Two decades ago, when the European currency system was last on the brink of collapse, the ultimate question was how much Germany, the continent's economic powerhouse, would do to save it. The peripheral economies were hurting, weighed down by a monetary policy that was appropriate for Germany but too austere for weaker European countries. Germany's central bank, the Bundesbank, had to make a choice. It could continue to set high interest rates, thus upholding its commitment to stable prices. Or it could cut rates and accept modest inflation -- and so save the rest of Europe from a prolonged recession.
We know which option Germany chose then. The Bundesbank brushed off suggestions that it should risk inflation for the sake of European solidarity; speculators correctly concluded that this made a common monetary policy intolerable for the weaker economies of Europe; and in September 1992, the continent's Exchange Rate Mechanism, a precursor of today's euro, shattered under the pressure of attacks from hedge funds. Almost 20 years later, the world is waiting for a new answer to the same question. How far will Germany go to keep Europe together?
The economist Rudiger Dornbusch observed that in economics, crises take longer to come to a head than you think they will, and then they happen faster than you thought they could. By the time you read this, the eurozone may have splintered. But whether or not that has happened, or soon will, one thing is certain. Since the beginning of the crisis, Germany has had the power to save the monetary union if it wanted to. The union's disintegration would be an optional catastrophe.
SUPERMAN CENTRAL BANKERS
To see why the euro's failure could be averted, one must first grasp the awesome power of today's central banks. Until World War I, the advanced economies were tethered to the gold standard, meaning that central banks could not print money in unlimited quantities. Likewise, for almost all the years since World War II, the power of the printing press has been checked, first by a diluted version of the gold standard and then by the fear of inflation. But the combination of fiat currencies and economies that are in a slump changes the game. Money, no longer tied to gold or any other firm anchor, can be created instantly, in infinite quantities, on the technocrats' say so. And so long as factories have spare capacity and unemployment keeps wages in check, there is unlikely to be any significant penalty from inflation.
Of course, central banks had this same power in the 1930s, when the world was in a depression and the gold standard had been abandoned. But they hesitated to use it, a decision documented and lamented by monetary historians from Milton Friedman to Ben Bernanke (the current chair of the U.S. Federal Reserve). Since 2008, by contrast, central bankers have been determined to prove that they understand history's lessons. Appearing on Capitol Hill shortly after the investment bank Lehman Brothers filed for bankruptcy in 2008, Bernanke himself informed Barney Frank, then chair of the House Financial Services Committee, that the Federal Reserve would stabilize the insurer AIG at a cost of more than $80 billion. "Do you have $80 billion?" Frank asked. "We have $800 billion," Bernanke responded. In fact, by December 2008, the Fed had extended fully $1.5 trillion in emergency financing to markets, dwarfing the $700 billion bailout fund authorized by Congress through the Troubled Asset Relief Program (TARP).
Central banks on the other side of the Atlantic have acted with equal resolve. For much of 2011, Europe's political leadership bickered about
the details of the European Financial Stability Facility (EFSF), a TARP-like bailout fund with an intended firepower of 440 billion euros. Then, one day last December, the European Central Bank provided 489 billion euros to the continent's ailing banks, and in February 2012, it repeated this stunt, effectively conjuring the equivalent of two EFSFs out of thin air through the magic of the printing press. Since the start of 2007, the ECB has purchased financial assets totaling 1.7 trillion euros, expanding its portfolio from
13 percent to over 30 percent of the eurozone's GDP. That means that the ECB has printed enough money to increase its paper wealth by an amount exceeding the value of eight years of Greek output.
This superman act has, at least as of this writing, saved the euro system from breaking up. Without the central bank's extraordinary support, private banks across the eurozone would have struggled to raise money and would have collapsed. Private firms, unable to take out bank loans, would also have gone under. The debtor countries would not have been able to rely on banks to purchase their government bonds and thus would have defaulted, in turn devastating the private banks that already held their bonds. The ECB's printing of money duly improved sentiment in the market. The interest rate on Italy's ten-year bonds, for example, tumbled, from around seven percent
to about 5.5 percent, although it has since risen.
The ECB will eventually use up its room for maneuver. Some observers fear that the sheer volume of freshly minted euros is bound to lead to serious inflation, either when money begins to circulate faster or when the mere prospect of that event creates self-fulfilling inflationary expectations. But the best bet is that, with growth flat and unemployment over ten percent, the threat of inflation spiking across the continent is remote: with plenty of spare capacity on hand, any rise in demand will be met with increases in supply rather than with higher prices. For the foreseeable future, therefore, the ECB can keep on printing money to prop up banks. It can expand its modest direct purchases of government securities to ensure that finance ministries can raise money at less than punitive interest rates. It could even extend its support to nonfinancial firms, for example, by announcing that it stands ready to hold loans to small businesses on its own balance sheet. Most obviously, the ECB can help manage the crisis by keeping short-term interest rates low.
Increasing the money supply is sometimes dismissed as a mere palliative. But in addition to propping up banks, businesses, and governments, easy money can facilitate structural adjustment. If the ECB prints enough money to hit its target of two percent inflation across the continent, this is likely to mean zero inflation in the crisis countries, where unemployment is high, and three to four percent inflation in Europe's strong economies, where workers are confident enough to demand wage increases. By delivering on its inflation target, in other words, the ECB can help Italy and Spain compete against Germany and the Netherlands, gradually eroding the gap in labor costs that lies at the heart of Europe's troubles. At the same time, a determined and sustained period of monetary easing would probably weaken the euro. That would boost the competitiveness of the crisis economies against the rest of the world, further increasing the odds of an export-led recovery.
In short, the ECB has real power. It can avert a market meltdown and at the same time gradually make the periphery more competitive. But for the ECB to deliver on its potential, Germany must resolve not to get in the way. It must allow for an expansion of the ECB's innovative rescue measures and accept German inflation of three to four percent. Over the past year, unfortunately, German financial leaders have sent mixed signals. The big question of 1992 -- how far would Germany go for the sake of European solidarity? -- has not been clearly answered. And so Europe's future remains cloudy.
THE PATH OUT
Germany's leaders are correct that the countries in crisis must earn their own recoveries; the ECB cannot save them on its own. In particular, they must improve the administration of public finances, cracking down on tax evasion and wasteful spending, and remove product and labor-market regulations that undermine competitiveness. But these reforms tend to pay off in the long term. In the short term, slashing budgets will shrink demand and quell growth, while some labor-market reforms that make it easier to fire workers may initially drive up unemployment, undermine consumer confidence, and reduce growth further. The most urgent complements to the ECB's response therefore lie elsewhere -- and they demand initiative from Germany.
Germany first needs to recalibrate its attitude toward public finances in the periphery. Thus far, the German strategy has emphasized deficit reduction, on the theory that countries that borrow less will accumulate less debt in the long run. But because deficit reduction keeps an economy from growing, it may defeat its own purpose. Over the past year, the eurozone has indeed cut deficits sharply, but the debt-to-GDP ratio has worsened. Germany needs to accept that aggressive austerity programs are neither politically sustainable nor economically wise. To get its debt under control, a country must attack its debt stock directly.
If Europe's leaders had mounted a forceful response earlier in the crisis, they could have imposed a meaningful debt reduction on private creditors across the continent. But by now, most private creditors have sold out, transferring their debt to the International Monetary Fund, the ECB, and other official creditors. (To be sure, private European banks hold large portfolios of European government bonds. But since the public sector stands ready to bail out these banks, they are not true private creditors.) Last year's restructuring of Greece's debt illustrated the problem. Almost two years into the Greek crisis, the country's private creditors were forced to accept a reduction of about 65 percent in the value of their claims. But at that point, most private creditors had already shed their government debt, so the resulting debt relief for Greece was far short of what the country needed to fix its finances.
Given that governments in the surplus countries and multilateral lenders have become significant creditors to the crisis countries, debt relief has to involve leniency on their part. This is unlikely to take the form of an explicit reduction in debt claims: the credibility of the International Monetary Fund and the ECB would suffer too much from an admission that their loans can be defaulted on. Nor is it likely to involve taxpayers in Europe's core explicitly paying off debts owed by the periphery: that would be politically explosive. The most plausible route to debt reduction is to create a eurozone bond, so that part of the debt of the crisis countries can be replaced by debt issued by the whole region. The German government's economic advisers have put forward a plan that would achieve this goal; now, the government needs to embrace it.
In addition to tackling governments' debt overhangs, Europe's leaders need to shore up the continent's banking system, which has been plagued by a surfeit of bad loans and, until recently at least, a deficit of honesty about them. Until the banks confess that loans to unemployed homeowners or ailing businesses won't be repaid on time, and until they set aside capital to cover their losses, their unacknowledged frailty will inhibit their lending: too few individuals and businesses will be able to borrow money, and growth will remain anemic. Moreover, the banks' return to health is a precondition for restoring confidence in the market, since the possibility of costly bank failures casts a shadow over the crisis countries. For the moment, the ECB's generous financing has guaranteed the banks' liquidity, inoculating them against the lending strike they have suffered in the private bond markets. But if millions of depositors begin to desert the banks at once, the ECB's liquidity may not be enough, and no amount of liquidity can address the banks' solvency. Unless banks keep more capital on hand, they risk collapse. Private investors are unlikely to provide these funds, and the governments of the crisis countries are too stretched to do the job alone. Some of the money will therefore have to come from stronger European governments.