Paul Krugman: When Austerity Fails

Is the ECB trying to provoke a financial crisis?:

When Austerity Fails, by Paul Krugman, Commentary, NY Times: ...In Europe,... the pain caucus has been in control for more than a year, insisting that sound money and balanced budgets are the answer to all problems. Underlying this insistence have been economic fantasies, in particular belief in the confidence fairy — that is, belief that slashing spending will actually create jobs, because fiscal austerity will improve private-sector confidence.

Unfortunately, the confidence fairy keeps refusing to make an appearance. And a dispute over how to handle inconvenient reality threatens to make Europe the flashpoint of a new financial crisis.

After the creation of the euro in 1999, European nations that had previously been considered risky, and that therefore faced limits on the amount they could borrow, began experiencing huge inflows of capital. After all, investors apparently thought, Greece/Portugal/Ireland/Spain were members of a European monetary union, so what could go wrong?

The answer to that question is now, of course, painfully apparent... What to do? European leaders offered emergency loans to nations in crisis, but only in exchange for promises to impose savage austerity programs, mainly consisting of huge spending cuts. ...

But ... Europe’s troubled debtor nations are, as we should have expected, suffering further economic decline thanks to those austerity programs, and confidence is plunging instead of rising. It’s now clear that Greece, Ireland and Portugal can’t and won’t repay their debts in full, although Spain might manage to tough it out.

Realistically, then, Europe needs to prepare for some kind of debt reduction, involving a combination of aid from stronger economies and “haircuts” imposed on private creditors... Realism, however, appears to be in short supply.

On one side, Germany is taking a hard line against anything resembling aid to its troubled neighbors, even though one important motivation for the current rescue program was an attempt to shield German banks from losses.

On the other side, the E.C.B. is acting as if it is determined to provoke a financial crisis. It has started to raise interest rates despite the terrible state of many European economies. And E.C.B. officials have been warning against any form of debt relief...

If Greek banks collapse, that might well force Greece out of the euro area — and it’s all too easy to see how it could start financial dominoes falling across much of Europe. So what is the E.C.B. thinking?

My guess is that it’s just not willing to face up to the failure of its fantasies. And if this sounds incredibly foolish, well, who ever said that wisdom rules the world?