Was Grexit Invevitable?

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So it appears the Eurozone crisis has finally crossed the rubicon. Greece is going to default on Monday and this likely will put in motion its departure from the currency union. The Eurozone as we know it may soon cease to exist.

Was this breakup inevitable? Many observers would say yes. The Eurozone, after all, is not an optimal currency area and therefore likely to create problems. Martin Feldstein, for example, in 1997 wrote this in Foreign Affairs:

This does seem prescient now as the tension between core and periphery countries in general and the Troika and Greece in particular have shown the inherent tension in the currency union. So maybe this path was preordained. Maybe ‘Grexit’ was inevitable. 

Or maybe not. Maybe the Eurozone crisis happened when it did because of colossal policy errors rather than being a necessary outcome of a flawed currency union. I make this argument in a new working paper and contend the policy errors were the ECB’s two tightening cycles in 2008 and 2010-2011. These tightening cycles were a huge mistake and arguably what set in motion the Eurozone crisis. They helped precipitate the sovereign debt crisis and gave teeth to the austerity imposed on the periphery.

In early 2008 the Eurozone began contracting, as seen in the first panel of the figure below. The growth of total money spending, a broad indicator of monetary conditions, had started declining even earlier. With monetary conditions beginning to tighten and the economy slowing down most central banks would have cut interest rates. The ECB, however, did nothing and kept its target interest rate pegged at 4 percent. Moreover, as seen in the second panel below, the ECB was signalling a rate increase which further intensified the slowdown. Thus began the first tightening cycle of the ECB in early 2008. Finally, in July 2008 the ECB raised its target interest rate to 4.25 percent and kept it there for three months. This tightening cycle was arguably that shock the triggered the Eurozone crisis. 

The second monetary policy tightening cycle began in late 2010 when the ECB began signaling again that it would be raising its policy rate to stem the burgeoning inflation. This too can be seen in second panel of the figure above. This expectation began stemming total money spending growth in early  2011. The ECB followed through on these expectations by raising its policy rate from 1 percent to 1.25 percent in April and then to 1.50 percent in July where it stayed for four months. This second  tightening cycle occurred even though Eurozone was still recovering from the first recession and is  arguably the shock the intensified the crisis in 2011.

As I show in the paper, these tightening cycles and preceded the financial panic of late 2008 and sovereign debt problems and appear to have given teeth the austerity programs. How different would the Eurozone look today had the ECB had instead cut rates in 2008 and started its QE program back then? I think the Eurozone would be a lot different. And no, Grexit would not be an inevitable outcome. There would still be problems for the currency union, but they would problems that could be sorted out in an economy not beset by a depression.

The ECB, in other words, bears a lot of the responsibility for the impending breakup of the Eurozone. Keep that in mind this week as the Grexit comes to fruition.