Standing in Southern European shoes

There is no such thing as a shoe that fits everyone. The same shoe will be so loose on one person that it will give them blisters, while someone else won’t be able to squeeze their feet into it. Divergent shoe sizes are the solution to this problem, obviously. One size fits all does not apply to monetary policy in the eurozone either, but the solution is more difficult.

We have one currency, so we can also have only one ECB interest rate. But where the interest rate is too high for one country, it is too low for another. And that leads to differences of opinion. In recent months we hear politicians from Spain, Portugal and Italy warning about the negative economic consequences of new interest rate hikes. Dutch politicians are less inclined to get involved in ECB policy. And if they did stir the pot in the past, it was more because they thought interest rates were too low. Very likely, the ECB will announce a new interest rate hike from 3.5 to 3.75 percent on Thursday, July 27.

The reactions from Southern Europe are understandable. Unemployment is a lot higher there than it is in the Netherlands. In Portugal and Spain it has even been rising again since last summer. And while the Netherlands and Germany had inflation well above the European average in June, Southern Europe did not. Spanish inflation has even dipped below 2 percent, the ECB’s target. This, of course, befits lower interest rates than ours, where the inflationary risk in particular sets the  scene.

The classic problem of a currency union is “asymmetric shocks”. These are shocks that affect the currency area differently everywhere. Ironically, the shocks of recent years - a pandemic, a war with an accompanying energy crisis - have actually affected supply and demand very similarly in different countries.

So where do these big inflation differences come from? Surely the main role here seems to be played by the government (including Minister Kaag and her predecessor Hoekstra). Whereas Italy, Spain and Portugal provided a net stimulus of about 1 percent of gross domestic product (GDP) through their budgets between 2019 and 2023, Germany and the Netherland did so by 4.5 and 3.5 percent, respectively. No argument about the intent of compensation measures - protecting unlucky people - but it was quite liberal and unfocused. That is throwing oil on the fire. In short, governments gave themselves an asymmetric shock here.

An additional problem is that interest rate sensitivity varies across economies. For example, the Netherlands has far more capital-backed pensions than other countries. Because those pensions benefit from higher interest rates, they may actually lead to a spending boost from pensioners, although the ECB’s intention is to cool the economy.

Another issue is that many homeowners in the Netherlands have their mortgage rates fixed for 10 or 20 years, whereas in Spain variable interest rates are common. So slowing down the Dutch economy with higher interest rates is more difficult. After all, you won’t hit most homeowners with it. Only the unlucky few whose interest rate expires or those starting out in the housing market. So even within the Netherlands, there is no one size fits all. The necessary economic adjustment - hand on the purse strings so that inflation falls - therefore has to come from a relatively small group of households and businesses. This does not spread the pain of higher interest rates. And because of our fixed mortgages, interest rates would actually have to go up even more for the desired cooling of the economy and inflation. But they don’t want that in Spain. Because of the variable mortgages, they feel a higher interest rate in their pockets much sooner.

Could the eurozone work better? One classic solution is migration to regions with a strong labor market - but that is difficult with our housing shortage. Another is fiscal transfers from boom areas to recession areas. That happens automatically within countries, but does not exist in this form within the eurozone. What would help is a less exuberant fiscal policy in the Netherlands and Germany. That would allow economies to come in line more, reducing not only inflation but also inflation differentials.

The alternative is that we in the North price ourselves out of the market through high inflation. In the years of low inflation, it was difficult for Southern European countries to gain competitiveness. High inflation in the North now makes that easier, though. Take Spain. In the last three and a half years, prices there have risen a total of 5 percent less than in the Netherlands. We should not be immediately alarmed by this, but if this development continues for too long, our growth will automatically come under pressure. That is ultimately the way inflation is brought to a halt. A bit like we saw happen earlier in Southern European countries. Monetarily speaking, the shoe will no longer be too loose in our case. Still, the other route towards it - controlled fiscal policy - is preferable. If the shoe fits...