Tight monetary policy in the EU

Tight monetary policy implies the Central Bank is trying to reduce the demand for money and limit the pace of economic expansion.

A tightening of monetary policy, could involve an increase in interest rates. – Higher interest rates increase the cost of borrowing and discourage investment and consumer spending. A tightening of monetary policy would be appropriate in a period of positive economic growth and rising inflation, above the inflation target.

Europe has neither. The Eurozone is facing an inflation rate of 0.4% and weak economic growth. However, monetary policy has been relatively tight.

Two graphs from Antonio Fatas help to illustrate this.

Real interest rates in US and EU

Source: Helicopter money A.Fatas

Real interest rates are the nominal interest rate – inflation rate.

Therefore, with base rates of 0.5% and inflation of 4%, the US would have a real interest rate of -3.5% – This negative interest rates, in theory, should be more encouraging for people to spend rather than save.

By contrast, the ECB have had higher real interest rates. This is partly because they increased nominal interest rates in 2013, but mainly because European inflation has been lower. The decline in Eurozone inflation to 0.4% has had the effect of increasing real interest rates.

UK real interest rates have been similar to the US. UK inflation has been higher than Eurozone inflation.

The increase in real interest rates in Europe are a serious cause for concern and a good illustration of one of the problems of deflation / low inflation.

With deflation, monetary policy can become unsuitable. Because you can’t cut base rates below zero, monetary policy can become tighter than market conditions allow.

Unfortunately the higher real interest rates and the tightening of monetary policy makes deflation more likely. It is a vicious circle.

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The need for a higher inflation target in the EU

The ECB inflation target is 2% – ‘it aims to maintain inflation rates below, but close to, 2% over the medium term. ‘

However, some economists argue that in the current situation, the ECB should have a higher inflation target of 3-4%.

The main reason for having a higher inflation rate would be to prioritise economic growth and help to reduce unemployment. Higher inflation would also help to contain and reduce government debt to GDP ratios – without excessive austerity.

Having a higher inflation rate will be resisted by many other economists and Central Bankers who believe that allowing higher inflation will lead to costs of uncertainty, lower investment and greater instability in the long-term. (see: costs of inflation) Also, some doubt whether higher inflation will actually help real economic growth.

EU inflation

EU inflation
EU inflation – St Louis Fed


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Is the Euro really a failure or is it a failure of policy?

Readers Questions: Could you not also argue not that the Euro is a failure but that it’s members/ECB are pursuing the wrong policy? Predictions of the death of the Euro seem to have been much exaggerated & surely Europe has the potential to be a world economic superpower to rival the US or China?

It is an interesting question, and to some extent inappropriate policy is a considerable factor in the ongoing European difficulties. However, there are still structural problems surrounding the Euro, which make economic stagnation more likely than in a floating exchange rate with independent monetary policy.

Poor Policy decisions in the Eurozone

1. Failure of ECB to intervene in bond market. One example of poor policy decisions is the failure of the ECB to stop rising bond yields earlier.


In 2011 and 2012, we saw a sharp spike in bond yields – because the ECB was, at the time, unwilling to act as lender of last resort and purchase any bonds or supply liquidity. This lack of intervention by a Central Bank meant that investors became nervous and bond yields rose to very high level. This rise in bond yields caused higher debt interest payments, but most damagingly were the motivation for deep austerity which caused a deeper recession in the affected Eurozone countries.

In 2012, the ECB changed its policy and became willing to intervene in the bond market. Bond yields fell – showing that decisive Central Bank intervention was needed. Therefore, despite higher government borrowing, bond yields are now much lower than in 2011 and 2012.

Before 2012, the ECB were partly blaming the constitution of the Eurozone where it seemed the Central Bank did not have a clear mandate to intervene and provide necessary liquidity in the bond market. However, the fact that bond yields have fallen in recent months suggests that the Euro can be more successful, if the Central Bank is given the authority and mandate to provide the necessary liquidity. Some Germany bankers are still unhappy at the ECB’s intervention – fearful it may encourage fiscal profligacy.

However, it is still more difficult in the Single Currency to intervene in bond markets. It is more complicated for a European wide Central Bank –  how much should it intervene? which countries should be supported ?e.t.c.

But, if the ECB had understood the necessity of intervening earlier, then we could have avoided that period of high interest rates, and partly avoided the lurch towards austerity and lower aggregate demand.

Exchange rate imbalances

A structural problem of the Eurozone is that without exchange rate fluctuations the south became uncompetitive. This led to large current account deficits in Portugal, Spain and Greece, and large current account surplus in Netherlands and Germany.

A better policy for the Eurozone would be for Germany to increase domestic demand – boost consumer spending and allow a moderately higher inflation. This would help the Eurozone to rebalance. It would lead to higher demand for southern exports and help deal with the trade imbalance in the Eurozone. It would help southern Europe restore competitiveness without just relying on deflationary policies.

Read moreIs the Euro really a failure or is it a failure of policy?

The great Europe debate

The rise of UKIP and Euro-scepticism in the UK inspired me to have another look at an old blog post – Benefits of the European Union.

I’ve spent the past four years criticising the economic policy of the EU, and more specifically the ECB. There are may good reasons to be dissappointed at the EU in recent years. But there is always a danger that people can lose any sense of perspective and see the EU only as an unmitigated bureaucratic disaster more reminiscent of the Soviet Union than a modern progressive block of countries, who have made substantial progress in the past couple of decades.

Researching the benefits of the European Union was a reminder to myself that despite all the problems of the EU, it is not quite as bad as some politicians would like to make out. If nothing else – there is nowhere else in the world I would rather live than within the EU, where there is the rule of law, respect for human rights and decent living standards.

The European Union can count many significant achievements of the past few decades.

  • Reduction of tariff and non-tariff barriers have led to increased trade and, despite problems of recent years, real prosperity for most of the population.
  • Promoting human rights and helping Europe to become continent of peace, rather than the near perpetual conflict which marred the first half of the Twentieth Century.
  • Harmonisation of rules and regulations has helped simplify trade and commerce, and enabled the free movement of people.

Yes, despite many impressive achievements, the EU do seem in danger of throwing away, or at least diminishing many of these hard won gains. I don’t see the problem as regulation on bendy bananas (which are usually false or exaggerated for effect by Daily Trash newspapers – who seem to latch onto anti-EU headline with a glee previously reserved for stories about Princess Diana). The real problem the EU faces is economic stagnation, mass unemployment and the alienation of a whole young generation.

What makes it doubly sad is that it didn’t have to be like this.

The biggest problem facing the EU is one of economic policy. The Single Currency was a bridge too far. The EU is simply  not an optimal currency area. The limitations of the Single Currency have been magnified by an attempt to deal with deflationary pressure through a combination of misplaced austerity and the dogma of suffering. What makes it worse is that countries who have suffered the most economically, have the feeling that their economic suffering has been imposed from the outside. And this just isn’t political rhetoric, that’s how a single monetary policy works. It’s the worst combination – economic stagnation caused by policies outside your country. With the toxic mix of unemployment and outside influence, it is hardly surprising that political extremism is on the rise.

EU unemployment

Source: ECB

The ECB may claim that in the coming months they may do more to combat the threat of deflation and low growth. Now the ECB is willing to effectively act as lender of resort, bond yields have fallen. The Euro may hold together. But, that doesn’t change the fact Europe has been failing for the past five years. The crisis was never about bond yields or EU debt. When bond yields on government debt rise to 12%, this doesn’t cause social alienation and a surge in political extremism. The social and political alienation is caused by mass unemployment and a sense of powerlessness.

Read moreThe great Europe debate

Euro revision notes

The Euro is the single European countries adopted by 18 out of 28 EU countries. The UK has not joined. The Euro involves: Common currency Common monetary policy – Eurozone interest rates set by the ECB in Brussels. Some fiscal rules, e.g. The Fiscal Compact (2012) limiting the amount of government borrowing (a balanced budget …

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France vs UK recovery

Useful post from Paul Krugman about a comparison between the French and UK recoveries. It stems from comments by a Conservative cabinet minister that ‘the French economy is being run into the sand.’ For those who can’t get past the NY Times paywall, I’ll post the two graphs here. UK and France since 2010 The …

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The depth of the European recession

Interesting graph which shows the depth of the EU recession compared to the great depression of the 1930s.

depth-euro-recessionSource stats | via Krugman

UK recession compared

This graph is from the start of 2013. Since, then the UK economy is showing signs of  picking up. But, it is still worth bearing in mind the length of the decline in GDP since the start of the recession.


Comparing different recessions

For the first 15 months, the decline in real GDP is comparable to the great depression of the 1930s. The great depression shows a bigger fall in GDP (-8.0%) from peak. But, during the 2008- recession, GDP stagnated the longest. 

Read moreThe depth of the European recession

Causes of Europe’s deflation problem

The European Union is facing the prospect of a serious bout of deflation (or at least, very low rates of inflation / disinflation) Deflation occurs when prices fall. But, very low rates of inflation are considered to raise problems associated with deflation.

In the Eurozone, the main index of inflation has fallen to 0.7% –  This is well below the ECB’s inflation target of 2%. Some regions and countries in the Euro, such as Greece are already experiencing deflation. In Greece prices fell 1.8% last year and the consumer price index reached the lowest level for 51 years (FT Link). Spain and Italy in particular, are nervous about the prospects of experiencing deflation in the future.

EU inflation

Inflation ECB – Inflation has since fallen to 0.7%

Causes of deflation in Europe


1. Unemployment. Unemployment in Europe has increased significantly since 2008, with the unemployment rate now reaching 12.2%. High rates of unemployment put downward pressure on wages, as the unemployed are more likely to accept lower wages.

2. Internal devaluation. A striking feature of the Euro is that countries which became uncompetitive in the boom period, can not devalue their currency to regain competitiveness. Therefore, the only option is for them to pursue internal devaluation. This means reducing prices and costs in the economy – primarily cutting wages. By reducing costs, they can make their exports more competitive and regain competitiveness. But, with weak external demand, it is proving a difficult and slow process for southern Europe to restore competitiveness compared to northern Europe.

3. Weak demand. The fundamental cause of deflation is weak demand within the Eurozone. Firstly, several Eurozone economies are pursuing fiscal austerity to try and reduce budget deficits. These spending cuts and tax increases are causing a significant drop in demand. Because of the relatively tight monetary policy, and strong Euro, demand is not coming from other sectors of the economy.

4. Fear of inflation in Germany. With inflation falling to 0.7% and unemployment of 12%, you would expect economists to be unanimous in the desire to overcome the threat of deflation and promote growth in Europe. But, in Germany the prevailing economic orthodoxy is still to worry about inflationary pressures and a possible loss of ‘confidence’ – should the ECB promote monetary loosening. Recently The ECB cut interest rates by 25 basis points, after the fall in inflation rate from 1.1 to 0.7%, but several Germany economists dissented arguing that it is wrong to cut interest rates given the possibility of ‘inflationary’ pressures in Germany. In the past, Angela Merkel has argued that Germany would need an interest rate increase if the German economy was taken in isolation. (FT link) The underlying fear of inflation means there is tension within the ECB and a reluctance to loosen monetary policy to target deflation.


Source: Eurostat: via Krugman

Read moreCauses of Europe’s deflation problem

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