Straining at the Seams
Yesterday (Thursday), the European Central Bank reduced interest rates by 50 basis points. To most people, that’s unremarkable, because central banks all round the world have been cutting rates sharply for months. The Americans and Japanese are already down to near-zero, the British are well on the way and many others (including the Bank of Israel) is in hot pursuit, as it were, in this race to ZIRP (zero-interest rate policy).
But the ECB decision is important, at least in the European context. At the press conference following the previous cut in November, and in subsequent speeches and interviews, the message from ECB President Jean-Claude Trichet and his colleagues was that there was no immediate need for further cuts – indeed, that there might be no meeting in January at all. What has changed in the last few weeks is a flow of economic data regarding the economies of European Union, its member states and their neighbours, that analysts describe in terms varying from ‘awful’, through ‘terrible’, to ‘disastrous’ -and these are not news anchors or headline writers looking to attract attention. When, for example, industrial production for the 15-member euro zone in November plunges at a rate of 1.6% from the previous month and by 7.7% over the preceding 12 months, that is not merely ‘the worst-ever decline in record’, but horrendous in absolute terms. Faced with so rapid and severe a deterioration in the economic environment, the ECB had no choice but to ignore its own rhetorical bravado and cut rates.
Nevertheless, the ECB remains the largest and most important remaining bastion of an ideology that sees central banks as committed first, foremost and always to fighting inflation. The ECB’s latest statement therefore says that a) it sees inflation risks as “broadly balanced” between inflation and deflation; b) it expects inflation rates will remain in line with price stability in the euro area (i.e. 1.5-2% per annum). Although it sees growth declining and remaining weak for the next several quarters, the ECB is unfazed about possible deflation. So long as this holds true, euro interest rates are unlikely to fall much below the 2% level they have now reached, and the idea of their approaching zero is a non-starter.
But what the ECB says and what it does are becoming two very different things – as the period from November to January highlighted. The awful, terrible, disastrous economic reality crowding in on Europe will force the ECB to continue to adapt, albeit belatedly and reluctantly. This reality is especially grim in the peripheral countries of the eurozone – the so-called PIGS group of Portugal, Ireland, Spain and Greece – which are all in deep trouble, as was evidenced by Wednesday’s downgrade for Greece by S&P. In even worse state than the PIGS are the newest members of the EU, Romania and Bulgaria which, together with the Baltic countries which joined earlier, are in danger of a financial collapse as well as a deep recession. Even the star performer of the former Communist bloc, the Czech Republic, is in serious trouble.
Meanwhile, in the EU heartland, Germany has just rolled out its second economic stimulus package within a few months. But Germany, at least, can afford to be pro-active and anti-cyclical, because its finances are in reasonably good order. Not so countries like Italy and Belgium (if Belgium still merits the title of ‘country’ in the accepted sense). Their ratios of debt to GDP are so high that the markets have dumped the myth that all euro-denominated sovereign debt is equally sound, so that the spread between the yields on Italian government bonds versus German government bonds has been widening for many months.
All of which begs the question of whether the European Monetary Union can survive at all. The Union’s physical expression is the euro, which celebrated its tenth birthday last Thursday, and has spent this weak falling sharply in value against the dollar and the yen. But the euro’s price is not the measure of its survivability. Indeed, most eurozone countries would be in much worse shape today had they faced the financial crisis on their own, rather than under the EMU umbrella. But the developing economic crisis will expose the structural faultlines in the very diverse economies grouped together under the Union and the resultant social and political pressures will create growing strains. The critical period will probably be late 2009 or early 2010, but whenever the crisis comes, the institution least likely to save the Union is its supposed guardian, the ECB.