by Andreas Hoffmann
In a recent article in the WSJ, David Wessel sees a “fundamental problem” in the euro zone’s one-size-fits-all policy.
We know from Mundell (1961) that a one-size-fits-all monetary policy cannot guarantee low inflation and unemployment in all members of a heterogeneous currency area, given e.g. labor markets are not fully flexible as in the euro area.
In general, capital market integration and free capital flows in two regions have the tendency to bring about convergence of real – not necessarily nominal – interest rates (assuming no risk premium) as capital is allocated to its best uses. But in a currency area, like the euro area, nominal interest rates are the same everywhere as they are set by a central authority. Thus, real interest rates can be zero or even negative in regions that experience higher inflation, while they are positive in regions with lower inflation. Then policy is too expansionary in some regions and too tight in others, while the average inflation rate may stay relatively stable at the target level.
Germany faced relatively tight monetary conditions when the ECB started to set nominal interest rates as an average of the euro zone. To not cause deflation and stagnation in Germany, the ECB seems to have loosened monetary conditions – D. Wessel argued it followed a German rule – which allowed for money growth of 6-8 percent above the productivity growth in the euro area. While risks were perceived widely equal throughout the union, for the periphery economies the ECB interest rate was too low. Inflation ate up real interest rates. Holding nominal interest rates even lower to prevent a stagnation in Germany, therefore, further pushed down real interest rates in the rest of Europe. This contributed to the bubble in the periphery economies.
Following Mundell (1973) financial and capital market integration distributes the risks of investment over the whole currency area. Therefore, when a bubble bursts in one region, other regions are drawn into the maelstrom of the crisis. For instance, German banks that financed the boom in Spain face losses. On the contrary, everybody participates in the the boom. Therefore, business cycles have a tendency to be widely synchronized in a currency area. But even though business cycles were highly correlated, when one region grows substantially more or has substantially higher inflation than another, one-size-fits nobody. We currently observe that this can be a major problem in the euro area.
For similar reasons, one-size-fits-all can be a problem in the dollar area. In fact, Mundell (1961) originally applied his argument to the US. The WEST was different from the EAST. Also today, different regions in the US develop differently. As Jerry O’Driscoll pointed out at the ‘Colloquium’ on monday, only 5 states saw a housing bubble. Clearly Texas, California. Iowa and Ohio are very different. Since unemployment in e.g. California is higher than in e.g. Texas, it is unclear whether labor markets are sufficiently flexible for a one-size-fits-all monetary policy. For one-time shocks, transfers could smoothen the cycle and make e.g. California better off (if this is a shock?). But transfers may cause moral hazard of the recipients and do not help if the differences are not due to a single shock that washes out in the medium run. In Ohio and Michigan whole industries are gone today.
Mundell, R. (1961): A Theory of Optimal Currency Areas. American Economic Review, 51, 657–65.
Mundell, R. (1973): Uncommon Arguments for Common Currencies, In The Economics of Common Currencies (Eds.) H. Johnson and A. Swoboda, London: Allen and Unwin.