Download Monetary Policy in the Euro-zone Does `one size fit all`? (This case

Monetary Policy in the Euro-zone
Does ‘one size fit all’?
(This case study expands on the arguments in Box 9.3 by considering the relevance of the
countries operating with a single currency – the euro.)
How does the impact of monetary policy differ from that under the ERM?
Under the old Exchange Rate Mechanism (ERM) of the EU, where participating countries’
exchange rates were pegged to each other, European monetary policy was essentially German
monetary policy. In order to keep exchange rates to the pegged level, countries’ interest rates
had to change whenever German rates changed. It was the attempt of the UK government in
1992 to keep UK interest rates lower than German rates (in order to boost the economy, which
was in recession) that caused the pound to fall below its permitted level in the ERM and thus
forced the UK to leave the system.
Although Germany is the biggest of the euro-zone economies (some 32 per cent of the total
GDP of the 12 single currency countries), monetary policy is based on EMU12 average inflation
rates (or output gaps or growth rates) weighted by GDP. The combined weight of France and
Italy is greater than that of Germany.
Compare the effect of shocks under the new and old regimes:
 An inflationary shock to the German economy.
 Under ERM, the Bundesbank (the German central bank) would raise interest rates and
fully compensate for this shock. Other countries would thus be given a deflationary shock.
 Under EMU, the ECB would raise interest rates by less (since the inflationary impact is
only approximately 1/3 of the magnitude for the EMU as a whole). Other countries would
thus be given a correspondingly smaller deflationary shock.
 An inflationary shock to another EU country (e.g. France).
 Under ERM, the Bundesbank would take no action. The impact of the shock in France
would be fully felt unless France adopted deflationary fiscal policy, or there were
downward pressure on the franc exchange rate (thereby allowing the French authorities to
raise the interest rate independently of Germany)
 Under EMU, the ECB would raise interest rates according to the amount that average
EU12 inflation was affected by the French shock.
What determines the effectiveness of ECB monetary policy?
Policy goals
Is its success to be judged purely in terms of meeting inflation (or money supply) targets, or is it
to be judged by the broader health of the member states’ economies?
How independent in the ECB?
 How successfully is the ECB able to resist political pressures from individual member states
or from the Council of Ministers, particularly the Council of Finance Ministers (EcoFin)?
Should it resist such pressures? To what extent are central bank governors on the Governing
Council of the ECB truly representing the interests of the euro-zone rather than their own
national interests?
 To what extent does the ECB carry public opinion with it, and is not seen as anti-democratic
and out of touch? It is important here that the ECB develops transparent procedures and has
successful communication through the media with the general public.
Transmission mechanisms
The success of monetary policy depends on the magnitude and speed with which changes in
interest rates affect aggregate demand. There are three main mechanisms whereby higher
interest rates reduce aggregate demand:
 The cost of borrowing rises, and thus reduces investment and consumer spending based on
credit (especially of durables).
 The cost of servicing debt rises for existing debtors, thereby reducing their disposable
income (the ‘income effect’) and hence their consumption.
 The exchange rate rises, thereby reducing exports (an injection) and increasing imports (a
withdrawal).
The strength of such mechanisms varies from country to country (see below).
Stability and predictability of the demand for money
Models developed by the European Monetary Institute (the forerunner of the ECB) suggest that
the demand for money is much more predictable for a core group of Germany (D), France (F),
Austria (A), Benelux (B, NL and L) and Ireland (IRE) than for all 12 together.
Problems of ECB monetary policy
Accountability
The ECB is independent, but still needs political credibility. This means that it must be open
and transparent and accountable, not just to politicians but also to the wider public. This was
indeed the case with the Bundesbank and the Fed. This is more difficult for the ECB – to whom
does it account? Will it become the scapegoat for all EMU’s ills? Will the public perceive it as
another manifestation of Brussels’ ‘undemocratic bureaucracy’?
Non-harmonisation of economies
Core countries (D, A, F, L and B) may require lower interest rates; periphery countries (E, P, I
and IRE) may require higher interest rates. Growth rates have been much higher in the periphery
(e.g. Ireland) than in the core countries (such as Germany).
Asymmetric shocks
One of the biggest problems in trying to operate a single monetary policy for 12 countries is that
they are likely to experience ‘asymmetric shocks’. In other words, different members of the
euro-zone may experience quite different shocks to their economies, whether from outside the
euro-zone (e.g. a fall in the price of one of their major exports) of from inside (e.g. a prolonged
strike). Then there is the problem that the effect of a shock of a given size will vary from one
country to another, depending on the size of its multiplier and the transmission effects of the
shock around the economy (e.g. via financial institutions). These asymmetric shocks would
imply that different parts of the currency area should adopt different policies. But with a
common monetary policy and hence common interest rates, and with no possibility of
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devaluation/revaluation of the currency of individual members, the scope for separate economic
policies is reduced
The costs of asymmetric shocks (and hence the costs of a single-currency area) will be
greater, the less the mobility of labour and capital, the less the flexibility of prices and wage
rates, and the fewer the alternative policies there are that can be turned to (such as fiscal and
regional policies).
Member countries respond differently to interest rate changes
 Exchange rate effects
 Countries with a low proportion of external trade will be less concerned about the impact
on the euro exchange rate with other world currencies: this reflects partly geography and
history. Ireland has 34 per cent of its trade outside the euro-zone, and Belgium has 21 per
cent. This compares with 10 per cent or less in France, Germany, Italy and Spain.
 It also reflects the balance between industry and services. Thus Germany with 38 per cent
of employment in manufacturing is more concerned about the exchange rate than
Netherlands with only 23 per cent (although the exposure of the service sector to
exchange rate fluctuations differs from country to country: e.g. France is more exposed
because of a high proportion of tourism to GDP).
 Differences in financial structures
 The higher the proportion of borrowing at variable interest rates, the bigger the effect on
aggregate demand. Austria and Italy have over 70 per cent of borrowing on such terms;
France, Germany and The Netherlands have only around 40 per cent (most is long term
and at fixed interest rates)
 The higher the proportion of consumer debt to GDP, the bigger will be the cost to
households of servicing a rise in interest rates (and hence the bigger will be the income
effect). This proportion is high in the UK and Sweden and relatively high in Germany. It
is low in Southern European countries.
 The more rapidly banks pass on rate changes to their customers, the more rapid the effect
on aggregate demand. In The Netherlands and Spain, central bank interest rate changes are
fully passed on into banks’ short-term rates within 3 months. In France and Germany, it is
much slower: only around 70 per cent passed on after 12 months.
 The greater the levels of private-sector debt, the bigger will be the effect of any change in
interest rates on aggregate demand. Germany and Belgium have relatively low levels of
private-sector debt, and thus the effect of a change in interest rates on consumer spending
will be relatively low.
In general, interest rate changes have a smaller effect in Germany (with low levels of variable
interest-rate debt, slow transmission of interest rate changes to banks, and a low proportion of
its trade outside the euro-zone) than average and a larger effect in Ireland (which has a higher
proportion of extra-euro-zone trade) and Italy (with a high proportion of borrowing at variable
interest rates).
But the euro will cause greater convergence and therefore common monetary policy will
become more and more appropriate over time.
Problems of targets
 Inflation.
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 A ceiling is set for inflation (i.e. 2 per cent). But how far should the ECB push inflation
below 2 per cent? Is some inflation desirable given the downward stickiness of money
wages and prices?
 Targeting inflation directly is a problem because if the inflation forecast differs from
target, it implies that policy is a failure!
 To what extent should the output gap (i.e. the degree of slack) in the euro-zone be taken
into account in giving an indication of likely inflation rates?
 Money
 Goodhart’s Law (as soon as you target something, it ceases to be a good indicator).
 Unreliable relationship between money supply and inflation. This a particular problem for
the ECB where there is no history of measuring the money supply in euros. Goodhart’s
law could be a particular problem here.
 Members of the general public will be less sympathetic to targeting the money supply as
‘the money supply’ means little to them.
 What account should be taken of the external euro exchange rate? The Monetary Condition
Index measures the size of an appreciation that would have the same effect on output as a 1
per cent rise in interest rates. For Germany this is currently about 1.4. For the USA it is about
10. In other words, in the USA there would need to be a much bigger appreciation than in
Germany to be equivalent to a given rise in interest rates. For the euro-zone the MCI is about
2.2: i.e. changes in the euro exchange rate will have less impact on EMU countries than
changes in the D-mark had on Germany, but much more impact than changes in the dollar
have on the USA. So the euro exchange rate will probably be an important policy objective
for EcoFin (and hence for the ECB in carrying out the policy).
Puts undue emphasis on fiscal policy
 In June 1997, at the European Council in Amsterdam, the EU countries agreed a ‘Stability
and Growth Pact’. This requires that governments adopting the euro should seek to balance
their budgets (or even aim for a surplus) averaged over the course of the business cycle,
and that deficits should not exceed 3 per cent of GDP in any one year. A country’s deficit
is only permitted to exceed 3 per cent if its GDP has declined by at least 2 per cent (or 0.75
per cent with special permission from the Council of Ministers). Otherwise, countries with
deficits exceeding 3 per cent are required to make deposits of money with the European
Central Bank. These then become fines if the excessive budget deficit is not eliminated
within two years. The effect of the Pact, therefore, is to limit the use of fiscal policy as a
instrument of stabilisation.
 It is difficult for boom countries with a budget surplus (like Ireland) to persuade the
electorate for the need to raise taxes or cut government expenditure!
 If fiscal policy is used, there are considerable time lags involved, which greatly limit its
effectiveness as a means of stabilising the economy.
Why problems of operating a common monetary policy for EU12 might not
be too serious
 There is greater divergence within member countries than between, and thus shocks can be
more damaging within countries (e.g. effects on coal industry): i.e. shocks are more likely to
hit individual industries or regions rather than individual countries. Thus changing the
exchange rate would be the wrong policy tool.
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 The effects of monetary policy changes are likely to become more similar over time as the
single market (in finance) develops.
 Fiscal policy can still operate (and countries’ public sectors are quite large in Europe (larger
than those of individual states in the USA, which operates as a single currency area).
 Over time, member economies are likely to converge, thereby reducing the likelihood and
effect of asymmetric shocks.
 In a European single market with no single currency, the possibility for devaluations would
become increasingly remote. The devaluing country would only gain a temporary advantage,
and may simply suffer higher inflation as a result. The other countries may be very resentful
of the devaluation (as was France of the UK and Italian devaluations after 1992).
General problems for monetary policy in the world of interdependent
economies
 Having only one instrument of policy (the rate of interest), but multiple goals (e.g. inflation
versus exchange rate). This is, in fact, less of a problem with a large country/zone such as the
USA and the euro-zone, than with a relatively small country, such as the UK, since external
trade accounts for a smaller proportion of GDP and thus fluctuations in the exchange rate are
less important to business.
 Different sectors or regions may require different types of monetary policy (e.g. in the UK,
the service-sector boom suggests the need for higher interest rates, while manufacturing
requires lower interest rates to reduce the exchange rate and make exports more competitive).
 Different response of different sectors to interest rate changes (e.g. manufacturing tends to be
harder hit by appreciation). This is less of a problem under the euro, with a relatively low
proportion of external trade.
 Lack of autonomy in global markets, with huge currency flows (but bigger strength of ECB
relative to Bank of England and other individual countries’ central banks).
Will the UK be able to pursue a truly independent monetary policy if it stays
outside the euro?
The Bank of England’s scope for pursuing a monetary policy independent from the ECB is
limited.
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53 per cent of the UK’s exports are to other EU countries and thus UK aggregate demand is
significantly affected by changes in the €/£ exchange rate.
Speculators are likely to move short-term finance between sterling and the euro depending
on their anticipated relative strength. This means that changes in the UK interest rate relative
to the EMU interest rate are likely to have large effects on the €/£ exchange rate, thereby
limiting the scope of the Bank of England to change the rate of interest independently from
the ECB without causing undesirable exchange rate effects.
Questions
??
1. How does the operation of monetary policy in the UK differ from that under the ECB?
2. Would monetary policy be more or less effective for the UK if Britain joined the euro?
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