence of factors at work here: yesterday's French growth numbers, longer term stagnant growth in Germany and Italy, Sunday's elections in the Federal Republic, the up and coming referendum in France, rumourology about forthcoming ECB rate cuts etc.

This downward pressure will in reality be welcomed in many quarters, since it could give some useful relief to hard pressed exporters, and it may help those (eg Spain) with serious balance of payments problems by offering some kind of corrective impetus.

But all of this only draws attention to one underlying fundamental of the situation: there has never been a 'strong euro story', it has always been a 'weak dollar' one. And it is here that things get really complicated, since it begs the question of whether the US is able and ready to live once more with a 'strong dollar', and if it isn't then this immediately poses the question as to what exactly the repercussions will be?

Brief recap: it should be remembered for the purposes of the present debate that the US economy is suffering from a number of well known problems, amongst these a long standing and generally deteriorating current account deficit, a labour market which is compartatively weak compared with equivalent phases in the recovery cycle in the past, and interest rates which have been again relatively low historically and which have been seen as facilitating the creation of 'mini asset bubbles' (Greenspan only yesterday was indicating there may be what he called 'froth' in the US property market).

In addressing these problems the Federal Reserve and the US Treasury (which is responsible for currency policy) have been persuing two policy stances: a de-facto 'weaker dollar policy', and a policy of 'measured' interest rate hikes. The measured bit is important, since it is generally recognised that any abrupt increase could make existing employment problems worse (it would also worsen the Federal deficit problem by making financing it more expensive, but that is another story), and at the same time would tend to undermine a weaker dollar approach.

There is another level to the problem which is not so widely recognised, and that is the significance of the fact that core inflation in the US is broadly recognised as 'benign'. This means - in Fed speak terminology - that whilst there is a need to be vigilant in anticipating any perceived inflation danger, the outlook still contains significant 'downside risks': ie that there is a danger that the underlying global disinflation could lead US inflation levels to a point which was perceived as dangerously low, dangerously low in the sense that it could make it difficult to use conventional monetary policy in the event of a recession. The US has no official inflation target, but it is generally agreed that a level of inflation on or around the 2% mark is desireable, no higher and certainly not much lower.

This is what is known as the 'deflation problem': but judging by the deafening silence with which my recent post on the danger in Europe was greeted, it appears that either the problem seems too obscure to be important, or that my raising it is seen as some sort of strange eccentricity on my part, when there is such a strong consensus that what we face is 'stagflation'.

Anyway back to the main point: all of the above carefully crafted Washington policy could be placed in serious risk by a combination of two factors:

* a significant disparity in base interest rates across the Atlantic.
* a euro crisis which suddenly sent the value of the dollar shooting up.

Any eventual reduction in rates at the ECB (to counter growing euro zone stagnation) would seriously cramp the ability of the Chairman of the Federal Reserve to conduct an independent monetary policy, and any dramatic rise in dollar valuation would only serve to worsen the already bad current account deficit as well as concurrently, and logically, making the labour market even weaker as demand for home products and exports was accordingly weakened.

Why should this matter to us here in Europe. Well........ as I keep mentioning the global economy currently rests on two pillars: China and the US. Anything which destabilises either of these economies will have repercussions across the globe.

Obviously at the time of writing it is difficult to see what the actual outcome of the French vote will be (although every indication is that the 'no' vote is consolidating rather than weakening: and remember if there is a French 'no' there is then a high probability of a Dutch 'no' directly after). I think the psychological blow will be important. I think we could be facing the first real 'euro crisis' in the short history of the common currency.

I repeat: in principle - from a European point of view - a controlled reduction in the value of the euro would be more than welcome, but if this were more a rout than a reduction this in itself would be deeply destabilising.

And remember: it's an ill wind that blows no-one good.

Postscript: You can find some further elaboration of the 'Dollar Weakness, not Euro Strength' argument: here, here and here.

Finally a couple of quotes from the FT article linked in the intro:

"On Friday, Wolfgang Clement, Germany's economics minister, joined Italian counterparts in blaming his country's economic weakness on the European Central Bank. Germany had become a ?victim? of the ECB's drive for price stability and the bank should take ?a very close look? at the country's low growth rate, he said in an interview with the dpa-AFX news agency. The ECB has kept interest rates at 2 per cent for 23 months. Currency traders said the euro's fall was primarily driven by the US dollar, which rose across the board amid continuing talk that hedge funds and other speculators are liquidating dollar carry trades borrowing dollars to buy non-dollar assets as rising US interest rates make these positions more expensive to hold."

"Julian Callow, economist at Barclays Capital, said: ?Investors are recognising that the euro does not have a happy set of fundamentals supporting it. The economic news is crumbling and political tensions are rising.? The gloomy figures came as opinion polls showed voters in France and the Netherlands were minded to reject Europe's constitutional treaty in referendums on May 29 and June 1 respectively."

Thursday, May 12, 2005

European GDP Numbers

Provisional GDP numbers for eurozone countries in the first quarter are out today. The German economy surprisingly bounces back, whilst Italy is now officially in recession after two quarters of contraction. Also worthy of note is that the Dutch economy contracted slightly in the first quarter, which may have some implications for the forthcoming constitution referendum there.

The noteworthy point about the German expansion is that it almost entirely export driven, and hence dependent on growth elsewhere. This evidently raises questions about sustainability in the coming quarters:

"Germany?s news was a positive surprise from an economy that has been performing below par for a decade but the real problem, the fact that consumer spending fails to match whatever thrust the economy gets from exporting, lingered on.

The statistics office said domestic demand actually fell and that the first quarter GDP rise was due exclusively to exports -- which remain vulnerable if the euro stays strong and oil prices high or world trade and foreign demand slows."
Source: Financial Times

Meantime things in Italy only seem to get worse. Gross domestic product shrank 0.5 percent in the first quarter, the steepest drop in six years, and this follows a contraction of 0.4 percent in the previous three months.:

"Italian industrial production, which accounts for about a third of the economy, dropped 0.6 percent in March, Istat said today, resulting in the third straight quarterly decline. Business confidence in April fell to the lowest in almost two years, according to a survey compiled by the Rome-based Isae institute.

There are few signs that the income-tax reductions worth 6 billion euros ($7.7 billion) are boosting consumer confidence and spending. Retail sales in Italy, fell for a ninth month in April, the Bloomberg purchasing managers index showed May 9."
Source: Bloomberg


Quotes of the day:

As member of the eurozone Italy cannot cut interest rates or devalue its currency as it has in previous significant downswings. The depth of the Italian recession ?is a whole new ball game, we don't have any precedent for dealing with this,? said Julian Callow, economist at Barclays Capital.


The federal statistics office (Germany) said that the improvement ?was exclusively based on exports?. Holger Schmieding, economist at Bank of America, added that leading indicators also suggested that German growth may retreat back to near-stagnation in the next few months. ?Although Germany may finally pass the sorry title of 'sick man of Europe' on to Italy, the German data do not change our overall outlook for Germany's future growth profile.?

Both these quotes come from this FT article.

Update 2

The FT Deutschland is reporting that pressure on the European Central Bank to consider an interest rate cut is expected to come next week from the OECD.

According to FT Deutschland a draft OECD report says ECB interest rates should be kept on hold while the indicators remain mixed, but if the ECB's economic assessment moves clearly in either direction, monetary policy should react. The OECD has also revised down its forecasts for growth this year to 1 per cent in Germany and 1.6 per cent in the eurozone, compared with the 1.4 per cent and 1.9 per cent forecast in November.

In other words if the downside risks continue, arguments for cutting the rate will mount up. This will be a real first for the ECB, and the first major test of the euro, since monetary policy has been, to date, relatively uncontroversial. Keep watching this space.

Monday, May 09, 2005

ECB: Rate Cut In The Autumn?

Despite a widespread feeling that interest rates in Europe may be about to rise, futures markets seem near to pricing in a rate cut for the second half of the year.

One interesting knock-on consequence of this that no-one seems to be twigging is that any such move might well cramp the style of Alan Greenspan over at the US Federal Reserve. To date everyone is imagining that interest rates in the US will continue to rise at a 'measured' or 'not so measured' pace. But with the current account deficit to worry about there will be a limit to how far Greenspan can push the difference in rates (or spread) without driving up the dollar, something I'm sure he dearly wants to avoid doing.

In principle Jean-Claude Trichet was ruling it out last week, but many analysts remain unconvinced, and feel that the next move in ECB rates may be downwards.

"Let me again be absolutely clear; we are certainly not preparing, madame, for any rate cut, not at all."

The problem is, for all the denials, the decision will really be a political one. The question is how much importance to give to the ill-fated German economy. Risks in the eurozone are not evenly balanced and there are assymetric downside risks involved in allowing German to wallow in the mire. The question will be how to weight those risks. Clearly any downward movement will be unpleasant news for any of the eurozone economies with an excess inflation problem, but that is part of the price you pay when you have a common currency:

Traders and investors had already ruled out any prospect of higher borrowing costs for the 12 countries using the euro. Now they are starting to bet that the Japan-style deterioration in the European economy may force an about-face from the ECB in the second half of this year.

The rate on the futures contract for June settlement has declined to 2.12 percent from 2.34 percent at the start of January, close enough to the ECB's benchmark lending rate of 2 percent to show that few investors believe Trichet's oft-repeated bulletins claiming rates are headed higher. The December contract, meantime, is down to 2.19 percent after a drop of almost half a point this year, as rate cuts ping the radar screen.

While that December value isn't yet low enough to guarantee that European rates are on their way down, it does show that those who see policy on hold are losing some ground to those expecting the ECB to be bounced into chopping the cost of money.
Source: Mark Gilbert, Bloomberg

Gilbert has a reasonable summary of the issues involved, so I won't waste time here going over them again.

As I said at the begining the really interesting consequence of any rate cut decision might be on currency values, and were a cut to happen we could see some subsequent surprises.

Wednesday, May 04, 2005

ECB: Plus ?a Change?

The ECB met earlier today to conduct the monthly review of interest rate policy. It came as a surprise to noone that the outcome was to leave everything just as it is. Surprisingly though the decision this month is surrounded by a little more controversy than has been the case of late since Italy's Berlusconi and economic opinion in Germany have been suggesting that some reduction of rates might be no bad thing, whilst Spain's economy minister (and former EU commisioner) Pedro Solbes is reported to have been pushing for an increase. Why the difference?

Well I think there are a number of good reasons why interest rate policy might be viewed differently depending on where you are sitting, but before going into any of these I could alert the economy freaks (and possibly also the masochists) among you the the 'grey men' of the ECB are actually going live with a video image webcast at 2:30 this afternoon where you can hear and see the statement read out and then follow the accompanying press conference.

(Short parenthesis, and following my post yesterday, it is immediately apparent to me that this 'webcast development' has a very interesting potential application in economics teaching).

Now for the nitty gritty.

The euro as a common currency has three known and clear problems: it is contingent on the evolution of a growing political union for its long term operability, it assumes that it is possible to evolve a single monetary policy for a diversity of economies, and it suffers from the difficulty of the well-known 'free rider' problem when it comes to fiscal policy and indebtedness.

I have drawn attention to the first of these - the political union dimension - in a post on the possible consequences of a (now apparently less likely but still possible) French 'no' to the constitution. Also Peter at EuroPolyphony linked earlier in the week to an FT editorial which gives a basic rundown on the issues, so I won't comment further here.

The second question, the 'one ring to fit them all' interest rate quandry is no less problematic. Basically the problem relates to possible differences between the inflation rate and the interest rate in each of the member countries. Essentially under 'normal' conditions a central banker would probably consider it desireable to maintain interest some 2 or 3 percentage points above the rate of inflation.

Such a setting would normally be considered 'neutral' since it neither tended to inflate nor deflate the economy. This then opens an arm of monetary policy for a central bank which can either raise the rate in order to reduce inflationary pressure or reduce it to ease oncoming recession.

Thus the US Fed (which is steadily and systematically raising rates incrementally) is being actively scrutinised for signs of anti-inflation tightening, whilst Japan (which has been suffering from some sort of deflation for the best part of a decade) maintains rates close to zero in a to date unsuccessful campaign to *provoke* inflation.

The US Fed policy at present is a kind of long march to achieve this 'normalisation' of rates precisely in order to restore some strength to monetary policy. But the weaknesses in the global economy following the bursting of the internet inspired assett bubble have made this an extremely difficult thing to do.

The ECB finds itself in a somewhat similar situation, with one important added difficulty: the inflation rate across the euroland member states in not uniform, and consequently what is known as the real interest rate (which is the difference between the central bank interest rate and the inflation rate) varies across the zone.

Germany and Italy would currently tend to favour a reduction since their economies are stagnating and inflation is relatively low, which means they have a positive real rate where a negative real rate might be indicated. Spain is at the other end of the scale, with an inflation rate of around 3.5% they have a minus 1.5% real rate and this is driving a mini boom based on a huge expansion in consumer indebtedness and a long property boom.

The clearest case of where the application of a single uniform rate would be extraordinarily unsound is that of the UK where the BoE currently has rates up at 4.75% precisely to try and reign in some of the problems which currently beset Spain. (This, of course, is precisely the reason that the UK is not in the euro).

Originally I suspect it was hoped that this problem would reduce in importance as euroland economies converged. Currently there is little evidence of this happening and my own feeling is that the problem will grow worse as the ineffectiveness of monetary policy only serves to make the imbalances worse.

Finally, a brief comment on the 'free rider' problem. Essentially membership of the eurozone has lead to a significant reduction in interest rates in those member states with living standards below the EU average. Initially this was considered to be one of the advantages of the euro, but inititially there was also a fairly strong and rigourous growth and stability pact in place.

This pact has now been significantly loosened and it remains to be seen how (if at all) the new version of the pact will be applied. It is in this context that the 'free rider' issue comes to the fore. Conventional economic theory has it that any government which allows itself to systematically run up debt will later have to resolve this problem by fuelling inflation to burn down the value of the debt (whilst simultaneously allowing the currency to fall), either it does this or it will face a growing finance problem as debt servicing (fuelled by higher interest rates) eats into current spending.

Now in the case of a currency union some of this no longer applies: weaker countries can continue to accrue debt almost without any financial constraint. This is what has been happening in some cases. The downside on this comes when there is some weakening in the guarantees and the financial markets start to sense this. Hence the jitters about the constitution votes.

Obviously the 'free rider' problem is a complex one. Two good background papers spell out in more detail some of the issues. The first from Marty Feldstein is a completely non-technical review from a long standing critic of the very idea of monetary union. The other from Barry Eichengreen is rather more technical (though it is possible simply to jump past the denser sections) and comes from an economist who is in general pro-euro.