Similar symptoms, contrasting remedies...

Both the U.S. and Europe are currently experiencing a similar economic environment. Growth is rapidly decelerating, unemployment is rising, commodities sparked inflation is creeping up and the mortgage business is in shambles. About the only stark observable difference between the two economies is regarding their respective currencies that are moving in opposite directions. The difference is reflective of monetary policies that are also moving in opposite directions. If the problems that are being faced are similar in nature, why would the central banks of the U.S. and Europe tackle them in such opposite ways, especially given the perception that there is a lot of cooperation between the two? Part of the answer lies in their economic histories and another part is a direct result of their respective mandates. 

In the case of the U.S., the deflation trauma of the great depression has not been forgotten. It is further kept alive by a Fed chairman who is an avid expert on the topic. It therefore should come as no surprise that in the current economic turmoil, the Fed would have a loosening bias for its interest rate policy.

The ECB, in contrast, has embarked on a tightening bias, citing the growing risk of inflation. Part of the decision is due to its single mandate of price stability (versus the Fed's dual mandate of price stability and employment). History is the other major factor influencing the decision making process of the ECB. More specifically originating from its dominant German Bundesbank heritage. During the interwar years, Germany had suffered a severe bout of hyperinflation. Other European countries were to follow suit during and after the Second World War. We can therefore conclude that the hyperinflation trauma was collectively experienced in Europe.

These differences (historical and political) explain to a large extent why the two central banks, although facing similar issues, have opted to tackle it in opposing ways. What is certain is that both cannot be right and it is unfortunately too early to say who is using the correct antidote.

There is a cost involved in every action...

Pledges and further action from the Fed and the Treasury earlier in the week were clearly designed to avert a total bloodbath in the mortgage business but, as institutions steadily yield more power and influence on market dynamics, two questions come to mind.

1. At what point does interference begin to stifle development, or put another way, at what point does the marginal benefit of regulation begin to be outweighed by the marginal cost of such regulation?

2. At what point does bailing out institutions that are effectively considered bankrupt lead to a significant increase in moral hazard (which just sows the seeds of future bubbles)?

Answering either question with any degree of precision is clearly a futile exercise. Greater regulation and greater intervention are both to some extent actions that counter the very principles of capitalism. By regulating markets, for example, we take away a certain degree of flexibility which can have an adverse effect on economic development. Certainly markets are smart and creative enough to find ways around such regulations (part of the reason why we find ourselves in the current mess is a result of shadow banking activities caused by regulation).

And what about the issue of bailing out businesses that, in normal circumstances, would go bankrupt? We are just emerging from an era in which access to capital was both cheap and very easily obtainable. That environment led to a lot of businesses that would normally go bankrupt to stay afloat. Now that rates are rising, a wave of bankruptcies are exacerbating an already difficult environment. We can draw similarities with the Fed's intervention to avert bankruptcies, but the objective is very different. In the Fed's case, the reason for bailing out is to avert systemic risk from taking hold. But doing so introduces another dilemma, the so called moral hazard put option. 

In the end, it is a delicate balancing act the final outcome of which only the passage of time will tell...  

A sentiment driven game of ping pong...

Markets of late are in a sort of tug of war frenzy, undecided on whether it is the deflationary forces of a worsening housing slump combined with a steadily deteriorating credit market or the inflationary forces of commodity prices that show no end in sight that will drag the world economy into a recession. Complicating matters is the geopolitical risk premium on oil which has been the dominant factor behind the recent volatility in prices. With so much uncertainty out there, it is no wonder that markets are trading on nothing else than emotional impulses, observable from the steady rise in volatility over the last couple of months. For rational behavior to return would first and foremost require a fix of the housing market which, unfortunately, is in such a dismal state that it wouldn’t be realistic to expect a recovery any time soon. It would also require an improvement in the financial sector that has been battered by several waves of mortgage related write-offs and a systemic risk potential resulting from the broad market exposure to derivative instruments such as credit default swaps that are suffering from uncertainty in counterparty risk. The Fed's Bear Sterns intervention back in March was designed to avert the very systemic risk that continues to threaten the global economy. Unfortunately these problems are likely to persist as long as home values continue to deflate and credit becomes increasingly difficult to obtain.

A measure of market sentiment...

With the recent slump in stock markets across the globe, many are now technically considered to be in bear territory (defined as more than a 20% drop from a peak of less than year). This is further confirmed by looking at global sector performances as depicted in the bar chart graph below. The red bars show the one year performances of the various sectors, whilst the blue bars represent the performances since the start of this year. A "defensive" sector rotation can be seen from the performances. We see, for example, utilities, heathcare and consumer staples as amongst the least battered by the current turmoil. We also observe performance characteristics that are highly specific to this particular downturn. Information Technology, a traditionally growth industry, has done relatively well, benefitting from its export orientation and the weaker dollar. Financials have been battered as a result of the subprime crises and all that has ensued. Energy and materials in contrast find themselves in positive territory because of the significant demand and supply imbalances in commodities that have been driving their prices up through the roof.