Scott Sumner  

How Europe did a "1937"

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In macroeconomics, "1937" is a metaphor for tightening too soon, before an economy has recovered from a deep slump, and falling back into another downturn. Here's the FT blog Alphaville discussing what went wrong in Europe:

The Riksbank faced this issue early as its measures during 2008-10 were far more effective than those elsewhere. Despite an output fall in 2009 identical to the UK and US, by mid-2011 GDP had recovered not only to pre-crisis peak but to pre-crisis trend. Further, inflation was above target, wages and employment were rising, and the IMF was so confident of robust global growth for 2012 and beyond that it called for immediate policy tightening in the Euro area and the UK. Thus, if those global forecasts were correct, it was reasonable (if not tardy)--even within a Keynesian framework--for the Riksbank to begin raising the repo rate from its floor from 2010.

But it clearly went wrong. Even though Sweden has since remained far closer to its pre-crisis GDP trend than any major country, its headline consumer price level is now falling, by 0.4 percent in the 12 months to September.

So what went wrong? It was the global forecasts. The IMF global forecasts at the time, a key input for Riksbank assessments, confirmed a buoyant global outlook.


A few comments:

I don't think Sweden's real GDP had recovered back to trend in 2011. And this post by Marcus Nunes shows their nominal GDP (which is what matters for monetary policy) was still well short of the previous trend line in 2011. But the mistakes at the Riksbank were minor compared to those of the ECB.

There was no plausible argument for tightening eurozone policy in April 2011, when they started raising rates. Over the previous 3 years, NGDP in the eurozone had risen by only about 1%. Not 1% per year, 1% over a period of three years. And that's not real GDP, that's nominal GDP. I have no idea why the IMF recommended that the ECB tighten policy; but it was a huge mistake, which could had been avoided if the ECB had followed market monetarist policy ideas and focused on stable NGDP growth.

And now Lars Christensen has found a paper by Athanasios Orphanides that criticizes the ECB from a traditional monetarist perspective:

The persistent and significant monetary policy tightness reflected in money and credit growth in the euro suggests that the ECB may have all but abandoned its monetary pillar. If it had not, the ECB would have pursued considerably easier monetary policy during this period, counteracting at least part of the dramatic fall in the growth of money and credit. If the ECB has abandoned the two-pillar strategy it had developed over a decade ago, as is strongly suggested by the data, this would represent a very unfortunate development.

...Faster money and credit growth over the past few years could have contributed to higher employment and greater economic growth and stability without compromising price stability. In this manner, faster money and credit growth would have led to better
fulfillment of the ECB's mandate as specified in the Treaty.


So ECB policy has been much too tight from a New Keynesian, traditional monetarist, and market monetarist perspective. It seems that it's been too tight from almost every perspective except that of Germany. And now the eurozone is in deep trouble.


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CATEGORIES: Monetary Policy




COMMENTS (8 to date)
Lorenzo from Oz writes:

The promise of the Euro was a Deutschmark for everyone. The problem with the Euro is that they got a Deutschmark for everyone.

This has been clear for years: what you are providing here is further and better particulars.

As far as I can see, to the extent there is "a plan" it is for Greeks, Italians, Spanish, French etc to become Germans, so to speak. With the Brits paying for it.

Good luck with that.

Ken from Ohio writes:

The ECB balance sheet has shrunk by 50% since 2012.

Today Draghi implied a promise to expand and Weidmann implied acquiescence.

But I am betting that this is mere " forward guidance" and the political powers within the Eurozone will block any significant (unconventional) monetary expansion.

In particular, the purchase of public bonds ( sovereign debt) even on the secondary market will never happen, and the purchase of private ABS will be insignificant.

ThomasH writes:

They even failed to maintain an average 2% inflation over the period. But governments failed to increase deficits to finance investment as borrowing rates fell. The failure was in both fiscal and monetary policy. Like the US, but much worse.

@Lonrenzo. It is worse. There have been periods, pre Euro, when Deutschmark inflation was high enough that ECB could have managed 2008 with out encountering the ZLB. They just set too low an inflation target and then did not meet it.

Roger McKinney writes:

This could be true or they could all be examples of the post hoc fallacy.

Keep in mind that the monetarist definitions of "loose" and "tight" monetary policy are circular in reasoning: Loose policy is when the economy is growing and tight is when it's not. The actual policy of the central bank doesn't matter.

IEA has published a new monograph by French economist Pascal Salin, Money and Micro-Economics in which he explains what is wrong with market monetarism.

Lorenzo from Oz writes:

Roger McKiinney: James Caton has posted a response to Salin here:


Brian Donohue writes:

Preach, Scott!

"Having eyes, see ye not? And having ears, hear ye not?"

Scott Sumner writes:

Roger, Which "monetarist" defines the stance of monetary policy in terms of whether the economy is growing?

Yancey Ward writes:
The promise of the Euro was a "free" Deutschmark for everyone.

Fixed that for you.

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