Watching Mario Draghi trying to gradually out manoeuvre some of his colleagues in order to rescue the Eurozone has a certain intellectual fascination, as long as you forget the stakes involved. I’m not an expert on the rules of this game, so I’m happy to leave the blow by blow account to others, such as Storbeck, Fatas, Varoufakis and Whelan.
What I cannot help reflecting on is the intellectual weakness of the position adopted by Draghi’s opponents. These opponents appear obsessed with a particular form of moral hazard: if the ECB intervenes to reduce the interest rates paid by certain governments, this will reduce the pressure on these governments to cut their debt and undertake certain structural reforms. (Alas this concern is often repeated in otherwise more reasonable analysis.) Now one, quite valid, response is to say that in a crisis you have to put moral hazard concerns to one side, as every central bank should know when it comes to a financial crisis. But a difficulty with this line is that it implicitly concedes a false diagnosis of the major problem faced by the Eurozone.
For most Eurozone countries, the crisis was not caused by their governments spending in an unsustainable way, but by their private sectors doing so (for example, Martin Wolf here). The politics are such that the government ends up picking up the tab for imprudent lending by banks. If you want to avoid this happening again, you focus on making sure governments do what they can to prevent excess private sector spending, which means countercyclical fiscal policy, and perhaps breaking the political power that banks have over local politicians.
Trying to do either of these things by forcing excessive austerity on governments is completely counterproductive. You do not encourage countercyclical fiscal policy by making it more pro-cyclical. In addition, creating major recessions in these countries makes it more, not less, likely that banks will be bailed out. Forcing excessive austerity, as well as doing nothing to deal with the underlying causes of the crisis, may even have made the short term problem of default risk worse. Not only have the size of any bank bailouts increased because of domestic recession, but in the case of Greece excessive austerity has generated political instability which also increases default risk.
In a monetary union, a ‘punishment’ for allowing excessive private sector spending (and therefore the incentive to avoid it) is automatic: the economy becomes uncompetitive and must deflate relative to its partners to bring its prices back into line. Adjustment should be painful for creditors and debtors alike. However there are two clear cut reasons why this deflation should be gradual rather than sharp. The first is the Phillips curve: gradual deflation to adjust the price level is much more efficient than rapid deflation. The second is aversion to nominal wage cuts, which makes getting significant negative inflation very costly.
It is in this context that the game of chess being played at the ECB seems so divorced from macroeconomic reality. By delaying intervention, and insisting on conditionality, the ECB is complicit in creating unnecessarily severe recessions in many Eurozone countries, and may even be making the problem of high interest rates on government debt worse. As the interest rate the ECB sets is close to the zero lower bound, it is almost powerless deal with the consequences for aggregate Eurozone activity, so the Eurozone as a whole enters an unnecessary recession. The OECD is forecasting a -4% output gap for the Euro area in 2013, and only an inflation nutter would call that as a success for the ECB.
It gets worse. By not using its power (which no one doubts) to lower interest rates on government debt, it has allowed a crisis of market confidence to become a distributional struggle between Eurozone countries. So in effect one set of governments started financing another, on terms that make it very difficult for debtors to pay, and so the crisis becomes one that could threaten the cohesion of the Eurozone itself. The ‘you will have to leave’ threats to Greece are just a particularly nasty manifestation of this.
There is a line that some people take that the current crisis shows that a partial economic union, where fiscal policy remains under the control of nation states, is inevitably flawed, and that the only long term solution for the Euro area is fiscal as well as monetary union. I think that case is unproven. If the ECB had undertaken a programme of Quantitative Easing, directed (as any such programme should be) at markets where high interest rates were damaging the economy, then economies would have been able to focus on restoring competitiveness in a controlled and efficient manner. That was never going to be easy or painless, but it need not have led to the scale of recession, and the political discord, that we are now seeing.
The current crisis certainly reveals shortcomings in the original design of the Euro. In my view these shortcomings could have been (and still could be) solved, if those in charge had looked at what was actually happening and applied basic macroeconomic principles and ideas. We have perpetual crisis today because too many European policymakers (and, with politicians’ encouragement, perhaps also voters) are looking at events through a kind of Ordoliberal and anti-Keynesian prism. If the current crisis reveals anything, it is how misguided this ideological perspective is.
This column was first published on Mainly Macro