Will the European Central Bank Solve the Euro Zone Crisis?

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Dean Baker
The Hankyoreh (South Korea), November 2011

It is painful for the world to see the convolutions shaking the eurozone economies. This is not just a matter of empathy; a collapse of the euro zone would shake the world financial system and likely create a second dip to the recession.

But of course no one is suffering to the extent of the people in the countries directly affected. Greece’s economy has already shrunk by more than 10 percent from its pre-crisis level. Current projections show that Greece will not return to its 2008 level of GDP until almost the end of the decade. Public services across the country have been slashed, as have pensions for retirees who have little prospect of returning to work.

Ireland and Spain both have high double-digit unemployment rates with no prospect of a substantial decline any time soon. Italy is also looking at years of stagnation given the austerity measures being demanded by the European Central Bank (ECB) and its negotiating allies in the European Commission and the IMF, often referred to as the “troika.”  

The bad situation will become considerably worse if there is meltdown, which would most likely occur if Greece or one of the other countries has a disorderly default. This could come about through any number of channels. For example, civil unrest may make it literally impossible for Greece to carry through further austerity measures. This is what happened in Argentina in 2002 leading to its default. Alternatively, a financial panic may suddenly send interest rates on the bonds of one of the heavily indebted countries soaring, giving them an unpayable debt burden.

The solution for this situation is evident. In the case of Greece, where the debt already exceeds 150 percent of GDP, there will have to be a substantial write-down of debt on the order of at least 50 percent. The budget situations of the other countries are considerably more manageable. Their biggest risk is from a self-perpetuating financial panic. When the interest rate on Spanish or Italian bonds was near the German level, interest on their debts was not a major problem. However, with the spread now hovering near 4.0 percent, the situation is qualitatively different. The obvious solution would be for the ECB to provide a guarantee on the debt of these countries to protect against this sort of self-fulfilling panic.

There are two major factors that prevent the ECB from providing this sort of guarantee. First, it would raise the risk of inflation. The ECB could not constrain its issuance of money if it is committed to guarantee the debt of its member states. Given the large amount of excess capacity in the euro zone, inflation should not be a major concern at present for the ECB, but unfortunately it is.

There are also legal obstacles that would make it difficult for the ECB to directly buy the debt issued by member states. However, there should be ways around this, for example by selling low cost credit default swaps on the debt of the troubled countries.

The other factor is that the troika has been using this crisis to force governments to cut back their social supports and to restructure their labor markets in ways that are likely to put downward pressure on the wages of ordinary workers. This exposes the incredible class bias in these institutions. At a time when the eurozone and the whole economy is teetering on the brink of another financial crisis, they are trying to take advantage of the situation to put in place measures that will further redistribute income upward. This is even more outrageous when we remember that the only reason the world economy is facing an economic crisis in the first place is because of mismanagement by these institutions.

It is also important to remember that the immediate cause of the crisis was not the profligacy of governments or the excess pay of ordinary workers. The immediate cause of the crisis was the ineptitude of both private and public bankers. Private banks made massive loans to fuel the housing bubbles across the eurozone and the excesses of some governments, most notably Greece.

The executives of these banks are paid large six- and seven-figure salaries to recognize risk; nonetheless they failed to recognize it. The same was true of the economists and top managers at the troika who also failed to understand the risk posed the housing bubbles. But it is not the bankers and bureaucrats who stand to suffer. It is retail clerks, factory workers and construction workers and retirees living on government pensions. That is the way things work in our political system.

The ECB and the rest of the troika sure do not want to see another freeze up of the financial system like the one that occurred after the collapse of Lehman. However, they are willing to risk such a freeze-up in order to further their agenda of weakening social supports and undermining workers’ bargaining power across Europe. It will be interesting to see how long the rest of the world is willing to tolerate this game.


Dean Baker is a macroeconomist and co-director of the Center for Economic and Policy Research in Washington, DC. He previously worked as a senior economist at the Economic Policy Institute and an assistant professor at Bucknell University.