Tuesday, October 14, 2014

Did the Fed cause the Great Recession in the Eurozone?

Scott Sumner's post on Euro-denial among the econ reminded me that I hadn't yet updated the Eurozone trend to account for the strange (and likely not relevant to inflation) impact of 500 € notes. Needless to say, I remain an ECB apologist. It still looks like the big shock of the recession was a result of being above trend:


The secondary shock in 2011 still looks like it came from being above trend as part of a rebound from the lows of 2010. If there is a shock happening now it may well result from external factors like Russia/Ukraine since the data appear fairly close to the trend line.

There was something interesting I saw, however. In this post, I showed that the deviation from the trend in the US in the lead-up to the Great Recession was due to monetary policy by plotting the monetary base on this same graph as M0 (currency). The dotted monetary base line appears to push the M0 curve above the trend and then falls away after the recession (graph reproduced from the linked post):


The monetary base controls the short term interest rates. When the two curves (M0 and MB) approach each other, yield curve inversion becomes more likely, which tends to be a precursor to a recession. The existence of minimum central bank reserves tends to keep the M0 line a constant distance to the left of the MB line. We can see the Fed raising short term interest rates in the mid-2000s and then rapidly lowering them as the Great Recession hits. However, after that, the MB line is so far from the M0 line, it has little to no effect on NGDP (a liquidity trap).

What does this curve look like for the ECB?


It looks like the monetary base has been too large since the inception of the Euro to have any impact on the NGDP-M0 path of the Eurozone economy. It is possible "tight money" (i.e. slow MB growth) pushed the M0 path above the trend in 2010-2011, like a miniature version of the US in 2008. Overall, though, it looks as if short term interest rates (monetary policy) haven't had any traction since 2002. Even with the base expansion, the ECB has mostly been spinning its wheels -- it's been in a liquidity trap this whole time.

Sumner puts the expert witness [3] on the stand:
But the ECB wasn’t even close to the zero bound in 2008.  I get that people don’t like NGDP growth as an indicator of monetary policy, and want “concrete steppes.”  Well the ECB raised rates in 2008. The ECB is standing over the body with a revolver in its hand. ... And then three years later they do it again.  Rates were already above the zero bound in early 2011, and then the ECB raised them again. Twice.  The ECB is now a serial killer.
The liquidity trap has little to do with the zero lower bound (although there is a sense in which they tend to occur together). Interest rates were already too low to move the economy in 2008 and continued to be low through 2011 (the MB curve was well to the right of the M0 curve).

The Eurozone has been like a rudderless ship since the Euro started -- it just so happens that the Great Recession is the only major shock they'd ever had to deal with and the fact that they can't do anything about it makes them look hapless. [1]

But that leaves a question: if the ECB didn't cause the path to rise above the trend (like in the US case), what did? Did the Eurozone import a financial boom from the US? Did the Fed cause the Euro crisis as well as the US recession? Was the ECB framed? [2]

Hmm...

[1] As an aside, I wonder if this explains the strange movements of the Euro monetary base during the Great Recession -- it's like the rudder inputs from a pilot who doesn't know he has lost the rudder, moving side to side, erratically.

[2] I thought about using the title "Has the Eurozone always been in the liquidity trap?" with a nod to The Shining, but Sumner's murder mystery was too much fun.

[3] The economists in denial, per Sumner's accusation.

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