It’s often said that one of the factors responsible for brewing the current eurozone crisis was the monetary union’s insistence on a converged interest-rate policy.
That is to say, one interest rate for all members — irrespective of whether the rate was more suitable for Germany than say Spain or Ireland.
As we all know, ECB rates ended up taking the following interest-rate path:
But there has always been one golden rule that central bankers could look to for guidance on where interest rates should be on an individual level. That is the so-called ‘Taylor rule‘, as derived from a country’s inflation rate and output gap.
In a bid to see where things might have gone wrong on this front — i.e. in which countries interest rates may have been too low or too high for too long, and by how much — Barclays Capital has back-analysed the rule for specific eurozone countries:
It seems almost every eurozone peripheral now in straits featured three-month interest rates far below the level implied by the Taylor rule for most of the early naughties.
As Barclays Capital puts it:
The contraction in investment is a key reason for the divergences in GDP expansion. As fiscal tightening becomes more pronounced, the divergences in domestic demand are likely to be especially wide. This is also exacerbated by not having a “one size fits all” monetary policy, which is apparent when comparing estimates of the “Taylor Rule” across euro area economies (Figure 17).
The divergences between the short-term (3m) prevailing interest rate and that implied by the rule have been particularly great across the “periphery” economies (RH chart) compared with the core (LH chart). This reflects a combination of the effect of the booms in domestic demand on the output gap, as well as stronger inflation in much of the periphery for the first seven years of EMU. The divergence of optimal interest rates from those prevailing has been much greater across the euro area than across US states .
So perhaps there is something to the Taylor rule after all?
Naturally, hindsight is a wonderful thing.
But just in case readers need reminding about the scale of belief in the one-size-fits-all policy for the eurozone back in the day, here’s how ECB executive board member Otmar Issing viewed the idea at the time.
From the concluding paragraph of a speech given in 2005:
To the question whether a single one-size monetary policy could fit all parties involved – be they national entities, social partners or economic actors – my answer was: “One size must fit all”. The political decision on the creation of EMU had resolved all discussions on whether monetary union should precede or follow political unity and the fulfilment of the criteria for an optimum currency area. Today, in light of the evidence gathered so far in the euro area, I am more confident in saying: “One size does fit all!”
And just for giggles, another choice extract regarding the the possibility of using collateral policy to force fiscal discipline on misbehaving members:
Let me take the occasion to briefly comment on an idea that seems to gain more and more support. It has been recently argued that the ECB should use its collateral policy as a sanction to exert fiscal discipline on those euro area member states that breach the 3 % limit.
One possibility would be for the ECB to impose haircuts on the bonds issued by those governments that fail to comply with the Pact, thereby making those bonds less attractive for counterparties to hold and use as collateral in the ECB’s regular operations. Although superficially appealing, this suggestion would be misguided.
First of all, such a measure would exceed the mandate of ECB’s collateral policy, which is to manage risk in monetary policy operations. Assigning additional roles to collateral policy would deflect it from its primary and crucial purpose. Second, such a proposal ignores the differentiation already applied by the ECB in valuing collateral.
All financial assets offered as collateral, including government bonds, are valued daily at market prices. In its collateral policy, the ECB therefore relies on the judgement of the market to distinguish among government bonds and, implicitly, the fiscal behaviour of member states.
Moreover, the ECB sets credit standards for the eligibility of assets as collateral and is bound by the Treaty not to distinguish between government and private issuers in the implementation of these standards. Third, and most importantly, it is clear that the design of the Stability and Growth Pact and its implementation are governmental responsibilities, to be controlled by parliaments.
Of course, in giving its assessment of macroeconomic developments, the ECB must always assess all elements that influence the outlook for price stability in the medium term, including changes to the fiscal framework and fiscal measures adopted by national governments. However, it is not and cannot be the ECB’s role to enforce fiscal discipline and to correct shortcomings in the implementation of the Stability and Growth Pact. Attempting to do so would politicise the ECB’s operations and ultimately threaten its independence, on which the credibility and effectiveness of monetary policy crucially rely. The ECB therefore focuses on its own mandate, with the primary objective to maintain price stability, leaving others to meet their own responsibilities.
Oh, how we reap what we sow.
Related links:
The Taylor rule debate - Calculated Risk
One size fits all! A single monetary policy for the euro area – ECB