The European Central Bank prescribes pain

“Market sentiment” is one of modernity’s great phrases. The markets sense that a European recession is looming: the euro exchange rate has fallen by 5% since July, interest rates on government bonds are falling; money is always quick to scare. Businesses are also beginning to sense that a downturn is coming: wage growth is slowing in the eurozone, despite the fact that several countries are experiencing record low unemployment. Such downturns — in the form of recession — have multiple causes; that’s a truism in economics: everything is multi-causal. Among the main causes, we could cite geopolitical factors: a war in Europe that is pushing up the prices of raw materials, and an emerging power, China, that is maneuvering to steal the spotlight away from the declining world power, the United States. Then there are the lingering effects of the pandemic in half the world’s fiscal space, supply chain difficulties and the combined shock of the technological and environmental revolutions; the list of causes is almost endless.

In Europe, there is another reason: the maneuvers of the European Central Bank (ECB), which has been rudderless since Mario Draghi left the role. His replacement, Christine Lagarde, has made a long list of blunders, including in communication, which her supporters claimed was her main asset when she first arrived in the position lacking any experience in the tempestuous area of monetary policy. She is not alone. Her number two, Luis de Guindos, went straight from being Spain’s Ministry of Economy under the Rajoy government to ECB headquarters in Frankfurt, that combination of Harry Potter’s Hogwarts, the Death Star and Scrooge’s office in Dickens’ A Christmas Carol. Lagarde has once again raised interest rates when it was not necessary to do so: her own forecasts anticipate that inflation will fall at the end of 2023 and next year. Her mandate — that famous inflation target “below, but close to 2%” — can only be achieved through rigor, the hawks who now dominate the ECB tell us.

The danger is that so much rigor will end up becoming rigor mortis. There are not many ways for a central bank to tackle inflation, beyond raising rates, sitting back and watching as economic actors are forced to lower wages and moderate prices because the economy has cooled down to the point of shivering. That can lead to a slowdown or, in the worst cases, a recession. We are headed in that direction, creating a little economic pain in order to tame down market forces in the form of prices and wages.

In its penchant for pain, the ECB has forgotten some things: the eurozone has suffered two major crises in the past 15 years, and the middle classes’ loss of purchasing power is bringing old demons out of the closet; the malaise is there, and every now, and then it causes a fright. The ECB has also forgotten that, as the Spanish case has shown, there are policies for fighting inflation beyond monetary policy. It has forgotten that the difference between a good policy and a mediocre one depends on the credibility of the institutions, not on meticulously following a handful of rules that were written in bronze a few decades ago for a world that no longer exists. The sacrosanct rule of keeping the price target at 2% is beyond debatable; for years, the best economic experts have been pointing toward 3%, even 4% to widen the central banks’ margin for action. And following the anti-inflationary rulebook to the letter is equally absurd: so much so that the ECB’s own mandate makes it clear that the ECB must also deal with financial stability and, in a more diffuse way, with unemployment and the economic situation.

The ECB was designed in the image and likeness of the Bundesbank, and in German economic thought, inflation is the worst of all evils, much like the United States’ worst nightmare is depression. Lagarde has taken out a hammer and sees nails everywhere, but stagflation — stagnation combined with inflation — is the issue before her, and that cannot be fixed by raising interest rates like there’s no tomorrow. The economy is a toolbox of options. This time, it would have been enough to let interest rates plateau for a while, but the ECB has chosen to ratchet up the pain in the name of so-called orthodoxy. Manca finezza; there are more ex-politicians worried about their reputations in central bank leadership positions than there are central bankers monitoring the eurozone’s stability. That’s 10 interest rate hikes since mid-2022; the most recent one is unnecessary and beyond questionable. We have not yet seen the full effects of this escalation. These things take time. But pain is a certainty; we are going headfirst into the rocks of a recession. Congratulations to the winners.

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