THE EUROZONE IS WRONG TO LOOK FOR THE EXIT / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( A MUST READ )

The eurozone is wrong to look for the exit


By Wolfgang Münchau

Published: October 10 2010 19:42

In May 2009, the European Central Bank lowered its interest rate for a final time to 1 per cent but rejected calls to adopt a zero rate policy. At the time, I heard the following explanation: what really mattered for the economy was not the official interest rate but the actual money market rates. And those were close to zero per cent because of the way the ECB operated its liquidity policies. So while official rates were higher than in the US, the real-world difference was not big.


If you accept that argument, then you must conclude that the ECB raised interest rates this month. By phasing out its liquidity policies, the money market interest rates have been creeping back up towards 1 per cent, the official short-term policy rate. The one-week Euribor rate, for example, went up from 0.35 per cent at the beginning of this month, to 0.7 per cent. In other words, by not doing anything, the ECB effectively doubled the rate. So while the US Federal Reserve and the Bank of England are currently considering another round of quantitative easing, the Europeans are not only thinking loud about a monetary policy exit – they have already started.


Is this the right time to leave? Abandoning the financial support policies is indeed justified. Through its liquidity policies the ECB has nurtured a dependency culture. Without the weekly liquidity fix, many banks would not be able to exist. I would go further and argue that the ultra-generous liquidity drip may even have prevented, or delayed, the necessary restructuring of the banking sector in some countries. These policies masked an underlying state of insolvency. This would have to end eventually.


But should the ECB also exit its monetary policies? There are various ways to answer the question, all of which yield the same answer. First, if you think about it formally, on the basis of a macroeconomic model, it is actually quite hard to find one that would call for a rise in interest rates at this point. Perhaps surprisingly, that observation is particularly true of a monetarist framework. A committed monetarist, if confronted with two years of a stagnating money supply and weak credit demand, would have long ago embraced a policy of zero interest rates and quantitative easing. The New Keynesians come to the same conclusion by a different argument. With eurozone unemployment at 10 per cent, large excess capacity and a virtual absence of inflationary pressures, interest rates must fall to bring the economy back to a full-employment equilibrium.


Second, unilateral measures taken by several countries outside Europe to improve their relative competitiveness via an exchange rate devaluation have become a fact of life in the post-crisis world. The eurozone should not participate in this global zero sum game but it cannot ignore it either. At a time when the Federal Reserve and the Bank of England are contemplating another round of quantitative easing, and when Japan, China and Brazil are already taking measures to maintain their external competitiveness, it would be folly for the ECB to tighten policy as though the external environment was neutral. If the EU was really serious in its wish to reform the global monetary system, a minimal prerequisite one would have thought would be for the ECB not run in a diametrically opposite direction to the Fed.


So what is it that leads European central bankers into a tightening mode at this point? I can only assume that it is a fairly mechanistic response to a recovery that was stronger than expected, the increased optimism of some forecasters, and perhaps signs of emerging wage pressures in some corners of the labour market. It is hard to pin any of this down. A truly old-fashioned conservative central banker would tell you that a 1 per cent interest rate is low by historic standards, and that monetary policy was “accommodative” – a phrase that is as ubiquitous as it is meaningless.


There are many problems with this approach. In times of crisis, externalities and unforeseen shocks dominate. There is still a lot we do not know about economies in crisis; for example we still lack a full understanding about Japan’s deflation. There, conservative central bankers ruined the economy for decades.


Of all the arguments, the presence of global quantitative easing is perhaps the strongest. Europe is the region in the world most at risk of losing a currency war. Unlike normal nation states, the eurozone lacks a legal and institutional framework to deal effectively with such a situation. The most likely outcome would be a further large real appreciation of the euro, which would ultimately lead to a significant slowdown in exports and growth. One of the numerous toxic effects likely to occur in such a scenario is the imminent failure of the European bank rescue strategy. Without strong growth, it simply cannot work. So it is hard to understand, why policymakers, who are otherwise generous in their liquidity support, want to take such enormous risks, especially given an almost total lack of inflationary pressures.


So no matter whether you look at monetary policy on the basis of a model, a financial risk management perspective, or from the perspective of international policy co-ordination, you come to the same conclusion. The time to raise the interest rates may come one day. But not yet.


Copyright The Financial Times Limited 2010.