Was Grexit Inevitable?

Includes: EU, GREK
by: David Beckworth

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:

Monnet was mistaken... If EMU does come into existence, as now seems increasingly likely, it will change the political character of Europe in ways that could lead to conflicts in Europe... What are the reasons for such conflicts? In the beginning there would be important disagreements among the EMU member countries about the goals and methods of monetary policy. These would be exacerbated whenever the business cycle raised unemployment in a particular country or group of countries. These economic disagreements could contribute to a more general distrust among the European nations.

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 the 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 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 be 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.

Update: Some observers question whether ECB monetary policy was really too tight during the crisis. The answer is yes. For evidence, see my paper or this earlier post that shows a tight relationship between Taylor Rule gaps - a measure of the stance of monetary policy - and economic growth in the Eurozone. Some are also reminding me that it was Jean Claude Trichet's ECB that made the mess, not Mario Draghi's ECB. Fair enough.

Other folks are pushing back against the monetary origin view altogether saying this crisis is really a balance of payment crisis or a creditor-debtor crisis. As a proximate cause, yes, but as an ultimate cause, no. To see this, recall that the deflation experienced in the periphery has meant creditor countries like Germany are getting real wealth transfers from the periphery. The ECB could have prevented this outcome had it prevented deflation and the lower-than-expected inflation that followed. Also consider what would have happened had the ECB adopted a price level target. It would have required a temporary period of higher-than-normal 'catch-up' inflation that would have further moderated the imbalance between creditor-debtor countries in the Eurozone.

Country-specific developments with the higher inflation growth would have further reinforced this rebalancing. Prices would first grow faster in the regions with the least excess capacity, the core countries. During this time, goods and services from the periphery countries would then become relatively cheaper. Consequently, even though the exchange rate among the regions would not change, there would be a relative change in their price levels making the periphery countries more competitive.

The Trichet ECB could have done a lot more to prevent the creditor-debtor problems from reaching this tipping point. Instead they behaved like Sadomonetarists, as noted by Paul Krugman. There is more on the creditor-debtor point in the paper.