A Political Currency

March 8, 2011 • Commentary
This article appeared in The Wall Street Journal Europe on March 8, 2011.

Since its inception in June 1998, the European Central Bank (ECB) has been error‐​prone. An initial and significant design flaw appeared when the ECB latched onto the fashion of the day: inflation targeting. In consequence, the ECB has displayed a propensity to either tighten or loosen monetary policy at precisely the wrong moments.

One of those inauspicious episodes occurred during the summer of 2008, when the ECB pushed interest rates upwards. By blindly embracing inflation targeting, the ECB ramped up interest rates, even though Europe had been in the grip of a recession for two quarters. More ominously, the biggest financial crisis since the Great Depression was brewing — a fact that had bubbled to the surface in the summer of 2007, when Europe’s interbank markets seized up.

Rather than correctly diagnosing Europe’s interbank malfunctions as a symptom of sovereign and bank insolvencies, the ECB and Europe’s political elites instead pushed the button marked “liquidity deficiency.” This placed the euro on center stage and took the public’s eye off the source of the problem: too much debt and associated insolvencies. The heart of the problem is simply too much borrowing that can never be paid back on the terms promised — not a euro problem per se.

The best antidote for over‐​indebtedness is a good haircut. But haircuts are not in the political cards. Instead, the ECB has morphed into the euro zone’s “bad bank,” taking on enough questionable credits to sink a battleship.

The euro remains a creature of politics, not economics and finance. Indeed, most of the economic arguments — both pro and con — have been, and continue to be, either wrong or irrelevant. The hallmarks of this project have been more politicization, more centralization and more “harmonization.”

What does the future hold for the euro? If history is a guide, the French will provide the direction and the Germans will foot the bill. But history is not an infallible guide. Everything depends on Europe’s politicos, whose priorities are unknown. There are good reasons for the skeptics to remain, well, skeptical.

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