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The ECB’s Lethal Inhibition

By Barry Eichengreen*

ΒΕRKELEY – Last December, with Europe’s financial system on thebrink of disaster, the European Central Bank stunned the markets with anunprecedented intervention, offering banks across the eurozone essentiallyunlimited liquidity against any and all collateral for an exceptional period ofthree years.The ECB’ssurprise liquidity operation put the continent’s crisis on hold. But now, justfourth months later, matters are again coming to a head. The big southernEuropean countries, Spain and Italy, battered by austerity, are spiraling intorecession. The deterioration of economic conditions is casting doubt on theirgovernments’ budgetary arithmetic, undermining political support for structuralreform, and reopening seemingly closed questions about the stability of bankingsystems.

Once again,the eurozone appears to be on the verge of unraveling. So, will it be once moreinto the breach for the ECB?The hurdlesto further monetary-policy action are high, but they are largely self-imposed.At its most recent policy meeting, the ECB left its policy rate unchanged,citing inflation half a percentage point above the official 2% target. Boardmembers may have also been concerned by evidence of cost-push inflation inGermany. The leading German trade union, IG Metall, has called for a 6.5% wageincrease in the next annual round of negotiations. And German public-sector workersobtained an agreement at the end of March that boosts wages by 6.3% in thecoming two years.But thisincrease in German labor costs is, in fact, precisely what Europe needs toaccelerate its rebalancing, because it will help to realign the competitivepositions of the northern and southern European economies.SouthernEurope needs to enhance its competitiveness and export more, and has beencriticized (not without justification) for failing to do more along theselines. But what matters are southern Europe’s costs of production relative tothose of Germany, Europe’s export champion. That is why the prospect of risingGerman labor costs, after a decade of stasis, is actually one of the fewpositive economic developments on the European scene – hardly something thatthe ECB should resist.And the factthat higher wages in Germany will be matched by lower wages across southernEurope suggests that continent-wide inflationary pressures will remain subdued.With eurozone unemployment above 10%, it is hard to see how things could beotherwise. The 2.6% headline inflation rate in March was heavily influenced byspiking energy prices, the effects of which should be transitory (events in theMiddle East permitting). Indeed, the ECB’s own forecast has inflation fallingin the second half of 2012 and again in 2013, suggesting that it has monetaryroom for maneuver.A secondargument against further monetary-policy action is that it should be consideredonly as a reward for budgetary austerity and structural reform, areas in whichpoliticians continue to underperform. Where spending cuts should, in principle,help to dampen inflation, European governments, like that of Spanish PrimeMinister Mariano Rajoy, are backtracking on their budgetary commitments.Similarly, where structural reforms should rein in price growth by encouragingcompetition, leaders like Italian Prime Minister Mario Monti, finding itincreasingly difficult to marshal support for unpopular measures, are wateringdown already-modest proposals to enhance labor-market flexibility.With governmentshesitating to do their part, the ECB is reluctant to support them. In its view,rewarding them with monetary stimulus – keeping the boat afloat with morespending – only relieves the pressure on national officials to do what isnecessary.If this isthe ECB’s thinking, then it is playing a dangerous game. Without spending andgrowth, there can be no solution to Europe’s problems. Absent private spending,budget cuts will only depress tax revenues, requiring additional budget cuts,without end. There will be no economic growth at the end of the tunnel, andpolitical support for structural reforms will continue to dissipate.The ECB ispreoccupied by moral-hazard risk – the idea that supporting spending willrelieve the pressure on governments to act. But it should also worry aboutmeltdown risk – about the danger that its own failure to act, by leading to adeep recession, will undermine political leaders’ ability to take the stepsneeded to put their economies on a sound footing.The ECB willobject, not without reason, that monetary policy is a blunt instrument withwhich to rebalance the European economy. A cut in policy rates or “quantitativeeasing” by another name will do nothing to enhance the troubled southernEuropean economies’ competitiveness.True enough.But, without economic growth, the political will to take hard measures at thenational level is unlikely to be forthcoming. Without support from the ECB,both goals – economic recovery and political leaders’ commitment to structuralreform – will remain purely aspirational.*BarryEichengreen is Professor of Economics and Political Science at the Universityof California at Berkeley, and a former senior policy adviser at theInternational Monetary Fund. 

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