November 24th, 2010
02:20 PM GMT
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The response of authorities to the latest stage of the crisis, where fears have moved on from individual company balance sheets to country balance sheets, has been very different.  The U.S. introduced quantitative easing (QE) and the UK followed suit, while Europe did very little.

While the European Central Bank has purchased European Sovereign bonds, this has been limited in size and, unlike the U.S., the ECB has attempted to sterilise all purchases by taking liquidity out away from banks in other ways.

The EU responded to the peripheral crisis in May by enacting a bailout for Greece and developing a structure that could be used for other sovereigns. However, the EU also recognised the need to address the core of the problem of rising deficits and ballooning Debt/GDP ratios driven by fiscal profligacy in the good times, and not merely slower economic growth.  The latter has shown up the unsustainable nature of the former, rather than actually causing it.

Therefore the EU response has been to ensure liquidity is available on condition of fiscal reforms to address the underlying problem. The result is spending cuts in most European countries with, Ireland now on its second austerity budget and among other reforms, long-needed tax reform in Greece and labor reform in Spain. Even the UK has now introduced a big fiscal austerity package.

What is clear is that the European Core - especially Germany - who have run a better balanced economy for years and suffered with slower growth in the boom times, are now re-asserting their own fiscal orthodoxy.

The Maastricht criteria was ignored during the crisis but was a key part of the original Euro creation to help the stability of a currency union that was not backed by political and fiscal union. A return to Maastricht budget deficit of 3 percent is a long way off, but the basic principles are being re-established.

In contrast, the U.S. response seems to have been to do whatever is needed to stimulate growth and jobs and worry about fiscal issues later.

The latest example is QE2 with the Fed effectively printing more money and the dollar responding accordingly. The surprise is that bar a recent move, this strategy has not resulted in higher bond yields as the U.S. Treasuries have continued to benefit from a flight to quality.

While there is general acceptance that QE1 was broadly beneficial in early 2009 for an economy on the brink of depression, there is much more scepticism of the benefits of QE2. One risk identified by numerous commentators is increased levels of tensions with international trade partners. One of the likely effects of QE will be to weaken the dollar and China has already been heavily critical of what it sees as an irresponsible and dangerous monetary policy. Other countries for example in Latin America have imposed capital controls to limit “hot money” flows out of dollars and into their own currencies.

Despite the benefits of QE1, the overall response of the economy in terms of growth and employment was disappointing. The reason was that QE failed to address the problem of lack of demand for credit as borrowers everywhere concentrated on restoring their own balance sheets.

In this environment, artificially lowering bond yield does little to encourage borrowing. At the same lending institutions are reluctant to increase loans. Banks are still generally very cautious on the outlook and are keen to keep liquidity. At the same time the introduction of new capital rules for banks means there is still doubt on future capital requirements with the only certainty being that it will be higher than before. This deadlocked scenario is known as a “liquidity trap,” and QE2 is therefore unlikely to make any bigger impact on these problems than QE1.

In short the crisis was caused by a sustained period of ever-increasing leverage with little attention paid to risk or understanding of the underlying assets.

The European response has been perhaps slower than the U.S., but has generally been characterised by ensuring that there is sufficient liquidity available to ensure that economies function where the markets are unable or unwilling to provide this.

At the same time Europe has addressed the issue of over-leverage by forcing the introduction of fiscal austerity and much need labour and tax reforms.

The U.S. approach has been to address the issue of over-leveraged consumer and corporate balance sheets by massively expanding the Fed balance sheet and continue to issue Treasuries in ever larger amounts to drive growth - leaving concern about the U.S. debt burden to a time when growth is once again strong.

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