The European Central Bank is Courting Disaster

Via Matt Yglesias, I came across this news.  The ECB has decided that it is time to raise interest rates by a quarter percent to 1.25%.

I can't think of a more irresponsible thing for the ECB to do, especially coming the day after the news that Portugal will become the third country to request financial assistance from the EU.

The sovereign crisis in Europe has slightly different causes and effects in different countries, but the predominant problem for Greece, Ireland, Portugal, etc. is the need to realign their prices and particularly wages with Germany and the Euro core.  Tightening monetary policy and raising rates is one of the easiest ways to exacerbate that type of debt deflation problem, as the US learned during the Great Depression.

It's difficult to imagine what goal the ECB is trying to achieve here.  Bond markets are already demanding prohibitively high yields on the debt of troubled nations.  This will make that problem even worse.  It will make the entire process of price realignment slower and more costly on the local populations of peripheral Euro nations.

This will very possibly have the other perverse consequence  requiring ANOTHER round of bailouts for Irish banks.  Higher rates means slower growth, more defaults and larger balances sheet problems for Irish banks and, ultimately, those banks' French and German creditors.

The combination of financial sector bailouts and austerity budgets has already destabilized the Irish and Portuguese governments.  There is already the chance that new successor governments in these nations may be less willing to play ball with EU authorities.

I suspect that this drives us much, much closer to one or more nations deciding to pull out of the Euro.  However, even if this doesn't undermine the Euro, I'd expect some very negative market reactions over the next week as people digest this change.

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