Paul de Grauwe has a good summary of the latest problem avoidance strategy masquerading as a “solution” to the European banking crisis (which is not a sovereign debt crisis).

Imagine an army going to war. It has overwhelming firepower. The generals, however, announce that they actually hate the whole thing and that they will limit the shooting as much as possible. Some of the generals are so upset by the prospect of going to war that they resign from the army. The remaining generals then tell the enemy that the shooting will only be temporary, and that the army will go home as soon as possible. What is the likely outcome of this war? You guessed it. Utter defeat by the enemy.

The ECB (European Central Bank) has been behaving like the generals. When it announced its programme of government bond buying it made it known to the financial markets (the enemy) that it thoroughly dislikes it and that it will discontinue it as soon as possible. Some members of the Governing Council of the ECB resigned in disgust at the prospect of having to buy bad bonds. Like the army, the ECB has overwhelming (in fact unlimited) firepower but it made it clear that it is not prepared to use the full strength of its money-creating capacity. What is the likely outcome of such a programme? You guessed it. Defeat by the financial markets.

That about sums it up. The European Central Bank has claimed that they are either unwilling or unable because of legal issues to provide the monetary impact needed to avert the crisis. Just announcing that they would use these means would have sent a communication signal to the financial markets that would have stopped the feeding frenzy on Italy and Spain. The ECB’s strategy of damning themselves for doing the textbook action when faced with their situation has had the predictable effect.

Basically, European leaders created the EFSF because the ECB wouldn’t do its job. Now they’re trying to lever up the EFSF to have enough money to handle the crisis, when the ECB could just generate the money necessary to the task. To the extent that the ECB is barred from doing this, it represents the central problem with the European monetary union, which simply requires a tighter fiscal union in a time of crisis.

The ECB’s refusal to provide either the lender of last resort facility or the monetary expansion the eurozone needs is creating a vicious circle of self-reinforcing austerity. Dick Baldwin got at this very well last week, although he was excessively optimistic about how long the fix would last; it was two days, not six months.

I’d still like to imagine that next week Mario Draghi, newly installed as ECB president, will suddenly reveal himself as a supporter of quantitative easing and a 4 percent inflation target, not to mention open-ended lending to crisis countries. And all this would be perfectly sensible — much more so than the way the ECB is actually behaving. But it’s not going to happen.

Given the crucible Draghi is about to enter, I agree that expectations are non-existent. Europe’s leaders have avoided the truth for this long, so what’s another couple months? The only problem with this, of course, is that it will lead to the destruction of the birthplace of democracy, among other things.

David Dayen

David Dayen

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