The ECB’s Reverse FDR, by Paul Krugman, in NY Times: Ryan Avent joins the chorus of those suggesting that the European Central Bank’s decision last spring to start raising rates — a decision that seemed crazy then, and looks even crazier now — was the point at which everything started to fall apart.
But how could what were, in the end, relatively small rate hikes have done large damage? As Avent says, here is where the expectations channel may have been crucial.
One way to look at it is as a reverse FDR. A few years ago Gauti Eggertsson published a persuasive analysis (pdf) of the big economic recovery of 1933-37; he argued that it had a lot to do with changed expectations of future monetary policy. Specifically, by taking America off the gold standard — a shocking move at the time — and explicitly calling for a return to pre-Depression price levels, FDR created an expectation of rising prices that had a salutary effect on demand.
So what happened in spring 2011? The ECB raised rates even though there was no sign of underlying inflationary pressure beyond a commodity blip, and even though the needed price adjustment in the periphery clearly needed a reasonably high inflation target.
Trichet might as well have gone on TV and announced, “My colleagues and I are determined to make the debt problems of southern Europe insoluble.”
And they’ve succeeded.