The Eurozone Great Depression

The eurozone is currently experiencing a smaller version of the Great Depression of the 1930s.  I’m not too interested in the statistical similarities (obviously the 1930s depression was more severe) but rather the intellectual similarities:

1.  On both occasions the conventional wisdom was that money was very easy, and hence monetary policy had nothing to do with what was happening.  Here’s Buttonwood from The Economist expressing the conventional wisdom:

It seems likely that central banks will maintain their very loose monetary policy; they can justifiably claim that, with inflation under control, they can focus on unemployment.

Why pick on Buttonwood?  Because this post is dramatically better than almost anything you will read in the media.  So if the best is screwing up this badly on the stance of monetary policy then you know everyone else is as well.  Milton Friedman pointed out that money was quite tight during the early 1930s, despite the massive QE and near zero rates. Eventually Friedman convinced the rest of the profession, but no one has done that for the current crisis. When I express views that all well-informed economists seemed to accept as recently as 2007 (lots of QE and zero rates don’t mean easy money), people look at me like I’m mentally ill.

2.  In both cases central banks faced an important constraint in their ability to stimulate demand and reduce unemployment.  In the 1930s you had the gold peg, and in the current depression you have the inflation target.  But, and this is very important, in both cases the constraint was entirely in the imagination of the policymakers, pundits and economists.  It was not binding.  During the late 1920s and early 1930 the world’s central banks actually increased their gold/currency ratios, indeed fairly sharply. Thus not only was the gold standard not a constraint, major central banks actually had a much tighter policy than you’d get from a sort of neutral “rules of the game” approach, by which I mean passively adjusting the monetary base in proportion to gold flows.  The same is true today:

THERE was striking news from the euro zone yesterday, the inflation rate fell to 0.7% in October, the lowest for almost four years. There is much speculation now that the ECB will have to ease monetary policy further. And the EU is not alone. Figures from the Conference Board show that the growth rate of the harmonised index of consumer prices (HICP), an internationally comparable measure, was 0.8% in the US in September this year, compared with 2.1% a year earlier. Japan and Switzerland are exceptions to the rule; they have edged out of outright deflation but only into very mild inflationary territory.

There’s a sort of unspoken assumption that there are two policy options, a hawkish single-minded focus on inflation, and a dovish dual mandate approach, which focuses on inflation and growth. Yet the European Central Bank has adopted a policy that is more hawkish than even a single-minded focus on inflation would entail. That’s exactly analogous to the interwar central banks adopting much tighter monetary policy than the rules of the game called for during the early 1930s. And yet, although this fact is right out in the open, almost nobody important seems to understand what is happening, just as almost no one important seemed to understand what was going on in the 1930s.  We’ve learned nothing.

I have sources in Europe that are well connected with European policymakers. They describe an almost total ignorance of monetary policy, nominal GDP, aggregate demand, and all the other things that we learned about from Friedman and Schwartz.  To the extent that there is a debate in Europe, it’s about the relative importance of structural reforms and fiscal policy. Even worse, Europeans can’t even use the zero bound excuse. At no time during the last five years has the ECB been at the zero bound, and in many cases they been both well above it and raising short term interest rates.  This is an active monetary policy; this is the ECB explicitly steering eurozone NGDP into a depression.

In the past I’ve blamed economists as a group for the Great Recession. After all, central banks pretty much follow the consensus view of economists. But perhaps we should distinguish between economists who understand monetary economics, the zero bound problem, the history of the Great Depression, etc., with the much larger group that do not. So it’s sort of a matter of degree. Those central banks managed by completely ignorant economists, such as the ECB or the Bank of Japan prior to this year, produce appallingly bad monetary policy. Those managed by people with knowledge of monetary economics, such as Ben Bernanke, produced somewhat better monetary policy, but nonetheless are constrained by the much larger mass of economists that simply don’t understand what’s going on.

PS.  The Buttonwood post mentions that inflation is rising in Japan and Switzerland. Of course those are the two countries that recently decided to depreciate their currencies. They succeeded in depreciating their currencies, despite the fact that the Keynesian liquidity trap model implies that cannot be done when rates are zero.

Just to be clear, I’m not saying that there is no respectable argument for near-zero NGDP growth rates.  I’m saying that there is no respectable argument for suddenly reducing NGDP growth from a 4.5% trend to near zero (since 2008) in the midst of the Mother of All Debt Crises and a period of very high eurozone unemployment and 0.7% inflation.  Or if there is, I’d love to hear it.

There’s a recent debate over the US report criticizing the German current account surplus.  Of course the report is silly; the Germans should be criticized for favoring tight money, and the Germans should be praised for their other policies.

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About Scott Sumner 492 Articles

Affiliation: Bentley University

Scott Sumner has taught economics at Bentley University for the past 27 years.

He earned a BA in economics at Wisconsin and a PhD at University of Chicago.

Professor Sumner's current research topics include monetary policy targets and the Great Depression. His areas of interest are macroeconomics, monetary theory and policy, and history of economic thought.

Professor Sumner has published articles in the Journal of Political Economy, the Journal of Money, Credit and Banking, and the Bulletin of Economic Research.

Visit: TheMoneyIllusion

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