The European Divide

The European Central Bank (ECB) as the main monetary authority connecting the central banks of the euro area has celebrated its 20-year anniversary on the 1st of June 2018. Its remit is quite wide, serving 340 million citizens who live in the 19 countries that have decided to share a single currency. This is not an easy task when one considers the divide that exists between the different European economies that make up the euro-block.

Monetary policy consists of the actions of a monetary authority (for example a central bank) that determines the size and rate of growth of the money supply, which in turn affects interest rates. Monetary policy is maintained through actions such as modifying the interest rate, buying or selling government bonds (quantitative easing), and changing the amount of money banks are required to keep in the vault (bank reserves). More on Monetary policy as explained on Investopedia.com.

For the last decade or so since the financial crisis of 2007-09, the ECB like many other monetary authorities has been on what is called an expansionary monetary policy stance. This means that it has been trying to stimulate economic growth by keeping interest rates low and buying government and certain corporate bonds which in turn would increase the money supply. If consumers and businesses can borrow at lower prices they will be able to afford to take on investment projects and spend more. This in turn would create economic growth and employment. There is a drawback though, that after a while there will be pressure on prices as the cost of living starts creeping up and inflation starts rising.

Inflation (the general increase in prices) in itself is not a bad thing but a kind of necessary evil. However, monetary authorities generally aim for a low and acceptable target level of inflation, for example “just below 2%”. This is all well and good that you have one currency and one ECB that controls the interest rate for all of the Euro area – after all the economies should be quite similar given their close geographical locations and similar cultures – Not Quite!

The North versus Peripheral Europe

There exists a clear divide between the northern countries such as Germany and France and the outer peripheral countries such as Greece and Italy. Since they are all subject to the same ECB the all have the same base interest rate of around 0% at the moment. However, economic growth and inflation are not the same across the different areas. Taking the countries just mentioned, we see that Year on Year the Gross Domestic Product (GDP) which is a measure of the total output that a country has generated over a year currently stand at 2.30% and 2.20% for Germany and France respectively. The same figures for Greece and Italy currently stand at 1.90% and 1.40% respectively. If we look at inflation rates, German and France are reporting 2.20% and 2% respectively, while Greece and Italy are registering 0% and 1.10% respectively. Looking at an important measure of economic stability, the jobless rate in Germany and France currently stand at 3.40% and 9.20% respectively. At the same time the jobless rate in Greece and Italy are currently 20.80% and 11.20% respectively.

What the above is suggesting is that Germany is in a position where interest rates might need to start going up and the expansionary monetary policy needs to be toned down and possibly reversed slightly. This could also be true for France, however with such a high unemployment rate it may not be desirable to increase interest rates in France as high or as fast as in Germany. With the cases of Greece and Italy, increasing rates is definitely not the ideal situation, especially when considering that these two countries have a debt to GDP rate of 178.60% and 131.80% respectively. This means that the two peripheral countries are heavily indebted and an increase in interest rates would mean the cost of servicing that debt would increase. We even have a divide between Germany and France here as in Germany the debt to GDP rate is as 64.10% while in France it is 97%.

The Bottom Line

In the end it is always difficult to have one monetary authority across many countries which are constantly in such different economic situations. This is also true for the United States for example where the 50 states are not in the same economic condition, yet all are subject to the same Federal Reserve as the main monetary authority in the USA. We will have to wait and see how the situation will play out in Europe. The pressure from tariffs imposed by the USA are expected to affect Germany particularly since it generates a considerable amount of its GDP from exports, notably car exports (think of Volkswagen, Mercedes and BMW for example). The effects of Brexit also still need to be assessed as both Europe and the UK will be affected as a result.

There is one thing that is certain in all this, we are living in interesting times!

(Source of figures: tradingeconomics.com)

Kyle Debono in the founder of FinancebyKD.com, a finance blog set up with the aim of providing financial education and investment ideas. Mr. Debono holds a Masters in Finance (University of London) and is a Business Consultant at Michael Grech Financial Investment Services Ltd. Mr. Debono also offers his services in a non-executive capacity with other investment services entities and is a visiting lecturer at the University of Malta, Banking and Finance Department. The views and opinions expressed in this post are solely those of Mr. Debono and do not necessarily reflect the views and opinions of any entity Mr. Debono is associated with.

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