Monitoring the European Central Bank: Update June 2000

The weakness of the euro could be a result of normal market behaviour and of market perceptions of the ECB, which make things look worse than they are. Four leading European economists argue that ‘the euro’s misfortunes may have no easily identifiable rationale...Freely floating exchange rates are known to follow wide and prolonged swings which are very hard to justify by economic fundamentals.’ Depreciation is accompanied by rising inflation. The two phenomena may have no serious repercussions, but they challenge the ECB and demand explanation.

The latest update of Monitoring the European Central Bank, published by the Centre for Economic Policy Research, analyses the key issues and rejects a number of familiar accounts of the new currency’s weakness. The eurosceptic view that the adoption of the euro was a bad idea is contradicted by the fact that its interest rates are well below their US counterparts. If anything, therefore, the markets expect a euro appreciation.

The US ‘new economy’ argument is also unconvincing because technology travels fast and Europe can, and does, imitate US practice. Furthermore, the euro is weak against other European currencies too. Some eurozone countries are sclerotic, but why should that hit the exchange rate when growth has returned without US-style payments deficits? Some argued that the strength of the dollar was partly based on the strength of the stock market, itself supposedly an example of the so-called New Paradigm. But recent falls in US stock prices have not dented the dollar, perhaps the opposite. Nor do different trends in budget deficits help explain the situation: the US budget improvement has hardly been greater than that of Europe in the last five years.

More plausible explanations are to be found in Frankfurt. There is ‘some evidence that the ECB’s credibility has been wavering.’ The ECB has been behind the Fed and ‘[i]t has probably also been behind the evolution of economic conditions in Europe with growth gathering steam throughout the area and inflation rising fairly fast in the closing months of 1999.’ The markets have felt frustration at the Bank’s communications strategy – ‘the monetary framework remains confusing,’ say the authors.fThere is therefore reason to assume that the euro risk premium has increased.

One problem may arise from the Maastricht Treaty. The paper discusses Article 109(2), which does not say if intervention is in the hands of governments or the Central Bank. One among many problems here is that perhaps ‘neither the ECB nor the political authorities are willing to take the decision alone on such a risky move – suggesting poor communication between the main policy actors.’ The same Article may demand unanimity on the part of governments, and that is lacking. The contrasting problems of Ireland and Spain on the one hand, and Germany and Italy on the other, lead to another conclusion: ‘Whatever one’s view on the desirability of intervention, the situation is yet another sign of unfinished business in Europe’s financial architecture.’

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Carlo Favero is affiliated to IGIER at Università Bocconi, Milan and is a Research Fellow in CEPR’s International Macroeconomics research programme. Xavier Freixas is Professor of Economics at Universitat Pompeu Fabra, Barcelona and a Research Fellow in CEPR’s Financial Economics research programme. Torsten Persson is Professor of Economics at the Institute for International Economic Studies, Stockholm University and a Research Fellow in CEPR’s International Macroeconomics and Public Policy research programmes. Charles Wyplosz is Professor of Economics at the Graduate Institute of International Studies, Geneva and Co-Director of CEPR’s International Macroeconomics research programme.