Friday, December 7, 2007

The ECB, Asymmetric Shocks, and Monetary Policy Dilemmas

. Friday, December 7, 2007

Standard theories of monetary union suggest that they work best when the participating countries experience the same shocks. They work least well when they experience asymmetric shocks. I have always found it difficult to teach this, because until now the EU's monetary union has not really had to deal with a big shock. The fall out from the US sub-prime crisis is imposing an asymmetric shock on euroland. Consequently, we now begin to see the dilemma that EMU creates for its members and its single central bank.

The core problem is that the ECB must choose between inconsistent objectives. As the Telegraph summarizes, "Mr Trichet has to tread a delicate path between the eurozone's Germanic and Latin blocs, pulling ever further apart. The credit and housing booms have begun to deflate in the Club Med region. The Bank of France's governor, Christian Noyer, said this week that Europe was facing a "huge shock" as contagion spread from the US sub-prime crisis...Spain in particular is now in serious trouble, with a "staggering" current account deficit of 9pc of GDP and a huge overhang of unsold property from the housing bubble."

Germany, in contrast, is struggling with rising inflation: "The hard-line bloc [is] led by the two German council members, Bundesbank chief Axel Weber and the ECB's chief economist Jurgen Stark. The latest spike in oil and food costs has pushed German inflation to 3pc, the highest since the launch of the euro and fast approaching the level where it may erode popular support for the currency."

Thus, one monetary policy but divergent economic developments across euroland. Someone has to accept a monetary policy that not only fails to address their current needs but will actually further worsen their situation. The dilemma is complicated by uncertainty; the more German unions question whether the ECB will use policy to keep inflation down in Germany (i.e., the more they believe that monetary policy will target Spain and the Med) the larger the nominal wage increases they will seek. Hence, to keep inflation down in Germany, the ECB must be hard line and build a reputation. But, being willing to raise interest rates to build this reputation risks making things even worse for "club med."

Not surprisingly, this "technical decision" is spilling over into politics, as French and Italian politicians have chastened Trichet for the hard line he is adopting.

It is precisely this problem that caused me to write, more than ten years ago, that EMU is not obviously a very good idea.


Benjamin Thomas Sutpen said...

How is this different from inner American differences (say between New York and Mississippi) or even a country as small as Germany (with West Germany having low unemployment, growth and population growth while East Germany has high unemployment (20% I believe), population loss (especially qualified people, no growth (again, I believe, it is lower in any case), one could even be more specific and point to the Ruhr area and its adjustment problems with its coal industry; to make a long question short, why is the ECB a worse idea than the Fed or the Bundesbank, in the end monetary policy will be a blunt tool and someone will suffer under it in any case?!?

Thomas Oatley said...

In principle, no different at all. In the US context, asymmetric shocks can and usually do provoke inter-regional financial transfers. In Germany, the unification shock prompted massive inter-regional transfers. In short, national governments use fiscal policy to channel resources from strong growth regions to areas hit by negative shocks. The EU lacks a fiscal policy capable of such transfers. And, the rules constrain national fiscal policies (though not in a fully binding manner).

The other solution is labor mobility; people in the low-growth area move to the high growth area. This happens often in the US; labor is less mobile in the EU.

The ECB, Asymmetric Shocks, and Monetary Policy Dilemmas




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