The escalating debt crisis in Europe has claimed the political career of one prime minister, George A. Papandreou of Greece, and threatened that of another, Silvio Berlusconi of Italy. Despite popular resistance, governments are racing to stay ahead of the bond markets by slashing their budgets. The drama of meetings, proposals, counterproposals and popular unrest seems destined to end in tragedy.
But the theatrical atmosphere of these negotiations within the European Union has overshadowed an event that may prove to be far more significant in the long run than the Greek referendum. It has also sustained a narrative about the sovereign debt crisis that is deeply misleading.
According to this narrative, the crisis shows the impossibility of managing a common macroeconomic policy in a system where decisions require the agreement of 27 member states, including the 17 that share the common currency, and a vastly diverse Continent with different countries that face different growth and consumption patterns and have different business cycles.
These are real problems. But they are not the reason for the systemic failure of the European financial system. Overwhelmingly, this failure has been caused by the policy choices of one of the few European institutions that has the capacity to act unilaterally and decisively: the European Central Bank.
Far from struggling to manage a “one size fits all” monetary policy, the bank has pursued a “one size fits nobody” policy of monetary contraction, at a time when no European economy is growing strongly. With great reluctance, the bank has agreed to support the markets for European sovereign debt through purchases of government bonds. But, unlike the policy of quantitative easing pursued by the Federal Reserve — in which the United States’ central bank amassed Treasury securities to push down long-term interest rates — the European Central Bank has insisted on “sterilizing,” or neutralizing, its purchases of government bonds by selling the securities to private-sector banks. Such a policy cannot be sustained on a scale sufficient to stabilize financial markets.
This is part of a broader problem: the European Central Bank’s conception of its own role. The bank was established in 1998, at a time when memories of the inflationary surge of the 1970s and 1980s were still fresh. It was therefore given a mandate that focused primarily on inflation, and has interpreted that mandate very narrowly.
Unlike any previous central bank in history, the bank has disclaimed any responsibility for the European financial system it effectively controls, or even for the viability of the euro as a currency. Instead, it has focused almost entirely on the formal objective of keeping inflation rates to a 2 percent target.
And this brings us to the most crucial recent event: not the drama in Greece but the departure of Jean-Claude Trichet as the central bank’s president on Nov. 1. More than any other single person, Mr. Trichet has embodied the systemic failure of European financial institutions.
Having failed to predict or resolve the crisis, Mr. Trichet has compounded his errors by denying them. Rather, he pronounced his own performance as “impeccable,” because inflation rates had been kept at or below the target level. Any change of course in European policy would require him to admit his mistakes, and that is clearly impossible.
In a desperate attempt to pretend that pre-crisis normality had returned, Mr. Trichet even raised interest rates in two steps, in response to marginal deviations from the central bank’s target inflation rate. This was the worst possible response to a debt crisis.
Mr. Trichet’s replacement, Mario Draghi, has shown no particular signs of independent or creative thinking. Nevertheless, he has one great asset: he is not Mr. Trichet. Free from the need to defend the past policies of the European Central Bank, Mr. Draghi has the opportunity to wipe the slate clean.
Indeed, he has already shown some signs of fresh thinking, with his decision last Thursday to cut the euro zone’s benchmark interest rate by a quarter of a percentage point, to 1.25 percent.
But Mr. Draghi needs to do even more if he is to avoid becoming the first central banker in recent history to preside over the collapse of the currency he was appointed to manage.
The crucial step is to announce that the central bank will stand behind the sovereign debt of euro zone members, if necessary at the expense of the 2 percent inflation target. This would give governments the financial resources they needed to recapitalize banks. Since the crisis is largely one of confidence, it is likely that bond markets would stabilize without the need for large-scale bond purchases, once there was a credible commitment to intervene where necessary.
In his first news conference as the central bank’s president, Mr. Draghi gave mixed signals. Rhetorically, he emphasized consistency with the failed policies of the past. But in practical terms, he announced a cut in interest rates, effectively admitting that the last increase, only four months ago, was a mistake.
The opportunity for him to take a new path will not last long. If current policies are pursued, the European Central Bank will end up by destroying the euro in order to save it from (largely hypothetical) inflation.
John Quiggin, a visiting professor of economics at Johns Hopkins University and the author of Zombie Economics: How Dead Ideas Still Walk Among Us.