ECB Credit To Periphery EU Governments Won't End Financial Fragmentation

Resolving the issue of broken monetary transmission (discussed here) in the eurozone will take more than buying periphery government bonds. David Powell from Bloomberg used the Taylor Rule to determine policy rates that would be appropriate for the various nations as well as the eurozone as a whole. The concept was first described by the San Francisco Fed:

FRBSF: The Taylor rule is a policy guideline that generates recommendations for a monetary authority’s interest rate response to the paths of inflation and economic activity (Taylor 1993). According to one version of this rule, policy interest rates should respond to deviations of inflation from its target and unemployment from its natural rate (Rudebusch 2010). A simple version of this rule is:

Target rate = 1 + 1.5 x Inflation – 1 x Unemployment gap.

The target rate recommended by the rule is a function of the inflation rate and the unemployment gap. That gap is defined as the difference between the measured unemployment rate and the natural rate, that is, the unemployment rate that would cause inflation neither to decelerate nor accelerate. The literature shows that this simple rule or close variations approximate fairly well the policy performance of several major central banks in recent years (see Taylor 1993 and Peersman and Smets 1999).

The current ECB policy rate turns out to be right on target (in agreement with the Taylor rule) for the eurozone as a whole, but the policy rates diverge wildly across the euro area countries.

Bloomberg: A Taylor Rule demonstrates the drastically different monetary policies required in those countries as a result of their domestic economic conditions. The model, based on coefficients estimated by the Federal Reserve Bank of San Francisco, signals the main policy rate should be minus 7.75 percent for Spain. It should be minus 3.75 percent for Portugal, minus 3.5 percent for Ireland and minus 10 percent for Greece. Germany is at the other end of the spectrum. It requires a main policy rate of 4.25 percent.

And as discussed here, this divergence made depositors question the sustainability of the euro due to potential re-denomination risks (in addition to bank solvency) and encouraged them to move funds out of Spain. Similar trends are taking place in other periphery nations.

Bloomberg: Those economic divergences appear to have led depositors to question the sustainability of the monetary union in the absence of large-scale fiscal transfers to cushion the weakness in certain countries. In Spain, the level of deposits from non-monetary and financial institutions, excluding government, declined by 74.2 billion euros in July, a record large drop, according to monthly data from the ECB. The year-over-year rate of growth stood at minus 10.9 percent.

ECB's asset purchases are unlikely to convince depositors to reverse this trend of capital flight. What's more, many eurozone periphery citizens will continue to move deposits out of the eurozone altogether. These euros will then be "trapped" as part of the foreign reserve accounts of the Swiss National Bank (discussed here) and Danmark's Nationalbank (discussed here).

Bloomberg: Draghi will probably have to convince market participants of the economic sustainability of the monetary union before the financial fragmentation of the region is ended. The large-scale extension of central bank credit to potentially insolvent countries is unlikely to accomplish that.