In light of the ECB rate rise yesterday the Wall Street Journal has a great article on the current perceived contradictory position held by the European Central Bank.
The European Central Bank is trying to rescue the euro and keep a lid on inflation. It will find it can do one of these, but not both. This because the ECB’s two aims are incompatible.
On Thursday, the bank took aim at Germany’s incipient inflation problem by raising its key interest rate by a quarter of a point to 1.50%. This follows a similar increase in April. The move was almost universally anticipated in the markets; ECB President Jean Claude Trichet had virtually promised it in his public statement after the bank’s June policy meeting.
Keynesian economists have long argued that the ECB’s focus on inflation is wrong-headed and ultimately self-defeating. In part, that’s because in seeking to pursue monetary policy to suit Germany and other core economies it is condemning the periphery to debt deflation.
Eurostat, the European statistics agency, estimated euro-zone inflation was 2.7% in June, unchanged from May’s level. That’s substantially above the ECB’s target of just under 2%. Although much of this overshoot is related to commodity price rises, particularly food and energy, and to tax increases in peripheral euro-zone countries struggling to rein in their budget deficits, the ECB is also worried about the German economy hitting its capacity constraints.
Germany’s manufacturing sector is growing at a scorching pace. Orders jumped 23% on the year to May. And it’s no longer just an export phenomenon; much of this upturn is credited to a hefty jump in domestic demand. German orders rocketed 11% on the month. German unemployment levels are at their lowest since the start of 1992 and though earnings growth has been well-behaved so far this year, economists expect wage demands to pick up to levels that could spur a domestically generated inflation cycle next year.
To hold German inflation at 2%, the ECB will have to keep raising interest rates. But given that peripheral euro-zone economies are already struggling to grow, rate rises will only cripple them further. Apart from their debt burdens, the fundamental problem with these economies is that they’re not competitive relative to Germany. To regain competitiveness, they need the cost of German labor and other inputs to rise faster than their own. But if the ECB is intent on containing German prices, those in peripheral Europe will have to fall.
Deflation makes it that much more certain these heavily indebted countries will default on their obligations. After all, deflation increases the burden of existing debt in real terms. And because wages adjust only slowly, it tends to push up unemployment, slow economic growth and force government deficits to widen. The Greek government failed to meet the budget targets set by its first bailout plan last year in part because austerity made it undershoot growth expectations. Both Portugal and Ireland are likely to have to tighten belts even further to meet their own shortfalls this year.
Eventually, governments pursuing ever more austerity with little or nothing to show for it throw in the towel. In their seminal study of sovereign defaults, “This Time Is Different,” U.S. academics Carmen Reinhart and Kenneth Rogoff showed that the most usual way for governments to escape crippling debt is to renege. Bond market yields suggest investors are almost certain of Greek and Portuguese defaults over the next couple of years.
Most commentators agree that a default by a euro-zone member would probably trigger its exit from the single currency. Of course, core European countries could take on the periphery’s debt burden, though this is a politically tricky proposition. More likely, they’d choose to recapitalize domestic banks hit by the default.
As the repository of huge volumes of peripheral sovereign debt, the ECB would be most in need.
As long as bond investors remained willing, core euro-zone governments would probably seek to raise funds in the market rather than force taxpayers to cover the losses immediately. But a fresh explosion of government borrowing, on top of what was already done during the financial crisis, would ultimately prove inflationary. Were governments to balk at refinancing the ECB, the central bank could always print money to cover its losses. But this sort of debt monetization also risks creating inflation.
So far, the ECB is still hoping it can control inflation in the core while allowing enough growth for banks to build their balance sheets up to a level at which they can withstand a series of peripheral defaults when they ultimately come, according to Edward Hugh, an independent economist specializing in the euro zone.
Mr. Trichet’s Italian replacement at the ECB, Mario Draghi, who takes over this autumn, will probably maintain the bank’s hawkish stance for fear of being seen as reverting to national stereotype and being soft on inflation.
But once this policy is seen to be precipitating an existential crisis for the euro as peripheral countries give up the ghost, the ECB is likely to abandon its commitment to price stability and go for inflation. Of course, by the time it does, it could well be too late.
As I have stated many times previously, a major issue for Europe is the fact that their macroeconomic environment doesn’t provide a stabilising mechanism in the trade between countries of differing productivity. It is no coincidence that Germany continues to gain in economic strength as the periphery fails, that is how the European economy functions. Europe has two choices, either one group of countries leaves Euro or it creates a true monetary and fiscal union where the richer nations accept that they will have to fund the weaker nations while profiting from them.
The raising of interest rates at a time when the European periphery is weak (and in some instances near default) will have very obvious consequences, yet at a press conference yesterday Trichet clearly stated his strong position that he will not accept any form of default by Greece and that it was up to the EU nations to work out a plan that would not lead to a default.
As German Chancellor Angela Merkel flirts with solutions to the Greek crisis that rating companies say would amount to a default, Trichet says leaders can’t repeat the mistakes made by U.S. officials when they let Lehman Brothers Holdings Inc. fail.
“No credit event, no selective default, no default,” he said at a press conference in Frankfurt yesterday.
However yesterday we also saw the ECB explicitly back Portuguese debt even as the rating agencies said it was “junk”.
The Governing Council of the European Central Bank (ECB) has decided to suspend the application of the minimum credit rating threshold in the collateral eligibility requirements for the purposes of the Eurosystem’s credit operations in the case of marketable debt instruments issued or guaranteed by the Portuguese government. This suspension will be maintained until further notice.
The Portuguese government has approved an economic and financial adjustment programme, which has been negotiated with the European Commission, in liaison with the ECB, and the International Monetary Fund. The Governing Council has assessed the programme and considers it to be appropriate. This positive assessment and the strong commitment of the Portuguese government to fully implement the programme are the basis, also from a risk management perspective, for the suspension announced herewith.
The suspension applies to all outstanding and new marketable debt instruments issued or guaranteed by the Portuguese government.
So on one hand we have Trichet stating that in the case of Greece it cannot default, but it isn’t up to the ECB to sort it out. Yet in the case of Portugal the ECB has very pro-actively changed its own rules to do exactly that.
The only way I can reconcile these two positions is to interpret Trichet’s stance on Greece as a jawboning manoeuvre to put pressure on European governments to accept his long term vision for the EU. With only 4 months to go as the head of the ECB it looks as if he is trying to jawbone the EU into accepting his grand vision.
[While] receiving the Charlemagne Prize for services to European unity on June 2, Trichet dared governments to give up at least some of their sovereignty to prevent a repeat of the region’s current financial turmoil.
“Economic and Monetary Union is itself an unprecedented achievement in the history of sovereign nations — a goal to which generations of Europeans have aspired,” he said. “It is vital that all nations engage fully in the European historical endeavor and look with confidence to the future.”
It is what they need, but I can’t see it happening.