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Wrecking the World Economy

The world is eagerly waiting to see if the European Central Bank (ECB) will take the steps needed to save the euro. Specifically, is the ECB prepared to act as a central bank and guarantee the sovereign debt of the countries in the eurozone as the lender of last resort ordinarily does in a crisis?

If not, there is little doubt what the outcome will be. The austerity being imposed on country after country will slow GDP growth and throw workers out of jobs. Higher unemployment will worsen deficits, since it means less tax revenue coming in and more unemployment benefits and other transfers being paid out. Higher deficits will cause investors to worry about the solvency of the government, leading interest rates to rise.

This gives us the famous downward spiral that already sank Greece’s economy and government. It will soon sink Italy and Spain if the ECB doesn’t start acting like a central bank. The fallout from disorderly defaults from these two countries will cause banks throughout the eurozone to become insolvent, leading to another Lehman-type freeze-up of the financial system.

The end result will be a second recession and another sharp spike in unemployment, not just in the eurozone, but almost certainly across the globe. The finances and the economies of the eurozone are too intertwined with the rest of the world to envision a meltdown that doesn’t also push the rest of the world into recession. At the end of this story, the euro itself is likely to be placed in the dustbin of history, another failed monetary experiment.

This story is especially painful since this crisis is the outcome of one set of failed policies layered on top of another set of failed policies. The original downturn came about because the ECB, like the Fed and the Bank of England, chose to ignore the buildup of enormous housing bubbles and the resulting economic imbalances.

It was 100 percent predictable that the collapse of these bubbles would lead to a serious recession. The financial crises that accompanied this collapse was also a predictable outcome of the rapid disappearance of trillions of dollars of wealth. Yet the central bankers at ECB and elsewhere were completely caught by surprise.

At least the Fed and Bank of England have been reasonably aggressive in trying to correct the damage they caused. They have both pushed their overnight lending rates to near zero and have engaged in large-scale purchases of long-term debt to try to directly lower long-term interest rates.

By contrast, the ECB never lowered its short-term rate below 1.0 percent and actually raised it to 1.5 percent last spring in order to dampen inflation. While other central banks were trying to boost their economies, the ECB was actually trying to reduce growth in the eurozone.

The question at the moment is whether the ECB will be allowed to continue this course to disaster or whether it will be persuaded by a combination of internal and external forces to change course. The joint action last week by the Fed and five other major central banks is encouraging in this respect. Their plan to extend lines of credit to eurozone banks in other currencies in effect meant that these central banks would supply the necessary liquidity to keep the eurozone economy moving forward if the ECB failed in this task.

While the immediate effect of this measure is limited, it was nonetheless important for two reasons. First, it is an acknowledgement that other central banks can fill the role of the ECB if it fails in its responsibilities to the eurozone economies. There are other deep pockets in the world that can provide the guarantees of eurozone sovereign debt that will be needed to prevent disorderly defaults and the resulting freeze-up of credit.

The second reason that the move was important is that it suggested that the other central banks, most importantly the Fed, would act to fill this role if it becomes necessary. This is not a question of being altruistic. The collapse of the eurozone would be a disaster for economies that are still reeling from the collapse of the housing bubbles in the United States and elsewhere.

In the case of the Federal Reserve Board, a purchase of a few hundred billion dollars of sovereign debt, coupled with guarantees on the debt of Italy, Spain, and possibly other indebted countries, will have far more impact in supporting growth than any other policy that it is currently contemplating. And, as the promoters of the TARP and other bank bailouts endlessly repeat, we will make money on the deal.

Once it is known that Fed is standing behind these countries debt, their interest rates will fall, causing bond prices to rise. This will allow the Fed to resell its holdings at a profit. (This is still a subsidy to the indebted countries, or in the case of the TARP, to the banks.)

The key point is that if the ECB still lacks the competence to manage the eurozone economy then the Fed and other central banks will have to step in. The eurozone is too important to the world economy to allow it be destroyed by incompetent central bankers.

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 article originally appeared in The Guardian

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

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