ECB paper says regional macro-prudential tools would mitigate eurozone imbalances

Applying macro-prudential tools on a regional basis would help to address the imbalances between eurozone countries, according to a European Central Bank working paper published earlier this week.

In Macro-prudential policy instruments and economic imbalances in the euro area, Michał Brzoza-Brzezina, Marcin Kolasa and Krzysztof Makarski observe that, since the eurozone was established, large imbalances have built up between its members, most notably in their housing markets.

In the periphery – Greece, Ireland, Portugal and Spain – housing investment, prices and loans boomed. Their growth in the core was muted by comparison.

The main cause of this divergence, the authors explain, was the "sharp fall" in periphery countries' interest rates after they joined the eurozone. Not only did their membership drive the boom, but it also robbed them of one of the main tools for managing it.

The authors examine whether macro-prudential tools can prevent similar imbalances surfacing in the future. They build a two-economy macro-financial dynamic stochastic general equilibrium (DSGE) model to simulate the effect such tools – including the use of loan-to-value limits and capital adequacy ratios – can have when the eurozone is hit by asymmetric shocks.

"We find that a countercyclical application of macro-prudential tools is able to partly make up for the loss of independent monetary policy in the periphery," they say. "Moreover, LTV policy seems more efficient than regulating capital adequacy ratios".

The authors stress the benefits stem from the policies being implemented regionally, and stress that area-wide macro-prudential policy is "almost ineffective" in this context.