Last week the President of the European Central Bank (ECB), Mario Draghi, announced that the ECB would become the Eurozone’s lender of last resort by starting to purchase the sovereign bonds of the area’s stricken economies. Paul de Grauwe addresses two major criticisms of the plan, saying that while this intervention was absolutely necessary, it alone is not enough to save the Eurozone, and that it is unlikely to increase inflationary pressures. He also argues that the ECB should resist the urge to insist on severe austerity measures in exchange for the purchase of government bonds; such measures may make the crisis even worse.
After much hesitation, the European Central Bank (ECB) decided last Thursday (6 September) to do what had become inevitable, i.e. to become a lender of last resort in the government bond markets. Fear and panic was pushing some Eurozone countries in a self-fulfilling way towards the economic abyss. Mistrust led investors to sell the bonds of these countries thereby leading to a surge in the interest rates and forcing the authorities to intensify budgetary austerity plans. All this brought down the economies even further and led to a new deterioration of public finances. Investors looked at it and saw that the state of the countries had become worse. They panicked even more. And so it went on.
The interest rate rises no longer reflected the economic fundamentals of these countries, but expressed sheer panic. The panic had to be stopped. The ECB has now announced that it wants to do this by committing itself to a program of unlimited sovereign bond purchases in the secondary markets. In this way, the steadily increasing upward pressure on interest rates and the ensuing panic in these countries can be stopped.
I have heard and read a lot of criticism against the decision of the ECB. I also have my share of criticism but more on that later. First I want to counter two of the most frequently raised points of criticism.
There was a lot of criticism to the effect that the bond purchases do not solve the fundamental problems of these countries, and therefore that the ECB is wrong to want to solve these problems by throwing money at them. The first part of this criticism is correct, the second part is wrong. It is true that the intervention of the ECB does not tackle the fundamental problems of these countries. But does this mean that the interventions of the ECB are not needed? Not at all. There is confusion between what is necessary and what is sufficient. The interventions of the ECB are necessary to prevent worse. Of course they are not sufficient to permanently save the Southern countries and to avoid a breakup of the Eurozone. In order to prevent the latter, structural reforms will be necessary.
Let me use a metaphor. Imagine a city where houses are constantly on fire. There is apparently a structural problem (a pyromaniac, inadequate fire safety regulations, or perhaps other causes). These structural problems will have to be addressed. But does that mean that if a new fire erupts, the firemen should not extinguish it? The fact that pouring water on the flames does not resolve the structural problems and that other fires will rage cannot be a reason to conclude, as critics of the ECB do, that the fire brigade should not try to extinguish the fire. It should. This is necessary to prevent a worse outcome, and to avoid more innocent victims. Extinguishing the fire is necessary but not sufficient. Similarly, the interventions of the ECB are necessary but not sufficient. An important distinction that to my surprise seems to have been forgotten by many critics.
A second criticism that I heard in Germany and other Northern European countries is that these interventions will lead to inflation. This criticism is based on a fundamental misunderstanding about what’s going on today. We are still in a financial crisis. This is characterized by the fact that after the excesses of the wild bubble years, financial institutions have become very risk-averse, and only sparsely grant credit to companies and households. All they want is to accumulate as much liquidity as possible to ensure readiness for the next crisis. The result is that the economy has been pushed into a downward spiral, as companies and households reduce their spending for investment and consumption. Total demand for goods and services decreases, with the result that there is a potential risk of deflation, not inflation. In some Southern countries this is already the case and prices decline. The fear that in such an environment the interventions of the ECB will lead to too much inflation, reminds me of the generals who are preparing for the last war.
The absence of an inflation risk today is also apparent from the following. The liquidity created by the ECB (which economists call the “money base”) does not seep through into the real economy. The banks are piling up the liquidity without doing anything with it. The extra cash injected into the financial system does not lead to more bank credit or to an increase of the money supply. And it is the latter which is important for inflation.
Most economists dealing with this problem understand this. Even Milton Friedman, the Pope of monetarism understood this when he stated that in a financial crisis, the central bank must be ready to pour liquidity into the financial system, in order to prevent a deflationary spiral.
I now come to my criticism of the ECB. The latter has made the purchase of government bonds conditional on further budgetary cuts in Southern countries. Most of these countries have made dramatically deep cuts. We now know that all too impetuous cuts are counterproductive, and can push countries into an economic and social abyss. Thus, one can hope that the ECB will use common sense and will not ask the Southern countries first to jump into the abyss before it helps them out with more cash.
This column was first published by EUROPP @ LSE