Online Extra: The Eurozone: Painted into a Policy Corner?
By Peter Luxton and Timo Klein, S&P MMS
As the eurozone economy continues to grind above recession -- but well below potential growth rates -- its policy paradigms, which limit the size of member economies' budget deficits and inflation rates, risk becoming more strained. Although the region's fiscal and monetary measures will loosen overall, their impact on growth will remain relatively limited in the near term. Meanwhile, policymakers look enviously at the aggressive easing in the U.S. and elsewhere.
The budget front is where there's most angst. The Maastricht budget-deficit criteria limits shortfalls to 3% of GDP before penalties are imposed. But as a result of the sharp economic slowdown, in evidence well before September 11 and exacerbated since then, most European Monetary Union (EMU) countries' budgets have moved well into the red under the pressure of declining revenues and additional spending. S&P MMS forecasts indicate that the deficits of the big three -- Germany, France, and Italy -- should be around 1.5% to 2% of GDP for this year, stepping up to the 2% to 2.5% range in 2002, after they had achieved a rough balance in 2000. However, last year's balance was boosted significantly by telecom-license receipts. Germany especially benefited from these funds, chalking up a surplus that hit 1.5% of GDP as a result.
Balanced budgets by 2003-04 are the aim of the Growth & Stability Pact, an agreement growing out of Maastricht that all 15 EU countries signed in 1997. Its immediate goal is to allow state spending on programs like unemployment benefits and social security that rise and fall with the economy, yet put budgets on a sustainable footing and prevent a return to the fiscal mismanagement that characterized the '80s and early '90s. However, the push toward budgetary reform waned after the advent of monetary union in 1999, leaving some key players, most noticeably the big three, with still a lot of work to do.
Hence, while current deficit projections may still be under the 3% Maastricht limit, the room for fiscal maneuvering is nevertheless shrinking rapidly. Moreover, the sharp rise in deficits goes against the spirit of the Stability Pact, eliciting continued scolding by the ECB about the fiscal laxness. If Europe's economy continues to struggle, state spending and the constraints of the pact could well become much more of an issue, unlike in the U.S., where its healthy budget position leaves plenty of room to spend its way out of trouble.
With European governments constrained by the 3% rule in using fiscal levers to jumpstart growth, they are looking much more toward monetary policy. The ECB has cut interest rates by only 150 basis points, to 3.25% on Nov. 8, under two-fifths of the average rate reductions of previous easing cycles since 1980 (splicing together the ECB's record with Germany's central bank prior to monetary union in 1999). Indeed, Euroland real interest rates remain positive at around just under 1%, while nominal rates are still above the 2.5% low in early 1999.
In contrast, the U.S. Federal Reserve has chopped rates by 450 basis points, to 2% currently, putting inflation-adjusted interest rates in negative territory -- levels last seen in 1992-93. Indeed, fed funds are at four-decade lows, and rate cuts in this cycle are more than two-thirds of the average of cutting cycles since 1980 (although bear in mind that the 6% average rate reduction would imply a fed-funds rate of zero!).
In part, the ECB's relatively hesitant approach can be attributed to its two monetary policy goals: A "not more than 2%" inflation target and a 4.5% reference rate for year-on-year money-supply growth (as reflected by a broad measure called M3). Progress toward the inflation goal was thrown off earlier this year as higher oil prices and elevated food costs (the one-off effects of the agricultural crises caused by foot and mouth and mad cow diseases) took their toll. Inflation is now coming back toward target, but even so, it leaves a bitter aftertaste for the ECB.
M3 is also moving away from target, chalking up a 7.6% rise year-on-year in September. However, investors' portfolio adjustments and shift into cash and away from equities are heavily distorting the number. The ECB thus does not see these numbers as such a barrier to lower interest rates.
The prospect of a rapid deterioration in the economic environment is fraying politicians' nerves. The denial of any spillover effects from the U.S. that had characterized much of the first part of the year has given way to policymakers struggling to meet a new set of circumstances.
Fiscal constraints have led leaders to pressure for a far easier monetary stance. The politicians' frustration boiled over, culminating in the final draft of the EU's Oct. 19 Ghent summit stating (politely) that "reduced inflation should provide room for the monetary authorities to take further decisive action". Many speculate that this had to be toned down from an earlier draft at the ECB's insistence. More recently, European Finance Ministers have stepped back from the Ghent statement, trying to relieve the unseemly political pressure on the central bank.
But the politicians' increasing impatience with the ECB's studied approach is only part of the problem. Rumors were rife after the last ECB press conference on Oct. 8 that some national central bank governors were unhappy with its decision to leave rates unchanged. This is the first time that there has been such specific speculation of dissent in the ECB's Governing Council meeting, where the unanimity and consensual nature of policy decisions have always been stressed.
Whatever the truth behind such talk, it adds to the feeling that European policymakers are at odds over how to deal with the current economic downturn. Speculation about divisions with its Governing Council will not help the ECB's cause.
Luxton is S&P MMS' global economic adviser, and Klein is chief European economist.
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