© THOMSON REUTERS 2011
3RD QUARTER 2011
Chart 2:Wicksellian differential– Germany, France,Ireland, Spain
Source: Thomson Reuters Datastream.
In terms o calculating the cost o equity, there is no standard approach to generating estimates.
However,it would appear more appropriate to use an implied equity risk premium that calculates expected returns,given that corporations make investment decisions on a orward-looking basis. In times o economic stress,the cost o investing in equities tends to rise due to increased perceived risk, and as the equity market booms,the cost o equity tends to all as perceived risk alls. As the costs o equity and debt are correlated, andgenerating a cost o equity is problematic, only the cost o debt will be taken into account in this analysis.Hence, it is worth noting that the Wicksellian dierential includes the cost o equity.
Optimal currency union?
Chart 2 plots the Wicksellian dierential or each country. The urther away rom zero the dierential is,the higher the level o excess liquidity. Moreover, the longer the dierential remains at high levels, thegeneration o excess liquidity accelerates. With that in mind, chart 2 shows that, according to Wicksell’sramework, interest rates in the 1990s were too low or the Irish and German economies, driving excessliquidity. However, by the early 2000s the return on capital was alling or Germany but increasing orSpain. By 2005 all economies were generating signicant excess liquidity due to the large Wickselliandierential. Ireland over the period demonstrated a signicant, and more importantly, sustainedWicksellian dierential due to the diering returns on capital and a singular interest rate.The Wicksellian ramework also shows that post-crisis, the return on capital in the core countries oFrance and Germany remains strong, thus increasing the likelihood o an increase in interest rates due topotential rising infation. However, i interest rates do continue to rise, Wicksell’s approach highlights thatIreland, with its negative returns on capital, may be adversely impacted as Japan was in the 1990s, wherethe cost o capital was greater than the return on capital.Sustained high levels o Wicksellian dierentials lead to excess liquidity being generated, thereore itshould be easible to spot this excess liquidity with available data. Indeed, a cursory look at asset pricesin Germany, Ireland and Spain clearly demonstrates where excess liquidity fowed to.