Monetary policy in the eurozone

Here is a picture worth a thousand words.

Update: further to my post yesterday, here is another piece on the fate of the eurozone by someone who has had a PIGS eye view of the crisis.

33 replies on “Monetary policy in the eurozone”

The real economies are divergent. A 2 tier monetary policy is possible: vary local bank credit rates via a central interest levy. Thus in our boom/bubble years, there would have been say a 3% levy on private credit, paid into a Central Bank fund. This fund could then fund an interest rate reduction now. This is all perfectly legit under Basel2.

Mind you…if we were doing such…we’d need to be really clear on what benefits/reason for our being in EMU, given that oour real economy diverges from the core.

Wow. This blew my mind a little bit. I’m guessing that the arguments for the Taylor rule function are calculated at averages (e.g., average employment gap in periphery countries).

For analyzing the policy shortfall, might it not be interesting to see a “GDP weighted” Taylor rule in which each country’s variable is weighted by the (relative) size of its economy?

On his blog, John Taylor has been getting a bit grumpy about people constructing “Taylor Rules” that call for negative interest rates. But that picture does indeed convey the problem. With hindsight perhaps the only way to make the system work would have been for the periphery to run big budget surpluses in the good years.

The constant real interest rate should be linked to average levels of physical depreciation, not to some arbitrary employment objectives.

Simply put: money should lose value at the same rate as the things it should buy.

It follows that if depreciation is the same across a monetary zone, so too should be the interest rate.

Another proxy local monetary policy tool:

Currency devaluation by tax and rebate:

Levy all personal earnings by x% tax…rebate straight to employer. Massive competiveness boost. Ditto could be done for VAT, though I suspect it shouldn’t.

This video shows the relationship between the core and the peripherals. The core is holding the tongs

‘With hindsight perhaps the only way to make the system work would have been for the periphery to run big budget surpluses in the good years’

Do any of the economists know of a way to model the effect of these unsatisfactory interest rates on Irish GDP. i.e. Work out the level of surpluses necessary to offset the gap between actual and preferable interest rates during the boom, to see if they would be politically possible. Is that possible?


Many thanks for this link. The last two sentences are priceless:

“The sovereign debt crises in three smaller euro area countries underline the urgency of a far-reaching overhaul of the fiscal and macroeconomic surveillance institutions in Europe. Here the governments of the Member States are called on to create the institutions that are commensurate with full economic and monetary union.”

In simple terms this means: “Let’s devote most of our efforts to ensuring fiscal governance procedures are in place to minimise any possibility that the small peripherals might repeat the fiscal policies that contibuted to them getting into this mess. But let’s not do anything constructive to assist them to get out of this mess. Indeed, let them stew in their own juices – and let’s add some more bile – while we kick the can down the road at a leisurely pace. And let’s not get too worried about EZ-wide deficiencies in bank supervision and financial regulation. And by all means let’s avoid any possibility of revealing solevency threats to some core EZ banks.”

I know central bankers have to measure their words with care, but the ECB’s stance, as conveyed in this piece, is simply criminal.

Of course monetary policy primarily deals with interest rates, but also money supply. So higher interest rates are plainly not helping us. But the decision to deleverage €70bn from covered banks, not to mention the withdrawal of BOSI/Halifax and restrictive new credit availability is also not helpful to our economy struggling to get back on its feet.

We don’t just need lower interest rates to recover, we need money supply.

@ Paul Hunt

I would not agree. The likelihood is that the ECB will emerge from the negotiations over the next two weeks with its reputation i.e. its credibility, fully intact. No less a person than the new head of the Bundesbank – former senior adviser to Merkel – has underlined in an interview in Suddeutsche Zeitung today its importance, saying that it is at the limit of the political risks that it can take and politicians must now recognise their responsibility. Those that Munchau has aptly described as the “dogmatists” in Germany are, hopefully, about to get a bloody nose.

@Humble Student

Philip Lane has been working on fiscal rules (see this blog’s archives) so I wouldn’t be surprised if at some stage he attempts to model how such a rule would have worked in the Irish case. Alas, the McCreevy rule is what we got: if I have it, I spend it.

The graph actually shows that the ECB target rate is further below the ‘Taylor rule’ rate for the core than it is above zero – the minimum feasible rate. Is the Bank not splitting the difference between what is feasible and what is ideal?

Ah, these Americans, they don’t understand how the monetary policy transmission works in Europe and how we must preserve the credibility channel so that the whole of Europe–not just the Eurozone–will benefit from the monetary channel that has been preserved throughout the crisis–even if three member countries are temporarily bankrupt–and … blah, blah, blah, blah.


I take your point. The ECB has been pushed far beyond the normal remit of any central bank to compensate for the grevious political and institutional deficiencies every else in the EU and EZ. The Economist commented on this recently, but concluded that it was its pride rather than any possible damage to its capitalisation that was driving it now.

But it might be better for the ECB to stay shtum in public while beating the politcos furiously over the head behind the scenes. Conveying the impression that there’s nothing wrong with the peripherals that a good dose of ‘rectal fiscitude’ and a future fiscal strait-jacket wouldn’t cure isn’t helpful.

@desmond brennan

I disagree to a point – fiddling with levies would I think have been deeply controversial and targetted immediately by lobbyists who would have painted it as a tax never to be repaid. The Dail would have cowered in the face of the combined phalanx of bankers, realtors and builders, not to mention Mammy and Daddy telling their children that rent was dead money.

@jagdip singh – not only is the country losing money through deleveraging foreign lenders, the NPRF – the principal vehicle which could have made massive purchases of distressed or underresourced infrastructure assets such as the national water systems – is instead fuelling the outflow of money by being used to pay off bondholders, many of whom are outside the State.

@ Paul Hunt

On your point about the ECB staying shtum, I would be in complete agreement. In fact, I am surprised that that Trichet, and others in the ECB, have not fallen off their perches long ago. But Draghi, by all accounts, is a more dour and, hopefully, taciturn, individual. The point made by The Economist can be dismissed. These people are professionals. Nothing personal, just business.

On the “fiscal rectitude” point, the job, as you know, of central banks is to take away the punchbowl when the party is about to get going. There were, unfortunately, too many central banks in charge of the decision. But the ECB could not conceivably abandon the underlying principle.

The arguement for leaving sterling is the same one we will use to leave the euro. The economic reality of trying to cut back a 10% deficit with net debt at 120% GDP and locked into a hard currency is an impossible circle to square. Whatever happen the current policy of the troika (IMF/ECB/EU) on Ireland will lead to default or restructure. The current Irish administration ability to do anything other than follow the curve is pointed out by the fact that they had to ask the troika for “permission” to spend our pension funds instead of giving it to the German banks. In fact the irish government has more akin to a county council and I think Scotland now has more fiscal freedom than Ireland.

Megan Greene writes in the article:

One of the only visionary leaders in the EU, European Central Bank (ECB) chairman Jean-Claude Trichet, suggested in a speech on 2 June the creation of a common European finance ministry, which could intervene in ailing member state economic policies if necessary.

It is somewhat of a pity that Mr Trichet’ss visionary skills were not in evidence several years ago when they might have been more useful.
As I recall the ECB lauded the “Peformance of the Irish economy” even up to 2007.

Vision, I don’t think so. He just does not want to ECB to declare bankruptcy on his watch and it helps if a few large French banks are shielded from the scaffold at the same time.

The politically motivated determination to join the Euro without genuine economic convergence was irresponsible for precisely this reason. Irish politicians and some economists fell over themselves in a foolish scramble to distance the country at every opportunity from Britain.

Grumpy writes,

The politically motivated determination to join the Euro without genuine economic convergence was irresponsible for precisely this reason. Irish politicians and some economists fell over themselves in a foolish scramble to distance the country at every opportunity from Britain.

There might be something in that. I listened on radio today, that we in Ireland are going to have a gambling ‘centre of excellence’, that will dominate both Irish and UK markets. We can’t seem to help ourselves, in our persistence to do better at everything than our nearest neighbours. It surely is a key factor, in political decision making. BOH.

Megan is in fairly pessimistic mood … Cheer up Megan ‘sll funny money when it is defaulted on.

Wonder could she figure out who owns all those naked credit default swaps on Irish sovereign debt?

Trichet a visionary …? Naw … don’t think so. Took his eyes off the ball on all those dodgy capital flows …

Nicky ‘de Nuke’ Sarkozy to win re-election? Not a hope in Hades!

On Greece, [ Mario Draghi ]argued that the effect of a default was difficult to predict. “Who are the owners of credit-default swaps? Who has insured others against a default of the country?” he asked. “We could have a chain of contagion.”

So Mario doesn’t know. Jean-Claude doesn’t know. Wonder does Geithner know? Does Minister Noonan know? Does anybody out there know?

@Bond Eoin Bond

Who are these aliens who own all these naked credit default swaps? Who are the other aliens who will have to pay out? Who presently really owns Ireland? Is the Matrix really real? Are we in it?

@ DoD

the big sellers of CDS have probably been French and German banks for the most part, maybe some insurance companies. The big buyers have been hedge fund types, and the sharper parts of pension and insurance companies (contrary to popular chatter, the big bond holders have not typcially been the big CDS buyers), maybe some of the investment banks (though they’ve probably only got small outright positions, usually happier just making the flow). Lot of cross exposures there, don’t think there’s any really big individual loser on CDS triggering, unlike the big French exposures to a hard Greek restructure.

@ Bond. Eoin Bond

Ta for that. ‘Spose we need to await a ‘credit event’, of the volcanic_ECB_variety to really find out …


I think there has been a shift in the last year that has left US banks more heavily exposed. Can’t recall exactly where that was, but can recall it looked very credible.

@ Gavin Kostick

That blog is the real desi Indian deal. No definite articles.

“On a visit to US embassy in Mumbai” .

For those that suggest we follow the Icelandic example, well, the Icelandics don’t appear to think we should…

“People should be careful when it comes to drawing comparisons between Iceland on the one hand, and Greece, Portugal, Spain and Ireland on the other,” Finance Minister Steingrimur J. Sigfusson said in an interview in Reykjavik. “Iceland didn’t have the ability to save the banks. Trying to
rewrite the events that led to that eventuality as some sort of an export product is irresponsible.”

Iceland’s success in rebuilding its economy has been contrasted with the plight of euro member Ireland by economists including Nobel laureate Paul Krugman . Ireland, where most bank debt has been protected by a state guarantee since 2008, would have been better off using Iceland’s “bankrupting yourself to recovery” model, Krugman argued in a Nov. 24 New York Times column. Sigfusson says the advice could be dangerous, as European leaders try to agree on how investors share the cost of a second Greek rescue.

“Iceland should be humble and avoid advising other countries, especially when it comes to banking,” Sigfusson said. “What happened was an emergency situation which couldn’t be avoided.”

@ Eoin Bond

“Iceland didn’t have the ability to save the banks.”

Or, Ireland could have done with a bigger more fundmental blow-out on the banks, which was immediately obvious to everyone couldn’t be covered by the state.

@ Gavin

well, i dunno if it would have been a good thing if it had been worse than even the current losses! But i know what you mean. The point is that Iceland’s losses were so immediately and obviously big that it wasn’t even a choice on whether to save or not. If we hadn’t had the double whammy of a huge fiscal deficit, there still would have been an argument that the banking losses would have been bearable, though obviously painful.

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