Blame the European Central Bank

The problem is not the euro. The problem is that the idea of the ECB is detached from economic reality.

As the euro zone stumbles towards a seemingly inevitable collapse, it is easy to blame the politicians involved or the whole idea of a common currency. The outcomes of the latest top-level meeting, including a pledge to create a single euro-zone banking supervisor and a relaxation in conditions for lending to Spain, are welcome enough but seem, yet again, to be too little, too late to save the common currency.

In reality, the real problem is not with the euro but with the institution set up to manage it, the European Central Bank. The idea behind its creation—a central bank completely independent from government control—is detached from economic reality.

The ECB’s disconnectedness was evident in the decisions by President Jean-Claude Trichet to raise interest rates twice during the course of 2011, at a time when the danger of complete collapse was already evident. Although these decisions were subsequently reversed, they killed any chance that Europe would grow its way out of the debt crisis.

The problem is not, in the end, one of personalities or managerial competence. Admittedly, Trichet makes himself an easy target, with an assessment of his own performance as “impeccable.” But the problem goes much deeper than the bad decisions of Trichet or his successor, Mario Draghi. The failure of the ECB reflects the failure of the central idea that formed the basis of its design—a completely independent central bank.

Central banks have always had a fair degree of independence from governments, and with good reason. The conduct of monetary policy often requires increases in interest rates and reductions in the availability of credit. Such measures are always unpopular, at least with borrowers, who are almost invariably more vocal and politically potent than savers. So it makes sense to ensure that the ordinary operating decisions of central banks are not subject to political interference. From the viewpoint of politicians, the operational independence of the central bank protects them from political responsibility for higher interest rates.

Until the 1980s, however, central banks were not independent of democratic control in the sense of being free to pursue whatever monetary policy they regarded as best. In the Keynesian system of economic management that prevailed in the postwar decades, the central bank’s monetary policy was operated in concert with the government’s fiscal policy, in which budget deficits and surpluses were used to stimulate, or contract, aggregate demand.

With the eclipse of Keynesianism in the 1970s, a new understanding of central-bank independence came into vogue. The key idea was that central banks should focus exclusively, or at least primarily, on stabilizing inflation and that they should do so without any regard to the views of the government of the day. During the 1990s, many countries entrenched the independence of central banks in legislation.

Despite these legislative guarantees, the theory of central-bank independence is normally tempered by political reality, as it is in the United States or the United Kingdom. So, while the Bank of England is independent of day-to-day political control, it nonetheless can't sustain a position of radical opposition to the policy stance of the government, particularly in a time of crisis like the present. Inevitably, some kind of accommodation must be reached.

The outstanding exception is the ECB, created in the 1990s, at a time when enthusiasm for central-bank independence was at its height and with an exclusive focus on inflation control. The ECB was designed to make any kind of political interference impossible. Because of the weakness of the EU’s confederal structure, the ECB has no European government to deal with and can dictate terms to national governments.

This became apparent early in the crisis, when the ECB forced the Irish government to guarantee the debts of the failed Anglo-Irish bank, owed mostly to German and French banks. The ECB has followed a similar line throughout the crisis, forcing democratically elected governments out of office and threatening dire consequences for voters who choose to defy it, while at the same time resisting any attempts to make bankers pay for the misjudgements that produced the crisis in the first place.

The EU needs a democratic counterweight to the unelected and unaccountable ECB. The most promising candidate is the “Eurogroup” consisting of finance ministers of EU countries. Under its current head, Jean-Claude Juncker, the Eurogroup has supported austerity, but a progrowth Eurogroup could push the ECB in the direction of expansion. The first step would be to make the ECB, rather than the Spanish government, pay for the bailout of the Bankia group, one of many banks that ran into trouble as a result of misconceived policies of financial liberalization adopted along with the creation of the ECB.

In this context, a seemingly trivial dispute at the recent Brussels meeting takes on new significance. Juncker’s term is about to end, and German finance minister Wolfgang Schaeuble is the leading candidate to replace him. Newly elected French president Hollande, however, has indicated that Schaeuble would be unacceptable.

Continuation of the austerity policies favored by Juncker, Schaeble and Draghi will lead to disaster. Only when the ECB is forced to coordinate its policy with a progrowth Eurogroup is there any chance of sustained recovery.

Pages