In the previous
posts, we’ve talked about the costs and benefits of a Greek exit. This post
will argue that if the eurozone is to continue, more aggressive policies by the
the European Central Bank (ECB) are desperately needed.
Germany’s Recession
and Recovery in the Early 2000s
Even if Greece exits
the euro and the ensuing financial contagion is limited, the euro area still
faces a lot of tricky problems. For the eurozone to survive, the ECB needs to
stop its obsession with inflation and focus more on growth. Monetary expansion
is needed to counteract the contractionary impact of fiscal austerity, though Germany seems
unwilling to accept this fact.
As Paul Krugman argues, when Germany was in a recession in the
early 2000s, its recovery was aided by a current account surplus against the
peripheral countries that are in deep financial trouble now. In the early
2000s, Greece, Ireland and Spain enjoyed strong economic growth. The low interest rates set by the
ECB were optimal for Germany but too low for these 3 countries.
On one hand, the low
interest rates helped Germany recover. On the other hand, the low interest
rates led to high inflation and even higher growth (to the point of
overheating) in the PIIGS. In economic boom, the PIIGS bought more exports from
Germany, adding an extra boost to Germany’s recovery.
Expansionary
Policies to Pull the PIIGS out of Recession
Now the monetary
policy is again optimal for Germany, but not expansionary enough for the PIIGS
countries. Last time the PIIGS helped Germany return to growth, and now is the
time for the reverse to happen.
Under monetary
expansion, Germany and the Netherlands will experience relatively high
inflation. While this may be unpleasant internally, wages and prices in the
South will be cheaper in relative terms as a result. This is exactly what
Europe needs to solve its key problem – the large
productivity gap between Germany and the troubled economies in the South.
With cheaper, more attractive exports, the PIIGS can sell more to Germany and
the rest of the world, getting out of recession.
Though deflation and
wage cuts in the South can narrow the gap too, deflation is contractionary
while wages are sticky in the short run. Hence, it’s much better to have
inflation in the North instead of deflation in the South.
Indeed, the ECB
should help narrow the productivity gap with more aggressive policies. Easing
measures can restore cost competitiveness of the PIIGS, which is the first step
to less unemployment and economic recovery. In turn, recovery will help
governments control the public debt and achieve balanced budgets.
Liquidity Injection
to Support Banks
Signs show that the
ECB is moving in the right direction. The long-term refinancing operations (LTRO) in December and
February injected liquidity in the markets by offering banks unlimited
short-term loans at interest rates as low as 1%. Many commentators think of the
LTRO as the European version of quantitative easing.
In addition to
boosting the economy, injecting liquidity is also a measure to strengthen the
firewall and prevent contagion. The ECB can inject liquidity by, for example,
guaranteeing to buy unlimited amounts of sovereign bonds in the event of a
Greek exit.
In this way, the ECB
can ensure that banks won’t collapse because of sour sovereign debt. This is
important because credit freezes if banks fail, which will result in a further
economic slump in Europe and probably the rest of the world.
The real question is
who should take the responsibility to bail out troubled banks, and the answer
is the ECB is in a better position to do so than the euro countries. Government
bailouts will add to the public debt and risk increasing borrowing costs for
the state. Obviously, this isn’t helpful and will only aggravate the sovereign
debt crisis.
(Entry 3 of 4 in the
Update
on the Euro Debt Crisis series)
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