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Europe's Central Bankers Blind to Imminent Disaster

European Central Bank
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European Central Bank

The extraordinary move by European leaders to adopt the ideology of expansionary austerity as a legal requirement was met with an even stranger reaction here in the U.S.

On Friday, twenty-six European countries signed on to a plan that would impose contractionary austerity policies across the continent.

At the same time, the European Central Bank’s Mario Draghi was clearly explaining the central bank would not use its balance sheet to bring down rates on sovereign debt .

And yet nearly everyone in the U.S. watched this and just assumed that the opposite would happen. The Eurocracy would not really follow through on its plan to impose austerity, and the ECB, many believe, would eventually step in and rescue Europe from disaster.

Why do so many people assume that last week’s promises of fiscal and monetary austerity won’t hold up? In a word: incentives.

In the U.S. — and especially on Wall Street — there’s a strong consensus that if the ECB does not start acting like the Federal Reserve of 2009 by buying sovereign debt, there will be no end to the crisis. We assume that the ECB is smart enough to figure this out — and smart enough to know that if the euro zone cracks under pressure it will mean the end of the euro and the ECB.

So even if we assume that the ECB leaders are deeply enthralled with the ideology of expansionary austerity, we expect that eventually they will give up this ideology in order to save their jobs. In the end, we figure they are strongly incentivized to not let Europe self-destruct.

Paul Krugmandoes an excellent job this morning explaining this line of thinking:

It’s actually quite remarkable how many sensible people base their analyses on the presumption that the ECB will do what has to be done. Barry Eichengreen, who is a genuine expert on all things euro, starts his analysis of prospects for 2012 with the confident assertion that Draghi will ride to the rescue.

But as far as anyone can tell, the monetary cavalry aren’t coming. And the bond market has figured this out.

What Anglo-Saxon economists need to understand is that the Germans and the ECB really, really don’t share our worldview; they really do believe that austerity is all you need. And all indications are that they will cling to that belief, even as the euro falls apart — an event they will insist was caused by the fecklessness of the debtors.

Given a choice between saving Europe and remaining righteous, they’ll choose the latter.

I’d put it slightly differently. What “Anglo-Saxon economists” are doing is confusing their own ideology with reality. Economists tend to look at economic problems as involving incentives. Align incentives properly, and problems are easily solved. The tricky part is all in the figuring out how to get incentives properly aligned.

This turns a blind eye, however, to the role of ideological commitment. The strong commitment on the part of European central bankers to austerity may make the incentives irrelevant. All the incentives in the world might not matter because at some level the central bankers believe that the necessity for expansionary monetary policy is incommensurable with their other ideas about how the world works.

To put it differently, the monetary experts in Europe may just be too ignorant of the peril they are in thanks to their world view. We cannot count on Draghi and others suddenly taking a more rational approach to monetary policy. They can remain irrational longer than Europe can remain solvent.

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