Another Preemption Fight

By Sebastian Mallaby
Monday, March 10, 2008

Watching the global economy right now is a bit like watching the lead-up to the Iraq war.

Fearing that weapons of mass financial destruction lie hidden inside Wall Street palaces, the United States is mobilizing the big guns: a fiscal stimulus, sharp interest rate cuts, the Fed's promise Friday to pump money into the markets. Meanwhile, Old Europe sits on its hands: The European Central Bank has left interest rates unchanged since June and has lectured governments about budget deficits. Whether American activism or European stoicism is vindicated in the end, one thing is sure: The transatlantic rift looks certain to grow.

The United States can make a good case for its activism. Japan's experience in the 1990s demonstrates the risks in holding back: Once a real estate bust starts interacting with a banking mess, a vicious cycle can kick in, with falling property values damaging the banks, which in turn weigh on the economy, which drives property values down still further. Add in an oil shock, and the problem gets worse. Add in modern financial engineering, and the risk that something somewhere will blow up reinforces the case for a preemptive strike in the form of lower interest rates and a stimulus.

But the Europeans also have a case to make. Their own economy is doing better than America's, and the United States may be overreacting to its problems. Last week's bad jobs number suggests that the U.S. economy may have entered a recession, but most forecasts still sound glum rather than panic-stricken. For instance, The Economist's poll of forecasters projects that U.S. gross domestic product will grow between 0.8 and 2.2 percent this year after adjusting for inflation, with 2009 looking stronger. On Thursday, Timothy Geithner, the president of the New York Fed, had some scary things to say about market conditions. But he was warning of a risk, not pointing to certain disaster.

Just as with Iraq, the risk presented by a festering threat has to be weighed against the risk inherent in preemptive action. Who knows what kinds of horrors the scientists have cooked up in their labs -- Geithner describes trading positions that get riskier as you try to control risk, because they cannot be sold without prompting markets to move against them. But the Fed itself is in a similar bind. If it responds preemptively to the danger of a financial meltdown, it will exacerbate a different danger -- resurgent inflation.

Inflation remains mild compared with the Carter years, but it has jumped sharply. Consumer prices in the United States are increasing at 4.3 percent a year, double the rate of a year ago. Once inflationary expectations get built into the national psychology, they are extraordinarily painful to root out: Last time around, it took a double-dip recession. In the countries of the euro zone, where prices are rising at just a 3.2 percent rate, the risk of entrenching an inflationary psychology is considered overwhelmingly alarming. Hence the European Central Bank's apparent sado-monetarism.

It's impossible to know whether American activism or European immobility is correct because of the nature of the challenge. Financial engineering is frightening precisely because it creates an unknowable potential for toxic explosions -- which makes it tough to determine how aggressively to respond. Property busts are frightening precisely because they take time to play out. There is a long period during which nobody can tell how many homeowners with negative equity will turn in their keys, how bad the hit to lenders will be and what it all means for the economy.

But one thing is plain: The divergence in approaches on either side of the Atlantic is likely to stoke tensions. Americans resent Europeans for not sharing the burden of stimulating the world economy, forcing them into unilateral action. Europeans resent Americans for blundering foolishly ahead, exacerbating inflation. For years there has been an unhealthy imbalance in the world economy, with the United States contributing disproportionately to the growth in demand and doing too little in the way of saving. The response to the current economic mess increases that lopsidedness. Americans are spending heavily to head off the risk of recession while Europeans close their wallets.

In European capitals these days, the anti-Americanism that flared up with the Iraq war is joined by a new schadenfreude. Americans thought they could splash money on foreign policy adventures and 50-inch TVs; now a nation fueled by debt is facing its comeuppance. But surely at least some foreigners can see the tragic dimension here. The United States went into Iraq because, even if mistakenly, it wanted to rid the world of a menace. For this, the world hated it. The United States is throwing money at its economic difficulties because it sees a threat to its prosperity and also to the wider world. For this, the world scorns it. Investors are responding to America's economic activism by dumping dollars the way they once dumped dot-com stocks. The would-be saviors of the world economy can no longer afford lunch in Europe.

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