Monetary Policy Can Save the Eurozone, For Now

The Weekly Standard has an article by Christopher Caldwell on the challenges facing the Eurozone. It is an interesting article that has as its main thesis the following:

Europe’s countries now face the choice of giving up either their newfangled money or their ancient national sovereignties. It is unclear which they will choose.

This is a conventional view, but is it correct? Are the choices really limited to saving the Euro or preserving national sovereignties? For the long-run the answer is probably yes. It is difficult to make a monetary union work without a political union. For many of the economic shock absorbers needed to make a monetary union work–common treasury, fiscal transfers, labor mobility, price flexibility–either require a political union or would be more effective with one.

In the short-run, though, there is another option: more monetary easing by the ECB. As Ryan Avent explains, further easing by the ECB would cause a real depreciation for the Eurozone periphery vis-a-vis the Eurozone core:

[T]he key to a relatively painless internal revaluation is inflation in tighter markets. And it’s here that the European Central Bank could play a particularly useful role. Were the ECB to adopt a looser monetary policy, we would expect inflation to pick up first in the markets with the least excess capacity, and that would obviously mean rising prices for Germany.

Prices, therefore, would increase more in Germany than in the troubled periphery. Good and services from the periphery would then be relatively cheaper. Thus, even though the exchange rate among them would not change, there would be a relative change in their price levels. This would make the Eurozone periphery more externally competitive. The relative price level change would not be a permanent fix to structural problems facing the Eurozone, but it would provide more time to address the problems. Unfortunately, this is not likely to happen. The one thing Germans hate more than Eurozone bailouts is Eurozone inflation.

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