Fiddling While the Eurozone Burns

So the European Central Bank (ECB) has decided to follow through on its plans to tighten monetary policy this year. The ECB will begin by raising its benchmark interest rate next month. This is unbelievable. The Eurozone is under severe pressure that could ultimately lead to its breakup and yet the primary concern at the ECB is tightening monetary policy according to schedule. If followed through, the consequences of this are not only bad for the Eurozone, but for the rest of the global economy too. The slow-motion bank run now taking place in the Eurozone could easily turn into another severe global financial crisis.

So why then is the ECB pushing so hard for monetary policy tightening? From the New York Times we learn the answer:

With Germany, the euro zone’s largest economy, growing so quickly that some economists fear overheating, the E.C.B. has been trying to nudge interest rates back to levels that would be normal in an upturn.

Silly me, I thought the ECB’s mandate was for the entire Eurozone not just Germany. Now Germany is the largest economy in the Eurozone and so its economic conditions have a large influence on the the Eurozone aggregates that the ECB targets. So maybe I am being too hard on the ECB here. Still, if the ECB really desires to save the Eurozone in its current form then tightening monetary policy is a move in the wrong direction.

Here is why. If the ECB were to ease monetary policy, it would cause inflation to rise more in those parts of the Eurozone where there is less excess capacity. Currently, there is far less economic slack in the core countries, especially Germany. The price level, therefore, would increase more in Germany than in the troubled countries on the Eurozone periphery. Goods and services from the periphery then would be relatively cheaper. Thus, even though the fixed exchange rate among them would not change, there would be a relative change in their price levels. In other words, there would be a much needed real depreciation for the Eurozone periphery. This would make Greece, Portugal, Spain, and other periphery countries more externally competitive.

Again, the relative price level change would not be a permanent fix to the structural problems facing the Eurozone–it is not an optimal currency area and there needs to be debt restructuring–but it would provide more flexibility in addressing the problems. Tightening monetary policy, on the other hand, would only make matters worse. It would force all of the needed real depreciation for the periphery on wages and prices in the troubled countries. That only increases the pain for them and makes it more likely they will leave the Eurozone. This seems so obvious to me. Why isn’t it obvious to ECB officials? Why are ECB officials fiddling while the Eurozone burns?

P.S. See Kantoos latest idea for saving the Eurozone: apply countercyclical haircuts on bonds accepted by the ECB for refinacing (HT Matt Yglesias).

Disclaimer: This page contains affiliate links. If you choose to make a purchase after clicking a link, we may receive a commission at no additional cost to you. Thank you for your support!

About David Beckworth 240 Articles

Affiliation: Texas State University

David Beckworth is an assistant professor of economics at Texas State University in San Marcos, Texas.

Visit: Macro and Other Market Musings

Be the first to comment

Leave a Reply

Your email address will not be published.


*

This site uses Akismet to reduce spam. Learn how your comment data is processed.