The ECB and the Test of Moral Hazard

It just occurred to me to think about the European Debt Crisis in this way: the European Central Bank is acting very differently from the way the US Federal Reserve acted in somewhat similar circumstances.

In 2008 the Fed, like everyone else, was terrified that the entire US banking system was going to come crashing down in the wake of the mortgage crisis.  So they did really extraordinary stuff to make sure that the banks could not fail.  Along with the Stimulus, this managed to keep the US out of a Depression, even if it wasn't really enough to get us booming again.

Europe now faces a different kind of debt problem: sovereign debt of the European Union member states. We're in a slow-motion run on the debt of the European countries with weaker economies.  This could be stopped by the ECB, but much to the chagrin of the liberal economists I read, they just won't do it.  German people, who control the ECB, just can't stomach the thought of bailing out lazy southern Europe.  Germans are terrified not of default by bond-issuing countries, but of inflation in Germany.

The ECB argument stresses a familiar topic in the US- Moral Hazard.  Some conservatives say that the US system should not have been bailed out in 2008, and that the investment banks should have been allowed to fail.  Yes, the argument goes, this would have created a much worse economic situation, maybe even a second Great Depression, but the alternative is to teach the banking sector that government will bail them out if they get in trouble.  Knowing that they have this safety net means they don't have to fear risk, and will continue to gamble recklessly.  Many of us would respond by noting that the Moral Hazard problem is real, but the harm in this area was worth it to avoid such a huge economic catastrophy, which would affect millions of people who hadn't done anything wrong.

But in Europe, the ECB is fixated on the Moral Hazard of allowing Greece, Spain, Italy, etc to escape their debt woes through bailout, write-downs, or even through deliberate inflationary policy.  They have to Feel the Pain so they learn their lesson!

So here we go: the ECB seems bent on demanding severe austerity for the debtor nations, which looks fated to fail since countries that slash and tax to balance budgets in a recession tend not to grow, which is what is ultimately needed to increase tax revenue and cover their debts.  This seems to be heading for another severe recession in Europe, which ought to teach Greece a lesson or two.  That must feel good to the Germans!

Except..... it's affecting lots of countries, even those which have been more responsible in their budgeting over the years.  And the recession will probably be worldwide.  And German bankers will probably lose their shirts too, since the loans aren't repayable and there will eventually be a default.  Lessons in Moral Hazard all around!