Thursday, December 1, 2011

U. S. Federal Reserve System Needs to Help European Central Bank Do What the European Central Bank Will Not Do for Europe

A Risky Policy That Should Not Have Been Implemented Unless the ECB Changed

[Editor's note:  Every now and then economic policy is implemented that is so incredibly stupid that The Dismal Political Economist cannot help himself and he produces a semi-incoherent rant.  This is one of those times. ]
The Fed has just entered into an almost unprecedented policy coordination with the European Central Bank, the Bank of England and three other  Central Banks to provide liquidity to the European Banking system.  Stock markets cheered the action

Global equity markets rose sharply Wednesday in response to the show of action by central banks. The Dow Jones Industrial Average rose 490.05 points, or 4.2%, to 12045.68. The Stoxx Europe 600 rose 3.6%, while the German DAX surged 5% and France's CAC-40 increased 4.2%. Gold and oil prices rose, and the dollar weakened against the euro.

proving once again, as if more proof was needed that the people who manage large portfolios that invest in stocks have no idea what is really going on, and only have a herd mentality.  Investors moved into stocks because they thought other investors were moving into stocks.

What’s wrong with the Fed’s policy?  It doesn’t address the problem.  It’s like taking out a person’s appendix because he suffers from heart disease.  At best it won’t do any harm.

The coordinated action doesn't directly address Europe's government-debt and budget woes. Instead, it is aimed at alleviating the impact of those troubles on global markets.

The policy addresses liquidity problems in European banks.  Since the Fed cannot directly lend to European banks (and it shouldn’t for too many reasons to count) it took this action.

Under the program, the Fed loans dollars to other central banks, which in turn make the dollars available to banks under their jurisdiction. The action Wednesday made these emergency Fed loans cheaper, lowering their cost by half a percentage point.

which does help the problem of bank liquidity.  But that is not the core problem.  The core problem is that private investors will no longer lend to many European countries at interest rates those countries can afford. There is real concern that Greece, Italy, Spain and Portugal will default.  The debt of Greece, Italy, Spain and Portugal is toxic and banks that are holding zillions of Euros of that debt are becoming toxic.

The only real solution is for the European Central Bank to support government debt of those countries, in return for immediate reform of those countries’ economies, including freeing up the labor markets by removing impediments to hiring.  But the ECB will not do this because in effect this monetizes the debt of those countries, increasing the supply of Euro’s, weakening the Euro and possibly producing inflation. 

in particular will not allow this.  The Germans want the other countries of Europe to suffer for their fiscal sins.  They also do not want inflation of any kind, yet inflation in this case would be a positive not negative result.  Germany thinks it is the moral leader of European economics.  It is not, it is imposing its will on a continent with the wrong economic policy at the wrong time.

So the Fed is an enabling agent here.  It is enabling the ECB and Germany to avoid doing what they have to do, what they must do, and what in all probably they will do once the crisis reaches a point that forces them to act.  By that time the damage will be severe, much greater than it had to be if responsible policy had been enacted, say, six months ago.

The one phrase that will be used to describe the history of this period will be this, “If the Fed and the ECB (and let’s be honest, they are who are calling the shots here, not the other four central banks in the group)  can do the wrong thing, they will do the wrong thing.”  But none of the elite central bankers will suffer, it will only be the millions of unemployed, underemployed and part time employed citizens of Europe.  And they won’t have to worry about inflation, because they will not have any income with which to purchase anything.

This action and lack of action comes at the worst possible time for the U. S.  The U. S. economy was starting to recover in the winter and early spring of 2011.  But in April the growth in employment sputtered to a halt, in part because of the growing perception that the paralysis of the Federal government would precipitate a crisis on the debt ceiling and other policy considerations.  Now the U. S. economy is showing more signs of a faster recovery.  Employment is growing, jobless benefit claims are down, consumers are enthralled with electronic gadgets and getting more confident, holiday shopping is up and it looks like the tax cuts that expire at the end of the year will be renewed. 

One thing that will bring all of this to a halt is a deterioration of the situation in Europe.  China is already beginning to see a slower economy because of a weakened Europe and is moving to expansionary monetary policy.  Germany thinks it is strong enough to continue to have growth even if Europe as a whole does not;  it is wrong.  A collapse or near collapse of the Euro will have huge negative effects on confidence and on growth.  In short unless Europe gets it economy under control a world wide slowdown will happen and a world wide recession may happen.

U. S leaders had the leverage to force Europe to act.  By requiring the ECB and others to implement the correct economic policy of ECB support for European debt and by stronger requirements of economic reform in Italy, Spain, Greece and Portugal the U. S. could have set Europe on a path for avoiding disaster.  But they didn't, everyone made nice with each other.  So now the question is whether or not Europe can do what is needed on their.  They probably cannot, and when markets realize that it will not be pretty.

This whole ugly episode illustrates another saying about governments and central banks and economic policy, “If things can get worse, they will get worse”. The health of the world economy for 2012 now rests on the hope rather than the expectation that this is not true.

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