Long live the ECB!

Politicians like scapegoats. There is no shortage of candidates. The European Central Bank is among them especially in France. It is unsurprising for several reasons: it is a bank, it is in Frankfurt, and a general lack of economic understanding mean that the electorate has limited knowledge of a central bank’s role and how it should act. As a result, the ECB’s positive effect on eurozone growth since 2001 is being completely overlooked.

The ECB is not obsessed with its objective of price stability. It acted pragmatically by reducing its refinancing rate to 2% and then holding it for 29 consecutive months even though inflation was above 2%, long-term bond yields were hitting historical lows, public deficits were expanding and the euro remained substantially undervalued. During this period, real short-term interest rates were zero or even negative. This policy led to a 60% increase in lending to French households, which is hard to square with claims of a restrictive attitude. Without the ECB’s accommodative policy, the eurozone’s growth – averaging 1.5% per year between 2002 and 2006 – would have been even weaker, by more than half a percentage point. Econometric analysis shows very clearly that the ECB places just as much importance on the economic cycle as the US Federal Reserve. Even today, the ECB is not adopting a restrictive policy, instead moving back to a neutral stance. By doing so, it is regaining some room for manoeuvre that could come in useful in the event of a negative shock.

Its monetary strategy is especially remarkable given the relative stability of eurozone prices. This shows that price stability – the objective assigned to the ECB by European governments – is not incompatible with growth. Nostalgia for the “trente glorieuses” – the 30-year period after World War II when growth and inflation coexisted in France – has led some people to hope for the return of inflation. They are forgetting the high interest rates during this period. Although inflation is now low, so are interest rates, and this is underpinning purchasing power and the ability to borrow long-term. Control over inflation increases visibility over relative price movements and improves the allocation of resources. The credibility of monetary authorities and a firm anchoring of expectations make it easier to attain the objective of overall price stability without having to raise interest rates too high. Conversely, doubts over the central bank’s independence and its commitment to price stability would prompt lenders to demand higher returns to compensate for the increased risk. This would push up interest rates, inevitably dragging down growth given the open economy and extensive use of market financing.

Neither can the ECB be accused of ignoring exchange rates. It is true that the euro is allowed to float, and started the decade seriously undervalued, without the ECB intervening. However, contrary to received wisdom, the ECB does take exchange rates into account. It does so indirectly through its inflation target, since a stronger euro puts downward pressure on prices, prompting it to set lower interest rates. It also does so in a more direct way: the euro’s effective exchange rate plays a significant role in its reaction function, which describes the way it sets its refinancing rate.

French politicians are keen to attack the ECB because they know how much lending growth has boosted growth and supported job creation. They know that the inevitable slowdown in lending will change the situation and require new economic policies. This will involve innovation incentives, but also greater competition in the services sector. Productivity in services must grow more quickly if per-capita wealth is to increase. However, this would require changes to the existing set-up, which is harder than simply criticising the European Central Bank. However, the resulting increase in purchasing power would be much greater.

7 Responses to "Long live the ECB!"

  1. christian   October 15, 2007 at 4:49 pm

    Europe Must Look East to Deal with the Euro
    http://www.iie.com/publications/opeds/oped.cfm?ResearchID=818

    The problem for Europe is that the inevitable further decline of the dollar will continue to occur mainly against the euro unless the large Asian countries and oil exporters permit substantial increases in the value of their currencies. Hence eurozone leaders should be addressing their concerns to Beijing, and to some extent Tokyo and Riyadh, rather than Washington, especially with the US current account deficit now falling and the budget deficit for fiscal 2007 at a mere 1.2 percent of GDP. Even if the euro were to rise a bit more against the dollar, large appreciations from the Asian countries and oil exporters would limit or even negate any further increase in its trade-weighted average and thus in the eurozone’s global competitiveness.

    Rather mysteriously, Europe has been largely absent from efforts to address global imbalances over the past three years, in spite of warnings that it had the biggest stake in a geographically diversified outcome. The obvious places to start are effective implementation of IMF rules against competitive currency undervaluation and “prolonged, large-scale one-way intervention,” and the World Trade Organization rules against “frustrating the intent (of the Articles) by exchange action” and export subsidies, as Ben Bernanke, Federal Reserve chairman, has labeled China’s currency practices. Perhaps a euro at $1.50 or $1.60 will focus European minds on these imperatives.

  2. Anonymous   October 15, 2007 at 8:01 pm

    Good piece and arguments. But some argue that the ECB cut rates too little too late in the 2002-2006 period and this explains in part the mediocre growth of the Euro area in that period. Even if one can agree that potential growth in that area is lower than the US – say only 2% or 2.3% – a growth rate of only 1.5% in that period cannot be explained by structural/trend factors alone. Thus macro policy – and tight ECB policy – may be part of the story. So i dont find it easy to fully cheer the ECB that may have been too inflation obsessed for too long.

  3. Anonymous   October 15, 2007 at 11:34 pm

    You say: “the euro’s effective exchange rate plays a significant role in its reaction function, which describes the way it sets its refinancing rate.”
    That is news to me: can you elaborate on this?

  4. Richard   October 15, 2007 at 11:36 pm

    Well taken critique of the ECB’s bashers. But what should the ECB do next based on your analysis: hold rates, raise them or ease them?

  5. Guest   October 16, 2007 at 5:11 am

    Negative Eurozone repo rates (vs.Eurozone PPI) since late 2002. Problems arising from this should spring from diversity in the Area. Perhaps one can differentiate countries on ;) :( scale.

  6. Guest   October 16, 2007 at 10:26 am

    How is the eurozone supposed to expand its capacity frontier via productive investment (i.e. not housing/construction) thus increasing potential growth and productivity and GDP per head along its way if the ECB steps in as soon as the current 2.25-2.5% potential growth estimate is approached? The conspicuous lack of investment in large eurozone countries in the past decade points in fact to a systematic demand deficit rather than a supply deficit.

  7. cm   October 17, 2007 at 2:35 pm

    http://www.petersoninstitute.org/publications/papers/paper.cfm?ResearchID=815
    by Michael Mussa, Peterson Institute
    For 2008, the slight moderation in the projected growth rate, down to 2 percent, is consistent with the accumulating evidence that the potential growth rate in the euro area is no higher than 2 percent and probably slightly lower. Additional evidence that potential growth is no greater than 2 percent comes from the fact that the unemployment rate in the euro area has declined further over the past year down to 6.9 percent while the economy’s growth has been only moderately greater than 2 percent. The fact that the present unemployment rate in the euro area is half of a percentage point below the minimum that was reached during the preceding expansion suggests that margins of slack may already have been exhausted. I would not push this point too hard. Levels of structural unemployment may well have declined in several euro area economies from what they were six or seven years ago—a good thing if it has happened. However, euro area unemployment rates probably cannot keep on declining by half a percentage point per year for much longer without raising inflationary wage pressures.