A year ago, if you had asked me, or most economics journalists, or most economists, if America would have another Great Depression, I would have said no. Thanks to Milton Friedman, we knew what had caused the Great Depression: the Fed's inappropriate tightening in the wake of a financial panic. We could not do that thing, and would therefore not have another major crisis.
Though in the public mind, all of economics is a war between Keynesians and Friedmanites, this wasn't particularly controversial between left and right (though people on both fringes disagreed). A generation of PhD candidates built their burgeoning careers on writing about "The Great Moderation"--the kinder, gentler business cycle we seemed to have discovered in recent decades. Financial regulators certainly bought it--indeed, who wouldn't love a theory that told them that the world no longer suffered through crippling economic declines because they'd just gotten so darned good at their jobs? That confidence was the genesis of the 2004 SEC rule allowing investment banks to lever up to 30-to-1 and other follies--many of them merely mirroring similar developments in Europe.
Alas, the pundits and the professors and the regulators all turned out to be wrong. We were wrong in part because we thought the theory was much better than it actually was at recognizing and preventing disaster. But as Matthew Yglesias points out, we were also wrong because central bankers can't always do the right thing:
But the central banker who holds sway over the largest economic unit is no longer the Fed Chair. Rather, it's the head of the European Central Bank, Jean Claude Trichet. His decisions have vast influence over the fate of the entire global economy. And he seems to not be doing a very difficult job, arguing confidently that there's no risk of deflation and maintaining the ECB's lifelong obsession with inflation.
This is a problem for Europe. But it's a problem for us, too. American households are increasing their savings rates which is macroeconomically counterproductive in a downturn. Counterproductive but probably unavoidable considering the past years of dissavings. But the world needs someone to be reducing savings and generating demand. And many of the people in a position to do that live in Germany. But absent a central bank that appreciates the gravity of the situation and is interested in stimulating demand, it won't happen. And all of us around the world will suffer for it. I think confidence had developed over the past few decades that whatever might come to pass, policymakers wouldn't just repeat the blunders of the Great Depression era. But that confidence seems to some extent misplaced.
Indeed--just look at the rising pressure for protectionist measures a la Smoot-Hawley. History may not repeat itself, exactly. But it stammers.
The ECB's inflation hawkery is partly just contagious German nuttiness. The German government attempted to inflate its way out of the heavy reparations exacted for World War I. The result was a grotesque hyperinflation, with workers famously being paid twice a day to counteract the daily upward march of prices. Inflation got so bad that a loaf of bread cost more than 100 million marks, and workers hauled their paychecks around in wheelbarrows. This episode has gripped the national imagination at least as powerfully as guilt over the Holocaust, leaving a powerful legacy of anti-inflationary sentiment that borders on mania. The entire northern European central banking culture is noticeably more conservative about inflation than its counterparts elsewhere.
So, of course, is the political culture in which it operates, and that seems to play a sizeable role. But it shouldn't--after all, that's why we make the banks independent. The big mystery is why the ECB behaves as if it were an arm of the German government.
Some of it is understandable. The ECB wants to establish credibility as an inflation hawk, because that credibility is a lot easier to maintain than to regain--just as Paul Volcker. And the Euro has several profligate members with a history of inflating their way out of debt problems or export woes--the ECB wants to keep it crystal clear that this will not be tolerated.
But even with the most sympathetic view of their actions, Europe is dropping the ball here. The euro area is being notably stingy with bost fiscal and monetary stimulus, and I'm not the only one who's stonkered by it. If fiscal policy remains too tight, it threatens the very union they're supposed to be protecting--how long can Greece and Italy, Ireland and Spain, suffer under a tight regime before one of them pulls out? And if one of them pulls out, the other weak sisters will pay sharply higher interest rates to compensate for currency risk, probably forcing them out as well.
It may be as simple as not wanting to face an outraged public. In which case, the theory of the Great Moderation, the independent central bank, may be even weaker than we thought.
We want to hear what you think about this article. Submit a letter to the editor or write to email@example.com.