Since the European Central Bank is the key institution in resolving the European situation, it’s worth paying attention to their forecasts for 2012 largely because they amount to the ECB predicting catastrophe. Here’s a glance at the nominal output they’re expecting:

A couple of things to note here. One is that if you assume the ECB is just trying to target Eurozone inflation and doesn’t care about anything else, this is the ECB predicting that it will fail and inflation will be too low at 1.6 percent. Alternatively, if you assume the ECB only cares about German inflation, the conclusion is again that the ECB predicting that it will fail and inflation will be too low, this time at 1.4 percent. Inflation will be above the ECB’s 2 percent target in the countries of Belgium, Estonia, Cyprus, Malta, Austria, and Finland. Nominal GDP across the Eurozone will average an anemic 2.1 percent, with Germany slightly higher and Italy slightly lower.

This is a recipe for disaster. When a central bank has a “prediction” like this months out, it ought to be running around promising to prevent it. It’s like predicting that your poor diet will give you a heart attack in six months when you should be resolving to eat better.

These guys are really insane:

The European Central Bank offered new emergency loans to banks on Thursday to help them through the turmoil of the government debt crisis, but decided to keep interest rates on hold despite fears of an economic slowdown.

President Jean-Claude Trichet did not even indicate that a rate cut was due in coming months, as many experts predicted would be necessary to stave off a possible new recession. The hesitation is likely to expose the bank to more calls from worried businesses to change course.

The basic story here is that when the ECB tightened money several months ago, a wide range of observers noted that this was a reckless action that was likely to tip at least southern Europe into recession and worsen the Eurozone’s sovereign debt problems. Well, tighter money worsened the growth outlook for Spain and Italy causing the sovereign debt problems to get much worse, and now the whole Eurozone’s on recession watch. The correct thing to do when you make a widely criticized move and then bad things happen is to reverse yourself. But to reverse himself at this point would entail implicitly admitting that he was wrong in the first place. And VIPs don’t like to admit that they were wrong. So now a few hundred million people need to suffer the consequences.

Kantoos has more on this.

The underlying issue in Europe is not sovereign debt or really debt of any kind. It’s the fact that the Eurozone is very far from being an optimal currency zone. As illustrated by the chart at right, the kind of ECB policy interest rates that would be recommended by a Taylor Rule for the different regions are quite different from one another. I’m not a huge fan of the backward-looking Taylor Rule as an approach to monetary policy, but it’s approximately right for these purposes. Europe is essentially living in the world that Ron Paul and other “Austrians” believe the United States to be living in. Efforts by the ECB to maintain decent growth in the “core” were creating a wildly inflationary dynamic in the “periphery,” pushing Spanish (etc.) wages up to an unsustainable level. Initially, this didn’t trigger mass unemployment. Instead people acted as if the wage levels were sustainable, and made wild investments in Spanish (etc.) property, creating employment in the construction sector. But the boom is followed by a bust, and now you have mass unemployment and all kinds of screwy wage levels and financial commitments that can only be properly addressed by the ECB if they’re willing to set off serious inflation in the core countries.

My view is that this is unworkable in some pretty profound ways unless Europe makes a lot of changes starting, but by no means ending, with a much more robust transfer union. Kantoos, who doesn’t like those ideas, thinks it’s instead possible for the ECB to implement regionally differentiated monetary policies. On the one hand they can “use regionally differentiated haircut policies to increase financing costs in overheating countries, while lowering it in countries that are economically lingering.” What’s more:

Besides increasing the cost of refinancing for banks in overheating countries, the ECB could use regulatory powers to mimic differentiated monetary policy. One idea is to increase the bank’s capital requirements for credit given to firms and households in overheating or bubbly economies. The advantage of this approach is that the location of the debtor matters, not of the bank that supplies the loans. The other approach, advanced by Markus, is to regulate collateral requirements for loans and mortgages to firms and households in such countries.

I’m not sure this couldn’t just be arbitraged away, so I’ll be interested to know what people who know more about actual financial market operations think about this. On a political level, I think the issue here is that it’s asymmetrical. This would have let the ECB implement monetary policy that was appropriate for Germany without touching off the unsustainable boom in Spain (etc.) by restricting lending, but after the crash, you can’t really force people to loan money to the countries in need. In terms of influencing forward-looking expectations, a lot of the credibility issues that I think are wildly overstated in the US context seem kind of severe here. So how much does this really help Spanish and Irish people? By the same token, if I were Angela Merkel, I would be jumping on this idea as quickly as possible since it’s clearly better for Germany than fiscal transfers or a breakup of Euroland. And the Euro has never been entirely rational. Italian civil servants looking to circumvent their political masters, Greeks eager for first world status, Irish desire to stick it to the U.K., Spaniards trying to draw a line under the Franco era, etc. have always been an important constituency. So maybe they’d go for this?

To agree with John Quiggin, the mystery to my mind of current European Central Bank policy is why are they insisting on money that’s too tight for German interests? It’s easy to see why the ECB isn’t implementing policy that as loose as would be optimal for Spain or Ireland. And it’s true that on some level there’s simply no way to set ECB policy in a way that works for everyone. But what they’re doing is too tight even for Germany where, for all the bragging, the actual output recovery has been kind of unimpressive.

After all, if the German industrial dynamo was really firing as robustly as sometimes people say you’d expect to see factories expanding operations and hiring workers away from the German service sector. Then unemployment Spaniards and Irishmen would migrate to work German service jobs. It’s true that Europe’s labor markets are imperfectly integrated, but they’re not that unintegrated either. If there was a true boom in Germany, people would make there way over there.

When Spain beat Germany in the World Cup, I tweeted that Germany was going to double its resolve to destroy the Spanish economic with deflationary monetary policy. And it’s really worth checking out this eye-opening chart from Stephen Gordon which shows the extent to which Spanish people are bearing the burden of economic pain in Europe:

If Spain were an American state (call it “Florida”) then the collapse of its economy would spur large net fiscal transfers that help bolster and stabilize its economy. What’s more, the labor market linkages between Spain and other states would be pretty tight, letting people move from place to place. Consequently, in the US all the regions of the country are pretty closely packed on the 45 degree line.

Alternatively, if Spain were an independent country, then the collapse of its economy would spur massive devaluation. Everyone would get suddenly poorer and less able to buy imported goods. But tourists from Germany and the Netherlands would flock in to pick up good deals, Spanish wine sales would boom, and I might be able to afford some jamón ibérico de bellota.

Instead, Spain is having its monetary policy set basically according to Germany preferences and German needs even though conditions are very different. And fiscal transfers won’t be forthcoming. Some people tweeted back at me that the Spanish government is doing an okay job of destroying its economy on its own. But it really isn’t. Before the crash, the Spanish government was running budget surpluses. And it’s simply not possible for your economy to prosper if your monetary policy is set by people who aren’t even trying to create conditions that are appropriate for growth.

I think it’s obvious that letting southern European governments collapse into insolvency would be bad for the world. But the larger issue is that while Greece combines irresponsible budgeting with a bad growth outlook, even countries like Spain whose budgeting is perfectly sound are going to collapse if they can’t grow. And they can’t grow unless they have appropriate monetary policy. So as Paul Krugman says the monetary aspects of the new European rescue plan are probably the most important part:

Announcement #2, from the ECB, changes things somewhat. It now seems that Trichet has been dragged kicking and screaming into becoming at least a semi-Bernanke, engaging in much more expansionary policies than before. (Yes, the ECB says that they’re only liquidity operations, and will be sterilized, yada yada — we can only hope that they don’t really mean it.)

A more expansionary monetary policy could make a real difference — especially if the ECB ends up accepting somewhat higher inflation. Suppose that Speece or Grain need to get relative prices down 15 percent over the next five years. If the eurozone has 1 percent inflation, that’s 10 percent deflation in the periphery. If the eurozone has 3 percent inflation, all you need is stable prices. Also, a stronger overall eurozone economy means higher GDP and hence higher revenue, making the fiscal slog less grim.

Unfortunately, my sense is that Trichet probably does “really mean it.” What’s more, the fact that its resolve is being called into question means the European Central Bank may feel compelled to err even more on the side of low-inflation, low nominal GDP growth policies.

Steve Erlanger has a great piece in the NYT about the coming austerity in Greece and the prospect that it might kill the patient in a way that ultimately makes debt-repayment impossible:

Embedded in the euro and thus no longer in control of its own currency, Greece cannot take the easy way out of its debt by devaluing. So Greece must either cut its spending sharply or default on its loans — which would badly damage German and French banks carrying a lot of Greek debt.

That is considered one reason President Nicolas Sarkozy of France has been so quiet on the Greek crisis, Mr. Fitoussi said. The Greek deal “is an indirect way of bailing out French and German banks,” he said. “The French understood this from the start, but Germany didn’t seem to.”

Katinka Barysch, an economist and deputy director of the Center for European Reform in London, said that that realization had hit home in Germany. “It might be unpopular for the Germans and Europeans to bail out Greece, but it will be even more unpopular for them to bail out the banks that owned Greek bonds,” she said.

I’m not in love with that explanation of how devaluation could have played into this. Greece’s debts to foreigners are largely denominated in Euros, so even if Greece did manage to get out of the Euros and start up some devalued New Drachmas they’d still have to pay off the full face value of the debt. Devaluation would help in that it might boost Greek growth (or more realistically, reduce the extent of Greek contraction) meaning that Greece would have more money to dedicate to the purpose of paying off their debts.

But quibbling aside, the point is that Greek ability to pay is related to Greek ability to grow, and the outlook there is very poor. The Greek economy has a lot of problems. The austerity package will make those problems worse. And on top of that, not only can Greece not devalue, but Greece’s monetary policy will be set for it by a European Central Bank that doesn’t care at all about whether or not its choices are appropriate for Greece.

(cc photo by simon_music)

Republicans caved on filibustering the motion to open debate on the financial regulation bill, so we’ll see what happens with that. The more important story continues to be the Greek debt crisis and the possible meltdown of European monetary institutions. Paul Krugman writes that he used to think leaving the Euro was impossible because it would cause massive bank runs, but that if Greece defaults and starts seeing massive bank runs anyway then leaving the Euro starts to look as possible as anything else.

Certainly my amateur opinion is that if a country can leave the Euro without that prompting a disaster (even if the only reason that’s possible is that a disaster is already under way), then that would look pretty compelling to me. The Euro is a questionable idea in economic theory, but it’s actually proven to be a worse idea in practice. Rather than try to run monetary policy that would be suitable for the median European economy, the European Central Bank has insisted on trying to run monetary policy that would be suitable for Germany. And not even suitable for Germany in general, but “suitable for Germany according to hard money fanatics.” That’s probably bad for Germany, but there’s certainly no reason to think it’s appropriate for southern Europe. Consequently, we’ve seen deflationary bias from the ECB for years and as Nick Rowe points out the ECB is likely to respond to this crisis with measures that prompt further disinflation.

This is a real human disaster for almost everyone involved, but never fear because one senior European monetary official once assured me that the purpose of central bank independence is that it gives him freedom to fight inflation “regardless of the human cost.” It’s true that Greece’s fiscal situation would be unsustainable regardless of monetary policy, but it’s also true that being subjected to Frankfurt’s monetary policy preferences make balanced growth in Southern Europe impossible regardless of fiscal policy. You just need to look at Spain, which pre-crisis was running a surplus with a low debt-GDP ratio:

But despite having done everything that’s now being urged on Greece, Spain is totally screwed. People like to see pat morality tales in macroeconomic events, so that today’s problem countries are being punished for past irresponsibility. But there’s honestly little reason to see that as a major part of the story. Worse than a crime, we’re looking at a mistake. A mistake for which a very large number of people around the world may wind up paying the price.

Interesting post from Yves Smith on the Bundesbank’s behind-the-scenes moves against a Greek bailout:

It seems the wheels are coming off the European experiment. Yesterday, we had a huge meltdown in Greek bonds. Media reports suggest that a recent article in German daily Frankfurter Rundschau are what triggered the latest selloffs in Greek sovereign debt (See the Telegraph’s account here; hat tip Swedish Lex). This article leaked portions of a Bundesbank report which demonstrated its vehement opposition to the joint EU-IMF bailout cobbled together by Angela Merkel and Nicholas Sarkozy.

The Bundesbank paper goes as far as to suggest such an aide package is unconstitutional. However, it also indicates that it fears the IMF will be less stringent than the Eurogroup, something that flies in the face of all logic. To me this suggests an institutional bias against a bailout for which the internal memo provides intellectual cover. Clearly, this level of institutionalized opposition to a bailout in Germany makes a bailout less likely, even with IMF involvement.

You can read the full source article here but it’s in German, so I’ll just be trusting Yves’ translation and summary. I’ll also say that by far the most terrifying conversation I ever had with a policymaker is when my junket to Germany last fall took us to an off-the-record chat with the President of the Bundesbank. Normally the host of a session like that is able to at least mildly impress his audience (or maybe I’m just easily impressed) but Axel Weber was acting like a cartoon version of a hard money German, giving the impression that he’d rather watch his mother starve to death rather than risk 2.7 percent inflation for a quarter.

Meanwhile, Ed Gresser sent me the Eurozone trade figures I couldn’t find the other day and they confirm that we do substantially more trade with the Eurozone countries than with China. We import a bit less from them than we do from the Chinese, but we export much more to them. So the failure of Europe to adopt growth-oriented policies strikes me as at least as much problem for the US economy as anything the Chinese are doing with their currency.