Higher Rates Are Hampering Europe
The euro zone economy is turning in its best performance in a decade. But the 3.6% growth rate forecast for this year is still nowhere near U.S. levels. So why does the European Central Bank keep ratcheting up interest rates when the Federal Reserve is happy to hold them steady? On Aug. 31, the ECB pushed up its key refinancing rate by 25 basis points, to 4.5%--the sixth time it has raised rates since last November. That can hardly help fuel the economic growth the euro zone badly needs if it is to close the performance gap with the U.S.--a prerequisite for a stronger euro.
Bank President Wim Duisenberg says the latest move was needed to combat inflation, which is being imported via the weak euro and high energy prices. The overall rate of inflation hit 2.4% in June and July. That's above the 2% upper limit that the ECB says is consistent with price stability. But core inflation is still just 1.3%, and there is no evidence that higher import prices are going to drive that figure higher.
The ECB move was unnecessary. It could also damage the economy. The biggest worry is that it will slow growth, making it more difficult for euro zone governments to push through much-needed structural reforms. Although they have made a start--by reducing taxes, for instance--a lot more needs to be done, especially on the pension and labor fronts. But liberalizing tough labor laws won't be easy if the economy isn't growing fast enough to create new jobs.
There's also a danger that hiking interest rates will slow the creation of New Economy industries in Europe. European companies invest just half as much on information technology as their U.S. rivals. As a result, productivity rates are well below U.S. levels. What European companies need is lower interest rates and access to cheaper money. The Fed has encouraged the growth of the New Economy in the U.S. by holding rates down even when growth and inflation were above historic trends. It has been rewarded with an economic performance that Europeans can only dream about. The ECB should follow the Fed's example. Otherwise, the Old World will never catch up with the New.