Recession obsession

News is trickling in on the backs of quarterly reports that suggests Asian and European economies are not nearly as decoupled from American economic conditions as previously thought. The contagion of the American "credit crunch" is spreading and though these markets may be technically independent from the US economy (i.e. they have not bought securitized loan packages from American banks) they still face a number of problems.

The instruments of financial (not monetary - the ECB is notoriously opaque) work in Europe are close to ours. The loan bubble that caused the "credit crunch" here exists in Europe as well; it simply manifests in a slightly different form. Look at the housing markets in Spain and Britain, unemployment pretty much anywhere but Germany, and contracting export margins throughout Europe and Asia (especially China and Japan). Unlike the quick action of the Fed, the sclerotic pace of EU regulation and the inflation-bent of the ECB won't do anything to counter these effects anytime soon.

There are a number of other significant problems in what is increasingly looking like a global recession, which Larry Summers ties up nicely. But the problems now seem beyond the scope of interventionist policy. Even if they were not, I am not convinced the Fed could responsibly round up enough liquid cash to implement any type of further "injection" to buoy the economy. With more and more banks facing huge writedowns and even insolvency, the Fed cannot feasibly expand its own balance sheet. The one thing policy wonks should not be adding to the cacophony is a cry for another stimulus. The term "credit crunch" conjures up ideas that the situation would be resolved if there was simply more money around to lend out. This simply isn't the case.

The Fed "injects" money into the economy (whether it's a tax stimulus or a bail-out) by controlling the reserve supply of cash to banks. To ease short term interest rates (and thus push money) the Fed buys securities by crediting the account of their primary dealer (who is free then to lend out these reserves) thus expanding its own balance sheet. This practice, if ensconced permanently in policy, will yield disastrous results: essentially, an even greater expansion of GSEs (and not just ones dabbling in mortgages either) with bills passed to the taxpayer and profits distributed to managers and shareholders. This encourages reckless and risky investment policies which will even further undermine the financial system.

The crunch needs to be felt by those who helped cause it, not passed indefinitely down the line. Free markets need to be free in the good times and the bad. If only Paulson had seen it coming.