Sunday, 8 August 2010

Europeans are from Mars

The Malta Independent on Sunday   - 08 08 2010
Men are from Mars, Women are from Venus goes the saying originated by the 1992 book of John Gray arguing that men and women are as different as beings from different planets. The stark difference between the US and European approach to the painful and long drawn economic recovery from the greatest recession since the thirties, makes me draw parallels that Europeans are from Mars while Americans are from Venus.

Jean Claude Trichet surprised many when on July 23rd he called for worldwide tightening backing tax rises and spending cuts to address the large fiscal deficits built into most governments budgetary position by the financial crisis of 2007 – 2009 when tax revenues fell and social spending increased alongside additional spending by governments to cushion their economies from spiralling into a depression. He was not just laying out monetary plans for the Euro area for which the ECB is responsible directly or for the total EU area for which it is indirectly responsible given that the ultimate destination should be for all EU members to join the Euro.

He was recommending world-wide tightening, giving advice, if not instructions, to others beyond European shores and stopping just short of a straight admonition about their misguided lax monetary and fiscal policy.

This contrasts sharply with the general approach adopted by Trichet’s counter-part on the other side of the Atlantic who regularly expresses the caution against tightening up too quickly before the economic recovery gets firmly entrenched, warning that any such pre-mature tightening could trip the economy into a double dip recession.

Both the US Treasury and the US Federal Reserve Bank extol the virtue of fiscal prudence for the long term, but like St Augustine they pray for latent rather than instant virtuosity. While Trichet was writing that “we have to avoid an asymmetry between bold, if justified, loosening and unduly hesitant retrenchment..... and with the benefit of hindsight we see how unfortunate was the oversimplified message of fiscal stimulus given to all industrialised economies under the motto ‘stimulate, activate, spend’ “ Bernanke was advising the US Congress that he supported fiscal efforts to boost demand before the US embarked on a well controlled long term deficit reduction plan. He was telling Congress that the prospects for the US economy were ‘unusually uncertain’ and that the Fed believes that the US ‘should maintain a reasonable degree of fiscal support , stimulus for the economy’.

Never before have there been such monetary duels between the two major economic blocks of the industrialised world. Another example of how the great recession caused by the financial crisis of 2007-2009 is changing the rules and game and leading to different views from different vantage points.

Let me speculate about the reasons leading to such duels. The simple reason, too simple really, is that whilst the ECB is only tasked with a unitary objective to keep inflation in the Euro area below but close to 2% p.a., the US Fed not only has no specific inflation targets but has additional responsibility to keep economic growth and employment as close as possible to the potential of the US economy.

So strictly speaking the ECB in setting its policies gives much less attention to the impact they may have on economic growth and employment and instead is guided solely by the single inflation objective irrespective of other macro-economic considerations. Whilst this is undeniably so, it is too simple to assume that in reality the ECB does make any macro-economic consideration other than inflation. This would be unrealistic as economies are dynamic systems and if they do not grow they contract and could fall into a depression, denying the possibility of honouring the close to 2% inflation target. In a depression prices retrench and real interest rates rise, causing an increased debt burden to suffocate new investment which is also discouraged by diminishing demand.

There must be other reasons why the ECB seems more relaxed about the prospects of the EU economy than the Fed is about the US economy. Amongst these is the fact that the property crisis which originated in the US on a nation-wide basis, was only replicated in Europe in some peripheral countries like Ireland and Spain but was no problem in the core EU countries like Germany and France where property prices neither hiked speculatively nor crashed horrendously when the US bubble burst.

So whilst the financial crisis created by the property bubble in the US was quickly exported world-wide due to the mobility of capital that rendered many European banks exposed to US financial products related to US mortgages, the property crash per se remained a largely US affair. Now that the financial system has stabilised it is the US not Europe that has a stranglehold around its monetary policy by the large number of consumers who are still nursing negative equity mortgages as property prices in the US continue to bump along the bottom.

Still I feel there is a more potent, often unspoken, reason for the contrasting approach of the ECB and the Fed. Whilst in the US the Fed oversees a political federation and is responsible for the economy of the whole federation there is a clear tendency in the Frankfurt building of the ECB to measure the fortunes of the EU by those of the core northern European countries with Germany as the core of the core. Policies are not tailored for the needs of the periphery countries who are expected to drudge along and shape their economies on the German model with little respect to the environmental, cultural and skill differences. Whilst the overall EU economy is struggling to grow, the German export machine, aided by the fall in the Euro and the rise of the US dollar in the first half of this year, is humming along with impressive speed and consistency.

Trichet is showing undue optimism if he thinks that Spain, Portugal and Greece amongst others can benefit the same way as Germany from Chinese demand for imports of investment machinery and luxury products. The fortunes of the Euro are already reversing. The Cassandras on the US side which just two months ago were predicting dollar parity with the Euro by end of summer are now eating humble pie as the US gently engineers a fall in the dollar value which is key to reviving export demand to fill the gap in the subdued internal consumer demand as the US consumer has to save more to nurse his/her negative mortgage.

It would be wise for Trichet to keep options open rather than paint the ECB into a corner from which it could exit only with an egg on its face as it did when it raised rates in June 2008, just a quarter before the crisis hit. And again as it had to do very recently when it was forced by the Greek sovereign crisis to start buying sovereign bonds of its members after denying any plans to do so. It would also be wise for the ECB to fine tune its policies with less German-centricity. As Trichet’s term nears its end, the ECB would be served better if it chooses by Banca d’Italia Draghi to lead it rather Bundesbank’s (BUBA) Weber unless the ECB is to be labelled BUBA mark 2.

Rather than Mars perhaps the ECB can come down to Earth. 


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