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

By Christian Reiermann

Never before have the central banks of the United States and Europe pursued such divergent strategies when it comes to dealing with a financial crisis. The increased value of the euro against the dollar reveals which strategy is working.

The euro is now valued at $1.60.
DDP

The euro is now valued at $1.60.

The world's two most powerful central bankers are two very different men, even when it comes to their outward appearance.

Jean-Claude Trichet, the president of the European Central Bank (ECB), has the bearing and style of a classic representative of Old Europe. He always wears the best suits, his gray hair is carefully parted and his voice is so unassuming that it sometimes comes across as more of a whisper. He is happy to swap the columns of numbers that are part of his job for a volume of modern French literature.

Ben Bernanke, Trichet's counterpart at America's central bank, the Federal Reserve (Fed), is an economics professor by trade and makes no secret of his dislike for suits. He once joked: "My proposal that Fed governors should signal their commitment to public service by wearing Hawaiian shirts and Bermuda shorts has so far gone unheeded." In his private life, Bernanke is an avid baseball fan.

The personalities of the two men are as different as their strategies and their approaches to their jobs. Trichet runs the ECB thoughtfully and with circumspection. The Fed, under Bernanke's leadership, is hands-on and decisive.

But which approach is more successful during an acute global financial crisis? And is it possible that the two key central bankers are in fact fueling the seemingly unending banking disaster?

The ECB remains calm -- sometimes to the point of doing nothing. Since the turbulence in the financial markets began last summer, it has left European key interest rates unchanged. The Fed, on the other hand, seems to take action to show it is doing something, sometimes to the point of hysteria. Since August of 2007, it has brought down the key interest rate at record speed, from 5.25 percent to 2.25 percent, to avert a recession in the United States.

The euro rises against the dollar.
DER SPIEGEL

The euro rises against the dollar.

But now it seems that all of the Fed's efforts have been in vain. Testifying before the US Congress, Bernanke was forced to admit that he expects the US economy to grow very little, if at all, in the first half of 2008. It "could even contract slightly," he said.

If a currency's value is a measure of confidence in an economy and its central bank, then the Europeans and their ECB are clearly emerging as the winners in the current crisis. Last week the euro climbed to a new record high of $1.60.

This has damaged confidence in both the Fed and its chairman. "Bernanke and his Fed are well on their way toward gambling away their credibility," says Thorsten Polleit, chief economist at Barclays Capital in Frankfurt.

Ironically, Bernanke planned to introduce a more modern political approach when he took over as Fed chairman in 2006. He wanted the decision-making process at the deeply traditional institution to be more transparent and less arbitrary than it was under his legendary predecessor, Alan Greenspan. Bernanke wanted to impose new rules on the Fed and its future decisions, making them clearer and more predictable.

From Frantic to Panic at the Fed

That attempt can now be considered a failure. The Fed's performance in recent months has been anything but clear or predictable. As recently as the beginning of last August, the Fed was refusing to cut interest rates, citing the attendant risks of inflation. Hardly two weeks later, it had a completely new situation analysis. Now it recognized the risks the growing financial crisis posed for the economy. Rate cuts were no longer a taboo, and in September the Fed introduced a first key interest rate cut. After that, it took only one month for it to announce the next cut. But, as Bernanke informed the markets, there would be no further cuts. The risk of inflation was simply too high.

That was his position until shortly before Christmas. But then, as the economic situation became increasingly bleak, Bernanke lowered interest rates again. He took his final step from frantic to panic in January. In a hastily scheduled videoconference call, Bernanke, fearing a market crash, committed the members of the Federal Open Market Committee to an extraordinary 0.75-percent rate cut.

A new cut came only a few days later. The Fed's interventions came to a head in mid-March, when it bailed out the investment bank Bear Stearns' by issuing a $29 billion (€18.1 billion) loan to cover its losses from bad investments. The venerable Wall Street firm had completely miscalculated when it invested in subprime mortgage-backed securities.

"Bernanke is making himself a slave to the stock markets," said Willem Buiter, a monetary policy expert at the London School of Economics. Trichet, on the other hand, has opted for a hands-off approach. Interest rates in the euro zone are still where they were before the crisis, despite a considerably worsened economic outlook for Europe.

But the ECB did not remain completely inactive. It provided the shaky banking sector with low-interest cash, a form of bridge loan. The banks needed the money because a lack of confidence had made them reluctant to lend each other money.

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