Much like Frances Coppola, I like charts. I think in pictures and words not numbers; I find it significantly easier to translate graphs into reality. But, unlike Frances, I hold the ECB peculiarly responsible for the Eurozone crisis, where she places more blame on the banking sector in general. I hope to present some graphs to convince Frances that the ECB is the real bad guy in Europe.
I have repeatedly called the European Central Bank insane for failing to save the Euro. That might be a little unfair, lots of banks acted insane during the 2000s, but the ECB’s monomaniacal and slavish adherence to inflation targeting led the bank to make two specific policy errors which have had grave consequences.
These policy errors exaggerated the errors of Europe’s banks and turned a balance of payments problem into a triple currency, banking and sovereign debt crisis. It wasn’t debt or deficits that sent the Eurozone periphery into crisis it was consistently importing more than they exported.
Such a lopsided Eurozone demanded flexible demand management, the right amount of demand for Germany had clearly been to inflationary for Ireland et al. However, when the crunch came the ECB was found wanting. Four times the ECB focussed too heavily on short term inflation and raised rates, or failed to cut rates, in error. Below is a graph of Eurozone interest rates as set by the ECB.
In 2008, rapid growth in the developing world pushed up commodity prices and headline inflation around the world. Simultaneous with this the world financial system had begun to blow up. In July 2008 the ECB hiked rates despite it being well aware it was operating in a period of acute financial stress (see chart 2). That is the first error, an over reaction to headline inflation. This error was felt across the world, as described by Lars here.
A few months later, in September, Lehman Brothers collapsed. In September the ECB did not alter its headline interest rate, it waited until October to cut rates. As a consequence of this passive tightening expected inflation in the Eurozone fell well below the ECB’s target rate (see chart 5) and the financial crisis began proper. That was the second error, it was quickly regretted and over the next eight months interest rates were cut to 1%, but no lower.
In April 2011, the ECB once again began to increase interest rates in April 2011 to fight higher inflation. This proved to be a mistake which was reversed between October and December 2011. The consquences of this mistake are plain to see. The below graph was cribbed from Tim Duy and shows the subsequent increase in unemployment.
The cause of this increase in human misery was decrease in aggregate demand and expected future aggregate demand. Caused by the same demand shock, the borrowing costs of the Eurozone periphery spiked compared with the borrowing costs of Germany. Greece’s ten year borrowing costs spiked from being 9.49% higher than Germany’s to 12.64% higher. Similar movements can also be seen for Ireland, Portugal and Spain by comparing this data from late March 2011, with this data from May 2011.
The ECB’s fourth and enduring mistake is keeping interest rates at 1%, rather than cutting all the way to zero, and in failing to communicate that they will continue to be as accommodative as is necessary to boost growth. The ECB has failed to use the conventional tools and has actively sabotaged itself by failing to convince anyone it is willing to be as accommodative as is necessary to rescue the Eurozone from crisis.
This isn’t entirely the ECB’s fault, they’ve been given a very narrow mandate to maintain price stability. But mandates can be reinterpreted as necessary and blowing up the world financial system and throwing millions out of work to keep a lid on poorly recorded, probably inaccurate, inflation rate is an insane way to interpret a mandate for price stability. So I’ll probably keep calling the ECB insane.