Here's another example of interest rates that were too low.
And it this case, it wasn't the fault of the central bank of the country, alright.
The case we're going to look at now is Spain.
And we've got again, the same picture I showed you with the United States.
We got the real short-term interest rate in red.
So I've taken the interest rate and subtracted inflation from it.
And then we've got the output gap in blue.
So again, like with United States, you can see there's a period of recessionary
gap in the mid-90s, alright, when that blue line drops below the zero axis.
And then we've got an inflationary gap the whole period from about 1998 to 2008,
and then it drops, as we know, with
the financial crisis into a big recessionary gap.
So, were interest rates appropriate?
Well, we would expect that interest rates would be rising in the
period of recessionary gap which lasts, as we said, throughout the early 2000s.
Instead, we find interest rates falling and then
becoming negative in real terms from 2003 to 2006.
Why on earth would they do that if the economy is growing so strongly?
We're looking at an output gap that goes
up to 4 percentage points above potential, right?
In other words, if the potential is 2, they're growing at 6.
Okay, why would they do that?
Well, there's a very simple reason, which is
that the interest rates were not set in Spain.
They were set by the ECB, by the European Central Bank, which exercises monetary
policy over the, at present, 17 countries that share the Euro as a currency.
So they all share this central bank, and the central bank
sets a target interest rate for the whole group of countries.
Well, sometimes they don't all need the, need the same interest rate.
So Spain, for instance, was in an
inflationary gap, it needed a higher interest rate.
However, Germany, as we'll see in a moment, was in a recessionary gap or
at potential, and Germany is much bigger in the Eurozone countries than Spain is.
So the ECB governor and his council, thinking about what's best for
most of the Eurozone, dropped interest rates until they were quite low.
And we also have to remember that the real interest rate
would be one thing in Spain and another thing in Germany.
Because even if we have the same ECB rate, let's say it's 3 in this period, okay?
If Spain had an inflation rate of 4, then we take
3 minus 4, that interest rate becomes negative in real terms.
But imagine that Germany had an inflation rate of 2, so
3 minus 2 means they still have positive real interest rate, okay?
So, these interest rates, because Spanish inflation was higher than German
inflation became too low for Spain, what happened in that period?
Well, we can, we know from history, this was
a period of a huge housing bubble developing in Spain.
In Spain people tended to invest in buildings rather than
putting their money into sort of exotic or risky financial assets.
And so all of the force of these excessively
low interest rates was felt in the housing market,
and by most indicators, Spain had the biggest housing
bubble of any country in the world in this period.
We can look at the next slide and we see the same picture.
You can see, again, the real short term interest rate dropping down
into negative terms, and now we're comparing it with real GDP growth.
Remember for, for monetary policy to be neutral, they should be roughly the same.
And look at the big difference between interest rates and GDP growth rates.
So clearly, that interest rate was very expansive for
Spain at a time when it needed a restrictive policy.
Now that same interest rate, if we look at Germany, was more appropriate, okay?
Here we're seeing the German output gap, okay?
And we can see that, whereas Spain had an inflationary
gap in that early 2000s, Germany had a recessionary gap, alright?
So you can see the real short-term interest
rates coming down to help Germany, which forms,
which is the biggest economy in the Eurozone,
to help Germany in that period of recessionary gap.
And then, they went up when Germany was
recovering, as you can see happen starting in 2006.
So, Germany got the right interest rates.
This is an appropriate monetary policy.
It was wrong for Spain.