ECB plans euro-11 shock absorber

Date: 16/07/1998

By Tim Jones

THESE days, it is a surprise when economic and monetary union surprises.

Despite the cat-fight at the May Day weekend summit in Brussels, the euro-process has trundled along at an entirely predictable and unstoppable pace since the beginning of the year.

Most commentators said 11 countries would take part and they will. Similarly, as the French feared, European Central Bank President Wim Duisenberg has already proved an able German Bundesbank clone. Policy discussions will be kept secret and minimum reserves will be exacted from commercial banks à l'allemand.

The ECB also seems to be aping the Bundesbank in another, more appealing way, with its semi-detached board members proving to be far more entertaining and enlightening than its paid employees.

It was for this reason that the EMU surprise, when it came, emanated from the unlikely city of Vienna and Austrian National Bank president Klaus Liebscher. During a discussion with foreign journalists, he let slip an original idea for coping with 'exogenous asymmetric shocks' once the euro is up and running.

In layman's terms, this refers to the impact on an economy of a shock event beyond its borders - a massive increase in oil prices, a collapse in Asian export prices or a refusal by Latin American nations to repay bank debt, for example - but which is felt very differently by different regions.

“So far, there are no signs that there will be any such asymmetric shocks. But we must think about what means will be available to us to deal with this possibility, without touching interest rates, since these must remain identical in all euro-zone states,” said Liebscher.

An imaginative answer may well be required. Even though EU economies have 'converged' with the advent of the single market and in response to the demands of the Maastricht Treaty, the fact is that they are still quite different.

Ever since the industrial revolution, economies have learned to specialise to compete.

In the US, services account for more than 70&percent; of total employment, compared with under 60&percent; in Germany and Italy.

Within the euro-11, the Netherlands employs 23&percent; of its labour force in industry and Ireland 28&percent;, while Germany still commits 38&percent; of its workers to manufacturing.

An external shock will usually hit manufacturing first and hardest while services, other than tourism, often depend on domestic demand.

In 1973, war broke out between Israel and the Arab nations while, at the same time, the Organisation of Petroleum Exporting Countries (OPEC) curbed oil production and hiked prices. This was a terrible asymmetric shock, hitting the big oil importers such as Germany and Japan much harder than the US.

Non-essential lighting was switched off, television broadcasts suspended, industry put on short-time working and, in Japan, rumours that toilet paper supplies would run out sent people scurrying to the shops.

The world had a similar experience in 1979-81 with the Iranian revolution and another 24&percent; OPEC price rise.

If anything, the world has the opposite problem today, with oil prices hitting a 25-year low. But for some countries, like the UK, Norway and Russia, the recent fall in the cost of oil is tinged with worry that their net oil exports are earning so little.

Until now, governments and central banks have been able to offset the effects of these shocks with currency devaluations and interest rate cuts.

During the recent 'credit crunch' in South Korea when banks were reluctant to continue lending to the corporate sector, the government encouraged banks to push down interest rates and revive lending by providing them with extra money.

This kind of autonomous action will no longer be possible in the single currency zone once the euro has been launched.

Take what might turn out to be an apt example: a collapse in the value of the rouble, Russian hyper-inflation, the refusal of domestic banks to lend to already cash-poor enterprises and a reluctance on behalf of both the government and private agents to repay debt to their foreign creditors.

Given that the White House itself has dubbed the current crisis in Russia to be a “moment of peril” and called on Moscow and the International Monetary Fund to settle their differences over an emergency aid package, this is no idle notion.

If the worst happened, it would have an impact on economic confidence throughout the world but its effects within the euro-11 would be varied.

The last time the Russian economy disintegrated, when the Soviet Union disappeared in the early Nineties, Finland alone fell into a black hole. In 1991-93, the markka lost 12&percent; of its value, the economy shrank by 11&percent; and joblessness soared from 4&percent; of the workforce to 20&percent;.

Nobody emerged completely unscathed, but only Finland was hit with this scale of ferocity.

In 1991-95, when the Finnish economy shrank by 0.5&percent;, close neighbour Denmark grew by 2&percent; and Luxembourg by 5&percent;.

A Russian crisis today would not only rip through central and eastern Europe and Austria and hit Finland again (although less hard than seven years ago), it would also threaten German banks with their estimated 30 billion ecu of outstanding loans in the country.

If the ECB 'accommodated' this shock by relaxing interest rates and guiding the euro lower on the foreign exchange markets, this might threaten to stoke up inflation in France or Italy.

Injecting extra cash into the euro-11 economy could spell trouble in countries which are already said to be overheating, such as the Netherlands, Ireland and Spain.

Liebscher has a solution. “We cannot change interest rates for one country but not the rest, but we have the possibility of dealing with it through the disposal of liquidity,” he argued.

In practice, this would mean that the national central banks which are part of the ECB's network would be allowed to inject extra money and very short-term financial assets into the economy via the banking system.

This could be done by reducing the amount of compulsory reserves the commercial banks have to deposit with the national central bank, or by declining to sell as much in 'repos' (sales and repurchase agreements) to the money markets, thereby leaving more cash in the economy.

Liebscher's critics claim, however, that pumping extra liquidity into one nation's banking system would be a mistake. It could not be contained. In a free capital market, the ECB could not be sure that the increased liquidity would not be borrowed by foreigners.

There would certainly be disincentives. If an Austrian slump were met by an increase in the supply of money to domestic banks, it is unlikely that German or Italian companies dissatisfied with their own bank managers' terms and rates would queue at the door to refinance loans in Vienna.

Nevertheless, the risk is there, and central bankers are not known for their fondness for risk.

They all know that during the first oil shock, some national authorities lost control of inflation after they accommodated what they though to be a one-off rise in the general price level. Instead, expectations of future inflation rose and they were incapable of preventing this price rise feeding through into domestic wages and other consumer prices.

Ultimately, the test for the ECB will be how 'credible' its general policy framework is and that will require much greater policy openness than the bank has so far been ready to show.

“Any central bank that wishes to accommodate temporary shocks to inflation must ensure that private sector agents understand their motives and accept the reasoning for the policy,” said Bank of England deputy governor Mervyn King in a recent speech.

“If the markets suspect that the central bank is not fully committed to its inflation target, then the outcome will be either a rise in inflation or a larger loss of output. Transparency and openness of the central bank's actions are a natural partner to its commitment to low inflation and to counter-cyclical use of monetary policy.”

Euro-11 growth patterns after shocks

GDP growth (average annual &percent; change)