Oh ECB, Shall The Bells Toll For Thee?
Issue   |   Wed, 11/30/2011 - 02:03

For a while, George Papandreou and Antonis Samaras indirectly put Amherst at the center of the Euro crisis. Now Greece, the markets and the Eurozone have moved on to a far more troubling situation with Italy, touching French, and recently even German bond sales as well.

As we all know, there are real issues with the indebtedness of some members of the Eurozone, but the real base of this problem is the introduction of the Euro in the first place. For all the benefits it provided as a single currency, it was created without true political integration and it was not intended to become a transfer union, despite its vastly disparate member economies.
While obviously there is some fundamental level of reforms that should happen with government budgets in the Eurozone, member nations can’t all implement austerity at the same time. As a market, the Eurozone largely trades within itself, which means that if there is cutting in one part, there needs to be spending in another part or aggregate demand will fall. As Christina Romer argued before an audience at Princeton several weeks ago, austerity is definitely contractionary.

Several times now, European governments have revised their growth estimates downward, leading to lower tax receipts, and thus further cuts. Yet certain European (and American) leaders and politicians have clung to the idea of expansionary austerity that Paul Krugman has dubbed “the confidence fairy:” the idea that businesses will have greater confidence and will spend, invest and hire. Yet, so far it is recession forecasts and not sightings of the confidence fairy that have actually appeared on the horizon.

However the immediate crisis isn’t just about those debt loads; it’s about the spiking interest rates faced by nations like Italy (which is actually running a primary account surplus) that make the continued servicing of the debt unsustainable. This is a crisis made worse by the intractable European Central Bank (ECB), which seems determined to bind Europe in a straightjacket of austerity, throw it over the Cliffs of Dover, and watch it sink beneath the waves while cooing to itself about how “impeccably” it has performed with regards to price stability. The periphery nations — Italy, Greece, Spain and Portugal — desperately need to regain competitiveness. Were they not members of the Eurozone, these countries would have seen their currencies depreciate, helped by their central banks’ purchases of government debt, making their exports more attractive to foreign buyers and their debt loads more tenable.

As members of a currency union (with the Euro being in many ways, a de facto gold standard), this hasn’t happened. One way to achieve the ultimate goal of restoring competitiveness would be through extremely painful internal devaluation, involving decreases in wages. Or a better way to get to that goal, as German Kantoos Economics argues, is for the ECB to allow inflation to rise in the core Euro countries.

Unfortunately, there’s a phrase making its way around economics blogs that rings all too true, and is starting to look ever more prescient — that the Euro’s epitaph will read “Because the ECB feared three percent inflation.” Indeed the bank’s myopic focus on combating nonexistent inflation (currently even less than the two percent normally aimed for by central banks) is making the problem even worse for the periphery. Coinciding with a universal acceptance of austerity, politics and policy, not profligacy, will be to blame if the Euro meets a bitter end. Both the Federal Reserve and the Bank of England have taken different views, and pursued quantitative easing. Even with this inflationary policy, and actual inflation at around five percent, the United Kingdom, which has control over its own currency, and is a lender of last resort, enjoys very low interest rates on its debt. A friend recently posited to me that this is actually because voters in the United Kingdom showed their support for their government’s austerity initiatives, but when you look to Spain, this argument falls flat. Spain just recently elected an austerity preaching conservative government, yet the interest it must pay to borrow money has nearly doubled in the past month. This is the case even though the country still has one of the Eurozone’s lower debt to gross domestic product ratios — and lower than that of the United Kingdom.

The only way out is for the ECB to expend some of its “political capital” and credibility by announcing that it will stand fully behind the debts of Eurozone nations, and assume a more Fed-like role. Support for this action isn’t limited to left wing academics like Krugman; The Economist has also called for “vast monetary loosening,” and for the ECB to become a lender of last resort to stop the self-fulfilling prophecy of spiraling interest rates from fears of default. Ironically, such a move might calm the markets enough to prevent the ECB from actually needing to do it.

Ostensibly, the ECB has chosen to follow a straight path of hard money because it is afraid of fueling moral hazard that periphery nations, once down from the hot seat, will lose the will to pursue the reforms the Eurozone’s leaders are demanding. And so the time is swiftly approaching that the ECB will have to ask itself a serious question — whether it would prefer to moralize all the way over those Cliffs of Dover, or whether it would rather still have a currency to be a central bank for. If it doesn’t act soon and change course, there will be no need for ECB-head Mario Draghi (or his predecessor, Jean-Claude Trichet) to ask for whom the bell tolls.