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It wasn’t that long ago that more and more economists were expressing concern about inflation and warning the US Federal Reserve to start draining liquidity and reserves from the banking system. Indeed, a number of politicians, bolstered by monetarist economists, were calling for a change in the mandate of the Federal Reserve. According to them, the Fed only should focus on inflation and not the overall state of the economy.

QE3 would never happen was the prediction of most economists when the Federal Reserve ended its QE2 program.

Now with the capital markets in turmoil, many of the same prognosticators are eagerly anticipating the Fed to announce QE3. As well, most expect the Fed to decide to keep interest rates at historic lows for several more years. These are the only tools left to the Fed to stimulate the economy. Deflation rather than inflation seems to be the greater concern today. So much for the prescience of monetarists and the inflation hawks.

The Fed’s counterpart in Europe, the European Central Bank (ECB), has shown itself to be as dysfunctional as the US Congress. Last year the ECB started increasing interest rates, as it feared a rekindling of inflationary pressures. It has deferred any further increases as it has become apparent, even to the ECB, that economic stagnation is the problem, not inflation. The ECB has initiated its own quantitative easing program in order to prop up the Eurozone and the bonds of the PIIGS.

But the ECB is steadfast in its opposition to any “selective” restructuring of the debt of Greece and possibly one or more of the other PIIGS. Restructuring would be in the best interests of the EU as a whole, except for their banks. The ECB has failed to supervise the banks and probably has insufficient data to assess the fallout of a selective restructuring. This is a sad indictment of the incompetence of the ECB.

The EU banks should have been forced to take their hits over time as the bonds of Greece and other countries declined sharply in value. But they were allowed to perpetuate the fiction that they would be fully repaid (perhaps this is not entirely fiction since the ECB appears to be the payer of last resort). Instead of making the credit default swap market transparent and requiring the sellers of these swaps to hold ample reserves (this by itself might have killed this market), this market continues to be opaque and grow as a haven for gamblers.

Then there is the great concern with government deficits and debts. Governments were lectured (not by me) that they had to live within their means; otherwise they would hit their debt walls -debt walls created by so-called bond vigilantes. But drastic actions to cut deficits when the economy is performing weakly only exacerbates the economic and budgetary problems as the economy weakens further and tax revenues continue to collapse. As the economy weakens in the midst of fiscal austerity, social unrest increases. Just take a look at Greece or the UK.

The renewed economic uncertainty, especially the increasing possibility of another recession, has contributed to the panic in the financial and commodity markets, but governments now have their hands tied since they are reluctant to resort to stimulative budgetary measures. They are in a Catch-22.

Be careful what you ask for!

Solutions are obvious; leadership is non-existent; and intelligence is in very short supply.

The opinions expressed in this blog are personal and do not reflect the views of either Global Brief or the Glendon School of Public and International Affairs.


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