Europe Defended Against Krugman

In a New York Times op-ed Monday, Paul Krugman criticized European governments for under-reacting to the financial crisis:

The clear and present danger to Europe right now comes from a different direction—the continent’s failure to respond effectively to the financial crisis.

Europe has fallen short in terms of both fiscal and monetary policy: it’s facing at least as severe a slump as the United States, yet it’s doing far less to combat the downturn.

On the fiscal side, the comparison with the United States is striking. Many economists, myself included, have argued that the Obama administration’s stimulus plan is too small, given the depth of the crisis. But America’s actions dwarf anything the Europeans are doing.

The difference in monetary policy is equally striking. The European Central Bank has been far less proactive than the Federal Reserve; it has been slow to cut interest rates (it actually raised rates last July), and it has shied away from any strong measures to unfreeze credit markets.

A strong rebuttal appears on the Models & Agents blog (also posted on RGE Monitor). Here’s an excerpt:

Krugman’s latest “prey” are European policymakers, in an op-ed piece that is so shallow and uncorroborated in its assertions, and so one-size-fits-all in its prescriptions, that it might have well been written by an American freshman student of European studies in a rush to finish his midterm exam.

Complacent? The ECB was the first to act back in August 2007 upon the first signs of funding pressures and liquidity hoarding by banks. It did so by providing banks with ample amounts of liquidity at longer maturities. A year later, when the (real) fireworks began, the ECB expanded its support measures by providing unlimited liquidity with maturities of up to six months, and by expanding considerably the list of eligible assets that banks could pledge as collateral.

As a result of these measures, the ECB’s balance sheet increased by 600 billion euros compared to its pre-crisis level. This is about 6% of eurozone GDP, which, actually, is almost the same as the Fed’s own balance-sheet expansion in GDP terms! Critically, Trichet has by no means signaled the end here. Au contraire!

“Shied away from any strong measures to unfreeze credit markets”? Given the above, I take it that by “strong measures” Krugman refers to the likes of the TALF or the MBS purchase program—i.e. measures taken by the Fed to bypass the banking system and support targeted dysfunctional credit markets directly (e.g. housing or credit card loans, auto loans, etc).

The ECB has yet to go that far and for a good reason. Bank-based lending is far more predominant in Europe than in the US, where capital markets play a substantial role in allocating credit. Addressing any dysfunctions in the banking sector in order to jumpstart bank lending is therefore of utmost importance in Europe, with TALF-like measures only secondary.

In fact, I would go as far as to suggest that restoring bank health is as important in the US (see here why) and any thought that the TALF could help revive credit by bypassing the US banking system is wishful thinking.

Read the whole piece here.

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