Global Briefing: ECB Foibles and the Euro

The ECB rate hike displays an antigrowth bias; stronger economic growth will do more to reduce Europe's budget deficits and debt than any austerity measures.
Publish date:


European Central Bank

just doesn't get it. Don't get me wrong, this is not a case of sour grapes. I have been

explaining since the middle of October why a 50 basis-point hike -- which is exactly what we got -- was likely at the Nov. 4 meeting. But I am concerned that the ECB's action demonstrates an inflexibility of its own with far-reaching implications.

The Wall might have fallen in Germany and the Soviet Union is no more. Technological advances are radically changing the way we live, work, and consume. But for the keepers of European monetary policy, nothing has changed. The immutable laws of the market economy remain undisturbed. They will have to be pulled kicking and screaming into the new millennium.

Capitalism during war, be it hot or cold, is different from capitalism during general peace. During war, economies shift capacity to weapons, materials and other single-purpose products, leaving less capacity for consumer goods. Workers are still employed, but there are fewer goods that they can buy; consumers don't buy tanks and warplanes. Money is chasing fewer goods, the classic definition of inflation. When that capacity is freed up during peacetime, more consumer goods can be produced, driving prices down. The former is prone to inflation, the latter disinflation.

Global investors reward growth. Whether the channel is portfolio investment (stocks and bonds) or direct investment (mergers and acquisitions), markets reward growth. The ECB's rate hike demonstrates an antigrowth bias. The market quickly offset some of the ECB's tightening by marking down the value of the euro and pushing market rates lower. The euro-zone economy will struggle to expand by 2% this year and regional prices are rising at a subdued rate of a little more than 1%. Next year, growth will likely accelerate to 3% and consumer prices to 1.5%, still under the ECB's self-chosen pain threshold of 2%.

With one fell swoop, the ECB has matched the

Federal Reserve's

tightening: Decisive, but decidedly wrong. Faster growth in Europe is no panacea, but it will make it easier to address its challenges. The U.S. economy has substantially more growth and almost twice the inflation than the euro zone. Among minority youths in the U.S., there seemed to be structural unemployment, not dissimilar from which many countries in the euro zone are experiencing. Yet the sustained growth the U.S. has experienced has seen this disadvantaged group's unemployment levels fall and wages rise.

The Gipper was right. You can grow your way out of a budget deficit. Stronger economic growth will do more to reduce Europe's budget deficits and debt levels than all austerity measures. Few economists would disagree with the proposition that the U.S. budget surplus is more the result of the sustained strong growth rather than attempts to rein in spending.

Yes, it is true that the U.S. has a large current account deficit, but the collective judgement of global investors is that the current account deficit is a function of the stronger U.S. growth rather than the loss of competitiveness. U.S. exports have risen in recent months, as world growth improved, and are actually at record levels.

To the extent that fundamental considerations favor the yen, which in my judgement is not the key to understanding the yen's fluctuations this year, it is not Japan's current account surplus. Rather, the surprise this year is the strength of the GDP numbers. Switzerland enjoys a current account surplus, which in relative terms is larger than Japan's, yet the Swiss franc has even been losing ground to the weak euro. The Canadian dollar appreciated around 4% against the U.S. dollar over the past couple of weeks as data suggest the Canadian economy is strengthening just as the U.S. economy appears to be slowing, albeit from heady levels.

ECB officials suggest that rather than hitting the break they are taking their collective foot off the accelerator. That sounds nice and all, but that's not an argument, its an analogy. That the rate hike will reduce market uncertainty is a bit disingenuous as ECB comments caused that uncertainty in the first place. That it won't hurt the recovery and that it offsets the risks of inflation are forecasts, but based as much on hope as rigorous analysis.

The euro sold off hard after the ECB's rate hike. The technical damage is serious. A similar scare took place in the middle of September and of course it subsequently recovered to new highs. A move back above the $1.0430 area would be encouraging, but a move above $1.0550 is really needed to signal a low is in place.

But if the race is whose economy is fundamentally stronger, the euro zone or Japan, my money is on the former and would look for the first sign that the euro has bottomed against the dollar at the yen-euro cross. This has been an arguably underappreciated axis in the foreign exchange market this year. Technically, signs are suggesting that the euro is indeed bottoming against the yen. To raise confidence, the euro needs to rise above the 111.00 area against the yen. This would signal a move toward 115-116 yen.

Marc Chandler is the chief currency strategist for Mellon Bank. At the time of publication, he held no positions in the currencies or instruments discussed in this column, although holdings can change at any time. While he cannot provide investment advice or recommendations, he invites you to comment on his column at