PALO ALTO, Calif. — The more French President Nicolas Sarkozy attacks the European Central Bank and the strong euro, the more he is criticized in the European media, by European finance ministers, European Union officials and the ECB itself.
The critics are right. The fundamental reason behind France’s current economic weakness is its lack of competitiveness even in other euro-zone economies where the euro is not a factor.
But Sarkozy has a point. A perfect storm is forming in the foreign-exchange markets that threatens to catapult the euro to levels that will make even the euro zone’s most efficient exporter — Germany — unable to compete in world markets. If German exporters can’t compete at 1.50 euro to the dollar, what chances do French exporters have?
The euro is gaining ground for several reasons. A precipitating factor is that the U.S. Federal Reserve has had a dramatic change of heart about the strength of the American economy. Fed Chairman Ben Bernanke is now extremely concerned that the economy’s housing market and mortgage problems will cause a recession unless interest rates are aggressively cut even if this means taking some risks with inflation.
This new “no recession” Fed policy has started the dollar down the path to new lows. The decline will likely be sustained by the substantial U.S. current account deficit, which found in Bernanke’s cuts the spark it needed to make its impact fully felt in foreign exchange markets.
Of course, if interest rates also were being cut in the euro zone, the fall in the dollar against the euro would be moderated. This is Sarkozy’s major point. But the ECB has made it clear not only that interest-rate cuts are not on the table — it is merely postponing, not abandoning, the interest rate increase originally planned for September.
The perfect storm is forming because both Europe and America, for different reasons, are following monetary policies that encourage the euro to rocket to dangerous levels.
The anti-inflation hawks in Frankfurt are not at all happy with Bernanke’s aggressive 50-basis-point cut and the promise of more to come. It gives comfort to ECB critics like Sarkozy, and otherwise puts pressure on them to drop the central bank’s inflationary bias because of its effect on the euro.
Some are recalcitrant and are more than willing to see the euro rise because, with rate hikes off the table, the strong euro may be the only way left for fighting the incipient inflation they fear.
But this policy is unsustainable. The ECB should drop its inflationary bias because the European economy is weakening, and the weaker economy will contain whatever inflationary pressures now exist. The anti-inflationary bias, which made sense until recently, now is seriously out of whack with current economic realities.
But European officials — and not only the ECB — seem very reluctant to admit that their economy is faltering, fearing that it will further weaken confidence and add to the slowdown pressures. Every soft number — and there have been plenty lately — is given a positive spin (“euro-zone economic fundamentals remain strong” or “the economy remains robust”) — and the media goes along with the deception.
The Ifo business confidence indicator in Germany has been down four months in a row but, according to Ifo, “the ECB does not have to change policy.” The European Commission’s economic index is plummeting, purchasing managers indexes are down, and so are German retail sales.
Ordinary Europeans will pay a high price for their leaders self-deception and mistaken policies. The longer the ECB maintains its inflationary bias, the steeper the consequent economic decline as the economy crumbles under the weight of the skyrocketing euro and interest rates that are too high for current economic realities (though lower than where the ECB hawks had planned to go before the current financial crisis hit).
Ironically, the ECB will have to cut interest rates sooner, and by greater amounts, because its inflationary bias is sending the euro to dangerous levels for the current state of its economy.
It will not do ECB credibility any good if takes an economic collapse to convince it that the coast is clear on the inflation front. The ECB is not the old Bundesbank, which had such public support and trust in Germany that it could get away with almost anything. The ECB’s margin for error is much narrower — the support of its constituents less deep. A major policy mistake and the same public officials now criticizing Sarkozy for attacking the ECB will be joining him.
Maastricht treaty or not, loss of public support for the ECB will diminish its independence.
Melvyn Krauss is a senior fellow at the Hoover Institution, Stanford University. Copyright 2007 Project Syndicate (www.project-syndicate.org)