The Eurozone NGDP Catastrophe

Suddenly we have everyone from Charles Evans to Mark Carney talking about NGDPLT.  Now that the idea is no longer confined within the tiny market monetarist community, perhaps it’s a good time to re-examine how policymakers stack up using this benchmark.

The US experience is well known.  Our GDP is up 9.59% from 2008:2 to 2012:3.  If it keeps chugging along at 1% per quarter it will be up 12.9% by 2013:2, a period of five years.  Recently I decided to take a look at the European numbers, but I never seem to be able to find NGDP numbers for the eurozone.  Fortunately one of my best students ever (Garrett MacDonald) sent me the data.  I knew it would be bad, but I expected bad like the US, not bad like Japan.

Eurozone NGDP is up only 2.47% since 2008:2.  The ECB expects contraction in 2013.  I could not find NGDP forecasts, but the deflator has been rising about 1.1% per year over the past nine quarters.  So NGDP growth will probably be very low.  A reasonable guesstimate is that three quarters from now the eurozone NGDP is likely to be up about 3% from 2008:2.

If you think that the 12.9% number for the US 5 year NGDP growth rate is horrible, how can we even begin to describe 3% NGDP growth over 5 years?  Even accounting for the fact that American trend NGDP growth is a bit higher (4.7% per year over the 8 years before 2008:2, whereas in the eurozone the previous 8 years saw 4.1% annual NGDP growth), these numbers are simply astonishing.

Even more appalling is the reaction of the economics community to this NGDP catastrophe.  Consider the following two hypotheses:

A.  The eurozone crisis was caused by a lack of competitiveness in the peripheral countries, banking distress, and huge public debt problems.

B.  The eurozone problem was caused by ultra-tight money at the ECB, which caused NGDP growth to fall 18.5% below trend.

Suppose you polled economists at January’s AEA meeting.  Which one would get 98% of the votes?

Now let’s compare the two hypotheses.  Suppose tight money was the cause, hypothesis B.  What does economic theory suggest would happen if a central bank ran a tight money policy that reduced NGDP growth 19% below trend?  The answer is simple; high unemployment, lack of competitiveness, banking distress and debt problems.  Of course this theory doesn’t explain why some regions are doing better than others, but that’s true of almost any adverse demand shock.  There will be regional differences based on different industry mixes, public debt burdens, etc.

Now look at hypothesis A.  How do we account for the sharp fall in NGDP?  Recall that people like Evans and Carney are increasingly likely to see stable NGDP growth as evidence of sound monetary policy.  Are we to believe that items listed in hypothesis A just happened to coincide with the biggest NGDP crash since the Great Depression? Obviously not.  Even the proponents of hypothesis A would see a link, but presumably with causation running from A to B.  OK, but then what if the ECB had not let NGDP growth crash, what then?  If you actually believe that tight money did not cause the crisis, you’d be forced to argue that the crisis would have happened anyway, even with sound monetary policy.  That would be absurd, as it would amount to claiming that an 19% crash in NGDP growth over 5 years would not slow RGDP growth, because the “real problem” was the items in hypothesis A.  A medical analogy would be that shooting a flu patient in the heart with a 45 would not worsen their condition, as their real problem was having the flu.

Now some will argue that the ECB cannot do more, as they have an inflation mandate.  Maybe so, but let’s look at the increase in the GDP deflator over the past 9 quarters:

1.58%, 0.96%, 0.82%, 0.44%, 0.50%, 0.87%, 1.16%, 1.07%, 1.31%.

What don’t you see?  Unlike the US and Britain, I don’t see any GDP deflator rates above 2%.  Yes, the CPI has been above 2% at times, but which variable matters more for economic stability, the price of stuff Europeans consume, like Saudi oil, or the price of stuff European companies produce?  In fact, inflation is probably even lower than the numbers I just quoted, as I am pretty sure they include the recent increases in indirect taxes, which is part of the fiscal austerity.  Tight fiscal policy triggers tight monetary policy–what a wonderful system!

Even if the eurozone was still operating as a fixed exchange rate system, as in the 1980s and 1990s, this data would represent a catastrophic policy failure.  But now that they have a single currency, it’s even worse.  Now individual countries are not able to fix their competitiveness problems with devaluation.  This makes it especially important to get monetary policy right–to provide the optimal amount of AD for the overall eurozone region–not the healthiest member of the group.  How far are they from the optimum?  Angela Merkel is now suggesting that even Germany needs fiscal stimulus.  Given that the entire edifice is teetering on the edge of disaster, don’t you think the European elite would go out of their way to do whatever it could?  Look at those GDP deflator numbers again.  The ECB seems willing to cross all sorts of previous lines in the sand, with radical policies such as buying sovereign debt and bailing out banks, but isn’t willing to produce enough AD to get GDP inflation up to say 1.9%, or 1.8%, 0r 1.7%, or even 1.6%, even in a single quarter.  Are they masochists, or do they not have a clue as to what’s actually going on?

Ultimately the eurozone crisis is a massive failure of imagination among the Very Serious People than run Europe.  We have a huge demand shock creating a depression with year after year of high (and still rising) unemployment, just as all the textbooks say it should.  You have a severe NGDP growth plunge producing a debt crisis, just as the textbooks say it should.  We have low interest rates being a very poor indicator of the stance of monetary policy, just as the textbooks say it is.  And even with this massive demand shock occurring right in front of their eyes, they can’t see it.  All they can see are the symptoms, and they assume those symptoms are the causes.

We spend years trying to teach our students to get beyond the superficial “common sense” explanations of macro events, to look deeper into the root causes.  And yet when our best and brightest are faced with the defining challenge of our era, they react like a bunch of ignorant freshman students, unable to see beyond the news headlines.

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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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