Base interest rates in the euro zone could fall close to 1 per cent over the next couple of years, as the European Central Bank (ECB) moves to revive economic growth, according to one of the leading economists in the US. Prof Paul Krugman warns that the main euro zone economies are at risk of slipping into a deflationary spiral, but believes that steady interest rates cuts by the ECB could avert this danger.
In Europe "the risks appear to be on the side of deflation, not inflation", according to Prof Krugman, speaking to The Irish Times before a visit to Dublin next week to address the IBEC national conference. As Ford International Professor of Economics at the Massachusetts Institute of Technology, he is one of the most influential economic voices in the US.
He takes a distinctly bearish view of European economic prospects.
"We could be sitting here in two years' time saying that Wim Duisenberg (the ECB president) missed the chance to cut interest rates in time" to head off even slower growth and possibly even deflation - a period when general price levels fall.
On balance he believes that as economic growth remains slow, "the ECB will respond by cutting interest rates quite a lot". Base euro zone interest rates could fall from 3 per cent now towards 1 per cent over the next couple of years, he believes.
Prof Krugman, like many other economists, raised doubts about the euro project before it started, because he argued that policy-makers would find it impossible to respond to economic shocks which hit one region more severely than others. Looking back on the first few weeks of the new currency, he says it has been "a kind of peculiar start". Preconceived views that the strength of the German economy and the weakness of the rest of the euro zone might cause problems have been turned upside down in the wake of extreme economic weakness in the former powerhouse economy. It appeared that the ECB "would have an easy first move" - cut interest rates further. Instead, in the face of demands for lower rates from Germany in particular, the Bank has got caught up asserting its independence from political influence. This despite the fact that "it looks like on average that the euro economies are operating below capacity and that unemployment is above where inflationary pressures would kick in". Against this background, he believes that further European rate cuts must come soon.
"Some of us are a little worried that the euro zone is fairly close to deflation . . . if any serious evidence of deflation does emerge, it may turn out to be too late" for policy action. Once a deflationary spiral sets in it can be very difficult to reverse, he points out. "Ask Japan", he points out, where interest rates have been cut to almost zero and the economy is still on its back.
He says that he is not forecasting that Europe is heading for deflation - but that it is now a real danger and one to which policy should respond.
One result of weak EU growth is that the euro is likely to remain weak against the US dollar and could easily slip below the one dollar rate. However, this "shouldn't matter". The exchange rate, he points out "should be a peripheral concern and not a test of virility . . . it worries me that people in Europe look at the exchange rate as a critical issue". This is one of the "psychological traps" into which Europe could fall. The ECB has been set up in such a way that it feels it must become a "Bundesbank plus". With the euro falling towards one dollar, there is a risk that if it falls to this level it could lead to "tears and rending of garments" in Europe and inappropriately high interest rates.
Looking at the longer term, he believes that it will be politically difficult for any state to opt out of the euro. But he says that economic strains and political tensions will persist with "lots of strain on the system, lots of times in which there will be conflicting interests".
For the Republic he points out that the authorities here now have "very very little room for manoeuvre" with the economy here now effectively a part of a larger region. "We don't think about macro-economic policy for New England" he points out and "I cannot see anything for Ireland to do but live with the cycle" set by the main euro zone economies.
The economy here cannot grow at 8 per cent in the long term, he points out, with shortages of labour set to act as a constraint. But in the euro zone "there is no reason why one region could not grow faster than the average - it is possible to somewhat buck the trend".
The IBEC annual conference takes place in Dubln Castle, next Thursday. Enquiries (01) 6051523
