Stephen King: Policy makers using the wrong weapons to fight Euroseizure

If the threat changes, so should your weapons. And there are good reasons to think that today's threat is different

Back in the 1980s, it was called "Eurosclerosis". Now it's more like "Euroseizure". The eurozone has failed to deliver. In the face of a US slowdown, many hoped that the eurozone would pick up the baton of economic growth. But, like a typical British sprint relay team, the baton was dropped (left-hand chart) and the eurozone's member states have been left ruing yet another lost opportunity.

Plenty of reasons have been given for Europe's failure to deliver. A lot of them make a good deal of sense.

Demographics are unhelpful: for a number of European countries, the population of working age has stopped growing or, even worse, has started to shrink.

Productivity is poor: even though new technologies have been available to European companies, few have been quick enough to reorganise their workplaces to take full advantage.

Debt levels are too high: profits expectations associated with telecoms and technology led to massive corporate borrowing but, in hindsight, the profits have not been delivered, leaving companies awash with indigestible liabilities.

Faced with these challenges, the eurozone's policy-makers increasingly look as though they've got a set of armaments that are aimed at the wrong enemy. As they look through their binoculars at the forces of inflation, they're still not convinced that a full-scale retreat is taking place. So they man the barricades and keep their monetary and fiscal policy guns fully loaded, ready to fire a salvo of spending cuts and unwilling to disarm their weapons of mass contraction.

Meanwhile, the enemy is reforming and rethinking its tactics. As the policy-makers' binoculars steam up with the fog of economic uncertainty, the enemy comes back in a different guise: this time, the attacks come in the form of structural rigidities, deflation, systemic dangers and default risk. When the binoculars clear and the new onslaught reveals itself, the policy-makers slowly realise that they have the wrong guns. Where are the weapons of mass expansion? And does anyone know how to use them?

The economic aims of the Maastricht Treaty were quite straightforward. Within the single currency area, the primary aim was price stability, broadly interpreted as the avoidance of inflation. Without prejudice to that objective, the European Central Bank would have to be generally supportive of the European Union's other aims, but they are so wide ranging as to be effectively irrelevant from a policy point of view. On the whole, then, inflation avoidance has been the dominant strategy.

Institutional macroeconomic arrangements have been designed with this over-riding objective in mind. The ECB is free from political interference. It sets its own inflation target. The Growth and Stability Pact – increasingly looking like an oxymoron – is designed to prevent the kind of fiscal naughtiness that might give rise to unwanted inflationary pressures. And, whereas the US Federal Reserve's ultimate objective is, through its lender of last resort role, the smooth functioning of the US financial system, the ECB appears to have no such role to play.

"So what?" you might say. At least the ECB doesn't go around supporting financial bubbles of the kind seen in the US. Absolutely true, of course. That does not imply, however, that the current set-up is ideal for all circumstances. If the threat changes, so should your weapons.

And there are good reasons to think that today's threat is different. True, inflation remains above the ECB's target, which requires annual price increases of less than 2 per cent (and, therefore, also suggests a bias against deflation). True, also, that people's perceptions about inflation haven't been helped by the introduction of euro notes and coin, a procedure that has created the belief – doubtless justified in some cases – that retailers are engaged in the "Great Euro Rip-Off".

But let's face it, there are few obvious signs of accelerating price pressures, both internally and externally (chart 2). This might suggest that the ECB's inflation target is just too tough. Inflation on both the headline and core measures is currently between 2 and 2.5 per cent. The Bank of England would be happy with that. So would the Federal Reserve. So, for that matter would be the Reserve Bank of Australia, the Reserve Bank of New Zealand (which has just relaxed its inflation target) and countless other central banks around the world.

Moreover, the inflation target is asymmetric. It's assumed – although never spelt out – that the ECB would ideally like inflation to average about 1.5 per cent per year over the medium term. That means that, relative to target, there's only 0.5 per cent on the upside but a full 1.5 per cent on the downside. If I were a German, I would be really worried about this. German inflation is currently running at about 1 per cent so, if the ECB managed to get overall eurozone inflation down to "target", there's a good chance that Germany would end up with deflation.

Things could get even worse. Germany is one of the "guilty borrowers", one of the countries that is fast bumping into the Stability Pact constraint on fiscal deficits. So not only could Germany be facing deflation, it could also end up having to raise taxes or cut public spending with the economy stretched out on the rack and the banking system apparently gasping for air.

This raises another problem. Because the ECB's role is couched in terms of price stability, it is not clear where the responsibility lies for a "lender of last resort" function. Let's say, for example, that the German banks really are in a mess and provide a "systemic risk" to the European financial system. Who is supposed to act? In America's case, faced with the Long Term Capital Management crisis in late-1998, the Federal Reserve not only co-ordinated a rescue plan involving a number of key commercial banks but also lowered interest rates quickly in order to guard against any systemic risk to the financial system. Does the ECB's mandate allow for similar action if need be? If not, are Germany's difficulties increasingly reminiscent of the Gold Standard constraints that beset so many counties during the 1930s?

Other "systemic risks" also provide a significant challenge to Europe's policy-makers. Another US example is worth considering. At the end of the 1980s, the US found that it had a crisis in its Savings and Loans (S&L) industry. Part of the resolution to that crisis was the use of taxpayers' money to bail out some of the S&Ls through the so-called Resolution Trust Corporation. In a federal system, this approach makes a lot of sense. But, within the eurozone, it's not at all clear that the same, ultimately successful, approach could be adopted: it would look suspiciously like a series of state bailouts that could well be frowned upon by the competition authorities.

No one should deny that inflation is a potential threat to economic and financial stability. But it is not the only threat and, today, it is probably not the biggest threat. A system that is geared predominantly to the defeat of inflation may find itself short of policy options if other threats begin to materialise. The end of the Cold War gave the impression that foreign policy would be a lot easier yet, in reality, it's become a lot more complicated. Similarly, the defeat of inflation seemed to offer a life of certainty for policy-makers. Ultimately, however, economic challenges never die: they simply mutate. And if policy-makers are not quick enough to spot the new challenges, we'll all end up suffering the consequences.

Stephen King is managing director of economics at HSBC.

stephen.king@hsbcib.com