The Shoving Match Over Rates

Germany vs. Europe's central bank: It may get nastier

When German Finance Minister Oskar Lafontaine sat in on a meeting of the new European Central Bank (ECB) for the first time on Feb. 18, the talk left him squirming in his seat. The 17 central bankers, who now dictate Europe's monetary policy from a 36-story skyscraper in Frankfurt, barely mentioned Germany's economic travails. In the end, they decided unanimously to keep rates at 3%.

Watch for political fireworks if that thinking continues. Just weeks after taking over European monetary policy on Jan. 1, the ECB is facing an unexpected challenge. The German economy has been dragged down by sagging exports and business leaders' plummeting confidence in the new government. The Bundesbank estimates that the economy contracted by 0.4% in last year's fourth quarter. Germany could well be the euro zone's worst performer this year: Private economists are figuring that growth could be as little as 1%, vs. 2% for the entire zone.

That sets up a potentially explosive confrontation between Bonn and the ECB. Germany's leaders, including Chancellor Gerhard Schroder, badly want a rate cut--and fast--to boost their faltering economy. But bankers at the ECB, whose mandate is to focus on the needs of Europe as a whole, are digging in their heels. Indeed, Salomon Smith Barney and Deutsche Bank, among others, predict a cut of only 0.25% this year, half their estimate of a few weeks ago. The unexpected 6% drop of the euro against the dollar since its debut on Jan. 1 makes steeper cuts unlikely, since the ECB may be more worried about the fall of the euro than about Germany's woes. "The ECB wants to build up credibility, and it can't do it with the euro so low," contends Gerhard Grebe, a Frankfurt-based economist with Bank Julius Baer.

Germany's ruling Social Democrats are unlikely to sit idly by if the ECB doesn't act. Chancellor Schroder has plenty of problems with his Finance Minister, a political rival who is trying to push the SPD far to the left. Schroder also thinks Lafontaine could tone down his public attacks on the ECB and try quieter, backroom tactics. But there's no disagreement between the two on the need for lower rates as the key to stronger European growth. And the Germans are likely to be emboldened by new calls from U.S. Treasury Secretary Robert E. Rubin for Europe to stimulate its economy more to help alleviate the economic crises in Asia and Brazil. "I predict a big fight between Lafontaine and the ECB over the next few weeks," says London-based Salomon Smith Barney economist Jose Luis Alzola.

A 50-YEAR LOW. But central bankers figure that structural rigidities, and not interest rates, are what really ails the German economy. Indeed, with 10-year bond yields hovering under 4%, the long-term European rate is already at a 50-year low. The central bankers' clear preference is for the government to forge labor-market, tax, and other reforms in order to boost economic growth. With "a flexible economy like the U.S.'s, we would have substantially higher growth," says ECB Chief Economist Otmar Issing (box). Adds Bundesbank President and ECB board member Hans Tietmeyer: "We all agree on the need to boost domestic demand. The crucial question is how."

Business leaders argue that the new government itself is largely responsible for Germany's woes. While business confidence stabilized in France, Spain, and most of the rest of Europe late last year, it has continued to plunge in Germany. Partly that's because of a falloff in exports: Real orders in Germany fell 2.2% in the fourth quarter, vs. the same period in 1997. But the government has also provoked a crisis of confidence by its failure to deliver substantive tax reform as well as its flip-flops on policy initiatives. Salomon Smith Barney, which until recently predicted that German capital investment would rise by 1.4% this year, now thinks angry company chieftains will cut their capital spending instead. "Most German companies are not yet exporting jobs and capital, but many of them are thinking about it," warns Heinz Greiffenberger, CEO of a Bavarian machine tool company.

One way the ECB could change its resistance to sizable rate cuts is if the rot starts to spread to other continental economies. That could add several new voices to Germany's clarion calls for lower interest rates. The other big worry that might cause the ECB to loosen the monetary reins is the possibility of deflation. Indeed, with inflation running at just 0.5% in the euro zone and at just 0.2% in France, "we think the risks of deflation in Europe are rising," says Morgan Stanley Dean Witter economist Joachim Fels. That's the main reason Morgan Stanley predicts the ECB will boldly cut rates a substantial 0.75% by August.

Such doomsday scenarios aside, European rates will cause rising friction between Germany and the ECB. Social Democratic governments like Germany's are under huge pressure to create jobs, and current growth rates won't do it. Indeed, France may soon join Germany in crying for lower rates, as it often has in the past. But given Germany's slumping economy, its politicians are likely to do the loudest yelling.

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