European Macroeconomic Policy: A Market Monetarist Perspective
Market monetarists believe that the central bank can and should stabilize nominal GDP over a currency union. A central bank cannot target either inflation or NGDP in any of the component states, only the overall average. While market monetarists are skeptical of fiscal stimulus, let us assume for the purposes of this article that it is just as effective as monetary policy. If that were the case, total spending in a Eurozone member would be a function of monetary stimulus, which is exogenously determined by the ECB, and fiscal stimulus, determined by that country’s government.
The ECB utterly failed to maintain the average growth trend of NGDP in 2008. From the market monetarist perspective, substantial monetary easing over the next few years is warranted. In order to stabilize each country’s relative performance, Germany should tighted fiscal policy and Spain and Italy should loosen dramamtically. However, those countries facing the lowest aggregate demand are the ones who are most restricted due to extremely high levels of government debt:
In order to get the average NGDP to increase, the ECB needs to loosen monetary policy dramatically. To balance the inter-country spending imbalance, Germany needs austerity relative to Greece and Italy. If that is to happen while maintaining sane levels of debt to GDP ratios in the periphery, Germany must embark on the austerity program to end all austerity programs. If one expects Italy to lower its debt to GDP ratio by 10%, and the fiscal multiplier is 2, that implies a decline in GDP of 20%. For Germany to reduce its NGDP relative to Italy by 10%, it would have to reduce government spending by 15%. In other words, if you want both stable NGDP growth across Europe, and you believe that the fiscal stimulus multiplier is greater than 0, Germany must cut government spending by more than the most troubled member of the Eurozone.
If you don’t believe that the fiscal stimulus multiplier is positive, you don’t have to come to such a strange conclusion. But under that assumption, there isn’t much hope for the euro either, because that implies there is no way to balance out the idiosyncratic shocks hiting Europe right now.
As shown in the graph above, wage growth rates are profoundly unstable between European countries. Monetary policy was too tight in Germany from 2000-2009 and way too loose in Greece. In the last 3 years, that trend has reversed, causing devastation to the southern European economies. Personally, I think the relative differences between the European economies are too great to be balanced out using fiscal policy. If Europe ever wants macroeconomic stability, the euro needs to go.