Much maligned, but some actually speak out in defence. Prominently amongst them, Melvyn Krauss in an article published in various newspapers. In fact, he wrote quite a couple of critical articles about the ECB. It’s interesting stuff, lets discuss some of the arguments.
He compared the early stages of the credit crisis to cancer.
Pretty strong stuff. He pins the analogy on the fact that in both cases you realize it’s a serious problem, but you do not quite know how serious, whether everything is already infected or if it’s just a local problem. Hence, in the early stages, the Fed had to grope around in the dark to a considerable degree.
We have to agree here, we wrote earlier that the credit crisis, and especially the sub-prime mortgage crisis and the securization that was supposed to spread and thereby reduce the risk and allocate it efficiently was like throwing risk into a blender and out came confetti and suddenly it was very hard to know just what was infected and to what extent.
Krauss relates how European banks felt safe at first, because they hadn’t engaged in these risky mortgages, but when a small Norwegian bank had to report substantial losses as a consequence of holding parts of the related risks on its balance sheet, this myth evaporated. It’s like a cancer that spreads, popping up in unexpected places and knowing no boundaries.
The myth of the European decoupling
Krauss argued that the Europeans thought their economies wouldn’t suffer from any real effects, and he disagrees. According to Krauss, there is a delay, which created the illusion of decoupling. Well, we fear he has a good point here, but it’s a matter of degree, and the jury is still out on that, we believe.
It can hardly be a surprise that European economies would be negatively impacted by events in the US. There are too many links, the sinking dollar is one of them that impacts Europe negatively, falling stockmarkets another. And one not to underestimate, the erosion of confidence through the media.
Critics of the Fed overestimate the inflation problem and underestimate the dangers of a downward economic spiral in the US
Perhaps. For instance, we actually think that oil will not go up much more. One argument Krauss uses is the remote risk of a wage-price spiral in the US, the labour market is way to weak for that. Indeed. He’s right on that. However:
- Inflation might not be always and everywhere a monetary phenomenon (as the late Milton Friedman had it), but it sure matters. Excessive money creation will pop up somewhere sooner rather than later
- In Europe, the danger of a wage-price spiral is actually a lot higher, due to the much higher real wage resisitance in most European economies compared with the US (basically, if prices go up wage earners will demand compensation for that to keep their real wages from eroding).
Krauss also doesn’t mention that extreme reliance on free-market ideology is what got the US in this mess in the first place. Markets are wonderful, but many of them need substantial regulation to function properly, especially markets were information is very asymmetric. People actually won Nobel prices for this argument.
You cannot actually leave things to free markets without taking care that these markets are able to function properly. And this is exactly what happened in the mortgage and (some of the) credit markets in the US. Ok, it’s not so much Barnake, definitely Greenspan though. Notwithstanding many warnings from serious people, he continued to argue against any bubble in the housing market.
We like Krauss’ conclusion though. A division of labour of sorts. The Fed fighting recession, the ECB fighting global inflation. One problem, this sure looks like a recipe for more dollar weakness, and that is actually making the ECB job that much harder.
So we forgot who cried out for a one-armed economist (some American president, we believe), but we sympathize. They have a habit of arguing like “on the one hand…., on the other….”
We cannot resist providing you with an earlier quote from the same Melvin Krauss though:
Federal Reserve Chairman Ben Bernanke has allowed global stock markets to railroad him into a whopping 75-basis-point cut in interest rates just one week before the regularly scheduled meeting of the Fed’s decision-making Open Market Committee. European Central Bank President Jean-Claude Trichet would never allow this to happen to the ECB – he manipulates markets; markets don’t manipulate him.
Not so terrific then, the Fed..