Monday, March 2, 2015

The Origins of the Eurozone Monetary Policy Crisis

I made the case in my last post that the Eurozone crisis was largely a monetary policy crisis. That is, had the ECB lowered interest rates sooner and begun its QE program six years ago the fate of the Eurozone would be more certain. Instead it raised interest rates in 2008 and 2011, waited until this year to begin QE, and allowed inflation expectations to drift down. In short, had the ECB been more Fed-like the Eurozone crisis would have been far milder.

This begs the question as to why the ECB failed to act more Fed-like. Why did it effectively keep monetary policy so tight for so long?

To answer these questions it important to note that there were actually two stages to the Eurozone crisis. The first stage began in 2008 when the ECB raised interest rates just as the Eurozone economy began to weaken. This explicit tightening along with the subsequent failure of the ECB to offset the passive tightening of monetary policy through 2009 adversely affected all of the Eurozone. In this stage nominal spending--or aggregate demand--fell in both the core and periphery economies. Consequently, real economic activity also collapsed in both regions. This can be seen in the two figures below. The first figure shows nominal spending for the two regions while the second one reports real GDP growth and the change in the unemployment rate.1

The above two figures also point to the second stage of the Eurozone crisis which begins in 2010. The first figure shows that while aggregate demand continues to grow in the core regions (albeit below trend) after 2010, it actually falls in the periphery. Likewise, the second figure shows that for the 2010-2013 period real GDP growth rises and the unemployment rate falls for the core, while the opposite happens to the periphery. The core heals while the periphery bleeds during this stage.

What these figures suggest is that the first stage of the crisis was a Eurozone-wide monetary crisis, while the second stage was only a regional Eurozone monetary crisis. In other words, the first stage of the crisis was not that different than what happened in the United States during 2008-2009. And for the core economies as a whole the ECB was sort of Fed-like for them after 2010. It was, then, the periphery economies that suffered from the absence of Fed-like policy after 2010.

This notion is borne out by looking at Taylor rules fitted to these two regional economies. Following the work of Fernando Nechio, I created Taylor rules for these two regions and plotted them alongside the actual ECB policy interest rates:2

This figure shows that monetary policy was too tight in 2008-2009 for both regions, but afterwards it was too-tight only for the periphery. Hence, the second stage of crisis was a regional monetary policy crisis localized to the periphery.

The fact that second stage of the crisis was a regional one speaks to what I see is the real underlying reason for the monetary policy crisis: the Eurozone is an unequally yoked currency union. It has member states that have economies so vastly different that applying an one-size-fits-all monetary policy is bound to create problems.

The Taylor rules in the figure above vividly illustrate s this problem. It shows a persistent pattern of the ECB setting its interest rate target in a manner more consistent with the core economies. For example, when the Eurozone first formed in 1999 the core economies--particularly Germany--were struggling so the ECB lowered interest rates to accommodate them. Doing this, however, meant monetary policy was way too loose for the periphery as seen by the large gap between the red and dashed lines above. Monetary policy would continue to stay too loose for the periphery up through 2008. After the crisis, ECB policy has again been more consistent with the core economies, but this time it has meant monetary policy has been too tight for the periphery.

Think about what this means for the periphery. Countries like Greece, Ireland, and Spain were on average growing in nominal terms anywhere from about 8 to 15 percent between 1999 and 2004. The ECB policy rate during this time averaged near 2 percent. This large spread between the nominal growth of periphery and the low financing costs screamed leverage. It is no surprise there was a buildup of debt, soaring asset prices, and large current account deficits for these economies. Conversely, with persistently tight monetary policy since 2008 it is no wonder the periphery has been in a depression.

The importance of the ECB's monetary policy can be seen if we take the actual difference between the ECB policy rate and the Taylor Rule rate for each country--a measure of the stance of monetary policy--and see how it changed over the 2010-2013 period and then plot these values against the real GDP growth we get the following figure: 

There is a very strong relationship here that indicates how well Eurozone economies fared over the second stage of the crisis depended on the stance of monetary policy. Even if we throw Greece out we still get a good fit:

All of this points to the Eurozone monetary crisis being the product of a poorly designed currency union. It is, in other words, far from being an optimal currency area. From this perspective, the monetary policy crisis in Europe can be thought as a structural crisis that is not going to go away anytime soon. Even a more robust monetary policy by the ECB--say a nominal GDP level target--that kept the periphery from going into a depression might still not solve the structural problem. It might solve the periphery's problems while causing overheating and buildup of imbalances in the core economies. It seems to me, then, ECB monetary policy will continue to create problems for the Eurozone moving forward.

So look forward to more Eurozone crises. Or a breakup.3

1Fernando Nechio of the San Franciso Fed,  I define the core as Austria, Belgium, Finland, France, Germany, and the Netherlands while the periphery as Greece, Ireland, Italy, Spain, and Portugal.
2 Like Fernando Nechio, I use the 1999 Taylor Rule. Here I use the harmonized core inflation and the IMF's output gap in the Taylor Rules.
3Alternatively, the periphery economies could reform their economies to be more like the core, but that does not seem likely. Nor does it seem likely that the shock absorbers needed in the Eurozone--increased labor and capital mobility and meaningful fiscal transfers--will be ever be forthcoming. Too much history.


  1. What is wrong with Figure on the Eurozone Taylor Rules? The ECB's main policy rate is not negative, as the figure shows.

    1. The ECB deposit rate is negative, no?

  2. Good post. Greeks need their own central bank and drachma.

  3. Aren't these very asymmetrical issues though? While tight money causes widespread drops in investment employment and production and is thus astronomically costly, "overheating" causes what?, increases in menu costs? If the ECB could just keep economies on the "warm" side, shouldn't things be massively better?

  4. great post.
    Wouldnt it be reasonable to break up the Euro zone into two parts.
    The core-part and the peripherie? With two central banks and two currencies?
    The implementation would be quite costly however.

    The eruo zone was always more of a political utopia than an economically reasonable union.