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An unstable monetary union leads to inflation

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An unstable monetary union leads to inflation

The divergences in the euro area are growing. This leads to inflation.

The ECB’s future monetary policy course remains uncertain. The ECB has defied inflation by significantly raising interest rates. However, despite continued high inflation, it is already considering a break in interest rates and is only hesitantly reducing government bonds in its balance sheet. Is this a sign that the euro is unstable?

The European Monetary Union has never been an optimal currency area because from the beginning the economic cycles in individual euro countries ran differently and crises were of varying severity. The ECB can only set a key interest rate and has therefore inevitably set the interest rate too high for some countries and too low for others. For example, interest rates were too low for Spain before the euro crisis and for Germany after the euro crisis, which at other times encouraged exaggerations in the real estate markets (see Figure 1).

Like Germany, the euro area does not have a common financial and social policy that could automatically equalize different economic cycles (De Grauwe 2008). For example, if Hesse is in crisis and Bavaria is booming, then the Hessians pay less taxes to Berlin, but the Bavarians pay more. Hesse makes more use of unemployment insurance and the social system, but Bavaria makes less use of it. A few years later it’s the other way around. There is also no extensive state financial equalization, which levels out the different economic strengths of the states in Germany, in this form in the Euroland.

If the workforce were mobile, then – as Robert Mundel (1961) has shown – workers would quickly migrate from a crisis country to booming regions. If wages were flexible, they could fall in crisis countries. Competitiveness would increase again and the crisis would be overcome through more exports. But flexible labor markets in the Eurozone only exist in the Baltics. In crises, calls for financial aid from Brussels become louder.

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The hope that with the euro the member states would become more integrated because they would then trade more with each other has not been fulfilled. However, the wealth gap has grown with the number of euro countries. Per capita incomes range from over 120,000 euros in Luxembourg to almost 20,000 euros in Slovakia (2022). The growth rates are very different. While Estonia shrank by 1.3% in 2022, Ireland grew by 12%. National debt as a share of gross domestic product is almost 20% in Estonia and almost 180% in Greece.

The perspectives on economic policy are also different. The southern euro countries want central bank-financed government spending. Many Germans depend on the stable German mark. Finance Minister Christian Lindner advocates sound public finances in Europe, which the southern countries dislike. While the ECB was anchored in the European treaties based on the model of the Deutsche Bundesbank, the southern European countries pushed ahead with the restructuring based on the model of the Banca d’Italia.

Inflation in the euro area was therefore (provisionally) 4.3% in September, well above the ECB’s two percent target. And the differences have grown significantly. Inflation rates ranged from -0.3% in the Netherlands to 8.9% in Slovakia (see Figure 2). It’s not just the harmonized consumer price indices that differ in the individual euro countries. National governments have recently also subsidized food and energy to varying degrees.

The euro was once intended to eliminate exchange rate-related fluctuations in competitiveness in the European internal market. But now the real exchange rates are drifting further and further apart, as Fig. 3 shows. Strong real appreciations of the currencies of the southern euro countries, Ireland and the Baltic countries led to large current account deficits from 2003 to 2007 and ultimately to the euro crisis. Since then, these countries have improved their competitiveness, but the problem persists in other countries.

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Meanwhile, the very different inflation rates result in different dynamics in wage negotiations. Where inflation is higher, unions tend to demand higher wages, which is likely to further perpetuate the divergence in real exchange rates.

We have developed a divergence indicator for the euro area. This measures the standard deviation of inflation rates, per capita income, real growth rates and debt levels as a share of the gross domestic product of the individual euro countries. We also measure the standard deviation of the fluctuations in the real price level-based exchange rates and the trade deficits with Germany. We scaled the standard deviations of the individual indicators and calculated an average for each year. The indicator created in this way (see Fig. 4) is clearly pointing upwards, which indicates growing heterogeneity and thus growing tensions in the euro area.

How will the European Central Bank react to possible new tensions? The indicator is trending similarly to the volume of the ECB balance sheet. This could be due to the fact that the ECB has stabilized the Eurozone in the past with extensive bond purchases and aid loans, as ECB President Mario Draghi said in July 2012 with his statement “Whatever it takes“also announced.

Since the euro crisis, the ECB has not only reduced interest rates for a long time in order to stabilize the euro area and has bought government bonds on a large scale. The ECB has also targeted particularly unstable euro countries such as Greece, Italy and Spain with its unconventional monetary policy. It has provided direct emergency liquidity support to Greece and Portugal, among others. It awarded the very low-interest, longer-term refinancing transactions disproportionately to banks in southern euro states such as Spain. The Target2 payment system has developed into a credit system for the southern crisis countries.

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The ECB is now tightening monetary policy, although the risks in highly indebted countries have not been eliminated. There are therefore already indications that a new crisis in the euro area could be the starting signal for further interest rate cuts and a further expansion of the ECB’s balance sheet. With the so-called transmission protection instrument, the ECB has already created the opportunity to preferentially purchase government bonds from highly indebted crisis countries. The pressure on the ECB would then be great to buy the government bonds of all euro countries again. This would further increase inflationary pressure in the euro area.

It would happen as the economist Wilhelm Röpke (1966) predicted. A monetary union in Europe is like a convoy of ships whose speed is always based on the slowest ship. However, due to the unfair distributional effects that a renewed increase in inflation within and between the euro countries is likely to have, political instability in the euro area is likely to continue to grow. That would be anything but conducive to the goal of a political union with a common financial and social policy.


De Grauwe, Paul 2018: Economics of Monetary Union, Oxford, Ch. 1, 2, 3 and 4.

Mundell, Robert 1961: A Theory of Optimal Currency Areas. American Economic Review 51, 4, 657–665.

ECB (2012): „Verbatim of the remarks made by Mario Draghi“, Global Investment Conference, 26 July 2012.

ECB (2022): „Monetary Policy Decisions“, Press Release, 21 July 2022.

Röpke, Wilhelm. 1966: „European Economic Integration and its Problems,“ Modern Age Quartely Review, Summer: 231–44.

University of Leipzig
University of Leipzig

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