By Farred Zakaria
Europe has been rescued. No, I’m not talking about the deal over Greek debt that was much in the news recently. The real rescue of Europe is being managed quietly, away from the headlines, by a low-key Italian, Mario Draghi, the new head of the European Central Bank (ECB). Over the past two months, Draghi has put the ECB to work, and the results show the power of central banks and the importance of using it effectively.
Don’t start cheering yet. I’m not suggesting that Europe has solved its problems. Despite the recent deal, Greece will not be able to pay back its loans and will face another restructuring, which is a fancy word for default. Portugal might face a similar fate. But now such defaults will not trigger a systemwide panic. There will be no Lehman Brothers–type financial collapse in Europe.
Why? There is a famous scene in the movie It’s a Wonderful Life: after the Crash of 1929, people run to the bank to pull their money out, and the Bailey Building & Loan just doesn’t have enough cash. Thanks to Draghi, Europe’s banks will have access to plenty of cash.
On Dec. 21, the ECB offered to lend Europe’s banks as much money as they wanted for three years at the astonishingly low interest rate of 1%. “In effect, he printed about $600 billion in a day and changed the game,” Sebastian Mallaby, a scholar at the Council on Foreign Relations, says of Draghi. Then Draghi suggested that he might do it again, possibly at a larger scale. “To put this in perspective, Europe and the IMF labored for almost a year to put together a rescue fund of about $500 billion. Draghi may end up creating one three times the size in two months,” says Mallaby. And he could do more. There is no theoretical limit to a central bank’s balance sheet.
The market has noticed. European stocks had their best January in nearly 15 years. Bank shares are up 20%. The rates at which governments borrow money have fallen. Investor sentiment is more bullish than it has been in months. Draghi has not fixed Europe’s longer-term problems of high debts and low competitiveness. But he has bought crucial time for Europe’s leaders to make structural changes to their countries’ economies and move toward growth. The ECB’s activism is not a new model for what a central bank can do. Here in the U.S., the Federal Reserve did the same thing–four years ago. For its actions, the Fed is under withering criticism from many on the right and left. Newt Gingrich has called Ben Bernanke the most “dangerous” chairman in the Fed’s history, Rick Perry practically accused him of treason, and even moderate Mitt Romney has criticized him and announced that he would not reappoint him when his term expires in 2014.
This is dangerous demagoguery. Bernanke is the single individual responsible for preventing the financial crash of 2008 from turning into something much worse. Discussions of the Fed’s role can get very esoteric, filled with concepts like fiat money and new monetarism. Let me try some common sense and a history lesson.
The fear that a central bank could cause inflation by printing money is justified–except these days. Inflation in rich countries is caused largely by rising wages. How can that happen at a time when unemployment is sky-high? New autoworkers in Michigan are making $14 an hour, less than half the union rate of a few years ago. Youth unemployment in Spain is about 50%. Under these circumstances, wages of Western workers are far more likely to fall than rise.
In an essay for the Financial Times, Mallaby provides a highly intelligent history lesson. After the Japanese tsunami, the Bank of Japan (the country’s central bank) printed trillions of yen to stabilize the economy–and it worked. Mallaby contrasts that with the aftermath of the San Francisco earthquake of 1906, a much smaller natural disaster but one that took place in an America that did not have a central bank. Within a year, GDP collapsed, the stock market declined by 50%, and unemployment almost tripled, to 8%. This was not an anomaly. In the recessions of 1873 and 1893, the economy went into free fall while unemployment rose to more than 10% for years–five years in the case of the 1890s. (By comparison, U.S. unemployment hovered close to 10% for three months in the current crisis.)
Modern economies have benefited greatly from having lenders of last resort that act wisely in a crisis. We should discuss how they should use this power. It will take special skill to withdraw, carefully, the cash that all the world’s central banks have put into the system in the past few years. But had they not done it in the first place, we would all be discussing a different problem–how to get out of a global Great Depression.