There is an old maxim that in any bureaucracy people will always rise to the level of their incompetence. This certainly seems to be the case with the European Central Bank (ECB). After totally ignoring the build-up of dangerous housing bubbles in most euro zone countries, as well as the imbalances that supported these bubbles, the ECB now seems intent on punishing the people in many of these countries for its mistakes.
This is the likely result of the policies that it is now pursuing, whether or not this is the intention. The insistence that the heavily indebted countries in the euro zone - Greece, Ireland, Portugal and Spain - pay off their debt in full will inevitably lead to years of high unemployment in these countries and trillions of dollars of lost output throughout the euro zone as a whole. The budget cuts demanded of these countries will force large reductions in pensions and other social supports at a time when macroeconomic policies ensure that few jobs are available.
It is difficult to see any plausible gain from this pain. If the purpose of the pain is increased respect for fiscal discipline then the guns are pointed in the wrong direction. Ireland, Portugal and Spain had surpluses or relatively small deficits in the years preceding the crisis. The problems that sank these economies were bad loans in the private sector and the bubbles they fueled.
It is difficult to see what lessons are taught by strangling the public sector. The austerity policies being imposed on these countries are unlikely to put serious dents in the fortunes of those who profited from these speculative bubbles.
Even in the case of Greece, which clearly did have serious fiscal problems, the austerity agenda only deals with half of the problem. Every reckless borrower needs a reckless lender. In this case, the reckless lenders in Germany and France are being bailed out by new loans from the euro zone rescue fund and the International Monetary Fund (IMF). It's not clear what lessons the lenders are learning.
Remarkably, for its larger macroeconomic policy, the ECB continues to maintain its fixation on its two percent inflation target, as though the economic collapse never occurred. This has caused it to already start raising interest rates at a time when more than 15 million people are unemployed throughout the euro zone. (It's worth noting that even at the peak of the crisis, the ECB never lowered its overnight rate below 1.0 percent, compared to the near zero rate maintained by the Federal Reserve Board for the last two-and-a-half years.)
The higher interest rate unnecessarily clamps down on badly needed growth throughout the euro zone, but its impact on the heavily indebted countries will be especially pernicious. In addition to worsening the employment situation, it is also likely to increase their interest burden as the interest rates paid by these countries will likely rise in step with the ECB rate.
There is a real risk that the ECB's policy may soon make the situation of the governments in the heavily indebted countries untenable. The populations of these countries are clearly willing to endure economic hardship for a period of time, under the belief that this suffering will lead to a better future. However, this prospect is getting more questionable by the day, as the better future gets pushed out ever further in the distance.
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The latest projections from the IMF show that Spain's GDP will not recover its pre-crisis peaks until 2013. It will take Ireland until 2015, and Portugal and Greece until 2016. Furthermore, given the consistent patterns of downgrading growth projections over the last few years, it is likely that it will take these countries even longer to regain their lost output on their current policy path.
This raises the possibility that governments of the heavily indebted countries will soon find it impossible to agree to the never-ending demands for austerity coming from the ECB and the IMF. The refusal to come to terms will inevitably lead to a financial crisis, as anyone with assets will seek to withdraw them from the banks of a country facing such a standoff.
In such circumstances, leaving the euro and reintroducing a domestic currency becomes a realistic prospect. No government would ever go this route unless it had no choice, because it is almost inconceivable that it could reintroduce a domestic currency without bringing on a financial crisis. However, if the crisis is already there, then the domestic currency route would suddenly look much more appealing.
Argentina provides the model for this situation. Its government had supposedly created an unbreakable peg between its currency and the dollar in the early '90s. When interest rates in the United States rose in the late '90s, and the value of the dollar rose as well, Argentina's situation became untenable.
After negotiating a series of austerity packages with the IMF, the resulting recession and cutbacks in public services created enough civil unrest that the country could go no further. With the situation spiraling out of control, the government had no choice but to break its unbreakable peg. The resulting financial crisis sent the economy spiraling downward. However, it stabilized after three months, and began leaping forward six months after the break. It continued to have strong growth for the next six years until the world economic crisis brought Argentina's economy to a standstill in 2009.
If the ECB and IMF do not ease up on their conditions, they may push the heavily indebted countries down a similar path. Greece is the most likely candidate, having experienced the sharpest fall in output to date and facing the highest burden of debt to GDP. While there is much about Greece's economy that is badly in need of reform, the current austerity policies are not helping them to accomplish this reform.
If Greece were to leave the euro, there would undoubtedly be considerable short-term pain, but with its own currency it would at least have a route to resume growth in a reasonable period of time. Greece's departure would also pave the way for other countries to follow. This may be the lesson that the ECB needs in order to develop more realistic policies for dealing with the enormous imbalances that it allowed to develop in the last decade. Maybe the ECB bureaucrats can still learn some basic economics before they take Europe's economy even deeper into a hole.