EUROPEAN THINK-TANK REVIEW – XXXVII. (November 2014)

Written by | Friday, November 21st, 2014
European Values

So Far Apart and yet so Close: Should the ECB Care about Inflation Differentials?
Zsolt Darvas a Guntram B. Wolff (Bruegel)

The euro area, much like other larger currency areas, contains regional inflation differences. These differences stem from the divergence of unemployment rates, price levels, economic cycle phases and other economic factors. The mandate of central banks, however, refers to the area-wide inflation rate. The European Central Bank (ECB) has clarified that it aims to maintain inflation below, but close to, 2 percent over the medium term for the euro area as a whole. However, other adjustment mechanisms such as labour mobility or financial and fiscal risk-sharing are less developed in the euro area, which makes the inflation differentials more problematic for this region. This situation raises significant questions for the European Central Bank and in particular for the conduct of monetary policy and macro-prudential policies.

Before the crisis, monetary policy was found to have roughly similar effects throughout the euro area. Currently however, there are a number of reasons to think that policy transmission has become less even. First, if the quality of the banking system’s balance sheets is low, a reduction or increase in interest rates might not be transmitted to firms and households. Second, nominal interest rates have reached the zero lower bound. As a consequence, ‘unconventional’ monetary policy measures such as targeted longer-term refinancing operations (TLTRO) purchases of asset backed securities (ABS) and bank covered bonds have been decided. However, it is important to note that the liquidity operations are not defined based on geographic criteria. As a result, the purchases will have different impacts on different countries.

A third reason lies in the still remaining financial fragmentation. If the monetary policy cannot be transferred equally to capital markets, the ECB should consider intervening. However, the ECB’s primary objective is to maintain price stability in the euro area as a whole and so it should consider regional differences only to the extent that they have an impact on its mandate. This is the case in times of crisis or financial fragmentation, and in such a situation the ECB should intervene to overcome an economic crisis or reduce financial differences.

Concerning macro-prudential policies, the ECB should consider using some of its new macro-prudential powers when inflation in a country becomes significantly higher than the average inflation rate. However, the ECB needs to be cautious and act only when there is an objective risk or an imbalance emerging. At the same time, the ECB might face significant political-economy problems as it would need to act against substantial national interests.
(The study can be downloaded here:http://www.bruegel.org/publications/publication-detail/publication/848-so-far-apart-and-yet-so-close-should-the-ecb-care-about-inflation-differentials/)

Trade Diplomacy in EU-Asia Relations
Maaike Okano-Heijmans (Netherlands Institute for International Relations – Clingendael)

The course of the EU trade diplomacy towards Asian states will again be subjected to change. In the past few years, the European Union has been taking inefficient, overly formalistic and sometimes even contradictory political steps – especially in the area of Southeast Asia. A change of strategy is therefore an obvious necessity.

The cumbersome strategy of the so-called ‘Common Approach’ formulated in 2009 was politically binding, and it included numerous political conditions which had to be met in order to launch trade negotiations. Concurrently, through such approach, the EU became more focused on bilateral agreements with individual states, and after partial failures (i.e. the failure to reach an FTA with ASEAN in 2007) it was withdrawn from multilateral agreements. The main objective behind these international activities was to gradually create contact with individual Asian states which would establish the foundation for larger future cooperation. To that end, it is the ambitious bipartite agreement between the EU and South Korea signed in 2011 that can be considered as a major achievement.

The economic integration of Southeast Asia in the past was not easy, be it due to the political discrepancies between individual actors or due to the Japanese-Chinese rivalry (which, however, also benefited ASEAN). In 2012, after certain disagreements, a compromise was reached: the Regional Comprehensive Economic Partnership as a suitable agreement on free trade turned out to be the common economic denominator for ASEAN, China and Japan. Among other important agreements are the Asia-Pacific Economic Cooperation (APEC) and the trilateral agreement between China, Japan and South Korea.

Although Europe can boast the best living conditions in the entire world and the lowest wealth inequality on Earth, the European leaders (in this case the EU leaders) find it hard to convert this economic power into political one. Similarly, though Asia is its biggest trading partner (28 percent of the whole international EU trade turnover), the EU has not been able to create a trade partnership with either of the aforementioned Asian organisations and instead it has focused on individual cases (South Korea; bilateral agreements with China and Japan being negotiated). It is obvious that without high-standard cooperation with Asian economic groupings, the EU can wield hardly any economic or political influence.
(The study can be downloaded here:http://www.clingendael.nl/sites/default/files/Trade%20Diplomacy%20in%20EU-Asia%20Relations%20-%20Clingendael%20Report%20%28Sept%202014%29.pdf)

Policy Recommendations for the New European Commission: Priorities for Stabilising EMU
Jan David Schneider, Fabian Zuleeg a Janis A. Emmanouilidis (European Policy Centre)

In 2010, Europe was hit by a profound economic crisis. In order to overcome it, the European Union had to create new safety mechanisms ex post. Among others it was the European Financial Stabilisation Mechanism, the Six-pack, the Fiscal Compact and the Banking Union. Now, when the crisis is over, it is necessary to continue building mechanisms ex ante, so that in the future Europe would be better prepared for potential crises and could possibly prevent more crises from occurring in the first place. The Banking Union should be deepened, the social dimension of the Economic and Monetary Union (EMU) should be strengthened and a fully-fledged fiscal union should be created.

In the new European Commission (EC), the emphasis on the economic and fiscal topics is underlined by the division of portfolios among more Commissioners, who are subjected to the relevant Vice-President of the European Commission. This represents a risk that the individual portfolios can variously overlap and thus create confusions. For instance, three different Commissioners are responsible for the EMU-related issues. The EC and the Council should also agree on what type of economy – saving or investing – should be promoted. Furthermore, the recommendations and coordination of the participants in the European Semester should be ameliorated as well as the fulfilment of the Stability and Growth Pact (SGP) rules.

Due to the fact that some of the euro zone members do not have sufficient budgets to recover from economic shocks, it is necessary to create such fiscal capacities which would be able to help these states in times of need, and which would also contain automatic stabilisers in cases of cyclical unemployment. Such capacities would also need an efficient supervision which would prevent its misuse.

Although the crisis in Europe seems to be receding and the GDP is slowly starting to grow, it is important that EU Member States execute structural reforms which would help them deal with budget deficits and strengthen their economic growth. Investments to education, health system and infrastructure should also be increased, while the internal market should be completed by reinforcing the areas such as services, digital economy, research and energy. It is, among other stakeholders, the European Investment Bank that should facilitate the support and stimulation of the euro zone economy.
(The study can be downloaded here:http://www.epc.eu/documents/uploads/pub_4858_policy_recommendations_for_the_new_european_commission.pdf)

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