Katie Quinn

The European Union

10/4/13

The Financial Crisis, the Federal Reserve, and the European Central Bank: A Comparative Analysis
It is not an easy or worthwhile task to make a comparison of the quality or effectiveness the Federal Reserves and the European Central Banks response to the global financial crisis which began in 2007 and is still plaguing the global economy today. Instead, I would like to analyze the decisions of each central bank across the different phases of the financial crisis in the context of each banks structure and policy goals. I will develop broad characterizations of the attitude of each central bank in mitigating the financial crisis and analyze them using the scope of their charter and details specific to each bank during the crisis. This will create a clear and comparative idea of the way each monetary system reacted to the global financial crisis and the reasons behind their policies. Two Phases of Crisis The failure of the US subprime market caused by the burst of the housing bubble spread quickly to the global money market and increased interbank tensions in August of 2007. Large central banks such as the Federal Reserve (Fed) and the European Central Bank (ECB) acted swiftly with unconventional and interventionist policies such as quantitative easing to provide much needed liquidity to the market. This first phase of the financial crisis took place largely in the United States, and both central banks intervened quickly and on a large scale to provide liquidity and stabilize the markets. But, the initial crisis triggered a global recession and exacerbated the debt of struggling Southern European economies which drew the European Union into a deeper crisis.1

1Gros, Daniel Gros, Cinzia Alcidi, and Alessandro Giovanni, Central Banks in Times of Crisis The FED versus the ECB, (Brusse ls, European Union, 2012), 13.

Katie Quinn

The European Union

10/4/13

The second phase of the financial crisis is known as the European Sovereign Debt Crisis and the epicenter of the crisis is in Europe.2 In the United States, the Fed responded to its prolonged recession with another wave of quantitative easinga broad market stimulation which expanded the Federal Reserves balance sheet to USD 1.6 trillion by the end of November 2011. In the Euro area, panic over Greek insolvency led to an increased credit spread in the interbank market and banks in distressed countries such as: Greece, Ireland, Portugal, Spain, and Italy were effectively cut-off from the sovereign bond market. In contrast to the United States, the ECB took on small targeted quantities of risky assets and acted as a credit mediator between the Northern savers in the Eurozone and the Southern borrowers.3 Quantitative Easing vs. Credit Easing One of the largest differences in the reaction of the Fed and the ECB to the second phase of the financial crisis is the continued policy of quantitative easing by the Fed, in comparison to the less interventionist, credit easing policy employed by the ECB to handle its sovereign debt crisis. Quantitative easing is the process of increasing liquidity in the market by purchasing riskfree securities with the hopes of achieving economic growth and price stabilization through a negative real interest rate.4 Credit easing, in the case of the Euro crisis, is a policy in which the ECB acts as mediator in the European interbank market. It pays 0.25% interest on the deposits from Northern saving countries such as Germany and France, and assumes the credit risk of lending to distressed Southern European countries at a 1% three-year loan. These Member States would not otherwise be able to cover their governments deficit spending.5

2 Ibid, 5. 3 Gros, Daniel Gros, Cinzia Alcidi, and Alessandro Giovanni, Central Banks in Times of Crisis The FED versus the ECB, (Brussels, European Union, 2012), 5. 4 Taryn Dozark-Frideres, How Did the Central Banks in the U.S. and Europe React to the Global Financial Crisis? in The University of Iowa Center for International Finance and Development E-Book, University of Iowa, 2010. 5 Daniel Gros, The Big-Easing, Project Syndicate, April 5, 2012.

Katie Quinn

The European Union

10/4/13

Reasons for Different Policies: Banks Structure and Goals One of the reasons for different central bank reactions to each phase of the financial crisis is that the second phase affected the European Unions monetary system in a very different way. The structure of each central bank also helped to determine the best policy response during each stage of the crisis. The Fed has to deal with only one Treasury and one sovereign debt, therefore, its policy remained similar in the first phase of the financial crisis when the panic was in the market, and the second phase of the crisis when the economy was in recession. The ECB, however, is made up of seventeen Eurozone Member States, each with its own Treasury and sovereign debt. After the first phase of the crisis when the problem shifted to economic recession, interaction between the debitor and creditor countries froze. In this decision sphere the best policy the ECB could take was that of credit easing. Differences in policy goals also help to explain different responses of the Fed and ECB at each stage of the crisis. The Federal Reserve has multiple policy objectives: price stability, full employment, and low long term interest rates. In the long run, it seeks to meet all of these goals, and in the short run it directs policy to target one or two of these areas. The ECB has one primary objective: price stability. According to the Maastricht treaty, the ECB may support the other general economic policies in the Union, as long as it is without prejudice to the objective of price stability.6 Analysis of the central banks reactions throughout the financial crisis show that the Fed and the ECB were following the goals outlined in their respective charter. During the first stage of the crisis, the Fed and the ECB both responded by immediately injecting liquidity into the market in order to stabilize prices in each monetary system. During the economic recession in the second phase of the crisis, the Fed responded with more liquidity to stimulate the economy and lower unemployment. However, the ECB turned to a credit easing policy maintaining its

6 Article 127, The Lisbon Treaty, 2013.

Katie Quinn

The European Union

10/4/13

primary goal of price stability, instead of trying to stimulate the distressed economies in the Eurozone.7 Conclusion Why would the central banks of two of the largest world economies react so differently to the 2007 financial crisis? Without careful consideration of the different factors in the financial crisis this question is difficult to answer. In fact, some investors criticize the European Central bank for acting too timidly and failing to restore confidence in the Eurozone. However, the reaction of the ECB was simply within the guidelines of its decision making structure and its primary policy goal of price stability. Differences in structure, goals and the type of crisis faced by each monetary system, explain their policy responses to each stage of the financial crisis. Today, the Sovereign Debt Crisis threatens and end to the Euro and the deterioration of 55 years of global efforts towards European integration. After analyzing the policy reactions of the Federal Reserve and the European Central Bank, I would argue that the Euro Crisis continues because of problems rooted in the politics of the governments of the Member States and not the ineffective response of the European monetary system.

7 Guillermo de la DEHESA, Monetary Policy Responses to the Crisis by ECB, FED and BoE, (Manuscript, Brussels, European Union, 2012), 5.

Katie Quinn

The European Union Works Cited

10/4/13

DEHESA, Guillermo de la. Monetary Policy Responses to the Crisis by ECB, FED and BoE. (Manuscript, Brussels, European Union, 2012). <http://www.europarl.europa.eu/document/activities/cont/201208/20120820ATT4 9767/20120820ATT49767EN.pdf>. Dozark-Frideres, Taryn. How Did the Central Banks in the U.S. and Europe React to the Global Financial Crisis? In The University of Iowa Center for International Finance and Development E-Book. University of Iowa, 2010. <http://blogs.law.uiowa.edu/ebook/sites/default/files/Part_5_5.pdf>. European Central Bank. The Eurosystems Instruments. <http://www.ecb.europa.eu/mopo/implement/intro/html/index.en.html>. European Union. European Central Bank. < http://europa.eu/about-eu/institutionsbodies/ecb/>. Eurozone Crisis Explained. BBC News Business. June, 19, 2012. <http://www.bbc.co.uk/news/business-16290598>. Federal Reserve Bank of St. Louis. The Financial Crisis: A Timeline of Events and Policy Actions. < http://timeline.stlouisfed.org/index.cfm?p=timeline#2010-11>. Gros, Daniel; Alcidi, Cinzia and Giovanni, Alessandro. Central Banks in Times of Crisis The FED versus the ECB. (Brussels, European Union, 2012). <http://www.europarl.europa.eu/document/activities/cont/201207/20120702ATT4 8168/20120702ATT48168EN.pdf>. Gros, Daniel. The Big-Easing. Project Syndicate. April 5, 2012. < http://www.projectsyndicate.org/commentary/the-big-easing>. Pollard, Patricia S. A Look Inside Two Central Banks: The European Central Bank and the Federal Reserve. Economic Research, Federal Reserve Bank of St. Louis (2003): 11-30. <http://research.stlouisfed.org/publications/review/03/01/Pollard.pdf>. The Lisbon Treaty. Article 127. 2013. < http://www.lisbon-treaty.org/wcm/the-lisbontreaty/treaty-on-the-functioning-of-the-european-union-and-comments/part-3union-policies-and-internal-actions/title-viii-economic-and-monetarypolicy/chapter-2-monetary-policy/395-article-127.html>.