Thursday, March 10, 2011

Monetary Policy and Regional Divergences

Gavyn Davies of the FT has a thoughtful piece up about the way that the Fed and ECB have generally tended, until recently, to act similarly. In particular, they have both tended to be in tightening or loosening mode at the same time:
Strange bedfellows – the Fed and the ECB

The behaviour of the world’s two main central banks, and the relationship between them, have profound effects on global financial markets. As a broad rule of thumb, the ECB (and the Bundesbank before it) have tended to act in a very similar manner to the Fed, except about 6-12 months later. In fact, that is one of the most well established rules in the analysis of monetary policy making.

...For three decades it has been fairly unusual for the ECB or the Bundesbank to strike out in an entirely different direction from the Fed. Yet that is what seems to have happened last week, when the ECB clearly threatened an imminent rise in interest rates, while leading figures at the Fed equally clearly reiterated their very accommodating stance on monetary policy.

Why has this divergence of opinion developed, and what will be the consequences? I will return to this subject in the near future.
There are a few reasons for the present divergence, I think. But a crucial one has to do with the fact that the Fed has a relatively coherent national economy to manage, while the ECB has authority over an area that, while similar in geographic reach and population to the US, encompasses much wider divergences in economic performance.

Here's a picture of the unemployment rates in the Euro-15 zone (which basically consists of the the original euro adopters), along with unemployment rates in the 5 largest euro economies.

Even when times were good, differences in unemployment rates among the major euro countries were 5 percentage points or more. And now, of course, the differences among the euro countries are far, far larger. And note that this chart doesn't even include the troubled peripheral countries such as Greece, Portugal, and Ireland.

Now look at the same chart for selected regions of the US. The Census divides the US into 9 divisions; to keep the chart a bit cleaner, this picture only shows the two best and two worst performing regions of the US, measured by average unemployment rates from 2001-2010.

Until the Great Recession, unemployment rates in the very best-performing regions of the US were less than 2 percentage points lower than in the very worst-performing regions. And even now the difference is less than 5 percentage points.

What does this mean for monetary policy? One thing that's going on now, I think, is that the ECB is conducting monetary policy exclusively based on the economic situation of the best-performing countries in the euro zone (which could possibly, by some stretch of the imagination, warrant an end to expansionary monetary policies). Meanwhile and somewhat inexplicably, the ECB is clearly ready to completely ignore the plight of the euro countries that are doing so badly right now. It's a classic illustration of why Europe's currency union has been so problematic for so many economists (at least on the US side of the Atlantic). It's also the reason why I wouldn't be surprised if we see more efforts (small-scale though they may be) in Europe's peripheral areas to try to escape the euro trap that they're in.

In the US, on the other hand, Ben Bernanke has a much easier job of it. Regional differences are not so great in the US, so he doesn't have to just make monetary policy based on how one part of the US is doing, regardless of the possibly substantial costs to other parts of the country.

I would never argue that Bernanke has an easy job to do... but at least his task seems a bit simpler compared to what central bankers are facing on the other side of the Atlantic.

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