Dean BakerBack to OpinionDean Baker

Time for the Fed to take over in Europe

The European Central Bank in Frankfurt, Germany. Photo: Flickr/mjaniec

The European Central Bank (ECB) has been working hard to convince the world that it is not competent to act as a central bank. One of the main responsibilities of a central bank is to act as the lender of last resort in a crisis. The ECB is insisting that it will not fill this role. It is arguing instead that it would sooner see the eurozone collapse than risk inflation exceeding its 2.0 per cent target.

It would be bad enough if the ECB’s incompetence just put Europe’s economy at risk. After all, there are tens of millions of people who stand to see their lives ruined because the bureaucrats at the ECB don’t understand introductory economics. But the consequences of a euro meltdown go well beyond the eurozone.

At the very least, the chaos following the collapse of the euro will mean a second dip to the U.S. recession. The loss of the European export market, and the likely surge in the dollar that will result from a worldwide flight to safety, would be enough to turn a weak positive growth number into a negative.

However, it is also likely that the financial panic following the collapse of the euro will lead to the same sort of financial freeze-up that we saw following the collapse of Lehman Brothers. In this case, we won’t be seeing unemployment just edge up by a percentage point or two, we will be seeing unemployment possibly rising into a 14-15 per cent range. This would be a really serious disaster.

Fortunately, the Fed has the tools needed to prevent this sort of meltdown. It can simply take the steps that the ECB has failed to do. First, and most importantly, it has to guarantee the sovereign debt of eurozone countries. The Fed simply has to commit to keep the interest rate yields on debt from rising above levels where it risks creating a self-perpetuating spiral of higher debt leading to higher interest rates, which in turn raises the deficit and debt.


This doesn’t mean giving the eurozone countries a blank check. The Fed can adjust the interest rate at which it guarantees debt, depending on the extent to which countries reform their fiscal systems. For example, if Greece and Italy crack down on tax evasion, this can be a basis for allowing a lower interest rate. If they allow their wealthy to freely evade taxes, then this can be a basis for raising rates. The difference between a 2.0 per cent interest rate and 7.0 per cent interest would be a powerful incentive to eliminate corruption and waste.

The idea that a foreign central bank would intervene to affect a country’s monetary policy should not be alien to people in the United States. The Chinese central bank did the same sort of intervention in the United States back in the years 2004-2006.

This was Alan Greenspan’s famous “conundrum” episode. He claimed that he could not understand why long-term rates in the United States stayed flat or even fell as he raised the overnight rate from 1.0 per cent in 2004 to 5.25 per cent in 2006.

This pattern is easily understandable if we recognize that China’s central bank was engaged in large-scale quantitative easing at the time. It was buying up hundreds of billions of dollars a year of long-term government bonds. The impact of China’s central bank buying up large amounts of long-term U.S. government debt is the same as the Fed buying up large amounts of long-term U.S. government debt; it pushes down long-term interest rates. The only mystery in this story is that Greenspan somehow didn’t recognize this fact.

In this case, the Fed would be intervening in the European economy for the same reason as China did with the U.S. — to sustain our domestic economy. If the eurozone collapses, there are no easy tools in the Fed’s bag of tricks that will allow it to quickly offset the negative impact on the U.S. economy. It would make far more sense to act preemptively to prevent this disaster from happening. This can be seen as an essential part of its legal mandate to maintain full employment.

Of course, this sort of intervention will look horrible from the standpoint of the eurozone countries. It will appear as though they cannot be trusted to manage their own central bank and deal with their own economic affairs.

Unfortunately, this is the case. They have entrusted the continent’s most important economic institution to a group of ideological zealots who are infatuated by the sight of low inflation rates, even as whole economies collapse in ruins and tens of millions of people needlessly go unemployed.

Perhaps the Europeans will respond to this affront by putting some serious people in charge of the ECB who are committed to maintaining a functioning economy in the eurozone. If that is the outcome, it will be a win-win for all involved. But if they can’t rise to the task, we should not allow the ECB ideologues to wreak havoc on the lives of tens of millions of innocent people in Europe, the developing world and here in the United States.

Dean Baker is co-director of the Centre for Economic and Policy Research, based in Washington, D.C. He is the author of several books, including “Plunder & Blunder: The Rise and Fall of the Bubble Economy,” “The Conservative Nanny State: How the Wealthy Use the Government to Stay Rich,” “Get Richer and The United States Since 1980″ and “The End of Loser Liberalism: Making Markets Progressive.”

 

Comments

  • John Ross

    The basic problem is the human growth syndrome. To grow the economy banks offer to loan money that can only be paid back if an economic adventure succeeds in making enough profit. My bank offers me so much credit that if I went for it I would be bankrupt in less than a year, and they know it, but that’s their policy toward everyone, to encourage them to go into business. But too much of any good thing turns it bad.

  • http://freeourfreemarkets.org Steve Banicki

    The Euro is the official currency of 17 countries in Europe comprising what is called the euro zone. Presently the Euro is under stress that has many similarities to the 2008 sub-prime loan meltdown in the United States. The current Euro problems may cause a similar, perhaps worse, financial setback as the sub-prime debacle did. These problems, if not solved quickly, will cause a further set back to the economy in the United States and the world. This is why the U.S. and China must help in any way we can. It is in our self interest to do so. More:  http://bit.ly/rFPCTd 

  • http://twitter.com/joeisright American Capitalist

    I’m a lifelong Democrat but my god I can’t figure out what the hell our government is doing. Every aspect of our economy has bubbles – internet bubble – housing bubble – the only element impervious – the stock market. In the past two decades, with government intervention, the stock market must always be going up – at any expense to the American taxpayer. After the backroom deal to give $7 TRILLION to the banks – we’re now offering foreign countries, some with NO prospect of repaying the same sweetheart deals we did US banks???

  • Flhxrider

    Step one should be obama being removed from office either by impeachment or the election, or he could be a man and just realize he is in way over his head and just step down.

  • Bogdan B

    Here we go again Feds saving big business again instead of main street people. But this time not in the USA but in Europe. Our tax money spent again on business so the Feds can raise our taxes to make us more poorer and suffer more economic pains.