Saturday, June 07, 2008

The European Central Bank - The Most Credible Bank in the World

The European Central Bank is ten years old this month. And they celebrated by demonstrating effortless superiority over the Federal Reserve Bank of America this week in a verbal duel over inflation.

The chairman of the Federal Reserve Bank, Ben Bernanke, unexpectedly made a speech last Wednesday on the dollar. He acknowledged that the slump in the dollar had triggered an "unwelcome" spike in inflation and the cost of imports into the USA. "We are attentive to the implications of changes in the value of the dollar for inflation and inflation expectations," Mr. Bernanke said and wowed that the Fed would "formulate policy" that took account of the weak dollar's input into inflation.

The dollar soared on news of the speech.

But on Thursday, at the customary news conference following the European Central Bank's monthly meeting, Jean-Claude Trichet also talked about inflation and revealed that the ECB's members had discussed raising rates and were seriously considering doing so next month. This came as a shock to many US analysts who had predicted that the ECB would "have" to follow the Fed and cut rates and thereby take pressure off the dollar, so the US could have both low rates and a strong dollar containing inflation.

The markets had to decide who was the most credible, Trichet or Bernanke. Trichet won hands down. Everyone knows that when Trichet mentions something in his monthly conference it is likely to happen. Bernanke's talk of "formulating policy" to take account of the weak dollar was judged to be just talk. The dollar slumped - making poor Bernanke's inflation problems even worse, as the oil price (which is priced in dollars) climbed in concert with the dollar's drop. There is not going to be any easy get-out for the Americans. If they want inflation to drop they are going to have to take some bitter medicine.

Given that the Federal Reserve Bank of America has been top dog for so long, this is a remarkable turn about, a historic event. Particularly as all the nay-sayers thought that the ECB and the euro project would never get off the ground. "I congratulate you on your impossible job!" said Nobel Economics Laureate Milton Friedman to the European Central Bank’s first chief economist, Ottmar Issing, in 1998.

Despite the Maastricht treaty being signed in 1992, and ratified by referendum in France (one of the countries joining the euro), many American (and some British) commentators continued to insist that the euro would not come into effect. But the ECB was born in June 1998, and the euro came into effect on 1st Jan 1999, with notes and coins coming into effect in 2002. The naysayers continued to predict doom - the press predicted chaos when the notes and coins came into effect (perhaps because the British press cannot imagine rolling out such a project among some 300 million people). But it went remarkably smoothly - perhaps a testament to the administrative skills of those Frankfurters at the ECB.

But the credibility of the ECB really took off when Jean-Claude Trichet took over as chairman in 2003. The Frenchman shared the desire of the Bundesbank members of the ECB for stern anti-inflation policy (when he was chairman of the Bank of France he operated the Franc Fort policy of using a strong currency to bring down inflation). But unlike the Germans (or his Dutch ECB predecessor Wim Duisenberg) he demonstrated an ablity to communicate with the markets. Instead of minutes being released, the ECB has a press conference straight after their meeting, where the chairman tells the press what has been decided and signals what will happen in the future. (The reason minutes are not released is to protect individual board members from undue pressure in home states, once a decision on rates is made, the ECB presents a united front). No other central bank holds such a monthly press conference and no other central banker takes questions from the press. Trichet's skill in negotiating the press conferences helped to anchor expectations on inflation and interest rates both among the eurozone public and in the markets.

The ECB's reputation rests on how it conducts monetary policy. Unique among central banks it sets it's own targets. And opted for the toughest targets around - a dual target of keeping CPI below 2% and monitoring money supply. They flatly refused to follow the Fed in cutting interest rates to 1% following 9/11, despite slower growth in the eurozone and near deflationary conditions in Germany, and determindly increased rates at the end of 2005 despite critics claiming the eurozone economy was too weak (the critics were wrong and the ECB was right).

Further the ECB was the first central bank to react to the credit crisis last year, providing swift liquidity to the markets when Ben Bernanke and Mervyn King dithered. As a result the euro-zone hasn't experienced a Northern Rock situation (and if only Northern Rock had a branch in the euro-zone, they'd have been able to borrow discreetly from the ECB and avoided the crisis altogether, in the way Barclays and others did - something all British banks will have noted). On the other hand the ECB hasn't made panic cuts in interest rates like the Federal Reserve which has cut from 5.25% to 2% in about six months. The ECB has held interest rates at 4% - providing operational flexibility combined with monetary hawkishnes.

The ECB's latest hawkish stance on inflation is very important for the world at large. The eurozone has grown to some 320 million people - they are a big enough market to affect global prices (unlike us in the UK). If the ECB in raising rates pulls off a lowering of commodity prices by slowing demand, they really will be the new masters of planet earth.

The ECB often comes under attack from economically illiterate politicians - especially that fool Sarkozy - but her growing reputation makes her more and more invulnerable. The euro project itself has had beneficial side effects. 16 million jobs have been created in the eurozone (more than in the USA despite the USA having a higher population growth rate). The original eleven countries have been joined by a further four countries, with Slovakia waiting to join shortly and Estonia, Latvia and Lithuania in the wings.

Many people wonder what would have happened if the UK had joined. Well the UK is such a large economy, the ECB would have had to take account of it when setting rates, which means that interest rates would have been higher in the eurozone if we were part of it - luckily for the europeans that we didn't join! Under Gordon Brown there are no plans to join at all. Future potential pro-European leaders of Labour like David Miliband will come up against resistance from anti-euro MPs like Ed Balls. But Labour is above all the pragmatic party. It all depends on events.

Finally, in pieces like this where you heap praise on Europeans, it is customary to find something, well British about them. I am happy to report that Trichet hails from Brittany (aka Little Britain) and is therefore a Celt and is therefore One of Us! ;-)

1 comment:

Anonymous said...


Thanks for the link. I don't suppose you could drop me an email?