Jewish World Review Nov. 14, 2002 / 9 Kislev, 5763

David R. Kotok

David R. Kotok
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Consumer Reports

Please stop bashing the ECB! | It was a one sided dialogue on CNBC's Squawk Box at 7:50 a.m. Friday, Nov. 8th. Anchor Mark Haines, Sr. Econ. Reporter Steve Liesman, guest host Gene Flood, and Pimco's Paul McCulley via satellite --- all bashing the European Central Bank (ECB) for their policy decision to leave interest rates unchanged.

Was there anyone explaining the ECB policy? NO. Were there any defenders? NO.

That's a shame. There is another side to the discussion.

The ECB held its policy rate at 3.25% after our Fed cut to 1.25%. Their reason: Euro zone inflation was 2.2% and the mandate of the ECB is 2% or lower. The CNBC panel criticized them for the ".2". A listener would have thought that the ECB was responsible for impairing the economic growth of the entire world.


It is easy to sit on American television and point a finger at a foreign central bank and blame them for our economic failures. They are a convenient target. But, isn't this intellectually dishonest? After all, the ECB is not responsible for America's tepid economic recovery. The ECB didn't create the NASDAQ fever, bubble and subsequent collapse. The ECB didn't seed the world's present excess capacity. The ECB didn't promote Enron and WorldCom and Arthur Anderson. 20

Let's look at ourselves, if we want to point fingers about policy or corporate governance errors which now haunt us with a questionable economy. Isn't that self examination the proper domain of financial journalistic television?

The ECB says it is a single mandate central bank and that the issue of economic growth is secondary to its policy direction. They're right.

To understand this one has to consider two things. First, their mandate is legal, defensible and the result of a political agreement among the Euro zone countries. Secondly, the single most important purpose of the ECB is maintain the euro as a strong and reliable currency which will not lose its value due to inflation. That is the raison d'etre for the ECB.

Let's define the stakes here because any deviation by the ECB could lead to a calamity.

The ECB is the instrument used for greatest currency transfer experiment in human history. Think of it: twelve different countries with different languages and differing internal policies and differing governmental political forms have banded together and given up their individual sovereign rights to their currency. They have agreed to a single currency via a treaty. In doing so they have also implied that their defense budgets would shrink because they would no longer engage in war with each other. They have opened their boundaries to cross border trade and movement. You can travel from France to Germany today easier than from Canada to the United States. They have introduced Europe-wide price transparency. They have reduced the cost of financial friction in transactions.

So far, this experiment is succeeding. Travel in Europe and one immediately sees that the single currency system is working. Kudos for the ECB. It passed the first series of tests. In only a few years, the euro progressed from a treaty formula to a virtual currency and is now real.

The next issue in front of the ECB is the eastward expansion of the European Union and, with it, the Euro zone. That means more debt issuance denominated in euro and much negotiation of details for subsidies and trade relationships. This process, too, is headed for success. The outcome will be difficult to achieve but not impossible.

One thing can derail this entire experiment. And that is inflation.

Any acceleration in prices will immediately translate into demands for wage increases by the unionized forces in those countries. The risk to Europe's union is a wage/price spiral. Organized labor has much greater power in Europe than in the United States. Europe's inflation rate is higher than in the U.S. Unit labor costs are rising there while falling here. There's less excess capacity there than here. And the measurement of inflation there is more conservative than here: they do not use hedonic price adjustments the way we do.

Deflation is not a high risk in Europe. It is here. That's why our Fed cut a 1/2 point last week.

Let's be clear. Of course, deflation is a risk in any economy if it morphs into a serious economic downturn. Witness Japan. That is exactly why the ECB will run a scrupulously enforced policy with 0% inflation lower bound just like their rigid 2% upper bound. And that is why the ECB must stay its disciplined course of inflation of above 0% and below 2%.

These reasons explain why the ECB didn't cut and also why they will soon do so. My guess is before yearend and by a 1/4 point. By then, inflation in the Euro zone should be under 2% and falling.


First, because Europe, too, is effected by the world's overcapacity in the tradable goods sector. The recent German reports are actually bleak. Europeans, too, are watching projections of weak world economic growth. They are rightfully worried.

Secondly, as the euro strengthens, the increasing buying power of the euro will result in lower relative prices of imported tradable goods. This stronger euro policy is correctly desired by the ECB.

The reverse is true for U.S. We want a weaker dollar but cannot openly say so. We don't want to create a dollar rout; we want the decline in the dollar to be orderly. A softer currency will help us offset our domestic deflationary forces.

Euro zone countries need a harder currency. It will gain them lower inflation in the Euro zone and that will allow the ECB to cut rates.

In addition, the oil price may slip after any Iraq premium is removed. Oil is priced in dollars. So when the euro is strengthening against the dollar, the oil price in the Euro zone declines. This is not as dramatic an effect in Europe as in the U.S. because of Europe's higher energy taxes. But it is an item that will give the ECB some room to maneuver.

We expect inflation in the Euro Zone to gradually decline. The ECB will cut rates as it follows the inflation rate down. Don't expect the ECB to lead until inflation is a lot closer to zero.

All this means the euro should continue to strengthen. Our initial targets of parity have been reached. For next year we are anticipating that the euro will trend toward 1.10 to 1.15. All this will happen as the U.S. economy grows moderately while European growth rates lag the U.S.

In sum: America's policy is now loose monetary and loose fiscal. Euro zone policy is tight monetary and loose fiscal. That chemistry should strengthen their currency against ours over time, especially since our current account deficit is headed above 5% of our GDP.

Understanding the rationale behind the ECB's stance is important. Bashing them on TV gains nothing.

JWR contributor David R. Kotok is President and Chief Investment Officer of Cumberland Advisors, Inc. His articles and financial market comments have appeared in The New York Times, The Wall Street Journal, Barron's, The Bond Buyer and numerous other publications. He can be seen on CNN, CNNfn and CNBC. Comment by clicking here.


11/08/02: Fed may have taken themselves out of debate but they've added to uncertainty by surprising the markets
11/07/02: The election and the Fed: Both validate stimulus
10/31/02: Welcome to the world of an enlarged and open Europe

© 2002, David R. Kotok