Who's In Charge Of Europe's Money?
Amid the hoopla surrounding the euro's launch on Jan. 1, 1999, Europe's new money was hailed as the Continent's answer to the dollar's half-century of domination of the global financial system. In the future, it was said, the euro would beef up Europe's dwindling economic and political clout as it became a reserve currency of choice for the world. Better yet, its strength and allure would be a magnet for capital from around the world. And the new European Central Bank in Frankfurt would usher in an era of hard money and economic prosperity as it set interest rates across the entire 11-nation euro zone and seized the reins once held by Germany's Bundesbank.
Instead, the euro has shriveled 17.4% in value since its introduction as investors fled to the greenback in search of better returns in U.S. stocks and bonds. The ECB's one-size-fits-all monetary policy is now creating a huge Continental divide that could crimp Europe's chances for economic convergence and noninflationary growth. Booming countries on Europe's periphery, from Spain to Ireland to Finland, need higher interest rates to tame a rising threat of inflation in their fast-growing economies, while the recovering economies of core countries such as Germany and Italy need all the help they can get from low interest rates.
BAPTISM BY FIRE. The euro's deepest humiliation came on Feb. 28. Battered by a big sell order in Tokyo, which some market participants say was more than $2 billion, the euro plunged 3.7% against the dollar, to a record low of 93.9 cents. What Europe's power brokers had forgotten in their early euphoria is that reserve currencies keep their value only when global investors are keen to hold them because they are backed by strong economies and central banks that inspire confidence. By that harsh test, the 15-month old euro is judged by many to be a flop and the European Central Bank a big disappointment.
For sure, the euro had a baptism by fire. European economies were in the doldrums at the time, and vast amounts of capital were pouring out of Europe and into the U.S. Last year, about $150 billion of portfolio and direct investment cash left the euro zone. Yet even if that flow reverses, the system will still have a major flaw: Unlike the U.S. Federal Reserve System, the ECB is trying to operate a uniform monetary policy in an area that isn't united politically and lacks a common fiscal policy. As a consequence, if the ECB's actions cut output and jobs particularly hard in one country, there are no automatic adjustment mechanisms, such as budgetary transfers or easy migration, to salve economic hardship or defuse political problems, as there are in the U.S.
The ECB is hardly to blame for a system set up by its political masters. But the way the bank works compounds the problem. The ECB conveys the impression of confused--and thus weak--leadership under its president, Wim Duisenberg. He employs a consensual management style, and as a result the ECB appears to have far too many bosses. The bank's five other full-time executive committee members often disagree with each other. Chief Economist Otmar Issing, for instance, hinted in February that an interest-rate increase was in the cards for Mar. 2 because the euro's decline had raised inflationary risks. Hardly had markets digested that before Deputy President Christian Noyer confused them by apparently saying exactly the opposite.
On top of that, the 11 heads of euro zone national central banks, who with the committee make up the bank's 17-member rate-setting governing council, often behave as if they each still ran an independent monetary policy. The Bundesbank twice attempted to block rate hikes because German unemployment is high. And the bank is a handy whipping boy for populist politicians, as when former German Finance Minister Oskar Lafontaine tried to force the bank to place much more stress on stimulating growth to foster job creation. "[There was] a multiplicity of voices in the early days," concedes Central Bank of Ireland Governor Maurice O'Connell. "That was our biggest problem."
Now, the bank's major headache is to win the respect of the markets. It won't be easy, because the bank has saddled itself with two measures to determine what its interest rates should be. The so-called twin-pillar approach mandates the bank to consider both money-supply growth and a broad-based analysis of inflationary risks when setting interest rates. That's asking for trouble because the two measures could easily send contradictory signals. And indeed they do. Since the euro's launch, broad money-supply growth has been consistently above the bank's 4.5% target--indicating that higher rates are needed. But until very recently, inflation has been well under the 2% upper limit that the ECB set for Europe--suggesting that steady or lower rates were required, especially against a background of anemic growth and high unemployment. "Things are made even murkier because the ECB is a new institution without a track record," adds Uwe Angenendt, chief economist at Frankfurt's BHF Bank.
LIQUID MARKETS. National rivalries die hard, too. ECB analysts claim that hidden agendas still muddy the waters occasionally. Noyer's public disagreement with Issing, some suggest, is part of a French plan to prevent the influential Issing, an old Bundesbank hand, from gaining too much clout.
Despite its travails, though, the ECB has scored some notable successes. The euro zone's 11 national money markets have been stitched together into a seamless whole. The ECB's Trans-European Automated Real-time Gross Settlement Express Transfer System, TARGET for short, linking the payment systems of the separate countries, works with nary a hitch. And despite its weakness, the euro is a clear No. 2 behind the dollar and ahead of the yen as a reserve currency. International companies issued more bonds denominated in euros than in dollars last year. The resulting deep and liquid capital markets are a big plus for European companies needing to restructure to meet fierce global competition or for new companies looking for startup money. "The bank has been a fantastic success," insists Jean-Claude Trichet, Banque de France Governor and Duisenberg's designated successor.
All the same, growing concern in financial markets about the ECB's performance is eroding its credibility. While a lower euro does have some plus points--by making European exports more competitive, for example--it can boost imported inflation when it drives up the cost of imported materials. And the currency's big swings in value are sapping public confidence and deterring investors. Instead of controlling the markets, the ECB sometimes seems to be controlled by them--a dangerous position for any central bank, especially a newly formed supra-national one. For example, some analysts figure the ECB was railroaded into jacking up its rates on Feb. 3 to 3.25% from 3% by the euro's persistent weakness. "The increase looked like a panic reaction to the euro's problems," says John Beggs, chief economist of AIB Group, the large Irish bank. "It was a last-minute knee jerk."
Just how deep the ECB's credibility problem is right now is shown in a straw poll by ECB watcher Thomas Mayer, co-director of European economic research at Goldman, Sachs & Co. in Frankfurt. In February, he asked readers of his daily bulletin how well they understood the reasoning behind the monetary policy decisions of several central banks--a key factor in credibility. The U.S. Fed topped the poll with 4.3 points out of a possible 5. The ECB came last with just 2.2. "When [Federal Reserve Chairman Alan] Greenspan tells you rates are going up, you know they're going up," says AIB's Beggs. "When the ECB says they're going up, you're not so sure."
CONFLICTING STATEMENTS. If talking the talk were enough, the ECB and the euro would already rule the world. President Duisenberg, an imposing Dutchman with craggy features and a shock of white hair, doesn't mince words. Trouble is, he sometimes changes what he says from one week to the next. That's enough to unnerve even the most unflappable currency traders.
Early last year, Duisenberg seemed to suggest that the ECB's attitude to the euro was one of benign neglect. By summer, he was saying that wasn't the case but that the euro's weakness didn't affect monetary policy decisions one way or another anyway. He was still singing that tune throughout most of January. But after the Feb. 3 council meeting, he declared that the euro's weakness had influenced the timing of the decision to increase rates. And just a few days after that he said it had weighed on the decision to raise rates. "These conflicting statements are very unsettling," says Stefan Schneider, a chief euro economist at Deutsche Bank in Frankfurt.
Still, U.S. Treasury officials rate Duisenberg as by far the most impressive central banker in the Group of Seven aside from Greenspan. But despite Duisenberg's technical brilliance, critics say, the relaxed way in which he chairs council meetings means that the ECB lacks a firm hand at the top. At rate-setting meetings, Duisenberg usually lets council members have their say and then sums up. The result is that he is more of a first among equals than a powerful chairman like Greenspan. "Duisenberg's attempts to be neutral are confusing and can be awkward," says one central banker. "And they can lead to a lack of discipline when council members speak in public."
Duisenberg and his team are criticized for failing to prepare markets adequately ahead of interest-rate moves, too. Last November's hike from 2.5% to 3% was flagged weeks in advance. But the cut from 3% to 2.5% in April wasn't even hinted at until the last minute. Critics also say that the bank's explanations for its actions are often unconvincing. Many economists were underwhelmed with Duisenberg's argument that the 25 basis-point hike on Feb. 3 was needed to counter threats to price stability brought on by the currency's weakness. They figure that the ECB would have preferred to wait until Europe's economic recovery was more firmly rooted before raising rates but that it was shocked into action by the euro's plunge below parity.
MOMENTS OF GLORY. To make matters worse, the bank doesn't yet have an effective communications strategy. Ideally, economists say, a central bank should have specific communications channels for looking back and explaining the reasoning behind the decisions--and different ones to set the stage for the future. And they shouldn't mix the two, lest they send confusing signals. The Fed's Greenspan, for example, mostly uses public speeches and press comments to explain past actions and his twice-yearly Humphrey-Hawkins testimony to Congress to foreshadow where the Fed is headed. Duisenberg's appearances before the European Parliament don't yet have the same impact. Meanwhile, the bank's monthly press conferences look both backward and, increasingly, forward. It's all a bit of a mishmash, confusing markets about what signals the bank is trying to send. "It's as if we're juggling with two balls when we could just be juggling with one," says Goldman's Mayer.
Despite all the carping about him, Duisenberg has had his moments of glory. "Just look at the way he handled Lafontaine," says one European central bank governor, referring to the period early last year when the former German Finance Minister was pressuring the ECB to cut rates because he was worried about unemployment. Duisenberg politely told him to mind his own business. "[Duisenberg's]...a safe pair of hands," adds Ireland's O'Connell. "Definitely the sort of person you want on your side."
If the ECB wants to win respect in the markets, though, Duisenberg needs to use that goodwill to forge better communication skills. And the national central bank governors will have to "sing with the same voice from the same hymn sheet," to use the cliche in vogue at the ECB's 35-floor headquarters. They might be able to manage that. Despite all the contradictory statements of recent months, the interest-rate moves the bank has made to date have been agreed upon without a formal vote.
The ECB will also have to hone its twin-pillar policy. It doesn't need to drop it completely, because the bank needs to take account of far more than money supply when measuring threats to price stability in a large and diverse area like the euro zone. Chief Economist Issing, long an advocate of the targeting used when he was at the Bundesbank, changed his mind when he moved to the ECB. "Empirical evidence for applying a monetary target to the euro zone seemed too weak," he says.
Maybe so. But Duisenberg and his colleagues need to explain more clearly to markets how the bank works. Until then, the ECB won't command the same respect as the Fed: It will lack credibility, and the euro will likely stay on its roller coaster.