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  Keep Calm and Don't Panic: What the Fed Could Learn from Europe's Central Bank

Keep Calm and Don't Panic What the Fed Could Learn from Europe's Central Bank

By Christian Reiermann

Part 2: Repeating Greenspan's Mistakes

In taking this step, the ECB made it possible for businesses and consumers to continue borrowing. Otherwise the financial crisis would have sparked over to the real economy.

The fresh infusions of cash are not driving up prices, because the banks must repay the loans. "From the very beginning, we made sure that the measures of monetary policy and liquidity policy were kept separate," says an official with the European Central Bank.

The ECB acted according to a clear maxim. It would help the banks, but there would be no financial injections for the economy as a whole. The fear was that this would only lead to inflation.

Meanwhile, the keepers of the euro are watching the activities of their American counterparts with a mixture of suspicion and unease. Although they would not say it publicly, they consider Bernanke's moves to be both dangerous and incorrect.

The Fed chief is following a controversial role model. When the dotcom bubble burst at the beginning of the decade, Bernanke's predecessor Greenspan quickly reduced interest rates to the historically low level of 1 percent.

The Trauma of the Great Depression

This helped soften the fall, but when the economy regained its footing, the resulting influx of cash fueled an unparalleled real estate boom.

Greenspan wanted to solve the problems of the New Economy, but in doing so he also laid the foundation for the next crisis.

His successor Bernanke and his colleagues at the Fed are familiar with the risk of economic roller-coaster rides, and yet they are well on their way to repeating Greenspan's mistake. There are historic reasons for this.

Americans today are still traumatized by the Great Depression of the 1930s, when the United States sank into a spiral of deflation and unemployment. The Fed, which looked on without doing anything, was largely responsible for the debacle.

Banks collapsed and the money supply shrank, leading to falling prices. Consumers hoarded their dollars and consumption plunged. Businesses could no longer sell their products and millions of workers were let go.

In his days as an economics professor, Bernanke studied the causes and effects of this global economic crisis with an attention to detail bordering on obsession. "I am a fan of the Great Depression," he once admitted.

His goal now is to prevent such a disaster from happening on his watch at all costs. This explains why he has been so willing to pave the way for an influx of cash into the economy. His job is complicated by the fact that the Fed serves a dual purpose: to keep prices stable and to promote "maximum employment." This in turn presents the Fed and its chairman with another dilemma. With inflation at 4 percent, Bernanke should in fact raise interest rates, a step he doesn't dare take for fear that it would be even more likely to ring in a recession.

A fatal mix of a stagnating economy and rising prices is on the horizon, a phenomenon that happened in the 1970s and became known as stagflation. At the time, the only solution to break the vicious circle was a radical shift in interest-rate policy. The Fed raised interest rates, irrespective of the effects on growth and employment, triggering a deep adjustment crisis.

Gradual Growth or Rollercoaster Ride

Trichet and his ECB have an easier time of it. They have only one goal: stable prices. This strategy is also the consequence of a trauma, namely the hyperinflation in Germany in the early 1920s and the collapse of the currency after World War II.

For this reason, the ECB has followed the German Bundesbank's lead by holding back with rate cuts. With prices currently rising at a rate of 3 percent, ECB representatives, unlike their American counterparts, are already talking about raising interest rates to keep inflation under control. They argue that keeping prices stable is the best way to promote growth.

The Europeans have even garnered praise from across the Atlantic. Unlike the Fed, the ECB, in the current financial crisis, has "demonstrated financial strength and reacted very decisively to the credit crunch," says Adam Posen, deputy director of the renowned Peterson Institute for International Economics in Washington.

The different schools of thought in the US and Europe affect key economic indicators. The Fed's tendency toward volatility has had a stronger effect on fluctuations in prices and economic growth in the United States than in continental Europe. Conversely, these fluctuations force the Fed to intervene more often. Actions and reactions overlap and begin to amplify each other.

The Europeans, on the other hand, are taking a softer approach, not just when it comes to the willingness to cut interest rates. Their steady-handed policy has softened fluctuations in the inflation rate, but also in economic growth. They prefer gradual growth over the US-style rollercoaster ride. So far, at least, their approach has been pretty successful.

Translated from the German by Christopher Sultan