by Peter Boone and Simon Johnson
The US government has moved dramatically, in what it argues is a comprehensive manner, to counteract serious problems in the financial system, and to reduce the risk of a serious recession or worse. Eurozone policymakers are far more reluctant to intervene. They remain inclined to handle growing bank failures on a case-by-case basis; and, while their central banks have provided liquidity, they have avoided using other fiscal and monetary policy tools. If the fortunes of the world economy depended only on the US policy response, we would predict just a fairly severe recession. The absence of any indication that there will soon be a decisive European policy response suggests we could be in for something considerably worse.
In the view that is increasingly prevalent in the US, we are not facing a Keynesian demand recession, nor the supply side shocks of the 1970s. It is a crisis of confidence very similar to the Asian crisis of 1997-98. The lesson from these events is when trust in highly leveraged financial markets weakens, there can be long and enduring repercussions across all sectors of the economy. The Federal Reserve’s implicit policy model since September 2007 appears to be tied in part to those events.
In contrast, the frame of reference for European authorities appears to be drawn from the lessons of the 1970s. They are concerned about inflation and second round effects from past commodity price rises, so they keep interest rates higher. They have not announced national programmes to bail out financial institutions and borrowers, in part, because of perceived costs relating to future moral hazard.