Ryan Avent reports on some research from the SanFran Fed that includes the above figure:
[I]t's clear what was going on; the ECB stood idly by while the periphery overheated because it was making policy with an eye toward the core nations. Now that the peripheral booms over which the ECB presided have collapsed, the central bank is...continuing to pursue a policy that's most appropriate for the core economies.
Now perhaps the ECB thinks it isn't responsible for managing divergent economic cycles within the euro zone. Indeed, the ECB may well be trying to force core nations to take on this responsibility and move toward closer fiscal union. If the ECB is unsuccessful in winning such progress from core governments, however, we shouldn't be surprised if peripheral economies find euro-zone policy intolerable and—eventually—drop out of the system entirely.
For those in the dark, the Taylor Rule is one simple device for determining what monetary policy should be. Krugman makes the appropriate caveat:
So here’s the thing: if you use the output gap Taylor rule that, for the US, corresponds to the unemployment version of the rule used in the SF Fed letter, it surely implies a negative interest rate. In short, the ECB has no business raising rates.
What is true, however, is that the rule might still point to a rate rise for Germany.
So the point is that while the ECB could suffer from a one-size-fits-all problem, the fact is that it isn’t even doing that; it’s tightening when only Germany even arguably needs it.
The deal underlying the foundation of the Euro was that peripheral countries would get a reduction in currency risk and therefore lowered borrowing costs. They would also get access to Europe's biggest markets at a fixed exchange rate. In exchange, they would lose monetary policy autonomy. That worked as long as their economies were growing, but obviously creates problems when the economy contracts. This is classic trilemma politics: fixed exchange rates are fine while there's growth, but monetary policy autonomy becomes more pressing during contractions. It's a lot like the Asian crises in the late 1990s.
Meanwhile, I see that Trichet is defending the eurozone by saying that the US is not an optimal currency area either. This gets said a lot, certainly more often than any definition of which currency area is "optimal" or even what that means, and there is certainly some truth to it. But my definition of what size zone is "optimal" would be something like: "As large as is politically feasible, as long as there is a fiscal adjustment mechanism included". In other words, I don't think size of area is the real problem. It's about the political organization of the area, and what other institutions come along with the currency.