The Great and Mighty (I do not use those words lightly) economist Scott Sumner has frequently claimed that the 2011-2013 Eurozone crisis was caused by the Eurozone Central Bank’s tight money and (bizarrely) that it’s Trichet’s fault, since it was under him that the Eurozone crisis began. Is this really justified by the facts?
This is perhaps the clearest graph showing my point. While the ratio between Real GDP and the price level stayed the same in the U.S. during the EZ crisis, in the EZ, the ratio sharply collapsed, leading to a far greater crash than explicable by simple differences in nominal GDP. Another look at the same fact, though less clear than the first, and certainly not suitable for viewing without having seen the first:
Reasoning from the above graph and imagining the RGDP/Price Level ratio was the same in Europe as in the U.S., while price levels were what they actually were, European RGDP would look something like this:
Assuming European RGDP was multiplied by the quotient of the American and European price levels, European GDP would look like this:
But, you say, this, of course, does not account for the effects of differences in NGDP, only for the effects of differences in price levels. But it does get us closer to imagining a Europe with NGDP problems, but without supply-side problems, which is what we want to do here.
And, indeed, this is what I’ve done. After literally hours of work and half a day after finishing this post (mostly spent asleep) I have at last created a graph that does account for differences in NGDP (or at least the average of the price level and Real GDP, which is close enough for our purposes). The formula should be easy enough to follow:
The red and blue lines are the Real GDPs of the U.S. and the Eurozone, respectively. The green line is Eurozone Real GDP assuming the quotient of the American and Eurozone Real GDPs was just as large as the quotient of the American and Eurozone price levels. The purple line is Eurozone Real GDP assuming the quotient of the American and Eurozone Real GDPs was as just large as the quotient of the American and Eurozone averages of the price level and Real GDP (our substitute for nominal GDP here).
If the purple line is to be used, the divergence between American and Eurozone Real GDPs between Q4 2007 and Q3 2013 would be 34.5% due to real causes. If the green line is to be used, the divergence between American and Eurozone Real GDPs between Q4 2007 and Q3 2013 would be 67% due to real causes.
Were an aggregate demand shock the only shock that led to the divergence between American and Eurozone Real GDPs after Q4 2007, Eurozone Real GDP should have been somewhere between the green and purple lines -that is, either none or a negative percentage of the divergence between American and Eurozone Real GDPs would have been due to real causes, as judging by the purple line. As you can see from the graph, in real life, it is most definitely not- somewhere between one and two thirds of the gap is a result of supply-side factors, depending on which line one judges by.
For reference, here’s a graph of the averages of the Real GDP and price level for both the Eurozone and U.S.
So in Europe, the facts are clear: the real problem is real. Let us have no more talk that an aggregate demand shock killed Europe. Were Europe’s problems solely due to aggregate demand, the Eurozone crisis of 2011-2013 would have been known as a two-quarter-long slowdown in late 2012.