The issue of economic heterogeneity within the Eurozone has been central to the academic and policy debate on macroeconomic governance reform. It will be central also to the review of monetary policy strategy that the European Central Bank (ECB) will be conducting in 2020.
The Economic and Monetary Union (EMU) is a unique experiment: it was born as an economic project, grounded into a theoretical framework – the theory of Optimum Currency Areas (OCA) – which was itself developed with the process of European integration in mind (European integration in fact features prominently in the opening paragraphs of Robert Mundell’s 1961 seminal paper OCA theory).
In the run-up to currency unification – when the Werner report was published – a fierce debate on economic heterogeneity pitted the ‘economists’ against the ‘monetarists‘. The economist view posited that real convergence towards a similar economic model ought to be a pre-requisite for monetary unification, to ensure that asymmetric shocks would not be de-stabilizing. The monetarists, on the other hand, were inclined to give the benefit of the doubt to the idea that the EMU could ‘evolve’ into an OCA.
Before the Eurozone crisis that broke out in 2010, a major debate still existed on whether the common interest rate set by the ECB was suitable for all Eurozone members, considering their very diverse economic conditions. Ex post, the answers is quite clearly negative: the convergence of nominal rates coupled with persistent inflation differentials contributed in fact to the development of massive macroeconomic imbalances across the Eurozone “Periphery”. But where do things stand, today?
We can evaluate this by estimating very simple Taylor rules for Eurozone countries. Named after the economist John Taylor, the Taylor rule is a policy guideline that generates recommendations for a central bank’s interest rate response to the dynamics of inflation and economic activity. Academic research on monetary policy rules finds that this function, while very simple, describes the actual central bank interest rates developments reasonably well. Here, we tried three versions of the rule: (i) a classic version based on inflation differential from target and unemployment gap with respect to the Non-Accelerating Inflation Rate of Unemployment (NAIRU); (ii) a generalized version, and (iii) a version that follows Nechio (2011) in using core inflation. Results across the three specifications point in the same direction.
Figure 1 – Taylor Rule recommendations for the Eurozone
[infogram id=”_/eUq6Kbk170AFRnoXcPF0″ prefix=”cLV” format=”interactive” title=”Taylor 1″]
Note: EZ North = Austria, Belgium, France, Finland, Germany, the Netherlands;
EZ South = Ireland, Portugal, Spain; EZ = EZ as a whole
In 2013, this exercise would have yielded drastically different interest rates prescriptions for different Eurozone countries – from +4% in Germany to -15% in Greece (see Darvas & Merler 2013). Today, however, things are very different. Following the massive macroeconomic adjustment carried out by the Eurozone “Periphery” – which we have discussed at length in a recent Policy Forum paper – most countries in the Eurozone are closer today than they have probably ever been in the past. As a result, our simple Taylor rule exercise suggests that today, the Eurozone Core and Periphery would be served fairly well by a common interest rate set at the level that is optimal for the area as a whole (Figure 1). Only for Italy and Greece would the rule still prescribe a negative rate. Against what claimed in the Italian Eurosceptic discourse, today Italy is thus one of the countries that benefits the most from the single monetary policy.
Synchronization of business cycles has also increased among Eurozone countries since 2016. This is evident in the fact that a substantial share of the variation in GDP growth across members is now explained by a common factor. The credit cycles – which in the pre-crisis period had been a source of massive divergence – have become aligned (Figure 2), suggesting that financial integration no longer drives economic asymmetry. Italy is again a special case, as its cycle remains stuck in a prolonged slump.
Figure 2 – Real Credit Cycles in the Eurozone
[infogram id=”_/LtaXIsC6AXjsx0pYi2iN” prefix=”wnQ” format=”interactive” title=”Taylor 2″]
Note: EZ North = Austria, Belgium, France, Finland, Germany, the Netherlands;
EZ South = Greece, Ireland, Portugal, Spain; EZ = EZ as a whole
The significant process of convergence observed since 2010 means that individual Eurozone countries today are much less exposed to idiosyncratic shocks than they used to be before the crisis. We seem to have evolved from a case of one-size-fits-none monetary policy towards a case of one-size-fits-(almost)-everyone, although this simple exercise does raise the question of how to deal with outliers such as Greece and (more importantly in terms of size) Italy. Overall, the fading away of economic heterogeneity in the Eurozone is a major development, and very good news for the ECB because it will facilitate the job of the (conventional) single monetary policy going forward – assuming we will at some point revert to a world of conventional monetary policymaking. Yet, important questions remain for the ECB to tackle in its monetary policy strategy review – first and foremost concerning the elusiveness of its aggregate inflation target despite its accommodative unconventional policy.
Silvia MERLER – Head of Research, Algebris Policy & Research Forum
Antonio FOCELLA – Junior Research Analyst, Policy & Research Forum
