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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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