The Wall Street Journal reports about ECB official responding to Krugman criticism.

(emphasis mine) [my comment]

ECB Official Responds to Krugman Criticism
By WSJ Staff

ECB executive board member Lorenzo Bini Smaghi published a letter in the Italian newspaper La Repubblica today challenging Paul Krugman's recent contention that euro zone governments and the ECB aren't doing enough to prop up the struggling economy. The following is the full text of the letter translated from the original Italian.

To the Editor.

In a recent article in the International Herald Tribune, Professor Paul Krugman states that Europe may have made a mistake in adopting the euro ten years ago. His point, he claims, is corroborated by the euro area's apparent institutional inability to react to the severe crisis we are facing at present, an inability which, he claims, may have disastrous results.

The claims made in the article are in no way supported by empirical evidence. I don't want to bother the readers with too many figures and statistics, but we should also avoid gross inaccuracies.

Let's get the facts straight, starting with the question of fiscal policy, an area in which — according to Krugman — Europe has failed, more so than the United States, to enact an effective recovery policy. This conflicts with recent IMF calculations, which show that the fiscal stimulus in European countries is wholly comparable to that seen in the United States, particularly when taking into account measures to cushion the effect of automatic stabilisers, which, by contrast with the United States, are a major factor in Europe. For instance, for the period 2009-10, discretionary measures adopted in Germany total 3.5% of GDP, compared with 3.8%in the United States. In some European countries, such as Italy, the size of such stimulus measures is relatively limited owing to the high levels of debt, but in other countries the total fiscal stimulus is larger than in the United States.

The perception that more has been done in the United States probably stems from the extensive financial measures adopted in support of the US banking system. It should be pointed out, however, that the US banking system was in greater need of such measures than the European banking system. When overall stimulus measures are considered in relation to the situation, the differences are indeed fairly limited.

As regards monetary policy, the degree of stimulus can be better measured by comparing market interest rates, rather than official interest rates. Such a comparison shows that European rates are more or less in line with those observed in the United States, and are even lower in some cases. For example, 6 and 12-month interbank interest rates in Europe are slightly lower than their US equivalents. Furthermore, real interest rates — i.e. net of inflation — are markedly lower in Europe than in the United States, and retail interest rates on mortgage lending and lending to non-financial corporations are of a comparable magnitude, if not somewhat lower in Europe.

As regards action taken by the central bank, following the initial liquidity injection of in excess of €90 billion in August 2007, the ECB's balance sheet has steadily grown, increasing by approximately €600 billion to reach a level of 16% of GDP (compared with 13% of GDP for the US Federal Reserve). There is a major difference, however: the ECB lends to the banking system against collateral, thereby reducing the risks for European taxpayers.

According to Krugman, the fact that the ECB does not have a government behind it which can cover any losses accounts for its being overly cautious [caution is a good thing. Recklessness got us into this mess]. However, this assumption implies that the taxpayer should bear the burden — through inflation — of the difficulties experienced by the banking system [ECB official doesn't believe taxpayers should bear the burden (through inflation) of the difficulties experienced by the banking system. Don't you wish fed officials were saying the same thing?]. I'm not so sure that this is what US citizens want [Do you want to pay for the mistakes of the "geniuses" at AIG? I don't.], and it is certainly not what people in Europe want.

To sum up, Krugman's argument is that it is better to have only one decision-maker in a crisis, rather than 16 governments which need to coordinate their actions, as is the case in the euro area. In theory, this seems reasonable. But it doesn't explain how the most fateful decision of all — the decision to allow a systemically important bank to fail in the midst of a financial crisis — was taken by a single decision-maker, while the 16 euro area governments have managed to avoid making such a large mistake. Neither does it explain how euro area governments have managed to agree on measures aimed at bank recapitalization, at guarantees to bank liabilities and on principles for removing toxic assets from banks' balance sheets, decisions which have become a point of reference for all the countries of the G20.

Krugman concludes that countries such as Spain would have been better off without the euro. A gain, in theory he has a point, since devaluing one's currency might seem attractive in the current circumstances. In practice, however, when global trade grinds to a halt and the financial market is in distress, the depreciation of a currency can trigger a loss of market confidence in the country, which can further aggravate the economic and financial crisis. This is what happened in Italy in 1992-93, for example. Krugman should travel to those European countries which do not yet have the euro and would really like to introduce it as soon as possible; he would not fail to notice that the reality is very different from textbooks economic theory.

Nobody can claim that Europe is perfect; quite the opposite. We should continue to strengthen economic integration and the coordination of financial and economic policies. We just need to build on what we already have, in particular the euro.

Lorenzo Bini Smaghi
Member of the Executive Board of the European Central Bank

My reaction: Lorenzo Bini Smaghi does an excellent job refuting Paul Krugman. Points to take away from this:

1) IMF calculations show that the fiscal stimulus in European countries is wholly comparable to that seen in the United States

2) Although the United States has adopted extensive financial measures in support of its banking system, this is not a sign that the US has done more to fight the financial crisis. It is a sign that the US banking system was in greater need of such measures than the European banking system.

3) Unlike the fed, the ECB is cautious because it does not have a government behind it which can cover its losses.

4) The US system is set up so that the taxpayer bears the burden (through inflation) of the difficulties experienced by the banking system. This probably is not what US citizens want.

5) The European system is not designed that way, most probably because of Germany's experience with hyperinflation.

6) When global trade grinds to a halt and financial markets are in distress, the depreciation of a currency can trigger a loss of market confidence in the country, which can further aggravate the economic and financial crisis.


Conclusion: The ECB has very different attitude towards money printing (quantitative easing) than the US fed. Basically, ECB does not believe taxpayers should pay for the banking system's mistakes through inflation, and the fed is expanding the US monetary base by 15-fold. Unlike the dollar, the euro will likely survive this crisis with most of its purchasing power intact.

As another example of this different attitude, the ECB recently warned Germany against a EU bail-out. Can you image the fed warning the US not to engage in bailouts? I can't.