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EU leaders need to go against the grain with debt crisis

When economic historians examine the wreckage of 2011, a fateful milestone will stick out: Jean-Claude Trichet's April 7 decision to raise interest rates in the euro zone.

Like kicking a guy when he's down, the European Central Bank's move was a classic pro-cyclical policy response. The rate increase, which took the ECB's key lending rate to 1.25 per cent from 1 per cent, compounded the downward spiral in the euro zone by ratcheting up the stress on the region's most indebted countries and their ailing banks.

The global economy has been feeling the aftershocks ever since.

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And the inflation threat the ECB president insisted he was fighting? It has proven to be fleeting and inconsequential. Prices for oil and other commodities have retreated.

Unfortunately, the world is now littered with similar economic policies that will exacerbate the problem of slow growth. (That's the definition of "pro-cyclical" - a policy that amplifies the prevailing economic trend, rather than counteracting it.)

For example: there's the so-called paradox of thrift, now playing out in Europe. No one doubts that some European countries must work down their debts. But the deep austerity now under way in Spain, Italy and elsewhere is pushing the euro zone to the brink of another recession, which will hurt government revenues and make the job of deficit-cutting even harder.

And last week, German Chancellor Angela Merkel and French President Nicolas Sarkozy pitched the idea of a financial transaction tax, ostensibly to fight speculation and help countries balance their books. But experts warn the tax would squeeze much-needed liquidity and lead to even more financial market volatility.

A similar story is playing out in the United States, where deep spending cuts are looming as the economy flirts with a double-dip recession. But Congress apparently isn't willing to pay for the government Americans have.

As for Europe's leaders, what they need to do is think counter-cyclically.

"Extraordinary times call for extraordinary measures," argues Dan Ciuriak, the former deputy chief economist at Canada's Department of Foreign Affairs and International Trade.

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Remember the Jubilee 2000 campaign aimed at getting rich countries to forgive Third World debt? It has worked relatively well, and Mr. Ciuriak says the ECB should do the same for the financial basket cases of the EU.

"The European Central Bank could monetize debt of the troubled countries by buying the excess debt and simply writing it off," he argues. "Think of it as QE4 – a way to pre-emptively avoid euro interest rates from being forced down to the zero bound from untimely, pro-cyclical fiscal restraint."

In other words, forget euro bonds or costly taxpayer bailouts. Just crank up the ECB printing press and churn out more euros with which to repay some of the debt of Greece, Ireland and others.

This would typically spur inflation. But as Mr. Trichet now knows, Europe is facing a greater threat from recession and deflation than inflation.

The conditions are as good as they get right now for printing money. The euro zone enjoys a current account surplus, low inflation and an overvalued currency. Demand from fast-growing China and India is lapping up the excess supply of everything the world's wealthy countries can produce.

Governments have shown a willingness to bail out systemically important companies. The ECB should treat euro-member countries the same way.

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Forgiving billions of euros worth of sovereign debt won't be easy, nor cheap. But it would be a bold move that would be a blow to speculators.

Italy and Spain have a combined €2.1-trillion ($2.9-trillion) worth of outstanding debt. Just to match the bailouts of Greece and Portugal, the ECB would have to forgive some €315-billion worth of bonds. And these countries would still need to roll over their existing debt in a market that could prove hostile.

But debt forgiveness would serve at least two purposes. It would lower countries' debt service costs, and would avoid more painful fiscal measures.

Above all else, in these volatile times, policy makers might want to remember the code of medical ethics: First, do no harm.

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About the Author
National Business Correspondent

Barrie McKenna is correspondent and columnist in The Globe and Mail's Ottawa bureau. From 1997 until 2010, he covered Washington from The Globe's bureau in the U.S. capital. During his U.S. posting, he traveled widely, filing stories from more than 30 states. Mr. McKenna has also been a frequent visitor to Japan and South Korea on reporting assignments. More

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