Can interest rate spreads stabilize the euro area?

Over the last few years significant spreads arose for both public and private debt between euro area countries. We check whether these spreads could be made to work towards the goal of providing more stability to the euro area. In particular we focus on reducing the imbalances that arose between the core and peripheral members of the euro area in the first decade of its existence. The idea is that stable, positive spreads in peripheral countries could have decreased domestic demand thus preventing the boom-bust cycles that plagued these economies. They could also prevent such developments in the future.Panel data analysis.Our results show that spreads between real interest rates of 1.5 to 5.8 percentage points would be necessary to reduce current account deficits in the four peripheral countries (Greece, Portugal, Ireland and Spain) to levels that would have stabilized these countries net foreign asset positions. The policy conclusion from this paper is that instead of fighting spreads accross the board, the ECB could accept their existence, provided that they behave in a relatively stable way and are close to the equilibrium levels that we calculate. Otherwise it cannot be excluded that the history of diverging current account balances, lost competitiveness and sharply rising spreads at the least desireable moment will repeat itself in a few years.