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Does Southern Europe Have A Central Bank?

There has been quite a bit of happy talk in the media about the "resolution" of the eurozone crisis. I'm not clear why, since Europe's depression continues unabated. Real GDP peaked nine quarters ago, unemployment remains at 12%, and the debt ratios have not changed their trajectories. The ECB's own forecasts are grim. One is tempted to ask if the eurozone's real output will ever return to where it was in 2011, given its current slope. And even more disturbing, nominal GDP growth has been flirting with zero. The eurozone economy has flatlined, like a corpse. The crisis isn't resolved.

But you wouldn't know this by listening to Draghi's press conferences. He is satisfied that the ECB has done all it can in terms of stimulus, and that recovery depends upon further structural reforms. He says that "low growth is the outcome of economies that need to have structural reforms", and that "structural reforms are the necessary and sufficient condition for recovery to happen". He reviews the dismal economic statistics (and the ECB's dismal forecasts) at his press conferences, and then concludes by congratulating the ECB for achieving price stability, its single mandate. The fact that inflation is running well below its 2% target is not a problem, since that demonstrates even greater price stability.

By blaming the eurozone's depression on structural deficiencies, the ECB has washed its hands of Southern Europe: if the southern tier want growth, they will have to tighten their belts and wait for their domestic price level to fall until they become competitive. A few more years of austerity, and growth will naturally resume. As Irving Fisher said in 1933, "This is the so-called 'natural' way out of a depression, via needless and cruel bankruptcy, unemployment, and starvation."

Barry Eichengreen*, an expert on the subject of the Great Depression, has accused the ECB's of having abandoned its core responsibilities as a central bank. In his view, structural reforms or the lack thereof are irrelevant and beyond the remit of a central bank, and cannot justify the abdication of a central bank's responsibilities as protector of the payments system, guardian of financial stability, and lender of last resort.

Eichengreen lays out the devastating data: "The numbers are alarming. Core inflation fell to an annual rate of 0.8% in October - a 47-month low - while producer prices fell by 0.5%, suggesting that deflation is already in Europe's economic pipeline. Annual growth of M3 money supply, meanwhile, dropped to 1.4% in October, from an already dismal 2% in September, while loans to the private sector contracted by 2.9% year on year."

He blames this state of affairs on the ECB's deference to German public opinion:

"A responsible central bank should not cater to irrational fears of inflation in what is in fact a deflationary environment, just as it is not an independent central bank's role to tighten the thumbscrews for fiscal and structural reform."

He deplores the ECB's decision to condition the performance of its core responsibilities on compliance with EU conditionality: "While a central bank should ensure the smooth operation of the payments and financial system, it makes no sense for this task to be contingent on governments' negotiation of a reform program with the European Union. The commitment to preserving the integrity of the payments system must be unconditional. If the ECB concludes that panicked investors are threatening the integrity of the payments system by selling a member state's bonds, then it should intervene, buying up those bonds on the secondary market, EU agreement or not."

He is concerned that the ECB's focus on German opinion is leading to a deflationary spiral: "It is reasonable for the ECB to be concerned about its public standing. But if its leaders are worried about the impact on its reputation of embracing unconventional policy, they should pause and reflect on the much greater damage that would follow from allowing the economy to slip into a deflationary trap from which it would be difficult, if not impossible, to escape."

Needless to say, the ECB does not agree with Eichengreen's diagnosis nor with his prescriptions. The ECB believes, instead, that its has been providing "extraordinarily accommodative" policy since the Crash, and that this policy is working. The ECB is also of the view that the preservation of the euro and the eurozone does not, will not, and cannot require the ECB to rescue individual countries or banks. They must save themselves by "bailing in" bondholders and uninsured depositors (in other words, default). That's the ECB's response to being asked to act as the lender of last resort.

Eichengreen is worried that a eurozone deflationary spiral would be difficult to reverse. Europe only has two economic levers: monetary and fiscal policy. Ideally, these levers would be pulled in concert: the ECB would monetize fiscal deficits, thus increasing aggregate demand and inflation. But the ECB has forsworn both tools by demanding fiscal balance and prohibiting "monetary financing". Both levers are locked in the ECB's closet. If deflation does gather momentum, the ECB will have no tools to fight it.

I have argued that, in the end, the authorities in developed countries will always choose financial stability when forced to do so by a crisis. I am beginning to think that this may not apply to the eurozone. The restoration of financial stability in a crisis requires the provision of unlimited liquidity by the central bank, and the support of a credible and responsible guarantor. When the US financial system was rescued five years ago, nobody worried that the Fed would withhold liquidity, or that the Treasury could not afford to recapitalize the banks. Everyone knew that the Fed had a printing press, and the US Treasury unlimited debt capacity. Once the TARP was up, the death spiral was stopped.

The ECB is not acting as the central bank for troubled countries in Southern Europe; it is acting more like the IMF, a provider of conditional assistance. Further, there are no credible guarantors in the eurozone. Germany is too small, unwilling, and not responsible for the rest of the zone. The ESM is tiny. Thus Europe lacks an effective central bank and a credible guarantor. Indeed, we have already witnessed the collapse of the financial system of one of the Southern European countries, which occurred with the knowledge and approval of their so-called "central bank".

Who will be next and what will happen to them? Under the Single Resolution Mechanism, depositors at all eurozone banks are at risk of default, conditioned on the financial resources of their governments. What stands between the next wave of insolvencies and financial collapse? Not the ECB.


*Barry Eichengreen is Professor of Economics at UC Berkeley, and a former senior policy adviser at the International Monetary Fund. His most recent book is "Exorbitant Privilege: The Rise and Fall of the Dollar and the Future of the International Monetary System". He has written extensively about the interwar gold standard. The piece from which I have quoted is "The ECB's Bridge Too Far", Project Syndicate, 10 Dec. 2013.