Fiddling While the Eurozone Burns

So the European Central Bank (ECB) has decided to follow through on its plans to tighten monetary policy this year. The ECB will begin by raising its benchmark interest rate next month.  This is unbelievable. The Eurozone is under severe pressure that could ultimately lead to its breakup and yet the primary concern at the ECB is tightening monetary policy according to schedule.  If followed through, the consequences of this are not only bad for the Eurozone, but for the rest of the global economy too.  The slow-motion bank run now taking place in the Eurozone could easily turn into another severe global financial crisis.  

So why then is the ECB pushing so hard for monetary policy tightening?  From the New York Times we learn the answer:

With Germany, the euro zone’s largest economy, growing so quickly that some economists fear overheating, the E.C.B. has been trying to nudge interest rates back to levels that would be normal in an upturn.

Silly me, I thought the ECB's mandate was for the entire Eurozone not just Germany.  Now Germany is the largest economy in the Eurozone and so its economic conditions have a large influence on the the Eurozone aggregates that the ECB targets.  So maybe I am being too hard on the ECB here. Still, if the ECB really desires to save the Eurozone in its current form then tightening monetary policy is a move in the wrong direction.  

Here is why. If the ECB were to ease monetary policy, it would cause inflation to rise more in those parts of the Eurozone where there is less excess capacity.  Currently, there is far less economic slack in the core countries, especially Germany.  The price level, therefore, would increase more in Germany than in the troubled countries on the Eurozone periphery.  Goods and services from the periphery then would be relatively cheaper.  Thus, even though the fixed exchange rate among them would not change, there would be a relative change in their price levels.  In other words, there would be a much needed real depreciation for the Eurozone periphery.  This  would make Greece, Portugal, Spain, and other periphery countries more externally competitive.

Again, the relative price level change would not be a permanent fix to the structural problems facing the Eurozone--it is not an optimal currency area and there needs to be debt restructuring--but it would provide more flexibility in addressing the problems. Tightening monetary policy, on the other hand, would only make matters worse. It would force all of the needed real depreciation for the periphery on wages and prices in the troubled countries.  That only increases the pain for them and makes it more likely they will leave the Eurozone.  This seems so obvious to me.  Why isn't it obvious to ECB officials?  Why are ECB officials fiddling while the Eurozone burns?

P.S. See Kantoos latest idea for saving the Eurozone: apply countercyclical haircuts on bonds accepted by the ECB for refinacing (HT Matt Yglesias).

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More Eurozone Burning While the ECB Fiddles

It is bad enough to passively allow monetary policy to tighten in an economic crisis, but to actively do so is unconscionable. Yet, as Michael T. Darda reports, that is exactly what the ECB's seems to be doing at this time (my bold):

Our main concern is that it’s not just Greece. Ireland and Portugal are in very similar predicaments, while Spain’s economy, with twice the debt load of Greece, remains in deep trouble with 20% unemployment and tightening debt markets. Italy, with three times the debt load of Spain, also remains on shaky ground. If the periphery is going to survive, there has to be some path to growth/recovery. As yet, there is none. Austerity programs have dented growth and shrunk the tax base. Data for the last week show that the ECB, inexplicably, is contracting high-powered liquidity at more than a 10% year-to-year rate. Broad money across the zone is weak. Peripheral debt spreads are in the stratosphere. And funding costs are inching ever higher. To us, this is a setup for the weakness of the periphery to spread into the core, rather than for the strength of the core to lift the troubled periphery. Therefore, we would be inclined to “fade” any rally related to “kicking the can” farther down the road in Europe.

Here is his graph:

Maybe my fiddling while the Eurozone burns analogy is off.  The ECB is actively reducing the monetary base which suggests an image of the ECB putting down the violin and throwing some gasoline on the Eurozone burning.  My fear is that the weakness in the Eurozone periphery may spread beyond the core and into the global financial system.



Update:  Michael T. Darda talks about the tightening of ECB monetary policy with the Wall Street Journal.

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