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  • The Week on the Hill

This week's change in interest rates was more symbolic than substantive. The Federal Reserve Board formally cut its benchmark rate from 1 percent to between zero and a quarter percentage point -- but the Fed's operations had already pushed the effective rate to about that level.

The move, and the promise to keep rates this low for as long as necessary, nonetheless underscored the Fed's broader message. In monetary policy, as in fiscal policy, the U.S. authorities are throwing everything they can think of at the recession.

If economic conditions worsen further, big questions will arise about the political future of the European Union.

Even weeks ago, the orthodox and unorthodox measures that the Federal Reserve is now resorting to would have seemed scarcely thinkable. The same goes for the fiscal stimulus of $500 billion or more that the Obama administration is preparing. Whether these amazingly bold interventions succeed is another matter, but nobody can question the Fed's or Treasury's willingness to suspend the usual rules and think big.

This zeal for dramatic initiatives is notably absent in Europe.

The European Central Bank, which controls monetary policy in the 15 countries that are members of the euro currency zone, has cut interest rates more slowly and far more reluctantly than the Fed. Most European countries are planning a fiscal stimulus, but there is no meaningful Europe-wide initiative. The individual countries' efforts are collectively very modest compared with what is intended in the U.S. This week the head of the ECB reminded the zone's members of their commitments under the "stability and growth pact" -- an agreement they reached when the euro was created. It forbids members to run fiscal deficits anywhere near as large (in relation to the size of their economies) as the one the U.S. is now contemplating for 2009.

Why is there such a marked difference in attitudes to this economic emergency in the United States compared with Europe -- and what, if anything, does Europe's reticence mean for the U.S. and the world economy as a whole?

The disagreement is partly a matter of ideology. The euro zone's principal architect was its biggest national economy: Germany. Without its sponsorship, the project would not have gotten started. This affected the character of the new system. Much more than in other countries, fear of inflation infuses Germany's preferences on economic policy -- which is understandable, when you recall the legacy of its hyperinflation of the 1930s. So, when the euro and the ECB were created, Germany insisted that the implacable opposition to inflation that had marked the postwar Bundesbank (Germany's central bank) would guide the new currency and its institutions.

The other European countries, where chronic inflation had often been a problem, thought this was a good idea. The new currency was their chance to import German rectitude and, they hoped, to begin emulating German economic performance.

The conservative attitude to fiscal policy that is enshrined in the stability-and-growth pact has the same intellectual provenance.

Some of the countries adopting the new currency (Italy and Belgium, to name two) had accumulated enormous public debts. The fear was that weak-willed governments would use their membership in the new strong-currency zone to borrow even more, with the other governments now tacitly guaranteeing their debt. The pact, with its deficit limits and debt caps, was partly intended to squelch that risk. The problem is that it was badly designed. Its focus should have been on balancing the budget over the course of the business cycle. In fact, it calls for continuous restraint, allowing governments far too little room to stimulate their economies in recessions.

If this deliberate tying of hands now seems crazy, remember that the currency is still new: It will be just 10 years old next month. ECB officials and euro-zone finance ministers were intent from the start on establishing its credibility as a secure store of value. They were going to do this even if it meant erring on the side of tight policy in the beginning.

The global economic crisis arrived before the new institutions had bedded down. Current circumstances call for heterodox thinking. They may even call, in the end, for deliberate measures to create inflation -- either to reduce the real value of debts or to ensure against the possibility of deflation. The commitments to prudence and sobriety that were made when the euro was born are still fresh in people's minds. There is a reluctance to say that everything has changed -- even though, for the moment, it has.

But anti-inflation ideology is not the only difference between the U.S. and Europe. Even if Europe wanted to stimulate its economy as aggressively as the U.S. is doing, it would find this more difficult.

America is demonstrating an amazing capacity to borrow. Its economy faces a severe and mostly homegrown recession; the value of assets such as property and equities may not yet have found their floors; the government has announced its intention to borrow hundreds of billions of dollars, and has already committed trillions to financial interventions and guarantees of one kind or another. In short, the U.S. looks like a poor investment right now.

But tell that to investors in U.S. government bonds. The more money the Treasury asks to borrow from the global capital market, the more long-term interest rates have dropped.

In this global financial emergency, U.S. Treasury bonds are one of the few assets that international investors want to buy. Demand for the government's IOUs has soared even faster than the supply -- which is saying something. That is why the price of bonds has gone up (and why the interest rate they pay, accordingly, has gone down). The dollar has strengthened lately as well. For as long as this lasts -- and we must pray that it does -- there is no financial constraint on the next administration's priming of the pump. If it can continue to borrow without limit, without provoking a swift kick in the teeth from the global capital market, it can be as Keynesian as it likes.

Europe is not so lucky. A government's borrowing capacity depends, in the end, on its ability to collect the taxes required to service its debt. The U.S. government has the country's entire economy as its tax base. Europe's borrowing capacity is unequally divided among its many member states, whose fiscal circumstances vary. Some of them are already too deeply in debt and have tax burdens that cannot be easily increased without provoking a popular backlash. Countries such as Italy are in an unenviable position: Germanic Europe-wide monetary policy is failing to deliver much relief, and its other options are limited.

Regardless of the fiscal stability pact (which, in the end, governments can ignore if they choose), the interest rate on Italian government debt has already widened significantly, as investors begin to doubt whether that debt is sound. Italy cannot go out and borrow as it sees fit.

Germany's finances, and the strength of its underlying economy, would most likely allow it to implement a big fiscal stimulus -- but, for the reasons mentioned, the government is unwilling. Many other countries are stuck. They have no monetary-policy levers to pull: that is out of their hands. And they cannot go it alone with a fiscal expansion unless they can find willing buyers for their debt. There are growing signs that this will not be easy.

If economic conditions worsen further, big questions will arise about the political future of the European Union. The constraints of the single currency will continue to hurt weaker economies (which are unable to cut interest rates or devalue their currency to boost exports). And although there is no exit strategy for members of the euro zone -- once you are in, there is no easy way out -- voters may start to demand one.

Alternatively, the euro zone may have to develop a more unified fiscal system, so that countries that need to borrow can do so with the full faith and credit of the European Union as a whole. That would be a huge step toward full political union. It would be resisted in Germany on fiscal grounds, and elsewhere for constitutional reasons. But without some such pooling of fiscal capacity, the economic strains of the zone's weaker countries may become intolerable.

Meanwhile, Europe's predicament matters for the United States.

Other things being equal, it strengthens the dollar, which makes imports cheaper and makes American exports less competitive. As a consequence, some of America's fiscal and monetary stimulus will leak away into a worsening trade balance instead of boosting jobs and domestic output.

If Europe chose to stimulate its domestic demand as strongly as America is doing -- and found a way to make that work -- export demand would help to lift the American economy and would reinforce what the Treasury and Fed are doing.

At the moment, the prospects for this kind of cooperative expansion of the world economy look poor. The global recession will last longer as a result.