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Monetary policy in the Eurozone

Intra-region divergences and possible alternatives1

Jos Ernesto Aldana Vizcano

The recent economic events taking part in the world have for obvious reasons strongly related to the group of phenomena which occurs in this continent. The world has, in recent months, inevitably turned its face towards Europe, and not particularly because of good news. The so called PIGS made the headlines of newspapers all around the world. Partly because of the world crisis in 2008, the worlds financial markets have, in recent years, been showing some signs of extreme uncertainty. This huge amount of volatility in capital markets has affected the investors confidence in assets that were once seen as safe purchases. This can, as an example, be seen in the recent worsening of some European countries government debt issues, e.g. France losing its AAA rating. 2 This uncertainty atmosphere is at the same time cause and effect of some deeper structural problems which had, for some reason, been unnoticed until now. Another big European event that has caught the worlds attention (and caused some fear) for a relatively long time is the situation in Greece. It is now common knowledge that the current state of financial and debt issues in that country is, at best, dramatic. But Greece is not an isolated country in economic terms. Greece is, ever since January 2001, member of the Eurozone, i.e. it has adopted the euro as currency. 3 The events currently going on in this and other European countries have reawaken some uncomfortable questions regarding the justification of the single currency, shared today by 17 European nations. One of those uncomfortable questions has to do with the existence of a single monetary policy, which has effects in each of the countries which integrate the Eurozone. The problem here is that the consequences of a common economic policy would be the same in each country, only if the current economic conditions were also equal. This, as can evidently be noticed, is almost impossible even in a world where globalization has somehow brought down some preexistent barriers. Even though they share a lot of characteristics, which constitutes the reason why
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This essay is written as an answer to: The Eurosystem asserts that, in its deliberations, it never pays attention to local (i.e. national) economic conditions. The reason is that there is a single monetary policy and that one size fits all. Discuss this approach and imagine alternative approaches. 2 France loses AAA rating as euro governments downgraded, article from BBC News, January 13th 2012. In <http://www.bbc.co.uk/news/business-16552623> 3 Baldwin and Wyplosz, The Ecoonomics of European Integration, 3rd edition, Mc Graw-Hill, 2009, p. 495.

the European countries have been able to merge and use a single currency, the effects of external shocks and internal monetary policy show up differently and at diverse time points in each of the members of the European monetary union. One of the main arguments used to explain the fact that every countrys economy shows distinct responses to the monetary policy executed by the European Central Bank (which is the monetary authority within the European currency union) has to do with the principle of the impossible trinity, which states that 1) full capital mobility, 2) autonomous monetary policy, and 3) fixed exchange rates, cannot be held at the same time. 4 In the European framework this means that by having achieved full capital mobility and having what can be called a fixed exchange rate, countries within the Eurozone have given up their autonomy when it comes to monetary policy decisions. What is written in the paragraph above means that every country integrating the single currency area has quit the opportunity of facing adverse shocks through monetary policy. Of course as the economy faces stable phases of the business cycle, this represents no major source of concern for both government and citizens. But what happens when things get a bit out of control? Usually a country has the opportunity to face adverse shocks using economic policy, i.e. fiscal and monetary instruments. Moreover, a country can use monetary policy, for example for adjusting the inflation rate to the economys current needs: raising the money supply when higher inflation can be allowed in order to promote economic growth, or, in the opposite case, applying a contractive policy when things have become a bit overheated. Evidently, Eurozone countries are no longer able to do this. The reason: the ECB controls monetary policy and cannot attend individually each countrys concerns. European countries can no longer depreciate the nominal exchange rate in order to gain competitiveness in foreign markets and promote production growth. For these nations case, competitiveness has to be gained through different methods. The real exchange rate can be modified no longer by nominal exchange rate alterations. The only way a European country can gain competitiveness with respect to other members of the monetary union, is through lower inflation. Usually, monetary policy is used as a tool for price level stability (Europe is not the exception), but members cannot individually do this. This actually imposes a hard-to-bring-down barrier to European countries when national matters are relatively different to those which the union faces. Within the Eurozone, the inflation tendencies from country to country have differed constantly. There are countries which have showed a low inflation over the years of the monetary unions existence (Germany, Finland, France), and others in
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Ibid., p. 289.

which the inflation has insistently presented higher-than-average values. Baldwin and Wyplosz (2009) give some possible reasons for this asymmetric phenomenon, e.g. rising prices in catching-up countries (Balassa-Samuelson effect), wrong initial conversion rates, and national wage and price pressure.5 Other reason for different responses to monetary policy is of course structural particularities of each different economy. For example market structure, or government-run economic activities. The influence of labor unions can play an important role in the stickiness of prices or wages. Each and every one of the factors mentioned above contributes to the fact that the monetary policy dictated by the European Central Bank cannot have the same consequences in different countries, and therefore, one size fits all is a phrase which cannot belong (at least) to the European case. To cope with this issue, there is still an economic policy tool which countries within the union can independently control. That is of course, fiscal policy, which can be thought of as an alternative to its monetary counterpart that can be used by governments to promote growth or manipulate certain economic variables. But let us remember that European Union membership is based on some macroeconomic stability criteria which include explicit reference to fiscal issues, in particular to public debt and budget deficit. This limits the field of action of the fiscal tools and therefore shrinks their potential effectiveness. Intra-region fiscal transfers could be another answer to the problem, but they involve some major political agreements which would be too hard to achieve. Markus Brunnermeier proposes another alternative for differentiating the effects of monetary policy within a currency area. This consists of the so called haircut policies which can be applied on assets offered as debt warrant by different countries. In his own words: the ECB should impose haircuts and stricter collateral requirements for mortgages or loans issued in member countries that experience high inflation and excessive capital inflows.6 He also states that this could be done without the need for any legal modifications, which acts as a major pro for this kind of strategy. The problem is, by discriminating in this way, the European Central Bank would be actually imposing different economic policy measures for each member of the Union. And moreover, who can actually guarantee that the ECB would be able to recognize 17 different situations and act according to each one of them? Economic history has proven that the selection of a proper monetary policy is hard even for national institutions dealing with a single countrys economy, how

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Idem., pp. 511-512. Brunnermeier, Markus K. Optimizing the Currency Area In The Great Financial Crisis: Lesssons for Financial Stability and Monetary Policy. Frankfurt: European Central Bank, 2010.

could we expect one central bank to act in 17 different ways and obtain satisfactory results? The European Central Bank leads monetary policy with the objective of maintaining price-stability within the European Union. This, as has been previously discussed, does not mean that every member country will have the same inflation rate. Divergences in economic conditions of the member countries are simultaneously cause and consequence of different monetary policy effects. There are alternatives to deal with each economys issues particularly, but their actual occurrence doesnt seem quite likely, mainly because of the incompatibility of their consequences with the convergence criteria of the Eurosystem. Monetary integration has, just as everything, its pros and cons. Some costs have to be paid in order to achieve good economic conditions for the whole region. The fact that affected countries may consider they are paying too much, brings up the matter of the survival of the currency union. Time will tell.