The ECB must act now to prevent deflation

Just over a year ago, the sub-prime mortgage crisis appeared at best a financial blip, and at worse the harbinger of a serious if manageable downturn.

But today, there is a real danger that - to use George Bush's folksy turn of phrase - this sucker is goin' down. Not just the US but the EU as well. Look at the way in which Eurozone bank shares have been falling: Dexia in Belgium (with assets greater than Belgium's GDP), Aareal, HRE and Commerzbank in Germany, Natixis in France and Anglo-Irish Bank in Ireland. The euro has given the Eurozone shelter from currency attacks, but not from financial contagion.

Of course, as the financial turmoil has worsened, so too has populist moralising to the tune of "It's all due to greedy bankers" and "Those responsible for the mess must pay". This is easy rhetoric, but no solution.

So what is the solution? Are we facing a banking crisis, a credit meltdown or the early stages of a new Great Depression?

In truth, we are facing all three.

Financial meltdown

Assuming that the free-market crazies in Congress don't veto the Paulson bailout again, there should be relative calm in the markets by the week's end.

But don't expect the calm to last. Even if $700 billion worth of non-performing assets were replaced by treasury bonds in the next fortnight, sentiment is now so volatile that a few more bank failures could send a tsunami of panic cascading through the world's markets. Moreover, there is a limit to the number of bailouts that can be organised within a much-weakened US banking sector and, as the negotiations prior to Lehman Bothers collapse showed, even big sovereign wealth funds are reluctant to buy shaky banks.

That leaves nationalisation of the US banking sector - in whole or in part - as the ultimate option.

The advantage of nationalisation is that the state would acquire both assets and the liabilities (as in the case of Freddie and Fanny), but things will have to get very much worse before Mr Paulson supports such an alternative. And of course, where would that leave the US public borrowing requirement? The US is already the world's largest debtor, financing some $700 billion in current consumption by overseas borrowing - mainly from the Middle East, Russia and China.

If further financial weakness were to precipitate a run on the dollar, well, let's not even think about it.

The real economy

The reason we've not yet seen widespread pain is that the financial crisis is only just starting to work its way through to the real economy.

The credit crunch has already hit the worker whose house is being repossessed, and the rate of house repossessions in the US and the UK is climbing precipitously. Next will be the small businesses to whom the local bank will cut off new credit, not to mention the jobs and livelihoods to be lost as the recessionary spiral deepens.

And what about the ordinary Joe whose final salary pension has disappeared and who will never qualify for a mortgage on a decent house? Or the German or Italian export producer caught between a stronger euro and a weakening world market?

Many leading economists in the US have been critical of the Paulson bailout because it fails to address the underlying weakness of the real economy.

Why give $700bn to the bankers when one could bail out the mortgage defaulters instead, thus addressing the cause of the sub-prime problem and not just shoring up bankers' balance sheets?

It's a good question.

The proximate answer is that had the Democrats voted against Paulson, thus increasing financial chaos, Barrack Obama's electoral campaign would be toast. But politics aside, the real economy is where the sickness lies, and the Fed must cut interest rates soon - and so must the ECB!

The Japanese precedent

The current crisis looks very much like what happened in the late 1980s in Japan when a few square kilometres in central Tokyo was said to be worth more than the whole state of California. When the property bubble burst in 1989, the Bank of Japan (BoJ) dithered for months before cutting interest rates.

As Keynes argued in the dark days of the 1930s, the antidote to a financial crisis and impending economic depression is to flood the market with cheap credit in order to prevent the general price level from falling (i.e., deflation). If deflation can be kept at bay, fiscal expansion can help put people back to work and stimulate a rise in national income.

But once deflation sets in, consumers postpone consumption even longer. In the US during the Great Depression, prices fell throughout the 1930s and despite FDR's public works programmes, the US economy only recovered when it went on a wartime footing. Japan has experienced two decades of stagnation and deflation from which it has still not recovered.

The true danger in Europe

While the EU's banking system may be better regulated than that of the Anglo-Saxon countries, Europe is not immune to financial contagion - as we are seeing at present - or to recession. Germany and France are already experiencing negative growth, and the barely positive growth projections issued by Brussels a fortnight ago will now almost certainly need to be revised downwards. The last time the core Eurozone economies were technically in recession was only four years ago, and ECB monetary policy was looser then than it is today.

The Eurozone is less well equipped than the US to combat deflation, in part because the ECB is obsessed with inflation and in part because of its self-imposed constraint on fiscal policy. The current financial crisis is highly deflationary.

If the ECB continues to sit on its hands over monetary policy and politicians in Brussels continue to believe neo-liberal dogma about self regulating markets and automatic stabilisers, expect things to get far, far worse.

The author is Professorial Research Fellow at the University of London, SOAS