Another great addition to the Euro debate from Paul De Grauwe & Yuemei Ji

In this blog, I not only try to look at theoretically and timely economic issues, but also at the techniques that economists use to obtain their conclusions. The latest VOX piece from Paul De Grauwe with Yuemei Ji covers both of these points (http://www.voxeu.org/article/panic-driven-austerity-eurozone-and-its-implications).

Paul De Grauwe has done a lot of great work, for example, in behavioural economics  and on the Euro crisis . This time, with Yuemei Ji, he has looked at the drivers of Eurozone economic policy. The analysis attempted to answer whether the austerity programs in the Eurozone were driven by deteriorating fundamentals or by the fear and panic that gripped both financial markets and policymakers.

Whilst I encourage everyone to read the column in full, I just wanted to focus on a couple of points. The following chart is Figure 3 from the column. It shows the change in the spreads of the Eurozone countries on the Y axis (the spread is the difference in the interest rates on government bonds between Germany and the other Eurozone countries) and the change in Debt/GDP ratio on the X axis.

 De Grauwe Figure 3 

As the authors note, the fundamentalist view of the Euro crisis – that the primary cause of panic was the underlying economic fundamentals of the individual peripheral Euro countries – would have expected this line to be upward sloping. That is, as the debt to GDP ratio increased, or got worse, the spreads would have also increased. This is obviously not the case, so what is going on here?

The clever part of this chart is that the Y axis, the change in spreads, is measured from 2012 Q2. This was the time that the ECB stepped in and claimed to do ‘whatever it takes’ to save the Euro. In effect, the ECB had committed itself to be the lender of last resort to the government bond market. Thus, this is a powerful chart to say that the economic fundamentals of individual countries were a poor predictor of Eurozone spreads. The concern was related to the institutional inadequacy of the Eurozone to deal with the internal imbalances (see here for a discussion of optimal currency area).

This chart, therefore, provided an important point, but it was also noticeable for its simplicity. It is a cleverly designed bi-variate regression – just two variables, which were expertly chosen to make the point. This shows that great economic analysis does not always have to be a complicated economic model – it can be done with the knowledge of where and how to look at the economic data.

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