ECB gets off to a very strong start

The ECB's move last week was the action of an institution already confident enough to do the right thing

THE EUROPEAN Central Bank announced its arrival on the scene a month early when it ordered the outgoing national central banks to reduce all interest rates in the EMU zone to 3 per cent last Thursday. How are the mighty fallen. The last significant act of the Bundesbank - once the most powerful institution in Europe as well as the body most impervious to outside influence - was meekly to cut rates in line with the command from the ECB, and thus indirectly to do the bidding of SPD finance minister Oskar Lafontaine.

Only the Bank of Italy, where governor Fazio is staking out a reputation as the hawk of the ECB, signalled dissent from this decision by temporarily leaving its rate 0.5 per cent higher than the rest. It too will have to come into line in three weeks' time.

It is hard to underestimate the significance of this moment for the balance of power within Europe. It is suddenly crystal-clear what the French have been aiming for during all those painful years in the ERM. Until now, Germany has enjoyed total pre-eminence in the setting of monetary policy within the ERM bloc. In future, it will have only two of the 17 votes on the ECB's decision-making body.

Has any nation state ever before ceded so much power in a single voluntary decision? And does the German electorate realise what it has allowed to happen? We shall see.

The ECB has made a very good start. A few months ago, there were many who feared that the new institution would be forced in its early days to increase interest rates in order to establish its independence from politicians and win credibility in the financial markets.

This has not happened. Instead, Europe's new central bankers have patiently explained that they would not cut rates simply because politicians were demanding easier policy. But nor would they deliberately leave rates too high, just to put the politicians in their place. Last week's move was the action of an institution already confident enough simply to do the right thing.

Since the ECB assumed the reins in September, average European interest rates have fallen by 0.75 per cent, exactly the same as the cut in the US and the UK. This probably would not have happened under the old Bundesbank- dominated ERM.

Furthermore, in the ERM, the financial crisis of last autumn would almost certainly have forced higher interest rates in countries such as Italy and Spain to defend their currencies against a rising deutschemark. And German industry would have been screaming about losses in competitiveness. These perverse moves in monetary conditions have been entirely avoided in the new monetary union.

Of course, none of this means that monetary union has suddenly become a perfect solution for all of Europe's economic ailments. The achilles' heel of the single currency - that one monetary policy might not suit all countries - is still there, waiting to cause problems in the future. But even the most ardent Euro-sceptics must realise in their hearts that the ECB has got off to rather a good start.

Where does this leave the UK? Many commentators have argued that the Bank of England now has no choice but to follow the ECB's rate cut by announcing a half point cut in the UK this week. If so, then Britain's monetary sovereignty has already been largely eroded, and there would seem little point in staying outside EMU. More blatantly, some EMU supporters have been claiming that Britain should join the single currency in order to enjoy the "benefits" of 3 per cent interest rates immediately. But this is rather over-egging the pudding.

In the first place, if 3 per cent interest rates really were beneficial to the economy, there would be nothing to stop the Bank of England making such a cut this very morning. It does not do so because it believes that inflation expectations remain higher in the UK than in the EMU bloc. This implies that higher nominal interest rates are actually beneficial for the economy. If the Bank is right, then a cut in UK rates to 3 per cent would be a cost, not a benefit.

This is just an illustration of the simple point that the UK still enjoys the advantage of a great deal of monetary freedom outside the single currency. Sometimes this might mean setting interest rates higher than those on the Continent, sometimes the reverse. But, either way, the freedom to set rates according to UK economic conditions is an untramelled advantage - especially now that UK monetary policy has been taken out of the hands of fickle domestic politicians. Above all else, this is what Britain will give up when it joins EMU.

So does the arrival of the ECB make no difference whatsoever to the Bank of England? Well, not exactly. What it seems to have done is concentrate minds in the financial markets on the assumption that sterling will join the single currency shortly after the next election, at a likely entry rate equivalent to about DM/pounds 2.50. As line A in the graph shows, the forward exchange rate for sterling has locked into that rate around 2002, and it no longer seems inclined to budge from there, almost regardless of economic events in the UK.

This has one immediate consequence. When the Bank sets UK interest rates, it is also essentially fixing the spot exchange rate for sterling in the foreign exchanges, since interest differentials will totally determine the path of the exchange rate towards its expected EMU entry rate of 2.50 in 2002.

For example, if the Bank allows interest differentials between the UK and the euro to rise by 1 per cent, then the spot exchange rate must jump by 4 to 5 per cent today in order to decline (along path B) towards 2.50 in four or five years' time. This implies that if the Bank does not like the exchange rate implied by this arithmetic, its freedom to set domestic interest rates is constrained.

This is not entirely different from the constraint that affects any small country, but it is more stark. The constraint can be changed only if the Government actively goes out of its way to dampen expectations about the likelihood of entry in 2002, or to create uncertainty about the probable entry rate. But why should it do this? The present situation is highly convenient, since it maximises the Government's freedom of manoeuvre in choosing the eventual entry date.

The expectation of membership in 2002 not only encourages British companies to prepare for that eventuality but, more importantly, ensures that sterling will smoothly "home in" on an acceptable entry rate in the run-up to a possible referendum in 2002.

This is vital, since a stable exchange rate is the only condition for EMU membership that the UK might not meet, and it has always been difficult to see how the Chancellor could ensure that stability is achieved without either joining the ERM or changing the Bank of England's inflation mandate, both of which look politically difficult.

When the time comes, it is still not certain that Tony Blair will opt for membership in 2002. That will depend on politics. But there should be no logistical barrier to entry if the Government does decide to take the plunge.