What to Expect from the European Central Bank
by admin
The European Central Bank (ECB) has become the second most important central bank in the world in less than ten year’s time. By historical standards, it’s still a small, fragile infant. Up till now, it’s behaved largely like the Fed did during the 1990s. But times are a-changing, the baby is growing, and forex traders might end up losing a whole lot of money if they assume the child always behaves like the baby.
Furthermore, since the inception of the ECB, scholars have been writing articles with titles such as, “New Euro Challenges Dollar Hegemony.[1]” That’s a pretty huge exaggeration. However, the euro – and with it, the ECB – is growing in importance very quickly. Simultaneously, the dollar has started showing discomforting levels of volatility as soon as everyone stopped believing in the strong dollar policy. So, while the ECB isn’t going to be taking the place of the Fed anytime soon, it is only going to grow in importance as the years go on.
What, then, is the true colors of ECB? Answering this question will make you a better forex trader, and will, over the long run, increase your profits on the forex market. This article will give you the background you need to have a better idea of how the ECB will behave in the long run.
Anyway, Once Upon A Time…
The euro came into existence on January 1, 1999. It became the only recognized currency of 12 of the EU nations in February of 2002. Those nations were France, Germany, Spain, Portugal, Luxembourg, Belgium, Holland, Austria, Finland, Italy, Ireland and Greece.
Making it 13 in 2007, Slovenia was the first of the new EU states to convert to the Euro. I’ve never met a forex trader that cares about this fact.
That the ECB is influenced by the political economies of all these countries, however, is important: The bureaucracy at the ECB is made up almost entirely of officials from these countries’ central banks and finance ministries. So, unlike the Fed, the ECB is made up of bureaucrats from different countries, schools of thought, and with different bases of political power.
It’s especially important to look at France and Germany here. These two countries are by far the most economically powerful nations of the euro currency zone. In the years before the euro, their central banks had very, very different outlooks on the world, and were often in sharp disagreement with one another. Still today, their finance ministries disagree on a great number of critically important issues
It’s hard to overstate the degree to which these two groups of financial experts have been at each other’s throats over the years. Think of them as the Bloods and the Crips of world of monetary policy. The German central bank, or Bundesbank, as it was known – it technically still exists, but not in a manner that anyone cares about – was composed of perhaps the most hardcore inflation hawks in the world. They held even more political autonomy from elected officials than the Fed, and they are widely accredited with causing at least one unnecessary recession in Germany with their hyper-focus on inflation.
The French central bank, on the other hand, was much less independent from the central government. Where the Germans would focus on inflation, the French would focus on growth. When the EU countries experimented with different schemes to protect their currencies from the swings of the forex market, the French and Germans were invariably at loggerheads, and the other countries would generally fall into line with one camp or the other.
While the policy differences are not as extreme as they were in the 1970s, those same loose political coalitions still exist in the world of European monetary policy. The Germans and Dutch still head up the inflation hawks, and the French, backed up by the less wealthy EU states, are the most reliably pro-growth.
Almost all of the leaders in the French central bank and finance ministries – as well as prime ministers and presidents – come from ENA, which is an acronym for Ecole Nationale d’Administration, or the National School for Administration. This is a graduate school that is selected almost entirely from graduates of Sceances Po. Sceances Po is like the French Harvard, MIT and Yale all rolled into one – except more selective, rigorous, demanding and devoted solely to the social sciences. From this elite group, only a handful of students are selected each year to go to ENA. ENA graduates generally consider themselves to be smarter than everyone else in the world. Adding an obnoxious air of legitimacy to their claims, they are, as a class, much more thoroughly trained as technocrats than any other country’s ruling elite.
ENA is mentioned here because the French officials that work at the highest levels of the ECB will almost invariably be graduates of the school. So, know that (a) they consider themselves more knowledgeable than the rest of the world and thus (b) will have the necessary confidence to do things that the rest of the financial world is telling them not to do. Keep that in mind when thinking that everybody knows for certain what the ECB is going to do.
But – fortunately or unfortunately, depending on you perspective – the French usually are not in charge of the ECB. When the diplomats finally finished negotiating, the ECB ended up looking a whole lot more like the Bundesbank than it did the French central bank. It is as firmly removed from the control of Europe’s elected political leaders as the Fed is from American politicians. Because no one knew how well the whole euro thing would work out, the French and their allies had to give way to the Germans and Dutch in negotiations over the makeup of the ECB, as those two groups of bureaucrats were much more trusted by the international financial markets.
Due to all this, the ECB ended up being largely controlled by bureaucrats from the Bundesbank and the Dutch government at its inception. During the day-to-day political tussles over inflation v. growth that have occurred since then, the inflation hawks have just about always won out. In fact, the founding mission of the ECB – as described in the Maastricht Treaty – is not to promote growth while keeping inflation low, as it is with most central banks. Rather, it is simply to keep inflation low.
So, to sum up in the most direct and accurate way possible the current behavior and makeup of the ECB: It is a massive, de facto clone of the Bundesbank. It is a hardcore inflation-fighter. It’s mission statement is completely devoted to price stability: “The European Central Bank and the national central banks together constitute the Eurosystem, the central banking system of the euro area. The main objective of the Eurosystem is to maintain price stability: safeguarding the value of the euro.”
If the past was inherently prologue for the ECB, that’s where this article could stop. I’d love for that to be the case. I could regurgitate a basic description of the actions and personality of the old German central bank, or just provide a link to some article on the subject, and then lay my head down on my pillow for some sweet, sweet rest. I’d be betraying my work ethos as a writer and student of political economy, but, hey, that stuff went out of style a long, long time ago.[2]
Past, however, is rarely prologue when important international institutions mature out of their infancy. It makes sense for the ECB’s almost maniacal focus on inflation to be enshrined into EU doctrine, as it does for the ECB to start off by building a reputation as a rabid inflation hawk. Both of these things establish the bank’s inflation-fighting street cred with the markets. That credibility will give it more policy wiggle room in the years to come. First impressions, even with markets – perhaps especially with markets – count for so much more than third or fourth impressions.
Another reason the ECB had some different prerogatives during the launch of the euro and throughout the first political economic era after its launch: There was no guarantee that the euro would succeed. The EU member states had been trying to get the upper hand on the forex market for many years, only to cost their economies billions, and all the while making themselves look like fools… George Soros making the Bank of England call him “daddy” in about a single day is only the most enjoyable of examples.
At any rate, the founding of the euro and the relatively innocent times that it took place in are now distant memories. The political economic realities the EU finds itself ensnared in nowadays are completely different than when the institution was created. Even now, member states are beginning to clamor for a more balanced approach at the ECB.
In part this is because of the low US dollar. Major European firms are beginning to be at a serious disadvantage vis-a-vis American firms in critical markets. The pressure on by Airbus – which recently had to raise its prices due to the euro’s strength and the dollar’s weakness – is perhaps the most visible example of this trend, though it certainly is not the only one.
It is clear that the ECB will have to give way and begin cutting rates at some point in 2008. What isn’t certain – and what is more important, in terms of the long term character of the ECB – is whether or not the bank can face a long term continent-wide recession without being forced to adopt a more casual – some say reasonable – attitude towards inflation.
To put the question another way: Currently, the makeup of the executive board of the ECB is dominated by the inflation hawks who don’t necessarily mind an extremely high currency that is beginning to harm the continent’s exporters. Even France, Italy and the other countries that generally emphasize growth over inflation have not appointed officials to the executive board that were particularly out of line with the mainstream of the ECB.
However, the political coalition that favored a Bundesbank-like approach to European monetary policy was forged at a time when the global economy was doing relatively well; Alan Greenspan had somehow managed to achieve near demi-god status; and the US dollar had yet to begin a full-throttled free fall partially resulting from his foul mis-reign.
The looming global recession shows potential to be both long and deep. As key European exporters begin to clamor for a weaker euro, and more governments begin to lose elections due to economic troubles, it is possible that the long standing majority status of the inflation hawk coalition will become seriously jeopardized.
It would take a lengthy process of political upheaval to penetrate the relatively apolitical executive board of the ECB. It is almost certain the ECB will never partake in the old French or Italian cavalier attitude towards inflation. However, it is entirely possible that the identity of the bank will move a significantly to the left.
Possible, but is it a likelihood? That is to say, will the ECB remain a massive, de facto clone of the Bundesbank even in the wake of the political battles over its policy decisions that a relatively harsh recession would spark?
This is where we enter uncharted waters. In the US, congressmen will make a scene if the Fed is doing politically impalpable things, but unless the Fed really just goes batshit crazy, it gets to do what it wants, and the next chairman won’t be a huge departure from the last. In times of recession, scrutiny gets a bit harsher. In general, though, there is a single dominant school of thought about how the economy works among US government elites – a view which is, by the way, quite thoroughly corrupted – and that view rarely if ever gets challenged. So, even if a group of Democrats will now and again clamor for a greater focus on jobs instead of inflation, we all know the Fed isn’t going to be changing much. Diane Feinstein and a bunch of other centrist politicians who are under the mistaken impression they know the slightest thing about economics virtually ensures this.
The same is true with most other countries’ central banks, minus the overriding technocratic legitimacy that the Fed and its economists have within bureaucratic circles.
As has already been noted about the euro area countries, however, there is a relatively heterogeneous group of elites that are simply not ideologically aligned with one another. More importantly, they do not share the same political base.
Even more importantly, these elites do not share the same political and economic concerns. While there is much political connection between all the EU member states, there is much more economic competition and disparity. In fact, one of the strongest arguments against the single currency was that it was an economically bad idea because the “European economy” was really a set of extremely diverse national economies. Germany, for instance, can be ticking away at a 4% growth rate while Spain is plummeting into recession. By removing national currencies, the euro robbed governments of the ability to orchestrate a national monetary policy appropriate to their particular economic situation.[3]
The ECB has up to the present day greeted calls from the Italians and others for a greater focus on eurozone growth with curt PR memos such as, “the ECB will continue to abide by its founding principles.” The ECB can afford this non-responsive strategy at least for a while longer
However, once the member states start experiencing a real recession, presidents and prime ministers will start looking at their political future in a manner like this: “Well, my reelection is in two and a half years. Right now, the ECB isn’t doing a thing to boost my growth rates and employment levels. And I will definitely lose my job if all these people are still unemployed come vote time. Perhaps I’ll start spending some real political capital in order to try to get interest rates down… inflation be damned.”
The ECB has one major weapon in its political arsenal to buy off the elected leaders that are willing to throw some real political chips on the table in order to reverse the ECB’s prime directive: It is the body that decides whether nations are indeed in violation of running budget deficits above 3% of its GDP. So, to a limited but significant extent, the ECB can respond to those leaders, “Look, monetary policy is staying as it is. But here, go a little crazy with fiscal policy, and everything will be all right.”
That will work for a while, as it did during the post 9/11, post-Enron economic downturns. However, it is likely the global economic troubles that are just beginning will be a good deal harsher than the last recession the US exported to some areas. Perhaps more importantly, the dollar wasn’t nearly as low as it is now – and it’s likely we’ll be saying the same thing about the dollar a year from now.
So, when exporters from all member countries, including the home of the inflation hawks, begin to truly start howling about their loss of market share to newly invigorated American exporters, start watching the press reports about the ECB. Until that time, the bank will stay an extreme inflation hawk until it is forced to change by EU member states.
Likely, the ECB’s board will try very hard to stave off appointments by member states of officials it feels will change its makeup. It would rather bend somewhat on policy than face elected officials who ultimately have the final say over who sits on the executive board.
So, when trying to predict the ECB’s moves during difficult economic times, watch the pressure of the member states before big decisions on interest rates. Is it the usual headline-grabbing hubbub? Or is there some small story out there that looks like member governments are exerting real political pressure from behind the scenes? Perhaps France will offer an unexpected pick to fill a vacancy on the board, or something along those lines.
Any number of examples will play out over the years, but the point is that, while the ECB is quite independent from Europe’s day to day politics, that independence is limited, and it is likely there will be many more times in the future when the bank’s decisions are as guided by politics as economics.
In conclusion, during good times, expect the ECB to follow in the Bundesbank’s footsteps, and show an almost shocking callousness towards everything except inflation. During times of slow growth or recession, however, keep in mind the uniquely diverse political power structure that underlies the ECB’s authority. When member states are truly clamoring for a cut in rates, look for signs of real internal bureaucratic tension. Stories will probably be floated in the press as shots over the ECB’s bow by bureaucrats from pro-growth nations.
Of course, the political picture is just one aspect of the equation. But by keeping it in mind and reading a given situation correctly, you can take advantage of all those traders who focus merely on the economic data and forget that the ECB is not like any other bank in the world.
· [1] Munetsi Madakufamba; Review of African Political Economy, Vol. 26, No. 79, Africa and the Drugs Trade (Mar., 1999)
[2] From dictionary.com: cur·mudg·eon – noun – a bad-tempered, difficult, cantankerous person.
[3] Indeed, it seems counter-intuitive, but the euro was actually a very bad idea economically. During the lead up to its creation, this fact was acknowledged by its serious proponents. Krugman being perhaps the most famous of the scholars making this point at the time. The single currency was, however, as Krugman and others notices, a very good idea politically, as it tied the EU countries together with binds that temporary political troubles could not sever. Perhaps this political benefit will, in the long run ,aid the continent’s economy, by preventing some drastic de facto unraveling of the EU. At that point, the politics of the euro will bring about economic benefits that are greater than the huge cost of stripping member nations of their ability to implement national monetary policies.
