Applying the Mankiw Rule to the Eurozone

 |  Includes: EPV, EWP, FEZ, FXE, IRL, VGK
by: Jake Huneycutt

The lack of independent monetary policy within the eurozone is one of the more economically destructive aspects of the system. Every individual nation in the 17-member grouping is forced to adopt a common monetary policy; even while they all continue to function as sovereign nations otherwise. The result is that money supply in each individual nation cannot be adjusted for the observed market conditions. In my view, this is the euro’s biggest flaw.

As a little experiment, I wanted to try to determine what sort of monetary policy the eurozone nations should be running right now. I’ve decided to take the Mankiw Rule in order to try to predict what the short-term interest rates should be in each individual nation.

Background on Mankiw Rule

There are two primary monetary policy rules that I am aware of: the Taylor Rule and the Mankiw Rule. Both provide a soft recommendation for short-term interest rates in the United States.

The two rules are fairly similar in terms of results, but the inputs are slightly different. The Taylor Rule emphasizes the output/inflationary gap and uses raw CPI in order to calculate an optimal Federal funds rate. The Mankiw Rule, on the other hand, uses core CPI, which is CPI excluding food and energy. Mankiw also factors unemployment into the equation. The formula for the Mankiw Rule is below:

Federal funds rate = 8.5 + 1.4 (Core inflation - Unemployment)

I’ve decided to use the Mankiw Rule, not because I have an overwhelming preference for one rule over the other, but because Mankiw will be easier to calculate with the data I can acquire quickly. While there will be minor differences between the two rules, we’re not focusing on precision here, so much as direction and degree.

With that, let’s jump to the results. I will deal with some of the flaws with this methodology afterwards.

Eurozone Mankiw Rule

There was one significant issue in calculating this data. It was far simpler to find raw CPI eurozone data in wholesale fashion; whereas, I would’ve had to spend more time digging up core CPI for each nation. While this should slightly alter our data, it won’t destroy its validity so much as require us to compensate for it.

The eurozone equivalent of the Federal funds rate is the marginal lending rate for main refinancing operations. This is currently set at 1.25% as a reference point.

All 17 eurozone member states are in the table below:

As you can see from the chart above, it suggests that monetary policy is too loose in the “Northern Block” of eurozone nations, which includes Germany, Luxembourg, the Netherlands and Austria. Austria and Luxembourg, in particular, appear to have very loose monetary policy due to the eurozone’s structural flaws.

On the other end of the spectrum, we see that Estonia, Ireland, Greece, Spain, Portugal, and Slovakia all have tight monetary policy, with Spain and Ireland falling into the “very tight” categorization.

Since I used raw CPI rather than core CPI, I tried to make adjustments for the more troubled block of nations, commonly known as the PIGS: Portugal, Ireland, Greece and Spain. In the chart below, for the first result, I adjusted raw CPI to estimate core CPI. This was not a scientific calculation; I merely based it off of what I’ve observed with CPI data over the past six months in most nations. In most cases, this means that CPI was lowered between 100 to 200 basis points.

For the second set of adjustments, I attempted to factor housing prices into CPI. For Spain, I assumed that housing would get a 25% weighting and prices had fallen 7.5% in the past year. This was based on some analysis I have read elsewhere and seems to be a reasonable estimate. For Greece, Ireland and Portugal, I merely assumed a 5% decline in real estate values and a 25% weighting. This is merely a guess and may not be accurate at all, as I had difficulty finding any easily accessible housing data to base this off of.

The results are below:

With these adjustments, monetary policy in all of these nations looks extremely tight. Keynesian economic theory would suggest that fiscal policy should be used to compensate for this disparity, but the problem is that the precise opposite result is taking place, with all four nations implementing austerity measures: higher taxes and lower spending. This has the effect of constricting money supply even further below its optimal level.

In my view, this is precisely the same situation that played out during the Great Depression. Nations could not increase money supply as necessary due to the gold standard. Except, this is even worse in a sense, because at least gold can be mined and supply increased; whereas the PIGS are essentially stuck in their predicament with very few options, unless they abandon the Euro.

Flaws with this Methodology

There are, of course, some flaws with using this methodology (the Mankiw Rule) and applying it to eurozone member states in the manner I did. As mentioned earlier, I used raw CPI data in the first table as opposed to core CPI. Because I wanted to do this wholesale and finding the core CPI rates would have taken a lot more digging, I decided to live with this limitation. In practice, food and energy prices are causing CPI inflation to be significantly higher, so a nation with 3.5% inflation might only have 1.5% core inflation. My second chart attempts to accommodate for this shortcoming for the four “troubled nations” (Mankiw Rule Modified #1).

Another problem, in my view, is that CPI does not account for housing prices in most nations. Personally, I believe this is a huge mistake, and that fixed asset prices are one of the most important considerations in monetary policy. If the US had accounted for fixed asset prices during the ‘00s, we would have likely clamped down during the housing boom, and it would have never become quite so out of control. However, it’s important to note that this is a flaw with both the Mankiw Rule and the Taylor Rule and applies to the US, as well. As mentioned already, I tried to accommodate for this in the second chart, as well (Mankiw Rule Modified #2).

The final flaw here is that the Mankiw Rule was meant to predict an appropriate level for the Federal funds rate in the United States. It’s not completely clear how well it will carry over to various eurozone nations. Some nations might have different long-term optimal unemployment rates, so that could make this rule somewhat off. It was more difficult to compensate for this potential shortcoming.

Even with the flaws, however, I believe this analysis shows why the problems in the eurozone are so severe. Without independent monetary policy, Portugal, Ireland, Spain and Greece are essentially unable to adjust their money supply in an adequate fashion. Iceland, which does have independent monetary policy, is now starting to recover some from its financial meltdown; while none of the eurozone nations have seen anything other than further problems.


From this data, I would suggest that Portugal, Ireland, Spain, Greece, Estonia and Slovakia would all be better off exiting the eurozone. A tight centralized monetary policy that does not account for the unique needs of these nations’ economies only exacerbates current issues.

Meanwhile, it would appear that Austria, the Netherlands, Luxembourg, and Germany are benefiting from loose monetary policy and an artificially weak currency. If several of the weaker states were to split off from the euro, it would cause the euro to strengthen and interest rates to rise, thereby weakening exports. If this downturn were combined with a banking crisis, initiated by sovereign debt restructurings, we could have a major eurozone crisis on our hands.

There are several solutions to these problems, but in its simplest form, the eurozone should either break up or enact reforms that make it more like a “United States of Europe”, rather than a dysfunctional conglomeration of independent states lacking an independent monetary policy. Until eurozone policymakers are willing to take one of these actions, the economic problems of the eurozone will likely continue.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.