The Untenable Euro-Area

The Euro-Area is in a very tight spot. The ECB has a real policy quandary. It seems that more economists are coming to the inevitable conclusion that the Zone countries go together like oil and water. Only if you continue to 'agitate' them will they remain mixed. Leave them to their own accords they will go in very different directions and with that sort of meandering in train what can a single central bank possibly do?

It's not just that some have debt problems and others do not. It's not that some are having problems with growth. A good deal of it is that competiveness differences have become so ingrained they will be hard if not impossible to equalize. But another aspect of these problems is that groups of countries within the Zone cluster together are running contrary business cycles within the zone itself. And that makes setting policy a very difficult job for the ECB.

The chart above tells the story rather well and remember that it looks better than it should because the German unemployment rate, which gets a large weight in EMU, is making the overall EMU rate look lower and more similar to the German rate itself.

Since 2009 the ECB has been confronted with an EMU that has key blocs of members going in opposite directions. For which group does it make monetary policy? How does it choose? Does it draw straws?

The table below identifies the various groups quite readily. Germany, Austria, Finland and Belgium (probably) fit into one group, Group I. We pack the rest of EMU into the next group. We are looking only at the first 12 members who have a long common history in the common Currency-Zone together. (we do not consider the UK or Denmark). If Greece's data were up to date it would be a charter member of Group II. For the moment Luxembourg and Ireland are not quite full members of either group. Luxembourg's historic relationships are more likely to put it in group I and Ireland which has found eco-religion after its own personal financial crisis would be more likely a Group II member despite its recent performance. But let's not be derailed by such issues. Our partitions of the Zone need not be complete to make the point that he Zone has two completely different cohorts with different characteristics and different needs. And that is the point.

After all the wear and tear in the Zone, the Netherlands have been ripped from the euro-core and now stand outside it with at least one foot outside the core, if not two Recently Citibank 'delisted' the Dutch as members of the Euro-Area core due to debt problems. Things in the Zone are changing. But after about 12 years of a common currency the cracks are showing. Simple spackle will not fill them up. These cracks are structural in nature.

The clear point is that the EMU has become unmanageable. It has no common fiscal policy and a single monetary policy cannot be applied in a region with such divergent monetary needs.

And the policy requirements of the members are divergent as well. As of February five of the original 11 EMU nations (plus Greece, a total of 12) have Yr/Yr core inflation below the ECB threshold of 1.9%.

Those countries with still-low core inflation were Ireland, Greece, Germany France and Spain. Ireland's Feb data are not in but it is an easy guess that its Yr/Yr rate is below 2%. Germany's rate has risen near the threshold of 2%, at 1.9% up from 1.6% in January. Greece and Spain are the uncomfortable members of club only there because of the impact of extreme austerity on inflation.

Among Group I members inflation's Yr/yr pace dropped in Jan from Feb but is still excessive. The same is true of Austria. Belgium's rate is still being pressured up. The rest of the Group II members have inflation stubborn over 2% but largely off peak

Year over year core inflation has accelerated in 10 of 12 states; still, inflation is at its 12-month peak rate only in Germany.

The core speaks more to inflation's trend and with energy prices still high the headline numbers are grimmer. Only three EMU members of these twelve have headline inflation below 2% (Greece, Ireland and Spain). Six of 12 are seeing inflation accelerate Yr/Yr. No country has headline inflation on a New Yr/Yr high but Germany has seen its inflation rate peak at 2.9% in April fall to 2.3% in January and now edge back up to 2.5%. Germany is worried about a resurgence with high energy prices in play and inflation is already 0.5% points too high in Germany and 0.7% points too high for the Zone as a whole.

So the inflation picture is not good but neither is it accelerating, meanwhile core inflation is largely corralled and several member states are in clear recession, some of them severe.

Germany wants the ECB to shift gears to battle inflation. Others would find such a policy shift very hard to sell at home.

What we see here is a vast difference in preferences and needs. The problem with EMU is that you can pool its data into aggregated EMU-goo and obtain 'Zone-wide' signals on inflation or unemployment but, since member countries retain their national and fiscal identity the 'policy demands' are not really about the aggregated data. In this case Germany has strong anti-inflation desires; it wants the ECB to tighten policy as its core inflation rate is about to tip over to 2% with its overall pace at 2.5% ad unemployment dropping. If this were Germany alone and the Bundesbank were making policy we would expect this move, but, it's not. What of the rest of the Zone and its 'needs?' Germany's policy demands do not swerve one bit for their needs. And Germany is powerful and is powerfully represented on the staff of the ECB. Germany also is pressing each notion on its austerity plan and not giving them any respite despite the depth of their downturns. Meanwhile Germany is growing, its unemployment rate is falling and it is in need of a rate hike, unlike most of the rest of Europe. On balance Germany is an unrelenting task master. And while that may work in Germany I don't see the zone standing for it...much longer.