Comparing the Eurozone and United States: The Most Important Chart from the Great Recession

Eurozone vs US

MKM Partners

Since the beginning of the Great Recession there have been voices within the Federal Reserve and American punditry that believe that the Federal Reserve actions are too loose and that the low interest rate and extraordinary measures taken will cause hyperinflation and a more unstable economy. Their predictions have been shown to be incorrect many times but the most important charts to come out of the Great Recession show how bad the American economy could have been if we followed their advice.

In early 2011 there were some weak signs that the economy may be recovering with inflation rising in the Eurozone, United Kingdom, and United States. During this time the usual suspects started advocating raising interest rates to combat their fears of inflation. At the time unemployment was hovering at 9% in the US, double the pre-recession level. By April of 2011 the European Central Bank (ECB) decided that their interest rate should increase by a quarter of a percent to 0.50%. There was increased pressure for the Fed and Bank of England (BoE) to increase their rates as well. The BoE was especially pressured with inflation at 4% which was double their target of 2% and much higher than the Eurozone. By May 2011 the OECD had called for the Fed to increase its interest rate to 1% by the end of 2011. The Fed and BoE did not bend to pressure. But the ECB raised their interest rate another quarter of a percent in July to .75%, and their credibility in ensuring recovery in the Eurozone was fatally compromised. Ryan Avent described the blunder by saying:

“It really is difficult to overstate the extent of the European Central Bank’s failure in recent months. Earlier this year, headline inflation rose in Europe behind rising commodity prices. The Bank of England and the Federal Reserve considered the increase in inflation, looked at emerging market efforts to tighten policy, tightening fiscal conditions in their economies, and general economic weakness and concluded that the bump would be short-lived. It’s not going too far to say that it was obvious it would be short-lived. But the ECB apparently suffers from a severe case of central-bank myopia, and so it responded to higher headline inflation with an April interest rate increase, despite the vulnerability of the euro-zone economy, and despite an extremely serious ongoing euro-zone debt crisis…  If the euro zone does fall apart, a fitting epitaph might read, ‘The ECB feared 3% inflation.’”

By tightening the Eurozone’s monetary policy the ECB sent the zone into a double dip recession that lasted from the beginning of 2012 until the fall of 2013. The United Kingdom and the United States were able to avoid most of the damage done by the ECB and did not enter a second recession.

Europe’s recovery was superior to the United States’ recovery at the time when the ECB raised rates. Look again at the charts. These are some of the most important charts to come from the Great Recession as they show what happens when inflation fears lead central banks to raise rates inappropriately. The Eurozone was doing substantially better than the United States until the ECB raised their rates and industrial production stagnated and fell while unemployment reversed its downward trend and rose to levels well above those caused by the initial recession. Six years after the financial crisis, the Eurozone’s employment problem is now as bad as the United States at the heart of the Great Recession.

If the Fed followed the ECB’s lead and raised rates prematurely then the Fed would be in the position that the ECB is facing at the moment. Currently, the Eurozone’s inflation rate was reported to be 0.3% for the month of August: stunningly close to deflation and trending in that direction. Currently two large countries within the Eurozone—Italy and Spain—are experiencing deflation, with devastating consequences for their citizens and Germany, the Eurozone’s largest and most stable economy, is on the verge of entering another recession.  The ECB is facing worse conditions than before 2011 and it will increasingly need to reach for extraordinary measures while the Fed and BoE exit such arrangements. The ECB is the first major central bank to set negative interest rates, which is currently set at -0.2% and the current ECB President Mario Draghi has started quantitative easing (QE) light and full QE is on the table, despite badly misguided German objections.

Reaching full employment—fixing the jobs—is key to a healthy economy and inflation cannot be the sole factor in determining whether monetary policy should change. The inflation of 2011 and the policies decided by the world’s major central banks were a real life experiment of monetary policy in which tens of millions of Europeans suffered because the ECB crippled the Eurozone’s nascent recovery. Going forward the Fed must take note of the lesson of 2011 and ensure that a full recovery is prioritized over unhinged warnings of future inflation. And the ECB—and their German colleagues at the Bundesbank—would be very wise to realize the error of their ways and rapidly target a return to full employment and more robust economic growth in the place of jumping at inflation’s shadow.

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  1. […] a supplement to our comparison of ECB and Fed policies: Brad DeLong considers the disastrous policies coming from across the pond and makes a provisional […]

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