FacebookTwitterGoogle+RedditEmail

The Cult of Incompetent Bankers

by DEAN BAKER

The world financial system had another serious scare last week. The immediate issue was the prospect that the euro could break up. With the debt crisis spreading from smaller countries such as Greece and Ireland to the eurozone giants of Spain and Italy, events were again getting scary.

A default by the smaller countries would create serious disruptions throughout the eurozone and the larger world economy, but no one doubts that these could be contained. The European Financial Stabilization Fund (EFSB) is large enough to paper over the mess that would be created by the default of Greece or Ireland.

However the default of Spain or Italy is an entirely different matter. If either country were to default, the repercussions would be enormous, dwarfing the resources of the EFSB. A default would almost certainly make several major European banks insolvent and lead to the sort of freeze-up of the financial system that we saw after the bankruptcy of Lehman in September of 2008. With the interest rate on Italian and Spanish debt soaring, the financial markets had to take this risk seriously.

The European Central Bank (ECB) rose to the immediate challenge, buying up large amounts of both governments’ debt and committing itself to buy more if necessary. This re-established confidence in the market and for the moment at least seems to have brought the crisis under control. Still, it is unlikely that anyone would bet that Europe and the world are through with this set of problems and for this the ECB bears an enormous amount of blame.

Just to be clear, this whole crisis came about because central banks did not take seriously their responsibility for maintaining the stability of the overall economy. They held the view that as long as the inflation rate was low and steady then everything else would take care of itself.

In the United States this meant ignoring the growth of an $8 trillion housing bubble, even though this bubble had clearly become the motor of the economy with near-record rates of construction and a housing equity driven consumption boom. In Europe, the ECB failed to notice housing bubbles through much of the eurozone, but most notably the ones in Spain and Ireland that were leading to massive borrowing and unsustainable current account deficits.

However, the Federal Reserve Board has at least been relatively aggressive in responding to the crisis, pushing its overnight lending rate to zero and buying up nearly three trillion dollars in long-term bonds through repeated rounds of quantitative easing. Last week it committed to keeping its overnight lending rate at zero for the next two years.

By contrast, the ECB seems determined to learn nothing from its past errors. It never lowered its overnight lending rate below 1.0 percent and never pursued quantitative easing as aggressively as the Fed. Even worse, it remains committed to its 2.0 percent inflation target as though nothing in the world had changed since the collapse of the bubble. As a result of this commitment, it has actually been raising interest rates in a deliberate effort to slow the eurozone’s economy and dampen inflation.

This policy is incredible for three reasons. First, Europe has no real inflation problem. The rise in the inflation rate targeted by the ECB comes almost entirely from the rise of the price of oil and other commodities. These price increases are the result of the growth in demand in places like China and India. They have almost nothing to do with growth in Europe and will not be reversed by a tighter ECB policy.

The second reason this policy is foolish is that the eurozone countries desperately need a boost from lower interest rates. The heavily indebted countries are all being required to implement austerity plans with large reductions in government spending and tax increases. This will further weaken demand in already depressed economies. Lower interest rates may not be the best way of boosting demand, but they are better than nothing. It is difficult to believe that the ECB would actually want to magnify the contractionary impact of fiscal austerity, but this is exactly what its policy is doing.

The third reason why this policy is foolhardy is that it will likely worsen the interest burden that the heavily indebted countries already face. If they have to pay higher interest rates on their debt then the problem of keeping the debt at a sustainable level becomes much more difficult. Of course the higher unemployment produced by fiscal austerity coupled with monetary contraction will also make it more difficult for these governments to hit their deficit targets.

A central bank that was committed to maintaining stability and laying the basis for future growth would be doing everything it could to promote expansion in the eurozone right now. This would mean at the least lowering the overnight lending rate to near zero. It would also mean large amounts of quantitative easing to directly reduce long-term interest rates. And it could even deliberately target a higher inflation rate (e.g. 3-4 percent) to reduce real interest rates enough to boost the economy. This is what a central bank would do if it was committed to economic growth and stability rather than worshipping a 2 percent inflation rate.

Unfortunately, there is no mechanism to force the ECB to end its obsession with its antiquated 2 percent inflation rule. It is a self-contained bureaucracy, just like the Communist Party in the days of the Soviet Union. The only people whose views matter are ones who have already committed themselves to the ideology, Communism in the case of the Soviet Union, 2.0 percent inflation in the case of the ECB. The inhabitants of the eurozone, like the rest of the world, will just have to wait for the wall to fall.

Dean Baker is the co-director of the Center for Economic and Policy Research (CEPR). He is the author of Plunder and Blunder: The Rise and Fall of the Bubble Economy and False Profits: Recoverying From the Bubble Economy.

This article originally appeared International Relations and Security.


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.

More articles by:

CounterPunch Magazine

minimag-edit

bernie-the-sandernistas-cover-344x550

zen economics

Weekend Edition
May 26, 2017
Friday - Sunday
Anthony DiMaggio
Swamp Politics, Trump Style: “Russiagate” Diverts From the Real White House Scandals
Paul Street
It’s Not Gonna Be Okay: the Nauseating Nothingness of Neoliberal Capitalist and Professional Class Politics
Jeffrey St. Clair
The ICEmen Cometh
Ron Jacobs
The Deep State is the State
Pete Dolack
Why Pence Might be Even Worse Than Trump
Patrick Cockburn
We Know What Inspired the Manchester Attack, We Just Won’t Admit It
Thomas Powell
The Dirty Secret of the Korean War
Mark Ashwill
The Fat Lady Finally Sings: Bob Kerrey Quietly Resigns from Fulbright University Vietnam Leadership Position
John Davis
Beyond Hope
Uri Avnery
The Visitation: Trump in Israel
Ralph Nader
The Left/Right Challenge to the Failed “War on Drugs”
Traci Yoder
Free Speech on Campus: a Critical Analysis
Dave Lindorff
Beware the Supporter Scorned: Upstate New York Trump Voters Hit Hard in President’s Proposed 2018 Budget
Daniel Read
“Sickening Cowardice”: Now More Than Ever, Britain’s Theresa May Must be Held to Account on the Plight of Yemen’s Children
Ana Portnoy
Before the Gates: Puerto Rico’s First Bankruptcy Trial
M. Reza Behnam
Rethinking Iran’s Terrorism Designation
Brian Cloughley
Ukraine and the NATO Military Alliance
Josh Hoxie
Pain as a Policy Choice
David Macaray
Stephen Hawking Needs to Keep His Mouth Shut
Ramzy Baroud
Fear as an Obstacle to Peace: Why Are Israelis So Afraid?
Kathleen Wallace
The Bilious Incongruity of Trump’s Toilet
Seth Sandronsky
Temping Now
Alan Barber – Dean Baker
Blue Collar Blues: Manufacturing Falls in Indiana, Ohio and Pennsylvania in April
Jill Richardson
Saving America’s Great Places
Richard Lawless
Are Credit Rating Agencies America’s Secret Fifth Column?
Louis Proyect
Venezuela Reconsidered
Murray Dobbin
The NDP’s Singh and Ashton: Flash Versus Vision
Ron Leighton
Endarkenment: Postmodernism, Identity Politics, and the Attack on Free Speech
Anthony Papa
Drug War Victim: Oklahoma’s Larry Yarbrough to be Freed after 23 Years in Prison
Rev. John Dear
A Call to Mobilize the Nation Over the Next 18 Months
Yves Engler
Why Anti-Zionism and Anti-Jewish Prejudice Have to Do With Each Other
Ish Mishra
Political Underworld and Adventure Journalism
Binoy Kampmark
Roger Moore in Bondage
Rob Seimetz
Measuring Manhoods
Edward Curtin
Sorry, You’re Not Invited
Vern Loomis
Winning the Lottery is a State of Mind
Charles R. Larson
Review: Mary V. Dearborn’s “Ernest Hemingway”
David Yearsley
The Ethos of Mayfest
May 25, 2017
Jennifer Matsui
The Rise of the Alt-Center
Michael Hudson
Another Housing Bubble?
Robert Fisk
Trump Meets the New Leader of the Secular World, Pope Francis
John Laforge
Draft Treaty Banning Nuclear Weapons Unveiled
Benjamin Dangl
Trump’s Budget Expands War on the Backs of America’s Poor
Alice Donovan
US-Led Air Strikes Killed Record Number of Civilians in Syria
Andrew Moss
The Meaning of Trump’s Wall
FacebookTwitterGoogle+RedditEmail