The Euro – A Monetary Strangulation Mechanism

In my previous post I claimed that the ‘Greek crisis’ essentially is not about Greece, but rather that the crisis is a symptom of a bigger problem namely the euro itself.

Furthermore, I claimed that had it not been for the euro we would not have had to have massive bailouts of countries and we would not have been in a seven years of recession in the euro zone and unemployment would have been (much) lower if we had had floating exchange rates in across Europe instead of what we could call the Monetary Strangulation Mechanism (MSM).

It is of course impossible to say how the world would have looked had we had floating exchange rates instead of the MSM. However, luckily not all countries in Europe have joined the euro and the economic performance of these countries might give us a hint about how things could have been if we had never introduced the euro.

So I have looked at the growth performance of the euro countries as well as on the European countries, which have had floating (or quasi-floating) exchange rates to compare ‘peggers’ with ‘floaters’.

My sample is the euro countries and the countries with fixed exchange rates against the euro (Bulgaria and Denmark) and countries with floating exchange rates in the EU – the UK, Sweden, Poland, Hungary, the Czech Republic and Romania. Furthermore, I have included Switzerland as well as the EEA countriesNorway and Iceland (all with floating exchange rates). Finally I have included Greece’s neighbour Turkey, which also has a floating exchange rate.

In all 31 European countries – all very different. Some countries are political dysfunctional and struggling with corruption (for example Romania or Turkey), while others are normally seen as relatively efficient economies with well-functioning labour and product markets and strong external balance and sound public finances like Denmark, Finland and the Netherland.

Overall we can differentiate between two groups of countries – euro countries and euro peggers (the ‘red countries’) and the countries with more or less floating exchange rates (the ‘green countries’).

The graph below shows the growth performance for these two groups of European countries in the period from 2007 (the year prior to the crisis hit) to 2015.

floaters peggers RGDP20072015 A

The difference is striking – among the 21 euro countries (including the two euro peggers) nearly half (10) of the countries today have lower real GDP levels than in 2007, while all of the floaters today have higher real GDP levels than in 2007.

Even Iceland, which had a major banking collapse in 2008 and the always politically dysfunctionally and highly indebted Hungary (both with floating exchange rates) have outgrown the majority of euro countries (and euro peggers).

In fact these two countries – the two slowest growing floaters – have outgrown the Netherlands, Denmark and Finland – countries which are always seen as examples of reform-oriented countries with über prudent policies and strong external balances and healthy public finances.

If we look at a simple median of the growth rates of real GDP from 2007 until 2015 the floaters have significantly outgrown the euro countries by a factor of five (7.9% versus 1.5%). Even if we disregard the three fastest floaters (Turkey, Romania and Poland) the floaters still massively outperform the euro countries (6.5% versus 1.5%).

The crisis would have long been over had the euro not been introduced  

To me there can be no doubt – the massive growth outperformance for floaters relative to the euro countries is no coincidence. The euro has been a Monetary Strangulation Mechanism and had we not had the euro the crisis in Europe would likely long ago have been over. In fact the crisis is essentially over for most of the ‘floaters’.

We can debate why the euro has been such a growth killing machine – and I will look closer into that in coming posts – but there is no doubt that the crisis in Europe today has been caused by the euro itself rather than the mismanagement of individual economies.

PS I am not claiming the structural factors are not important and I do not claim that all of the floaters have had great monetary policies. The only thing I claim is the the main factor for the underperformance of the euro countries is the euro itself.

PPS one could argue that the German ‘D-mark’ is freely floating and all other euro countries essentially are pegged to the ‘D-mark’ and that this is the reason for Germany’s significant growth outperformance relative to most of the other euro countries.

Update: With this post I have tried to demonstrate that the euro does not allow nominal adjustments for individual euro countries and asymmetrical shocks therefore will have negative effects. I am not making an argument about the long-term growth outlook for individual euro countries and I am not arguing that the euro zone forever will be doomed to low growth. The focus is on how the euro area has coped with the 2008 shock and the the aftermath. However, some have asked how my graph would look if you go back to 2000. Tim Lee has done the work for me – and you will see it doesn’t make much of a difference to the overall results. See here.

Update II: The euro is not only a Monetary Strangulation Mechanism, but also a Fiscal Strangulation Mechanism.


If you want to hear me speak about these topics or other related topics don’t hesitate to contact my speaker agency Specialist Speakers – e-mail: or

Mussolini’s great monetary policy failure

Benito Mussolini is known for having been a horrible warmongering fascist dictator. However, he was also responsible for a major failed monetary experiment – the so-called Battle of the Lira.

Hence, in 1926 Mussolini announced a major revaluation of the Italian Lira as part of his general plan to revive the greatness of Italy.

This is how the Battle of the Lira was described in the New York Times in August 1927:

“It is just one year since Premier Mussolini, speaking at Pesaro, delivered that oration, destined to remain famous in the annals of modern Italian history, in which he announced his intention to revalue the lira.

‘We shall never inflict upon our wonderful Italian people, which for four years has been working with ascetic discipline and is ready for even greater sacrifieces, the moral shame and economic catastrophe of failure of the lira,’ he declared.

Looking back upon the last year, one must admit that Primier Mussolini has more than kept his word. In August 1926, the average exchange rate was 30 1/2 lira to the dollar. By October it had already dropped to 27 …the lira steadily continued its descent till in May (1927) it reached 18 to the the dollar, where it has remained ever since”

Hence, Mussolini engineered a nearly 70% revaluation of the lira in less than one year. Not surprisingly the economic impact was not positive. This how that is described in the same New York Times article:

“But the result has not been obtained without servere…jolts affecting all classes of citizens.

…Revaluation has led to a period of general stagnation and lack of enterprise in industry, for the gold value of money has increased automatically while the revaluation process was in progress and people preferred to leave their money in banks to rising it in ventures of any kind.

Unemployment is twice as high as it was in this month last year and greater than it has been at any time since 1924. Average quotations on stock exchanges have fallen 40 per cent. Wholesale prices have fallen about 30 per cent, but retail prices lag far behind and show a decrease of less than 15 per cent…

…Despite these somewhat depressing indications, the Government is convinced that the benefits of revaluation will ultimately far outweigh the drawbacks. The official opinion, indeed, is that now that the whole country has become adjusted to the new value of the lira, a rapid improvement will be expirienced.”

That of course never happened. Instead the Italian economy was hit by yet another shock in 1929 when the global crisis hit.

Finally in 1934 Mussolini decided to give up the gold standard and in October 1936 the lira was devalued by 41%.

What role Mussolini’s failed monetary policy played in his domestic policies and particularly in the foreign policy “adventures” – his war against Abyssinia in 1935-36 and his decision to ally himself with Hitler and Nazi-Germany in WWII – I don’t know, but there is nothing like war to take away the attention from failed economic policies.

Or as it was expressed in an article in New York Times in April 1935 at the start on Mussolini war against Abyssinia (but before the 1936 devaluation):

Behind each new political move in Europe, which expresses itself in the mobilization of larger armies, may generally be found an economic cause.

The article also touches on another key issue – the fact that (über) tight monetary policy historically has led to protectionist measures and that the logical consequence of such protectionist measures often is war:

The foreign trade of Italy is, figuratively, “shot to pieces.” The decrees against imports , the unwillingness to do business except where equal valued are exchanged by a foreign nation and the high rate of the lira have produced an alarming situation for a country that today under unobstructed movements of goods, would have an unfavorable trade balance.

One of the major efforts of Mussolini has been to place Italy on a self-supporting basis. Much has been done in this direction. As Italy is poor in natural resources that enter into processes of manufacture, the handicaps to attaining self-sufficiency are not easy to surmount.”

It is too bad today’s European policy makers didn’t study any economic history.


Related blog posts:

“If goods don’t cross borders, armies will” – the case of Russia
Denmark and Norway were the PIIGS of the Scandinavian Currency Union

And posts on the early 1930s:

The Tragic year: 1931
Germany 1931, Argentina 2001 – Greece 2011?
Brüning (1931) and Papandreou (2011)
Lorenzo on Tooze – and a bit on 1931
“Meantime people wrangle about fiscal remedies”
“Incredible Europeans” have learned nothing from history
The Hoover (Merkel/Sarkozy) Moratorium
80 years on – here we go again…
“Our Monetary ills Laid to Puritanism”
Monetary policy and banking crisis – lessons from the Great Depression

“The gold standard remains the best available monetary mechanism”
Hjalmar Schacht’s echo – it all feels a lot more like 1932 than 1923
Greek and French political news slipped into the financial section
Political news kept slipping into the financial section – European style
November 1932: Hitler, FDR and European central bankers
Please listen to Nicholas Craft!
Needed: Rooseveltian Resolve
Gold, France and book recommendations
“…political news kept slipping into the financial section”
Gideon Gono, a time machine and the liquidity trap
France caused the Great Depression – who caused the Great Recession?

Who did most for the US stock market? FDR or Bernanke?
“The Bacon Standard” (the PIG PEG) would have saved Denmark from the Great Depression
Remember the mistakes of 1937? A lesson for today’s policy makers
I am blaming Murray Rothbard for my writer’s block
Irving Fisher and the New Normal


Italy’s Greater Depression – Eerie memories of the 1930s

This is from the Telegraph:

Italy was hit by strikes, violent demonstrations and protests against refugees on Friday as anger and frustration towards soaring unemployment and the enduring economic crisis exploded onto the streets.

Riot police clashed with protesters, students and unionists in Milan and Padua, in the north of the country, while in Rome a group of demonstrators scaled the Colosseum to protest against the labour reforms proposed by the government of Matteo Renzi, the 39-year-old prime minister.

Eggs and fire crackers were hurled at the economy ministry.

On the gritty, long-neglected outskirts of Rome there was continuing tension outside a centre for refugees, which was repeatedly attacked by local residents during the week.

Locals had hurled stones, flares and other missiles at the migrant centre, smashing windows, setting fire to dumpster rubbish bins and fighting running battles with riot police during several nights of violence.

They demanded that the facility be closed down and claimed that the refugees from Africa and Asia were dirty, anti-social and violent.

Some protesters, with suspected links to the extreme Right, yelled “Viva Il Duce” or Long Live Mussolini, calling the migrants “b*******”, “animals” and “filthy Arabs”.

…A group of 36 teenage migrants had to be evacuated from the centre in Tor Sapienza, a working-class suburb, on Thursday night after the authorities said the area was no longer safe for them.

The sense of chaos in the country was heightened by transport strikes, which disrupted buses, trams, trains and even flights at Rome’s Fiumicino airport. Demonstrations also took place in Turin, Naples and Genoa.

Unemployment among young people in Italy is around 42 per cent, prompting tens of thousands to emigrate in search of better opportunities, with Britain the top destination. The overall jobless rate is 12 per cent.

Mr Renzi’s attempts to reform the country’s labour laws, making it easier for firms to dismiss lazy or inefficient employees, are bitterly opposed by the unions.

The ongoing recession has also exacerbated racial tensions, with some Italians blaming refugees and immigrants for their economic woes.

It is hard not to be reminded of the kind of political and social chaos that we saw in Europe in the 1930s and it is hard not to think that the extremely weak Italian economy is the key catalyst for Italy’s political and social unrest.

By many measures the Italian economy of today is worse than the Italian economy of the 1930s. One can say – as Brad DeLong has suggested – that this is a Greater Depression than the Great Depression.

Just take a look at the development in real GDP over the past 10 years and during the 1925-1936-period.

crisis Italy

If you wonder why Italian GDP took a large jump in 1936 (year +6) it should be enough to be reminded that that was the year that the Italian lira was sharply devalued.

Today Italy don’t have the lira and everybody knows who I blame for the deep crisis in the Italian economy.

It is sad that so few European policy makers understand the monetary causes of this crisis and it is tragic that the longer the ECB takes to act the more political and social unrest we will face in Europe.

PS I do not mean to suggest that Italy do not have structural problems. Italy has massive structural problems, but the core reason for the Greater Depression is monetary policy failure. Don’t blame Renzi or the immigrants – blame the Italian in Frankfurt.


It’s Frankfurt that should be your worry – not Rome

This week investors have been spooked by the election outcome in Italy, but frankly speaking is there anything new in that shady characters are doing well in an Italian election? Is there anything new in a hung parliament in Italy? Nope, judging from post-WWII Italian political history this is completely normal. Ok, Italian public finances is a mess, but again that not really news either.

So if all this is ‘business-as-usual’ why are investors suddenly so worried? My explanation would be that investors are not really worrying about what is going on in Rome, but rather about what is going on in Frankfurt.

Last year I argued that the ECB had introduced ‘political outcomes’ in its reaction function:

This particularly is the case in the euro zone where the ECB now openly is “sharing” the central bank’s view on all kind of policy matters – such as fiscal policy, bank regulation, “structural reforms” and even matters of closer European political integration. Furthermore, the ECB has quite openly said that it will make monetary policy decisions conditional on the “right” policies being implemented. It is for example clear that the ECB have indicated that it will not ease monetary policy (enough) unless the Greek government and the Spanish government will “deliver” on certain fiscal targets. So if Spanish fiscal policy is not “tight enough” for the liking of the ECB the ECB will not force down NGDP in the euro zone and as a result increase the funding problems of countries such as Spain. The ECB is open about this. The ECB call it to use “market forces” to convince governments to implement fiscal tightening. It of course has nothing to do with market forces. It is rather about manipulating market expectations to achieve a certain political outcome.

Said in another way the ECB has basically announced that it does not only have an inflation target, but also that certain political outcomes is part of its reaction function. This obviously mean that forward looking financial markets increasingly will act on political news as political news will have an impact of future monetary policy decisions from the ECB.

And this is really what concerns investors. The logic is that a ‘bad’ political outcome in Italy will lead the ECB to become more hawkish and effectively tighten monetary conditions by signaling that the ECB is not happy about the ‘outcome’ in Italy and therefore will not ease monetary policy going forward even if economic conditions would dictate that. This is exactly what happened in 2011-12 in the euro zone, where the political ‘outcomes’ in Greece, Italy and Spain clearly caused the ECB to become more hawkish.

The problems with introducing political outcomes into the monetary reaction function are obvious – or as I wrote last year:

Imaging a central bank say that it will triple the money supply if candidate A wins the presidential elections (due to his very sound fiscal policy ideas), but will cut in halve the money supply if candidate B wins (because he is a irresponsible bastard). This will automatically ensure that the opinion polls will determine monetary policy. If the opinion polls shows that candidate A will win then that will effectively be monetary easing as the market will start to price in future monetary policy easing. Hence, by announce that political outcomes is part of its reaction function will politics will make monetary policy endogenous. The ECB of course is operating a less extreme version of this set-up. Hence, it is for example very clear that the ECB’s monetary policy decisions in the coming months will dependent on the outcome of the Greek elections and on the Spanish government’s fiscal policy decisions.

The problem of course is that politics is highly unpredictable and as a result monetary policy becomes highly unpredictable and financial market volatility therefore is likely to increase dramatically. This of course is what has happened over the past year in Europe.

Furthermore, the political outcome also crucially dependents on the economic outcome. It is for example pretty clear that you would not have neo-nazis and Stalinists in the Greek parliament if the economy were doing well. Hence, there is a feedback from monetary policy to politics and back to monetary policy. This makes for a highly volatile financial environment.  In fact it is hard to see how you can achieve any form of financial or economic stability if central banks instead of targeting only nominal variables start to target political outcomes.

Therefore investors are likely to watch comments from the ECB on the Italian elections as closely as the daily political show in Rome. However, there might be reasons to be less worried now than in 2011-12. The reason is not Europe, but rather what has been happening with US and Japanese monetary policy since August-September last year.

Hence, with the Fed effective operating the Bernanke-Evans rule and the Bank of Japan having introduced a 2% inflation target these two central banks effective have promised to offset any negative spill-over to aggregate demand from the euro zone to the US and the Japanese economy (this is basically the international financial version of the Sumner Critique – there is no global spill-over if the central banks have proper nominal targets).

Hence, if Italian political jitters spark financial jitters that threaten to push up US unemployment then the Fed will “automatically” step up monetary easing to offset the shock and investors should full well understand that. Hence, the Bernanke-Evans rule and the BoJ’s new inflation target are effective backstops that reduces the risk of spill-over from Italy to the global markets and the global economy.

However, investors obviously still worry about the possible reaction from the ECB. If the ECB – and European policy makers in general – uses political events in Italy to tighten monetary conditions then we are likely to see more unrest in the European markets. Hence, the ECB can end market worries over Italy today by simply stating that the ECB naturally will act to offset any spill-over from Italy to the wider European markets that threatens nominal stability in the euro zone.

Related posts:
News of Berlusconi once again slipped into the financial section
Spanish and Italian political news slipped into the financial section
Greek and French political news slipped into the financial section
Political news kept slipping into the financial section – European style
“…political news kept slipping into the financial section”

Spanish and Italian political news slipped into the financial section

One of my favourite Scott Sumner blog posts is on the connection been monetary policy failure and the impact of political news on the financial markets. I have quoted Scott many times on this issue, but let me do it again:

I once read all the New York Times from the 1930s (on microfilm.)  You can’t even imagine how frustrating it was.  They knew they had a big problem.  Then knew that deflation had badly hurt the economy (including the capitalists.)  They knew that monetary policy could reflate.  And yet . . .

Weeks went by, then months, then years.  Somehow they never connected the dots.

“Monetary policy is already highly stimulative.”

“There’s a danger we’d overshoot toward too much inflation.”

“Maybe the problems are structural.”

“There are green shoots, things are getting worse at a slower pace.  The economy needs to heal itself.”

“Consumer demand is saturated.  Even workingmen can now afford iceboxes and automobiles.  We produced too much stuff in the 1920s.”

And the worst part was the way political news kept slipping into the financial section.  Nazis make ominous gains in the 1932 German elections, Spanish Civil War, etc, etc.  In the 1930s the readers didn’t know what came next—but I did.

It has been a long time since political headlines really have been able to move the global financial markets (remember the fiscal cliff story never really did it). However, just take a look at these two stories from today:

 Ten-year Spanish government bond yields rose on Monday as the country’s opposition party called for the resignation of Prime Minister Mariano Rajoy over a corruption scandal.

…and here:

Ten-year Italian government bond yields also rose on concerns that a scandal involving Monte Paschi bank could see a rise in the popularity of the centre-right party in the polls, whose election charge is being led by former prime minister Silvio Berlusconi.

Since August-September the Federal Reserve and the Bank of Japan the have moved in the direction of easing monetary policy and a significantly more ruled basked monetary policy and even the ECB has eased up with ECB chief Draghi’s promising to do “whatever it takes” to save the euro. And Mark Carney has given investors hope that the Bank of England will move towards some form of NGDP level targeting. As a result the “euro crisis” has more or less disappeared from the headlines in the newspapers’ “financial section” (just take a look at what Google trends has to say).

Hence, it seems pretty clear that the markets’ “responsiveness” to political worries is a function of the tightness of global monetary conditions with tighter monetary conditions leading to a bigger impact of political jitters.

So where are we now? It to me all dependent on the ECB. If the ECB move towards a clearly rule based regime – in a similar fashion as the Fed and the BoE (and likely soon also the Bank of England) then we are likely to see markets becoming more immune to political jitters. On the other hand if the ECB moves back to the bad habit of conditioning monetary policy on political outcome then once again the markets will start worrying about the finer details of Italian and Spanish politics.

PS Some would argue that European monetary conditions have become tighter recently as a result of higher money market rates and yields. However, I don’t think that is the case. Higher yields and rates reflect growth optimism – just look at European stock markets and implied inflation expectations in the European fixed income markets. Market Monetarists don’t run for the door in panic when yields rise – rather we argue that you should not make the interest rate fallacy and confuse higher (lower) rates/yields with tighter (easier) monetary policy. As Milton Friedman reminds us rates and yields are high (low) when monetary policy has been easy (tight).

The reason Mario Monti is beginning to sound (very) desperate

When the eurocrat Mario Monti became Prime Minister last year we were told that he was the man to turn around the Italian economy. We were told that technocrats would do the job rotten and incompetent politicians were not able to do. However, the eurocrat Papademos did not last long in Greece and now Mario Monti is beginning to sound rather desperate. On Thursday he told reporters that EU policy makers had one week to save the euro. That is somewhat of a stern warning from somebody who is supposed to be a cool-headed technocrat.

Why this sudden desperation from Monti? Well, it is pretty simple – Italian nominal GDP is declining sharply, while Italian funding costs are increasing sharply day-by-day. With NGDP declining rapidly the public debt-to-GDP ratio obviously is exploding and as investors know that the ECB has not shown any willingness to curb the decline in NGDP then Italian debt as share of GDP is likely to continue to increase no matter how many budget cuts and tax increases the Italian parliament passes. It is very simply – without growth in NGDP the Italian government will fast become insolvent.

Therefore, it is not really Angela Merkel Mario Monti should be asking for help to solve the crisis, but rather his namesake and countryman ECB chief Mario Draghi. The ECB can end this crisis by introducing a determined policy to curb the drop in euro zone NGDP (or rather to increase NGDP markedly). On the other hand if Draghi does not act then it might very well be that Monti is right about his warnings.

PS Meanwhile Monti’s predecessor is having other ideas (remember Italy never defaults – Italy inflates…) and it is not the first time.

A history of bunganomics

Market attention has changed from Greece to Italy. As in Greece the centre of attention is the dual concerns of public finance trouble and political uncertainty.

A look at Italian economic and monetary history, however, reveals some interesting facts. While Greece is a serial defaulter Italy has in fact only defaulted on it’s public debt one time since Italy become an independent and unified nation in 1861. Contrary to this Greece has been in default in more than 50% of the time since it became an independent nation in 1822 (1830).

Minimal knowledge of Italian history will teach you that the country is notorious unstable politically and that public finance trouble historically as been as much a norm as in Greece so how come that the Italian government has not defaulted more than once?

Some Unpleasant Monetarist Arithmetic will help us explain that. Sargent and Wallace teach us that public deficits can be financed by either issuing public debt or by printing money. Historically Italian governments have had a clear affinity for printing money.

Rogoff’s and Reinhardt’s “This Time is Different” provides us with the statistics on this. Hence, among the present euro countries Italy has been the third most inflation-prone country historically – after Austria and Greece. Hence, since 1800 Italy has had inflation above 20% in more than 11% of the time. The similar numbers for Austria and Greece are 20% and 13% respectively.

Michele Fratianni, Franco Spinelli and Anna J. Schwartz have written the “Monetary History of Italy” and the authors reach the same conclusion – that the core of Italy’s inflationary problems is the Italian government’s lack of ability to balance the budget.

This time around the money printing option is not easily available – at least not if the Italian government wants to keep Italy in the euro zone. Sargent and Wallace would tell us to watch inflation expectations to see whether the Italian government is credible or not when it says it will not leave the euro.


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