There is a lot of finger pointing going on these days about a whole variety of issues but that is totally pointless. Eurozone countries have to consider policies followed over this past decade in order to highlight policy mistakes and not repeat them, not just to shift blame from one of them to another.
According to my view, one of the policies that have to be reviewed is uniform monetary policy in the Euro-zone. Let’s get going then.
The following graph shows inflation rates (Harmonized Index of Consumer Prices – HICP) for Ireland, Greece, Spain and Germany.
For the whole of the decade inflation and growth in peripheral Europe was significantly higher than in core Europe. Hence suitable monetary policy for these countries was different than the one for core Europe. But that was impossible since the EU was all about one-size-fits-all monetary policy. Of course a policy like that was not without consequences as the current multi-faceted crisis showed. The following graph shows the main refinancing operations rate of ECB along with the above pictured inflation rates.
There will be a lot of charts in this post, so I hope they won’t make you feel dizzy. Here it goes, for about 5 years in the middle of the 00s real rates for Ireland, Greece and Spain were negative, while real rates for Germany were positive for the whole length of the decade. Maybe that explains the high savings rate that mainstream media claim that Germany has, although I haven’t found any related stats, so allow me to take that claim with a pinch of salt.
For Greece the results were exactly, as I expected them. Real rates were deeply negative, something that when present it induces consumers/investors not to save but either to consume or to seek for superior returns elsewhere. The bursting of the 1999 bubble in the Athens Stock Exchange, had made the vast majority of Greek households wary to invest in stocks again so real estate was the obvious choice. I don’t have access to house prices before 1995 but popular wisdom in Greece was that house prices never fall and that it is a good hedge against inflation. In the years that preceded Eurozone membership, Greece faced high inflation rates something that could up to a certain degree explain the constant rising of house prices in the past.
|source: ECB, Bank of Greece, own calculations|
|source: ECB, Bank of Greece, own calculations|
The most important effect that such low rates have is that they make housing more affordable through the availability of cheap credit. Real mortgage rates in Greece were really low, helping the housing market to take off.
To derive the real rates, I subtracted HICP inflation from the nominal rates (average rates for deposits and mortgage rates for mortgages with a maturity greater than 5 years). Here is the evolution of house prices (annual % changes) in urban areas in Greece, not bad, is it? Well low rates can do that…
|source: Bank of Greece|
But it is not just Greece, the same went down, maybe with much greater force in Ireland and Spain. There, house prices just soared and soared. In Spain the ascend of prices was boosted further by the fact that many northern European pensioners acquired holiday homes in Spain, with the intent to spend half of the year or more there to avoid harsh winters at home.
Real rates on deposits were negative from 2003-2005 in Ireland too, a period which saw a pickup in the growth rate of house prices after a relative slowdown in the beginning of the 00s.
Unfortunately I wasn’t able to find deposit rates data for Spain, at least for a period that would make comparisons meaningful.
|source: Central Bank of Ireland, ECB, own calculations|
On the other hand house prices in Germany were flat for the length of the period pictured in the graph (1997-2009). Here is evidence of one business cycle that is not synchronized with those of peripheral countries.
But monetary policy is not the only one to blame for the housing bubbles in Ireland and Spain (Greece too if you want my view). We have to put human greed in the equation. I know that I’ve said that in other posts too but it is true. If bankers didn’t expand their loan books this aggressively housing wouldn’t seem affordable to people that really could not afford it and if developers were not greedy too, there wouldn’t be such a high inventory of unsold properties right now.
The million dollar question though is, what can be done about monetary policy in Europe ? I think it is clear that uniform monetary policy is not suitable, at least in its present form. Unless of course business cycles of Euro-zone member states get completely synchronized, something not quite likely in the foreseeable future.
Different rates for different countries under the same currency is an idea. I’m not sure though if that would work. We shouldn’t forget what happened with peripheral sovereign bonds. They were denominated in the same currency as core sovereign bonds, hence FX risk was absent. That induced huge inflows to peripheral debt in the search for higher yields and helped build the situation that we are facing today with the European crisis. In the same way, if depositors think of banks in countries with higher rates as exactly the same with bank in lower rates countries then these banks will experience an influx of deposits. That will give them abundant capital and one cannot be sure if it will be deployed prudently or recklessly and help build bubbles. Bankers’ track record is not pristine.
Another solution could be to divide Euro-zone countries into two or three groups that their business cycles are more or less synchronized and face the same challenges. But this would run the same risks as the solution discussed above.
Maybe just a better weighting of policy impacts on separate countries would be preferable and it would produce better results than the current policy mix.
Of course there are no easy solutions, if there were I’m sure that EU policymakers would have implemented them. It is important that Europe gets through this crisis. I think that the EU will not exit this crisis in the same form that it entered it. It will either have become more unified or it will split up in the case member states interests cannot be aligned.