European Economic Perspectives 26

Benign Neglect

An Update to Monitoring the European Central Bank (MECB) 2

Two recent developments are challenging the ECB: rising inflation and the weakness of the euro. Neither of these is likely to have serious economic repercussions over the long term, the latest MECB Update concludes, yet both call for explanations. For good and bad reasons, those provided by the ECB so far have left the markets unsatisfied. In a world where perceptions greatly matter, things look a lot worse than they really are.

Some popular explanations for the recent weakness of the euro are dubious. The ‘new economy’ view that information technology has transformed the US economy does not explain why Europe could not adopt the same technologies. Nor does it explain why the euro is weak against other European currencies such as the Swedish krona and Swiss franc. Likewise, ‘eurosclerosis’, in its various forms, is a fact among the largest euro-zone countries, but why should it hit the exchange rate now that growth has returned to Europe and without any US-style current account deficit? Nor is there any evidence to support the view that continuing budget deficits in Europe hurt the euro.

‘Easy money’ is one explanation that carries some weight. Various estimates suggest that the ECB has been behind the curve – and behind the Fed – in reacting to the growth turnaround in the closing months of 1999. Increases in the interest rate have been lagging and long-term rates reveal market doubts about the ability to contain inflation below 2%.

The ECB’s oft-criticised communication strategy also remains wanting. The monetary framework is poorly equipped to deal with conflicting signals. The widely advertised, self-imposed ceiling of 2% for inflation makes the ECB more vulnerable to temporary overshooting than is, for example, the more pragmatic Fed. More importantly, perhaps, a continuing gap between ECB words and deeds may result in a risk premium that affects the interest rate, the exchange rate or both.

Europe’s monetary architecture is unfinished, and this may further raise uncertainty. The Maastricht Treaty is unclear on who is in charge of the exchange rate: the ECB or national governments. Foreign exchange market intervention is controversial, which encourages prudence but only up to a point. With unclear attribution of responsibilities, neither party may be willing to take a risk. What is more, governments are likely to take different views among themselves as they face diverging economic conditions.

In the end, however, the current euro weakness may simply be yet another instance of vagaries in the foreign exchange markets. Freely floating exchange rates are known to fluctuate wildly with little link to the fundamentals. In the face of such fluctuations, there is nothing wrong with benign neglect – provided it is explicitly accepted. Once again, it is not the policy that is at fault but some lack of clarity in its formulation.

The full text of MECB 2 Update is available from CEPR. The full report was published by CEPR in January 2000: ‘One Money, Many Countries – Monitoring the European Central Bank No. 2’ by Carlo Favero, Xavier Freixas, Torsten Persson and Charles Wyplosz.

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