Thursday, September 23, 2010

One-Size-Fits-All Monetary Policy Does Not Work

Many times I have discussed here how the Eurozone is far from an optimal currency area--its member countries have different business cycles and insufficient economic shock absorbers in place--and the problems that this reality creates for the ECB in conducting monetary policy.  One of the key problems is that the ECB is applying a-one-size-fits-all monetary policy to vastly different economies.  For example, consider the case of Ireland and Germany.  When the Euro was adopted in 1999 Ireland was growing close to 10% while Germany was growing around 3%.  Should the ECB be responding to Ireland, Germany, or the average in setting its target interest  rates?  As the figure below shows, up through the end of the housing boom period Ireland was consistently growing faster than Germany. (Click on figure to enlarge.) 

Via Ralph Atkins we learn of Barclays Capital report that looks closely at this issue. Unsurprisingly, it finds the following:
ECB interest rates have generally corresponded more to economic conditions in Germany - the eurozone’s biggest economy - than the eurozone as a whole.
This means ECB monetary policy was well-suited for the low-growth German economy, but way too easy for the hot Irish economy.  Easy monetary policy, therefore, must have been an important contributor to the housing boom in Ireland during this time. I think Josh Hendrickson would agree.


  1. So how is this different from the US? New York, California, the South, the Midwest, Texas... all have very different economies that somehow the Fed has to balance with only one monetary policy. Each has a different fiscal policy, different imports and exports, different economies. Hence, monetary policy has tended to be tighter than a Southern US Fed would have allowed in order to favor New York City.

  2. Derrill:

    That's an interesting question. I have addressed it in the past here:

  3. Does the same hold true for the U.S. and China "dollar bloc"?

    If China tries to raise rates to quell an inflation overshoot, it pulls in more yield-seeking investment from abroad. The PBOC sponges up those dollars to maintain the peg, replacing them with more yuan, which of course juices the Yuan money supply. The result is that, as long as China maintains the peg, it has trouble running its own monetary policy.

    The "monetary superpower" concept now has an ironic twist: the Fed is so far unable to spark velocity here, and yet U.S. banking system reserves must somehow be finding their way to China where velocity is raging. This likely explains the steep rise in commodity prices. It will continue until China revalues to stave off domestic inflation, at which time we would experience a one-time inflationary shock (it is a safe assumption that China's competitors would also raise prices). Given the likely direction of rents -- even with additional QE -- we may be returning to the 2008 "inflating headline/deflating core" inflation regime.

  4. David Pearson:

    While I have been calling for more Fed action, I often question the long-term implications of such actions. One key reason is the point you bring up: the Fed's monetary superpower status and its current impact on global liquidity conditions. I also wonder about the long-term impact in terms of the risk-taking channel of monetary policy. Thus, while on balance I believe the Fed should do more I do so without the certainty that folks like Scott Sumner, Paul Krugman, and others seem to have.

  5. This post probably reveals more about the preoccupation with monetary policy in economic discussion these days than about optimal currency areas. Monetary policy is only one of many economic policy instruments, and a blunt one at that. If Eire's problem was mainly a housing boom, surely some policy precisely targeted at that, such as minimum downpayments or an increase in land value taxation would have been a better response than raising the return on loanable funds across the whole economy. I see no reason why such policies could not have been used within the eurozone. I suspect that the real reason why nothing was done was that the boom was popular, and brought in lots of tax revenue to fund government largesse.