The Origins of the Eurozone Monetary Policy Crisis
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 Eurzone 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 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
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.
So look forward to more Eurozone crises. Or a breakup.
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.
Source: http://macromarketmusings.blogspot.com/2015/03/the-origins-of-eurozone-monetary-policy.html
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