The Wall Street Journal

May 19, 2003

 Euro-Zone Inflation Falls on Strong Euro, Cheaper Oil2
 ECB Leaves Rates Alone to Cut Risk of Deflation3

The 'Average' Interest Rate
In Euro Zone Helps No One


BERLIN -- To get a sense of what ails the euro-zone economy these days, take a look at the euro bank notes introduced last year for the 12 European countries that share the new common currency.

Unlike most bank notes, euros have no images of famous natives or local landmarks, such as, say, Beethoven or the Eiffel Tower. Instead, generic bridges and archways are displayed.

The reasoning: Rather than risk offending euro-member countries not represented on the notes, the European Central Bank opted for images that don't relate to any one country.

The same thinking applies to its monetary policy. The ECB looks at the currency zone as one region, rather than 12 separate countries with different economic conditions. The problem is that when the countries tied themselves to the euro in 1999, their economies hadn't yet converged -- and still haven't. The result is an interest-rate policy that doesn't quite suit any country.

[Cautious Europeans]

"Since no country is average, you've ensured that every country has the wrong monetary policy all the time," says Carl Weinberg, chief economist with High Frequency Economics Ltd., an economics advisory firm in Valhalla, New York. Setting interest rates is "hard, if not impossible, if you set it according to the average in the euro zone."

A host of factors explains the underperformance of the European economy -- which appears on the brink of a recession after Germany, Italy and the Netherlands reported last week that their economic growth shrank in the first quarter, bringing euro-zone growth to a standstill. Most economists expect growth this year for the zone of 1% or less, half the rate expected for the U.S. economy.

Inflexible labor markets, high wages, prohibitive tax rates and regulated markets head the traditional list of so-called structural problems that plague the European economy. Inflexible labor markets, high wages, prohibitive tax rates and regulated markets head the traditional list of so-called structural problems plaguing the European economy. The euro's rise of recent months -- up 10% since November -- is also crimping the recovery. The strong euro makes exports less competitive and makes U.S. earnings of European companies less valuable when converted back to euros.

Plus, European firms have been much slower than their American counterparts in working out balance-sheet problems after the technology-driven bubble burst two years ago. With 90% of their financing still in the form of traditional bank loans, European firms are under much less pressure to return to profitability than American companies, who receive just 12% of their financing from bank loans, according to John Lipsky, chief economist with J.P. Morgan Chase. American firms get the majority of their financing from securities markets, which are more demanding than banks.

But even more decisive in explaining the current growth gap of the two economies are monetary- and fiscal-policy differences, economists say. While the Bush administration has introduced the biggest U.S. fiscal loosening in decades, swinging a big surplus into an equally large deficit, euro-zone countries are laboring to keep their deficits under the limit of 3% of gross domestic product mandated in the Maastricht treaty. Faced with sanctions from the European Commission for its high deficit, Portugal last year slashed public spending, which pushed up unemployment by one-third to 6% and halted growth. Germany and France, too, are under pressure to cut their soaring deficits.

Interest rates may be even more problematic, as the case of Germany shows. Unlike the U.S. Federal Reserve, whose mandate is to fight inflation and maximize employment, the ECB must only keep prices stable, defined as an annual growth rate of consumer prices of 2%. While inflation in the euro area is falling, it remains above that level, at 2.1% in April, which is why the ECB has been reluctant to cut rates further.

But behind that average lie wide variances in inflation rates among the member countries. Poorer countries like Spain and Portugal, which are trying to catch up to wealthier countries like Germany, have inflation rates above 3% at the moment. Germany's inflation rate is below 1%, prompting fears of deflation.

If the German central bank, the Bundesbank, were still setting rates, Germany would have a rate up to a percentage point or more below the ECB's current 2.50% rate, says Luigi Buttiglione, European economist in the London office of Barclays. "This inflation target is too low for an area of such diverse economies," he says. In the meantime, its policy hands tied, Germany is sinking bank into recession, possibly pulling down the rest of the region with it.

The ECB has shown a willingness to listen to its growing legion of critics. It has scrapped its adherence to money-supply growth as one of its policy-setting criteria, seen as a senseless leftover from the Bundesbank days, and earlier this month slightly loosened its definition of price stability.

Still, some economists say the central bank's manifold duties run counter to setting sound monetary policy. As a new institution, it must be careful to respect the feelings of member countries. With 18 individuals deliberating policy, compared with 12 members of the U.S. Fed's Federal Open Market Committee, a no decision is likelier than any action. "It's like a small parliament," says Charles Wyplosz, a professor of economics at the Graduate Institute of International Studies in Geneva. "And I don't like the idea of a parliament making monetary policy."

Write to Christopher Rhoads at christopher.rhoads@wsj.com1

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Updated May 19, 2003

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