The Case Against the Euro

Euro bills and coins
Euro bills and coins

There has been a lot of talk about whether Europe’s monetary union is endangered by the sovereign debt crisis on its periphery. But instead of arguing about whether the monetary union can survive this crisis, perhaps we should be arguing about whether it should survive.

In an economic policy letter published today by the Federal Reserve Bank of San Francisco, Fernanda Nechio presents a set of charts indicating that, according to one well-respected monetary policy rule of thumb, Europe’s central bankers have the wrong policy for the peripheral countries.

Nechio looks at the ECB move in the context of the so-called Taylor Rule, a widely used policy guideline named for economist John Taylor that looks at how far inflation and unemployment have departed from official targets. The rule says monetary policy makers should adopt a "tight" monetary policy when inflation is above its target or when the economy is above its full employment level, and a relatively easy monetary policy when inflation is lower than targets or unemployment higher.

According to Nechio’s calculations, the ECB actual target rate—including the recent hike—seems to be close to the Taylor Rule recommendation for the euro area as a whole and slightly below where the Taylor Rule would say they should be for the so-called "core" states." In other words, the ECB is adopting the policy the Taylor rule says is optimal for the core states.

The "peripheral" countries are considered to be Greece, Ireland, Portugal, and Spain. While Austria, Belgium, France, Finland, Germany, and the Netherlands are considered "core" states.

For the peripheral states, however, things are very different. The current target rates are far above where the Taylor Rule would recommend.

But things look very different when the Taylor Rule is applied separately to the euro area’s core and periphery. The policy target rate recommended by the Taylor Rule for the peripheral countries remains deeply negative—far from the situation in which a rate raise would be justified.

Fascinatingly, Nechio discovers that "the divergence between the ECB’s actual target rate and the rate recommended by the Taylor Rule for the peripheral countries is not new, but has reversed itself."

Before the 2008 crisis, the ECB target rate lay below the level predicted by the Taylor rule for the peripheral countries. In fact, from the inception of the euro to the 2008 financial crisis, the actual ECB policy rate was below the rate predicted by the Taylor Rule for the peripheral countries and more in line with Taylor Rule recommendations for the core euro-area countries. During the financial crisis in 2008, the peripheral countries fell into deep recession, which was followed by a debt crisis from which they have yet to recover. By contrast, recovery in the euro-area core has been more robust. These events reversed the historic pattern and positioned the ECB policy rate above the Taylor Rule recommendation for the peripheral countries.

What I find most interesting about this is that although there is a relatively persistent small gap between the Core Taylor Rule rate and the actual rate, the gap with the Periphery Taylor Rule rate is often quite large. The ECB’s actual rate is either much too high or much too low for the economic health of the periphery.

In other words, if you are a country in the peripherals, the ECB’s monetary policy has been consistently wrong.

As Nechio notes, "One size cannot fit all when economic conditions in two regions of a monetary union are so markedly different."


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