It’s time to rediscover ECB’s reference value for M3 growth

A couple of days ago I read an interview with ECB’s former chief economist Otmar Issing about the euro crisis. I frankly speaking didn’t find the interview particularly interesting and Issing brings little new to the discussion.

Issing rightly repeats the worries about moral hazard problems and he is critical about the ECB’s credit policies even though it is clear that he fails to point to the difference between credit policies (which central bankers should stay far away from) and monetary policy (which central banks have a mandate to conduct).

Even more depressingly Issing completely fails to recognize the monetary nature of the euro crisis.

This is particularly depressing given Otmar Issing certainly knows his monetarist theory and he used to be know as the monetarist at the ECB.

It was Otmar Issing who famously put monetary analysis based on the quantity theory of money at the centre of thinking in the ECB’s early days. Hence, Issing was the main architect behind ECB’s so-called two pillar strategy. The one pillar was that the ECB should look at a broad range of economic indicators when assessing the monetary policy stance. The second pillar was the monetary pillar which emphasized monetary (essentially montarist) analysis.

What happened to the reference value for M3 growth?

At the core of the monetary pillar was what came to be known as the reference value for M3 growth.

This is how the ECB (read Otmar Issing!) used to define the reference value:

This reference value refers to the rate of M3 growth that is deemed to be compatible with price stability over the medium term. The reference value is derived in a manner that is consistent with and serves the achievement of the Governing Council’s definition of price stability on the basis of medium-term assumptions regarding trend real GDP growth and the trend in the velocity of circulation of M3. Substantial or prolonged deviations of M3 growth from the reference value would, under normal circumstances, signal risks to price stability over the medium term.

So what we are talking about here is the growth rate of M3, which over the medium-term will ensure 2% inflation given the trend-development in money demand (trend real GDP growth and trend-velocity growth).

We can operationalize this by looking at the equation of exchange (in growth rates):

(1) m + v = p + y

Where m is M3 growth, v is the growth rate of M3-velocity, p is inflation (in the GDP deflator) and y is real GDP growth.

If we define v* as trend growth in M3-velocity and y* as trend/potential real GDP growth and finally assume inflation should hit the inflation target of 2% then we can re-write (1):

(1)’ m + v* = 2% + y*

Re-arranging further we can get a target for M3 (m-target), which will ensure 2% inflation over the medium-term:

(2) m-target = 2% + y* – v*

The ECB used (2) to calculate the reference value for M3 growth by assuming v* was around -1/2% and y* was 2%, which would give you a reference value of 4.5%.

The ECB kept this target constant over time despite the fact that neither the trend in velocity nor the trend in real GDP growth are constant over time.

If we instead want to take into account changes in v* and y* over time we can try to “estimate” these variables by applying a Hodrick–Prescott filter (HP filter). Somewhat simply said a HP filter is just a sophisticated moving average.

Introducing the policy-consistent M3 growth rate

While Otmar Issing might have given up on monetary analysis I have not. In fact monetary analysis is at the core of the new publication on Global Monetary Conditions, which my advisory – Markets & Monetary Advisory – will start to publish in the coming months.

In this publication we in fact calculate what we term the policy-consistent M3 (or M2) growth rate for the 25-30 countries, which will be covered in the publication (see more here).

The graph below shows actual M3 growth (the blue line) in the euro zone compared with the policy-consistent M3 growth rate (the red line).


The grey bars are the a 3-year weighted moving averages of the difference between actual and policy-consistent M3 growth and as such is a measure of the monetary policy stance. Negative (positive) bars indicates that M3 growth is too slow (too fast) to ensure that the ECB will hit the 2% inflation target over the medium-term. We can here term this as the ‘money gap’.

In our new  monthly publication we will focus on four different monetary measures to put together one monetary conditions indicator (M3 growth, nominal GDP growth, interest rates and the exchange rate), but if we only focus on our measure of the policy-consistent M3 growth rate we nonetheless get great insight about monetary conditions in the euro zone.

Looking at the development in the ‘money gap’ we see that monetary conditions were broadly speaking from the euro was established in 1999 and until 2006. However, from 2006 monetary conditions clear became too easy.

That, however, change dramatically as M3 started to slow rather dramatically in early 2008 and already at the time should have been clear that soon the M3 would drop below the ECB’s reference value for M3 (and our policy-consistent M3 growth rate). Despite of this the ECB hiked its key policy rate in July 2008! This is of course was the first major policy major the ECB made in the crisis. More disastrous policy mistakes of course followed in 2011 when the ECB hiked interest rate twice!

Hence, had the ECB only focused on M3 the ECB would certainly have tightened monetary policy more aggressively in 2006 and 2007, but even more importantly it would never have hiked interest rates in 2008 and 2011. Rather judging from M3 growth relative to the ECB’s own (old) reference value or our policy-consistent M3 growth rate the ECB should have slashed interest rates aggressively in the Autumn of 2008 and in 2009 and should have initiated quantitative easing once interest rates hit zero.

Otmar Issing should be angry (but for the right reasons)

Hence, Otmar Issing is indeed right to be angry with the ECB, but he should be angry for the right reasons. Issing might point to problems of moral hazard and I certainly share these concerns, but what Otmar Issing really should be angry about is that the ECB complete have given up on taking Issing-style monetary analysis seriously as a result at least six years after 2008 monetary policy far too tight!

Unfortunately Issing seems to have given up on his own analysis as well. That is deeply regrettable.  So we can only hope that Otmar Issing will go back to proper monetary analysis of the typical ‘Calvinist preaching’, which unfortunately is so common among German policy makers – both in Frankfurt and Berlin.

If he did that he would continue to criticize the ECB for trying to distort bond market pricing and encouraging moral hazard, but he would also recognize that ECB chief Mario Draghi has been right pushing for quantitative easing and that it should be continued as long as necessary to keep M3 growth around at least 4.5-5% as this ensures that inflation will be close to ECB’s 2% inflation target.

PS I don’t think re-introducing the reference value for M3 growth would be the best policy framework for the ECB, but it certainly would be better than the present non-policy-framework and very much doubt that we would still would be talking about a euro crisis had the ECB taken the reference value serious.

The Euro – Monetary Strangulation continues (one year on)

Exactly one year ago today I was with the family in the Christensen vacation home in Skåne (Southern Sweden) and posted a blog post titled The Euro – A Monetary Strangulation Mechanism. I wrote that post partly out of frustration that the crisis in the euro once again had re-escalated as Greece fell deeply into political crisis.

One year on the euro zone is once again in crisis – this time the focal point it the Italian banking sector.

So it seems like little has changed over the past year. After nearly eight years of crisis the euro zone has still not really recovered.

In my post a year ago I showed a graph with the growth of real GDP from 2007 to 2015 in 31 different European countries – both countries with floating exchange rates and countries within the euro areas and countries pegged to the euro (Bulgaria and Denmark).

I have updated the graph to include 2016 (IMF forecast).

Monetary Strangulation Summer 2016.jpg

The picture is little changed. In general the floaters (the ‘green’ countries) have done significantly better than the peggers/euro countries (the ‘red’ countries).

That said, I am happy to admit that it looks like we have had some pick-up in growth in the euro zone in the past year – ECB’s quantitative easing has had some positive effect on growth.

However, the ECB is still not doing enough as new headwinds are facing the European economy. Here I particularly want to highlight the fact that the Federal Reserve – wrongly in my view – has moved to tighten monetary conditions over the past year, which in turn is causing a tightening of global monetary conditions.

Second, if we look at the money-multiplier in the euro zone it is clear that it over the past nearly two years have been declining somewhat due in my view to the draconian liquidity (LCR) and capital rules in Basel III, which the EU has pushed to implement fast.

Furthermore, given the increase in banking sector distress in the euro zone recently the euro zone money-multiplier is likely to drop further, which effective will constitute a tightening of monetary conditions. If the ECB does not offset these shocks the euro zone could fall even deeper into a deflationary crisis.  If you are interested in what I think should be done about it have a look here and here.

Concluding, the monetary strangulation in the euro zone continues. Luckily, again this year at this time it is vacation time for the Christensen family so I will try to enjoy life after all.


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:

When effort and outcome is not the same thing – the case of Greece

Greece has made yet another other deal with the EU and IMF on its debt situation. Or rather as one EU official described it to the Financial Times “If it looks like we are kicking the can down the road that is because we are”.

Said in another way, this is not really a deal to solve the fundamental problem, but rather a deal to avoid dealing with the fundamental problem.

So what is the fundamental problem? Well, at the core of this is that the Greek government simply is insolvent and can’t pay its debts, but at the same time the EU is refusing to accept this fact.

The IMF seems to understand this and probably so do the eurocrats, but politically it seems impossible to accept because that would mean the EU would have to accept that the strategy to deal with Greece’s problems has been wrong and it would mean accepting a major debt write-down on Greece sovereign debt something with likely would not be popular with voters in for example Germany or the Netherlands.

Some are arguing that Greece haven’t done enough to solve its own problems and that letting Greece off the hook with a major debt write-down would just encourage even more bad habits and that is probably right, but it does change the fact that it is very hard to see how Greece will be able to pay of the debt.

Furthermore, it is wrong when some are arguing that Greece hasn’t done anything. In fact, Greece has done more fiscal austerity than any other nation in Europe. So if we for example look at the accumulative tightening of fiscal policy in Greece since 2009 then we will see that Greece in this period has tightened by 18-20% of GDP (measured as the accumulative change in IMF’s measure of Greece’s structural budget deficit). By any measure, this a massive fiscal tightening.

However, one thing is the effort another thing is the outcome and here the story is quite different. Hence, since 2009 Greek public debt has grown from 108% of GDP in 2008 to more 180% of GDP this year. Hence, despite of massive fiscal austerity public debt has continued to grow every single year since 2008.

Greece debt and fiscal policy

The reason for this depressing development is the fact that Greece has seen a massive collapse in economic activity. Hence, since 2008 nominal GDP in Greece has dropped by nearly 30%. A true economic disaster. No matter how fiscally conservative a country is it is impossible to stabilize the debt ratios with such an economic contraction.

Therefore, to fundamentally solve Greece’s debt problem it is needed to solve Greece’s growth problem and that is not easy. Fiscal stimulus could of course be a solution, but Greece don’t have the money for that and the markets will not be willing to finance a fiscal stimulus package.

Another solution is massive structural reforms and that is somewhat more promising that fiscal stimulus, but given the depth of the crisis even the most comprehensive reform package is not likely to be enough and that leaves on one solution – monetary easing.

But since Greece is not in control of its own monetary policy because the country is a member of the euro zone that is not really possible either. Or rather it is – if Greece decides to leave the euro area. That seems like a very risky strategy, but it is blatantly obvious that this is really the only solution that would work.

Therefore, it is not a question whether we will get a ‘Grexit’, but rather when it will happen. The German taxpayers will not forever be willing to pay the price for kicking the can down the road.

PS Marcus Nunes also comments on Greece.

PPS The IMF has a new paper, which once again shows that Greece is insolvent and urgently needs a debt write-down.


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:




Are we about to get a new ”euro spasm”?


I hate to say it, but I fear that we are in for a new round of euro zone troubles.

My key concern is that monetary conditions in the euro zone remains far to tight, which among other things is reflected in the continued very low level of inflation expectations in the euro zone. Hence, it is clear that the markets do not expect the ECB to deliver 2% inflation any time soon. As a consequence, nominal GDP growth also remains very weak across the euro zone.

And with weak nominal GDP growth public finance concerns are again returning to the euro zone. This is from Reuters:

Spain plans to ask the European Commission for an extra year to meet its public deficit targets, El Pais reported on Sunday, after missing the mark with its 2015 deficit and raising the prospect of further spending cuts to narrow the budget gap.

The country last month reported a 2015 deficit of 5 percent of economic output, one of the largest in Europe and above the EU-agreed target of 4.2 percent. To reduce that to the 2016 target of 2.8 percent of gross domestic product (GDP), the Spanish government will need to find about 23 billion euros ($25 billion) through tax increases or spending cuts.

The economy ministry declined to comment on the newspaper report, which cited government sources as saying that acting Economy Minister Luis de Guindos would include revised economic projections in the stability program to be presented to Parliament on April 19.

And Spain is not the only euro zone country with renewed budget concerns. Hence, on Friday Italy’s government cut it growth forecast for 2017 and increased it deficit forecast. Portugal is facing a similar problem – and things surely do not look well in Greece either.

So soon public finances problem with be back on the agenda for the European markets, but it is important to realize that this to a very large extent is a result of overly tighten monetary conditions. As I have said over and over again – Europe’s “debt” crisis is really a nominal GDP crisis. With no nominal GDP growth there is no public revenue growth and public debt ratios will continue to increase.


So why are we not seeing any NGDP growth in the euro zone?

Overall I see four reasons:

  1. Global monetary conditions are tightening on the back of tightening of monetary conditions from the Fed and the PBoC.
  2. Regulatory overkill in the European banking sector – particularly the implementation of the Liquidity Coverage Ratio (LCR), which since mid-2014 has caused a sharp drop in the euro zone money multiplier, which effectively is a major tightening of monetary conditions in the euro zone.
  3. Continued fiscal austerity measures to meet EU demand is also adding to the negative aggregate demand pressure.
  4. And finally, the three factor above would not be important had the ECB been credibly committed to its 2% inflation target. However, has increasingly become clear that the ECB is very, very reluctant in implemented the needed massive quantitative easing warranted to offset the three negative factors described above (tighter global monetary conditions, regulatory overkill and fiscal austerity). Instead the ECB continues to fool around with odd credit policies and negative interest rates.

Therefore, urgent action seems needed to avoid a new “euro spasm” in the near-future and I would focus on two factors:

  1. Suspend the implementation across of the new Liquidity Coverage Ratio until we have seen at least 24 months of consecutive 4% nominal GDP growth in the euro zone. Presently the implementation of the LCR is killing the European money market, which eventually will be draining the overall European economy for liquidity.
  2. The ECB needs a firm commitment to increasing nominal GDP growth and to bring inflation expectations back to at least 2% on all relevant time horizons. Furthermore, the ECB need to strongly signal that the central bank will increase the euro zone money base to fully offset any negative impact on overall broad money growth from the massive tightening of banking regulation in Europe.

So will we get that? Very likely not and the signs that we are moving toward renewed euro troubles are increasing. A good example is the re-escalation of currency inflows in to the Danish krone. Hence, the krone, which is pegged to the euro, has been under increasing appreciation pressures in recent weeks and Danish bond yields have as a consequence come down significantly.

This at least partly is a reflection of “safe haven” flows and fears regarding the future of the euro zone. These concerns are probably further exacerbated by Brexit concerns.

Finally, there has been signs of renewed banking distress in Europe with particularly concerns over Deutsche Bank increasing.

So be careful out there – soon with my might be in for euro troubles again.

It’s the economy stupid – this is why Le Pen won

I have argued it again and again – the continued crisis in the European economy is the primary source of political radicalisation, populism, extremism and outright fascism.

The French regional elections provided yet another sad testimony to that thesis. Here is the one-graph version of that idea.

Le Pen

The graph shows the support for the extremist/populist anti-immigration party Front National (FN) against the unemployment rate across different regions in France. Each dot represents a region.

The simple regression ‘model’ shows that a 1%-point increase in unemployment increases support for FN by nearly 5%-point.

So it might be that FN is helped by the recent terror attacks in Paris and by the ‘refugee crisis’, but this is mostly about a weak French economy.

So if you want to blame anybody for the electoral success of Front National you should point the fingers at Jean Claude Trichet who as ECB-chief in 2011 hiked interest rates twice and at president Holland who has done everything to worsen the already bad competitive position of the French economy since he became president in 2012.

HT: This post have been inspired by a post on the same topic on Bloombergviews by .


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

The very unpleasant echo from the 1930s

I am trying very hard not to become alarmist, but I must admit that I see very little positive news at the moment and I continue to see three elements – monetary policy failure/weak growth, the rise of extremist politics (Trump, Orban, Erdogan, Putin, ISIS etc) and sharply rising geopolitical tensions coming together to a very unpleasant cocktail that brings back memories of the 1930s and the run up to the second World War.

It has long been my hypothesis that the contraction in the global economy on the back of the Great Recession – which in my view mostly is a result of monetary policy failure – is causing a rise in political extremism both in Europe (Syriza, Golden Dawn, Orban etc) and the US (Trump) and also to a fractionalization and polarization of politics in normally democratic nations.

That is leading to the appeal of right-wing populists like Donald Trump, but equally to the appeal of islamist groups like ISIS among immigrant youth in for example France and Belgium. Once the democratic alternative loses its appeal extremists and populists will gain ground.

The geopolitical version of this is Ukraine and Syria (and to some extent the South China Sea). With no growth the appeal of protectionism and ultimately of war increases.

Unfortunately the parallels to the 1930s are very clear – without overstating it try to look at this:

  • Syrian war vs Spanish civil war: Direct and indirect involvement of authoritarian foreign regimes (Stalin/Hitler vs Erdogan/Putin)
  • Euro  zone vs the gold standard
  • The rise of populists and extremists: Communists, Nazis and Fascists vs Syriza, Golden Dawn, Jobbik, Orban, regional separatism in Europe, anti-immigrant sentiment, Trump and ISIS (in Europe) etc.
  • The weakening (failure?) of democratic institution: Weimar Republic vs the total polarization of politics across Europe – weak and unpopular minority governments with no “political muscle” for true economic reforms across Europe.

Maybe this is too alarmist, but you would have to be blind to the lessons from history not to see this. However, that does not mean that history will repeat itself – I certain hope not – but if we ignore the similarities to the 1930s things will only get worse from here.

PS if you are looking for more empirical evidence on these issues then have a look at Manuel Funke, Moritz Schularick and Christoph Trebesch’s recent very good post on on The political aftermath of financial crises: Going to extremes.

HT Otto Brøns-Petersen.


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

My lecture at Columbia University on the euro crisis

As the followers of my blog would know I recently did a 11 day speaking tour in the US. I want to share a bit of that with my readers.

Here you can watch my lecture at Columbia University on the euro crisis.

And this is the Powerpoint presentation from the lecture.

I want to thank my big hero Adam Tooze who is head of the Europe Institute of Columbia University for the invitation to speak at Columbia.


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

The Christensen Media Blitz on the euro, ‘Open Borders’, China and ‘currency war’

I have been in a bit of media blitz recently. Here is some of it:

I have been on Russia Today’s Boom-Bust show to talk to Ameera David about the euro and why I think the euro is a Monetary Strangulation Mechanism. Watch here (after 3:35).

And while we are talking about the euro here is an op-ed of mine from the Danish newspaper Jyllandsposten on the same topic (in Danish).

Then something completely different – here I am telling Berlingske Business the story of my Great-great grandfather Sven Persson who emigrated to Denmark from Sweden in 1880 and hence contributed to the economic development in both countries. I make the case for completely Open Borders and argues that that we could double global GDP if we removed all anti-immigration regulation globally. See my ‘video blog’ here (also in Danish).

Here is an op-ed from the Danish Business Daily Børsen on the Chinese on the Chinese devaluations and why the talk of ‘currency war’ mostly is nonsense.

Finally here is an interview (in French) with about the risk of a repeat of the 1997 Asian crisis, My answer is yes, the Chinese situation is worrying, but the good news is that we have floating exchange rates across Asia rather than fixed exchange rates.


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

Horror graph of the week – Greek PMI collapses

If you ever read Friedman and Schwartz’s “A Monetary History of the United States” you know what happens when a central bank fails to act as a lender-of-last resort in the event of a bank run and/or at the same time fails to offset the impact on broad money growth of such bank run.

It of course happened in the US in 1930-31 and again in Europe after the collapse of Credit-Anstalt in Austria also in 1931. In both cases the result was a deep depression. Now it has happened again in Greece, but Greece is already in a deep economic depression.

Just have a look at this shocking graph from

Greek PMI

There is no great reason to trust eyeball-econometrics, but judging from the sharp drop in Greek July PMI (released today) then we should expect another 10-15% drop in Greek real GDP in the next couple of quarters. That would mean that we soon will have seen Greek real GDP being halved since the start of this crisis.

I think it will be very hard to find any other example of a (peacetime) collapse of real GDP of this magnitude in any other country in the world in the past 200 years and there is nothing positive to say about this. It is the terrible consequence of massive policy failures in Brussels, Frankfurt, Berlin and Athens.

A truly Greek tragedy.

HT Joe Wiesenthal.


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:

Also note that I am on a Speaking Tour in the US in October. See more here.

The Euro – A Fiscal Strangulation Mechanism (but mostly for monetary reasons)

In my earlier post The Euro – A Fatal Conceit I argued that had the euro not be introduced and had we instead had freely floating exchange rates then “European taxpayers would (not) have had to pour billions of euros into bailing out Southern European and Eastern European government”. Said in another way had we not had the euro then there would not have been a European “debt crisis” or at least it would have been significantly smaller.

A simple way of illustrating this is to have a look at the debt development in the euro countries (and the countries pegged to the euro) and comparing that with the debt development in the European countries with floating exchange rates.

I use the same countries as in my previous post – The Euro – A Monetary Strangulation Mechanism. 21 euro countries (and countries pegged to the euro) and 10 countries with more or less floating exchange rates.

The graph below shows the development in (median) gross public debt (% of GDP) in the two groups of countries. (All countries are hence equally weighted).

debt change 2007 20014 floaters peggers

The picture is very clear – while both the floaters and the euro countries saw their public debt ratios increase sharply on the back of the 2008 shock (albeit less extremely for the floaters than for the euro countries) – from 2011 there is a very clear difference in the debt development.

Hence, from 2011 the floaters have seen as seen a gradual decline in gross public debt (as share of GDP), while the euro countries (and the peggers) have seen a steep increase in public indebtedness.

So while the floaters have seen their public debt increase by just above 10% of GDP from 2007 to 2014 the euro countries have seen a rise in public debt of more than 25% of GDP!

The graph below shows the individual breakdown of the data.

Publ debt green red

Again the picture is very clear – the euro countries (and the euro peggers) have had significantly more negative debt dynamics than the European floaters. Even if we disregard the PIIGS countries then the euro countries are on average doing a lot worse than the floaters in terms of public debt dynamics .

The euro countries are trying harder, but are succeeding less

One could of course argue that the difference in debt development simply reflects that some countries are just less prudent than other. However, the graph below shows that this is not a very good explanation.

Fiscal tightening

The graph shows the annual change in the fiscal stance (measured as the annual change in IMF’s estimate for the structural public balance as share of GDP). Positive (negative) values are a fiscal easing (tightening).

A few interesting conclusions emerge. First of all overall both euro countries and floaters seem to have had rather pro-cyclical fiscal policies – hence, both groups of countries eased fiscal policy in the ‘good years’ (2005-2009), but tightened the fiscal stance in the ‘bad years’ (2010-14.)

Second, it is notable that the fiscal stance of the euro countries and the floaters is highly correlated and is of a similar magnitude.

So even if the fiscal stance has an impact on growth in both groups of countries it seems a bit far-fetched to in general attribute the difference in real GDP growth between the two groups of countries to difference in the fiscal stance. That said, it seems like overall the euro countries and peggers have had a slightly more austere fiscal stance than the floaters after 2010. (Some – like Greece of course have seen a massive tightening of fiscal policy.)

This of course makes it even more paradoxical that the euro countries have had a significantly more negative debt dynamics than the floaters.

It is not a debt crisis – it is an NGDP crisis  

So we can conclude that the reason that the euro countries’ debt dynamics are a lot worse than the floaters is not because of less fiscal austerity, but rather the problem seems to be one of lacking growth in the euro countries. The graph below illustrates that.

NGDP debt

The graph plots the debt dynamics against the growth of nominal GDP from 2007 to 2014 for all 31 countries (both euro countries and the floaters).

The graph clearly shows that the countries, which have seen a sharp drop in nominal GDP such as Ireland and Greece have also seen the steepest increasing the public debt ratios. In fact Greece is nearly exactly on the estimated regression line, which implies that Greece has done exactly as good or bad as would be expected given the steep drop in Greek NGDP. This leaves basically no room for a ‘fiscal irresponsibility’ explanation for the rise in Greek public debt after 2007.

This of course nearly follows by definition – as we define the debt ratio as nominal public debt divided by nominal GDP. So when the denominator (nominal GDP) drops it follows by definition that the (debt) ratio increases. Furthermore, we also know that public sector expenditure (such as unemployment benefits) and tax revenues tend to be rather sensitive to changes in nominal GDP growth.

As a consequence we can conclude that the so-called ‘Europe debt crisis’ really is not about lack of fiscal austerity, but rather a result of too little nominal GDP growth.

And who controls NGDP growth? Well, overall NGDP growth in the euro zone is essentially under the full control of the ECB (remember MV=PY). This means that too tight monetary policy will lead to too weak NGDP growth, which in turn will cause an increase in public debt ratios.

In that regard it is worth noticing that it is hardly a coincidence that the ECB’s two unfortunate rate hikes in 2011 also caused a sharp slowdown in NGDP growth in certain euro zone countries, which in turn caused a sharp rise in public debt ratios as the first graph of this post clearly shows.

Consequently it would not be totally incorrect to claim that Jean-Claude Trichet as ECB-chief in 2011 played a major role in dramatically escalating the European debt crisis.

Had he not hiked interest rates in 2011 and instead pursued a policy of quantitative easing to get NGDP growth back on track then it seems a lot less likely that we would have seen the sharp increase in public debt ratios we have seen since 2011.

Of course that is not the whole story as the ECB does only control overall euro zone NGDP growth, but not the NGDP growth of individual euro zone countries. Rather the relative NGDP growth performance within the euro is determined by other factors such as particularly the initial external imbalances (the current account situation) when the shocks hit in 2008 (Lehman Brothers’ collapse) and 2011 (Trichet’s hikes.)

Hence, if a country like Greece with a large current account deficit is hit by a “funding shock” as in 2008 and 2011 then the country will have to have an internal devaluation (lower prices and lower wage growth) and the only way to achieve that is essentially through a deep recession.

However, that is not the case for countries with a floating exchange rate as a floating exchange country with a large current account deficit does not have to go through a recession to restore competitiveness – it just has to see a depreciation of its currency as Turkey as seen since 2008-9.

Concluding, the negative debt dynamics in the euro zone since 2008 are essentially the result of two things. 1) The misguided rate hikes in 2011 and 2) the lack of ability for countries with large current account deficits to see a nominal exchange rate depreciation.

The Euro is Fiscal Strangulation Mechanism, but for monetary reasons 

We can therefore conclude that the euro indeed has been a Fiscal Strangulation Mechanism as fiscal austerity has not been enough to stabilize the overall debt dynamics in a numbers of euro zone countries.

However, this is only the case because the ECB has first of all failed to offset the fiscal austerity by maintaining nominal stability (hitting its own inflation target) and second because countries, which initially had large current account deficits like Greece and Spain have not – contrary to the floaters – been able to restore competitiveness (and domestic demand) through a depreciation of their currencies as they essentially are “pegged” within the euro zone.

PS I have excluded Croatia from the data set as it is unclear whether to describe the Croatian kuna as a dirty float or a dirty peg. Whether or not Croatia is included in the sample does not change the conclusions.

Update: My friend Nicolas Goetzmann pointed out the Trichet ECB also hiked interest rates in 2008 and hence dramatically misjudged the situation. I fully agree with that, but my point in this post is not necessarily to discuss that episode, but rather to discuss the fiscal implications of the ECB’s failures and the problem of the euro itself.


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

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