The underlying issue in Europe is not sovereign debt or really debt of any kind. It’s the fact that the Eurozone is very far from being an optimal currency zone. As illustrated by the chart at right, the kind of ECB policy interest rates that would be recommended by a Taylor Rule for the different regions are quite different from one another. I’m not a huge fan of the backward-looking Taylor Rule as an approach to monetary policy, but it’s approximately right for these purposes. Europe is essentially living in the world that Ron Paul and other “Austrians” believe the United States to be living in. Efforts by the ECB to maintain decent growth in the “core” were creating a wildly inflationary dynamic in the “periphery,” pushing Spanish (etc.) wages up to an unsustainable level. Initially, this didn’t trigger mass unemployment. Instead people acted as if the wage levels were sustainable, and made wild investments in Spanish (etc.) property, creating employment in the construction sector. But the boom is followed by a bust, and now you have mass unemployment and all kinds of screwy wage levels and financial commitments that can only be properly addressed by the ECB if they’re willing to set off serious inflation in the core countries.
My view is that this is unworkable in some pretty profound ways unless Europe makes a lot of changes starting, but by no means ending, with a much more robust transfer union. Kantoos, who doesn’t like those ideas, thinks it’s instead possible for the ECB to implement regionally differentiated monetary policies. On the one hand they can “use regionally differentiated haircut policies to increase financing costs in overheating countries, while lowering it in countries that are economically lingering.” What’s more:
Besides increasing the cost of refinancing for banks in overheating countries, the ECB could use regulatory powers to mimic differentiated monetary policy. One idea is to increase the bank’s capital requirements for credit given to firms and households in overheating or bubbly economies. The advantage of this approach is that the location of the debtor matters, not of the bank that supplies the loans. The other approach, advanced by Markus, is to regulate collateral requirements for loans and mortgages to firms and households in such countries.
I’m not sure this couldn’t just be arbitraged away, so I’ll be interested to know what people who know more about actual financial market operations think about this. On a political level, I think the issue here is that it’s asymmetrical. This would have let the ECB implement monetary policy that was appropriate for Germany without touching off the unsustainable boom in Spain (etc.) by restricting lending, but after the crash, you can’t really force people to loan money to the countries in need. In terms of influencing forward-looking expectations, a lot of the credibility issues that I think are wildly overstated in the US context seem kind of severe here. So how much does this really help Spanish and Irish people? By the same token, if I were Angela Merkel, I would be jumping on this idea as quickly as possible since it’s clearly better for Germany than fiscal transfers or a breakup of Euroland. And the Euro has never been entirely rational. Italian civil servants looking to circumvent their political masters, Greeks eager for first world status, Irish desire to stick it to the U.K., Spaniards trying to draw a line under the Franco era, etc. have always been an important constituency. So maybe they’d go for this?