As a policymaker, what should you do faced with an economy with a huge current account deficit, a currency that's under pressure, a housing market that's hit a brick wall, a banking system that's in crisis, a mortgage lender that might be on the verge of bankruptcy, and a budget deficit that's larger than it once was?
Oddly enough, the answer seems to depend on which side of the Atlantic Ocean you live. If you're an American, you cut interest rates, you make a promise of lots more interest rate cuts to come, you allow the currency to find its own level, you use implicit government guarantees to shore up the mortgage market, you cajole Bank of America into purchasing Countrywide, and you have a serious debate about providing fiscal help both to reduce housing foreclosures and to stave off the risk of a deep and long-lasting recession.
If you're an Englishman or Scotsman, you refuse to cut interest rates because you worry about an unwelcome currency collapse, you're unable to do much to help the mortgage market because you never got round to creating a quasi-government agency to offer protection when things go wrong (even though the Americans did so 80 years ago), you fail to find a solution for Northern Rock despite having had months to sort the problem out, and you certainly refuse to provide any fiscal help because you're in danger of breaching your golden rule.
Last week, we saw a stark demonstration of these differing approaches. The Bank of England chose not to cut UK interest rates when it had the opportunity to do so. The Federal Reserve, in contrast, provided the clearest of messages that interest rates in the United States might fall quite a lot further. Specifically, Ben Bernanke, the chairman of the Federal Reserve, said "in light of recent changes in the outlook for and the risks to growth, additional policy easing may well be necessary ... . we stand ready to take substantive additional action as needed to support growth and to provide adequate insurance against downside risks."
Bear in mind that the Federal Reserve already has lowered policy rates from a peak of 5.25 per cent to 4.25 per cent currently, whereas the Bank of England has, so far, offered only an insubstantial reduction from 5.75 per cent to 5.5 per cent. Are these two central banks living on different planets? Are America's economic problems really much worse than those in the UK? Or, alternatively, is one of these central banks about to make a monumental policy error?
Admittedly, economic conditions on either side of the Atlantic are not perfectly aligned. The US housing market has been in free-fall for about two years now, whereas the UK housing boom has only recently shown signs of coming to an end. The right policy for the US now may prove to be the right policy for the UK in, say, a year's time.
Meanwhile, the Bank of England would doubtless argue that the exchange rate plays a bigger role in influencing inflation in the UK than it does in the US (the UK is a much more open economy, which implies that import prices have a bigger effect on domestic price expectations). And, a few days ago, Npower announced a massive increase in electricity and gas prices that will have left some members of the Bank of England's Monetary Policy Committee feeling a little sickly.
However, these arguments are not completely convincing. America's economic problems may have begun in the housing market, but the biggest difficulty now lies at the heart of the financial system. The money market crisis last summer has now evolved into a major tightening of credit conditions. Banks and other financial institutions are less willing to extend credit on favourable terms. Borrowers can no longer easily get access to loans. And, with a big spike upwards in US unemployment last month, the broader economy is now beginning to suffer.
Much of this, though, is also true of the UK. The money market crisis was, after all, a transatlantic event. The Bank of England's own surveys show a severe restriction of credit availability not dissimilar to the American experience. And while there's been no obvious sign of a deterioration in labour market conditions, retailers appear to have had a rotten Christmas, while financial institutions are licking their ever-increasing wounds. Moreover, if the US is heading towards recession – the obvious subtext of Mr Bernanke's remarks last week – the UK should brace itself for a chill westerly wind.
Given these similarities, why is there such a reluctance to act in the UK? We've had one rate cut, and sterling has fallen a reasonable way (although, for British shoppers, Fifth Avenue is still remarkably cheap), but beyond this there's little sign of the mobilisation of economic policy weapons we're now seeing in the US.
The obvious answer is that the UK, as yet, has not had the single "gee whiz" statistic suggesting recession might be around the corner. It's notable, for example, that the Fed'stune appears to have changed in response to the sudden, and shocking, rise in US unemployment.
Beyond this, though, there are other, institutional, reasons for the contrasting policy approaches.
First, the Federal Reserve sets policy with "collective cabinet responsibility". Although, theoretically, the Federal Open Markets Committee (FOMC) has "one member, one vote", in reality, public disagreements have been rare. Indeed, ever since Paul Volcker stamped his authority on the FOMC in the early 1980s, the chairman's views have tended to dominate.
The Bank of England's Monetary Policy Committee is a very different beast. The Bank makes a virtue out of disagreement, with each member of the MPC encouraged to express his or her own views. In times of uncertainty, though,this may simply lead to discord and a lack of policy leadership.
Second, although Ben Bernanke is sympathetic towards inflation targeting, the Federal Reserve enjoys a so-called "dual mandate". It has responsibility not only for price stability but also for high employment (and, hence, the avoidance of recession). Admittedly, this leads to a lack of clarity and the need for continuous judgement calls, but it also suggests that the Federal Reserve will be quicker than the Bank of England to react to signs of economic weakness (indeed, the Bank of England and European Central Bank would probably argue that the Fed reacts too quickly). In the UK, thanks to Npower, the Governor of the Bank of England might end up later this year writing another letter to the Chancellor explaining why inflation is so high even in the midst of a recessionary downswing.
Third, the US doesn't bother to tie its hands with publicly stated fiscal rules. Arguably, this reflects the dollar's role as the world's reserve currency: everyone needs dollars, so the US doesn't really have to try too hard to behave itself fiscally. In the UK, however, the current Government has made an explicit commitment to limited borrowing, and its rules are already in serious danger of being breached. It would be embarrassing if the golden rule were to all-too-quickly turn to base metal.
The biggest single difference, though, is philosophical. The Federal Reserve is prepared to act quickly because the institution still blames itself for its failure to deal properly with the onset of the Great Depression in the 1930s. The Bank of England's approach, in contrast, is focused more on the desire to avoid the inflationary excesses ofthe 1970s.
Let's hope that, this time around, our central banks and finance ministries choose to fight the right battle.
Stephen King is managing director of economics at HSBC firstname.lastname@example.orgReuse content