Stay the Course

In Europe, “two percent” means more than a healthy content of milk fat in morning cappuccinos. It is the target rate of yearly inflation mandated by the conservative European Central Bank (ECB). The Bank believes that this end justifies any means.

Yet powerful continental politicians like French President Nicolas Sarkozy and Italian Premier Silvio Berlusconi disagree, and wish the unified monetary authority would pursue less stringent policies. They would rather have the ECB lower interest rates and increase monetary supply to sustain growth, especially in the wake of the ongoing global financial crisis. Although these politicians worry about short-term political costs, the policies of the ECB are necessary for continued price stability and long-term growth.

Anyone planning to cross the Atlantic in the foreseeable future knows how expensive Europe has become. After some misinterpreted comments by a French policymaker, the single European currency hit a new all-time high against United States currency last Tuesday: It briefly cost 1.60 dollars to buy a euro. The dollar’s weakness predates the current financial crisis investment banks are fretting about and the prophecy of recession. Driven by gargantuan budget deficits in Washington and compounded by a negative American trade balance, the euro has been gaining ground against the dollar for years.

While this may seem beneficial for the European Union (EU), such a strong euro is not in the region’s best interest. Just as high prices may lead a backpacker to choose to venture elsewhere this summer, airlines considering Airbus planes and bankers wondering about BMW coupes and Château Lafite Rothschild wines may think twice before purchasing. In fact, Airbus’s parent company European Aeronautic Defence and Space Company announced this week its flagship plane, the A380, will cost five million dollars more starting next month, for it has always been quoted in American currency. In short, a strong euro reduces European exports, which are at the core of many continental economies like France’s and Italy’s.

Unsurprisingly, elected European leaders whose job security depends on economic performance are not thrilled about slowing exports that could easily translate into lower growth and higher unemployment. Because of this, Berlusconi promised yesterday that he would create a “Rome-Paris” axis with Sarkozy, a long-term critic of the ECB, to pressure the Bank into relaxing its strict monetary goals. According to some analysts, the administration of José Luis Rodríguez Zapatero in Spain could also join the alliance in fear of its own housing bubble woes worsening employment prospects.

Soon enough, three of Europe’s largest economies may be lobbying the ECB to effectively behave more like the American Federal Reserve. After all, since the beginning of the write-down debacle in Wall Street, renowned Great Depression scholar and Fed Chairman Ben S. Bernanke ’75 has strongly favored loose economic policy (and a weaker dollar) to mitigate any economic downturn. Interest rate cuts have grabbed most headlines, but more money floating around will inevitably translate into higher inflation. It is only a matter of time.

The mandate of the ECB, as well as its leaders’ beliefs, differs significantly from that of the American Fed. Since its inception in the Maastricht Treaty of 1992, and largely due to the powerful influence of the conservative German Budnesbank, the ECB’s main charter goal is not to ensure growth (and the political survival of politicians in office). Rather, it is to “maintain price stability.”

At first, and especially if we contrast it with the short-term outlook of the Fed’s recent movements, this seems ridiculous. Why not allow looser standards, drop the two percent inflation goal, inject further liquidity, and appease both bankers worried about profits and politicians losing sleep over approval ratings?

ECB officials know better or, at the very least, have better memory. The goal of maintaining price stability effectively means pursuing a responsible monetary policy to avoid spiralling inflation, which this year will be well above the two percent goal because of high commodity and energy prices. Even disregarding the Weimar Republic nightmares of the twenties, European bankers remember the dangers of stagflation in the late seventies, and the misallocating effects of irresponsible inflationary policies in continental Europe before the euro. After all, before being constrained by the ECB straightjacket, central bankers in countries like Italy gave in to politicians, expanding monetary policy and allowing growth in the short run. Overall, though, such policies only delayed needed reforms and stifled development.

The biggest danger with inflation is that expectations quickly become internalized. Once the inflationary door is open, closing it is especially painful. This issue is only graver in places like Europe with very effective trade unions and powerful export lobbies.

John Maynard Keynes once famously remarked, “In the long run, we are all dead.” And as with almost everything else he said, he was right. At these crossroads, however, Europe’s long-term and short-term goals are aligned: It should stick to its responsible monetary polices and avoid inflation in order to protect the purchasing power of most Europeans. Especially in the context of Fed moves, if the ECB gives in to irresponsible and demagogic politicians, Europe will eventually suffer not only from higher unemployment, but also from higher price levels brought about by internalized expectations.

Instead, perhaps Europe should set in stone yet another rule to go along with the ECB’s tight two percent goal: Whenever Berlusconi favors a policy, run the other way.



Pierpaolo Barbieri ’09, a former Crimson associate editorial chair, is a history concentrator in Eliot House. His column appears on alternate Thursdays.