The Most Bizarre Monetary Policy DecisionOf Recent Times?

This was Wolfgang Munchau writing in the Financial Times a week ago:

"The pre-announced interest rate rise that the European Central Bank is due to agree this Thursday must rank as one of the most bizarre monetary policy decisions of recent times. The economic recovery in the eurozone remains fragile, as last week’s German confidence indicators have shown. Even the ECB’s own forecast for headline inflation is relatively optimistic, while core inflation remained unchanged at 1.5 per cent in October."

and he issued a warning:

"It is still not too late to propose ECB reform as part of the next treaty revision. For as long as EU leaders maintain the status quo, they have the central bank they deserve."

Central bank independence seems to be once more 'a l'ordre du jour', and the ECB may well live to find to its cost that there is one thing worse than actually playing the game, it's playing the game and losing. Now why?

Well as I try to explain in this post, we really are locked into a very weird at wonderful economic conjuncture right now. The US economy is exhibiting relatively sound and sustainable growth. Germany, Japan and Italy are not. This is producing all manner of imbalances, and this is what the controversy is all about.

Opposition to the decision to raise rates has been pretty universal from eurozone finance ministers, and it has been pretty general from ECB independent economists too. Paul de Grauwe, also writing in the Financial Times thinks it was a simply victory for the policy hawks inside the bank. As he said:

Barely two weeks ago the European Central Bank issued its monthly bulletin containing an analysis of the perspectives for inflation in the euro area. In a nutshell the story was the following.

Yes, yearly inflation has increased to 2.5 per cent (October 2005) and this is a source of concern for a central bank that has promised to keep inflation below 2 per cent. But, as we all know, a central bank that targets the rate of inflation should be forward looking and base its interest rate decisions on the expected future rate of inflation. The remarkable thing about the analysis is that, after voicing its concern about current inflation exceeding 2 per cent, it came to the conclusion that the perspectives for future inflation were favourable.

It is worth quoting the conclusion: “The latest indicators do not point to a strengthening of underlying domestic inflationary pressures in the euro area. Wage increases, in particular, remained contained against a background of ongoing moderate economic growth and of labour market prospects that are still subdued. This assessment is broadly shared by private sector forecasters”. And, indeed, these forecasters almost all predicted and continue to predict a rate of inflation around 2 per cent for the next two years.

The sensible conclusion from this analysis was and still is that there is no reason for a central bank that cares only about inflation (let alone one that cares about other things too) to raise the interest rate. So the ECB correctly concluded two weeks ago that there was no reason for an increase. Of course, it added that vigilance was required, but do we not all have to be vigilant in a world where risks of all kinds lurk around every corner?

So what happened since the beginning of November?

Exactly, what has happened since the 1st November, well, at the risk of being a pain, I would say that the threat of a yield curve inversion in the United States has increased significantly - with the disconnect between US and eurozone growth as the driver - that is what has happened.

As the FT notes, EU politicians are trying to put a brave face on things, but this is uphill work. Perhaps the most significant among the many comments was not the observation from Dominique de Vllepin's politically correct “My belief is that the ECB wouldn’t do anything that would compromise economic growth in the EU.” but rather Christian Noyer - Governor of the Bank of France - saying ``we don't have anything else in our pocket for now......it's not forecast that it's the beginning of the cycle.'' (M. Trichet it will be noted is French, and this decision - and indeed even a bit more of the same - would arguably be quite appropriate for the French economy).

So the ECB 'easing cycle' may well be over, even before it actually got started. My own view is that this has been an extremely foolish move on the part of the Bank, and - as Munchau indicates - they are playing with fire here (as is incidentally and on the other side of the planet the Bank of Japan). If they have read the tealeaves badly (and I think they have) and if the German data fail to improve and the Italian data turn downhill again (which I think might well happen) then this may be the last time the ECB will dare to make a decision which isn't approved of by the finance ministers first.

So was this a balanced risk? Was it wise - or even, god forbid, prudent - to try and call the shots when only a quarter point is in play. I think not. If I was going to make a risky call, one which could threaten my long term independence methinks I would want to do it for something a bit more susbtantial.

But then wishy-washyism has long been one of the defining characteristics of the ECB.

One last, almost anecdotal point, the ECB has, as the FT indicates taken this decision laregy on M3 money supply grounds, viz: "ECB fears had been reinforced by its analysis of money supply figures, which it regards as signalling long-term inflation trends – in spite of scepticism among other central banks".

The scepticism which the FT is referring to is the recent decision of the Federal reserve to stop monitoring M3, which is the key indicator currently used by the ECB. Irony on irony I think.

Many economists have pointed out that, at the end of the day, a quarter point change, even if it's a quarter point in the wrong direction, isn't a make or break issue. Quite right. Let's not get things out of perspective. This won't be disastrous, except, of course, just possibly, for the ECB itself. As Dave Altig says "the ECB has played its hand", fine, but let's just hope that this time next year it is is still in a position to be able to deal the cards.

Between A Rock And A Hard Place

US Economist Arnold Harberger once asked what Thailand, the Dominican Republic, Zimbabwe, Greece, and Bolivia had in common that merited their being placed in the same growth regression analysis. I can't help having the same feeling about Germany, France, Italy and Spain. As I indicated in a post on A Few Euros More yesterday, its sometimes hard to see the common thread.

Be that as it may, this post is only about one of the 'big four': Italy. As I say in the Afem post, Italy is bucking the trend. Unfortunately it is bucking it in the wrong direction.

Growth in Italy in the third quarter actually decined from a 2.8% annualised rate to a 1.2% one. This suggests the Italian economy is losing steam not gaining it. Add to this two additional pieces of data.


Firstly inflation: Italy's EU-harmonised consumer price inflation was 2.6 percent year-on-year in October, actually increasing from September’s 2.2 percent rate. This put Italy again in sharp contrast with the picture in the two biggest Eurozone economies, Germany and France (Spanish inflation continued apace). German annual inflation was 2.4 percent in October (down 0.2 percent from September), while French inflation slowed to 2.0 percent (down 0.4 percent from September). This increase in inflation in an Italian economy which is slowing down is distinctly worrying, bevasue it seems to suggest that productivity may well still be in negative territory, and that the Italian economy is resisting the restructuring pressures in a way in which the German one, for example, didn't.

Secondly, Italy's balance of payments situation continued to deteriorate, and this despite the declining euro. Italy’s trade deficit increased to 2.15 billion euros. That was up from a revised 0.39 billion euros in August and suggests the depreciation of the euro this year has done little to boost export competitiveness. The widening of the trade balance in Septemberalso came despite a rise in the value of Italy’s exports to just under 26 billion euros (up from 19.43 billion in August), and thus logically it is the result of a sharp increase in imports, from just under 20 billion euros in August to over 28 billion in September. These results are probably way to early top see what the full impact of the euro devaluation will be, but stil they are hardly encouraging.

I emphasise all this, since we had some debate last week about how real the threat of a sovereign debt downgrade for Italy was in practice. Well, all I can say is that if these numbers continue like this, it is hard to see the Italian government risking deteriorating the situation even further by really implementing meaningful fiscal tightening, and if they don't introduce meaningful fiscal tightening it's hard to see how they can avoid further downgrades. As I said: between a rock and a hard place.

Promises, Promises, But More Than A Technical Detail

Well the eurozone government deficit problem has hit the agenda with a thud again in the last few days. Yesterday the FT ran a story about how the ECB has decided that it will not accept government paper (bonds) in the future from any country which has not maintained at least an A- rating from one or more of the principal debt assesment agencies. (Dave Altig at MacroBlog has also covered the story here, and Nouriel Roubini here). Today the FT has another story about how Trichet has confirmed the policy, and how the Commission too plans to get tough (well they would, wouldn't they, since this may now become a credibility auction).

This topic must appear appaulingly technical and yawn-provoking to the non-economist. In fact nothing could be further from the truth. Let me explain a bit.

Basically the situation we have had to date has been that the ECB has accepted the bonds of any one country as equivalent to the bonds of any other, just like a one euro coin from France is treated as equivalent to a one euro coin from Finland in any shop in the Eurozone. The ECB makes its presence felt on this via the assets it accepts as reserve deposits from eurozone central banks.

Now basically this decision is a vote of only limited confidence in the mechanisms put in place by the EU commission via the Stability and Growth Pact. Italy has been given two years grace to put its house in order. Serious doubts remain as to whether anything will really change significantly during the next two years, but if it doesn't the fiscal credibility of the Commission will be in tatters. The ECB is cleary concerned that its credibility may also go west in the process (a clear case if there was one of 'credibility rot'). So the bank has put up a marker: here and no further. This is always a difficult thing to do, since if you ever say never, and then change your mind, you obviously end up with egg all over your face (the 'moral hazard' issue is all about this).

This decision is an important one (I would even say a landmark one) since it is hard to see how there can be a turning back. Basically the ECB is saying to the Italian government: you may be able to pull the wool over their eyes up in Brussels, now try the same ploy with the rating agencies.

Well, if the Italian government desists from excess deficits there will be no issue, but my fear is that they may not be able to.


Basically, and plagiarising Brad Setser and Nouriel Roubini just a little: 'demographics also matter'. The problem isn't simply that Italy has had a series of governments that have been systematically profligate. It also has possibly the most rapidly ageing population on the planet (it is about to overtake Japan, and then in turn be overtaken by Spain as the oldest country if the UN projections are valid). So this is about sustainable fiscal dynamics and tax wedges vis-a-vis employment generation. The Italian government really is between the proverbial rock and the hard place.

In reality I imagine that what we will see is a steady drift away from central bank willingness to hold Italian paper in reserves (it is important to bear in mind here that the ECB itself has relatively little capitalisation, and each country still has its own central bank, and its own reserves). So the other central banks (and who knows, Asian central banks and anyone else who holds sizeable quantities of eurozone paper) may well slowly move Italian paper out of their reserves. After all, if the ultimate guarantor isn't willing to accept at par, who else is going to risk it.

The consequence of this is that the so-called yield spread - the difference in effective interest rate operating on a 10 year German bund and that on a similar bond from the country in question - should start to widen (at presnt Italian bonds are trading with a differential of a little over 20 base points, or 0.2%, over the German bund). This is very likely now to widen: probably slowly but steadily.

Morgan Stanley economist Joaquim Fels (who I do think is at least listened to over at the ECB these days) has been arguing for some time now that the fact that the ECB treated all euro-govt-bonds at par was one of the principal anchors preventing a thickening in the yield spread. Well now the anchor has been cut (rather than weighed). What can now happen is that each time the Italian deficit fails to comply with promises and forecasts, someone, somewhere can try and test the spread. In the beginning I imagine this will be a non event, but just give it time. A little crack has open up in the wall, and now some will know no rest until it has finally been breached. The ECB decision has opened up the real possibility of speculative attacks against sovereign debt inside the eurozone, and this is obviously a first, in fact *the* first new possibility on the horizon since the euro was launched.

As I say, I think a decision like this is very hard to go back on, so it is difficult to see how the ECB could 'blink' here even if it wanted to. A 'bail out' could be arranged indirectly if the yield spread grew too much, but to keep doing this you need to be convinced that Italian growth and fiscal policy will get back onto a sustainable trajectory. I am not convinced that they will, and thus there may well be a 'high-noon' situation.

Of course, we are only at the begining of a long process here, butas I say I think this decision is a landmark one.

Also, again plagiarising Nouriel Roubini and the late lamented Rudi Dornbusch: politics matter. The backdrop to all this is the recent failure of the EU constitution vote, long standing frustration at Eurostat about blatantly falsified Italian data, and now the Fazio affair, where EU internal market commissioner Charlie McCreevy seems to be so frustrated that he is actually demanding that legal action be taken against the governor of the central bank in a sovereign state. I guess this would also be another euro first.

Many worry these days about the level of tolerance for globalisation and the dangers of protectionism, but my guess is that the danger of a kind of 'internal protectionism' inside the EU, with citizens in one country being reluctant to bail out citizens in another, is a much more real and present danger. Note how Dutch finance minister Gerrit Zalm has taken a ringside seat to applaud the ECB initiative.

Bottom line: we've just pushed the boat out and there may now be no easy way to draw it back in again.


Anybody wanting a more serious academic background explanation to all this could do worse than this paper by Buiter and Sibert: How the Eurosystem’s Open Market Operations Weaken Fiscal Discipline in the Eurozone (and what to do about it) (Hat Tip to Nouriel Roubini).

ECB Interest Rate Policy

Brad Setser has a post today on Kate Moss, not provoked by her evidently economically intriguing modelling properties, but due to the Kate-Moss-thin credit-spreads which Bloomberg's William Pesek refers to in this article. What really turns Pesek on it turns out isn't Kate Moss at all but the possible existence of links between China's economic boom and the recent surge in popularity for credit derivatives.

And it is in the context of this evolutionary chain that Brad Setser's work on China and Systematic Risk offers itself as some kind of missing link.

But as I continued reading Brad's post, and even more so Pesek's argument that current global growth "comes against the backdrop of a readiness by China -- and other Asian central banks -- to keep its currency from rising and the U.S. dollar from falling. It has put a floor under the dollar and a ceiling above U.S. debt yields.", I couldn't help but forget Kate Moss and move onwards and upwards to the issue of the current interest rate policy debates revolving around the ECB.

Essentially I think there's a topic here which isn't getting the discussion it deserves. The US Federal Reserve is currently taking responsibility for attacking some of the global imbalances which everyone is talking about. It is doing this by starting to target house prices in the US. On this topic see this post from Stephen Roach, and this speech from Alan Greenspan, in particular this:

"...it is difficult to dismiss the conclusion that a significant amount of consumption is driven by capital gains on some combination of both stocks and residences, with the latter being financed predominantly by home equity extraction. If so, leaving aside the effect of equity prices on consumption, should mortgage interest rates rise or home affordability be further stretched, home turnover and mortgage refinancing cash-outs would decline as would equity extraction and, presumably, consumption expenditure growth. The personal saving rate, accordingly, would rise."

"Carrying the hypothesis further, imports of consumer goods would surely decline as would those imported intermediate products that support them. And one would assume that the U.S. trade and current account deficits would shrink as well, all else being equal. How significant and disruptive such adjustments turn out to be is an open question."

Ergo, squeezing mortgage rates squeezes consumption which ultimately hits imports and reduces the US trade and current account deficit. This is thus the path on which Greenspan has embarked.

There is a problem though..... if the Fed continues the interest raising process, but the ECB stays put, the dollar will continue its gentle rise driven by the yield differential, and this will offset what Greenspan and Co are trying to do with the US CA deficit.

So..... my guess is that at the ECB they are already coming under significant pressure to raise in the not to distant future simply to support the Fed initiative (which I am sure Trichet would be the first to accept is in everyone's interest). This pressure was, I feel, evident in the emphatic statements coming from Trichet after the last ECB meeting, statements which are, perhaps hard to comprehend if you don't look at the complete picture.

But of course, raising eurozone rates will be controversial politically, since in the case of Germany (and almost certainly Italy) it is hardly indicated.

Bloomberg this morning draws attention to the great lengths to which the EU finance ministers went yesterday to stress that they didn't think inflation was a great looming problem in the eurozone. This can only be read as directed at the ECB.

Reporting on the meeting Austrian Finance Minister Karl-Heinz Grasser stressed that he didn't " see any inflationary pressure..Interest-rate moves are not necessary, at least this year.''

Economics Commissioner Joaquim Almunia basically backed them up: "There continues to be no evidence of second-round effects stemming from higher wage growth, but there is no room for complacency,''

I imagine they really loved this over at the ECB and, of course, across the pond at the FED.

Basically what I am arguing here - for reasons which flow essentially from the great Kate Moss debate - is that either the Fed stops, or the ECB has to raise. Globally, if you take the rebalancing arguments seriously the first can't happen, so the second - at some stage - has to. But just watch out for the fall-out.

Eurozone More Exposed?

Chief OECD economist Jean Philippe Cotis wasn't only proferring recommendations to the Federal reserve yesterday. He was also not backward in coming forward with his opinions about future growth in the eurozone. Even if Cotis isn't exactly my favourite economist I feel here he may be a little nearer the truth.

The occasion for M. Cotis' observations was the official press briefing for an interim OECD assessment of the economic situation in Europe, the United States and Japan.

As the Financial Times puts it:

The eurozone economy is suffering chronically weak demand, is more vulnerable than the US to an oil price shock, and could be at risk from deflation, the Organisation for Economic Co-operation and Development warned yesterday.

In his latest global economic assessment, Jean-Philippe Cotis, the OECD's chief economist, said signs of a pick-up in European economic activity could not be described as "anything other than a technical recovery at this stage", although some recent German investment data had been more encouraging. Monetary policy needed to be "highly accommodative", he said.

But there's more:

Mr Cotis argued that the eurozone's "chronic demand deficiency" had been reflected in the trend decline in the "core" inflation rate - excluding energy and food prices - to an historic low. One, optimistic, explanation was that prices had become more flexible, helping to ensure price stability over the long term. A more pessimistic interpretation was that the eurozone "could be in danger of entering into deflation", Mr Cotis said.

Mr Cotis argued that coping with the oil price shock was likely to be easier for countries such as the US, where the economic expansion was broader based. In the eurozone, the shocks had been milder but "resilience is below that in the US".

Now this comes hot on the tail of an earlier report in the FT (which strangely still has offered us no details of its source) that ECB research was leading to a lower eestimate of the potential long-term growth rate of the eurozone economy:

According to the FT, it emerged on Monday (5 September) that long-term growth in the Eurozone lies no higher than 2 percent ? and possibly even below that. The ECB primarily blames demographic factors for the shift in its growth projections. While European populations have continued to grow older, participation of several groups in the labour force has been disappointing ? sparking sluggish productivity growth.

The bank sees its changed forecasts as a call upon governments in the Eurozone to step up structural reforms in their economies, particularly in their labour market, the FT notes. Long-term growth projections in the UK, which is outside the Eurozone, lie at just below 3 percent, while the "potential" growth in the US is even higher - at 3 percent or more.
(Source EU Observer)

I've cited the EU Observer version here, since it is actually more explicit than the original FT version I saw. They obviously have had sight of a document I have yet to see. As regular readers will appreciate I regard this as 'light at the end of the tunnel' news, since I think this marks the first time I have seen the demographic issues (which have long been around in things like the pensions debate) explicitly recognised as a factor influencing immediate growth problems and listed amongst topics to address in even short term monetary policy. After years of arguing without response, is there a chink of light here?

On the other hand Cotis's 'throw money at the situation' suggestion, seems well behind the curve, since, in case he hasn't noticed, they're already doing that, and in the German case it just isn't working.

Oooops It Isn't Baaack....

Morgan Stanley team members Steven Jen and Eric Chaney (joined by Takehiro Sato and David Miles) debate today the interesting question of whether the eurozone economies have entered a liquidity trap (LT). Those who have no idea what one of these would look like could do worse than read Paul Krugman's classic article on the topic: It's baaack! Japan's Slump and the Return of the Liquidity Trap (pdf).

So what is all the fuss about?

Well first of all my apologies if this is pretty sketchy, but as you probably have noticed my principal attention is elsewhere right now.

Basically the problem that is getting people scratching their heads is why the eurozone is so resillient against growth. With interest rates at a pretty low level, and monetary aggregates very generous, why isn't the thing taking off? (This is a bit like the other part of the puzzle, Bernanke's savings glut, either you get it or don't get it IMHO).

Now what do they mean by a Liquidity trap? Well the first thing to note is that they aren't referring to it in the strict technical keynesian sense (as Takehiro Sato points out). Len says he is using a loose definition of a liquidity trap in the sense that monetary easing has muted effects on domestic demand. Eric Chaney points out that this is a necessary, but not sufficient condition for having an LT:

"I see two well documented macro situations where a Keynes-type liquidity trap is emasculating monetary policy. The first one is when real interest rise independently from monetary policy because of outright deflation. The second one is when banks are not able to pass lower rates to their customers because of damaged balance sheets. This case may be reinforced by regulations such as solvency ratios. These two types are not exclusive."


Actually the damaged balance sheet issue is normally associated with the bursting of a bubble, and this may be an entry route to deflation, but it is not the only one, and it is not the defining characteristic.

Enter Krugman:

"A liquidity trap may be defined as a situation in which conventional monetary policies have become impotent, because nominal interest rates are at or near zero - so that injecting monetary base into the economy has no effect, because base and bonds are viewed by the private sector as perfect substitutes. By this definition, a liquidity trap could occur in a flexible-price, full employment economy; and although any reasonable model of the United States in the 1930s or of Japan in the 1990s must invoke some form of price stickiness, we can think of the unemployment and output slump that occurs under such circumstances as what happens when the economy is ?trying? to have deflation - a deflationary tendency that monetary expansion is powerless to prevent."

I'll stick with Krugman's definition I think. The key point is that it proves impossible to get negative interest rates, and for this reason monetary policy is inefective, not just that monetary policy is in itself ineffective.



Now in the context of the present situation of the eurozone economies the first thing to say about all this is that there is a basic methodological problem: IMHO you just can't create an ideal type entity - the eurozone - and start talking about it in general terms in the way the MS team do. I think it's just rudimentary economics - and strangely Christian Noyer was echoing this this morning when he spoke about the structural differences between the eurozone economies in his FT interview - that you have 12 different economies with one common money. So while some of these economies may well be candidates for entering a liquidity trap in the forseeable future - Germany (were people actually reduced their credit exposure last year, and house prices are falling, and have been for some years), or Finland which is very near negative inflation, others like Ireland and Spain obviously aren't. France clearly isn't. Then you have Italy, Portugal and Greece, which don't have a liquidity trap, but have serious structural problems including BoP ones which no-one knows what to do about. So the issue doesn't arise in this way, but the problem is, in order to start thinking about the real problems, you have to break the mindset, and stop thinking eurozone, and stop thinking common monetary policy.


The Japan issue is in this sense a red herring, as Japan entered deflation and the LT following a burst bubble. This would possibly be relevant to the UK, which is not in the eurozone, and to Spain which is, should the housing bubbles turn bad. Technically this would be called (by me at least) Irving Fisher style debt deflation, and this may have been a part of Japan's problem before the demographics took over. (This issue is the 'old horse' that the MS boss - Stephen Roach - flogs tirelessly to death IMHO. A Sisyphus without smiles, the dour Sisyphus).


One last point before I turn my mind back to what is happening in the UK: the idea that increased credit creation may not be generating additional domestic demand (in Germany, as I've said this isn't true in Spain and Ireland) or the reasons why corporate spending (investment) is not taking off not being the level of interest rates, where does this take us? Not to a liquidity trap, but to a demographic trap. That is what Germany is caught in.

Maroni Update

Here's the FT's reading of the situation.

Note this extract: "As financial markets digested the remarks of Roberto Maroni, Italy's welfare minister, the interest rate differential between Italian and German bonds rose to 23 basis points, the widest spread since November 2002."

These are the numbers we will be following at Afoe moving forward. Maroni is a member of a Northern xenophobic party that wants an independent country for the north of Italy. But *note*: he is in the government, and responsible for an important part of the Lisbon agenda, labour reform. So this is not some complete outside crank. Bottom line: Berlusconi's government is an unstable coalation, and this very instability *is* cause for concern, especially since we have just seen mainstream politicians lose important votes in two of Europe's more stable democracies.

One more irrelevant detail:

I used to keep a blog called Italy Economic News and Analysis, which I subsequently discontinued. I am reloading a new template at blooger now. They are only bits and pieces, but they may have some interest.

Basically I am a great admirer of the late Karl Popper, especially interms of his idea of science as being moved by daring conjectures, and then attempts at refuting them. When I came to the conclusion that demography might be more important for economic theory than it was fashionable to accept today, I treid to set myself an objective, a hypothesis whose confirmation, or absence of it, would help me decide if I was on the right lines.

Japan was already mired in crisis (we are talking about 2001 here), so I asked myself, if you are right what should happen next. Italy should enter a sudden and otherwise relatively unexplicable economic decline was my response. This is why I started the blog, and this is why I have maintained a continuing interest in Italy.

Having said that, I am not a reductionist. Italy's demographic problems form an important backdrop for the present 'embarrasment of difficulties', but of course it is by no means the only factor.

Another stab at what I think is the problem in Italy can be found in this post.

Italian Referendum Call

But in this case the vote would be about Italy's continuing membership of the euro-zone, rather than the EU constitution. Now before going any further, I feel the need to advise extreme caution in the face of such developments.

In the first place the call comes from the Italian Labor Minister - and member of the separatist Liga Del Norte - Robert Maroni: It was made in an interview published by the Italian newspaper La Repubblica. He was not making a statement on behalf of the government, he was in all probability 'electioneering'. (See Fran's post: those politicians).

On the other hand, Berlusconi is pretty vulnerable at the moment, remember he has just put together a new coalition, and elections are coming next year.

Apart from the political dimension, it is important to remember that Italy is now in an economic crisis which is every bit as profound, if not more profound, that that being experienced by Germany.

Quickly summarised Italy's problems are:

* What appears to be enduring economic stagnation
* An outdated economic structure (poor product mix)
* Lack of competitiveness and a deteriorating balance of payments
* A currency which is too high to recover competitiveness
* A rate of interest which may be too high
* An extraordinarily poor productivity performance
* Massive and accelerating public debt (over 100% of GDP and rising)
* Europe's most rapidly ageing population
* A noted aversion for accepting immigrants

I will try and flesh this out a little more calmly over the weekend. But in broad brush strokes this is it. Now, vis-a-vis the euro, it is unsurprising that Maroni should choose today to make this statement, since Economics Commissioner Joaquim Almunia has set June 7th 'D' day for initiating a formal excess deficits procedure against Italy and Portugal. As I indicated before the French vote there is every reason to imagine that the new version of the pact will be strictly enforced (this was emphasised by Almunia's presence at yesterday's ECB press conference), especially after the French and Dutch votes and the need to convince everyone that 'the euro *is* a huge success.

Secondly, the ECB yesterday gave no indication of having any inclination of coming to Italy's assistance by lowering the refinance rate.

So it may well be that some Italian politicians can see that it's 'game over'.

Add to this the fact that some people in Italy were extremely relucltant about the euro even on from first day, and you have all the ingredients of an ongoing problem.

Remember too that with elections coming next year, someone may try and make this an election issue.

Background: The following Country Study From Ecfin (may 2005): Italy Stuck In A Rut

Summary

The Italian economy has shown weak growth ever since the beginning of the 1990s. More recently it has developed two particularly striking, interlinked symptoms: a discouraging performance by exports and the longest stagnation of output in the tradable goods sector in post-war history. In contrast to previous episodes of weak growth, the current difficulties are not caused by supply shocks such as excessive wage increases. On the contrary, the dismal export performance has fallen within a period of wage moderation, and, since the late 1990s, of buoyant employment growth. The persistent loss of export market share would seem to chiefly result from the unfavourable product specialisation of the Italian economy ? more recently coupled with a marked slowdown in productivity growth. Italy?s product specialisation, unlike that of countries such as Germany or France, has not significantly changed over past decades in reaction to global economic developments. Italian industry remains strong in traditional, low-skilled labourintensive sectors for which global demand is growing below average. The inertia is generally attributed to a number of structural factors which are hampering change, including low levels of R&D investment, low human capital, low competition ? issues that fall within the remit of the Lisbon strategy.

Also this weeks NTC Research PMI survey: the sharpest deterioration in 41 months in May,

and the OECD's latest economic outlook for Italy.

That's why when Maroni says "We're already heading towards Argentina, that's why we have to change direction," I'm inclined to believe he is in earnest.

ECB Holds Rates at 2%

The European Central Bank held its main refinancing rate constant at 2% for the 24th consecutive month this afternoon. No real surprise here. Perhaps the most revealing comment has been: "Whether others like it or not, the ECB isn?t an activist central bank,? a view offered to the Financial Times by one Julian Jessop, economist at Capital Economics.

The FT also points out that: "the 5.5 per cent slide in the euro to $1.226 against the dollar since the ECB?s last meeting may have done some of the Bank?s work for it. The weakening of the euro is stimulative to growth in the same way a rate cut would be, and, if it persists, is likely to be an upward drag on eurozone inflation".

We will see. The euro has had a much calmer day today, clawing back this morning most of the ground lost in hectic trading last night. It is currently going for around $1.2279 in a fairly volatile afternoon.

The - oh they've all gone quiet over there - European Commission seems determined to sit things out till the June Summit, while Barroso appeals for calm:.

"?What I am asking for now is that political leaders, in particular government chiefs, not take individual, or unilateral decisions. I ask political leaders to show responsibility, to show caution"

Jean-Claude - into the valley of death rode the 600 - Juncker, Luxembourg's prime minister and holder of the rotating EU presidency, continued to insist ratification should go forward as planned. Since Luxembourg is to have the next scheduled referendum, it will be interesting to see whether he in fact leads the troops more than the statutory 'half a league'.

Europolitix has it that behind the scenes (and this is really the problem about how we do politics in Europe) a revolt is brewing amongst those who would be asked to follow Junker's noble sacrifice: Poland, Denmark, Ireland, the Czech Republic, and, of course, the UK.

He Would Say That Wouldn't He II

In some ways I think this story may run and run over the months to come. Bloomberg have an update on their earlier article. According to the latest account:

1/. The German Finance Ministry have declined to comment on the Stern report that discussions took place last week between Finance Minister Hans Eichel, Bundesbank President Axel Weber and various economists on a possible failure of European Monetary Union.

2/. Stern magazine have been forced to pre-release the article today: it asserts that the above mentioned group discussed a scenario for the single currency's collapse as differences in inflation and growth rates within the union grow. An internal ministry document formed the basis of discussions. (All this, as I keep saying is perfectly plausible, since it describes a reality - the difference in inflation and growth rates, and incidentally balance of payments situations - the scenario is simply that, a scenario, a thought experiment. This reality is only really strongly denied by the Chief Economist at the ECB Otmar Issing).

3/. The Finance Ministry - in the shape of spokesperson Sandra Hildebrandt - has clarified that it "doesn't comment on internal papers or meetings". This implies, since there is no denial, that there was a meeting and that there is a paper.

4/. Stern suggest that Fels said: Inflation and growth differentials ``can lead to a meltdown in a couple of years, the collapse of the euro,'' . This doesn't especially ring true as I have strong doubts that he would commit to a time scale. This sounds like journalese. Not what he said in a meeting. And since Fels is now 'missing' (possibly he is the most wanted man in Europe right now) I doubt they would have got this out of him in a phone interview.

What is Fels saying:

"I think, that Europe is on a slippery slope towards disintegration and instability -- a stunning reversal of the long march towards integration and stability in the last half-century. Of course, nobody can confidently predict the endgame of such developments."

"First, political disunity within Europe raises doubts about the long-run viability of the euro."

"a disunited Europe could also lead to plausible scenarios characterized by fiscal and monetary instability in which some member states would want to leave the single currency. Investors in long-dated eurozone bonds have to factor in the break-up risk and should demand a premium in bond yields. Needless to say, the permanent spectre of a potential break-up should also make it difficult for the euro to rival the dollar?s status as a reserve currency."

The above can be found here.

Again:

"Far more worryingly, the European Union (EU) appears to be heading for a serious political crisis, which could, eventually, even put the single currency at risk. The currency markets may have started to smell these risks: the euro failed to rally against the dollar last week despite a larger-than-expected US current account deficit and accumulating signs of a slowing US economy."

This was back in April.

I would happily sign on the dotted line to any of this, but it is nothing like what Stern attribute to him.

5/. The document also asserts that: "The gap risks widening, so that the danger of an adjustment crisis is growing bigger,''. This is plausible, in particular since it is true.

6/. And possibly most interestingly of all: Germany's lower house of parliament has commissioned a legal opinion on a possible reversal of EMU and the right of one of its members to leave the currency. This is asserted by Stern. I have no idea if it has any validity, but it would be surprising if they made this claim without backing. My impression is that someone somewhere, probably someone who has been against the euro from the begining, is leaking.

Lastly Stern claim: " The introduction of the euro has cost Germany its former advantage of lower financing costs, which partially explains why it's lagging behind the other euro members". This is balderdash. The ECB rate is extremely low by historic standards. The rate could and should come down to meet Germany's present needs, but that is not what Stern appear to be saying.

The interesting question now is whether the euro will become an election issue in Germany. Over to Brussels and Frankfurt tomorrow.

He Would Say That Wouldn't he

For those who are not old enough to remember, these are the immortal words of Mandy Rice Davies.
Now throwing a link quickly back across the Atlantic, Dave Altig at Macro blog picked up my ECB post and added a response from Hans Eichel.

But, the plot does thicken a bit.

The Forbes article Dave links-to mentions a confidential research note from the German Finance Ministry which points out that:

"under the EU monetary union, Germany has lost its economic advantages because the country can now no longer lower interest rates compared with other European states".

"The report said states which had high interest rates before the monetary union was launched -- and named Greece, Ireland, Portugal and Spain as examples -- have used the euro currency to its 'enormous financial advantage' while in Germany, the euro has effectively put a brake on economic growth."

This rings true, since this is what many of us have been arguing (I would rewrite 'enormous financial advantage' with 'to get enormously into debt via excessively cheap interest rates, but then I am a pedant). And given that the Franco-German axis can no longer be relied on, and that the ECB is ignoring German pleas for help, it is only reasonable that they should be thinking about what is happening and requesting the appropriate policy oriented research. They would be irresponsible if they didn't.

Finally, I'll conclude with the comment I just posted on Dave's blog:

The interesting thing is that no-one is denying that this meeting took place. Possibly it was a lecture by Fels, where he outlined his already well know difficulties. Fels is refusing to comment.

The significant thing is that this is even coming on the radar. The euro is alive and well, but Eichel and Weber clearly feel the need to be briefed on a plan 'b' should the day ever arrive.

I think we need to take this a day at a time, and just see how long it takes the EU bankers and politicians to put the ship upright again.

On the denials, this reminds me of Christine Keeler (sorry, it was in fact Mandy Rice Davies, oh, what the hell) during the Profumo affair: well he would say that, wouldn't he! :)

ECB: Just Look At This!

I had promised myself a quiet day. I may have to eat my words. Look at this on the euro, and remember my post yesterday.

The currency also weakened after Germany's Stern magazine reported German Finance Minister Hans Eichel and Bundesbank President Axel Weber discussed a possible failure of European monetary union. The euro is off to its worst start of a year since 2001, down 9.3 percent compared with the dollar.

``This is extremely bad timing and has undoubtedly compounded euro selling,'' said Monica Fan, head of global foreign-exchange research at RBC Capital Markets Ltd. in London.

The euro retreated from as high as $1.2341 after the magazine said Eichel and Weber, who represents Germany on the ECB's policy committee, discussed the euro's potential failure with economists. The magazine quoted Joachim Fels, chief fixed- income economist at Morgan Stanley, who took part in the meeting. Fels declined to comment.

``We can neither confirm nor deny'' that a meeting took place, said Bundesbank spokesman Wolf-Ruediger Bengs in a telephone interview. ``We hope to issue a statement shortly.''

This is incredible stuff, and that it is breaking in the press must also be indicative of something. I go back to my post last week. It seems what I suggested is right: the ECB is deeply divided, and this 'quietism' and the policy of twirp is causing alarm in two important economies (Germany and Italy). This is not the end of the euro, but this discussion could mark the begining of the end. It all depends on how rapidly events unfold, and how long 'ostrichism' prevails in Frankfurt and Brussels.

Postscript: I am following the evolution of the Euro/USD over at our other page: A Few Euros More.

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.

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?

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."

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

Update:

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.

and

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.

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.

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.

Scary Stuff

In a post which appeared earlier this week Tobias asks us whether, given some of the possible consequences of a French "non", it might not be reasonable to 'scare' voters a little by spelling out some of the potential fallout which might follow a French rejection of the Constitution Treaty.

Perhaps the phrasing is unfortunate, but undoubtedly voters in Eurozone countries need to think long and hard about one especially sensitive area of impact: the future of the euro itself.

Obviously it is precipitate to start speculating about what would happen 'if'.......... In the first place the final outcome is far from decided, and in the second next months vote will hardly be the end of the story. One thing is sure though: if the French were to vote no the future of the institutional structure of the EU would become much more uncertain. And if there is one area where such uncertainty can be painfully expensive it is that of financial markets. Hence the interest in the euro.

And this is where the 'scary movie' might just begin. I think it isn't spelt out often enough and clearly enough that the existence of the single currency is predicated on the long term evolution of an integrated political platform to make it solvent. This is why those states which have shown most reticence at the idea of European federalism have understandably (the UK is the most obvious case) been the most reluctant to adopt the common currency. This is also one of the reasons why a no vote in France would be much more important than a no vote in the UK. In the worst case scenario of an eventual British rejection it could be just possible to find some alternative structure to work round, but to have the eurozone's second largest economy institutionally 'out' would be really unthinkable.

The implications of just such a development are explored by Morgan Stanley economist Joaquim Fels in an article entitled "euro at risk". Now this is not the first occasion on which he has expressed views which might seem alarmist to some. Back in January 2004 he wrote a piece entitled Euro Wreckage? which evidently drew blood since it evinced an immediate response from Nobel economist Robert Mundell (intellectual 'parent' of the euro) in the EU Observer. Simply put Fels pointed out there that the technical and legal obstacles to leaving the euro were not as great as was often thought. Some evidence to back this point of view might be found in the fact that Greek expulsion from the common currency was one remedy proposed in some quarters after the 'deficit manipulation' scandal came to light.



This time Fels makes three central points:

As I see it, there are at least three developments with potentially lethal implications for European integration: (1) the surge of protectionism, especially in Germany, against perceived ?wage dumping? from Eastern member states; (2) the probability of a rejection of the EU constitution in France and the Netherlands; and (3) the prospect of much larger fiscal deficits in coming years now that the Stability and Growth Pact has been watered down beyond recognition.
Source: Morgan Stanley Global Economic Forum

Now adroitly side-stepping the first - protectionist - problem (which could reasonably involve a separate post), the second and third points do seem to me to be interconnected in a way which gives some force to Fels' argument in the sense that a combination of the two could lead to increasing speculation about the very viability of the euro itself.

Essentially the 'loosening' of the stability pact has meant that there is now much less control on the continuing accumulation of deficits. This in the medium term wouldn't necessarily present an insurmountable problem (ie one which was going to produce a 'crisis' situation) if the problem of the ongoing political unification didn't present itself. Put bluntly the latter is necessary to guarantee the solvency of the former. If the economically stronger states are not going to be bound (morally if not legally) to bail out the weaker ones, then one day the markets will wake up to this and pressure on the government debt of these states will begin to pile up. Italy and Greece are prime canditates here with relatively stagnant economies and government debt already above 100% of GDP.

The FT today offers one indication of what might become an ongoing trend: divergence on the relative interest rates paid by the various eurozone governments on their debt (the so-called 'sovereign spread') is increasing:

The French referendum on the European Union constitution is starting to unnerve debt markets, prompting investors to become more discriminating about eurozone bonds.

In particular, the price of German bonds has recently diverged from Greek or Italian instruments, because investors are favouring paper issued by stronger eurozone countries. This helped to push the 10-year yield on German government bonds down to just 3.389 per cent on Thursday the lowest rate for at least four decades.

(meantime).... the cost of protection against a default by Greece or Italy, using credit default swaps, has risen. Last month it cost about ?14,000 to insure ?10m of Greek or Italian debt; it now costs ?23,000 and ?17,500 respectively. The swap spread between Greek and German assets has also risen by 6 basis points in the past month from a normal spread of 10-15bp.
Source: Financial Times

In other words it now costs more for the Greek and Italian governments to raise money. As the FT points out these differences are currently relatively small (and indeed miniscule in comparison with the differences prior to monetary union). However as political union proceeded these spreads had been converging, now they are diverging. A major hiccup like a French no, coupled with a failure to seriously address the deficit problems would only see this process accelerating, and it would be this acceleration which could seriously place the unity of the eurozone in question. Ironically government finances in Greece and Italy are only sustainable due to the very low interest rates made possible by euro membership. Should debt costs start to escalate (remember we are talking here about servicing debt to the tune of 100% of GDP) then financing interest payments would almost inevitably lead (as we saw in the case of Argentina) to an ongoing spiral of expenditure cuts, economic stagnation and even higher interest rates. The end result would almost certainly be default, and normally default would require the significant devaluation of a currency and the application of an independent monetary policy, both of which imply the return to an independent national currency.

Of course, telling the French electorate that they need to vote yes so the will be able to shore up those eurozone economies with serious public debt problems may not be the best way to convince them (there *is* intended irony here NB), so perhaps those who suggest we shouldn't be in the business of scaring people (we can leave that in the capable hands of Wes Craven) may be right after all.