Running a major central bank is never a particularly easy job. An enormous amount of pressure—the weight of an entire economy—is riding on you. Among your major responsibilities is the job of stomping on an economy when it begins to run too hot, generating economic weakness to defang inflation. You’re rarely given credit for your successes and often blamed for problems of others’ making. Yet most central bankers have it easy compared to Mario Draghi, who last week assumed the job of President of the European Central Bank.
Draghi’s situation could scarcely be more difficult. The very future of the currency he manages is in doubt. The euro zone’s third largest economy–Italy–teeters on the edge of a bankruptcy that could bring down the euro. The economy he oversees is descending back into recession on the heels of the worst downturn since the Great Depression. The member economies of the euro zone are vastly different and still only poorly integrated; an ideal policy for one state will inevitably be too tight or too loose for another. While most central banks have the luxury of operating alongside mature governments, which manage the currency area’s fiscal policy and sovereign debt, the euro area has virtually no fiscal governance—just a bickering gaggle of eurocrats. Perhaps most importantly, those leaders have very strong ideas about what the ECB should and should not be doing, and Draghi risks losing the confidence of critical constituencies with every move he makes.
For all these reasons, however, the new president does not have the luxury of sitting back and waiting to see how events play out. The future of Europe and of the global economy depend on the decisions he’ll make in coming months. But what could, and should, he do?
The first responsibility of the central bank is monetary policy, and indeed, Draghi’s first major decision was the choice to reduce the ECB’s benchmark interest rate by 25 basis points, from 1.5% to 1.25%. More—and perhaps a lot more—may ultimately be necessary. The ECB, unlike its peers at the Bank of England and the Federal Reserve, opted to raise interest rates this year in response to surging commodity prices. The ECB bet that rising food and energy costs would bleed into sustained inflation, which the Fed saw as unlikely given the high level of unemployment—if wages aren’t rising, you can’t get an out-of-control inflation spiral. The Fed had it right and the ECB wrong. Inflation in the euro zone is now levelling off as the economy seems poised on the brink of recession. Industrial production is dropping across most of the single-currency area, and unemployment is rising, even in the formerly perky German economy.
A deep euro-zone recession might well doom the euro. Without growth, there is little hope that austerity measures will work. Spending cuts and tax increases will raise unemployment but little revenue, and the euro zone may collapse under the weight of debt and joblessness. To give the single currency the best chance for survival, the ECB needs passable growth, and therefore must loosen monetary policy dramatically. Unlike the Bank of England and the Fed, it has room to cut its benchmark interest rate, and it should continue to do so, from the new 1.25% rate to near zero.
Draghi should then turn to quantitative easing (QE) programs like those deployed by the Bank of England and the Fed. QE supports economic activity through several different channels. It can boost market expectations of future growth. It can increase inflation expectations; higher expected inflation can encourage current spending and reduce the effective cost of borrowing, which also encourages new spending and investment. QE should also reduce the value of the euro. Since Europe’s governments are busily crushing domestic demand through austerity, they’ll need to export as much as possible to avoid a deep downturn. A falling euro makes euro-zone goods more affordable in foreign markets, boosting exporters and helping to support a weak euro-zone economy.
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