Combating Debt and Inflation European Central Bank Faces Interest-Rate Dilemma

The European Central Bank wants to show toughness. On the day Portugal requested a multi-billion-euro bailout package, the ECB moved to raise interest rates for the first time in nearly three years. But the interest rate increase remains far too small, and success is highly questionable.
European Central Bank President Jean-Claude Trichet: Standing tough on the euro.

European Central Bank President Jean-Claude Trichet: Standing tough on the euro.

Foto: dapd

When the European Central Bank (ECB) raised its prime interest rates on Thursday, the message was clear. The euro zone is not yet down and out. The ECB is taking a stance against inflation. And the euro remains a currency to be reckoned with.

That, at least, is the message that Europe's central bankers hoped to send out. Still, it is anything but certain that the Frankfurt institution can succeed in slowing the trend of rising prices. Even after the interest rate hike, after all, the prime interest rate still remains at an extremely low 1.25 percent.

Three factors currently inhibit the kind of decisive measures needed to successfully fight inflation:

  • a sovereign debt crisis that continues to build
  • internal ECB structures
  • the global inflationary pressures

Let's start with the debt crisis. Ironically, the decision to increase interest rates came on precisely the same day that Portugal became the third euro-zone country -- after Greece and Ireland -- to seek an EU bailout  because it is unable to float bonds on financial markets under reasonable conditions. Now market players are speculating as to whether Spain will have to follow suit.

Fears of a Euro Zone Wildfire

Were that to happen, the situation would become critical for the euro zone. Although it might just be possible to prop up Spain with the funds remaining in the current bailout fund, there wouldn't be enough for any additional countries. Should the debt virus spread to highly indebted countries like Italy or Belgium, the euro-zone wildfire would become all but impossible to contain.

It is precisely this scenario that has European central bankers concerned. If they raise the prime interest rate too high, it would choke the fragile economic recovery in debt-ridden countries thus exascerbating their budget problems.

Indeed, European central bankers are faced with a dilemma. If they go too far in increasing interest rates, they could damage the ECB's independence in the longer term. Should the budgetary problems worsen in Athens, Dublin and Lisbon -- and possibly elsewhere -- worsen, the European Central Bank could be force to once again step in an buy up government bonds from the stricken countries.

It's the kind of intervention that the central bankers do not want to undertake. Such moves put the central bank's independence at risk and they make fighting inflation that much harder. But they might be left with no other choice -- because no other institutions in the euro zone are capable of doing so. (The recently agreed to European Stability Mechanism will only go into effect in 2013 and, funded with only €500 billion euros, will also have limited means at its disposal.)

Bad News for Germany

In the face of that dilemma, the ECB is only able to raise interest prices slowly and piecemeal. For stronger euro-zone economies, that's bad news. Especially for Germany, which from a domestic perspective would like to see much higher interest rates.

In a calculation produced for the business monthly manager magazin, the Kiel Economics Institute in the northern German port city concluded that if the ECB's monetary policies took only Germany into account, the prime interest rate would currently be at 3 percent and could even rise further. Because separate interest rates are impossible in the currency union, however, the low interest rates are ensuring fervent growth -- the result of which is rising prices.

The difficulties created by the economic divergence is further complicated by a second factor: internal ECB structures.

The ECB is a highly complex organism that is equally difficult to lead. No other central bank in the world has as large a governing council. With 23 members, the ECB Governing Council bears a greater resemblance to a parliament than to a lean top executive body. And no other central bank forces a relatively lightweight six-member executive board to answer to the central bank chiefs of 17 member states. And those bank chiefs are guided by the political and economic situations back home. "As a result, the common interest sometimes slips into the background," one insider told the business monthly manager magazin in a comprehensive profile of the inner workings of the ECB in the current issue.

The fact that the ECB is able to function relatively well is attributable to President Jean-Claude Trichet of France and Chief Economist Jürgen Stark of Germany, two men who are persuasive and unbending. They have largely been successful in setting the agenda behind the scenes and forging common positions within the the heterogeneous ECB Governing Council. Thus far, they have nearly always succeeded in forging consensuses backed by both the ECB and the euro zone member states. Inevitably, though, these consensuses are built on compromises.

Consensus Could Get Tougher

With the increasing economic divergence and a growing debt crisis, it will become even harder to build this consensus, especially after Trichet's planned departure this fall.

It is questionable whether his successor will be as adept as Trichet at managing the euro-divide between the different goals of the ECB (price stability and financial stability), between the interests of the euro zone as a whole and its member states, and among its individual members. It is possible that the ECB Governing Council in the future will only be able to come to agreements on the lowest common denominator, a development that would effectively preclude a clear-cut streamlining of monetary policy.

The third factor creating problems in Europe is the dynamic of growing global inflation. The central banks of the United States, Japan, Great Britain and the largest emerging countries are still pumping gigantic amounts of liquidity into the markets. This flood of money has been reflected for some time now in rising commodities prices. And wages could start rising again soon, too, as is already happening in China.

It will hardly be possibly for the ECB to fully shield the euro zone against this wave of inflation. During the 1970s Germany was unable to do it -- despite having its own currency, the deutsche mark, an independent central bank and being comparatively less interwoven with the international economy. Back then, the average inflation rate in Germany over a 10-year period was 5 percent. That was a low number in comparison with other Western nations such as Italy, Great Britain, and the US, but high by German standards.

The ECB is proud of having kept inflation rates low in the first 12 years of the euro era. On average, the rate has been 1.97 percent, and 1.5 percent in Germany. How will things progress? Doubts are appropriate. Measured against future challenges, the euro era to date has been calm.

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