France announced on August 18 that the informal meeting of the EU economics and finance ministers on September 12-13 should focus on developing a coordinated response to the threat of Europe-wide recession.
This raises the question of whether the meeting is more likely to reveal divisions among member states about the structure of European economic governance than it is to generate a solution to economic problems. Instruments and targets. The threat of recession and the structure of economic governance first came together in the credit crisis that started in August 2007. Sarkozy made the connection shortly after the September 2007 meeting of EU economics and finance ministers (ECOFIN), when he criticized the European Central Bank (ECB's) efforts to inject liquidity into the market without lowering interest rates:
· Sarkozy charged that the ECB should be consistent in lowering the cost of liquidity while at the same time increasing the supply.
· The ECB responded that it had to safeguard price stability while at the same time shoring up the functioning of Europe's financial markets.
· Meanwhile, a chorus of voices from the Monetary Affairs Commissioner Joaquin Almunia to euro-area group chair Jean-Claude Juncker insisted that Sarkozy should leave the ECB alone.
The ECB emerged from that initial debate in a strong position. Most analysts complemented the bank's liquidity practices and were willing to hold judgment on its decision to focus interest rates on the maintenance of price stability. As inflation accelerated -- and as German trade unions secured record wage increases -- the ECB's strategy of matching instruments to targets won ever more support.
Moment of weakness. Now the tide of opinion appears to be turning. The problem is not limited to the weakening of economic performance. The ECB has also had to acknowledge concern that its liquidity practices have been subject to abuse. European banks have taken advantage of the ECB's weak collateral rules to offload some of their more risky assets and they have built intermediation strategies to profit from short-term liquidity injections as well.
The resulting distortion of credit markets has had far less negative effects than would a full-blown liquidity crisis across the euro-area as a whole. In this sense, the ECB's cure is still better than the conditions it addressed. Nevertheless, recognition of the distorting influence of ECB liquidity practices has brought the bank's broader strategy for setting instruments and targets into question. As such it has added weight to market speculation that the ECB will moderate its interest rate policies as a result.
Finding an alternative. Sarkozy's early critique of the ECB's response to the credit crisis, while not entirely vindicated, no longer seems completely unreasonable. His finance minister, Christine Lagarde, will certainly make that point when she convenes the informal ECOFIN meeting next month. However, she will struggle to offer a meaningful policy alternative:
· Liquidity problems. Lower interest rates by themselves are not the answer. If there is a liquidity problem in the euro-area at the moment, it is not due to cost but to supply. Moreover, that problem is likely to get worse if the ECB tightens its collateral rules and if banks have difficulty rolling over their medium-term financing instruments.
· Different underlying causes. Meanwhile, the problems facing Europe's national economies are very different. In Spain, Ireland and the United Kingdom they originate in the housing market and household consumption. In Italy, they stem from market rigidities. In Germany, they derive from traditionally weak domestic demand, fuelled by business and consumer pessimism. In many medium-sized countries such as Belgium and the Netherlands, they are found in the weakness of foreign demand.
In this sense, the ECB may be right to suggest that the one common denominator is the danger that currently high commodity prices will translate into permanently high inflation expectations for the future. Hence the best it can contribute, the ECB argues, is a firm guide for inflation expectations, so that the member states can look to their own real-economy concerns.
As elsewhere, the EU risks getting bogged down in questions about institutional design rather than policy content. If the French EU presidency is serious about responding to the threat of recession, it will have to look for a policy solution within the existing framework of institutions rather than against it.