Monday, April 4, 2011

How Would ECB Easing Help the Eurozone?

In my previous post I argued the ECB could help the Eurozone not just by refraining from interest rate hikes, but by easing monetary policy.  I said doing so would lead to a real appreciation in the core economies of Germany and France and a much needed real depreciation in the periphery.  This would not solve the periphery's problems, but it would make them more manageable.  This is an argument I fist heard from Ryan Avent and I find it compelling.  Let me explain it in more depth.

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 less economic slack in the core countries, especially Germany.  The price level, 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.  

Again, the relative price level change would not be a permanent fix to the structural problems facing the Eurozone--it is not opitmal currency area and there needs to be some kind of debt restructuring in the periphery--but it would provide more flexibility in addressing the problems. Tightening monetary policy, on the other hand, would only make matters worse.   Fortunately, more folks are raising their voices against the ECB tightening monetary policy.

Ultimately, what will happen to the Eurozone will depend on what the Germans want.  As Rebbecca Wilder notes, Germany is not thrilled about debt restructuring in the periphery.  Meanwhile, Germany also remains opposed to large-scale bailouts that would be needed in the absence of such debt restructuring.  Finally, Germany does not want to ease monetary policy in the manner described above.  This has to end.  Germany cannot keep kicking the can down the road forever. 

3 comments:

  1. "it is not opitmal [sic] currency area and there needs to be some kind of debt restructuring in the periphery"

    how does debt restructuring create an optimal currency area ('OCA')?

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  2. Anonymous:

    I didn't say debt restructuring would create and OCA. I was just listing the two big problems with the Eurozone I see. One could argue, though, that because the Eurozone is not an OCA there now needs to be debt restructuring.

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  3. Thank you for the clarification.

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