European Central Bank President Mario Draghi has been making pronouncements that many have interpreted as positive for the future of the euro.
I think his words mean things are going to get ugly.
On July 26, Draghi said his institution would do “whatever it takes” to preserve the euro, and reinforced this with a nice turn of phrase: “Believe me, this will be enough.” He followed this up last week with a more official statement that the ECB “may undertake outright open market operations of a size adequate to reach its objective,” signaling that the bank is preparing to buy more bonds to lower the borrowing costs of struggling governments such as Italy and Spain.
Optimists hope that Draghi is trying to put an end to the policy uncertainty that has characterized the euro crisis. In the run-up to 2008, many investors thought there were big potential bailouts implicit in the structure of the currency union -- a view reflected in the nearly identical yields on German, Greek, Italian and Spanish bonds. This confidence collapsed as events in Greece, Ireland and Portugal demonstrated that the ECB would not support all government debt irrespective of the circumstances. Now, the logic goes, if Draghi could just restore the promise of unconditional and unlimited “support,” he would put the genie back in the bottle.
A better analogy would be that it is easier to make fish soup from fish than to do the reverse. Once you have understood that the ECB does not necessarily stand behind euro-area government debt, it is hard to disabuse yourself of the notion. Presumably this is why markets sank last week when Draghi failed to offer concrete action to ease monetary policy, either by lowering the bank’s target interest rate or by buying more bonds.
A broader question is what, if anything, Draghi might achieve with a looser monetary policy. The euro area has many problems, including a lack of competitiveness in the periphery, chronically poor growth in countries such as Portugal and Italy, deeply damaged public finances in Greece and Spain, and a labor force that’s not mobile enough to go where the jobs are. Which of these could be resolved by reducing interest rates across the board?
Perhaps the bet is that easy money will inflate nominal wages and prices in the Germanic core of the euro area while weakening the euro, so that peripheral countries become more competitive in relation to Germany and the rest of the world. It’s hard to see how this would work in practice. It certainly wouldn’t change the fact that Germany keeps getting more productive and pulling ahead of its partners.
Maybe Draghi’s policies can buy time for deeper “structural changes” in the periphery, although quite what those are and what difference they would make in the near term remains elusive. Firing public-sector workers in the midst of a steep recession won’t boost growth and transform industrial productivity. It’s hard to see how providing politicians in troubled countries with unlimited credit will increase the likelihood of real reform of any kind.
More likely, a shift in ECB policies would make the European situation uglier. For one, Draghi would essentially be conceding fiscal dominance, demonstrating that if governments run budget deficits, they can count on the central bank to finance them. More important, the political consequences could be dire if the ECB actually succeeded in stoking German inflation and weakening the euro.
Inflation is unpopular and very unfair. People who think that higher inflation would somehow help the poor and hard pressed in the European Union should study economic history more carefully. It could lead the Germans to question the viability of the euro, increasing the risk that the currency will break apart for political reasons. The Germans didn’t turn over their monetary sovereignty to the ECB to facilitate bailouts of irresponsible governments and the crazed banks that funded real-estate bubbles. Throwing greater fiscal transfers from Germany into the mix will serve only to worsen the situation.
Perhaps Draghi is planning the same game with fiscal authorities that the Banca d’Italia used to play with Italian politicians in the 1980s and early 1990s -- keep interest rates low enough to prevent fiscal collapse, yet high enough to keep fiscal prudence as a priority. Make no mistake about it, inflation or not, this is a strategy of high real interest rates.
But debt levels in Italy and other euro area countries are much higher now than they were then. And relatively high real interest rates won’t be conducive to private-sector growth, which is what Europe needs more than anything else.
Draghi and the ECB are increasing the risk that the euro area will fall to pieces. This scenario would be ugly for many people, and not just in Europe.
(Simon Johnson, a professor at the MIT Sloan School of Management as well as a senior fellow at the Peterson Institute for International Economics, is co-author of “White House Burning: The Founding Fathers, Our National Debt, and Why It Matters to You.” The opinions expressed are his own.)
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