The Eurozone debt crisis poses an unprecedented challenge to policymakers in Europe. A very peculiar situation has emerged – a common, area-wide monetary policy is associated with country-specific, and very heterogeneous, nominal and real long-term yields.
Figure 1 illustrates this point by reporting, over the sample 1991-2011, the yield to maturity of 10-year German government bonds (panel 1), the spreads of 10-year yields of other Eurozone countries on German Bunds (panel 2), and the consumer price inflation differentials between Eurozone countries and Germany (panel 3).
Figure 1. Europe pre- and post-euro
The empirical evidence shows that, in a period of a downward trend for German long-term yields, there are three different phases of yield spreads and inflation differentials in Europe.
- In the pre-EMU period, sizeable nominal yield differentials are associated with comparable inflation differentials that resulted in relative exchange rate fluctuations.
- After only one year from the introduction of the EMU in 1998, the market for fixed-income government securities was taking the form of an almost perfectly integrated market. The spreads between high-yield member states (Portugal, Italy, Spain) moved from the high peak of 300 basis points in the pre-EMU to less than 30 basis points after the euro was introduced. Real yields also converged, as inflation differentials also quickly disappeared. The differentials among different national bonds remained low, although not negligible, for almost 10 years and in the first decade of EMU the same monetary policy was associated with very similar long-term yields in the Eurozone.
- With the burst of the subprime financial crisis and the euro debt crisis, the differentials between nominal yields have become very heterogeneous across different countries and very sizeable for those countries that feature an issue of sustainability of their government debt. During all this period inflation differentials have, however, remained negligible and high nominal spreads have generated high real spreads.
One monetary policy, different economic impacts
The ECB monetary policy controls directly nominal short-term rates, that are obviously common in the Eurozone, but investment and consumption decisions, and therefore growth, depend on the real yield of long-term bonds, which is now very heterogeneous across different EMU countries (Black 2010).
As long-term yields are affected by national fiscal fundamentals and the market sentiment that might determine contagious spillover of local fiscal diseases, the same monetary impulses reach the different national economies in very different ways.
High long-term yields negatively affect consumption and investment, and those countries who are in the highest need of growth to help fiscal stabilisation are those most penalised by the current situation. As a matter of fact, growth differentials have emerged between Germany and the rest of Europe that are particularly sizeable for the high-yield countries.
The existence of a common currency has prevented the emerging growth differentials from being compensated by exchange-rate movements and therefore countries with more severe fiscal sustainability problems are now experiencing higher unit labour costs and loss in competitiveness that makes the prospects for stabilisation of their public deficits and debt even bleaker.
Conclusion: Learning to live with differentials
Long-term yield differentials are here to stay for some time, as they are very persistent by their nature and there is clearly a lot of uncertainty on the timing and the nature of the solution to the Eurozone crisis. It is very urgent that fiscal authorities of state members take bold action to restore convergence of long-term yields in Europe.
The optimality and the sustainability of a common monetary policy with different impact on the economies of member states fostering further divergence is, at least, highly questionable.
Black, Stanley W (2010), “Fixing the flaws in the Eurozone”, VoxEU.org, 23 November.