Is Europe an optimal currency area?
Is the euro doomed? This column argues that economic differences within Europe, clearly exposed by the current crisis, are reasons to doubt the sustainability of the single currency.
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The Eurozone debt crisis poses an unprecedented challenge to policymakers in Europe. A very peculiar situation has emerged – a common, area-wide monetary policy is associated with country-specific, and very heterogeneous, nominal and real long-term yields.
Figure 1 illustrates this point by reporting, over the sample 1991-2011, the yield to maturity of 10-year German government bonds (panel 1), the spreads of 10-year yields of other Eurozone countries on German Bunds (panel 2), and the consumer price inflation differentials between Eurozone countries and Germany (panel 3).
Figure 1. Europe pre- and post-euro
The empirical evidence shows that, in a period of a downward trend for German long-term yields, there are three different phases of yield spreads and inflation differentials in Europe.
The ECB monetary policy controls directly nominal short-term rates, that are obviously common in the Eurozone, but investment and consumption decisions, and therefore growth, depend on the real yield of long-term bonds, which is now very heterogeneous across different EMU countries (Black 2010).
As long-term yields are affected by national fiscal fundamentals and the market sentiment that might determine contagious spillover of local fiscal diseases, the same monetary impulses reach the different national economies in very different ways.
High long-term yields negatively affect consumption and investment, and those countries who are in the highest need of growth to help fiscal stabilisation are those most penalised by the current situation. As a matter of fact, growth differentials have emerged between Germany and the rest of Europe that are particularly sizeable for the high-yield countries.
The existence of a common currency has prevented the emerging growth differentials from being compensated by exchange-rate movements and therefore countries with more severe fiscal sustainability problems are now experiencing higher unit labour costs and loss in competitiveness that makes the prospects for stabilisation of their public deficits and debt even bleaker.Conclusion: Learning to live with differentials
Long-term yield differentials are here to stay for some time, as they are very persistent by their nature and there is clearly a lot of uncertainty on the timing and the nature of the solution to the Eurozone crisis. It is very urgent that fiscal authorities of state members take bold action to restore convergence of long-term yields in Europe.
The optimality and the sustainability of a common monetary policy with different impact on the economies of member states fostering further divergence is, at least, highly questionable.References
Black, Stanley W (2010), “Fixing the flaws in the Eurozone”, VoxEU.org, 23 November.