It’s Not Just the ECB / es ist nicht nur die EZB

A guest commentary by Henry Kaspar [with update]

Paul Krugman and other commentators are singing the euro’s swan song, treating the disorderly break-up he euro area as a quasi fait accompli. Moreover, Krugman writes a first draft for the history books:

Let’s just say that the euro was an inherently flawed idea that can work only given a strong European economy and a significant degree of inflation, plus open-ended credit to sovereigns facing speculative attack. Yet European elites embraced the notion of economics as morality play, imposing across-the-board austerity, tightening money despite low underlying inflation, and have been too concerned with punishing sinners to notice that everything was going to blow apart without an effective lender of last resort.

… leading inevitably to:

The only route I see to avoid something like this involves the ECB totally changing its spots, fast.

I am less convinced that this is the euro’s final hour (I don’t see, for example, why recent events should break the currency union between France and Germany – or the Netherlands and Germany, for that matter). But this apart, there is much in Krugman’s post I agree with. Yes, to be able to function, a heterogeneous currency union needs more inflation than a homogeneous industrial country. This is why the ECB cannot copy the Bundesbank. And some European policymakers tend indeed to over-emphasize quasi-moral principles over pragmatic solutions. This was reflected in the refusal to grant the EFSF a banking license – and therefore quasi-unlimited firepower – due to alleged „monetization of fiscal deficits“ (but then, listen to a Republican U.S. Presidential debate…).

And yet, the Krugman-type characterization is too incomplete to do the euro crisis justice. As Kantoos and I have argued repeatedly, a currency union needs not only inflation and open-ended credit – policies that, one may argue, are within the realm of the ECB. It also, and critically, needs the member states’ ability and willingness to adjust, to ensure they remain solvent and their economies competitive. And this is the responsibility of individual governments.

Our critics have dismissed such arguments with sweeping claims like “Italy isn’t insolvent, but the victim of a self-fulfilling speculative attack“. The trouble is that the data simply don’t support this view. The „Italy isn’t insolvent“ part ignores that Italy’s price competitiveness – and therefore its ability to grow and repay debts – eroded faster since euro introduction than that of any other major euro area economy, with a surge in export prices of 25 percent and in manufacturing unit labor cost of 8 percent relative to the rest of the union. And as for the „self-fulfilling speculative attack“ part, I wonder how our critics make sense of this (I know, this is not new):

If the surge is self-fulfilling – i.e.,  excessive risk spreads undermine public debt sustainability, and therefore feed into even higher spreads – why did it not affect for Spain, that entered recent turbulence with spreads 100 bps above Italy? The shock to Italy’s risk spreads did not occur in the context of a general market panic, but as a idiosyncratic event that coincided with a political summer theatre during which Italy’s political class made every effort to convince investors of its incapacity for reform. While the ECB provided massive and almost unconditional liquidity support all along. Yes, it made a feeble attempt to coax Italy’s government into reforms by briefly pausing bond purchases; but when these reforms were not forthcoming the ECB purchased Italian bonds anyway, and it still does. And markets always knew this would happen.

It takes two to tango, and it was Berlusconi’s government that refused to dance.

This leads to a wider point: it is too easy to blame the ECB for everything that is wrong in Europe.Yes, if the ECB could and would act unconstrained, it could, in some instances, be more effective. But the underlying problem is that the euro’s founding fathers – i.e., the Helmut Kohls and Francois Mitterands – gave the ECB an impossible mandate: managing a currency union in a quasi-Bundesbank fashion that features a wildly heterogeneous membership, limited labor mobility and labor market flexibility, no crisis resolution mechanisms, and no mechanisms to reign in unsustainable fiscal or private sector behavior at the national level.

The ECB resembles a fire brigade being asked to put out a fire in a house where gas streams out of all faucets – and with no authorization to turn the faucets off. The ECB fights a brave fight in the circumstances, and it should not be given the entire blame if the house takes damage.


Update. Several posters have pointed to Brad Delongs article on Project Syndicate that follows the „it’s all the ECB’s fault“ theme. DeLong writes:

When the European Central Bank announced its program of government-bond purchases, it let financial markets know that it thoroughly disliked the idea, was not fully committed to it, and would reverse the policy as soon as it could. Indeed, the ECB proclaimed its belief that the stabilization of government-bond prices brought about by such purchases would be only temporary.

It is difficult to think of a more self-defeating way to implement a bond-purchase program. By making it clear from the outset that it did not trust its own policy, the ECB practically guaranteed its failure. If it so evidently lacked confidence in the very bonds that it was buying, why should investors feel any differently?

The trouble with this argument is that it was not the ECB that made financial markets wary of Italian bonds, but the very public, intense and enduring feud between Italy’s Prime Minister Silvio Berlusconi and his Finance Minister Giulio Tremonti.  No happy smile and convinced posture by Trichet when announcing the bond purchase program could have undone the devastating impression left by Italy´s political leadership.

I am not surprised that Paul de Grauwe – who probably still has to find an ECB decision he likes – blames the ECB anyway. But it is a tad disappointing to read this from Brad Delong, who is among my intellectual heroes. I suppose the thousands of miles of clean air between the campus of Berkeley and the realities on the European ground have their part in this.