For the duration of the ongoing European financial crisis, the German-directed European Central Bank (ECB) has been preaching one panacea: austerity. And it has been disastrous – for the Eurozone, for Europe’s governments, and, most of all, for the European people. It seemed almost as if Germany was unaware of the paradox of thrift.
In any economic crisis, it is within the best interests of an entity to cut back on spending. However, if everyone cuts back simultaneously, the reduction in expenditure would slow growth to a halt. This is the exact opposite of the Keynesian mode of “spending your way” out of a recession. What was individually rational becomes collectively disastrous. With continent-wide austerity, it seemed that the ECB was recklessly committing the first sin of macroeconomic management.
Why would the ECB – staffed with, presumably, hyper-competent technocrats – do this?
This really goes back to the Euro. With a shared currency and common market, it was as if every international transaction within the Eurozone suddenly became a domestic transaction. If a Viennese bank bought an Italian asset, there would be no (significant) qualitative difference if it had purchased, instead, an asset in Salzburg. This worked – and worked quite well – for the longest time, stimulating sluggish Eurozone markets and ushering a high water period for trade and growth.
The problem with this domestic trading was that it really wasn’t. They were still, fundamentally, international trades. But unlike "true" international trade – say, if Europe was trading with America or China – there were insufficient resolution regimes. If the Italian asset tanked, would it be an Italian problem or an Austrian problem? Would the Viennese bank be liable or would its Milanese subsidiary have to pick up the pieces? There was – and still is – no way of knowing.
Compounding the issue is the health of Eurozone banks in general. European banks never had the benefit of a Glass-Steagall Act and, as a result, diversified, speculated, and got massively leveraged. A small turn in the markets could utterly decimate a bank and send shockwaves throughout the system. If the American financial meltdown was disastrous, with American banks holding total liabilities just shy of American GDP, the possibility of a European meltdown, with total liabilities topping several times European GDP, would sweep the European economy clean. In the United States, a bank could rely on a government bailout; in Europe, they would not have the same luxury.
Although it lacks the formal ability to direct monetary policy, ECB-proffered directions are virtually gospel. And because of the underlying structural problems of the Eurozone, instead of ‘merely’ dictating austerity measures for the failing economies, the entire Eurozone has to undergo a regime of cutbacks. The ECB requires governments to turn a surplus if only to buy some breathing space for when the feared inevitable happens, to allow the governments of Europe some measure of recourse when the contagion does spread. Austerity – and all its ills – is an unforeseen consequence of the Euro.
In the current public debate, pro-austerity pundits are arguing for the right policy for the wrong reasons. Austerity should always be a measure of last resort but the worst is already happening. And that is why European financial reform needs to happen immediately.