Krugman on European growth and the euro

In a recent post I responded to this claim by Paul Krugman:

I’ve already argued that the fall in the euro is much bigger than you can explain with monetary policy; it seems to reflect the perception that Europe is going to be depressed for the long term. And if that’s what drives the weak euro/strong dollar, it will hurt US growth.

I said (without reading the linked to post):

I agree with the reasoning process in the last sentence.  But I don’t think it applies to the current case, as it seems very unlikely that lower growth expectations are what is depressing the euro.  Here’s what we do know:

1.  Eurozone growth expectations have been in the toilet for years.

2.  The euro was valued at about $1.35 for years, and then gradually fell to about $1.05 over the past few months.

3.  During the past few months the growth forecasts of the eurozone have been revised upward, as the euro has been falling.

You don’t need to be an EMH fanatic like me to see a problem with Krugman’s argument. Kudos to him for not reasoning from a price change, for not lazily assuming that a weaker euro meant more growth.  But I think’s he’s gone too far in the other direction, in assuming that the cause of the weaker euro was lower growth expectations.

Vaidas Urba suggested I do look at the linked post.  And I was quite shocked to find it began as follows:

Watch that plunging euro! Actually, it’s good news for Europe. European growth numbers have been better lately, and the weak euro “” which makes EZ manufacturing and other tradables more competitive “” is surely a large part of the explanation. Not so good for Japan or the US. But how should we think about this?

Wait, that’s my argument—the weaker euro is associated with stronger eurozone growth.  Therefore it’s monetary stimulus at work.  But if you read the entire post you’ll see Krugman does actually have a good argument, albeit one that raises as many questions as it answers.  And I might add that it’s one I’m pretty sure that 99% of his readers would not have understood.

Let’s first discuss Rudi Dornbusch’s (1975) overshooting model, which is sort of lurking in the background.  Dornbusch thought about the impact of monetary stimulus in a world of interest parity, PPP and sticky prices.  The result is quite odd. Suppose the ECB does a once and for all permanent 10% increase in the money supply.  The quantity theory says this will raise prices by 10% on the long run.  And PPP says that will depreciate the euro by 10% in the long run.  So far, so classical. But sticky prices imply a liquidity effect, thus the monetary injections lower nominal interest rates for a few years.  And because of the interest parity condition, lower interest rates imply a higher expected rate of appreciation in the euro. But didn’t I just say the euro would depreciate?  Yes I did, and there is no contradiction.  If you are not seeing the answer, you need to think outside the box. First do some brain exercises.  Connect these 9 dots with 4 lines, without taking your felt tip pen off the paper:

Screen Shot 2015-03-16 at 12.25.14 PM

For simplicity, suppose we started with US and eurozone interest rates being equal. After the monetary injection the eurozone rates are lower.  So the euro is expected to appreciate.  But in the long run it’s expected to be 10% lower.  That means the immediate effect of a monetary stimulus shock must be a more that 10% decline in the euro.  Dornbusch called this exchange rate overshooting.  The model is composed of 4 theories (QTM, PPP, IPT, liquidity effect.)  Most of us are not as adept at juggling 4 theoretical balls in the air at the same time as Krugman, so we struggle with the concept.  As for empirical evidence, these things are hard to test. I’d argue that each component is pretty well established, and that’s good enough (and I suspect Krugman would agree.)  In any case, it’s too beautiful a theory not to use once and a while.  Here’s Krugman:

So, can we say anything about how the recent move in the euro fits into this story? One way, I’d suggest, is to ask how much of the move can be explained by changes in the real interest differential with the United States. US real 10-year rates are about the same as they were in the spring of 2014; German real rates at similar maturities (which I use as the comparable safe asset) have fallen from about 0 to minus 0.9. If people expected the euro/dollar rate to return to long-term normal a decade from now, this would imply a 9 percent decline right now.

What we actually see is almost three times that move, suggesting that the main driver here is the perception of permanent, or at any rate very long term European weakness. And that’s a situation in which Europe’s weakness will be largely shared with the rest of the world “” Europe will have its fall cushioned by trade surpluses, but the rest of us will be dragged down by the counterpart deficits.

Now, this is not how most analysts approach the problem. They make a forecast for the exchange rate, then run this through some set of trade elasticities to get the effects on trade and hence on GDP. Such estimates currently indicate that the dollar will be a moderate-sized drag on US recovery, but no more. What the economic logic says, however, is that if that’s really true, the dollar will just keep heading higher until the drag gets less moderate.

Krugman’s looking at real rates to abstract from inflation.  While the Dornbusch overshooting model does a nice job of explaining the recent dramatic plunge in the euro, the model also predicts that the real exchange rate is unaffected in the long run. But that’s because interest rates are unaffected in the long run.  Krugman’s readers don’t know this, but unless I’m mistaken he’s arguing that the recent fall in long-term interest rates in Europe is the income effect, not the liquidity effect.  I actually like that argument, but it’s not the way Keynesians usually look at changes in long-term rates occurring in close proximity to QE.  Most Keynesians would say the ECB is driving bond long term bond yields lower.

So Krugman’s arguing that the big fall in the expected 10-year future exchange rate reflects worsening prospects for long term European growth, not just monetary stimulus.  That argument makes sense to me.  But he’s also arguing that this increasing long-term pessimism occurred at almost exactly the same time that expectations of short-term growth became more optimistic.  That might be true, but I kinda doubt it. And yet I can’t think of a better explanation for the fall in the future expected value of the euro.

So I’ll file this under “unresolved problems.”

PS.  He ends up relying on liquidity trap arguments to draw policy conclusions for the US.  But as I argue in today’s Econlog post (later this afternoon), those arguments are rapidly approaching their “sell by date.”

PPS. The eurozone demand side recession is likely to be over in 10 years.  That means Krugman’s hypothesis implies severe structural problems in Europe—bad news for a continent with 7% of the world’s people, 25% of the world’s GDP, and 50% of the world’s social spending.

PPPS.  Oh yeah, the puzzle.  Because Ray claims his IQ is only 120, he probably provided answer #2. But answer #1 is correct.  I’m sure Rudi would have been able to solve the puzzle. My dad did it first in a competition among friends back in 1962.

Screen Shot 2015-03-16 at 1.23.08 PM



39 Responses to “Krugman on European growth and the euro”

  1. Gravatar of benjamin cole benjamin cole
    16. March 2015 at 09:41

    “The eurozone demand-side recession is likely be over in 10 years.”–Sumner.
    Interesting post.
    In Japan monetary policy suffocated demand for 20 years. Recession? Well…maybe just very ow growth and perma-recession for the southerners…
    But…I have been looking at cash in circulation, now at $7500 in Japan, dollar equivalent. Oh? And no one says, “You know, they use the yen to do drug deals.”
    Things may be better than measured in developed nations, due to large cash economies.

  2. Gravatar of benjamin cole benjamin cole
    16. March 2015 at 09:47

    $7500 per capita

  3. Gravatar of E. Harding E. Harding
    16. March 2015 at 09:55

    I didn’t realize you were allowed to go outside the boundaries of the square.

  4. Gravatar of Pemakin Pemakin
    16. March 2015 at 10:03

    A small variation of #2 is the “solution” for connecting 9 dots with three lines.

  5. Gravatar of foosion foosion
    16. March 2015 at 10:07

    OT, from Brad DeLong:

    “I am happy to say what I have gotten wrong since 2005:

    “Believing that central banks would make stabilizing the path of nominal GDP around its previous long-term trend their first and overwhelming priority, and would not rest until they had done so.”

  6. Gravatar of TravisV TravisV
    16. March 2015 at 10:20

    Is Krugman’s feud with Sumner substantive at all or does he just fear Sumner?

  7. Gravatar of TravisV TravisV
    16. March 2015 at 10:22

    Recent context (where Krugman discusses Dornbusch):

    Reading those posts, I’m convinced Krugman is a Market Monetarist, he’s just pretending he isn’t one. Here’s more proof:

    “Beckworth offers as an example of how it should be FDR’s exit from the gold standard, which was expected to “” and actually did “” signal a permanent increase in the monetary base. Indeed, if you want to get monetary traction at the zero lower bound, that’s how to do it.”

  8. Gravatar of Thanos Thanos
    16. March 2015 at 10:33

    Mr Sumner i have one question:

    What would the consequences of a Grexit be for the Eurozone?? I live in Europe and the politicians here everyday say they are convinced that a Grexit would be a non-event for the Eurozone! Can this be possible??

  9. Gravatar of Brian Donohue Brian Donohue
    16. March 2015 at 10:55

    @E. Harding, classic inside-the-box thinking.

  10. Gravatar of Brian Donohue Brian Donohue
    16. March 2015 at 10:58

    @TravisV, I agree. The reason “Keyensians who know” don’t trumpet MM ideas more loudly is that they can’t get past their desire for big new fiscal projects, notwithstanding the fact that, five years after the recession, the federal deficit is still almost $500 billion per year while the Boomer entitlement tsunami inches closer and closer.

  11. Gravatar of Ray Lopez Ray Lopez
    16. March 2015 at 11:05

    I admit: I had seen solution #1 before, but at this late hour (it’s 3:00 AM in Manila) I forgot it, and failed. My IQ must be slipping. But in fact, on a sphere, the solution #2 is correct (Riemann geometry) and only three lines need be used (each straight line going to the poles, where they meet).

    As for the substance of this post, I have no comment, but it reminds me of the “J-curve” in trade theory, which also assumes sticky prices (and volumes), see:

    I think Sumner is brilliant–when he sticks to microeconomics. That’s true probably for most economists.

  12. Gravatar of TravisV TravisV
    16. March 2015 at 11:31

    Brian Donohue,

    Thanks! I think Krugman genuinely had it wrong in early 2009 and Sumner eventually persuaded him that he had it wrong. Of course, Krugman is never going to admit that, but deep down he probably knows it.

    Larry Summers also had it wrong for years. As a result, the Fed has never been a priority for Obama and the economic recovery has been horribly horribly weak.

    See this brilliant analysis by Yglesias:

    Even today, almost no elite liberals grasp how crucial an issue monetary policy is. They take their cues from Krugman and Summers, so they deserve the lion’s share of the blame for that failure.

  13. Gravatar of ssumner ssumner
    16. March 2015 at 12:47

    Ben, Do you have a link for that earlier comment about the Fed refusing to provide info on what countries get our currency?

    I’ll address the other comments later.

  14. Gravatar of Brian Donohue Brian Donohue
    16. March 2015 at 12:50

    @TravisV, Yeah, I was guilty of underestimating monetary policy myself. It’s taken me a long time to even partially get my brain around Sumner’s position. Most people aren’t close. Not just on the left either.

    The left wants fiscal stimulus, while the right don’t trust those shifty-eyed money printers at the gubmint, and half of them stop listening upon seeing the word ‘aggregate’ anyway.

  15. Gravatar of flow5 flow5
    16. March 2015 at 13:09

    James Picerno has an interesting graph on the MB [sic] and QE; (deflates it by using the CPI).

  16. Gravatar of TravisV TravisV
    16. March 2015 at 14:13

    Brad DeLong is negative on the Efficient Market Hypothesis but it’s hard to pin down exactly whom he’s criticizing…..

  17. Gravatar of dtoh dtoh
    16. March 2015 at 14:55

    Scott, the real question is can you do it with one line?

  18. Gravatar of dtoh dtoh
    16. March 2015 at 15:37


    And BTW, this is the same reason you need four theories to explain the fall in the Euro. If you properly understood the transmission mechanism for monetary policy, you could explain it with one theory.

  19. Gravatar of ssumner ssumner
    16. March 2015 at 17:21

    E. Harding, Well I did say think outside the box. 🙂

    Foosion, I got exactly the same thing wrong.

    Thanos, I think it would be a significant event, but I really don’t know how significant. It depends how committed the rest of the countries are to keeping it together.

    Ray, You said:

    “My IQ must be slipping.”

    Below 120?

    dtoh, Oh, I forget to say “straight” lines. 🙂

    I don’t need four theories to explain the fall in the euro, I said there are 4 hypotheses. That’s very different.

  20. Gravatar of Benjamin Cole Benjamin Cole
    16. March 2015 at 20:36

    Side note to Scott: See link below. This paper discusses the pallets of 640,000 Benjamin Franklins each the Fed sends to other central banks (of more than 100 nations):

    See page 11. You will note you can read this whole report until your eyes pop out, thinking you must have missed something, but no…they never reveal who gets the pallets.

    On “confidential,” that comes from the researcher you already know, Edgar Feige, University of Wisconsin (now there is a state).

    But then, in a footnote in a 2012 paper, Feige says the data, at least in broad form, is no longer confidential. See page 1 bottom,

    Still, I think the data is largely confidential, in that no county-by-country figures appear available. There is some aggregate figures Feige works with.

    BTW, Feige musters evidence that perhaps only 25% or less of US currency is actually abroad. He has been looking at cash for decades.

    I will address this topic in a pending Marcus Nunes guest post. The real story seems to be that high income advanced nations with high tax rates have a lot of cash in circulation. As in Japan, with $7,500 per capita. So the “all the U.S. cash is doing drug deals” story line begins to look weak.

    There is a vague reference made to a Fed researcher named Judson, who may or may not have revealed some of the confidential data at some point, but when I read her 2012 piece, I see no national numbers:


    So there you go. If you do find any details on when and where the pallets of $64 million are shipped let me know. It seems to me that somewhere I read about $70 billion going to Russia, and of course there were stories about cash pallets in Afghanistan.

  21. Gravatar of Lupis42 Lupis42
    17. March 2015 at 02:04


    Why not just draw a W, like so:

    | | |

    The pen never need leave the paper, and the dots are connected with 4 lines. There’s nothing saying the pen can’t retrace it’s steps, or that each line must be drawn from start to finish in one pass…

  22. Gravatar of dtoh dtoh
    17. March 2015 at 03:46

    Then I’ll rephrase the question and the statement.

    “Can you do it with one straight line?”


    “You could explain it with one theory instead of 4 hypotheses.”

    And I think you said “theories” not “hypotheses” in you post.

  23. Gravatar of Ray Lopez Ray Lopez
    17. March 2015 at 05:11

    @ Benjamin Cole — This is crazy interesting, thanks for the paper, it may explain why M1 broke down as a monetary guideline in the 1980s. Your post to Sumner sounds like an Illuminati coded message, perfect for this blog! LOL.

    As for one line to connect all nine dots, that’s easy, just glue the paper onto a globe, and simply trace from North pole to South pole and back, through the three rows. By definition straight lines on a sphere meet at the North and South poles, unlike in a Euclidean plane. And in the real world due to gravity there is always curvature of space so we live in a non-Euclidean geometry.

  24. Gravatar of dtoh dtoh
    17. March 2015 at 05:34

    There are Euclidian solutions as well.

  25. Gravatar of J.V. Dubois J.V. Dubois
    17. March 2015 at 06:23

    “The eurozone demand-side recession is likely be over in 10 years.”

    This may be true for the demand side recession experienced today (with double digit unemployment and all that). But what about demand side recession that we may see 9 years into the future? If ECB keeps being hopelessly behind the curve then the inefficient monetary policy framework as a whole becomes one of the key “severe structural problems”. It would not be for the first time where inept monetary policy created problems for years and decades.

  26. Gravatar of Edward Edward
    17. March 2015 at 07:47

    Your thoughts on Israel’s economy and the Israeli election.

  27. Gravatar of Edward Edward
    17. March 2015 at 07:47

    Your thoughts on Israel’s economy and the Israeli election.?

  28. Gravatar of TravisV TravisV
    17. March 2015 at 08:51

    Noah Smith praises the IP protections in the Trans-Pacific Partnership:

  29. Gravatar of ssumner ssumner
    17. March 2015 at 13:50

    Thanks Ben, There’s a couple things I like about the recent Feige paper:

    1. He cites me.

    2. He estimates that most currency is held in the US, which was my view 30 years ago when I researched this topic.

    Lupis. Excellent.

    dtoh, I look forward to your one theory proof of overshooting.

    JV, You said:

    “It would not be for the first time where inept monetary policy created problems for years and decades.”

    Actually I think it would be the first time that inept monetary policy had a significant impact on output several decades later.

    Edward, I don’t really know enough to comment, but I might say something about Israeli inequality in a future post.

  30. Gravatar of TravisV TravisV
    17. March 2015 at 14:55

    Wow, German stocks are up 40% over the past five months!

    Incredible turnaround from five months ago: “Mario Draghi’s German problem”

  31. Gravatar of Derivs Derivs
    17. March 2015 at 16:20

    “Wow, German stocks are up 40% over the past five months!”

    Oct was pretty volatile and a tough month to benchmark with, but using Aug as a benchmark it looks almost exactly where it should be.

  32. Gravatar of Major.Freedom Major.Freedom
    17. March 2015 at 17:01

    Benjamin Cole:

    “In Japan monetary policy suffocated demand for 20 years.”

    20 years is more than enough time, according to MM principles, for the Japanese economy to have adapted to the BOJ’s policy.

    It is clear you are falsely identifying the causes of the data you observe.

    There is more to the Japanese economy than BOJ policy the last 20 years.

    You use the word “suffocate” as if people breathe government issued paper.

  33. Gravatar of dtoh dtoh
    17. March 2015 at 17:04

    Scott, you said, “I look forward to your one theory proof of overshooting.”

    You will need to re-read and digest my past comments. Then it will be obvious.

  34. Gravatar of Matt McOsker Matt McOsker
    17. March 2015 at 17:05

    Been thinking about the mechanics here. I, own euro denominated bonds, which I now sell to the ECB. Once sold, I reinvest the proceeds to dollar denominated securities, driving the euro down and dollar up. Ok monetary policy at play. So another issue is if countries like Greece, Spain, Italy stay in the euro. So could be flight caused by countries that may leave to gain back monetary sovereignty. One of the most intestine monetary and fiscal experiments ever. The results TBD.

  35. Gravatar of J.V. Dubois J.V. Dubois
    18. March 2015 at 02:59

    Scott: “Actually I think it would be the first time that inept monetary policy had a significant impact on output several decades later.”

    This is interesting. So you do not think that if there is let’s say monetary policy decision to keep price of gold fixed – that this single decision will have adverse effects on economy 10 years down the road?

    I can see many instances of where bad monetary policy created problems for years, mostly due to targeting wrong things like exchange rates, real variable like unemployment.

    This is really strange because in every other occasion you stress how it is setting and following rules that is the most important aspect of monetary policy.

  36. Gravatar of Quotes & Links #52 | Seeing Beyond the Absurd Quotes & Links #52 | Seeing Beyond the Absurd
    18. March 2015 at 03:16

    […] 7) Krugman on European growth and the euro […]

  37. Gravatar of ssumner ssumner
    18. March 2015 at 07:28

    dtoh, I don’t recall you ever explaining Dornbusch’s overshooting model. Can you link me to the comment where you do so.

    JV, Rules are very important, nothing I said here contradicts that. My only point is that nominal shocks don’e have significant real effects many decades out in the future. In the long run money is roughly neutral.

  38. Gravatar of Dollar Rising | The Only Winning Move Dollar Rising | The Only Winning Move
    19. March 2015 at 03:43

    […] that the dollar is hardening faster than at any time snce 1976. Scott Sumner and Paul Krugman are in a sort of debate about what it means. They seem to agree it’s bad, but to different degrees (though Sumner is […]

  39. Gravatar of Don Geddis Don Geddis
    20. March 2015 at 12:55

    @Ray Lopez: “As for one line to connect all nine dots … simply trace from North pole to South pole and back, through the three rows

    Bzzzt. Nope. That wouldn’t be “one line”. (Multiple lines intersecting, doesn’t somehow make them a single line.)

    By definition straight lines on a sphere meet at the North and South poles

    Wrong again. I do enjoy how your understanding of mathematics seems on par with your understanding of macroeconomics.

    (Perhaps your confused 120 IQ brain needs a little help. Try thinking “the equator”. Just one example, among many. In fact, “most” lines on a sphere, don’t go through the poles.)

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