Commentary: Europe's Central Bank Can't Fight Stagflation Alone

Sometimes it seems as if the European Central Bank is cursed. The inflation-phobic ECB has been a model of monetary virtue. It has done everything in its power to crush rising prices in the euro zone--and suffered withering opprobrium for strangling growth in the process. And what harvest is it reaping? An increasing number of commentators say the result is stagflation, that ugly combination of a flagging economy and rising prices that put central bankers in such a quandary in the 1970s. Back then, if they raised rates to quell inflation, growth slowed more. If they cut, prices took off.

To be sure, conditions aren't as dire as in 1973, when the first oil-price shock pushed inflation to an average of 13% in industrialized countries, bringing recession with it. Yet the confluence of higher world oil prices, a weak euro, and a global slowdown has left the ECB in the same boat as the central banks of 30 years ago, especially since the ECB's creators gave it only one mandate, inflation control. That affords the bank less flexibility than the U.S. Federal Reserve, which has a broader brief.

"WORST NIGHTMARE." In recent weeks, numerous indicators have shown that the region's economy, which grew at an annual 3% in the first two months of 2001, won't top 2% for the year. Meanwhile, consumer prices rose an annualized 2.9% in April. Not the end of the world, but way over the 2% threshold beyond which the ECB thinks prices are becoming unstable.

The local picture is worse. First-quarter growth in the Netherlands was just 0.1%, while inflation topped a 5% annual rate for April. "If this isn't stagflation, I hate to think what is," says a senior Dutch banker. Adds Paul Podolsky, chief foreign exchange strategist for U.S. bank FleetBoston Financial Corp: "The ECB's worst nightmare is unfolding."

There are certainly grounds to criticize the ECB's stewardship of the euro-zone economy. For example, by setting its inflation target so low, it had to keep interest rates too high for too long. And ECB President Wim Duisenberg's clumsy way with the currency markets hurts the euro. Traders dumped it on May 24 after he said that "the exchange rate of the euro is not a target" for the ECB. That told them: Don't worry about intervention, boys. Sell away.

But the ECB's impotence points up the flawed way Europe makes economic policy. As the only politically independent euro-zone body, the ECB is left holding the bag when things go awry. The one thing that could have given Europe more resistance to the U.S. slowdown was structural reform. But pols dally over pension and welfare cuts, labor-market deregulation, and tax relief. That's why Bundesbank President Ernst

Welteke and other central bankers press leaders to face these issues. As Welteke notes, with less red tape, more German companies would hire, boosting consumption and growth.

BIG DRAG. Those aren't quick fixes, but showing resolve would give psychological support to the euro, mitigating inflation and easing the ECB's bind. The chronically weak euro drives up imported energy costs, thus slowing growth--leading to a weaker euro. It doesn't even help exporters much, since foreign demand is down. In Germany, inflation hit a seven-year high of 3.5% in May, while first-quarter foreign orders fell 5.8% from the last quarter of 2000. All this is in the euro's price. After rallying in January, the currency was at $0.8471 on June 6, beneath the $0.8550 at which central banks intervened on Sept. 22. But intervention can't do much against a flood of bad news.

European leaders should take a hard look at what they've wrought. The ECB must be independent to be credible, but it can't manage the economy alone. Politicians have to assume more responsibility for its long-term health. As it is, elections in France next spring and by next fall in Germany will keep the ECB in limbo. Eventually, the U.S. will rebound, oil prices will succumb to weak demand, and Europe will recover. Meanwhile, euro-zone residents suffer. Stagflation still hurts.

By David Fairlamb

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