The above remark was made by Fed Chairman Ben Bernanke recently as a comment to the current crisis. Bernanke is a leading expert on the Great Depression and has written several papers on how the breakdown of credit intermediation was an important reason that the Great Depression became so protracted. Policymakers responded in an orthodox manner with fiscal policy focused on balanced budgets and a monetary policy focused on defending the dollar. He also highlights that the Fed was misled in judging monetary policy by only looking at the nominal rate to judge the looseness of monetary policy. At that time, deflation became widespread and hence real rates were not low. And credit intermediation broke down completely. Hence, overall financial conditions were far from loose even though nominal rates were low.
This is also very much the case today, which is why the Fed is so aggressive and starting to use unorthodox measures. In Euroland, rates have also been lowered more than usual, but tighter lending standards and a substantial widening of credit spreads mean that overall financial conditions are not loose at all. Hence, in our view, there is need for more stimuli in terms of lower rates from the ECB. This was highlighted this week which saw more extremely weak data for Euroland (see Euroland).
We think a very long recession can be avoided but it requires that the policy response is significant – to match the size of the shock – and comes early.
Unfortunately the ECB is already starting to show reluctance to ease policy much further. The meeting next week will be an important guide of how great this reluctance is. We expect a cut of 50bp, taking the leading rate to 2.0%. But there is a risk that the ECB passes this time.
