Commentary: Tight Money: The Wrong Shelter For This Storm

Anyone who's still wondering whether the economic disaster in Russia and a year of crises in Asia will have a major impact on the world's industrial economies need only look at Europe. All the bad news has made forecasting economic growth there even more hazardous. For the 11 nations that must bring their interest rates to the same level by Jan. 1 to prepare for the euro, the uncertainty couldn't come at a worse time.

But from across the Atlantic, a lifeguard is watching over Europe's troubled waters. When Federal Reserve Chairman Alan Greenspan on Sept. 4 signaled that he had shifted his attention from inflation to growth, he gave the industrialized world the green light to fight deflation by allowing easier money. Japan took the hint, cutting its overnight lending rate to a record low 0.25% on Sept. 9. Europe's central bankers would be well advised to follow suit.

READ HIS LIPS. Already, the gyrations in world markets have reversed the outlook for where the members of European monetary union will fix their rates at yearend. When stock markets were flying high and growth predictions were sanguine, observers expected Germany's Bundesbank to set a tight-money benchmark for the euro zone. Instead, Europe may face a downturn. Analysts had been expecting a range of 3.5% to 3.75% for euroland's initial interest rate. Now, "we think 3.3% is a better bet," says Elisabeth Waelbroeck-Rocha, chief European economist for Standard & Poor's DRI in Brussels.

That means the Bundesbank, which had been expected to raise rates half a percentage point by yearend, may hang fire. And Bundesbank President Hans Tietmeyer seems to have read Greenspan's lips, suggesting the central bank will stay neutral for now. There's little reason for him to budge. Inflation in core Europe, discounting a rise in value-added taxes, is near zero. "There is a very strong case to keep rates unchanged," says Eric Chaney, co-head of Morgan Stanley Dean Witter's European economics team in Paris.

A lower benchmark would force Italy, with rates of 5%, and Ireland, with 6.75%, to loosen monetary purse strings even more than anticipated to close the gap. Bank of Italy governor Antonio Fazio is already fretting that his country's money supply is growing too fast. Italian rates are at historic lows. But Italy's economy grew at an annual rate of only 1.2% in the second quarter, down from 2% in the first. So Fazio had better take a leaf from Greenspan's book, as Spain already has. The Bank of Spain plans to lower short-term rates, at 4.75% now, nearly a full percentage point by yearend.

The danger, of course, is that faster-growth countries such as Ireland will court inflation with a drastic rate cut. But if the German economy slows down, so will the rest of Europe. With high unemployment in the euro zone and stiff labor competition from central Europe, wage pressures are nowhere in sight. In addition, Greenspan has made it easier for Europe to lower its interest-rate threshold by ensuring that higher U.S. rates won't suck money from the Continent.

Easier money won't necessarily mean the euro will be born weak, either. Investors have voted their approval of European monetary policy by treating the Deutschemark--the euro's proxy--as a safe haven. The mark has strengthened against the dollar over the last few weeks. "De facto, a certain amount of money has been flowing into the euro," says John Llewellyn, chief global economist for Lehman Brothers in London. Llewellyn points out that in times of crisis, money flows to countries with few overseas liabilities. U.S. foreign debt is about 13% of gross domestic product, while Europe is a slight net creditor. America's huge current-account deficit bodes well for the euro's strength.

Credibility will be an issue for the new European Central Bank when it takes over next year. Its governors want it to start life with a tough anti-inflation stance. But choking off growth in the midst of deflation would be a lousy start to EMU. Instead, Europe's central bankers should lay the groundwork for growth that can ride out global crises like today's. All they need to do is watch the lifeguard on the far beach.

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