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EU: ECB's 'One Interest Rate Suits All' Policy Raises Doubts

  • Mark Baker

The European Central Bank operates on the principle that one interest rate for the euro applies to all 12 countries that participate in the EU's common currency. But in fact, the 12 euro-zone nations all have different growth and inflation prospects -- and in some cases, those differences are broad. RFE/RL correspondent Mark Baker looks at the pressure the bank is under to try to determine economic policies and interest rates that are appropriate for the euro-zone as a whole.

Prague, 17 May 2001 (RFE/RL) -- When the European Central Bank was established two years ago, its framers knew the bank's task would be difficult.

Central banks traditionally perform two -- sometimes contradictory -- roles: they try to maintain price stability and foster stable growth. The main tool at their disposal is to raise or lower interest rates, depending on whether they want to slow or stimulate an economy.

The job is hard enough for central banks operating within one country and with one central government. But for the European Central Bank, which must coordinate monetary and interest rate policies for the 12 national economies of the EU's euro-zone, the task borders on the impossible.

Economies across the euro-zone are now growing at vastly different rates. Ireland and other peripheral economies are expanding well above the 3 percent average for the group, while the German economy, for one, is slowing.

The contrast between France and Germany, the euro-zone's two largest economies, is marked. The French economy is expected to grow by 3 percent this year, while German growth may be less than half that. As a result, France could be expected to argue for keeping interest rates stable, while Germany might press for a reduction.

Neville Hill, an economist for the Credit Suisse First Boston investment bank in London, says the ECB faces a real problem:

"It shouldn't be underestimated that the ECB's task in trying to manage [all] euro-12 countries is tremendously hard, and it's very difficult for them to establish what is an appropriate interest rate for the whole of the euro [area]."

The ECB last week lowered its benchmark rate for the euro by 0.25 percentage points to 4.5 percent, after coming under strong international pressure to stimulate the euro-zone. Central banks around the world have been cutting interest rates in recent months to counter the global economic slowdown.

ECB President Wim Duisenberg justified the rate reduction last week by saying that, based on statistics on inflation and money supply in the euro-zone, the 4.5 percent rate is what he called "appropriate":

"On the basis of the information available, this is the appropriate level of interest rates to ensure that the euro area will be able to maintain price stability and thereby to continue sound economic growth."

But Hill says it's hard to say whether any interest-rate level can truly be appropriate for 12 countries. He says a "one interest rate fits all" policy has significant risks, heating up already overheated economies, while preventing weaker economies from recovering.

"One interest rate for all 12 euro-area economies is likely to -- could -- create some imbalance, as some countries may be at different points in the economic cycle and need different interest rates. Obviously, if you've just got one single interest rate, the economy is not going to be able to adjust using interest rates."

For its part, the ECB says it does not base its decisions on what is happening in specific countries, but looks at the euro-zone as an aggregate. It also says its main task is keeping inflation in check, so it chooses a rate that it believes will maintain inflation within the euro-zone at 2 percent per year or less.

Daragh Maher, a senior economist at ING-Baring investment bank in London, says that given the bank's mandate, it is possible to speak of an appropriate interest rate for the euro-zone.

"[At] the end of the day, the ECB is constrained by its mandate, which is to maintain price stability for the euro-zone as a whole, in other words, the aggregate. And on that basis, they can argue that there is an appropriate interest rate for them to achieve that target."

But Maher agrees with Hill that one interest rate, realistically, cannot suit the needs of all economies. He cites the example of rapidly growing Ireland, which has recently pushed for a rate rise, instead of a reduction:

"I think they can talk in terms of an appropriate rate for the euro-zone as a whole, [but] it may not be appropriate for individual countries. Only a week before the ECB meeting the Irish central bank governor pointed out that he would make no secret of the fact that he is prepared to see interest rates go higher."

So far the 18 members of the ECB's governing council have done a good job of keeping private any disagreements on rates that they might have. Hill says the council increasingly speaks with one voice and that the market is slowly adjusting itself to the bank's behavior.

The only noticeable problem might be with the timing of the bank's actions, which tend to lag behind other central banks. Hill points out that it's harder for the ECB to reach a consensus than, for example, the U.S. central bank, the Federal Reserve.

But over time that may change. When the ECB was established, it was hoped that the individual economies would slowly converge, making the job of the central bank easier.

Hill is optimistic. He maintains that the euro-zone economies will eventually converge and that this trend will get a psychological boost next year when euro notes and coins are introduced:

"I think [convergence] is very likely. You have to remember that it's still very early days for the single currency. We've only had [the euro] now for a couple of years. And we have not yet introduced notes and coins, and that's likely to be a convergence factor. But it may be that the ECB has boxed itself into a corner and made life a bit hard for itself, having such a tough inflation target for what is perhaps a transitional stage."

Maher agrees. He says there will always be differences, but that these will become smaller with time:

"I think there's always going to be contrasts between how some [countries] are faring. There will always be the laggards, there will always be the leaders. I think the ECB would acknowledge that. What they would hope, presumably, would be that the disparities will become progressively less."

In the meantime, Maher points out that even though national governments are no longer in charge of setting their own interest rates, they still have significant influence over their respective fiscal policies, which have a strong impact on the economy. "Interest rates aren't the only tool open to governments and finance ministers to control the economic backdrop. Fiscal policy is obviously one the ECB would also point to [that gives] nations, at the national level, some discretion in terms of setting the pace on the economy."

It's not clear, however, how long this autonomy will last. The EU recently criticized Ireland's fiscal budget for this year, saying that the level of public spending envisioned would fuel inflation.