The Failed Dogma of the ECB

The European Central Bank (ECB) is run by people who are not very good at economics. They continue to adhere to a fundamentally wrongheaded view of the economy and the central bank’s role within it. Unfortunately there is no internal pressure for change because, like the Communist Party in the Soviet Union, acceptance of the ideology is the price for admission into the clique of economists who can influence the ECB.

The central tenet of ECB dogma is that the central bank should target a low inflation rate (2.0 percent) and pretty much ignore everything else in the economy. In the last decade this meant ignoring the massive housing bubbles that were driving the economies of Ireland and Spain. The bank was happy all through the period in which the bubbles were growing to ever more dangerous levels because it was hitting its inflation targets.

More recently, the ECB has been raising interest rates even as most of the eurozone economies remain mired with high unemployment. These interest rate hikes slow growth and job creation. Higher interest rates also exacerbate the fiscal problems facing heavily indebted countries, since they make it more expensive for them to service their debt.

In other lines of work, the disastrous consequences of the ECB’s recent and current policies would get people fired. However, no one is really in a position to fire the ECB bank president and top staff, so they could in principle continue their failed policy approach indefinitely.

But there is hope. Because the people running the ECB are not very good at economics, they keep running into difficulty with their plans to “rescue” Greece, Spain, and the other eurozone countries facing fiscal crises. As a result, they have to continually run back to these countries and work out new loan packages. Each package involves new and more onerous conditions for the debtor countries.

What the ECB has failed to recognize is that its own policies are making it more difficult for these countries to make their loan payments. This is due both to the fact that the policies are contractionary for the eurozone as a whole and also because the conditions imposed on debtor countries slow growth. With weaker growth, tax collections fall and more money is paid out in unemployment insurance and other transfers to the unemployed. The result is higher deficits.

This is where the popular movements like 15-M in Spain come in. While the governments may be willing to inflict whatever pain on their population the ECB requests, the popular movements are making this an increasingly difficult process. The governments of these countries are being forced to recognize that they must consider public opinion and not just accept the dictates of the ECB.

In fact, since the ECB would never want to see one of the eurozone countries default, the popular movements could find themselves in a situation where they are effectively negotiating with the ECB, since they can set bounds on the conditions that their governments can accept. This will allow them to teach the ECB crew some basic economics.

First on the list of lessons is to tell the ECB that the days of worshipping 2.0 percent inflation targets is over. That might have been cute policy before the downturn, but everyone now knows that it was boneheaded. Central banks have to take greater responsibility for maintaining stability and high levels of employment. Furthermore, a low rate of inflation like 2.0 percent provides insufficient room for the adjustments that must be made in the sort of crisis the world economy now faces. The popular movements can assign the ECB staff the excellent paper on this topic by Olivier Blanchard, the IMF’s chief economist.

The second item, which would be especially relevant to Spain, would be a requirement that governments take strong measures to get vacant homes back on the market. According to government data, Spain’s building boom left the country with more than 1 million vacant units. This is pure waste – what economists call “deadweight loss.”

The government can give the builders or banks that own these properties a strong incentive to sell or rent them by imposing a large tax (e.g. 5 percent of value) on units that are vacant for long periods of time. If the tax isn’t paid, then it could seize the property and then make it available directly. It could even use sound free market principles, for example allowing people to take possession of property and then become the owners if they live in and maintain it for a long enough period of time. This would follow the example of the Homestead Act in the United States.

Finally, governments can take the lead from the United States in another area and adopt bankruptcy laws that make it easier to shed debt. As it stands, many people who bought homes at bubble-inflated prices stand to spend the rest of their working life paying off their debt. In addition to being cruel to people who made a mistake, it also creates enormous disincentive to work or to work in the underground economy.

If a person has to commit 15 percent of their income to paying off debt, it has the same effect on incentives as a 15 percentage point increase in the income tax. Economists understand that taxes can have a disincentive effect. They should be able to understand that debt repayments can also have a large disincentive effect.

This would be the start of a good economics lesson for the ECB. It will mean better policy and maybe it can even help turn the people running the ECB into competent economists.

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 column was originally published by Al Jazeera.

Dean Baker is the senior economist at the Center for Economic and Policy Research in Washington, DC.