One size fits none
A big problem with the euro zone’s one-size-fits-all monetary policy is that it risks fitting nobody. That, indeed, was a key cause of the crisis. Early in the century, countries such as Spain and Ireland were booming, while Germany was in the doldrums. Setting interest rates at a level that worked well for the euro zone on average had the effect of inflating the Spanish and Irish property bubbles while pushing up wages so their economies became uncompetitive. When the bubbles burst, the damage was devastating.
It would be hard to argue that any part of the euro zone is currently booming. Even Germany will eke out GDP growth of only 0.3 percent this year, according to the International Monetary Fund. But it may not be long before the problems of a one-size-fits-all monetary policy are back to haunt the zone. Even though the German economy isn’t growing strongly, it is still outperforming the average. What’s more, labour is in short supply in Germany and house prices are rising at a moderate clip – a big contrast to the average, let alone recession-inflicted countries such as Italy.
The European Central Bank’s policy of keeping interest rates at the current 0.5 percent level or lower for an “extended period” is right for the euro zone on average. The weaker countries would benefit from even looser monetary policy. Germany, though, may already need something tighter. If the “extended period” of low interest rates goes on for years, it could experience a boom.
Many observers view one-size-fits-all interest rates as one of the zone’s design defects, about which nothing can be done. Others advocate policies – such as full fiscal union – which are not going to be adopted and wouldn’t really hit the spot even if they were. But the outlook isn’t quite so pessimistic. There are two policies that could mitigate considerably the damage of the single monetary policy – and they don’t even require any treaty changes.
The first is for euro zone countries to pursue vigorous “macroprudential” policies. Since Lehman Brothers went bust five years ago, it has become fashionable to call for bank regulators to have the tools to prevent future bubbles. The main idea is that they should be able to stop credit and asset prices growing too fast by directly intervening in the way banks lend. One way of doing this would be to jack up the minimum capital buffers banks have to hold if the economy is overheating; another would be to cut the size of mortgages they are allowed to make.
Such macroprudential policies are a good idea everywhere. But they are particularly important for the euro zone because individual countries can’t use interest rates or the exchange rate to stop overheating. Using macroprudential policy wouldn’t just restrain future booms; it would mean that a country’s banking system would be better placed to weather the subsequent bust.
The European Union is gradually putting the necessary building blocks in place. One element of this is for countries to give authorities the job of conducting macroprudential policy. Ten of the 28 EU members including Germany had done this by July, while the rest were working on legislation. Meanwhile, an EU law which sets out broadly how macroprudential tools should be used comes into effect next year.
Within the euro zone, rather than the wider EU, both the ECB and national authorities will have a say over using this anti-bubble toolkit. This is because, from next year, the ECB will add bank supervision to its duty of running monetary policy. The basic principle is that national authorities will be expected to take action but, if the ECB believes they are not doing enough, it can use the tools too.
It has to be said, though, that both macroprudential policy and the way it would be organised within the euro zone are in their infancy. When it was used by Spain during its housing bubble, it wasn’t very effective. Some observers think the whole policy is overrated; others that it just wasn’t pursued vigorously enough. The best guess is that macroprudential policy would help if it was actively implemented but that it would be wrong to expect it to do the whole job of stopping an economy from overheating. This is why euro zone countries should adopt another approach as well: “counter-cyclical” fiscal policies.
During the crisis, many countries have been forced to adopt austerity. This has been “pro-cyclical” – exacerbating their recessions. In some cases, such as Greece, that was unavoidable because their finances were in such a mess to start off with.
But, in future, countries should take exactly the opposite approach: running up fiscal surpluses in the good times and then allowing their budgets to go into deficit in the bad times. This is classic Keynesianism, except that most Keynesians forget the essential part about building up surpluses in booms. Such an approach would not just restrain the booms; it would mean that countries would have the financial wherewithal to run an expansionary fiscal policy during the busts rather than be forced into austerity.
Counter-cyclical fiscal policy is a good idea for all countries. But, as with macroprudential policy, it is particularly appropriate for the euro zone. It needs these tools to mitigate the defects of its one-size-fits-all monetary policy. Before too long, some countries will need the courage to use them.