Tuesday, March 10, 2009

Policy divergences across the Atlantic - shock and awe versus gradualism


We are seeing clear policy divergences between the US and EU that are actually growing deeper. Now both are using monetary and fiscal stimulus, but the form and size that it is taking differs markedly.

The US has moved to a quantitative easing to provide as much stimulus as possible to the shadow banking system. The trillion dollar TALF program begins on March 25th which will further balloon the Fed balance sheet. The stimulus bill has been passed and there is now the debate on further increases in the Federal budget. Treasury deficit financing has exploded.

The EU monetary policy through the ECB has been more measured. While most will argue that the ECB has fallen behind the curve, there is still talk from the central bankers about a cautious approach to lower interest rates. the balance sheet of the CB has increased and swap lines and other forms of credit expansion have been provided but on a more limited basis. The is partially due to the differences in the credit intermediation process in the EU, but still less aggressive than the Fed. Fiscal policy through increasing government expenditures has been also used, but many individual countries have been more measured with their approach waiting to see how exiting stimulus works before adding more. Funding by some countries have been ahead of schedule so more money has been raised to reduce the need to come to debt markets later in the year.

These are large gambles. The US is trying to use shock and awe or overwhelming impact, albeit the negative talk by the administration has blunted the impact. The EU is being a gradualist. Some of this is a problem of policy coordination and divergences. The US monetary policy of trying to bring down interest rates and raise credit expansion provides an environment where fiscal stimulus can be undertaken aggressively. The lack of EU coordination because monetary policy is done on a EU wide basis while fiscal policy is done on a country basis creates more measured environment.

This leaves us with EU rates decline more slowly and following the US and the Eur exchange rate declining based on expected growth shortfall. If the gradualists are right, and the recession slows later this year we should a reverse of the dollar as the excessive stimulus leads to an inflation issue.


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