After the end of the Bretton Woods system, mainly due to the oil crisis in the early 70’s, the world entered in a flexible exchange rate regime. However, Europe started a process which would end up in the European Monetary Union and the common currency, the euro.
The first mechanism created was “The Snake” (1971-1979) which never achieved the stability but was important for two factors (Werner Report): first, because Europe comes from an international monetary system (Bretton Woods) to a European one; secondly, because it is the start of a new German leadership.
The new system after The Snake was the most successful one in terms of longer monetary stability for the European Community, it was called European Monetary System (EMS, 1979-1992). The EMS was based also in a fix and adjustable exchange rate and had a virtual currency, in terms of a basket of national currencies, called ECU. This quasi-fixed exchange rate made Bundesbank to become de facto the European Central Bank (ECB), since the other currencies were pegged to the Mark. Indeed, the German currency was the most stable one since the Bundesbank was the first independent Central Bank (not dependent of the government).
The problem was that Bundesbank was not committed to work for the non-German economies; hence, the EMS implied less monetary sovereignty for the other countries. That was a powerful political reason for the other countries in the EMS (especially France) to push for the European Monetary Union (EMU, 1992-?). With a new European Central Bank the monetary policy would take care of all members.
Nonetheless, a lot of criticism has come up against the European Central Bank policy during this short lifetime of the common currency. They accuse ECB of having been more concerned about the German needs than the others’. This is especially a mainstream opinion in the so-called peripheral countries, especially the southern ones.
In order to test whether it is true or not, that is, if the ECB policy has been more beneficial for some countries than others due to non-justified factors (political bias), we need to know which would have been the best monetary policy for each country.
Therefore, I have used a simple version of the Taylor rule, a widely used guideline for setting interest rates. Indeed, the interest rate is not the only tool that Central Banks have to undertake their monetary policy but is the most observable, simple and important one.
Target rate = 1 + 1.5 * inflation – 1 * unemployment gap
First of all, in order to check the ECB propensity to response to countries’ necessities we computed the correlation between them: effective ECB interest rates and each target rate (that is, the interest rate that should have been applied to each country separately).
The ECB line represents the realized interest rate while the other lines represent the best fitting interest rate for each country obtained using the Taylor rule.
Regarding the data, it seems that the ECB responded to peripheral countries’ necessities, showing up high correlations between what was needed and what was applied.
On the other hand, core countries did not see their needs satisfied regarding the fluctuations in the interest rate. Moreover, although France has a weak correlation, Germany has it negative (very close to 0).
Thus, from this we could conclude that ECB policies were more beneficial to peripheral countries than to the core ones and, therefore, the ECB policies had nothing to do with the previous ones applied by the Bundesbank.
However, it would be a wrong conclusion since this analysis is misleading. Indeed, the best measure to test if the ECB policy satisfied the needs of certain countries is calculating how close was the ECB interest rate to each country’s Taylor rule target. In fact, fluctuations in the same way help to get closer to the needs but this analysis does not take into account the real gap between the necessity and the effective interest rate, which is what really matters. Hence, a further analysis is required.
In the following parts the gaps commented before are analysed :
Gap = ECB interest rate – Target rate
The gap measures how was the ECB interest rate relative to each country optimum. During the boom years peripheral countries enjoyed an interest rate much lower than what they needed while during the recession period it was too high for them. In contrast, the core countries fluctuated closer to the zero gap, meaning a more beneficial monetary policy for them. Italy is in both analysis in a middle point. It is important to point out that Germany experienced an increase in the gap during the last years
To resume this graph in just one figure I computed the absolute gap means:
Here we can see how Ireland and Spain were in average less benefited by the ECB policies while the other not. Nevertheless, to test if there is a “political bias” in the ECB policies, that is, if ECB helps more some countries than others not due economic reasons, we computed the relation between gaps and countries’ weight in the EMU. This way, since ECB should care about EMU economy as a whole if its policies are closer (lower gap) to a certain country necessities but such country has a high weight in the EMU we couldn’t consider this a “political bias” but a normal consequence of following a general Taylor rule for the whole Eurozone (EZ).
Thus, I considered a good proxy of weight the share of the Eurozone GDP.
The following graph and table shows this relation.
The coefficient is negative and significant at 5%, meaning that as we said, the more weight a country has in the EZ the more will affect to ECB decisions (in an economic view, not political). Moreover, the R squared is 0.8021, also meaning that the variations in the gaps are mainly affected by the weight in the EZ. Nonetheless, there is still room for “political bias” since there is almost a 20% of the variation not explained by the weight in the EZ.
Although the number of observations could seem to weaken our analysis, these countries represent the 78,1% of EZ GDP.
Finally, notice that the conventional wisdom that ECB has favoured Germany turns out to be false. In fact, even having a higher weight than France, Germany has benefitted less (higher gap). As it can be seen in the graph, those countries above the line have benefitted less than those under the line taking into account their weight. Hence, France might be the main winner from the EMU and also Italy regarding the fit of the interest rate.
To sum up, these results contradicts the idea of Germany being the most benefitted by the EMU.
Weighting each country is crucial to not reach misleading conclusions. Moreover, it also has to be pointed out that all this conflict of interests is due to the divergence and asymmetries. We would not be speaking about this issue if such differences didn’t exist.
Finally, although there are missing variables and countries who could slightly change our results, this work gives useful insights in a hot debate.
Acknowledgements: Albert Medina and Carles Lorente for our previous work together and Gerard Valldeperes for the review and interesting comments.