Inflation is public enemy number one for ECB hawk

Sirkka Hamalainen, the only woman director on European Central Bank, may be the beleaguered institution's best public relations tool.

A straight talker who speaks English rather than economese, she is a complete believer in the European project.

She has a tough reputation and her CV, like most of the other executive council members, is formidable. She has been the Finnish central bank governor, a governor of the International Monetary Fund and chairman of the Finnish Financial Supervision Authority. But she is also on the board of the Finnish national theatre, the cultural foundation, and of a theatre group called the Raging Roses.

Thought of as a hawk, or as a person who is very tough on inflation, she is not afraid to speak her mind. The ECB is there to fight inflation - it is the big enemy. Even if this damages growth slightly, growth can recover over the medium term. However, undoing the damage inflicted by inflation is a far harder task.

With figures this week showing Irish inflation remaining at 6.2 per cent, Ms Hamalainen refused to talk about particular countries but said it was important that national governments listened to central banks and that "the surplus run should be structural and not just the result of buoyant tax revenues".

She also implies that interest rates are heading higher because of rising oil prices. Increasing fuel costs are inflationary in the short term, but are also deflationary over the medium term as high prices tend to reduce growth. But Ms Hamalainen appears to firmly believe that the risk of inflation is more important to combat.

"We must not repeat the same mistakes as the 1970s when monetary policy was very accommodative in the face of the oil price shock. We must avoid inflation."

She added that while growth may be adversely affected, "that is a burden that must be borne by all parties" including workers, and if adversely affected by an oil shock it "should recover in the medium term". On the other hand if it fed through to inflation it would be more dangerous.

Perhaps because she is a Finn she insists that monetary union is of particular benefit to smaller countries. It is protective, allows them to box above their weight and provides stability. Monetary union means the state is no longer vulnerable to capital flows or a run on the currency, and it promotes stability.

Small central banks can come into their own around the table in Frankfurt if their research and analysis are up to scratch, she says, perhaps explaining the large-scale recruitment of economists by the Central Bank in recent months.

But the problem is, of course, that monetary policy is not necessarily appropriate. The smaller countries in the euro zone make up to 30 per cent of overall GDP. However, not all are in the same cyclical position. Ireland, Finland and Spain may be booming, but Austria for example is not.

However, according to Ms Hamalainen, smaller countries are focused on at the top table in Frankfurt and in some cases are seen as a leading indicator. Belgium for example is a leading indicator for the ECB, she says. This means that a growth spurt in Belgium would be seen as a possible harbinger of growth in, say, Germany or France.

Of course, she repeats the ECB mantra that smaller countries have to take on more responsibility themselves and will not or cannot be bailed out by the ECB. She warns that fiscal or tax and spending policy must be used. If not, "adjustment can always come by lower growth and higher unemployment".

She does admit that fiscal policy is not easily changed and has to be even more medium-term oriented than monetary policy or interest rate changes. The actual detail of which taxes should be raised or what cut is pending is not mentioned. It is enough, she says, to point out that "in the good times the surplus should be large enough to give room for manoeuvre in bad times".

In the financial markets many analysts have feared that the ECB does not believe that the European economy can grow by much more than 2.5 per cent without generating inflation. This is one reason they are expecting further rate rises from the ECB. However, Ms Hamalainen appears to scotch this theory.

"It is possible that the potential for growth is much higher than it has been in the past and the euro has been the catalyst for that. We have seen structural changes as well as reorganisation and consolidation, particularly in telecommunications and banking. This is very important for competitiveness although a lot still needs to be done."

She also pointed to labour market flexibility in smaller countries and to tax cuts in many countries

Surprisingly for a central banker she admits to being optimistic about future growth prospects. "I have an optimistic view. I believe very seriously we are in the phase that the US was in five to seven years ago."

She is optimistic that growth can continue if the changes are implemented, despite the big difference in labour market mobility in Europe compared to the US.

According to Ms Hamalainen, this is due to a combination of factors, including a positive impact from the introduction of the euro, which has meant the reduction of currency risk. The fostering of European thinking as well as global competitiveness which makes all economies more efficient have also helped.

However, she insists Europe is different from the US and that core values need not change.

"There are a huge range of permutations between the current European model and the US. It is very important that we take care of people who cannot take care of themselves, but we also need incentives to work and incentives to employ people."

She also admits that change will require some decisions to be made which are difficult politically. But she nevertheless insists that "when lowering taxes, it is important to see at the same time that there must be expenditure cuts".

When asked if it would be useful to have a political voice for Europe the way there is in the US, she said: "Part of the European problem and one of the motives behind integration is to get a stronger voice for Europe. And particularly with common monetary policy, we have one voice but we do not have it with other areas. In particular more co-ordination may be needed in the area of fiscal policy.

"It would be useful to have it in a way that does not interfere with the ECB, but co-ordinates and discusses. Both need to be fully independent of the other."

She is quite defensive on the subject of the euro's continuing weakness, saying far too much attention is paid to it, in a narrowminded way. She also insists that the old volatility between the Deutsche mark and the dollar was even greater than recent euro volatility.

She also insists that the euro's weakness is unrelated to the euro project and has more to do with difficulties in the European economy. The downward trend of the European currencies began well before the euro came into existence, she says.

Nevertheless, she insists that the euro is now misaligned and all monetary authorities believe this, as the recent intervention showed. "There is always overshooting in the exchange market. We would prefer to have an exchange rate that is in harmony with fundamentals. That is a view which all authorities, in particular all countries which were involved in intervention, believe in."

Referring to the controversy earlier this week when ECB president, Mr Wim Duisenberg, appeared to rule out intervention, she said that no central banker ever speculated on whether intervention would be used and no central banker ever implied definitely.