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Once Again, Europe And The Eurozone's Problem Is Monetary, Not Fiscal

This article is more than 9 years old.

If you're a Keynesian you'll be pointing at the current economic malaise in the eurozone and shouting that this is a fiscal problem. That governments should, in a recession or near depression, be spending more, fiscally stimulating the economies. It's only because everyone is in thrall to austerity that the bad times are continuing. If you're of a more monetarist cast of mind you'll equally be leaping up and down shouting that it's all a monetary problem. Europe has tight money and that's not what you need in a recession or near depression. So get on with the quantitative easing already and let's get this thing solved. You could also be of either flavour and agree with Robert Mundell that the eurozone isn't an optimal currency area and this would immediately become apparent the moment there were any economic difficulties. That third idea is obviously correct but there simply isn't the political will to do what must be done, which is break up the euro.

It's also true that the loss of GDP in many areas of the eurozone is now worse than it was during the Great Depression (although for almost everyone, not as bad as the US had it at that time). Equally, for a number of countries not in the eurozone this time around has been much milder than that Great Depression. So, working out which answer is correct, Keynesian or monetarist is something of a certain amount of interest.

And here's some interesting work about Finland: and Finland is especially interesting because they had a third near depression, when the Soviet Union broke up. And that evidence is?

So here is the paradox – in 1931 two years into the crisis and with a real GDP lose of around 5% compared to 1929 the Finnish government decided to implement significant monetary easing by devaluing the Markka.

In 2011 three years into the present crisis and a similar output lose as in 1931 the ECB decided to hike interest rates! Hence, the policy response was exactly the opposite of what the Nordic countries (and Britain) did in 1931.

The difference between monetary easing and monetary tightening is very clear in the graph. After 1931 the Finnish economy recovered nicely, while the Finnish economy has fallen deeper into crisis after the ECB’s rate hikes in 2011 (lately “helped” by the Ukrainian-Russian crisis).

This really is all about monetary policy. The original creation of the euro was a mistake: it could have been done reasonably in a much smaller area, perhaps Germany, Austria and Benelux but no larger. Once any of the Latin countries came in it was a bad idea. But it's been made worse than it needs to be by the way that the ECB is set up. It's not actually allowed to do extensive quantitative easing in the same way that the Fed of the Bank of England can. And it has also been pursuing a policy of tight money in a time of recession: exactly what it shouldn't be doing and the very thing that Ben Bernanke pledged not to do because that's the mistake the Fed made in the 1930s.

Essentially, what's happening here in Southern Europe at present is the result of a bad design combined with incompetent management of monetary policy. And what makes it all the more appalling is that almost all of us who read this, plus those who make the policy, will be almost entirely unaffected by it. It's those 50% of Spanish and Greek youth, the 40% of those here in Portugal, who do have to suffer it. And all because of a simple misunderstanding about monetary policy.

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