Thursday, July 3, 2008

Lessons of History or Mistakes of the Past?

A specter is haunting Europe, but we can't agree on which one...

The European Central Bank is raising interest rates in an effort to keep inflation in check, while the Fed has the fed funds rate target at 2% (so the real interest rate is actually negative). Real Time Economics excerpts an analysis from Deutsche Bank that argues the trans-Atlantic divergence in monetary policy is rooted in differing historical experiences:
In the United States: “The traumatic experience of the deflation and extreme levels of unemployment that occurred during the Great Depression in the 1930s – and the Fed’s mistakes during this period — play a prominent role in the discussion of monetary policy by both practitioners and academics. Accordingly, Fed policy makers have been very sensitive to the risk of asset price collapses and debt deflation (note, for example, the Fed’s reaction to the 1987 stock market crash, the [Long-Term Capital Management] crisis, and the burst of the dot-com bubble).”

In Europe: “Probably the most prominent economic trauma in Europe were Germany’s hyperinflation after World War I and currency reform after World War II. Throughout its existence the Bundesbank was extremely sensitive to inflation pressures, and willing to take significant risks with growth to keep inflation in check (note, for example, the Bundesbank’s reaction to the two oil shocks of the 1970s and its reluctance to follow the Fed in 1987). German sensitivity to inflation risks of course had a strong influence on the institutional design of the ECB and more recently on the implementation of the euro zone’s monetary policy.”

The Telegraph's Ambrose Evans-Pritchard thinks the ECB is repeating the mistakes of the 1930's, in an excessive zeal to avoid repeating the mistakes of the 1970's:

Sadly, we are witnessing the sort of strategic errors that turned the recession of 1930 into a global catastrophe.

The European Central Bank is now hell-bent on a course of action that will have a knock-on effect across the world and risk a dangerous implosion of the credit system...

The ECB mantra is that Europe and the world is on the cusp of a wage-price spiral along the lines of the 1970s. This directly contradicts Ben Bernanke at the Fed, who insists -- correctly -- that today's conditions are not remotely like the 1970s....

By taking this militant 1970s line, he is in effect kicking Bernanke in the teeth. Or put another way, the ECB is trying to pressure America into a tighter monetary stance. Regrettably, this has in part succeeded. The Fed badly needs to cut rates further -- probably to 1per cent. It cannot do so because the ECB keeps threatening to pull the plug on the dollar.

This is madness. It is the mirror image of the early 1930s, when the Federal Reserve (cowed by the Chicago liquidationists) precipitated the collapse of 4,000 banks, and transmitted their fervour to rest of the world through the Gold Standard. This time there is no Gold Standard. But the globalised capital and currency markets -- egged on by Trichet -- are playing much the same role.

That comes to my attention via Naked Capitalism. This is not the first time the choice of the correct historical analogy has been at issue (see, e.g., this earlier post).

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