Economics vs politics in the eurozone
The basic laws of economics are threatening to pull the eurozone apart, just as politicians are trying to pull it together. As usual, the ECB is stuck in the middle of the mess, and it doesn't like it one bit.
For two and a half years, interest rates in the big industrial economies have only gone one way - down. Central banks slashed rates to historic lows in the wake of the financial crisis and then left them there. But not any more. Now the ECB has broken ranks, with today's long-anticipated quarter point rise.
Jean-Claude Trichet says not to assume it's the first of many. Unlike Mervyn King, he seems to think that a single rate rise can improve your anti-inflationary credentials, without endangering the recovery. But, today of all days, you have to consider which eurozone recovery he's talking about.
Germany grew by 3.6% in 2010 - and the forecast for 2011 is 2.5%. We found out today that German industrial production in February was nearly 15% higher than a year ago. That is what you call a recovery. And crucially, Germany accounts for 28% of eurozone GDP. Spain, Portugal, Greece and the Republic of Ireland between them only account for 17% of eurozone GDP.
The single largest reason why Portugal is now requesting a European bail-out is that it's no longer enjoying any recovery at all. Independent forecasters now expect the Portuguese economy to shrink by over 1% in 2011, after growing by 1.4% in 2010. The consensus for Spain is for growth of 0.6% this year - the first positive annual growth since 2008. The forecast for the Irish Republic is for growth of 0.4%. Greece is expected to shrink again, by 2.9%.
As I've discussed before, the shoe was on the other foot in the first years of the eurozone - when the "one-size-fits-none" nature of eurozone monetary policy delivered an interest rate that was probably too low for Spain and the Irish Republic, and too high for Germany. And back then, inflation was also higher in the periphery, meaning that real rates were even higher in Germany, and even lower in Spain.
The sad thing for Portugal is that it did not even get the boom that other "Club Med" (or Celtic Tiger) countries got. Growth between 2001 and 2007 averaged only 1.1%, making it the slowest growing country in the entire Eurozone during this period. Growth in Portugal's GDP per head was even slower - only 0.6% a year.
But that was then and this is now. The problem for Portugal and the rest - in many ways the root cause of the entire crisis - is not that these countries are insignificant. It's that they're different.
The Netherlands only accounts for around 6% of eurozone GDP, but it does just fine. Why? Because, to all intents and purposes, it's just like Germany. Ditto Austria. Even, to some extent, France. That is why these economies have always been considered the Eurozone's "hard core".
The reason we still talk about the "periphery" is that Portugal, Spain and Ireland are still quite different. One difference we all know about is that they are less competitive. Another, which adds insult to the injury of the ECB's rate increase, is that their economies are much more dependent on variable rate debt.
It's a sad feature of the conflicting economics and politics of the Eurozone today that the countries which least need an interest rate rise are going to be most affected by it. The majority of mortgages in Spain, Portugal and Ireland have floating rates. Germany, as we know, has less debt to begin with, and most of it is fixed rate.
All of which might lead you to wonder why - oh why - the ECB feels it necessary to torture the periphery, if a rate rise will have so little impact on the countries where inflation is now picking up? But of course, that is precisely the point. It is because rate rises are likely to have relatively less impact that the ECB feels a greater need to start the tightening cycle early.
Ever since the ECB began, critics - especially American ones - have complained that it is too focussed on inflation and not focussed enough on growth. That debate, I'm sure, will continue in the months ahead. But there is academic research suggesting that a given interest rate change in the eurozone will have less impact on inflation than it would in the US. There is also - the MPC might be interested to hear - some evidence suggesting that inflation "shocks" like the oil and food price rises of the past year or two tend to stay in the system for longer in the eurozone, and have greater "second round" effects.
The ECB has had to do a lot of things that it didn't want to do in the past two years, providing vast amounts of financial support to banks and - indirectly - governments in trouble, in effect substituting for a fiscal union that does not exist. It is still providing that support today. But the lesson of today is that it is not going to put its entire monetary policy framework at the service of Europe's politicians. And rightly or wrongly, that framework says that rates have to go up.