Washed Away on the QE2

Nobel prize-winning economist Paul Krugman, who berates the Fed for not opening the monetary sluice far wider, showed the follies of the crude Keynesian approach nearly a decade ago. In August 2001, he wrote that, The driving force behind the current slowdown is a plunge in business investment. But, [t]o reflate the economy, he told us, the Fed doesn’t have to restore business investment; any kind of increase in demand will do. In particular, Housing, which is highly sensitive to interest rates, could help lead a recovery.

A year later, with the Fed not having moved aggressively enough for him, Krugman divined that it needs soaring household spending to offset moribund business investment. And to do that [it] needs to create a housing bubble to replace the Nasdaq bubble. Wish granted.

But neither the US nor the world can afford a sequel. The outside world, which relies on the dollar as its primary trade vehicle and therefore reserve asset, cannot be expected to watch passively as dollars continue to pour into their currency, commodity, and asset markets, with no clear end in sight.

Europe, Germany in particular, has been highly critical of the US approach of placing its central bank at the center of its recovery strategy. But the eurozone is doing the same.

Consider the Irish bailout sorcery. The Irish National Asset Management Agency (NAMA) was set up in 2009 to clean up Irish banks’ balance sheets. But it does this by giving the banks newly conjured government IOUs – not euros – in return for dodgy debt. The banks then dump the IOUs on the European Central Bank, which then provides the actual cash.

Since NAMA swaps IOUs for bank debt at only about half its face value, the three-way transaction can result in a Ђ1 capital loss for every Ђ1 the banks get from the ECB. Of course, the IOUs now lodged with the ECB may themselves have to be written down, threatening to undermine the ECB’s own balance sheet.

What is the logic of this crazy carousel? German banks hold at least Ђ48 billion in Irish bank debt, British banks hold another Ђ31 billion, and French banks hold Ђ19 billion. Since June 2008, German, British, and French banks have withdrawn Ђ253 billion worth of credit from Irish banks and other Irish borrowers – 70% of the total foreign funds withdrawn. These countries’ authorities are now trying to shield their banks from losses by feigning neighborly concern for the Irish government.

For decades, the US and Europe lectured the world on the importance of cleaning house in the wake of a financial crisis: in particular, repairing or resolving zombie banks. It is time to swallow our own medicine and resume the hard work of repairing our banking systems. To rely instead on central banks to refloat the US and European economies is an abdication of responsibility that will cost us dearly in the future.

Benn Steil is Director of International Economics at the Council on Foreign Relations and co-author of Money, Markets, and Sovereignty, winner of the 2010 Hayek Book Prize.

Copyright: Project Syndicate, 2011.www.project-syndicate.org

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