How Europe Avoided Our Mess

Last week's Federal Reserve's rate cut of a quarter point is said to be the last one for a while. The Fed is about out of tricks.

Though our central bankers have now cut short term rates from 5.25 last September to the current 2.0 percent, credit costs to long-term borrowers are higher than they were a year ago -- because lenders fear increased inflation.

Some of this is the Fed's own doing. Its cheap-money policy, necessitated by the Fed's own failure to police harmful speculative practices, has further weakened the dollar, raising prices of imported commodities.

Many credit markets are still frozen for lack of investor confidence -- something that low interest rates cannot bring back. Losses continue to mount on the balance sheets of banks that made foolish speculative investments, causing credit to contract further.

None of this had to happen. The credit crisis, which is sapping America's economic strength, was the result of an almost religious belief in deregulation whose excesses are now coming home to roost.

It is instructive to compare the American financial mess with the economic situation in nations that resisted deregulation. Old Europe tends to get a scornful press in the U.S. But Europe is not suffering a financial meltdown today -- mainly because Europeans (with the exception of Britain and Switzerland) took only a few sips of the financial Kool-Aid so heavily promoted by U.S. banks.

A few European banks did get into trouble last summer, because they had been persuaded to buy toxic sub-prime securities made in America. Germany's powerhouse Deutsche Bank continues to suffer some big losses. But the European Central Bank, in its first real test since the Euro made its public debut in 2002, has performed well and the crisis has largely passed. On our side of the ocean, the Fed keeps lurching from bailout to bailout.

France had one bank fraud caused by a rogue trader, but no general credit crisis -- because French banks and their supervisors discourage speculative mortgage lending. Hence: no subprime mess. The French even have a banking requirement called obligation de conseil -- the banker's duty to counsel a borrower on the true costs and risks of credit. A senior French banking official told me, "If a banker promoted these sub-prime mortgages here, he would go to jail."

Spain, like the U.S., currently has an overhang of too much real estate development and falling housing prices. But unlike in the U.S., Spain's banks did not engage in subprime lending or create exotic mortgage-backed bonds. So Spain's housing problems did not spill over into a general credit crisis. And since Spain's government—led incidentally by fiscally prudent social-democrats—has a nice budget surplus, Spain has the money to stimulate its economy with public investments.

Europe also has high domestic savings rates and balanced trade accounts with the rest of the world. Europe, unlike the U.S., is not increasingly in hock to China. The high Euro, the flipside of the cheap dollar, protects the European economy from inflation. And despite using an expensive Euro that has appreciated 60 percent against the dollar in six years, Germany is running record trade surpluses.

How can that be? As German Chancellor Angela Merkel once twitted Britain's then Prime Minister Tony Blair, "Mr. Blair, we still make things." By contrast, the Brits and their American cousins think financial engineering is economic salvation. They don't seem to mind that if manufacturing keeps moving offshore, which is devastating for the trade balance.

In a recent interview, Germany's Gunter Verheugen, the vice-president of the EU, told me, "We need a strong and competitive industrial base in order to have a strong service economy. Don't try to be cheaper. Try to be better. Don't try to compete on low social standards."

So as the U.S keeps trying to contain a needless crisis caused by an extreme faith in financial engineering, the Europeans have kept their heads and a more balanced form of capitalism. While Europe has its own debate about the right balance between market innovations and social protections, there is little enthusiasm for taking more lessons from market-besotted Americans who have managed to sink what was once the world's strongest economy. The main worry is how much contagion from America will spill over onto Europe.

This column originally appeared in The Boston Globe.

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