I argued last week that the right way to think about what’s going on in Europe is as a game of chicken. The ECB was unwilling to act as a lender of last resort to Italy because it did not want Italy’s chronic indebtedness to drive Europe-wide inflation rates. If it loosened the money spigots and allowed high enough nominal growth for Italy to continue to service and pay down its debts, but there was no European institution capable of enforcing fiscal discipline on Italy, then there was the risk of moral hazard – Italy could operate in a business-as-usual manner, and rely on the ECB to keep it from paying the price, which would instead be paid by northern Europe (preeminently Germany).
Of course, it would be absurd for the ECB to actually destroy the Euro in its efforts to prevent this hypothetical future problem. But it’s not obviously absurd for the ECB to play chicken – to withhold help until the moral hazard problem is resolved, and some mechanism is put in place to, in so many words, give Berlin a veto over Rome’s budget. It’s just a bet that Rome will blink first.
But Ryan Avent makes a good case that the ECB hasn’t just played chicken as the crisis has unfolded, but that the ECB engineered the crisis:
The ECB raised its benchmark interest rate in April of this year. It raised that rate yet again in July. Each move was just 25 basis points, but the signaling power of those moves was significant: the ECB, markets were informed, would not let dormant core inflation, a fragile economy, high unemployment, and an intensifying financial crisis stand in the way of its commitment to low headline inflation. As Paul Krugman and David Beckworth point out, the market impact of the ECB’s actions was dramatic. Inflation expectations tumbled. Nominal output across most of the euro zone switched from expansion to contraction. And as the OECD pointed out today, euro economies are now in recession.
The ECB successfully engineered a collapse in demand (not without assistance from governments, of course). It would be shocking if this didn’t feed into a move from a solvency to an insolvency equilibrium in economies relatively close to the threshold.
The conclusion of his piece points to why the ECB might have wanted to engineer the crisis, and it’s consistent with my views:
Some might argue that responsibility for the crisis must nonetheless sit with the debtors. The Italian economy is a mess, Tyler Cowen says, and though Italy could make a substantial dent in its debts through a large tax on wealth it opts not to. It is broken Italian governance that dooms the euro. Neither Germany or the ECB can be expected to save an Italian economy that won’t take reasonable steps to meet its obligations. But as Mr Cowen is fond of saying in other contexts, the central bank moves last. If the ECB is willing to permit contagion, then no Italian action is a sufficient defence. If the ECB is willing to engineer a recession to wring out inflation, then no Italian reform will generate strong growth.
Some might well argue that responsibility sits with the debtors – more specifically, creditors might argue that. In other words: Germany might argue that. Central banks are generally biased in favor of creditors; the ECB was specifically organized to be biased in favor of Germany. (That was the price for getting Germany to agree to give up the Deutschemark in the first place.) One way of looking at the sequence of events is to say that the ECB was willing to permit contagion in order to wring out inflation. I think a better way of looking at it is to say that the ECB was willing to threaten Italy with insolvency in order to give Germany more formal control over Italy’s finances.
That’s incredibly hard-ball politics, but if you are not accountable to anybody (which the ECB, basically, is not) then you can play really, really hard-ball politics.
And, at a high human cost, the bet seems to be working:
“I will probably be the first Polish foreign minister in history to say this,” he said, “but here it is: I fear German power less than I am beginning to fear its inactivity.”
That’s Radek Sikorski yesterday, calling for new budget procedures that would give European institutions – the Commission, the Council and the Court of Justice – formal veto power over member states’ budgets, and to suspend the voting rights of member states that repeatedly violate the rules. When the Polish foreign minister is begging Germany to turn other European states into quasi-colonies, I’d say you’re getting some traction.