Mr. Trichet Has Much to Learn From History

By Desmond Lachman

Mark Twain famously observed that history does not repeat itself but it does rhyme. Considering how Europe's sovereign debt crisis is playing out, one has to be struck by Mark Twain's prescience. For the European sovereign debt crisis bears an uncanny resemblance to the 2008-2009 U.S. financial crisis. And it gives every indication of having the potential to shock the global economy in a manner not too dissimilar from the way in which the U.S. subprime crisis did.

Back in March 2007, when signs began to emerge that the U.S. housing market bubble was bursting, Fed Chairman Ben Bernanke assured markets that the U.S. sub-prime loan problem was of limited significance. His reasoning was that since U.S. residential investment constituted only 6 percent of US GDP, problems in the U.S. housing market would be of only limited significance to the overall health of the U.S. economy.

Even as signs of a serious housing market bust proliferated, it was only in August 2008 that Mr. Bernanke apparently realized that potential defaults on the U.S.$2 trillion in sub-prime mortgage lending could inflict serious damage on the financial system and hence on the overall U.S. economy. For it was only then that Mr. Bernanke began the cycle of interest rate cuts in a belated and timid effort to limit the fallout from the U.S. housing market bust.

In a manner all too reminiscent of Mr. Bernanke's soothing reassurances in 2007, over the past year Jean-Claude Trichet, President of the European Central Bank (ECB), has been assuring markets that the Eurozone debt crisis will have only a limited impact on the overall European economy. To support his claim, Mr. Trichet never tires of reminding us that the combined GDP of Greece, Ireland, and Portugal constitutes only around 5 percent of the Eurozone's overall GDP. And he makes these reassurances seemingly oblivious to the U.S. experience with sub-prime lending and to the fact that, at around U.S.$2 trillion, the total sovereign debt of Greece, Ireland, Portugal, and Spain is uncomfortably similar in size to the amount of U.S. sub-prime mortgage debt outstanding on the eve of the U.S. financial crisis.

Apparently not learning from Mr. Bernanke's monetary policy mistakes in the run up to the U.S. crisis, Mr. Trichet now appears intent on compounding the Eurozone's sovereign debt crisis by having the ECB start an interest rate tightening cycle. For the last thing that Europe's periphery needs right now is higher European interest rates and the associated Euro strengthening at the very time when the periphery is engaged in draconian budget tightening and in a major effort to restore international competitiveness.

Yet another disturbing way in which the Eurozone debt crisis resembles the earlier U.S. subprime crisis is the way in which European policymakers are engaging in self delusion. They do so by fooling themselves that the problems with which they are dealing are ones of liquidity rather than solvency. And at each stage of the crisis they manage to convince themselves that they have ring-fenced the crisis.

Back in March 2008, the Federal Reserve seriously believed that the Fed-orchestrated JP Morgan takeover of Bear Stearns would contain the crisis. And U.S. policymakers did the same when they put Fannie and Freddie under conservatorship later that summer. It now is also apparent that American politicians had no clue as to the seriousness of Lehman's solvency problem on the eve of its collapse in September 2008. Nor did they understand how central Lehman was to the rest of the U.S. financial system.

In May 2010, at the time that the U.S.$140 billion IMF-EU bailout package for Greece was announced, markets were asked to believe that Greece's case was sui generis. They were also asked to believe that the Eurozone's periphery was suffering from only liquidity problems and that these problems would soon dissipate once market confidence was restored. Yet six months later the IMF and EU had to bail out Ireland. And today nobody doubts that Portugal will soon have to be bailed out as well.

Despite record high interest on the sovereign bonds of Europe's periphery even after massive IMF and ECB support, European policymakers keep up the charade that Greece, Ireland, and Portugal do not need a debt restructuring. And despite Spain's serious problems of external over-indebtedness, a major housing bust, and a highly troubled savings and loan sector, European policymakers are asking markets to seriously believe that Spain will not be the next domino to fall.

Perhaps the most disturbing aspect of the Eurozone debt crisis today is how little European policymakers are asking of the European banking system to raise additional capital to cushion itself against the inevitable large write down in the periphery's sovereign debt. In that respect too they are providing additional evidence for George Santayana's adage that those who do not learn from history are bound to repeat it.


Desmond Lachman is a resident fellow at the American Enterprise Institute. 

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