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What Should the Fed Do Next?

The decision by the Federal Reserve to reduce the interest rate and extend the duration for its dollar swap facility with the European Central Bank is at best a temporarily ameliorative measure that does not come close to addressing the fundamentals of the eurozone crisis.

The problem is that the markets lack confidence in the ability of heavily indebted countries, most important Italy at the moment, to be able to pay their debts. This creates a downward spiral where interest rates rise, making their budget situation more precarious, which in turn leads to higher interest rates.

The austerity conditions imposed by the troika (the European Central Bank, the European Union and the International Monetary Fund) as a condition of past support have made the situation worse. Cutbacks in spending and higher taxes have slowed growth. Slower growth reduces tax collections and raises payments for programs like unemployment insurance. It also leads to a higher ratio of debt to gross domestic product, since slower growth means a lower GDP.

The way out of this situation is for the ECB to temporarily guarantee a manageable interest rate for the heavily indebted countries. It also should aggressively pursue expansionary policies to support growth and ideally aim for a somewhat higher rate of inflation within the eurozone, which would gradually reduce the burden of the debt.

For a variety of reasons, the ECB has refused to step up and play the role that a central bank should play in this situation. Given this failure, the Fed should step in to fill the gap, guaranteeing manageable interest rates for the heavily indebted countries. This is consistent with the Fed’s mandate to promote full employment, since if the euro were to collapse it would virtually guarantee that the United States would have another recession, with unemployment possibly rising by as much as four percentage points.

The Fed’s actions today, while grossly inadequate to solve the crisis, are important because they both acknowledge the importance to the U.S. economy of protecting the euro zone and show that the Fed can act to affect outcomes there. If there is a collapse in the euro, it will be because Ben Bernanke and the Fed allowed it to happen, inflicting even more hardship on tens of millions American workers.

Dean Baker is the co-director of the Center for Economic and Policy Research (CEPR). He is the author of False Profits: Recovering from the Bubble Economy.

This originally appeared in Room for Debate in the New York Times.

More articles by:

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.

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