The European Central Bank (ECB), at the insistence of Germany’s government, was created with a single mission – price stability. Its mono-mission represented an explicit rejection of the U.S. Federal Reserve’s dual mission of price stability and full employment. The usual explanation for this choice is German’s phobia about inflation arising from the searing experience of hyper-inflation during the Weimar Republic. The hyper-inflation discredited the Republic and is often blamed for Hitler’s electoral successes. One must be cautious about this explanation, however, for the demands of the German public did not drive the creation of the ECB. The creation of the euro required the creation of the ECB. Polls showed that had the German public’s policy views prevailed, Germany would have rejected adoption of the euro by a wide margin. German businesses, particularly its banks, pushed Germany to adopt the euro and they made sure that the German public was not permitted to vote on the creation of the euro and Germany’s adoption of the euro.
German banks did not trust Italy and demanded that the EC’s sole mission be preventing inflation (more precisely, any inflation above roughly 0.5 percent annually.) The ECB was to be run strictly along the lines of German Central Bank’s holy war against inflation. Implementing the ECB’s exclusive focus on stopping inflation created a political tension with France, Germany’s partner in running the EU. France successfully demanded that the first head of the ECB serve only half his term and be succeeded by a French official. Germany’s obsession with avoiding even modest inflation, however, was shared by many senior EU central bankers so regardless of nationality, ECB senior bankers have acted as if they were conservative German central bankers.
The ECB praised its mono-mission and asserted its superiority over the U.S. model. The mono-mission was the perfect accompaniment for the rising cult of theoclassical economics. The active use of fiscal policy to counter recessions was anathema, a tool of the Keynesian devil. The ECB’s theoclassical dogma was clear and proud: (1) democratic governments have perverse incentives to seek to lower unemployment, (2) which create an inflationary policy bias, which (3) can only be countered by a rigorously independent central bank, with (4) a mono-mission set by statute which rested exclusively on preventing inflation regardless of its short-term effect on unemployment, and (5) a belief that ending inflation would automatically minimize long-term unemployment.
In essence, the ECB declared that inflation causes recessions and that wage increases drive inflation. The ECB dogma on unemployment was internally inconsistent. The ECB (mostly) believed in a Phillip’s Curve – that reducing unemployment inevitably increased inflation and that a fanatic devotion to maintaining price stability maximized employment.
The problem, as a number of economists pointed out when the euro was being created, was that these ECB policies, together with the severe constraints (even in a recession) of the EU’s “growth and stability” pact, would inherently lead to a crisis when the EU faced a severe recession. Economic critics of the euro pointed out that the nasty scenario would be a recession that was far more severe in the periphery because ECB policies would be set by the German-French core with minimal policy input from the periphery. The core would demand austerity, which would lock the periphery, unable to devalue given their adoption of the euro and unable to adopt effective counter-cyclical fiscal policies due to the EU’s oxymoronic “growth and stability” pact, in a severe recession and expose the periphery to attacks on its debt. Nations that adopt the euro give up their fiscal and monetary sovereignty. The theory of the euro and the ECB was to let the people of the periphery twist slowly in the wind in the event of a serious recession.
The ECB was actually proud of this policy of indifference to the suffering of the periphery’s residents. The ECB reveled in its insistence on what might be called “tough love” for the never-to-be-trusted southern periphery. The inhumanity of the ECB’s mono-mission was intended. The unintended consequences of the ECB’s mono-mission, however, threatened the survival of the euro and the ECB. Indeed, the unintended consequences exposed the grave limits of the German and French devotion to creating an “ever closer European union.” The Great Recession revealed that the Germans and French did not really feel that they were part of a European nation dealing with fellow countrymen and women who were in need. No, they were being asked to bail out indolent Greeks, shiftless Irish, and easy-to-ignore Portuguese. The willingness of Germany’s leaders to bail out the periphery has almost nothing to do with EU solidarity and everything to do with bailing out German banks through a “below the radar” mechanism.
The ECB inherently must perform effectively four missions if the euro is to avoid causing repeated crises and, eventually, collapse. In addition to fighting severe inflation, the ECB must (1) minimize unemployment, (2) serve as a lender of last resort to member nations and banks, and (3) serve as a “regulatory cop on the beat” to prevent the epidemics of accounting control fraud in EU banks that hyper-inflated financial bubbles, rendered most of the EU’s largest banks insolvent, and caused the financial crises that shut down hundreds of financial markets and drove the Great Recession. The ECB, however, is not permitted to serve these other three missions under is mono-mission statute. It remains true however, that the prospect of being hung in a fortnight (or less) focuses central bankers’ minds most wondrously. The ECB has repeatedly risen above its theoclassical principles and the law governing its mission. Necessity has forced the ECB to adopt the lender of last resort function and (in economic substance regardless of the nominal structure) bail out banks and member nations.
The ECB remains indifferent, however, to the periphery’s unemployment. Indeed, the ECB’s demand for what our CIA refers to as “draconian” austerity programs (in Ireland), is the principal cause of increasing unemployment in much of the periphery. The ECB’s pro-cyclical policies are economically illiterate and will generate recurrent economic and political crises in the periphery that will soon bring to political power some of the most odious extremists in the EU. If the ECB continues its pro-cyclical policies it will produce a lost decade in the periphery and cause some nations to withdraw from the euro.
The ECB remains blind to the fact that it must ensure effective financial regulation, particularly of the systemically dangerous institutions (SDIs), if the euro and the ECB are to be effective. Accounting control frauds drove the crises in several European nations. Those crises imperiled the EU, the ECB, and the euro. The regulators must stop the “Gresham’s” dynamic that causes bad ethics to drive good ethics out of the financial markets. EU financial regulation suffered from what the authors of the book Guaranteed to Fail (Princeton 2011) call the “race to the bottom.” This perverse race towards anti-regulatory policies, another form of a Gresham’s dynamic, was decisive throughout the EU. Anti-regulators cannot break the Gresham’s dynamics that accounting control frauds create that lead to hyper-inflated financial bubbles and endemic fraud. Individual nation states cannot break the Gresham’s dynamic. They can divert the frauds to other nations by serving as the “regulatory cops on the beat,” but they cannot safeguard the EU. Only the ECB is in a position to provide that effective regulation and break the Gresham’s dynamic throughout the EU.
The ECB has, as predicted, risen above its principles and the mono-mission that the ECB championed. Its mono-mission imperiled the ECB’s ability to respond to the (not-so) sovereign debt crisis of the periphery and the European banks’ private and public debt crises. The ECB needs to rise above its principles and law to reduce the severe unemployment and economic suffering caused by the current crisis and become an effective regulatory “cop on the beat” to prevent or at least sharply limit future crises.