Since the launch of the euro in 1999, economists have debated whether a “one-size-fits-all” monetary policy can work for so many economies; Estonia’s entry from January will take eurozone membership to 17 countries. The answer given by Jean-Claude Trichet, European Central Bank, has always been: mais bien sûr! Eurozone growth and inflation divergences are no greater than between US state, he argues. But life is not as simple as that in the eurozone.
Barclays Capital has just published an extensive review of divergences in growth rates, inflation and labour markets (looking also at the persistence of divergences). It finds something to support both sides of the argument. Eurozone growth rates, for instance, have converged – although the process may have gone into reverse as a result of the credit and construction booms and busts in Spain and Ireland. Divergences in eurozone labour markets, however, are greater in the US.
What makes the study interesting is that Barclays Capital then goes on to calculate what would be the appropriate interest rates for the 11 largest eurozone countries – using the so-called “Taylor rule” by which interest rates are set according to the inflation rate and “output gap” (roughly, the amount of slack in the economy). The report finds a much greater variation than would be the case for the 11 biggest US states. The reasons lie in the greater variation in eurozone inflation rates and rigidities in the region’s labour markets.
Such divergences make the ECB’s task in setting interest rates “significantly more complicated than that facing the Federal Reserve System,” concludes Julian Callow, the report’s author. Eurozone central bankers “must pay especially close attention to individual country-level developments.”
That explains, first, why the ECB is constantly urging labour market reforms and, second, why it is currently putting a lot of stress on “macro-prudential supervision” - that is, preventing future credit booms and busts from undermining Europe’s economic convergence. Neither will be easy to achieve.
Mr Callow hints at how the ECB overcomes all the difficulties in practice. His analysis suggests that ECB interest rates have generally corresponded more to economic conditions in Germany – the eurozone’s biggest economy – than the eurozone as a whole.