Thursday, November 15, 2012

Europe in Crisis, Part 93814


Well, as you may have finally heard, Europe stopped teasing us with the prospect of recession and cut straight to the chase today, finally contracting by 0.4% last quarter and officially entering a recession. Although this new-found distinction is meaningless in the grand scheme of things since Europe's been on the ropes for years now, it gave me an excuse to write about it. Also, I'm doing a presentation on the Eurozone today and felt like sharing some of my discoveries.

My particular presentation is about the European Central Bank's (ECB) reaction to the crisis. Or is it crises, now? Anyways, up until Mario Draghi announced his unlimited bond-buying program, I've felt that the ECB's reaction to the crisis was incredibly inadequate. More specifically, I think that its monetary policy has been far too tight. I would say that there are probably two reasons for this:
  1. Germany's fear of/hatred of inflation in any and all forms.
  2. The price index that the ECB uses to gauge inflation has a fairly severe flaw.
The first reason is one that I've explained before, so I'll outsource on it:
"The Germans, of course, have an almost paralyzing fear of inflation, one which brings up images of wheelbarrows full of cash being used to buy bread, as well as the rise of Hitler and the Nazi Party. While the bit about wheelbarrows is true, the fact is that hyperinflation had little to do with the Nazi Party's rise to power. Hyperinflation ended in 1924 in Germany, and Hitler wasn't sworn in as Chancellor until January of 1933. Might there have been something happening during those nine years? Something of the "Great Depression" variety? Via Clayton White:
"Inflationary finance did not bring about the Nazis; mass unemployment did. Crushing debt burdens owed to foreigners did. Foreign mandates imposed in a beleaguered population did. THAT'S the kind of environment that leads to radical leaders whose messages of spite and hatred can take root."
Between 1924 and 1929, the German economy was pretty prosperous, by the way. So Germany ought to get its facts straight, lest the rest of Europe pay an even higher price just because the members of the Bundestag didn't pay much attention in history class."
The second reason is probably far more interesting (to me, at least). The ECB's inflation target is to achieve a yearly increase in consumer good prices of around 2% a year. That's fair enough, I suppose. Here's the issue though: the price index they use doesn't include house prices. There's an obvious problem with this, of course. You all might have heard a little something about housing prices plummeting around 2008. So what's the implication for the ECB's monetary policy?

Well, without including depressed housing costs into their price index, the ECB is overstating the overall level of inflation in Europe. This, in turn, has led them to be far more fearful of actually easing monetary policy, to the point of not even cutting interest rates to zero percent! So it isn't as if they can't ease at least a little bit more, it's just their fear of inflation which is exacerbated by their faulty price index. To help illustrate matters, here's a graph of two different measures of inflation in Europe, one with housing prices and one without them:



The graph below is also pretty informative, too. You'll notice that the Eurozone has fallen way below trend on inflation.



Of course, I'm not arguing that all of that disparity is due to housing prices, but you can't realistically deny that some of it is. 

All of this leads me to conclude that money in Europe during the crisis has been too tight. Sure, interest rates are low, but interest rates are fairly meaningless when they're not put in context. For example, interest rates in Europe were cut during the crisis, which means money was easier, right? If money is easy, you'd expect a growth in the overall money supply, right?

Exhibits A and B:



This is of course, not to confuse the difference between the monetary base and the money supply. Just as an aside, the monetary base is the total money "printed" by the central bank, whereas the money supply is all of the money in the economy. The point of using the total money supply rather than the monetary base here is to show that the central bank has failed to ensure stable money supply growth that is critical to economic growth. But I digress...

Anyways, if the ECB wanted easier money, shouldn't the money supply have started growing faster around late 2008, not slower? There's a notable shift to slower money growth there, which is really the only meaningful way to know the stance of monetary policy, as you'll see below.


And this graph, inspired by Clayton White does a great job of illustrating my point: interest rates fell along with the growth rate of the money supply. South Park best explains my sentiments on this:



Money is loose, they said! Interest rates are at historic lows, they said.