Edward Hadas

The Federal Reserve deserves some sympathy. The U.S. central bank did everything it could to stage-manage its minimal tightening moves, announced late on Feb. 18. But markets reacted as if to serious bad news.

The changes really are small. The main one was to increase the Fed’s discount rate, which is not currently crucial to the financial system, by a token quarter of a percentage point. That widens the spread between the policy interest rate, currently zero, and the discount rate, which is used for emergency lending to banks, to half a percentage point. Before the crisis, the gap was a full percentage point.

The Fed tried to keep markets calm. It had hinted the move was coming and the press release announcing the changes started by explaining that they were a response to the “continued improvement in financial market conditions”. To hammer the point home, the Fed added that the moves “do not signal any change in the outlook for the economy or for monetary policy”.

If the monetary shifts were as trivial as the Fed claims, then the market response was ridiculous. Stock prices and oil fell by 1 percent or more, while the dollar and U.S. government bond yields rose. Why fly to safety when there is no new danger? If anything, it might seem that investors should welcome small and carefully calibrated moves in the direction of normalcy.

But while investors may have got a little carried away, they are right to consider the beginning of the end of the Fed’s extraordinary measures as bad news for them.

The whole economy has been helped by the ample liquidity support provided by the world’s central banks to counter the financial crisis. But markets have been the greatest beneficiaries. The ample flow of cheap official liquidity has made it possible to bid up the price of all sorts of assets.

The artificial market stimulus is now starting to decline. The pace may be slow, but as the markets’ fuel gets more expensive, they are likely to find the journey bumpier.

It isn’t just the Sophocles connection that makes it easy to think of Greek fiscal woes as a tragedy in the making. A chorus of euroskeptics has been chanting a persuasive ode of despair. They wail that a currency union without a fiscal union is always doomed. The no-bailout clause, the cheating Greeks and the mean spirited Germans — woe, woe, woe are the euro zone and the euro.

The skeptics interpret each hesitation as a sign of trouble. So they gloat that the European Union’s statement last Thursday was weaker than hoped and the market was unexpectedly skeptical. But while their assessment is almost instinctive, these are no random ululations. Their case is cogently argued, mostly from the western side of the English Channel. The logic is that workers in the euro zone will not take wage cuts or losses on savings, so overpaid or overleveraged members of the single currency cannot hope to restore normalcy. There is also a dark reading of history.

Look at the failures of the Latin and Scandinavian Monetary Unions in the early 20th century.

This tragic chorus predates the euro. The pan-European ideal was widely dismissed as unrealistic from the formation of the European Iron and Steel Community in 1951 onwards.

But Europe has spent six decades getting more united. While the journey has been slow, bureaucratic and often not very popular, there have been few backward steps. The deepest recession since the World War Two probably will not destroy what the fall of Communism strengthened. The peripheral economy drama looks like the sort of challenge the EU has been good at resolving. As with the creation of single market and the single currency, many meetings, some new laws and a bit of money could gradually change long established bad nationalist habits.

Europhiles are generally less rhetorically skilled than euroskeptics. It is harder to wax lyrical about incremental bureaucratic solutions than about the inexorable logic of markets. But the euro zone story may be less an ancient tragedy than a modern bourgeois romance — with a happy ending.

By Edward Hadas and Richard Beales

It is easy to imagine a better candidate than Ben Bernanke to run the Federal Reserve. But actually finding one is another matter. The current chairman should get a second term, even though he does not unequivocally deserve it.

Bernanke has worried too much about deflation, and not enough about excessive leverage, trade imbalances, financial deregulation and fiscal irresponsibility. He has probably not paid enough attention to the global role of the dollar. He was arguably too soft on the financial industry when that industry was riding high — and he may now be too eager to consolidate regulatory power at the Fed.

In his defense, though, he did well in the thick of the banking crisis in 2008. Along with the New York Fed and the Treasury, he helped rescue and reshape the industry after the bankruptcy of Lehman Brothers.

That policy flexibility belies his reputation as an excessively pure academic and probably avoided a series of confidence-crashing bank failures. Moreover, for all its failings the Fed did a less bad job of financial regulation than most other U.S. watchdogs.

Overall, that’s no ringing endorsement. But consider the alternative. A new chairman would need experience in central banking — this is no time for an amateur. He or she should have post-crisis intellectual credibility — say, a long record of warning about the dangers of asset price inflation. The post-Bernanke Fed boss should command immediate respect from counterparts at other central banks. And both Democrats and Republicans should be keen.

Dream on. The only candidate who comes close is the 82-year-old Paul Volcker, Fed chairman from 1979 to 1987 and currently the big man in the Obama administration’s anti-bank attack.

Volcker might still be up to the Fed job. But his hawkishness could rattle some lawmakers once they thought about it. Besides, his talents are better used helping shape President Obama’s regulatory and fiscal plans than in a nostalgia-driven third term at the Fed.

It’s hard to imagine anyone else with the requisite experience and ready-made reputation. The central banking profession owes the world an apology for its negligence during the credit bubble. Bernanke could do his penance by serving another term — and promising to be harder on excess this time around.

A new Great Depression has been avoided. Gargantuan efforts from governments and monetary authorities have limited the damage of the credit crunch to a bad recession. But the world’s political and business leaders can’t spend too much time on the ski slopes at the World Economic Forum in Davos, Switzerland this week. It’s time for them to build a consensus for higher interest rates

There are too many signs of financial excess for anyone to be relaxing much. Chinese real estate, commodity prices and credit spreads are all worrying. Wall Street is overflowing with excess again. Bankers are making fortunes despite best efforts to rein in bonuses. And why not? When the bubble popped, all the borrowing that propelled asset prices to new highs hardly declined. It was just shifted from the private sector to governments.

If asset prices keep rising, they can just as easily fall suddenly. A renewed recession or a sudden loss of confidence in some doubtful currency or country could restart the downward spiral of losses and reduced lending.

Investment and commercial banks around the world would call on the government for help. The official cavalry would certainly try to ride to the rescue again. But with all the bazookas that have already been fired, the saviors are almost out of ammunition.

Policy interest rates cannot be reduced further. Government deficits and total debts are already reaching high levels. Since few governments would have the capacity to oblige by adding substantially to their deficits, a new crisis would call for new measures. Governments and their central banks might resort to the ultimate weapon in the official arsenal — money printing.

In theory, money can solve many problems. Some cash can be pumped into banks as equity capital. If consumers and companies are flooded with funds, then prices and wages should start to rise. That inflation would reduce the real value of current debts. It should also increase governments’ tax take, perhaps faster than higher interest rates would increase the burden of debt.

Money printing is risky. The first problem is that the cash might just get hoarded rather than being spent. Japan has learned this lesson the hard way over the past two decades. But historically a more common problem is that once inflation gets started, it can be hard to stop. What was supposed to be a little healing inflation tends to end in tears.

And if the authorities were reluctant to turn on the printing presses in response to a second burst bubble, their options would be very limited. The world would be staring at widespread defaults on corporate and government debts.

The smarter option for politicians, bankers and industrialists is to agree to do whatever is necessary to keep a new bubble from developing. Most economists agree on what needs to be done. Over the next few years, they say the supply of bubble-fuelling debt should be cut back. That means tougher financial regulation, more balanced global trade and a return to balanced government budgets.

Even if everyone were to agree on that complex agenda, it would take several years to make the necessary changes. The one move that can be made right away is to bring the era of near-zero policy rates to an end.

Of course, there are good arguments to keep extreme monetary stimulus going. Growth in the world economy, with the exception of a few countries such as China, is tepid. Banks need the support and many borrowers, including governments, would find higher rates hard to bear. Jacking up policy interest rates might trigger a double-dip recession.

But consider the alternative. A new popped financial bubble could easily end in monetary chaos — uncontrolled inflation or unexpected sovereign defaults. It would be hard to avoid a deep depression.

It’s true that tighter monetary policy around the world might slow down the recovery. But higher borrowing costs would make future bubbles less likely to arrive and smaller if they come. And having raised rates, central banks would at least have the scope to cut them again when the next bubbles burst.

The economic worst is past. But there are many issues left to worry about.

Start with the good news. GDP is now growing almost everywhere, while the unemployment rate is hardly rising anywhere. Businesses and consumers are less fearful. As much as half of the 20 percent decline in international trade has been erased.

Perhaps the best news is what has not happened. There have been no national defaults, countries dragged into political chaos, bitter divisions among the great powers or, with a few tiny exceptions, massive declines in consumption. The global political-economic-financial system is still in business.

Still, little has been done to address the three underlying and interlocked issues that tripped the world into financial crisis and recession. Their persistence helps explain why the recovery has been frustratingly slow up to now. If anything, they are all looking more intractable than ever. Meanwhile an old problem, unemployment, is rearing its head.

Start with financial dysfunction. At the micro level, there has been some progress. Regulators are becoming more active and banks are building up capital cushions. Risk models are being reconsidered. But viewed globally, the dysfunction has merely changed shape, becoming more threatening in the process.

The private sector has not shed all of its excessive debts, but governments have abandoned all pretence of fiscal discipline. The burgeoning debts of the United States, home of the world’s reserve currency, are particularly worrying. Meanwhile, policy interest rates are too low to help ration capital, and cross-border holdings of government debt continue to increase.

Second, global governance remains painfully weak. Yes, a trade war has been avoided and the G7 has gracefully yielded to the G20 as the talking shop for world leaders who matter. But none of the institutions that helped keep international economic relations fairly friendly over the last half-century — the United Nations, International Monetary Fund, World Bank, the Bank of International Settlement and the World Trade Organisation — were much help. Ad hoc arrangements are better than no arrangements, but competent and respected global institutions are in short supply.

China’s post-crisis behaviour suggests the supply is not likely to increase soon. Beijing has dismissed sensible international calls to revalue the yuan and move towards balanced trade as hostile to its national interests. It may be that as a still-poor country and a newcomer to the circle of global power, China simply doesn’t share the worldview of the traditional global powerbrokers.

Third, the shift of global economic power away from the United States looks messier than it did before the crisis. The shift should be a good thing. A country that accounts for 5 percent of the world’s population cannot expect to dominate global trade forever. But the leaders in Washington and on Wall Street have shown little regard for making the transition easy.

During the good years, Americans consumed and borrowed too much, while neither the government nor the central bank worried about the dollar’s international role. In the bad years, the government has borrowed with abandon, while all but cheering as the bulk of the world’s currency reserves were devalued. The current policy mix is almost exactly what economists would recommend if the goal were to create a dollar crisis a few years from now.

The recession has also brought a very old economic problem back to life. Unemployment has been identified as a threat to industrial prosperity for almost two centuries, but in early years of the last decade it looked like strong growth and the right sort of labour laws could create jobs for all.

Such optimism now looks excessive. True, fast government action has kept reported unemployment rates from skyrocketing in many countries. But the jobs of too many workers now rely on funding from governments that cannot really afford the subsidies they are providing. And where actual unemployment is high, most notably the United States and Spain, the obvious solution of lower jobless benefits and lower wages is politically hard to swallow.

Financial dysfunction, global governance, an epochal power shift, and now a resurgent threat of joblessness — it’s quite a list. These topics may not come into the headlines in 2010, but they will not all stay away forever.