June 05, 2003

The Economist Sounds... Shrill

The Economist sounds "shrill"... like Paul Krugman, in fact... as it contemplates the state of European monetary policy, the start of a new recession in the industrial core of western Europe, and the still-low but non-zero dangers of deflation. I wish it had come to the party earlier, but the refreshments the Economist is bringing are still very welcome:


Economist.com: ...The euro-area economies are caught in a bind. The ECB has been consistently reluctant to use monetary policy to provide the sort of short-term stimulus which countries like Germany urgently need. Europe?s largest economy is now technically in recession, and the growth outlook for the euro area as a whole is grim this year and next. Careful examination of what the ECB has said about the role of monetary policy and what it has actually done shows that it has in the past been prepared to pay attention to broader economic objectives and not confine itself only to questions of inflation. Rate cuts have sometimes been implemented when inflation was above the target range. But what appears to be, at best, the ECB?s own confusion about its role has ensured that, on balance, monetary policy has been less effective in preventing an economic slowdown than it might have been.

Even worse, for Europe?s policymakers, is the fact that they cannot rely on fiscal policy instead. Alan Greenspan, the influential Fed chairman, said on June 3rd that he was generally opposed to using fiscal policy for short-term stimulus. But he then went on to concede that the timing of the controversial tax-cut package recently signed into law by President George Bush was fortuitous. In Europe, though, the rules agreed when the euro was established impose tight budgetary constraints on governments. Where the budget rules are being breached, Germany being an obvious example, policy is geared to bringing the deficit back within the limits--just at a time when most economists would argue some fiscal relaxation is desirable.

The ECB has regularly blamed Europe?s poor economic performance on the failure of euro-area governments to implement the necessary structural reforms which would make labour markets more flexible and reduce the large welfare costs that currently bedevil many countries. The ECB has a point. But such economic reforms, even when embraced with enthusiasm, can take years to have any impact. Arguing the case for reform is a red herring when what Europe most urgently needs is stimulus.

The question now is whether the ECB will cut interest rates further in the coming months. The bank?s governing body almost visibly bridles when economists and politicians seek to apply pressure for monetary relaxation. But more pressure there is bound to be. The sharp rise in the euro in recent months has had the effect of tightening monetary policy: it is not clear that the latest rate cut fully offsets that...

Posted by DeLong at June 5, 2003 10:07 AM | TrackBack

Comments

They've been criticizing the ECB and the stability pact for quite some time now-- at least as long as they've been criticizing US farm policy (not as heavily as France's, I might note).

Did you see the profile of global real estate bubbles last week? That was also a ringing alarm bell.

Now, whether "shrill" is a compliment, I don't know.

Posted by: verbal on June 5, 2003 10:24 AM

Yes, "shrill" is a compliment...

Posted by: Brad DeLong on June 5, 2003 10:28 AM

The ECB's ease today was followed by a sharp rebound in the euro, interpreted by some as reflecting expectations that: A) the ECB, having cut by 0.5%, is done for a good while, or B) the Fed is more likely to do 0.5% now that the ECB has, or C) both.

"A" worries me, while I take "B" to be a profound misunderstanding of how the Fed makes policy decisions. However, look for B) to get a good bit of attention if the Fed really does cut by 0.5%.

Posted by: K Harris on June 5, 2003 11:23 AM

One thing driving the eur/usd is the fear by foreigners that Greenspan is willing to do anything against deflation, including printing money. This all-out battle is supported by many, although in the next breath they will say *of course* they don't want to do anything which devalues the dollar. Could someone please tell me how you can do this?

Posted by: Andrew Boucher on June 5, 2003 12:41 PM

Since the ECB's move was widely anticipated, I don't think that a euro rise has to be particularly meaningful. However, I think it is more likely than not that the Fed will cut rates this week, especially with the not-so-good employment and manufacturing orders data.

As the Fed continues to pump liquidity into the system, it is going to be hard for the ECB not to follow suit.

Posted by: Matt Wilbert on June 5, 2003 01:09 PM

What looks irrational to me is that when expecting the ECB to lower the rate made the $/ go down, and when the ECB effectively lowers that rate that ratio goes up by nearly a 2% (the had almost the same behaviour, why? there were no changes of rates involved)

DSW

Posted by: Antoni Jaume on June 5, 2003 02:34 PM

"What looks irrational to me is that when expecting the ECB to lower the rate made the $/ go down, and when the ECB effectively lowers that rate that ratio goes up by nearly a 2% (the had almost the same behaviour, why? there were no changes of rates involved)"

Expectations, it's all about expectations ...

Posted by: Abiola Lapite on June 5, 2003 04:36 PM

I dont think it matters what the ECB does now - its already too late for monetary policy to be effective. The current crisis (and it is a crisis) was perfectly foreseeable a year ago and they should have been acting then.

If I was his Maastricht partners I'd be telling Schroder to forget the stability pact for a while; it's in no-one's interests for Germany to go the way of Japan. If this upsets the bureaucrats and lawyers too much, then his buddies should connive at him using Enron-style accounting for a while ("reforming" the accounting treatment of Germany's share of the EU budget might do some of the trick).

Posted by: derrida derider on June 5, 2003 04:40 PM

I dont think it matters what the ECB does now - its already too late for monetary policy to be effective. The current crisis (and it is a crisis) was perfectly foreseeable a year ago and they should have been acting then.

If I was his Maastricht partners I'd be telling Schroder to forget the stability pact for a while; it's in no-one's interests for Germany to go the way of Japan. If this upsets the bureaucrats and lawyers too much, then his buddies should connive at him using Enron-style accounting for a while ("reforming" the accounting treatment of Germany's share of the EU budget might do some of the trick).

Posted by: derrida derider on June 5, 2003 04:41 PM

I don't agree that ECB action doesn't matter. It is quite possible that it is too late to stimulate the Germany economy effectively, but that isn't the same thing.

Without rate cuts, the Euro will continue to rise against the dollar, weaken exports, intensify the European deflationary trend, and possibly push other countries into Germany's unfortunate sitation. That said, the stability pact is a bad idea, and we can hope that some method of circumventing it can be found.

Posted by: matt wilbert on June 5, 2003 06:13 PM

It's not about short-term interest rate cuts. The ECB could cut them to close to zero over the next year, and I don't think that would change the market perception. The idea in the market is that the U.S. might - not will, but there's a probability much greater than 0 - debase the value of its money, in order to fight deflation. Does a rational individual wait the future date when the money gets debased? No, he gets rid of his dollars now.

Posted by: Andrew Boucher on June 6, 2003 02:15 AM

We are discussing two different time frames here. The notion Andrew Boucher raises, an intentional weakening of the dollar, should not have changed as a result of the ECB cutting rates, so doesn't do much to explain the wiggles in Eur/Usd rate around the ECB policy announcement. Watching the wiggles around the ECB announcement could be helpful in judging expectations. On that count, Abiola Lapite's comment echos an old traders rule -- buy the rumor, sell the fact. The dollar had firmed against the euro for a few days prior to the ECB move (buy rumor), and upon the ECB doing what was expected, those positions were covered (sell fact). Which leaves us fairly sure the ECB is getting better at telegraphing policy, but not knowing much about the future -- the trend in Eur/Usd does not seem to have changed.

Posted by: K Harris on June 6, 2003 04:52 AM
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