Thursday, 6 January 2011

Why the Eurozone is not an optimal currency area

What should the ECB do? Should it increase interest rates or leave them where they are?

The property market in Vienna strongly suggests that it is time for a rate increase. Home prices in the Austrian capital jumped 10 percent this year. Property price inflation is outstripping income growth; a sure sign of a bubble. Viennese property speculators need a slap in the face to bring them back to reality. Only a hefty rate hike can do that.

Dublin, on the other hand, is a housing market Chernobyl. Prices in the Irish capital are down 22 percent this year and almost 50 percent since the property bubble peak.. Here the situation is quite different. Everyone in Ireland apart from the parish priest is on a Euro-tracker mortgage. Somewhat surprisingly, Irish mortgage holders have continued to service their debts. The mortgage default rates is comparatively low. A rate hike would probably push many homeowners over the edge. This could generate a further round of banking losses.

More generally, inflation rates across Europe are picking up. The post-crisis surge of liquidity is feeding through into the real economy. Unfortunately, the Eurozone is travelling down two quite separate tracks, as the housing market of Dublin and Vienna amply demonstrate.

Rock? Hard place?


Anonymous said...

The decline in dublin is, well, unbelievable. Wow!

dearieme said...

Of course the Eurozone is not an optimal currency area; nor is the USA, nor the UK, nor would Germany be. An optimal currency area is an ideal - no real country or group of countries can be one. The question is: how far from being an optimal currency area is the Eurozone? And the answer is: much further than the USA, or UK, or.....

Ed said...

Trying to obssessively manage interest rates is what makes the natural boom and bust cycles worse. What is needed is a free market in money and interest rates which would naturally correct overshooting asset prices.