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Euro-sclerosis has become even more debilitating than it was before the euro's introduction. European productivity growth has stalled while Brussels' powers over the economy have expanded. European interest rates are stuck at almost double the U.S. level, while inflation is stubbornly above target. This reverses Germany's traditional advantage over the U.S. of lower inflation and interest rates. Above all, economic growth has slowed to a snail's pace. Part of the blame rests with politicians, socialism, and even the United States, whose strong dollar policy of the 1990s undermined investment around the world. These are all daunting problems offering no quick solutions. But euro-sclerosis is not just a micro-economic problem — it applies equally to Europe's inflexible monetary and fiscal policies. At each turning point in the Continent's recent economic travails, I think the European Central Bank could have chosen a more constructive path. In 1999, the ECB could have softened the euro's collapse rather than fueling it with talk of benign neglect and the supposed silver lining in a competitive devaluation. In 2000, it could have held interest rates steady in response to global deflation, rather than carrying out six euro-weakening rate hikes. In 2001, the ECB could have safely cut interest rates in the almost certain knowledge that rate cuts would strengthen, not weaken, the euro and would thereby lower the inflation rate. This option is still open today. An ECB rate cut would, I believe, strengthen the euro, increase investment and production, and lower the inflation rate. These repeated monetary-policy missteps are the product of the ECB's practice of targeting backward-looking consumer-price-index inflation. This approach is doomed to fail, as I have argued before. Inflation targeting raises constant problems. As the euro weakened in 1999, the lag in the inflation rate meant that the ECB would misjudge the risk from the devaluation, then have to pay for the mistake for years. The OPEC-engineered increase in oil prices in 2000 helped force the ECB to raise rates, even though the oil-price spike hurt economic growth in Europe. Today, the mechanical formula of keeping interest rates high until inflation falls, regardless of oil prices or changes in the value of the euro, means that a pro-growth, pro-euro interest-rate cut is off the table. The ECB says its interest rates are "appropriate," end of discussion. Thus, in addition to structural issues, a major obstacle to investment in Europe is the threat that the ECB's flawed inflation targeting process will consistently force higher average interest rates than the global investment market will bear. A better, more pro-growth approach would be for the ECB to commit to euro stability, adding and subtracting liquidity from the economy based on the euro's value in terms of gold, commodities, and the dollar. By responding quickly to euro strength or weakness, this approach, called a price-rule monetary policy, would allow lower inflation and lower average interest rates. Like its monetary policy, Europe's fiscal policy rules are mechanical, misdirected, and anti-growth. With European economies in malaise, fiscal deficits have widened. The fear is that this will turn out to be just the tip of the iceberg in Euroland's growth and demographic problems with the public-debt burden. With tax receipts faltering, budget deficits in a few key countries — including Germany itself — will almost surely exceed the arbitrary 3% limit, the German-inspired straitjacket in the Growth and Stability Pact. Last week, the EU announced that Germany and Portugal both face possible disciplinary action for their deficits, even as European Commission President Romano Prodi was out giving interviews calling the stability pact "stupid." Rather than balancing budgets on a timetable, Europe's fiscal plan should be built around labor flexibility, tax reform, fuller employment, and faster economic growth, all of which would rapidly improve the fiscal outlook. Instead, weak growth and the concrete fiscal timetable are perversely discouraging the tax-rate cuts critical for encouraging European employment and investment. Germany's ruling Social Democrat/Green coalition has responded to the rising fiscal deficit projections with a patently anti-growth recipe — a myriad of tax increases that will not only hinder any economic recovery but also undermine the longer-term efficiency of the economy. The urgency in increasing labor flexibility and rewriting the ECB's monetary and fiscal plans is clear. The only growth in the lackluster Eurozone economy in the first half of 2002 came from stronger exports, much of which went to the U.S. Domestic demand was stagnant, with capital spending continuing to fall. Europe's export growth is fading now, with no offsetting increase from the domestic economy in sight. The closely followed IFO index of western German business confidence fell for the fourth consecutive month in September, including the expectations component. In effect, Europe has been in a private-sector recession, with the overall growth rate supported by government spending and rising public-sector indebtedness. One way to quantify Europe's growth problem is to contrast the number of flexible workers between Europe and the U.S. After factoring in Europe's problems with unemployment, big government, and a high degree of unionization, the growth challenge seems intractable — Europe has barely half as many flexible workers per citizen as the U.S. The gap is widening, meaning Europe will be lucky to run at half speed. In sum, the Eurozone economy is suffering a double dip after a small rebound in the first part of 2002. It needs multiple fixes in order to achieve normal growth. These include sweeping labor reform, lower tax rates, less government, lower interest rates, and a new monetary policy to replace the backward-looking inflation target and euro instability of recent years. In the meantime, the European outlook, hampered by a powerful but misdirected central bank, is for a half-speed economy and euro weakness. — Mr. Malpass is the Chief International Economist for Bear Stearns. This article first appeared in the Wall Street Journal Europe. |
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the 1990s, supporters of the euro, myself included, hoped that the single
currency would bring constructive structural change, faster growth, and
more jobs to the European Union. These days, that view looks romantic.
While the euro has been a success in causing interest-rate convergence,
the European Union has failed in many of its other economic goals. Ironically,
Germany, the fiscal hawk in negotiating Europe's "stability pact,"
announced last week that it is set to exceed the euro zone's 3%-of GDP-deficit
ceiling. 
