In July, 2008, on the eve of the biggest financial crisis in memory, the European Central Bank did something both predictable and stupid: it raised interest rates. The move was predictable because the E.C.B.’s president, Jean-Claude Trichet, was an inflation hawk; he worried about rising oil and food prices and saw a rate hike as a way of tamping them down. But the move was also remarkably ill timed. The crisis was already under way, European economic growth had slowed to a crawl, and within a couple of months the global economy had collapsed, inflation had disappeared, and the E.C.B. was forced to slash interest rates, in an attempt to avert economic disaster. That July rate hike was like kicking the economy when it was down
One might have thought that the E.C.B. would learn from the experience. No such luck. This year, Europe has been wrestling with high unemployment, slow growth, and a continuing debt crisis, with the economies of Portugal, Ireland, Italy, Greece, and Spain (the so-called PIIGS) struggling to avoid default. Given the situation, Trichet could have decided to keep interest rates where they were, as both the Federal Reserve and the Bank of England have done. Instead, the E.C.B. raised interest rates in April and, once more, in July. Again, as if on cue, European economic growth stalled and the continent’s debt crisis deepened, which has created problems for markets around the world.
Policymakers make bad decisions all the time, of course. The E.C.B.’s failures, however, are the result not of mere bad judgment but of obsession. That obsession may not have created Europe’s problems, but it has amplified them. The continent’s economic woes boil down, really, to two issues: too much debt and too little growth. These things are connected to each other: the PIIGS are struggling with their debt loads largely because their economies are growing too slowly. By raising interest rates, the E.C.B. increased borrowing costs and slowed economic growth—the opposite of what was needed. And, while the E.C.B. did step up and buy Italian and Spanish government bonds last month, in order to keep those countries afloat, by doing this it was plugging a hole that its own actions had done much to create.
The E.C.B.’s actions have been especially damaging because they’ve come at a time when, in response to the debt crisis, European countries have been forced to take austerity measures, slashing government spending and raising taxes. When fiscal policy is contractionary, expansionary monetary policy can help make up the difference. This is what the Federal Reserve has tried to do in the U.S.—albeit not aggressively enough. The E.C.B., by contrast, has decided to tighten, which means that both fiscal policy and monetary policy are hitting the brakes on the economy.
The perplexing thing about the E.C.B.’s approach is that it’s hard to see who benefits. The traditional explanation for the bank’s anti-inflationary zeal hinges on the fact that the continent’s stronger economies, in particular Germany’s, don’t need any help growing, and don’t like the fact that inflation reduces the real value of assets. So while the PIIGS might prefer a monetary policy that shrank debts and spurred growth, Germany wants low inflation, and Germany wins. Yet right now the entire continent would benefit from easier money. Germany’s economy may have been doing well earlier this year, but it isn’t anymore; in the past quarter, it grew just 0.1 per cent, more slowly than the U.S.’s. Germany is heavily dependent on exports, including exports to the rest of Europe, which means that it can prosper only if other countries do. On top of that, the debt crisis has hurt German banks, which had lent heavily to the PIIGS. Once upon a time, you could argue that the E.C.B.’s approach was helping Europe’s big economies at the expense of the smaller ones. But the current tight-money strategy is making every country a loser.
To be fair, the E.C.B. isn’t alone in its paranoia about inflation. That bias reflects the preferences of many voters, whose hatred of inflation tends to be disproportionate to its real costs. (Cue Rick Perry saying that looser monetary policy would be “almost treasonous.”) Most studies of moderate inflation find that its costs are quite small, but a study of elections in thirteen European countries from the nineteen-sixties to the nineties found that voters were far more likely to toss out politicians when inflation rose than when unemployment did. Inflation hits everyone, after all, even those who have jobs, and it’s easier to get angry about expensive gasoline than about that raise you might have got if the economy were stronger.
Still, the fact that the E.C.B.’s attitude is widely shared doesn’t make it any more excusable. In times of crisis, policymakers need to identify the threats that matter most. Today, rising prices are not a real threat to Europe; recession and debt default are. Trichet is fond of pointing out that the E.C.B.’s primary mandate is to maintain “price stability.” But prices in Europe, where inflation is around 2.5 per cent, are not unstable. And, by acting as if Europe were in danger of repeating the nineteen-twenties, when Weimar Germany succumbed to hyperinflation, Trichet is running the risk of repeating the mistakes of the early thirties, when central bankers’ tight-money policies and zeal for austerity made a bad situation much, much worse. (It’s worth remembering that it was the Depression, not hyperinflation, that toppled the Weimar government and brought Hitler to power.) The E.C.B. has spent this year fighting off the phantom danger of inflation. It’s time for it to face up to the real danger of recession. ♦
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