Don't Follow the Fed
By Leszek Balcerowicz
Published in: THE WALL STREET JOURNAL
Date: March 7, 2008
Leading Central banks in Europe and emerging market economies are under pressure to follow the U.S. Federal Reserve in aggressively relaxing monetary policy. They should resist these calls as the Fed strategy is fraught with risks for the U.S. economy and would be outright dangerous for the long-term growth prospects for most other countries.
The Fed's recent easing is being presented as another application of its risk-management approach to monetary policy -- a strategy that focuses on the worst-case scenario for the economy. However, if the Fed's monetary therapy of radically easing rates turns out to be based on the wrong diagnosis, the economy's health is likely to deteriorate. The Fed seems to fear that financial-market strains could spill over to the broader economy, thus creating an adverse feed-back loop.
But the undeniable financial disturbances do not necessarily have to result in a financial meltdown. Besides, there is little evidence to suggest that aggressive monetary easing would be the best response to such a threat. More targeted measures such as the rapid recapitalization of the troubled financial institutions -- preferably with the help of private investors -- and increased liquidity provision by central banks can be more appropriate as they cause less risky side effects.
Many policy makers and commentators, though, seem to sense a parallel with Japan's deflationary experience in the 1990s or even with the Great Depression in the U.S. This is greatly exaggerated.
First, the bursting of the Japanese asset bubbles and the ensuing credit crunch might not have been the only reasons for the more than a decade of stagnation in Japan. The economy also suffered under increasingly anticompetitive regulations that crippled the Japanese service sector in particular.
Second, even if the financial disturbances played a decisive role in Japan's stagnation, it should be remembered that the country's assets were much more overvalued and its companies much more in debt than is the case now in the U.S.
Finally, the true lesson from Japan is that policy must not contribute to the astronomic growth of assets in the first place. The focus should be on what Japanese policy makers were doing in the 1980s, when expansionary monetary policy inflated these bubbles, and not on what they did after the bubbles burst. Asset bubbles and related financial disturbances should not be regarded as completely independent from monetary policy. The Fed heeded deflation fears in 2003 and lowered interest rates to 1%, raising them only slowly later. This move, as many now recognize, contributed to an intensified search for yield and to the growth of asset bubbles in the U.S.
Even more exaggerated is the notion that the present financial stresses in the U.S. could culminate in a catastrophe akin to the Great Depression. It suffices to say that back in the 1930s money supply collapsed, whereas it had been steadily growing at a rate of about 5% before the Fed even began its recent aggressive monetary easing. Inflated estimates of catastrophic risks are not the best application of the risk-management approach to monetary policy.
Therefore, the scenario of a financial meltdown where financial institutions would sharply cut lending and thus trigger a deep economic contraction does not need to be a realistic diagnostic basis for a therapy of radical monetary easing. But perhaps other factors, especially the risk of reduced consumer spending due to collapsing asset prices, could produce a deep slowdown and disinflation in the U.S. economy that might justify the Fed's move. The central bank's aggressive rate cutting could then mitigate recessionary tendencies. Such a scenario cannot be ruled out, but neither is it the most likely one.
The balance of disinflationary forces as a consequence of slower growth may turn out to be weaker than proponents of easy monetary policy assume. Loose monetary policy can generate the seeds of future inflation, which would hit investment and hamper the longer-term growth of the economy. Radical monetary easing would then contribute both to high inflation and slow growth. This risk would be reduced if the Fed were flexible in both directions -- i.e., decisively reversing its policy once the incoming information suggests that its original diagnosis of an inflation-reducing slowdown is incorrect. It remains to be seen whether the Fed is that flexible.
While the policy of aggressive monetary easing is fraught with risks for the U.S. economy, it would be outright dangerous for other central banks. For in most of the world's economies, inflation has visibly increased while the scope of an inflation-reducing economic slowdown appears to be more limited outside the U.S. That's because their labor and product markets are not as flexible as those in the U.S. For example, wages in most other economies would not react as quickly to a slowdown as they would in America. Instead, price and wage rises in response to inflation spikes could be more pronounced outside the U.S., leading to more severe "second round" inflation there.
Consider these figures: In early February, inflation in China was 7% compared to 2.8% a year ago. The corresponding figures for Chile are 7.5% and 2.8%; for South Africa 9% and 5.8%; for Poland 4% and 1.4%; for the Czech Republic 7.5% and 1.3%; Israel 3.4% and 0.1%; and in Sweden 3.% and 1.6%.
In the euro zone, inflation has increased to 3.2% from 1.8%, and recent polls suggest that Europeans are worried about the loss of purchasing power. Thousands of public-sector workers went on strike across Germany on Wednesday, demanding an 8% wage increase for some two million employees.
If wages started to chase inflation, the euro zone would face the same kind of inflationary spiral that plagued the Continent in the 1970s and early 1980s. Money supply has also been growing much faster in the euro zone than in the U.S. That is why it is only prudent that the European Central Bank remains conservative in its monetary policy. Other central banks seem to take the inflation risks seriously as well, as witnessed by recent interest-rate hikes in Australia, Sweden and Poland.
Inflation-target purists have criticized the ECB for its explicit use of monetary developments (the so-called monetary pillar) in its overall assessments of economic prospects. In fact, this may be an advantage. It induces moderation in interest-rate cuts during periods when inflation is low but the money supply is rapidly growing. It thus may help to avoid feeding asset bubbles through excessively easy monetary policy. Such moderation is even more understandable at times like these, when inflation is high while money supply is growing at a brisk pace. The Fed's exuberance, though, is no model.
Mr. Balcerowicz, a former governor of the National Bank of Poland, teaches at the Warsaw School of Economics. He is also a Distinguished Fellow at the Center for European Policy Analysis (CEPA).
The views expressed in this article are those of the author and do not necessarily reflect the opinions of the Center for European Policy Analysis.