MONETARY POLICY AND THE EUROPEAN CENTRAL BANK - FLAWED FROM THE START - Summary and Analysis of The Euro: How a Common Currency Threatens the Future of Europe - Joseph E. Stiglitz

Summary and Analysis of The Euro: How a Common Currency Threatens the Future of Europe - Joseph E. Stiglitz (2016)



At the heart of the monetary union is the European Central Bank (ECB), an institution that has proven itself to be the strongest and most effective institution within the eurozone, and perhaps within the broader European Union. Indeed, Mario Draghi, head of the European Central Bank since 2011, may have saved the eurozone, with his famous speech that the ECB would do whatever it takes to preserve the euro1—and in saying that, restoring confidence in the bonds of the countries under attack.

While in that instance the ECB played a constructive role in preserving the eurozone, the mandate, governance, and actions of the ECB have, over the decade and a half of its existence, raised questions about whether the ECB, as presently constituted, is “fit for purpose”: Can and will it conduct monetary policy that ensures growth, stability, and shared prosperity for the entire eurozone? The bank has a mandate to focus only on inflation—even when today, as we’ve seen, the critical problem facing Europe is unemployment and many are worried about deflation or falling prices. More broadly, its behavior sometimes seems to manifest what critics view as its basic defect—flawed governance, evidencing the democratic deficit that, as we noted in chapter 2, has been undermining the greater European project. What it does seems often more consonant with the interests and perceptions of bankers than of the citizens of the countries that it is supposed to serve.

This chapter argues that critics of the ECB are fundamentally correct. Like the euro itself, the ECB was flawed at birth. Its construction was based on certain ideological propositions that were fashionable at the time. These beliefs, however, are increasingly questioned, especially in the aftermath of the 2008 global financial crisis. While other central banks, most notably the US Federal Reserve, have reformed, focusing much more on unemployment and the stability of the financial market—and even beginning to talk about how their policies affect inequality—the ECB’s mandate is limited by the Treaty of Maastricht of 1992 to a single-minded focus on inflation.

The deeper problem of the ECB is the absence of democratic accountability. Conservatives have tried to frame monetary policy as a technocratic skill. Hire the best technocrats, and one will get the best monetary policy. The euro crisis and the global financial crisis, in which central banks played such a central role, revealed that central banks were making intensely political decisions. But central banks always have made political decisions—even when limited to assessing the risks of inflation; they simply made a pretense of just being technocratic. The decision to make the ECB independent, without adequate political accountability, and to focus only on inflation, were themselves political decisions, with strong distributive consequences.

In this chapter I will describe the structural flaws in the ECB and how these flaws have translated into policy decisions, some of which have worked well, but others of which have weakened the eurozone economy and increased the divides within it.


When the ECB was established in 1998 as part of the process that created the euro, it was constructed expressly to limit what it could do. It was given a single, clear mandate: to maintain price stability.2 This is markedly different from the mandate of the US Federal Reserve, which is supposed to not only control inflation but also promote growth and full employment. In the aftermath of the 2008 crisis, the Fed was given a further mandate—maintaining financial stability. It was ironic that this had to be added to the list, for the Federal Reserve was founded in 1913 to protect the integrity of the financial system after the panic of 1907. Indeed, in the decades before its founding, the problem facing the American economy was deflation.

Over time a belief developed within large parts of the economics profession (especially conservatives, espousing what we referred to earlier as “neoliberalism” or “market fundamentalism”) that for good macroeconomic performance it is necessary, and almost sufficient by itself, to have low and stable inflation maintained by the monetary authorities. Of course, now we know that is wrong: the damage done by the financial crisis is far greater than any damage that might be inflicted by all but rampant inflation. In chapter 3, I explained how in Europe alone, the cumulative loss in GDP from the financial crisis is in the trillions of dollars. No one, not even the most ardent advocate of the ECB focusing on inflation, ever thought the cost of inflation would be even close to that. The bank’s priorities were wrong, but it wasn’t the ECB’s fault: inflation had been its mandate; it was simply doing what it was told to do.

This belief that the central bank should focus on inflation was based on a simplistic ideology, supported by simplistic macroeconomic models that assumed efficient markets.3 This ideology was essentially incorporated into the charter of the European Central Bank,4 where it was mandated to “act in accordance with the principle of an open market economy with free competition, favouring an efficient allocation of resources.”5 Europe seemed to be saying that an open-market economy with free competition resulted in an efficient allocation of resources, in spite of the massive body of economic research, theory, and empirical evidence showing that that was not the case in the absence of adequate government regulation.

In this view underlying the ECB, then, government was the problem, and government had to be constrained. The gold standard had done this, but under the gold standard, the supply of money was essentially random, determined by the luck of finding new sources of gold (or other precious metals, if they became part of the monetary system). The result of this “system” was a period of high inflation when the supply of gold increased enormously—for example, after the discovery of the New World—and periods of deflation, such as the end of the 19th century in the United States, when there was a shortage of gold.6 In the 20th century, the world moved off gold-backed currencies to fiat money—paper bills and nonprecious coins backed only by the guarantee of the government; it was this guarantee that gave these pieces of paper their value. The risk with paper money was that the government could print too much, and prices would spiral out of control, interfering with the smooth workings of the market. Thus, the only thing that one needed to worry about was inflation. The job of the central bank was to prevent this, by regulating the amount of money.

There was a contrasting view that developed in the aftermath of the Great Depression. Government intervention could help restore the economy to full employment faster than the market would on its own. Monetary and fiscal policy (changes in taxation and expenditure) were both required—with the relative role of each varying with the circumstance. In the United States, these views were incorporated in legislation by the Employment Act of 1946, which gave responsibility for maintaining stability in inflation and employment to the federal government.7

The worst fluctuations in output and employment were, moreover, created by the market themselves; they were not just acts of nature. This was made especially evident in 2008: a man-made housing bubble brought the global economy down. But the 2008 crisis was itself only the most recent manifestation of issues that have plagued capitalism from its origins.8 Over the past 40 years, economists have come to understand the “market failures” that give rise to bubbles, booms, panics, and recessions. Market failures are particularly prevalent in financial markets. Good financial market regulation can at least reduce the frequency and depth of crises brought on by the excesses of the financial market players: the regulations introduced after the Great Depression prevented a recurrence for almost a half-century. Interestingly, while some central bankers recognized that “irrational exuberance”9 might drive markets to behave irrationally, they still refused to intervene to dampen the bubbles. Their devotion to the ideology of free markets was simply too strong.

On both sides of the Atlantic, central bankers overestimated the rationality of markets and underestimated the costs that underregulated markets could impose on the rest of society. Fundamental to these failures, in turn, were others: a failure to understand the linkages among financial institutions and between financial institutions and the “real” economy, and a failure to grasp the incentives confronting decision-makers in the financial industry; these naturally led market participants to act in a shortsighted way that embraced excessive risk-taking—including actions creating systemic risk, which made the entire economic and financial system more unstable.10


While the most obvious, and most costly, consequence of the fixation on inflation was that insufficient attention was paid to financial stability, even without the crisis Europe has paid a high price for imposing too narrow a mandate on the ECB. It was virtually inevitable that with no focus on unemployment at the ECB, the average unemployment rate would be higher—higher than it would have been had full employment been among its principal mandates, regardless of whether there were a crisis or not. There would always be a greater gap between actual and potential output.

An inflation mandate also can lead to a counterproductive response to a crisis, especially one accompanied by cost-push inflation arising from, say, high energy or food prices. In such situations, workers suffer from inflation due to high oil prices. But then they are told, “You should suffer doubly”: higher interest rates (raised to fight inflation) will dampen demand, leading to lower employment and wages.11

The single-minded focus on inflation was particularly unsuited for a global environment in which other central banks had more flexible mandates. While the Fed lowered interest rates in response to the crisis, the continuing inflationary concerns in Europe meant that the Fed’s actions were not matched by reductions there.12 The upshot was an appreciating euro (as the higher relative interest rates increased demand for European bonds) with downward effects on European output. Had the ECB taken actions to lower the euro’s exchange value, it would have stimulated the economy, partially offsetting the effects of austerity. As it was, it allowed the United States to engage in competitive devaluation against it.13

There were those in America who celebrated Europe’s flaws—at least in a shortsighted, selfish way. Europe was giving us a big gift, allowing us to export more at the expense of their exports and to import less from Europe. This was one of the reasons that the United States recovered more strongly than Europe; and one of the reasons that Europe languished.

In short, the result of the ECB’s focus on inflation is that growth and stability are lower than they otherwise would have been—ironic, since the alleged purpose of the economic framework of the eurozone was to promote growth and stability. But the eurozone’s framework for the ECB was worse, as we shall see: other constraints imposed on the ECB further limited its ability to promote stability and growth; and the way it conducted monetary policy meant that whatever growth occurred benefited those at the top disproportionately. The ECB played a role in exacerbating Europe’s increasing inequality.


Long-standing battles over monetary policy center on what constraints should be imposed on monetary authorities. The mandate to focus just on inflation is an example of a major constraint. Conservatives don’t trust government—and the central bank is part of government. Some, such as archconservative Milton Friedman, even believe that central banks caused the Great Depression by restricting the supply of money.14 Monetary policy during the 2008 crisis did much to disprove his theory: central banks everywhere massively increased the money supply. In Friedman’s theory, the economy would have quickly been back to full employment and even would have faced inflation. Instead, economic growth in Japan, Europe, and the United States was anemic, and many countries even faced deflation.

Standard wisdom among conservative bankers, including at the ECB, constrained what central banks did even more. Conservative economists like Friedman believed that central banks should exercise no discretion, simply increasing the money supply at a fixed rate;15 or when that theory failed to stabilize the economy, to increase or decrease the money supply according to a simple formula, dictated by the inflation rate.

So, too, the set of instruments, it was argued, should be limited: central banks should only buy and sell short-term government bonds. German members of the ECB Board resisted quantitative easing (QE)—entailing the buying of long-term bonds, some of which might not even be government bonds—long after policymakers in the United States and Japan had augmented their tool kit with QE.16 (QE was supposed to stimulate the economy by lowering the cost of long-term borrowing, lowering the exchange rate, and increasing the value of the stock market. In practice, these effects turned out to be small.)

These limitations greatly weakened the scope of what the ECB could do—even beyond the limitations imposed by the inflation mandate. Especially after the crisis, the ECB, the most important economic institution in the eurozone, had an impossible task: to restore all of the countries of the zone to full employment with its hands tied behind its back.

The lack of fiscal policy—with limited spending by the EU as a whole and debt constraints facing each of the countries—put a special burden on monetary policy. Even with no constraints, the ECB’s powers, its ability to maintain growth and employment throughout the eurozone, were limited. But rather than asking how to maximize what it could do, the economic conservatives dominating the construction of the ECB focused on imposing limitations on it. They fixated on the downside risk of an excessively exuberant ECB leading to inflation, not the upside potential of higher growth and employment.

Broadening the ECB’s instruments to include regulatory policies (like capital requirements and capital adequacy standards for banks) might be used to create a more nuanced financial policy, sensitive to differences in the economic situation in different countries. Discretionary regulatory policies could have allowed the ECB to influence lending in individual countries in different ways. While with the euro, there is a single euro interest rate for effectively riskless bonds throughout the region, I have explained how firms borrowing in different countries can face markedly different costs of capital. Those in weak countries face a higher interest rate—when they really need a lower one. At least by providing scope for the banks in weak countries to lend more, one can reduce the magnitude of the tilt in the playing field so that credit in weak countries would not contract as much as it otherwise would.17

Faith in markets by neoliberals not only meant that monetary policy was less needed to keep the economy at full employment; it also meant that financial regulations were less needed to prevent “excesses.” To conservatives, the ideal was “free banking,” the absence of all regulations. Milton Friedman persuaded Chile’s oppressive dictator Augusto Pinochet to try it beginning around 1975. The disastrous results were predictable and predicted: banks recklessly created credit, and when the credit bubble eventually broke, Chile entered a deep recession. It would not be until long after, more than a quarter-century, that the debt Chile undertook to get out of this mess was finally repaid. More recently, the Great Recession was a textbook example of the dangers of underregulated markets.

Central banks can play an important role not only in preventing the financial sector from imposing harms on the rest of society (“negative externalities,” such as credit card abuses and excessive risk-taking) but in helping ensure that the sector does what it is supposed to: providing credit, for instance, to small businesses.18

To be fair, there are disagreements among economists about these issues. Keynesians are especially sensitive to the waste of resources, the human suffering, the long-term costs of lower growth, all of which result from unnecessarily high unemployment. Both in its structure and its functioning, the ECB made a political choice that reflected the views of economic conservatives.


As we noted in the preface, monetary policy, as technical as it may seem, has long been recognized as being political: inflation reduces the real value of what debtors owe, helping them at the expense of creditors. No wonder, then, that bankers and bond market investors rail so strongly against inflation. On the other hand, the fight against inflation typically entails raising interest rates, which lowers growth and hurts employment and workers. Balancing inflation and unemployment is, or should be, a political decision.

In the 2008 crisis, hundreds of billions of dollars were effectively given (or lent at below-market interest rates) by central banks in the advanced countries to commercial banks, in the most massive government-assistance program to the private sector ever conceived. This program of corporate welfare for the suffering banks was greater by an order of magnitude than any welfare program constructed by any government to alleviate the suffering of ordinary individuals. Much of the money was provided through central banks, not appropriated by parliaments or national congresses—again, an intensely political act, without democratic accountability.19

If monetary policy were simply a technocratic matter, it might be left to technocrats. But it is not. There are large distributive consequences. Indeed, central banks may have played an important role in increasing inequality.


Today, in most countries around the world, inequality is viewed as one of the greatest threats to future prosperity. At Davos, where the world’s economic leaders come together every January, recent surveys of global risks have consistently placed inequality at or toward the top of the list.20 Inequality is important because divided societies don’t function well; it leads to a lack of cohesiveness that has political, economic, and social consequences. In my book The Price of Inequality, I explained the mechanisms by which greater inequality leads to poorer economic performance—lower growth and more instability. Since then, a wealth of studies at the IMF and elsewhere has corroborated this perspective.21

Unfortunately, central banks everywhere, and especially the ECB, have largely ignored their role in creating inequality. Their excessive focus on inflation—even when their mandates are nominally broader—has led to higher unemployment, which has increased inequality. Central bank policies have helped ratchet wages down. In recessions, real wages typically fall, but then, in the recovery, just as they start to increase, inflation hawks scream about the risks of inflation, interest rates rise, and unemployment increases to a level making further wage increases difficult.22

But the role of the ECB in increasing inequality was worse. Central bankers have enormous influence that goes beyond monetary policy narrowly defined—for instance, to setting interest rates and the money supply. The head of the ECB is looked to for setting the economic agenda, and, not surprisingly, there is a tendency to focus on their narrow remit, inflation, thinking that by controlling inflation, growth and prosperity will be advanced. Jean-Claude Trichet, the ECB governor during the run-up to the crisis, perhaps in his pursuit of the ECB’s mandate of stable prices, used his influence to push for policies that increased inequality. In the early days of the crisis (from 2008 to 2011) he repeatedly argued that there should be more wage flexibility (a euphemism for saying that wages should be cut—part of the “blame the victim” approach to unemployment discussed in chapter 4, in which workers are blamed for their unemployment, for asking for wages that are too high and for employment contracts with a modicum of security). Of course, wage cuts were in the short-run interests of corporations and their owners: I say short-run interests because he should have realized postcrisis Europe faced a lack of demand and that cutting wages would weaken demand and deepen the recession.

Trichet went so far, in a secret letter to Spain’s prime minister, José Luis Rodríguez Zapatero (which Zapatero published in his memoirs),23 to hint—actually, more than hint—that he would be willing to help Spanish banks if and only if they agreed to enact labor market reforms that would lead to lower wages and less job protection.24 Zapatero apparently refused but, interestingly, introduced reforms that had much the same effect; and the assistance was forthcoming.25


The political nature of the ECB became especially apparent with the euro crisis—who was blamed, who was saved, and under what conditions. Most dramatically, the bank decided not to act as a lender of last resort for Greece in the summer of 2015. As Greece negotiated with the Troika, the country’s banks were forced to shut down, and behind the scenes, the ECB threatened to impose further costs on Greece if it didn’t knuckle down to the Troika’s demands. The ECB had become Europe’s sledgehammer, the tool by which Greece was forced to accede to what the Troika wanted.

More generally, as the ECB decides on what collateral to accept, and with what haircut (for example, to provide a loan of €70 against the collateral of a €100 bond), it may be deciding on the life and death of a financial institution; and when a country is in a crisis, with many precarious banks, the ECB effectively decides on the life and death of the country’s banking system. No decision could be more political. There is no technical manual available; such decisions are a matter of a judgment—of the future viability of the institution—but in reality, it is a judgment strongly colored by the political consequences of alternatives.26

The prioritization of banks over citizens was as evident in Europe as it was in the United States during the crisis,27 and at times almost as evident in his successor, Draghi, as it was in Trichet. As Ireland’s crisis emerged in 2010, Trichet demanded that Ireland assume the liabilities of its bankrupt banks28—and the cost of restructuring the banks led to an increase in Ireland’s debt-to-GDP ratio from 24 percent in 2007 to an estimated 95.2 percent in 2015. While there is some debate about whether Ireland would have assumed some of these debts without intervention, there is little question that some of the debt was assumed only because the ECB made it a condition for getting assistance. (Indeed, the Troika was divided on the matter: the IMF believed that the government should not have had to bear all of these liabilities; there should have been deep debt restructuring, with bank shareholders and bondholders bearing more losses. Ordinary laws of capitalism require the government should not have assumed any liabilities until shareholders and bondholders had been entirely wiped out.)29

The ECB apparently worried about the effect that forcing shareholders and bondholders to bear more of the costs in Ireland might have had on other European banks. But they should have worried about this before the crisis, ensuring that European banks were adequately capitalized and had not engaged in excessive risk-taking.

The critical issue is this: the Troika was asking ordinary Irish citizens to pick up the tab for regulatory failures of the ECB and other regulatory authorities within the eurozone. To me, this is unconscionable—as it seems to most Irish people with whom I have discussed the matter. But evidently not to the bankers in the ECB.


Among the critical decisions any society has to make are those related to governance, who makes the decisions and to whom are those who make decisions accountable? And how transparent is the decision making process? Many of the criticisms of the European Union, in its current form, relate to governance. But in the case of the eurozone, and its most important institution, the European Central Bank, the problems of governance are especially severe. This is partly because financial markets have successfully sold the idea that independent central banks lead to better economic performance. Europe has taken this mantra to an extreme.30

The central question of governance is the extent of accountability of the ECB to democratic processes. There is, in fact, a wide range of degrees of de facto and de jure independence. In the UK, for instance, the government every year sets the inflation target, but that country’s central bank, the Bank of England, has independence in implementing the target. While in principle, the US Federal Reserve is independent, in fact, some of its central bankers have understood very much the limits of that independence: as Paul Volcker put it, “Congress created us, and Congress can uncreate us.”31

The crisis of 2008 provides perhaps the best test of the hypothesis of the virtues of central bank independence—and those countries without independent central banks performed far better than those with.


The main reason for this difference in performance is simple: there is no such thing as a truly “independent” institution. All institutions are “captured” to some extent or another by some group or another. We would like a central bank to reflect the broad interests of society. But central banks in most countries—including the European Central Bank—are captured by a small group, the financial market.32 Both the interests and beliefs of the financial market differ from those in the rest of society. Although for a long time, both in the United States and Europe, those at Goldman Sachs and other large banks have been trying to sell the idea that what is good for Goldman Sachs and the other big banks is good for all, it simply isn’t true. And anyone who subscribed to this idea was surely disabused of it by the Great Recession and the abuses of the financial sector.

Many, if not most, of the central bankers came from and/or went to the financial sector after they finished their tenure. (Draghi himself had spent years at Goldman Sachs before moving on to the Bank of Italy.) In many ways, this is natural: one needs and wants expertise in finance, and much of that expertise resides in those who have worked in the financial sector.33 While even then most didn’t buy into the idea that what was good for Goldman Sachs was good for the economy, it was not that difficult for these democratically unaccountable central bankers to go along with ideas such as “self regulation.” It appealed especially to those who believed in meritocracy and technocracy. Running a central bank was (in this view) like running a mine: put a good engineer (or economist) in charge and all will be well.

But our earlier discussion made clear that the decisions central bankers make are not just technocratic: there are potentially large distributive consequences, and so long as that is the case, there cannot be full delegation to technocrats. Moreover, the one thing economists agree on is that incentives matter. The revolving door meant that it was in the interest of central bankers to do what they could to help their friends in the financial sector, from whence they came and to which they would go.34 Helping friends in banks needn’t even be a conscious decision—though it surely has been in some cases. Rather, the mere proximity and entanglement of central bank leadership and staff with the private financial markets—an inescapable symptom of the revolving door—ensures a convergence of priorities and perspectives. (This is sometimes referred to as cognitive capture.)

Self-regulation turned out to be a joke: those in the financial sector did not have the incentives (and in many cases, even the skills) for self-regulation. Even in the best of cases, the banks would have no incentives to take into account the externalities that their actions (or their failures) would have on others. But it should have been obvious that the incentives of banks and bankers were to engage in excessive risk-taking and socially unproductive—and in some cases destructive—activities. It was willful neglect that central bankers, in Europe and America, failed to take this into account.35


Every aspect of central bank policy, both in Europe and America, in the run-up to the global financial and the euro crises, and in their aftermath, reflected the capture of the central bank by the financial sector—with perhaps the most dramatic manifestations occurring in the midst of the crises themselves. In 2012, Greece needed to restructure its bonds. Prudent banks had bought credit default swaps (CDSs) as insurance against a default in the bonds they owned. A CDS can provide the bondholder with a payment equal to the loss he would otherwise face if there is a default. When bonds are restructured, new bonds are issued in exchange for the old. The new bonds typically stretch out the repayment period, but there is also a write-down, with the nominal value of the new bonds markedly lower than that of the old.36 If this happened, the CDSs would make up for the losses.

There are some ways of restructuring that “trigger” the CDSs—that is, which result in a payout. Of course, a bank that bought a CDS as insurance would want the restructuring to be done in a way that the insurance policy paid off. And a good regulator would want the banks who hold risky bonds in their portfolio to have insurance and that the insurance pay off.

The ECB, however, insisted that the restructuring be done in such a way as not to trigger the CDSs. Their position was unfathomable—until one realized that (1) while some banks had bought insurance (CDSs) against the loss of the value of their bonds, other banks (typically big banks) had sold CDSs. (When someone buys insurance, there has to be someone else on the other side of the market, selling insurance. Obviously, when the insured against event occurs, the firm/bank selling the insurance is worse off.) These banks had sold CDSs as nontransparent gambling instruments. And (2) the ECB was more interested in the big banks that were engaged in selling insurance—essentially gambling and speculating on whether Greece could pay off its debts—than in the ordinary banks that had bought insurance.37


These examples, as well as our earlier discussions about monetary policy decisions about inflation versus unemployment, make it clear that central banks—including the ECB—make political decisions. They face trade-offs. There are large distributive consequences of their decisions. There are different risks associated with different policy choices. In the United States, when they gave money to the banks, they could have imposed conditions, such as that the banks lend to small and medium-size businesses. In Europe, they could have demanded that Ireland not bail out its banks, rather than that it do so.38 They could have demanded that the Greek restructuring be done in a way that the CDSs paid off.

Not even the leaders of the ECB would deny that they face such choices. But if trade-offs exist, the people making them need to be politically accountable. In Europe, the governance is even worse than in the United States. Europe pretended that it could get around the problem of governance by giving the ECB a simple mandate—ensuring price stability (also known as fighting inflation). Inevitably, there are going to be judgments about what price stability means (zero inflation or 2 percent or 4 percent), and in making those judgments policymakers will have to consider the consequences of different targets. If pursuing a 2 percent inflation target versus a 4 percent target were to lead to much slower growth, I doubt that many voters would support that target given the chance.

There are winners and losers in most economic policies. In making their decisions, policymakers in the ECB have to make judgments with distributional consequences. These are not merely technocratic issues, like the best design of a bridge. Slightly higher inflation might lead to lower bond prices, even as it led to higher employment and wages. Bondholders would be unhappy, even if the rest of society celebrated. But central banks that are not democratically accountable almost always pay more attention to the views of the bondholders and other financiers than to the workers.

At one point, the European Commission thought that if Spain’s unemployment were to fall below 25 percent, there would be an increase in inflation. Later, they revised that number down to 18.6 percent. Others think these conjectures absurd.39 But here again there are trade-offs, this time in who bears the risks. By acting as if the critical threshold is a high number, like 25 percent, or even 18.6 percent, when it is in fact lower, one condemns unnecessarily large numbers of people to unemployment, and the higher unemployment results in lower wages for many workers. Those in the financial market and business sector might welcome these lower wages; workers obviously do not.

There is a political agenda in pretending that setting monetary policy is a technocratic matter best left to experts from the financial sector. Reflecting the mindset of those in the financial sector, these “experts” respond to the apparent tradeoffs in a markedly different way than would ordinary workers. Removing central banking from political accountability, at least in the way that it has been done in the United States and Europe, effectively transfers decision-making to the financial sector, with its interests and ideology.

The crises themselves should have shown that it was not expertise and wisdom that the wizards of the financial market brought to the table. The deregulation agenda that financiers pushed in Europe and America was really about rewriting the rules and regulations of the financial market in ways that advantaged those in the financial markets at the expense of the rest of society. It was not about creating a financial market that would lead to faster and more stable growth, and that was why what emerged was lower growth and increased instability.40


The neoliberal argument for central bank independence—the argument that prevailed at the time the ECB was established—seemed to be predicated on three critically flawed assumptions: first, that all that mattered was inflation; secondly, that fighting inflation through monetary policy was a purely technocratic matter; and thirdly, that central bank independence would strengthen the fight against inflation.

I have already explained what was wrong with the first two hypotheses. The third hypothesis was based on a deep distrust of democracy. It was feared that democratic governments would be tempted to inflate the economy before an election. A stronger economy would help get the government reelected—with the price of inflation paid afterward. Only by taking monetary policy out of the hands of politicians could this kind of inflationary pattern be broken; and with confidence that the technocrats assigned to limit inflation would fulfill their mandate, inflationary expectations would be brought down, and thus economic stability ensured. Democratic electorates are, however, more intelligent than this hypothesis gives them credit. Indeed, governments have the same incentive to spend before an election. No one has proposed taking away the spending power from government, to ensure that they don’t “misbehave.” And in fact, democratic electorates have strongly punished governments that overspent. Fiscal responsibility—in some cases excessive fiscal responsibility, with a focus on deficits that exceeds practical sense—regularly features in elections.41


Even if one believed that an independent central bank would result in better monetary policy, one could have constructed a European Central Bank that was more representative, that is, which viewed the inherent policy trade-offs, including the hidden trade-offs, in a more balanced way. Some countries have recognized this—for instance, forbidding those from the financial sector from being on the board of the central bank, since they have a vested interest and particular perspectives on monetary policy. Some countries require that there be representatives of labor—since they often see the world through a different lens than do those in the financial sector. The eurozone has done neither. This tilts the balance, even given the ECB’s inflation mandate: a more hawkish concern over inflation, an insufficient concern over the consequences for growth and employment.


A central thesis of this book is that certain ideas—certain economic models—shaped the construction of the eurozone; these ideas are at best questionable, at worst wrong. In computer science, there is an old adage: garbage in, garbage out. So, too, in the construction of institutions: institutions built on faulty ideology are not going to work well; economic institutions built on flawed economic foundations are going to serve the economy poorly. This chapter has amply illustrated this in the context of monetary policy and the central institution of the eurozone, the ECB.

While the single mandate and the narrow view of the instruments at their disposal may have narrowed the set of actions that the ECB could undertake, the ECB has been, to say the least, controversial. It has been charged, especially within Germany, with acting beyond its mandate, and acting improperly. Even though in its construction, conservative ideas predominated, since the crisis it has used new instruments and undertaken new responsibilities, which conservatives say go beyond its remit. It has been sued for its program of buying government bonds, for engaging in quantitative easing, and for its new supervisory roles. The ECB is governed by a board, the members of which have views about what the bank can do and what the bank should do that markedly differ. The Germans have consistently argued for a narrow construction, and in spite of common wisdom that they enjoy hegemony in the eurozone, the ECB has on a number of times—most notably with the undertaking of QE—taken actions vehemently opposed by Germany, both on grounds of policy and that the actions are beyond those allowed to it.

Institutions evolve. The problems confronting Europe and the world today are different than what they were when the eurozone was designed. Even when the eurozone was founded, inflation was not the issue. The world had moved into a new era, with inexpensive Chinese goods helping to dampen prices. It was clear that growth and employment would be among the issues of the future. The 2008 crisis reminded everyone why some central banks were created in the first place—to maintain financial stability—a responsibility that had been almost forgotten in the years when an obsession with inflation dominated the scene. The strong restraints on the ECB clearly limit its ability to adapt in ways that it could and should. The ECB’s narrow mandate and narrow set of instruments puts Europe in a distinct disadvantage.

The ECB has had three heads in its short history, each with a distinctive style, each leaving his mark. Trichet will be remembered for his colossal misjudgments, in particular raising interest rates at moments where the economy was contracting. He demonstrated a commitment to fulfilling the ECB’s mandate, fighting inflation, come what may. The costs of these mistakes were palpable. He played a disastrous role in the development of the euro crisis, forcing the Irish government to assume the liabilities of its banks. The Irish people were unjustly forced to pay the price for others’ mistakes—a double injustice, because it was in effect a transfer of money from the poor to the rich. But Trichet knew where he stood: he was an ally of the bankers against ordinary workers, constantly demanding wage cuts that would lower their standards of living.

If Trichet did much to undermine the eurozone—could it have survived if he had remained in office?—Mario Draghi is given credit for its survival, with his famous 2012 speech promising “whatever it takes.” Few speeches in history have had such impact—bringing down interest rates on sovereign bonds throughout the region.

The speech was magical in another way as well: no one knew whether the ECB had the authority and resources to do “whatever it takes.” A few academics and pundits worried, what would happen if the promise was tested? If there was a run against Italian bonds? If suddenly, there was a shift in mood, and investors came to believe that the ECB did not have the resources to sustain high prices for the enormous numbers of outstanding Italian bonds? What would happen if Germany successfully opposed the ECB doing “whatever it takes”? In short, no one knew whether Draghi was an emperor with or without clothes. It was, of course, in no one’s interest to find out, or at least not at the time. And so long as it was not shown that the emperor had no clothes, remarkably, the market acted as if he did, whether he did or didn’t.


Quantitative easing, which was grudgingly adopted, with strong opposition from some members of the ECB Board, has not restored Europe to robust growth. Neither has it resulted in massive inflation, as its critics once feared. Over the nearly two decades since its creation, the ECB has not been able to assure full employment and economic stability for all of Europe. That might be asking too much: given the diversity among the countries, critics of the eurozone would say that that was an impossible task. But it has not even achieved reasonable growth, employment, and economic stability on average. Chapter 3 vividly described the eurozone’s dismal performance: it has had a double-dip recession and repeatedly faced threats of deflation, with an unacceptably high level of eurozone unemployment.

In the brief history of the ECB, we have seen costly misjudgments and the use of its enormous power to obtain outcomes that benefit the banks and the major powers within the European Union at the expense of citizens and the weaker countries. This should be deeply troubling.

The main point of this chapter is a simple one: there are alternative ways of structuring central banks—with different mandates, different instruments, and, more importantly, different governance—that are more likely to lead to better economic performance, especially from the perspective of the majority of citizens. Doing this should be high on the agenda of reform for the eurozone. It is one of the essential tasks if the eurozone is to be restored to growth and prosperity.


The eurozone is a monetary union, so it is important to understand the ideas concerning money and monetary policy that prevailed at the time the eurozone was created and subsequently. This section describes the evolution of the dominant doctrines over the past third of a century. Ideas that were fashionable at the time the eurozone was founded—such that all that a central bank had to do was to focus on inflation and that would ensure growth and stability—are now widely discredited among both academic economists and policymakers, including those at the IMF. Yet these ideas are set in stone in the ECB, and still widely held within powerful groups inside the eurozone. This puts the ECB in a difficult position: following its mandate puts it on a course that is opposed by large fractions of European democracy. It is important to have rules, but having the wrong rules, as we noted earlier, can be a disaster.

In recent decades, central banking has been dominated by a succession of beliefs—one might call them religious beliefs, for they are held with firm conviction, even passion. And this is so, even though the empirical evidence underlying them is at best weak. The good news concerning central bankers is that their religions evolve, even if they change their beliefs very slowly in response to evidence against the currently fashionable doctrines.


At one point, the religion was called monetarism—all central bankers believed that one should increase the monetary supply at a fixed rate and, accordingly, monetary authorities should keep their eye on the money supply.

Monetarism was never really a theory; it was based on an alleged empirical regularity—that the ratio of the money supply to the volume of transactions (called the velocity of circulation) was fixed. There was no theoretical reason that this should be so. No sooner had Milton Friedman announced this new law of nature than nature played a trick on him, and on the countries that followed his dicta: the velocity of circulation started changing. Those of us who had studied more deeply the nature of financial markets understood and predicted these changes. New forms of financial instruments, like money market funds that we now take for granted, were coming into play, and there were changes in the regulations governing financial markets.

Monetarism swept the world of central bankers as the cult of the day. It was based on a simplistic model. It could be grasped easily by central bankers with limited abstract capacities, and it provided rich opportunities for empirical testing. There was enough ambiguity in the theory to lead to heated discussions: What was the right definition of money? How should it best be measured? What was the right measure of GDP? How should it be measured?

Interestingly, conservative central bankers following such doctrines actually exposed the economies for which they were responsible to real risk. At the time the experiment with monetarism began, its full implications were not known. At the time (the late 1970s) the United States faced what was widely viewed as an unacceptably high inflation rate, Paul Volcker, newly chosen to head the Federal Reserve, responded with this new tool. Interest rates shot up beyond anything that had happened before, and beyond what most had expected—the Fed fund rate eventually reaching 19 percent. But while this new “theory” seemed to work in bringing down inflation, from 13.5 percent in 1980 to 3.5 percent in 1983, the medicine had serious side effects. America’s deepest recession since the Great Depression, with unemployment reaching 10.8 percent in 1982, in spite of a massive stimulus from fiscal policy with the large 1981 Reagan tax cut; and debt crises throughout the world in countries that had borrowed in the 1970s to offset the effects of the oil price rise, in the perhaps-reasonable belief that so long as interest rates remained within the realm of what had happened in the past, they could manage things. The result was the lost decade of the 1980s in Latin America.


As this monetarism religion waned in the onslaught of overwhelming evidence that it did not provide good guidance—even ignoring its noxious side effects—a new religion took its place, inflation targeting.42 If inflation was the only thing that central banks should care about, it made sense for them to target their policies to inflation. Never mind about unemployment or growth—that was the responsibility of someone else. Countries around the world adopted this philosophy, and with conservatives loving rules, there developed a rule, named after John Taylor, with whom I taught at Princeton and Stanford, and who was to go on to be the under secretary of the Treasury for International Affairs in the Bush administration. His rule (the “Taylor rule”) prescribed by how much the central bank should raise interest rates in response to a level of inflation in excess of its target. One didn’t really need a board to set interest rates, just a technician, who would calculate the inflation rate (government statistical offices do that) and then plug the number into the formula. The interest rate would pop right out. The money supply should be increased or decreased until that target was reached. One didn’t have to ask why inflation was high or whether the disturbance to the economy was temporary or permanent. Those judgments, made by mortal government appointees, would inevitably be more fallible than the infallible rule.

Countries following such a simplistic policy also had disastrous results. When food prices rose very rapidly in 2007, inflation—especially in developing countries where food is such an important part of the market basket—rose, too; but it made no sense to raise interest rates: raising interest rates would not lower food prices. The problem of food prices was global, but even in a moderately sized country, raising interest rates would have a negligible effect on global food prices. The only way the monetary authority could have an effect on inflation was to drive down other prices—have deflation in the nontraded goods in the economy. And the only way to achieve that was to cause those sectors to go into depression, by raising interest rates very high. No matter how important one thought that inflation was, the cure was worse than the disease.

The European Central Bank never went so far as to go to either the extreme of monetarism or the Taylor rule, but it did something almost as bad. It focused exclusively on inflation—after all, that was its single mandate—and for a long time it continued to use as an indicator of its monetary stance (whether monetary policy was loose or tight) the rate of growth of the money supply, a holdover from the days when monetarism reigned king.


When the Federal Reserve put interest rates down to zero—and still the economy did not recover—it felt it could and should do more. One idea was to purchase long-term bonds, driving down the long-term interest rates and providing more liquidity to the economy. This was called quantitative easing. The ECB was slow to introduce quantitative easing. It did so long after the United States, and even after Japan. Even as it undertook QE, the ECB may not have grasped why quantitative easing had such a limited effect in the United States—and why therefore the benefits would likely be still weaker in Europe. The problem in quantitative easing in the United States from 2009 to 2011 was that the money that was created wasn’t going where it was needed and where the Fed wanted it to go—to increase spending in the United States on goods and services. Important credit channels, especially to small and medium-size businesses were clogged. So the money naturally flowed to foreign countries, especially economies that were already growing strongly and beginning to face inflation; they didn’t want the extra money, and they created barriers to these flows—imperfect, but still somewhat effective. The three main channels through which quantitative easing helped the economy were all weak: a slight weakening of the value of the dollar helped exports—but these effects were eventually countervailed by America’s trading partners; mortgage rates were reduced as long-term interest rates fell, but the monopolistic banks—and bank concentration after the crisis was greater than before—took much of the lower interest rates and simply enjoyed it as extra profits; and the stock market bubble led the very rich to consume a little more, especially of luxury goods, many of which were made abroad. What the economy really needed was more lending to businesses, but big businesses were already sitting on $2 trillion of cash and were essentially unaffected by QE. And because the Fed and the Obama administration had fixed their attention on the big New York banks and other international banks, the ability of the smaller regional and community banks to make loans remained impaired.43 The result was that years after the crisis such lending remained before its precrisis level.

By the time that the ECB considered undertaking quantitative easing, it was known that it was a weak instrument. The ECB could and should have realized that the benefit it would get from the exchange rate was likely smaller than what the United States had gotten. First, because everyone was now doing it, Europe wouldn’t get the benefit of competitive devaluation. Secondly, the emerging markets had set up controls to ensure that they were not disadvantaged. Thirdly, and most importantly, little domestic demand would be created unless the credit channels were fixed, and in this respect, Europe was much worse off than the United States, as we saw in the last chapter, with dramatic decreases in SME lending and a shrinking of the banks in the periphery countries. The ECB could have taken more aggressive measures to ensure that the money didn’t go into credit bubbles, and that more of the money went into supporting new businesses and expanding old businesses. Their philosophy of “trusting the market” may have made them hesitant to do so.

Some were worried that QE would result in inflation. But massive QE had not resulted in inflation in the United States, and there was even more of a reason not to be worried about incipient inflation in Europe. Much of the money was held by banks. The problem was that the banks were not lending out money. Much of the money that the Fed and the ECB helped create simply stayed within the Fed and the ECB, or in any case, didn’t lead to more lending. Since the additional liquidity was not leading to more spending, it could not lead to more inflation.

There were, however, other risks associated with this massive expansion of central bank balance sheets. One was that it could lead to asset price bubbles—just as the earlier easy-money policies had contributed to the real estate bubble. The breaking of those bubbles, in turn, might lead to economic volatility. The Fed at least had tools to deal with such a problem. It could raise margin requirements (the amount that investors had to put down when they made an investment in, say, a stock or commodities). And in the aftermath of the crisis, it even had a mandate to do so—it was required to ensure not just low inflation, high growth, and full employment but also financial stability. Unfortunately, the European Central Bank, with its mandate formulated in the period of neoliberal ascendancy, focused just on inflation, leaving it to others to worry about the stability of the financial system.


Monetary policy, in the way it has been managed in Europe and the United States, has proven of limited effectiveness in the restoration of robust growth. Long ago, Keynes had argued that when the economy was in a recession, or worse, depression, that was likely to be the case. But there has been a strand in economics which has questioned more broadly the effectiveness and desirability of an active monetary policy, one directed at maintaining the economy at full employment, more broadly; and these ideas have been especially influential among conservatives.

Critics of an active monetary policy argue that if one tried to get the unemployment rate below a critical level, called the natural rate, and hold it there, there would be ever-increasing inflation.44 This theory greatly narrowed what central banks should do: if one was committed to avoiding superinflation, at most one could have a short period of unemployment below this threshold, to be offset by another period while it was above. In this view, central bankers faced no trade-offs. Their job was simply to keep the unemployment at the “natural rate.”

This theory has been increasingly questioned.45 If one looks at the data, one can’t see a systematic relationship between inflation, or the increase in inflation, and unemployment. If there is a natural rate, it is a movable target, and we almost never know where it is. Thus, policymakers have to guess, and in making that guess, there are big trade-offs: a risk of much higher unemployment than necessary versus a risk of somewhat higher inflation than we might desire.

Thus, even if the simplistic models that say there is no trade-off between unemployment and inflation were correct, once we take account of the fact that we don’t know what the natural rate of unemployment is, there are trade-offs. The risks of underestimating the natural rate and overestimating it are borne by different people. Central bankers—in Europe and America—have managed these risks focusing more on financial markets than on workers, and in doing so there has been an unambiguous loss in output and an increase in inequality from what otherwise would have been the case.