The swift and decisive U.S. response to the financial crisis and deep recession should be a model for other large developed economies. Yet Europe, which is now facing sovereign debt and banking problems and a slowdown in growth, seems reluctant to follow America's lead.
The United States emerged from its 2008 economic cataclysm with relative speed because policymakers learned from history. Federal Reserve Chairman Ben Bernanke had famously internalized the charge that the central bank had contributed to the Great Depression. (As he told economist Milton Friedman on his 90th birthday in 2002: "You're right, we did it. We're very sorry. But thanks to you, we won't do it again.") The frenzied response of the Bernanke Fed—guaranteeing all sorts of assets and markets, purchasing mortgage-backed securities, adopting a zero-interest rate policy, and expanding its balance sheet to $2.3 trillion—can be seen as signs of overcompensation. And from Japan's experience in the 1990s, the Fed learned the need for speed.
After the Lehman Bros.' failure, U.S. banks quickly raised capital, slashed leverage, shed problem assets, and recapitalized—frequently with an assist from the government. Treasury Secretary Tim Geithner has been urging his European counterparts to conduct stress tests on big banks and make the results available to the public, a move that would prod banking executives to act quickly. But the Europeans, who did stress tests last year, aren't in any rush to do so again, according to the Wall Street Journal: "European Union officials said national regulators already are well aware of the health of their banks." And most of the large European banks, which avoided subprime exposure, haven't bothered to deleverage, as U.S. banks have. The alarming chart in this Wall Street Journal article (subscription required) shows that, as of the fourth quarter of 2009, the largest European banks were running debt-to-common-equity ratios as high as 21-to-1 for Banco Santander, 25-to-1 for Societe General, and 49-to-1 for Deutsche Bank. Those levels are reminiscent of the debt levels of the large investment banks pre-Lehman Bros.
While some critics have charged the U.S. fiscal stimulus was too small, the data suggest that the stimulus package has been a significant contributor to job retention and growth. Increased federal spending was needed in part to combat the declines in government spending by states. In the United States, the federal government helped prop up the states with injections of cash. In Europe, which lacks a powerful overarching federal government with the ability to tax and spend, fiscal policy is all bitter medicine and no spoonfuls of sugar. From the United Kingdom to the Czech Republic, and all points in between, governments are cutting spending and raising taxes. But these contractionary policies will retard economic growth, which will in turn lead to more problems for the banks.
Europe also isn't following America's example in monetary policy. The European Central Bank lacks the courage, or, frankly, the legitimacy, to mimic the Fed's efforts to guarantee money market funds or commercial paper loans. While the package put together by the ECB and the International Monetary Fund aimed at avoiding a default in Greece and restoring confidence to Europe's government bond markets was big, the execution has been slow and timid. As of last Friday, the ECB had purchased about $43 billion in government debt. But it's offsetting the efforts to put money into the capital markets by pulling cash out of the banking system—i.e., by collecting more deposits. "In simple words: We are not printing money," said ECB Chairman Jean Claude Trichet. And so while the U.S. money supply rose sharply as the Fed battled a banking crisis, money supply in Europe isn't growing much at all.
Which brings us to the crux of the matter. The ECB and European governments are embracing fiscal austerity and comparative monetary tightness in these extraordinary times because they remain paralyzed by a terrible fear of inflation. The Federal Reserve has the dual mandate of controlling inflation and promoting employment. The ECB, by contrast, is concerned primarily with inflation. Never mind that the OECD data on inflation shows it is under control. The Europeans remain freaked out by the prospect of inflation at some point in the future. In its outlook, the OECD writes: "On inflation, the issue is not whether it is a risk today—it is not—but whether it will be a risk in two years' time."
In the United States, the desire to avoid mistakes made in the distant and recent past have led to perhaps excessively vigorous fiscal and monetary policies. For Europeans, the desire to avoid mistakes made in the distant past has led to an excess of caution. When they look to history for guidance, European policymakers aren't looking at Washington in 2009, or Japan in the 1990s, or the United States in the 1930s. Rather, they look to Europe in the 1920s, a period when hyperinflation ravaged economies, disrupted the social order, destroyed social democracies, and led to the rise of Nazism. A whiff of inflation and we think about Jimmy Carter. In Germany, when there's a hint of a whiff of a trace of inflation, they think about Hitler.