European leaders earlier this month announced a plan that, on the face of it, was pure nonsense.
Faced with a crisis that is mainly about the balance of payments,with fiscal crisis as a secondary consequence, they supposedly committed everyone to severe fiscal austerity, which would guarantee a recession while leaving the real problem unaddressed.
But all this was supposed to work, according to many observers — and, briefly, the market — because the pain would provide the cover the European Central Bank needed to step in and buy lots of Italian and Spanish bonds. In effect, the plan is supposed to rely on a Draghi ex machina, which turns contractionary policies expansionary.
It’s actually quite remarkable how many sensible people base their analyses on the presumption that the E.C.B. will do what has to be done. Barry Eichengreen, the economist who is a genuine expert on all things euro, starts his analysis of prospects for 2012 with the confident assertion that Mario Draghi, the president of the E.C.B., will ride to the rescue.
“The collapse of the euro zone would, of course, be an economic and financial calamity,” Mr. Eichengreen wrote in a recent column for Project Syndicate.
“But that is precisely why the European Central Bank will overcome its reluctance and intervene in the Italian and Spanish bond markets, and why the Italian and Spanish governments will, in the end, use that breathing space to complete the reforms that the E.C.B. requires as a quid pro quo.”
But as far as anyone can tell, the monetary cavalry aren’t coming. And the bond market has figured this out.
What Anglo-Saxon economists need to understand is that the Germans and the E.C.B. really, really don’t share our worldview; they really do believe that austerity is all you need. And all indications are that they will cling to that belief, even as the euro falls apart — an event they will insist was caused by debtors’ fecklessness.
Given a choice between saving Europe and remaining righteous, they’ll choose the latter.
The E.C.B.’s Reverse F.D.R.
Ryan Avent, The Economist’s economics correspondent, recently joined the chorus of those suggesting that the European Central Bank’s decision last spring to start raising rates — a decision that seemed crazy then, and looks even crazier now — was the point at which everything started to fall apart.
“Maybe the single currency will survive. It will certainly be disastrous if it doesn’t,” Mr. Avent wrote in an online article on Nov. 28. “But if the E.C.B. manages to rescue the euro zone with a life-saving infusion of cash delivered via massive bond purchases, we shouldn’t forget that it was the E.C.B. that nearly killed it in the first place.”
But how could what were, in the end, relatively small rate hikes have done large damage? As Mr. Avent says, here is where the expectations channel may have been crucial.
One way to look at it is as a reverse F.D.R. A few years ago Gauti Eggertsson, an assistant vice president at the Federal Reserve Bank of New York, published a persuasive analysis of the big economic recovery of 1933-1937 in the American Economic Review; he argued that it had a lot to do with changed expectations of future monetary policy. Specifically, by taking America off the gold standard — a shocking move at the time — and explicitly calling for a return to pre-Depression price levels, President Franklin D. Roosevelt created an expectation of rising prices that had a salutary effect on demand.
So what happened in spring 2011? The E.C.B. raised rates even though there was no sign of underlying inflationary pressure beyond a commodity blip, and even though the needed price adjustment in the periphery clearly required a reasonably high inflation target.
Jean-Claude Trichet, the E.C.B. president at the time, might as well have gone on T.V. and announced, “My colleagues and I are determined to make the debt problems of southern Europe insoluble.”
And they’ve succeeded.
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Paul Krugman joined The New York Times in 1999 as a columnist on the Op-Ed page and continues as a professor of economics and international affairs at Princeton University. He was awarded the Nobel in economic science in 2008.
Mr Krugman is the author or editor of 20 books and more than 200 papers in professional journals and edited volumes, including "The Return of Depression Economics" (2008) and "The Conscience of a Liberal" (2007).
Copyright 2011 The New York Times.