David McWilliams: EU now being threatened by its own central bank

By David McWilliams

Wednesday May 04 2011

IN the late 1980s, while studying at the College of Europe in Bruges, I was struck by just how pragmatic the European project appeared to be.
Many of the lecturers and professors were deep EU “insiders” — distinguished academics from all over Europe who had excelled in their own fields. They seemed to be the pinnacle of cosmopolitan sophistication, enlightened and aware of the various strands that had to be pulled together carefully to make the EU work.

Back then, any moves towards more European power were characterised by patience and prescience — a little move here, a pull back there, never overplaying the hand and, above all, the entire process seemed to be non-ideological.

Over the past 10 years, this has changed. European wisdom has been replaced by EU dogma; lateral thinking exchanged for tunnel vision. The ECB is to blame.

Those who, during the boom, pointed out that there was a central problem at the heart of the euro were dismissed as cranks. Now there appears to be a realisation that, from Ireland’s point of view, the entire euro project might not have been the smartest thing to do. And from an economic perspective, it is becoming apparent that we can’t get out of this mess quickly in a single currency with low inflation.

Historically, when a country has been hit by the bursting of a property bubble, a bank crisis and the destruction of the national balance sheet, this has been followed by a massive devaluation of the currency.

This allows three things to happen. First, the country becomes internationally competitive quickly and the exporting sector — not only the multinational sector but also the domestic exporting sector – gets an immediate boost. Second, the subsequent inflation allows a drop in public sector salaries and the wage bill without huge pay cuts — which is politically easier to achieve. And third, the same inflation begins the process of inflating away the huge debts built up in the boom, reducing the need for debt forgiveness and reducing the likelihood of default.

That’s the way the economy works. It is what happened in the Asian Tigers in the late 1990s and Finland and Sweden in the early 1990s. It is not that complicated really.

However, in a currency union, this process can’t happen. What happens instead of the currency falling is that people’s wages are supposed to fall. It is important to remember that we are flying blind here. We are in a trial and error process because there has never been a currency union without political union, so we don’t know for sure where this will end. But what looks likely is that the dogma of the ECB will cause successive Irish governments to try to grind down wages and prices in order to be competitive. This will take years and much strife.

What does this “drawn out” grinding process do to an economy? In an economy that is facing a balance sheet meltdown — where the middle classes’ balance sheet is bust — such an approach will result in more financial insecurity, causing people to spend less, not more and result in higher unemployment. Higher unemployment results in a higher social welfare bill, which combined with less taxes causes the budget deficit to explode. This increases the default risk. This is exactly what the financial markets are saying to us. The rate of interest on Irish bonds is over 10pc because the market thinks that the “ECB” approach will make default more, not less, likely.

Unfortunately, our deep establishment — the political, the academic and the media — has adopted a position which sees any questioning of the euro project as being “unpatriotic” and “dangerous”. Therefore, debate on the currency and the likely trajectory for the Irish economy and people is being actively quashed because to question the wisdom of European central bankers is being seen as unpatriotic. When did questioning a German or French banker’s motives and intelligence become anti-Irish?

But this is what has happened. The ECB — which is only a central bank after all — has a veto on Irish economic policy. Isn’t it time for all of us to question just who are these people, who has mandated them and who are they to dictate anything to anybody?

These guys are there to represent the banking industry, not the people. If the banks’ interests and the people’s interests move in tandem, then the ECB’s world view might reflect our world. But when that changes, as is the case now, we should change and they should listen. But will that happen? Not likely.

Anyone who actually cared to think about it and had any experience with European central bankers would have known that giving a faceless bunch of central bankers the veto over economic policy might have resulted in problems. In the boom, the legates of the ECB in Ireland — top brass of the Irish Central Bank and the Regulator — failed miserably and the ECB did nothing. In fact, the ECB presided over a financial crack house with banks in the core lending recklessly to banks on the periphery.

Now the ECB is behind the policy of paying bank bondholders every cent, while the real people of countries like Ireland have to endure deep reductions in their living standards. The logic is that all this austerity will somehow lead to economic growth.

But we know that the Irish economy is shrinking, bank lending falling, insolvencies rising and unemployment rising. This is not growth; it is the opposite of growth. The problem with the ECB is that it seems to believe that there is no economic problem that cannot be answered by austerity.

So, for example, when the economy is growing and in danger of overheating, the solution is cuts in public expenditure and increases in taxes. But when the economy is moribund and in danger of depression, the answer is again, more cuts and increased taxation.

When there is inflation, the answer is austerity and when there is deflation the answer is austerity and when there is stagflation the answer is — yes, you guessed it, austerity!

So these guys are stuck in an intellectual cul de sac. They have only one policy solution for every economic problem.

For Ireland, the end of the cul de sac is a sovereign default. In addition, by reducing people’s wages we involve ourselves in a race to the bottom. If every peripheral euro country cuts wages as the way to growth, we will cannibalise each other. This would truly be a one-way ticket back to poverty on the periphery of Europe — which was precisely what the EU regional funds and years of regional policy were supposed to arrest.

The EU is waltzing up a financial, economic and ultimately political cul de sac. It is now threatened, not by the likes of Ireland and Greece, but by its own central bank. Students of the 1920s and 1930s, when overly powerful and ultimately stupid central bankers helped destroy the world economy, might not be too surprised by this.

But what was that they said about history: “Those who don’t learn from it are destined to repeat it”.


– David McWilliams