BSI ECONOMICS FLASH: March 7, 2014
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News: The implementation of a common monetary policy in the eurozone may have exacerbated the asymmetry of shocks linked to the financial and economic crisis between 2007 and 2010. A single key interest rate applied to all Eurozone countries may have contributed to the emergence of three macroeconomic imbalances in the so-called peripheral countries: excessive increases in credit, real estate prices, and the inflow of capital from abroad. These three factors contributed to an increase in the share of GDP held by commercial banks in the Eurozone from 197% to 268% between 2002 and 2009.
Jézabel Couppey-Soubeyran and Salim Dehmej propose a policy mix that could reduce economic imbalances while ensuring greater financial stability for the eurozone. Explanations.
An expanded Taylor rule: an insufficient solution to reduce the gap between the interest rate appropriate for each economy and the key interest rate applied to the eurozone as a whole
The expanded Taylor rule would take into account the output gap (potential output minus actual output), the gap between inflation and the target level, and real estate prices or credit trends. This extension would result in a higher key interest rate (see chart below) for all eurozone economies, but would be insufficient to mitigate macroeconomic imbalances in southern Europe: the gap between the appropriate interest rate capable of resolving imbalances and the single rate applied to the zone would still be too wide for peripheral countries (Italy, Spain, Ireland, Portugal, Greece).
ECB policy rate and Taylor rate plus credit, calculated for the eurozone as a whole, the core and the periphery
The solution: the implementation of macroprudential tools to move closer to the optimal interest rate for each economy in the eurozone
A combination of monetary policy and macroprudential policy would then constitute an effective policy mix, meeting the dual objectives of monetary stability and financial stability: » The accommodative (restrictive) effect of monetary policy for countries with inflation above (below) the union average can be offset by more restrictive (looser) macroprudential measures, such as increased (reduced) capital quality/quantity requirements, a strengthening (weakening) of countercyclical buffers, credit ratios. »
Jézabel Couppey-Soubeyran and Salim Dehmej propose three justifications for this mechanism:
– there would be no conflict of objectives for public decision-makers: monetary policy could focus solely on monetary stability, while macroprudential policy would ensure financial stability and could even prove complementary or substitutable by curbing inflation without necessarily requiring a sharp adjustment in the key interest rate.
– The macroeconomic environment could benefit from this type of policy mix, which would be all the more effective in a context of conventional monetary policy ineffectiveness.
– The countercyclical component of the policy mix would reducethe adverse effects of unconventional measures on financial stability, with a relaxation of prudential constraints to support activity.
This type of policy mix is already being used by some countries to compensate for the lack of autonomy in their monetary policy due to exchange rate regimes. Credit control ratios have been introduced in Hong Kong and South Korea, while reserve requirements have become widespread in Latin America.
Establishing a monetary/macroprudential policy mix for each country, or even for each sector of activity, could contribute significantly to financial and monetary stability, thereby reducing imbalances in the eurozone.
References:
– Jézabel Couppey Soubeyran, Salim Dehmej (2014), » Towards a new policy mix in the euro area: The combination of monetary policy and macroprudential policy in the service of economic stability in the euro area. » Policy Paper No. 4, Labex Réfi.
– Clément Bouillet (2014), » Financial stabilization: core countries and periphery , » BSI Economics.
– Thibaut Duprey (2014), » What is macroprudential policy? », BSI Economics.
– Simon Ganem, (2014), » Macroeconomic stabilization in the Eurozone (I), » BSI Economics.
– Victor Lequillerier (2013), » Financial (in)stability, macroprudential policy, and financial regulation: a vast undertaking, » BSI Economics.
