Local asset price dynamics and monetary policy in the Eurozone

With hindsight the debate over whether Europe constitutes an optimal currency area overlooked the elephant in the room. Following Robert Mundell’s considerations, the expert debate in the 1990s focused on the question of whether Europe’s capital and labor markets were sufficiently integrated to cope with different real shocks. Financial stability considerations and the fear that a common European monetary policy might endogenously trigger asymmetric financial boom and bust cycles in periphery countries did not feature in the debate and was not foreseen by the US critics of the common European currency either. Yet such a financial cycle has morphed into the most profound challenge facing the Eurozone: an initial boom triggered by excessively low real rates inflated real price and wage levels in periphery countries, created a debt overhang problem, and engendered the massive transformation of private debt into public debt with joint liability among Eurozone countries. The resulting low growth, mass unemployment and potentially large fiscal transfers all undermine the political legitimacy of the common currency project. This short article summarizes new evidence on how low real rates in some Eurozone countries encouraged risk-taking on the part of households, created capital flows from low-risk money market funds into riskier equity funds, and inflated equity prices. We highlight that the segmentation of the European equity market is an important element of the asymmetric transmission of monetary policy: we show that monetary policy that is too expansionary for a Eurozone country generates local equity fund inflows, largely boosts local asset prices, and thus magnifies the local boom; whereas an integrated capital market would distribute the inflationary effect over the equity market of the entire currency union.