Is the euro crisis real or nominal?

The answer is both.  But I think the nominal aspect may be greater than people realize.  First let me concede that there are severe real problems in the heart of the eurozone.  Here is Wolfgang Munchau:

What is the size of the problem? International Monetary Fund estimates suggest that the eurozone is well behind the US in terms of writing off bad assets. I have heard credible reports suggesting that the underlying situation of the German Landesbanken is even worse than those estimates suggest. Last year, a story made the rounds in Germany, according to which a worst-case estimate would require write-offs in the region of €800bn – about a third of Germany’s annual GDP. If you were to add this to Germany’s public debt, you might jump to the conclusion that Greece should bail out Germany, not the other way round. While that is probably a little exaggerated, there are serious questions about whether the eurozone is still in a position to issue such massive guarantees. So, given what happened to those subprime CDOs, what hypothetical rating should we then attach to that €440bn eurozone SPV? A triple A?

By they way, I found this in an excellent Arnold Kling post, which also links to a rather astounding aspect of our new health care bill.

But let’s also consider the recent trends in asset prices.  Since the peak of May 3rd, the Greek crisis  (along with some other related issues) have depressed commodity prices more sharply in American than Europe.  No surprise there, as the dollar has appreciated.  But look at these recent stock market movements in local currency terms:

US S&P500:  Down 12%

Belgium:  Down 6.6%

France:  Down 13%

Germany:  Down 8%

Holland:  Down 9.6%

(Update:  My apologies, the Dutch and Belgian numbers were off, down 12% and 9.4%.  So the difference is perhaps too small to be significant.)

So stocks in the heart of the eurozone, the area with many banks that are highly exposed to Greek and Spanish debts, are actually down a bit less (on average) than the US.  Perhaps the strong dollar is part of the reason.  Perhaps monetary policy has become tighter in the US than Europe.  I’d be the first to admit that these data are merely suggestive, and next week the stock markets may tell a completely different story.  But when combined with commodity prices, TIPS spreads, etc, it suggests to me that the problem is not just the real effects of financial turmoil, but the way the real sector shocks interact with monetary policy to cause unintentional tightening.

Just to be clear, I think the problems in Greece and Spain are mostly real.  Tight money has made their problems worse, and that’s unfortunate.  But they also had real fiscal and housing problems than can’t be papered over with modestly higher NGDP in the eurozone.  Tyler Cowen has a very good article on Greece.

There are a couple blog posts by David Beckworth and Ryan Avent that discuss whether we are in danger of a second dip.  I basically agree with Ryan, although at the risk of sounding wishy-washy I think David’s prediction will be right in the end.  By that I mean that financial market indicators have reached worrisome levels, as Ryan notes, but are not bad enough to push the risk of a double-dip recession over 50%.  Indeed I think it’s more like 20% or so, if I had to guess.  But avoiding an outright double-dip shouldn’t be the measure of success, so I am with Ryan on the need for central banks to be more aggressive.

Update:  Well that didn’t take long; the late day rally in the S&P somewhat reduced the US market’s decline since May 3rd.  But until the European markets have a chance to react, we won’t know whether the gap has actually been narrowed.  (Maybe traders read my post and realized; “Wait, Sumner’s right, there’s no reason for the US market to fall more sharply than European markets.”)


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10 Responses to “Is the euro crisis real or nominal?”

  1. Gravatar of Mark A. Sadowski Mark A. Sadowski
    25. May 2010 at 14:16

    The S&P European 350 index (IEV) is off about 20% since late April.

    I think its hard to make a judgement as to whether financial markets are signaling a greater decline in AD here or in Europe. One problem is that the dollar still holds an inherent risk advantage over the euro, so whenever there is a global decline in AD the dollar goes up relative to the euro. However, if one looks at 10 year bond yields I would have to point out that there’s been a larger decline (about 100 vs 80 basis points in the core eurozone vs the US) over a longer period (11 months vs 7 weeks in the core eurozone vs the US) in yields in the core eurozone than in the US. I would argue that monetary policy has been tightening in the eurozone for a while whereas there has been a more recent and sudden shock to money demand in the US.

    In the nominal vs real debate I think I lean even more in the nominal direction than you Scott (if that’s possibe). Greece’s problems do have a large real component as there is plenty of evidence of fiscal profligacy and other policy failures. However, Spain and Ireland? Sure they had a housing bubble but they had relatively low public debt levels and were running fiscal surpluses prior to the recession.

    The negative AD shock hit those European countries that were growing the fastest, with the highest levels of investment, and the largest current account deficits the most. This includes such neoliberal wonders as Ireland and the Baltic states (which are of course pegged to the euro). I find it hard to believe that there is anything “real” that caused NGDP to decline by up to 30% in those countries. I also believe that a boost in eurozone NGDP would not affect each country symmetrically. My intuition tells me that the countries that have deflated the most would also be reinflated the most.

    Those that argue for real causes are pointing primarily to the real estate “bubbles.” But I remind them that both Australia and Poland had large real estate price booms and yet neither has even suffered a recession probably due to the fact they both kept NGDP growing at a steady rate.

  2. Gravatar of pct pct
    25. May 2010 at 14:21

    Here is what showed in by inbox this morning from the WSJ: “All of the Dow’s 30 components opened in the red, led by a 5.5% drop in Caterpillar.” Banks don’t use bulldozers to move bad loans off their books, and the Greek heavy construction equipment market has to be pretty trivial in the grand scheme of things. It looks to me as if investors are worried about deteriorating growth in the actual real economy when they trash CAT.

  3. Gravatar of Norman Norman
    25. May 2010 at 16:10

    Slightly off-topic: It occurs to me that the term you use, ‘unintentional tightening,’ is pretty central to your broad thesis for this blog. The mainstream view in economics seems to be that, since central banks (supposedly) control the M in M*V=P*Q perfectly, all monetary policy is by definition active and intentional. I think a big part of educating policymakers and other economists has to do with realizing that tightening and loosening of monetary policy can be passive as well as active.

    I realize you’ve talked about this before, but this is the first time the distinction really crystallized for me.

  4. Gravatar of scott sumner scott sumner
    25. May 2010 at 16:57

    Mark, Very good observations. My only question is the 20% figure for stocks. Have other countries gone down much more than the ones I mentioned? I ask because even if you started in late April I don’t think those have fallen by 20%, but perhaps I made an error somewhere.

    But your general point that nominal shocks have differential real effects is a good one.

    pct, Yes, and this might also reflect China worries. They sell quite a lot of equipment to China. Asian stocks are also off sharply, so I worry about a global slowdown. Of course the US and China are joined at the hip through the dollar peg (monetarily, not in real terms.)

    Norman, Good point, although the mainstream view is more complicated. For many Keynesians a tightening in policy means higher interest rates. For monetarists it is a lower money supply. Those are two very different things (as we saw in the Great Depression. So both groups think I am weird, but they also think each other is weird.

    I believe (like Lars Svensson) that the Fed should target expectations. So for me falling expectations of inflation, or better yet NGDP, means tight money.

  5. Gravatar of Mark A. Sadowski Mark A. Sadowski
    25. May 2010 at 17:55

    Scott,
    I don’t know why the IEV is off so much. I only point to it as one more piece of evidence.

  6. Gravatar of StatsGuy StatsGuy
    26. May 2010 at 05:32

    Kling also writes:

    “Snarkiness aside, what should “we” do about irresponsible parents? The libertarian answer is that “we” should not do anything as a state… From that standpoint, the failure to advocate the use of the state to alter other people’s objectionable behavior amounts to condoning such behavior.”

    Kling never ceases to amaze. So long as libertarians rigidly apply their anti-communitarian ethos to children – treating them like property – then they will continue to marginalize themselves in the court of public opinion.

    It seems there are two challenges to state intervention to protect children: the ideological challenge, and the competency challenge. The competency challenge is a tough question – can local govt. actually help? (Has provision of publicly funded schools – whether publicly administered or charter – increased chances of children to emerge from violent/dysfunctional homes, etc.?)

    But Kling doesn’t engage the empirical challenge. He goes right after the ideological challenge, indicating not that the state can’t successfully intervene, but that it SHOULD NOT intervene.

    Why, again, do you hold this fellow in such high esteem?

  7. Gravatar of W le B W le B
    26. May 2010 at 07:17

    When central bankers and politicians wrongly interpret the components of inflation they tighten when they should be easing. Because they are ideologically opposed to admitting the importance of money they remain blind to the process and consequences of the destruction of money. In the UK out money supply figures for M4 and M4 lending should be triggering alarm bells but among commentators there is no reference to them. They can be found here: http://www.bankofengland.co.uk/statistics/m4/current/index.htm

  8. Gravatar of ssumner ssumner
    26. May 2010 at 09:12

    Statsguy, As you know I am a libertarian, so I won’t defend Kling on this. I find him to be a very astute critic of the flaws in governmental regulation. He’s sees lots of things I missed, but felt I should have seen–like the silly family income aspect of the health bill. I think he also undertands the value of decentralization as compared to central planning much better than most.

    BTW, What if the Congo offers no opportunities for those with primary eduication? Maybe it would be rational for dads to drink in such a dead end environment. Of course I’m being provocative, and I don’t doubt the other side is probably right, but I really don’t think I know enough about their world to make a snap judgement.

  9. Gravatar of ssumner ssumner
    26. May 2010 at 09:15

    W le B, I am dubious of the aggregates, but have made the same argument as you. Those who focus on money should be sounding alarm bells now, but most aren’t. So I’m glad you are making this point.

  10. Gravatar of TheMoneyIllusion » Using the “I told you so” argument TheMoneyIllusion » Using the “I told you so” argument
    9. November 2010 at 14:44

    [...] Of course people could argue that “hindsight is 20-20″ and that the Fed had no way of knowing last spring that the euro crisis would end up hurting the US more than Germany.  Unless, of course, they read TheMoneyIllusion.  The following essay was published by the online Economist in August, but note the embedded quotation that was published in my blog back in May: Back in May and June there was a lot of talk about the bleak outlook for the euro zone. Recall that the problems in Greece, and more broadly all the so-called “PIIGS”, had created doubts about the soundness of banks in France, Germany, and the Netherlands. In late May I made this observation in my blog: [...]

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