As the ECB grapples with high unemployment it could learn from the US Fed Frankfurt fiddles while Paris burns

Comment Antoin E MurphyRiots in France, now spreading to other countries in Europe, are a direct result of the EU's inability to deal with unemployment and sluggish economic growth.

In France the 10/20/30 unemployment syndrome has appeared. Ten per cent of the population is unemployed, 20 per cent of young people are unemployed and more than 30 per cent of young people in low income areas, where the rioting has occurred, are unemployed.

Germany has a similarly high unemployment rate to France and will probably experience similar pressures from its young, dispossessed and unemployed.

Unfortunately for governments in the EU, they no longer possess the range of macroeconomic weaponry that could be used in the past to tackle such unemployment problems. Economic and Monetary Union (EMU) removed the exchange rate weapon from the arsenal of participating governments, severely restricted their use of fiscal policy, and transferred monetary policy to the European Central Bank (ECB).

From the perspective of demand side macroeconomic policy European governments have become macroeconomic eunuchs, in that they have transferred a large part of macroeconomic control to the ECB.

In this altered macroeconomic environment Dominique de Villepin and Nicolas Sarkozy could trace the cause of the rioting to ECB policy objectives rather than national fiscal strategy.

It's arguable that part of the core problem may be laid at the door of the ECB in Frankfurt because of institutional reluctance to contemplate reducing unemployment by stimulating demand in the European economy.

Both the ECB and US Federal Reserve strategies for dealing with this problem are illuminating, raising the question as to whether the ECB could advantageously draw some lessons from the approach of its American counterpart.

At a time when many Europeans are prepared to be critical of the growing trend of Americanisation, it may be appropriate for all Europeans to ask why the Fed has been so successful in guiding the US to a far more impressive macroeconomic performance than Europe.

The template for the future ECB was determined at Maastricht in 1991 when price stability was presented as the major macroeconomic objective for EMU.

Consistent with this, membership of the union necessitated low inflation rates, tightly controlled budget deficits and movement towards maintaining a low level of government indebtedness.

There are other macroeconomic objectives, such as employment and growth, that could have been considered and given equal weighting with the inflation objective.

However, they were excluded. In part this was due to the Bundesbank's acute fear of inflation. A further reason was that intellectuals influencing economists and policymakers had undergone a considerable metamorphosis in their approach. By 1991 there had been a profound reaction against the former Keynesian demand side consensus which had prevailed up to the late 1970s.

The new approach came to be known as New Classical Macroeconomics. It stressed that people were able to anticipate changes in macroeconomic policy. If, for example, the central bank sharply increased the rate of growth of the money supply, sensible people would realise the inflationary consequences of such action and seek immediate pay rises to compensate for the higher anticipated rate of inflation.

If one accepted the premise of this approach, rational expectations and very quick clearing markets, then it led inevitably to the conclusion that macroeconomic stabilisation policies were ineffective. Demand side policies were jettisoned. Neither the central bank nor government had the ability to hoodwink a public that rationally calculated and reacted against expansionary macroeconomic policies.

The combination of German fixation with price stability and the changed intellectual environment due to the emergence of New Classical Macroeconomics ensured the future ECB was given a uni-dimensional objective - that of price stability.

This approach contrasts sharply with that of the Federal Reserve system. The modern template for the Fed developed through enacting the Humphrey-Hawkins Act in 1978 prior to the full-blown emergence of New Classical Macroeconomics. It gave the Federal Reserve system not only an inflation objective but, also, objectives with respect to employment and interest rates.

Unlike his counterpart in the ECB, Jean Claude Trichet, chairman of the Federal Reserve system Alan Greenspan has not been constrained by a uni-dimensional inflation objective. He can undertake an expansionary monetary policy if he believes that the US economy needs to be stimulated to achieve higher rates of employment and growth.

Indeed, and again unlike his European counterpart, Greenspan has never been forced to state publicly his desired inflation target.

This is of considerable advantage to him for the desired inflation target necessarily changes with shocks, such as 9/11 and when higher oil prices hit the economy.

By having a number of different objectives Greenspan has been able to balance US macroeconomic policy to such an extent that many regard him as a more important policymaker than the president of the United States.

The contrast between policy approaches of the two main central banks in the global economy is quite marked.

The EU, experiencing high unemployment and sluggish economic growth, has its central bank president warning financial markets he may be forced to increase interest rates in order to reduce inflation, caused by increased energy prices.

This mentality is difficult to understand. European consumers paying more for oil, petrol, diesel, electricity and gas are finding that they have less to spend in other markets.

Oil price increases will have a natural deflationary effect on consumer spending, yet Trichet is considering adding to the deflationary pressures by raising interest rates. Higher interest rates will compound the effect, strengthening the euro and further depressing demand for European goods.

Trichet needs to assist European governments by helping to stimulate the European macro-economy. He can do this by reducing, rather than increasing, interest rates.

Sitting in the ECB in Frankfurt ruminating on the need to reduce an already low inflation rate, without acting to assist the major unemployment problem, smacks of Frankfurt fiddling while Paris burns.

Antoin E Murphy is a professor of economics in Trinity College Dublin.