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exchange-rate overshoot, which on top of the fall in global demand for
European export goods could have devastating effects on exporters,
much worse than anything we have seen so far. Unlike 10 years ago,
there is not much scope for wage cuts this time, 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.

The second reason is a somewhat increased probability of deflation. I
still think the probability of outright deflation =96 a sustained fall
in the overall price level =96 is not very high. But the probability
will go up if the economy continues to deteriorate at the current
rate.

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.

Third, monetary policy must somehow compensate for a fiscal response
that has been too timid, too structural and too unco-ordinated.
Germany plans another stimulus early next year, but of less than 1 per
cent, and mostly on infrastructure investment. 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.

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 =801,290bn. It is now =802,050bn ($2,854bn,
=A31,904bn).

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.

I am sceptical 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.

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.

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.

But we should not delude ourselves into thinking that monetary policy
can save the world. It can play a useful role, especially since we do
not have the stomach for an optimal fiscal policy response. But it
will not prevent the worst slump of our generation.

Send your comments to munchau at eurointelligence.com