The ECB’s Lethal Inhibition
Barry Eichengreen
12 April 2012
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.BERKELEY – Last December, with Europe’s financial system on the brink of disaster, the European Central Bank stunned the markets with an unprecedented intervention, offering banks across the eurozone essentially unlimited liquidity against any and all collateral for an exceptional period of three years.
The ECB’s surprise liquidity operation put the continent’s crisis on hold. But now, just fourth months later, matters are again coming to a head. The big southern European countries, Spain and Italy, battered by austerity, are spiraling into recession. The deterioration of economic conditions is casting doubt on their governments’ budgetary arithmetic, undermining political support for structural reform, and reopening seemingly closed questions about the stability of banking systems.
Once again, the eurozone appears to be on the verge of unraveling. So, will it be once more into the breach for the ECB?
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The hurdles to further monetary-policy action are high, but they are largely self-imposed. At its most recent policy meeting, the ECB left its policy rate unchanged, citing inflation half a percentage point above the official 2% target. Board members may have also been concerned by evidence of cost-push inflation in Germany. The leading German trade union, IG Metall, has called for a 6.5% wage increase in the next annual round of negotiations. And German public-sector workers obtained an agreement at the end of March that boosts wages by 6.3% in the coming two years.
But this increase in German labor costs is, in fact, precisely what Europe needs to accelerate its rebalancing, because it will help to realign the competitive positions of the northern and southern European economies.
Southern Europe needs to enhance its competitiveness and export more, and has been criticized (not without justification) for failing to do more along these lines. But what matters are southern Europe’s costs of production relative to those of Germany, Europe’s export champion. That is why the prospect of rising German labor costs, after a decade of stasis, is actually one of the few positive economic developments on the European scene – hardly something that the ECB should resist.
And the fact that higher wages in Germany will be matched by lower wages across southern Europe suggests that continent-wide inflationary pressures will remain subdued. With eurozone unemployment above 10%, it is hard to see how things could be otherwise. The 2.6% headline inflation rate in March was heavily influenced by spiking energy prices, the effects of which should be transitory (events in the Middle East permitting). Indeed, the ECB’s own forecast has inflation falling in the second half of 2012 and again in 2013, suggesting that it has monetary room for maneuver.
A second argument against further monetary-policy action is that it should be considered only as a reward for budgetary austerity and structural reform, areas in which politicians continue to underperform. Where spending cuts should, in principle, help to dampen inflation, European governments, like that of Spanish Prime Minister Mariano Rajoy, are backtracking on their budgetary commitments. Similarly, where structural reforms should rein in price growth by encouraging competition, leaders like Italian Prime Minister Mario Monti, finding it increasingly difficult to marshal support for unpopular measures, are watering down already-modest proposals to enhance labor-market flexibility.
With governments hesitating to do their part, the ECB is reluctant to support them. In its view, rewarding them with monetary stimulus – keeping the boat afloat with more spending – only relieves the pressure on national officials to do what is necessary.
If this is the ECB’s thinking, then it is playing a dangerous game. Without spending and growth, there can be no solution to Europe’s problems. Absent private spending, budget cuts will only depress tax revenues, requiring additional budget cuts, without end. There will be no economic growth at the end of the tunnel, and political support for structural reforms will continue to dissipate.
The ECB is preoccupied by moral-hazard risk – the idea that supporting spending will relieve the pressure on governments to act. But it should also worry about meltdown risk – about the danger that its own failure to act, by leading to a deep recession, will undermine political leaders’ ability to take the steps needed to put their economies on a sound footing.
The ECB will object, not without reason, that monetary policy is a blunt instrument with which to rebalance the European economy. A cut in policy rates or “quantitative easing” by another name will do nothing to enhance the troubled southern European economies’ competitiveness.
True enough. But, without economic growth, the political will to take hard measures at the national level is unlikely to be forthcoming. Without support from the ECB, both goals – economic recovery and political leaders’ commitment to structural reform – will remain purely aspirational.
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Barry Eichengreen is Professor of Economics and Political Science at the University of California at Berkeley, and a former senior policy adviser at the International Monetary Fund. He is renowned for his examination of the world’s financial system at its most perilous turning points, from the breakdown of the gold standard in the 1930’s to the reconstruction of the world economy following World War II. His most recent book is Exorbitant Privilege: The Rise and Fall of the Dollar and the Future of the International Monetary System.
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