Thursday, April 7, 2011

The Countdown Has Begun for the Eurozone Breakup

The ECB decided to raise interest rates today, despite the strain it is going to put on the Eurozone.  Michael T. Darda explains in the WSJ what this could mean for the currency union:
If the ECB starts to tighten policy as expected, it could be a "lights out" situation for the beleaguered European periphery and a potential threat to the euro zone itself.
In more blunt terms, this move may have begun the countdown to the Eurozone breakup.  It is hard to see how else this can turn out.  The Germans--the folks who really call the shots in Europe--are reluctant to see the needed debt restructuring in the periphery and are equally reluctant to provide bailouts large enough to fix the problem. So far the Germans have been kicking the can down the road on these issues. With ECB monetary policy now tightening they will soon run out of road to kick the can down.

Maybe the breakup was inevitable from the start and this is just hastening that outcome.  After all, the Eurozone is not an optimal currency area (OCA).  But if Europeans do want to save their currency union the ECB should be easing monetary policy not tightening it.  Doing so would make it far easier to make the structural adjustments necessary to bring the Eurozone closer to an OCA.  How so?  Here is Darby again:
To understand why, we need to recognize the depth of the hole from which the euro-zone economy is trying to emerge. Nominal GDP, a proxy for nominal income and the tax base, is a staggering 10% below its pre-bubble, post-bust trendline. If anything, this would call for more support, not less, from the ECB... Europe's fiscal bailouts, which began last spring, have transferred resources from stronger countries in the core of Europe to weaker ones in the periphery. They have bought some time, but they are not a substitute for nominal demand in aggregate, which is why debt stresses persist.
Another reason why ECB easing would help is that it would lead to a real appreciation in the Germany and and a real depreciation in the periphery.  This would increase the periphery's external competitiveness relative to the core's and thus allow them to run current account surpluses.  Such surpluses would make it easier for them to manage their debt. But apparently ECB leaders don't see things this way.  And sadly, they probably don't care what some blogger from Texas thinks about their monetary policy.  Maybe, though, they might listen to one of their own:


  1. Well, I'll double-negative you:

    It doesn't matter if they don't care what some blogger from Texas thinks.

    The blogger from Texas is correct.

  2. Man, oh man. There just seems to be a continual conflating of good and bad ideas. Yes, limited government is good. Yes, you cannot print your way to prosperity.

    But, at the bottom of a recession is no time for austerity, and there are times for monetary stimulation.

    I guess this is like the chubby girl who decides to abstain from sex, and go on a strict diet to improve her self-esteem, after getting pregnant.

    Good ideas--at the right time.

  3. Off-topic but:
    DB: over at interfluidty, Steve Waldman says he talked to you about MMT. Are you going to do a post on MMT sometime? Might be interesting!
    I think they have some good ideas - certainly in rejecting the outworn money multiplier theory for example - but I think their ideas would only work if everybody was "in their paradigm". In other words, any government that announced it was adopting an MMT framework would see their currency sold like Zimbabwe hotcakes and would find a sharp reduction in their living standards due to rising import costs. They don't seem to get that, probably because they think like accountants not economists.

  4. A Eurozone break up seems preferable. The Bundesbank already risked its credibility once (German unification); it is reluctant to do so again in favor of its Periphery peers. The German polity seems to agree. Why force it? The Periphery central banks are better off engaging in QE/NGDP targeting on their own. Sure it would come at a cost of higher inflation, but that is a cost they willingly absorbed for decades before the Euro. Now they want the benefits of the Euro (low borrowing costs due to Bundesbank credibility) without the costs (Bundesbank discipline). I'm not sure this is a reasonable request in the long term.

  5. That has to be one of the top endings to an economics blog post.

  6. ECB:

    I will leave that to Nick Rowe. He has handled them well. I do agree with you, though, that a fundamental difference is that they view things from a mechanical, accounting framework where we don't.

  7. David:

    If a break up of the currency union is what they want, then they should be explicit about it. I would understand that better than what they are doing now. On on hand they they want to preserve the Eurozone, on the other they aren't willing to make the tough choices needed to do so.

  8. Europe is from Sweden wich is outside the euro area, so that's not "one of their own" unfortuanately :)

  9. After the widely expected official bailout for Portugal, Today's ECB hike is like the Fed hiking on the day they bailed out AIG. Can you imagine that? I am amazed how comfortably numb the markets have been today.

  10. "After all, the Eurozone is not an optimal currency area (OCA)."

    Quite beside the point. (After all, what is?)

    All of this would would make more sense if the German economy were overheating. But it isn't. (Not by a long shot.)

    After 11 quarters German real GDP is still down 1.1% and real exports are up by only 0.3%. Headline HICP is up at an annual average rate of 0.5% since July 2008. Yoy core HICP is running at only a 0.6% rate (and falling).

    The countdown has begun alright, but it's not just for Eurozone breakup. It's for perpetual German stagdeflation.

    P.S. At least the Germans have Kurzarbeit so they can share the task of producing their stagnant output from now till the end of time.

    P.P.S. This is what happens when you put a mining engineer in charge of a central bank.

  11. Damn! I can't post and listen to the music at the same time!

    Unfortunately, I think you are probably right.

    The big questions are:

    Will this also lead to the breakup of the EU?

    How will this impact the rest of the world?

    off-topic on MMT: thanks David. I have already engaged in comments on Steve Waldman's latest blog post:
    Let's see how this plays out.

  12. David,

    I don't see why the ECB tightening portends a breakup of the Eurozone. All it does, in my view, is ensure that policymakers will face another crisis.

    European policymakers are treating what is so clearly a banking crisis as a fiscal crisis - that's a mistake. They think that quashing domestic aggregate demand will both reduce budget deficits and inflation. They are right on the inflation side - but the result will be deflation and stagnation AND rising deficits.

    But the question of break-up is different. Because so far European policy makers (especially German policymakers) have demonstrated that they want the Eurozone to survive, at least they do right now. They've showed this through the creation of various lending programs, EFSF or ESM, and the creation of the banking authority, for example. Sure, these programs are grossly insufficient, as represented by bond yields in the weaker economies, but it's progress nevertheless.

    The ECB tightening just reiterates that policy objectives are clearly insufficient for the Eurozone. So when tight monetary policy + tight fiscal policy results in deflationary recession (possibly) and another banking crisis, will policy adjust to allow the Eurozone to survive? Will they ultimately move toward the printing of money and the creation of a unified European bond system (or some sort of fiscal unification)? I don't know.

    Although a break-up is not obvious, at this point in time, what is certain is that current policy is destroying productive resources. See this article by Stiglitz and Cragg.

    Thanks, Rebecca

  13. Wanted to make sure you saw this chart in the WSJ of the timeline of various central bank interest rate decisions around the world from 2004 to today.

  14. Can one of you academics (David, Mark) please explain the economic theory behind the following:

    1) why regaining the previous peak in GDP is so important

    2) why you think that the previous trend in nominal or real GDP growth should be re-established (despite plenty of evidence from prior crises that this does not happen or happens far more slowly than over three years)


  15. Anonymous:

    The idea is to stabilize nominal GDP--not real GDP--which is nothing more than total current dollar spending. The Fed has a lot of influence over that. It creates money and can influence the spending of money by shaping expectations of future current dollar spending.

    If the Fed did stabilize total current dollar spending, it would ignore changes in real GDP and the price level. See the below links for more:

  16. that didn't answer either question. i'm well aware of the arguments in favor of nominal real GDP targeting.

  17. (postscript)

    i don't recall NGDP targeting involving the claim that any recession must see the prior peak in GDP reclaimed before the CB tightens, nor do i recall the claim that an unsustainable trend in NGDP must be maintained. but if i'm wrong, please correct me.

  18. Anonymous:

    No one advocating NGDP targeting has ever said Real GDP should return to its previous peak before tightening. The emphasis has always been on NGDP (though by doing so RGDP will tend to be more stable as a byproduct).

    The idea behind stabilizing NGDP is that by doing so one is stabilizing money expenditures. This is important in a world of sticky prices and dollar-denominated debt (i.e. debt is nominal terms). If one stabilizes money expenditures there can still be falls in real GDP. There also can be sector adjustments in the economy. See this post where I show that the housing sector was contracting just fine in 2006 and 2007 with labor finding its way from it into other sectors. Only in mid-2008 did the Fed allow money expenditures (i.e. NGDP) to start falling and this caused broader economic problems.

    Regarding NGDP returning to trend (not peak), the idea here is that by doing so the Fed will have restored stable money expenditures. Alternatively, it can viewed as the Fed fixing an excess money demand problem (which caused money expenditures to fall).

    Now where the NGDP trend should be is a debatable issue. My own view is that NGDP was above trend during the housing boom. Thus, the correct trend should be based on this period. Here is a  post where I talk about my preferred trend.

  19. thank you.

    why is your trend non-linear with an increasing rate of change in nominal spending? this would seem to imply accelerating inflation and/or real growth.