"But we should not delude ourselves into thinking that monetary policy can save the world. "

This is kind of obvious, but I like Munchau on the FT:

"Following the Fed cannot save the world

By Wolfgang Münchau

Published: December 21 2008 18:59 | Last updated: December 21 2008 18:59

One forty, one forty-four, one forty-seven, one thirty-nine. This was just four days. The speed at which the euro rose against the dollar and sterling last week, before its reversal against the dollar on Friday, has been astonishing. In trade-weighted terms the euro touched its highest level ever.

This convulsion in foreign exchange rates is the direct response to unsynchronised monetary policies ( TRUE ). The Federal Reserve announced last week that it would switch to aggressive monetary easing, a policy to increase the liquidity in the economy by purchasing financial assets outright.

The Bank of England said it might consider going down the same road. The European Central Bank did not signal anything. And the euro went through the roof( JUST GET TO THE EASING ).

Will the ECB follow the Fed to the zero boundary? My guess is the Europeans will follow the Americans all the way to the zero boundary, or almost, for the following three reasons( I JUST SAID THEY WOULD ).

The dramatic appreciation in the euro over the last couple of weeks constitutes a significant amount of policy tightening, which offsets almost all of the recent interest rate cuts. The US has shifted to a policy to generate inflation in the long run and I suspect the Fed will succeed. The Fed will probably be in no hurry to reverse the policy, so inflation will be allowed to build up in the US – and this will weaken the dollar further, to put it mildly.( OK )

From a European perspective, there is an acute danger of an extreme exchange-rate overshoot, which on top of the fall in global demand for European export goods could have devastating effects on exporters( THEIR GOODS WILL COST TOO MUCH ), much worse than anything we have seen so far. Unlike 10 years ago, there is not much scope for wage cuts this time( THAT'S INTERESTING. IT MIGHT BE THE OPPOSITE OF OUR SITUATION. WE'LL HAVE TO WAIT AND SEE. HE MIGHT ALSO MEAN AS OPPOSED TO LAYOFFS ), so this crisis will hit profits. The pressure on the ECB to go down to zero per cent will become immense just for that single reason( TRUE ).

The second reason is a somewhat increased probability of deflation. I still think the probability of outright deflation – a sustained fall in the overall price level – is not very high. But the probability will go up if the economy continues to deteriorate at the current rate( THAT'S TRUE ).

The German economics ministry is now forecasting a growth rate of minus 3 per cent for 2009. The speed with which forecasts have been revised downward is breathtaking. While the ECB does not target economic growth, it cannot ignore such a rapid deterioration either, as it poses price stability risks. In any case, the risk that inflation will exceed the ECB’s own target in the medium term must now be considered very small indeed, so that there is more room for manoeuvre compared with a couple of weeks ago( MAKES SENSE. INFLATION IS LESS OF A WORRY ).

Third, monetary policy must somehow compensate for a fiscal response that has been too timid, too structural and too unco-ordinated( THAT'S TRUE, BUT EXPECTED. IT'S BEEN BEGGAR THY NEIGHBOR, AT LEAST A SOFT FORM OF IT, FROM THE BEGINNING ). Germany plans another stimulus early next year, but of less than 1 per cent, and mostly on infrastructure investment( I READ IT WAS GOING TO BE HIGHER ). For the eurozone as a whole, there will be almost no fiscal support for the economy in 2009 beyond the effect of the automatic stabilisers. This is why monetary policy has to do all the heavy lifting it can( NOT SURE OF THAT ).

The situation is somewhat different for the UK. The fiscal response has been more forceful than in the rest of Europe and the exchange rate is very weak and likely to weaken further. The fall in the exchange rate in itself means a loosening of monetary conditions in the UK. It greatly reduces the need for another quick interest rate cut. But the economic downturn in the UK will be so extreme that policy will be excessively loose for some time.

But will the Europeans go all the way and adopt the other plank of the Fed’s policy toolbox of quantitative easing and blow up their balance sheets by issuing new money to buy securities? In some respects, they have already done so. At the beginning of this year, the ECB’s balance sheet, for example, was €1,290bn. It is now €2,050bn ($2,854bn, £1,904bn).

Unlike the Fed, the ECB is not buying up dodgy securities to boost the balance sheet, but it allows a larger group of securities to serve as collateral against which it provides the banking system with liquidity( MORE ALONG BAGEHOT'S LINES ).

I am sceptical( WE'RE ALL SKEPTICAL ABOUT EVERYTHING ) about the benefits of the Fed’s new policy of quantitative easing. We do not have a liquidity crisis, but a solvency crisis, which expresses itself in large spreads and dysfunctional money markets. I cannot see how adding more and more liquidity to the system solves this problem.( I SEE IT AS A LINKED FEAR AND AVERSION TO RISK. SOLVENCY CAN BE GUARANTEED. )

Instead of propping up each bank, and swamping the market with cash, we need to restructure and shrink the banking system, as a first step to a sustainable solution to this crisis. Quantitative easing without deep structural financial reform could cause lot of trouble in the long run( THAT MAKES SENSE,ASSUMING THAT YOU CAN BE SPECIFIC ).

I think, however, there is a case for temporary interest rate cuts in Europe, but only on condition that this policy would be forcefully reversed once credit markets start to recover, and once the economy emerges from the slump( WE ALL HOPE THAT ).

But we should not delude ourselves into thinking that monetary policy can save the world( REALLY? ). It can play a useful role, especially since we do not have the stomach for an optimal fiscal policy response( HE MIGHT BE UNDERESTIMATING THAT ). But it will not prevent the worst slump of our generation( TIME WILL TELL ).

It's a good post, but needlessly pessimistic. There's no point in continually reminding us that things can go sideways at any point now. We've gotten the e-mail.