Stephen King: The ECB needs to look at the bigger picture beyond the German economy

Outlook: With 70 per cent of the eurozone in a sickly economic state, is it right that interest rates should be going up?
Click to follow
The Independent Online

The Bank of England has the wrong name but tries to do the right thing. The European Central Bank has the right name (well, almost) but ends up doing the wrong thing. Even though it doesn't trip off the tongue quite so easily, the Bank of England should ideally be re-named "The Central Bank of the UK" or something along those lines. After all, Mervyn King and his colleagues in Threadneedle Street have to worry about economic conditions (and, so it now seems, evil banks) not just in England but also in Scotland, Wales and Northern Ireland.

Still, at least the Bank of England put Adam Smith, one of the true Scottish greats, on the £20 note, thereby allaying any fears of English favouritism. In the world of central banking, diplomacy is sometimes as important as interest rate decisions.

The ECB doesn't have to worry about every country in Europe for the rather obvious reason that not every European country uses the euro. It is, however, supposed to worry about every country in the eurozone and to think about outcomes that are appropriate for the eurozone as a whole..

Following Jean-Claude Trichet's use of the phrase "strong vigilance" on Thursday – which, when decoded, means the ECB is going to raise interest rates at next month's meeting – I'm not sure the ECB really is behaving in this manner. Indeed, perhaps it should be renamed the "The Central Bank of Greater Germany" or, more simply, the Bundesbank.

As a practical step, it wouldn't be too difficult. After all, the existing Bundesbank is only an Autobahn junction away from the ECB in Frankfurt. The mail could simply be redirected from Kaiserstrasse, a stone's throw from Frankfurt's red light district (a funny place for a central bank to be), to Wilhelm-Epstein-Strasse, where the Bundesbank's stern facade offers nothing other than concrete austerity.

If the Bundesbank's monetary masters were running the show and worrying about developments in Germany alone, the case for higher rates would not be difficult to make. The German economy is enjoying its moment in the sun. Output has risen sharply; business surveys are mostly very buoyant; exports to the emerging world are booming; unemployment is very low, not only by German standards but also, remarkably enough, by US standards; and wage inflation is on the rise. With oil and other commodity prices heading ever higher, Germany's high priests of monetary stability would have the perfect excuse to tighten the monetary screws a notch.

But as Germany soaks up the sun's rays, much of the rest of Europe lies under an economic cloud. At less than 7 per cent, the German unemployment rate may be low but, for many other eurozone nations, it's a different story altogether. Excluding Germany, the eurozone unemployment rate is above 11 per cent (and, including Germany, is around 10 per cent). German growth last year came in at 3.6 per cent, even allowing for a fairly miserable final quarter. France, however, expanded at less than half that pace, Italy grew at only around 1 per cent while Spain, Ireland and Greece all contracted (source: Eurostat).

Germany is, thus, the exception, not the rule. Germany is, of course, a very big economy but it accounts for less than 30 per cent of euro-17 GDP. With the other 70 per cent of the eurozone still in a sickly economic state, is it really right that eurozone interest rates should now be going up?

Would the Bank of England set interest rates on the same basis? Imagine, for example, that Scotland, Wales, Northern Ireland and the North of England, which account for a little less than 30 per cent of UK GDP, found themselves expanding at an unusually rapid rate. Might the Bank of England choose to raise interest rates on the basis of their strength alone, ignoring economic developments in London, the South East, Birmingham, the rest of the Midlands and everywhere else in the UK? It is, of course, a totally implausible scenario.

There's worse. As eurozone interest rates rise, countries will be affected in different ways (as noted in a recent article by Janet Henry and Astrid Schilo, my HSBC colleagues). The ECB controls only short-term interest rates. That matters a lot for households in Italy and Spain, for example, who tend to have variable-rate mortgages. It doesn't have much of an impact on households in Germany, however, who typically tend to have long-term fixed-rate mortgages. If the aim of monetary tightening is to put some kind of brake on German economic expansion, the policy is likely to backfire. The rest of the eurozone will find itself in recession before the average German begins to feel the pinch.

There is a simple solution to all of these difficulties. Economic data on individual countries in the eurozone should be abolished (or, at the very least, published only with a huge lag). That way, the ECB would be forced to look at the economic picture in the eurozone as a whole. No longer would it be tempted to make decisions on the basis of economic developments in individual countries.

Admittedly, this reform isn't likely to happen any time soon. There would, however, be plenty of advantages. Most obviously, countries would have to adjust in ways that, while perfectly legitimate, would today be regarded as wholly unacceptable.

For example, if the peripheral nations are to improve their competitive positions within the eurozone, they need to ensure that their prices and wages rise less than the eurozone average. That means, however, that other countries would have to see their prices and wages rising faster than the eurozone average. In other words, Germany would have to put up with an inflation rate of well above 2 per cent to allow the ECB to hit its target of a little less than 2 per cent. That would be much easier to achieve if Germany simply stopped publishing inflation data, choosing to opt for localised ignorance for the good of the eurozone.

It's difficult to see this argument finding favour with a German public absolutely focused on the need for price stability. Yet, for the eurozone to operate properly, nations will eventually have to accept that they cannot choose their own inflation rates. All they can do, instead, is make their contribution to price stability at the European level. Better, then, to focus on eurozone data in aggregate than to worry about specific developments in, say, Germany.

There is one area where this has already happened. It no longer makes sense to talk about German, French or Italian money supply because all these nations use euros and those euros, in turn, can hop across borders with impunity.

So perhaps we should judge inflationary risks in the eurozone via money supply growth, a number unlikely to be contaminated by national interest. The annual growth rate of eurozone M3 is currently 1.5 per cent, a shockingly low outcome and enough to make old-school Bundesbankers want to cut, rather than raise, interest rates. If I were a Bundesbanker told to focus on the eurozone, rather than the German economy, I'd be worried about generalised economic weakness, not localised strength.