Almost two months ago I posted an entry decrying the shift in American politics from a focus on unemployment to one on the debt and inflation. Aside from a parenthetical reference to the troubles in Europe I focused upon the unfortunate changes in the United States. Now with the possibility of a break-up of the Euro seeming ever more likely by the day lets look at the role of ideological inflation hawks in creating the present situation. In April and July the European Central Bank (ECB) raised its benchmark interest rate 25 basis points (0.25%) due to its fears of increased inflation above its Euro zone target level of 2% (never mind the fact that others were arguing that the apparent rise in prices was simply a temporary commodity blip). At the same time new governments in Europe (and in the United Kingdom) pushed for what they called “expansionary austerity.” Proponents argued that austerity measures would signal a commitment to low inflation, low interest rates, and a shrinking role for the government in the economy. In response private businesses would gain more confidence in the long-term prospects of the economy and increase their levels of investment thereby stimulating economic growth. To put this simply and gently expansionary austerity has failed. European economies have slowed and in turn reduced tax revenue and increased government expenditures on social safety nets resulting. Meanwhile inflation has stayed low, but this has only amplified the debt crisis, as higher inflation would reduce the real value of countries’ debts. However, while the doctrine of expansionary austerity contributed to the debt problem, it is the ECB’s actions that have truly exasperated problems into a crisis and provided for the possibility of a Euro break-up.
The raising of interest rates in the spring and summer while peripheral Euro zone countries were seeing their borrowing rates soar signaled to investors that the ECB would continue to concern itself solely with inflation regardless of other events in the markets. As many have noted the ECB renounced the traditional central banking role of lender of last resort and accordingly the responsibility of safeguarding the financial system. The culture of the ECB, heavily influenced by German thought on inflation, sees maintaining low inflation as the bank’s only mandate. Thus it resists any actions that might lead to higher inflation even if such actions are necessary to protect its member countries. The bank’s policy on open-market bond purchases of sovereign debt exemplifies this point. In the late summer the ECB reluctantly agreed to begin purchasing government bonds of certain European countries (Italy, Spain, etc.) on the secondary market as a means to reduce the rising interest rates these governments were facing. However, due to fears of encouraging bad behavior (remember we need austerity!) and of the potential for higher inflation (despite arguments that higher Euro zone inflation is necessary) the bond purchases were too small to significantly affect interest rates. Furthermore, due to its prior raising of interest rates investors know that the ECB does not want to undertake further open-market operations if those actions could cause inflation. Thus, government borrowing rates soar higher and the sovereign debt crisis expands while the one institution with the necessary firepower sits on the sidelines content that it has maintained its ideological purity.