Did the ECB Tank the Euro Zone?

Why did US growth diverge from that of Europe after 2011?

From 2006 until 2011, the US and Europe largely tracked each other.  The European Union (EU) and Euro Area countries outperformed the US from 2006 to 2008, but essentially ceded this advantage during the recession.  Europe and the US largely tracked each other during the recovery from 2009 to 2011.  In 2011, the Euro Zone fell back into recession even as the US found its footing.   

Euro Zone EU US GDP Cume Growth.png

Index of Cumulative GDP Growth (2006 = 100)

Source: OECD.StatExtracts (Expenditure approach)

What explains this stark divergence of growth?  Did monetary policy play a role?  Some economists, for example, Scott Sumner of Bentley University, argue that the European Central Bank tightened monetary policy at a particularly inopportune time, raising the Euro Zone discount rate by 0.25% in each of April and July 2011, from 1.75% to 2.25%.  The Euro Zone promptly fell into a recession from which it had not emerged three years later. 

Euro US Discount Rates.png

US and Euro Area Discount Rates 2004-2014

Source: FRED

There can be no question that these interest rate increases were poorly timed and contributed to the downturn in the Euro Zone.  However, one has to question whether a 50 basis point interest rate bump is sufficient to send a continent into a three year downturn, particularly when the increase was reversed within six months.  It seems to imply some sort of nuclear hair trigger, in which a small interest rate adjustment pushes an economy over a cliff from which it falls without end.   To make this case plausibly, one must make three arguments. 

First, one must argue that the economy was in some specific state, standing at the edge of an economic cliff, as it were, from which a small interest rate move triggered a larger economic meltdown.  This is no mean feat.  Both the US Federal Reserve and the German Bundesbank (before the establishment of the European Central Bank) raised interest rates by as much or more on many occasions without prompting recessions. Indeed, the Fed terminated QE1 and raised the US discount rate by 25 basis points in early 2010 without plunging the US back into recession.  Why then did ECB’s modest 2011 rate increase sink Europe?

Further, the interest rate effect must be asymmetrical.  An increase must be more damaging, indeed, much more damaging than an interest rate cut.  The rapid reversal of the mid-2011 interest rate did not result in a recovery of the European economy.   Why would this be so?

Finally, the destruction must be enduring.  Even the financial crisis of 2008 lasted only five quarters.  Since 1970, the longest previous recession in the Euro Area was associated with the Second Oil Shock and lasted 10 quarters, from early 1980 to late 1982.  The 2011 European recession had lasted 12 quarters as of the writing of this book.  Thus, the “hair trigger” view would argue that a half percentage point increase in the discount rate could lead to the longest European recession since the Great Depression.  This seems rather a stretch.

Nor can the divergence between Europe and the US after 2011 be attributed to some innovation in US monetary policy.  QE1 had ended in early 2010.  QE2 was launched in Nov. 2010, a full year before the Euro Area relapsed into recession. 

Moreover, the Fed itself considered the effect of QE2 to be small, fleeting, and indirect.  For example, Fed economists estimated that QE2

added about 0.13 percentage point to real GDP growth in late 2010 and 0.03 percentage point to inflation.

[Our model suggests] the 0.13 percentage point median impact on real GDP growth fades after two years. The median effect on inflation is a mere 0.03 percentage point. To put these numbers in perspective, QE2 was announced in the fourth quarter of 2010. Real GDP growth in that quarter was 1.1% and personal consumption expenditure price index (PCEPI) inflation excluding food and energy was 0.8%. Our estimates suggest that, without LSAPs, real GDP growth would have been about 0.97% and core PCEPI inflation about 0.77%.

Our analysis suggests that forward guidance is essential for quantitative easing to be effective. Without forward guidance, QE2 would have added only 0.04 percentage points to GDP growth and 0.02 to inflation.

Our estimates suggest that the effects of a program like QE2 on GDP growth are smaller and more uncertain than a conventional policy move of temporarily reducing the federal funds rate by 0.25 percentage point.

In other words, by Q3 2011, the effects of QE2 on the US economy would have been minimal, not more than 0.07 percentage points of GDP.  Therefore, we can conclude that on the only material difference in monetary policy between the US and Europe during late 2011 was a 50 bp ECB interest rate increase in mid-2011. 

We have also determined that there is no clear relationship between fiscal stimulus and GDP growth, and indeed, the US fiscal deficit was declining faster than that of the European Union throughout the post 2011 period.  

Therefore, it may be fair to argue that there is no clear fiscal or monetary event that explains the lasting divergence of European from US growth paths after late 2011.  Those seeking an answer will be compelled to look elsewhere.

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http://www.frbsf.org/economic-research/publications/economic-letter/2013/august/large-scale-asset-purchase-stimulus-interest-rate/