ECONOMICS: Divergences between the core and periphery are greater than the architects of the euro ever dared consider

“Frankfurt’s monetary way is particularly unsuited to Irish conditions. Along with very high debt levels and ongoing and extreme fiscal contraction, the last thing this economy needs is monetary tightening

THE EUROPEAN Central Bank (ECB) has begun tightening monetary policy. As discussed in this column four weeks ago, the case for tightening on a strict inflationary basis is not at all strong. Across the euro area, underlying inflationary pressures are weak to non-existent: unemployment remains unusually high; there is still lots of spare manufacturing capacity; growth in money supply is at historically low rates; and expectations of future inflation are well-anchored. Other than the spike in the headline rate of inflation caused by soaring global commodity prices, price stability looks assured for the foreseeable future. The bank should have held fire.

Given the risks of choking off the zone’s recovery and sending the Continent back into crisis, the ECB’s pre-emptive move against possible future inflation appears difficult to comprehend.

The extreme hawkishness of the ECB’s stance is put into sharper relief when compared to the positions of other big developed world central banks – in the US, Japan and Britain. None has moved to raise rates from historic lows. And this despite a far stronger case for tightening, in Britain at least, where inflation has been considerably higher for longer, and is being driven by factors other than soaring commodity prices.

Frankfurt’s monetary way is particularly unsuited to Irish conditions. If underlying inflationary pressures are limited on a euro-zone-wide basis, they are very weak here. None of the other 16 economies faces less inflation risk.

Along with very high debt levels and ongoing and extreme fiscal contraction, the last thing this economy needs is monetary tightening. But that is what we have.

Last week, this column argued that the main cause of bubbles in so many developed economies was underpriced and oversupplied credit, channelled via an internationalised and risk-blind financial system; not excessively low, ECB-determined short-term interest rates.

But that is not to say that unduly high rates in the future, while the Irish economy is stuck in a rut, could not contribute to keeping it in that rut.

In the wider scheme of things, it was always understood that in a large monetary union, many component countries and regions would not have interest rates ideally suited to their economic conditions, as measured, for instance, by the Taylor rule (which uses real and potential output measures along with real and targeted inflation measures to arrive at an interest rate that is most likely to keep an economy from overheating or underheating).

In a very large continent-sized economy, such as the euro zone or the United States, interest rates will be almost certain not to be Taylor rule-compliant for all regions at all times.

This raises the question as to whether Ireland should have joined EMU in the first place (it does not raise a question about leaving now, as doing so could not be achieved without massive public and private sector default caused by euro-denominated external liabilities soaring when expressed in a devaluing new pound).

It is worth revisiting the context of the debate in the second half of the 1990s – the time when the choice had to be made on adopting the euro or staying out.

The de facto collapse of the precursor to EMU – the exchange rate mechanism – in 1992/1993 led to the Irish pound floating in a very wide band against other European currencies until the launch of the euro in 1999. It was the first time since independence that Ireland had had such a floating exchange rate and the consequences were anything but bad.

To describe the second half of the 1990s as a growth miracle hardly does justice to a period in which annual gross domestic product growth rates averaged almost 10 per cent. No already-developed economy has ever grown as fast. That time truly was different.

As it happens, in the late 1990s, the concern of most academic economists about participation in the euro centred on the non-participation of Britain, this economy’s most important trading partner. (Much of the theoretical benefit of creating currency unions is based on the trade-boosting removal of exchange rate uncertainty, and with only about one-third of total trade accounted for by the euro zone, the benefits were limited.)

The issue of losing control of the setting of interest rates was much less of an issue simply because small, open economies have limited scope to use interest rates to influence demand conditions directly. For small economies, interest rates are used as much, if not more so, to influence the exchange rate. If, for instance, Ireland had followed Denmark’s example – of staying out of the euro but pegging its currency rigidly to the euro – interest rates would have moved in lock-step with the ECB, as has happened in Denmark.

Given the range of variables, it is impossible to predict with great accuracy what might have happened in the event of Ireland staying out of the euro, but the notion that there is a clearly preferable alternative scenario to euro membership is just not the case. All currency regimes have their challenges. The euro certainly has, and never more than now.

A one-size-fits-all monetary policy was not without problems in the first decade of European monetary union. It is likely to be much more problematic in the second decade as divergences between the core and periphery are now greater than the architects of the project might dared to have considered.