The case for a cut in interest rates by the European Central Bank is overwhelming, argues Colm McCarthy
A familiar criticism of the euro as a common currency is that the European Central Bank (ECB) can only pursue one policy at a time, in particular one interest rate for Europe. Unless "one size fits all", some of the 12 eurozone member states will at times face a monetary policy which does not suit them.
But an even greater risk is that ECB policy is too tight or too loose for the eurozone as a whole, and that the ECB's one size fits nobody. The present danger is that policy is too tight. This risk is compounded when the constraints on budgetary policy contained in the Stability and Growth Pact (SGP) have begun to bite in such a way as to prevent member states from offsetting an inappropriate stance by the ECB.
The weakening in eurozone economic performance in recent months, and the clear evidence of weaker expectations for a turnaround, come at a time when several member states are running budget deficits close to the permitted limits. Their instinct to allow the deficit to rise must, however, be suppressed given the inflexibility of the stability pact, and the responsibility for counter-cyclical action rests by default with the bank.
But the ECB seems firmly set on holding interest rates at current levels despite the economic slowdown, and several member governments are under pressure from the EU Commission to tighten fiscal policy. If you sincerely believe the eurozone economy is about to enter a sharp recovery, this policy stance sounds fine. But the evidence does not point to an imminent rebound, and the case for an interest rate cut is growing.
The most recent data for output in the eurozone is for this year's first quarter. Output (GDP) was up just 0.3 per cent on the first quarter of last year. The unemployment rate is now 8.4 per cent, up from 8.0 per cent a year ago. Capacity utilisation in manufacturing is just 80.7 per cent.
If there were reasonable grounds for optimism that economic recovery is round the corner, these figures would not necessarily signal that a policy easing - a cut in interest rates - was appropriate. But the forward-looking confidence indicators from Eurostat have turned sharply negative. The readings for industry, construction and the retail trade are gloomy, and consumer confidence is down too. Economic forecasts are being trimmed, and analysts in several eurozone countries are predicting that governments will not meet their fiscal targets for this year, due mainly to weakness in tax revenues.
Under the Stability and Growth Pact, eurozone members are required, under threat of financial penalties, to keep deficits below an absolute ceiling of 3 per cent of GDP, and to aim for a zero deficit on average over the economic cycle.
Surpluses have been melting and deficits rising sharply as recession takes hold. Portugal was in breach of the limit last year, and the new government there has announced an austerity programme. The German government is claiming it can stay within the limit, but independent analysts think Germany is likely to break the 3 per cent ceiling. France and Italy are flirting with the ceiling, and some other countries, including Ireland, have seen large surpluses turn into deficits.
Adherence to the terms of the SGP requires each member-state not merely to avoid a breach of the 3 per cent ceiling, but also to start the journey back to surplus at some stage, since the average deficit over the cycle has to be zero. The pact has been widely criticised by academic economists, who feel it is unnecessarily restrictive.
The borrowers who are being restrained, the European governments, include a large proportion of the world's dwindling supply of AAA-rated debt issuers. The pact, they argue, has a deflationary bias, and will encourage untimely pro-cyclical tightening. Some London-based financial market commentators have taken to calling it the RIP, for Recession and Instability Pact! Political pressures to amend the pact are inevitable, but it is binding for now, and since it is a treaty matter, it will take years to change.
The response to the recessionary threat in the United States has included a big fiscal injection, and interest rates down to 1.75 per cent with the prospect of another cut in September.
In Europe, rates remain at 3.25 per cent, but several governments are now under pressure to contract on the fiscal front. The euro has been appreciating as the dollar has weakened, which means that US policy is more accommodating of recovery under all three headings - monetary, fiscal and exchange rate - than is Europe.
Of course the ECB is required to watch the pace of growth in the monetary aggregates, and to avoid any upward drift in inflation rates. But there seems to be little to worry about on either score.
The broad money supply on the ECB (seasonally adjusted) figures is still growing, but the impetus seems to have slowed in this volatile series. Consumer prices, after a jump in the annual rate early in the year, have slowed quite a lot. In justifying its decision at the August 1st meeting to leave rates unchanged, the ECB monthly bulletin notes that "the governing council concluded that while recent developments continue to send mixed signals, risks to price stability have become more balanced".
When the ECB say risks to price stability have become more balanced, I think they mean that they have fallen, which would be consistent with the data. Risks to the real economy, Government tax revenues, and employment prospects have, to use ECB language, become less balanced, that is, they have risen.
At its meeting next month the ECB council should act on the evidence and cut interest rates.
Colm McCarthy is managing director of DKM Economic Consultants