How the ECB heeded Corporal Jones's advice

Being pre-emptive is all very well if you know what is going to happen in the future
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The Independent Online

"Don't panic! Don't panic!" Wise words, perhaps, but Corporal Jones' actions were, ultimately, far more revealing. I'm not sure whether Wim Duisenberg and his colleagues at the European Central Bank (ECB) have ever settled down to watch an episode of Dad's Army. Nevertheless, it's fairly clear that, unlike Walmington-on-Sea's family butcher, panic is the last thing on their minds. Despite a collapse in Germany's Ifo business climate survey to levels seen only in previous recessions (see top chart), the ECB chose last week to leave interest rates unchanged. Ernst Welteke, the Bundesbank President and, of course, one of those responsible for setting Europe's interest rates, said on Friday that the ECB should not act "hectically" at the moment. Calmness, apparently, is designed to instil confidence. Then again, Captain Mainwaring was never one to panic ...

The ECB's soporific attitude might seem a bit odd in the light of current circumstances. However, it's worth noting that, since the 11 September attacks, the ECB has reduced interest rates by exactly the same amount as the Bank of England. It's just that the ECB made its changes all in one go whereas the Bank of England has adopted a more gradualist approach.

More importantly, the ECB, alongside the Bank of England, faces a tricky dilemma. The collapse in the Ifo German business climate survey and, subsequently, the fall in the CBI's measure of business optimism (see bottom chart) are seriously worrying. At these levels, it would be perfectly reasonable to think that recession is on the way in Germany and the UK. But do these collapses presage a genuine economic slowdown? Or, instead, are they simply "moments of panic", knee-jerk responses to the 11 September attacks, the Anthrax scare and the military activity in Afghanistan?

"Moments of panic" have been seen before. During the 1998/99 Asian crisis, for example, the CBI business optimism series collapsed but proved to be a completely false signal. Recession was apparently on the way yet, ultimately, it never arrived. Admittedly, the Bank of England cut interest rates – which may have gone some way to avoiding recession – but it's difficult to believe that this was the only reason why the CBI's members turned out to be "crying wolf".

The main difficulty was associated with expectations. Business optimism collapsed because people saw only the negatives associated with the Asian crisis – falling exports, greater uncertainty, potential job losses, lower consumer spending. At the time, it was more difficult to see the positives – lower commodity prices, lower interest rates, capital inflows from Asia and, as a result, higher asset prices. Had these been correctly anticipated, it is doubtful that businesses would have complained to the same extent.

In other words, the collapse in business optimism was, in effect, a forecasting error. It was based on the – false – assumption that there was a readily identifiable relationship between a shock in one part of the world and that shock's impact on countries elsewhere. The problem today is similar. We knew that the US had big economic difficulties earlier in the year. We now know – post 11 September - that those difficulties have got even bigger. But we only think we know that this is bad news for everyone else.

So what should the ECB do? Let's assume that Europe's central banking platoon thinks that the survey data are no more than a "moment of panic". Based on that judgement, one option is to do absolutely nothing other than to reassure Europeans that there are no fundamental problems within the European economy. On this basis, aggressive interest rate cuts now might simply undermine the stability of the European economy. Growth might be too strong, the euro could be undermined still further and inflation might rear its ugly head (although I would suggest that these dangers are relatively slight).

Alternatively, assume that the Ifo business climate survey is absolutely right. After all, unlike the CBI survey, it's never given a false signal in the past. On that basis, the ECB should be cutting interest rates very aggressively. Failure to do so could, again, jeopardise the ECB's ambitions on inflation, this time by leading to an unwanted undershoot in response to an early move into recession. Unemployment would be higher, profits would be lower and Wim Duisenberg would be about as popular as Warden Hodges.

Which path should the ECB choose? Central bankers, generally, are more interested in minimising failure than maximising success. On that basis, they will choose neither path. Given that they simply do not know whether the Ifo business climate indicator is "telling the truth", they will hedge their bets. That means only modest action in the short term with a recognition that, should the message from Ifo be confirmed, there will be a lot more work to do on interest rates in, say, the first half of next year. A similar argument might equally be applied as far as the Bank of England is concerned.

This might seem like a rather weak response but, in current circumstances, it may be the best that our central bankers can do. We tend to assume that bankers' crystal balls work pretty well and that, in our new world of low inflation, they can act a lot more pre-emptively to any given shock. These assumptions may be partially true but they're certainly not the whole truth. Being pre-emptive is all very well if you know what is going to happen in the future but, otherwise, it's just a calculated gamble. Moreover, it may be the case that you simply cannot, through policy alone, force your economy on to the most desirable path.

A good example comes from the US. It's generally assumed amongst economists that changes in interest rates take a year or so to feed through to the economy at large. The US economy showed initial signs of distress in the second half of 2000. Those distress signals, of course, became a lot more obvious in the first half of 2001. If the Federal Reserve was going to be truly pre-emptive to deal with this slowdown, it should have been cutting interest rates in the second half of 1999 and the first half of 2000.

But hang on a minute. That was the period in which one of the biggest and most crazed bull markets of all time was at its zenith. Would it really have been sensible – let alone credible – for the Federal Reserve to have been cutting interest rates back then? Of course not. The problem for central bankers, of course, is that they have no direct influence over people's expectations. Had they cut rates in the second half of 1999, the Fed's policymakers would simply have inflated a bubble that was already wildly out of control. That might have delayed the eventual downswing. But it might also have made the downswing even worse than it's now going to be.

At the end of the day, there are limits to the pre-emptive nature of economic policy. We don't live in a world of perfect foresight, a world of "push-button" economics where a timely change in interest rates will save the day. Central bankers can hope to have some influence on people's economic expectations but they are certainly not able to control those expectations. In my opinion, interest rates in Europe now need to fall quickly. But I doubt that the ECB will be persuaded to cut by more than 25 basis points over the next few weeks. After all, Wim Duisenberg does not want to take the risk of being told by one of his more hawkish colleagues a year down the road: "You stupid boy – hike."

Stephen King is managing director of economics at HSBC.