by Don Alexander, MBA
Associate, RSD Solutions Inc.
European politicians, in their attempt to create the euro, did so with the view that one size fits all. In this case, they overlooked basic economic fundamentals such as competitiveness, labour productivity and assumed a uniform monetary policy should be the same for all countries. They did not think to establish guidelines to monitor potential risks. This question is now being asked.
Is Europe an optimal currency area? Is the euro doomed? The author, Carlo Faverro, argues that economic differences within Europe, exposed by the current crisis, are reasons to doubt the sustainability of the single currency. One element is an optimal currency is an area-wide monetary policy associated with country-specific and very heterogeneous nominal and real long-term rates.
The author looks at the relationship between long-term rates from the pre-EMU period through the next 10-11 years after EMU formation in 1998 and the subprime financial and euro debt crises. The first period showed nominal yield differentials associated with inflation differentials. After the euro introduction, nominal and real long-term rates converged as inflation differentials disappeared. However, in the crisis period, long-term rates have diverged as long-term real rate spreads have gapped higher, despite minimal inflation differentials.
The ECB’s common monetary policy controls short-term policy rates, but does not control investment and consumption -- key components of growth that depend on real bond yields. High real long-term rates negatively impact consumption and investment, especially in peripheral countries where growth is needed to help fiscal stabilization. The common currency has prevented exchange rate movements that normally offset emerging growth differentials. The peripheral countries are experiencing higher labour costs, loss of competitiveness and surging deficits: factors that could dampen growth prospects. The inability to reduce fiscal deficits may not be enough to restore real long-term yield convergence. The doubtful attempt to sustain a common monetary policy with differential economic impacts casts doubt on the sustainability of the euro as a common currency area. However, it might be reduced to a smaller area.
Do you know your potential exposures and risks?
For more on the Euro’s current issues, click on the link: http://tinyurl.com/42c23vj
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