The ECB met earlier today to conduct the monthly review of interest rate policy. It came as a surprise to noone that the outcome was to leave everything just as it is. Surprisingly though the decision this month is surrounded by a little more controversy than has been the case of late since Italy’s Berlusconi and economic opinion in Germany have been suggesting that some reduction of rates might be no bad thing, whilst Spain’s economy minister (and former EU commisioner) Pedro Solbes is reported to have been pushing for an increase. Why the difference?
Well I think there are a number of good reasons why interest rate policy might be viewed differently depending on where you are sitting, but before going into any of these I could alert the economy freaks (and possibly also the masochists) among you the the ‘grey men’ of the ECB are actually going live with a video image webcast at 2:30 this afternoon where you can hear and see the statement read out and then follow the accompanying press conference.
(Short parenthesis, and following my post yesterday, it is immediately apparent to me that this ‘webcast development’ has a very interesting potential application in economics teaching).
Now for the nitty gritty.
The euro as a common currency has three known and clear problems: it is contingent on the evolution of a growing political union for its long term operability, it assumes that it is possible to evolve a single monetary policy for a diversity of economies, and it suffers from the difficulty of the well-known ‘free rider’ problem when it comes to fiscal policy and indebtedness.
I have drawn attention to the first of these – the political union dimension – in a post on the possible consequences of a (now apparently less likely but still possible) French ‘no’ to the constitution. Also Peter at EuroPolyphony linked earlier in the week to an FT editorial which gives a basic rundown on the issues, so I won’t comment further here.
The second question, the ‘one ring to fit them all’ interest rate quandry is no less problematic. Basically the problem relates to possible differences between the inflation rate and the interest rate in each of the member countries. Essentially under ‘normal’ conditions a central banker would probably consider it desireable to maintain interest some 2 or 3 percentage points above the rate of inflation.
Such a setting would normally be considered ‘neutral’ since it neither tended to inflate nor deflate the economy. This then opens an arm of monetary policy for a central bank which can either raise the rate in order to reduce inflationary pressure or reduce it to ease oncoming recession.
Thus the US Fed (which is steadily and systematically raising rates incrementally) is being actively scrutinised for signs of anti-inflation tightening, whilst Japan (which has been suffering from some sort of deflation for the best part of a decade) maintains rates close to zero in a to date unsuccessful campaign to *provoke* inflation.
The US Fed policy at present is a kind of long march to achieve this ‘normalisation’ of rates precisely in order to restore some strength to monetary policy. But the weaknesses in the global economy following the bursting of the internet inspired assett bubble have made this an extremely difficult thing to do.
The ECB finds itself in a somewhat similar situation, with one important added difficulty: the inflation rate across the euroland member states in not uniform, and consequently what is known as the real interest rate (which is the difference between the central bank interest rate and the inflation rate) varies across the zone.
Germany and Italy would currently tend to favour a reduction since their economies are stagnating and inflation is relatively low, which means they have a positive real rate where a negative real rate might be indicated. Spain is at the other end of the scale, with an inflation rate of around 3.5% they have a minus 1.5% real rate and this is driving a mini boom based on a huge expansion in consumer indebtedness and a long property boom.
The clearest case of where the application of a single uniform rate would be extraordinarily unsound is that of the UK where the BoE currently has rates up at 4.75% precisely to try and reign in some of the problems which currently beset Spain. (This, of course, is precisely the reason that the UK is not in the euro).
Originally I suspect it was hoped that this problem would reduce in importance as euroland economies converged. Currently there is little evidence of this happening and my own feeling is that the problem will grow worse as the ineffectiveness of monetary policy only serves to make the imbalances worse.
Finally, a brief comment on the ‘free rider’ problem. Essentially membership of the eurozone has lead to a significant reduction in interest rates in those member states with living standards below the EU average. Initially this was considered to be one of the advantages of the euro, but inititially there was also a fairly strong and rigourous growth and stability pact in place.
This pact has now been significantly loosened and it remains to be seen how (if at all) the new version of the pact will be applied. It is in this context that the ‘free rider’ issue comes to the fore. Conventional economic theory has it that any government which allows itself to systematically run up debt will later have to resolve this problem by fuelling inflation to burn down the value of the debt (whilst simultaneously allowing the currency to fall), either it does this or it will face a growing finance problem as debt servicing (fuelled by higher interest rates) eats into current spending.
Now in the case of a currency union some of this no longer applies: weaker countries can continue to accrue debt almost without any financial constraint. This is what has been happening in some cases. The downside on this comes when there is some weakening in the guarantees and the financial markets start to sense this. Hence the jitters about the constitution votes.
Obviously the ‘free rider’ problem is a complex one. Two good background papers spell out in more detail some of the issues. The first from Marty Feldstein is a completely non-technical review from a long standing critic of the very idea of monetary union. The other from Barry Eichengreen is rather more technical (though it is possible simply to jump past the denser sections) and comes from an economist who is in general pro-euro.