The ECB’s high wire act

from Dean Baker

At this point the sovereign debt crisis in Europe is almost getting boring. We’ve seen the same script played out over and over with country after country. The basic story is the markets begin a run on the debt of a country: Greece, Ireland, Italy, Spain etc.

The troika, the European Central Bank (ECB), the European Union (EU), and the International Monetary Fund (IMF) then demand a series of austerity measures. In addition, they sometimes demand measures unrelated to fiscal policy, such as a lower minimum wage in Ireland or weaker employment protection legislation in Italy, that are intended to weaken workers’ bargaining power. As a quid pro quo, the troika then arranges enough bond purchases or other supports to get through the immediate crisis.

Of course these measures don’t actually solve the underlying problem. If the troika took the steps needed to ensure that the indebted countries got past this crisis, it would lose the ability to demand further austerity and other steps that weaken welfare state supports for workers. The troika is not willing to give up its leverage at this point.

That is why the ECB repeatedly declares its refusal to guarantee support for sovereign debt any time it seems as though the financial markets believe that it is committed to supporting the debt of the troubled borrowers. This insistence by the ECB, coupled with the other policies it pushes to stifle growth, ensures that the crises will continue. The same countries will have to keep coming back for another dose of punishment and new countries will be added to the list as the contagion of slumping demand, deteriorating bank balance sheets, and dwindling confidence spreads.

The negotiating teams at the troika surely must know that the path they are following can only lead to further crises. Their medicine of austerity is irrelevant to the disease that is afflicting the debt-burdened countries.

Most immediately they are suffering from a lack of confidence in their debt. The commitment by the ECB or any other sufficiently deep-pocketed institution (e.g. the IMF, the European Financial Stability Fund or even the Federal Reserve Board or Bank of China) to support the debt would immediately end the crises. If the heavily indebted eurozone countries could again borrow at rates anywhere close to those paid by Germany or the United States, with the exception of Greece, they would have no near-term budget issues.

These countries also all continue to suffer from a shortfall in aggregate demand. This is the continuing fallout from the collapse of housing bubbles across much of Europe. There is no new source of demand to replace the demand that was generated by the bubbles in Spain, Ireland and elsewhere. In this area, the austerity drive directly worsens the problem. The cuts in government spending are not replaced by increased private sector spending. Furthermore, each country’s turn to growth slowing austerity reduces the exports of its neighbors, dampening growth elsewhere in the eurozone.

Then there is the longer term structural problem that costs in southern Europe are out of line with costs in the North, most importantly Germany. Germany continues to maintain a massive trade surplus with the southern European members of the eurozone. The devaluation that would ordinarily occur is impossible within the confines of a single currency.

This leaves differential inflation rates as the only path for adjustment. Ideally this would mean that the northern European countries would run an inflation rate that is somewhat higher than normal. This would allow the southern eurozone countries to regain competitiveness by running low, but still positive inflation rates.

However, the ECB is not going this route. Instead, it is insisting on keeping to its 2.0 percent inflation target for the eurozone as a whole. That means that the southern European countries will be forced to have deflation in order to regain competitiveness. This is an extremely difficult process implying many years of high unemployment. It also means that mortgages and other debts rise in value relative to wages, making households, businesses and the government more heavily debt-burdened through time.

It is almost inconceivable that the ECB and the rest of the troika are not fully aware of the basic facts of the situation as described here, yet they continue with crisis perpetuation policies. This course of action is understandable if the goal is to use the crisis to roll back welfare state protections for workers as much as possible. Presumably once they feel satisfied with the extent of the concessions, they will then take the steps needed to end the euro debt crisis once and for all.

This is a horribly cynical misuse of public institutions. It also runs the risk of backfiring. While it may be the case that no government will deliberately want to incur the costs of defaulting and leaving the euro, the possibility that they will be pushed to this point cannot be ruled out.

This was the story with the IMF and Argentina in 2001. The Argentine government did not intend to default on its international debts and break its peg with the dollar. However, the extreme demands of the IMF eventually left it with no choice, as it became impossible for a democratic government to impose further austerity.

The consequences of a disorderly default by one of the eurozone countries would be much greater for the European and the world economy in today’s environment than was the case with Argentina’s default in 2001. We all share an interest in avoiding this sort of calamity. Unfortunately there is little reason to believe that the troika negotiators will be any more competent in tempering their demands than were their IMF predecessors a decade ago.

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