Trichet worries about a case of speculative wind

Has Jean-Claude Trichet, president of the European Central Bank (ECB), just had an "irrational exuberance" moment?

In 1996 Alan Greenspan, then chairman of the US Federal Reserve Board, used the phrase about the emerging boom in US stocks. He then decided it was the Fed’s job to wait until it crashed in order to pick up the pieces.

At the over-hyped World Economic Forum in Davos last weekend (27 January) Trichet expressed real angst about the threat that another asset price bubble has been building globally. Investors, he said, need to prepare for a "repricing" of some assets because of potentially "unstable" conditions. "There is now such creativity of new and very sophisticated financial instruments...that we do not know fully where risks are located. We are trying to understand what is going on, but it is a big, big challenge."

On 29 January Jean-Claude Juncker, chairman of the Eurogroup of eurozone finance ministers, weighed in on this subject. He expressed concern about one of the symptoms, the plunging value of the Japanese yen on the foreign exchange markets. This is widely attributed to the way international banks and hedge funds are borrowing the Japanese currency at near zero interest rates and then selling to speculate in more rewarding (they hope) assets in other currencies - the so-called yen ‘carry trade’. The speculative bubble is actually much wider than this.

In January William White, economic adviser at the Bank for International Settlements, warned that hedge funds which are currently the "grease" in the global economy, could suddenly become the "sand" which brings it to a shuddering halt. In 2000 a collapse in asset prices - the dot.com crash - triggered a global slump. Now, he adds, rampant speculation is again misallocating capital, directing too much of it at high-risk assets. He did not say so, but, if we did know what the figures are, we would probably find that the speculative sums at stake in 2000 are peanuts compared with today.

So what is to be done? The ECB - with its recent cautious string of interest rate increases - has been leaning against the speculative wind. Unlike the Fed, it believes that it is the job of the central bank to curb exuberance, not wait until Wall Street and London’s speculators have gorged themselves and then clean up the vomit.

This fundamental division between the two sides of the Atlantic in monetary policy, philosophy and practice has been treated as grist for the mill of academic seminars. Wrong. This schism is dangerous. Financial markets are global. There is not much point in the ECB trying to lean against the wind if the Fed is busy at the other end of the wind-tunnel blowing as hard as it can. Real long-term interest rates in the US are still too low. Trichet may even be hinting that they are still too low in the eurozone too.

It is not just the central banks which need to get their act together. The EU is having serious difficulty getting its national financial market regulators to co-operate. Transatlantic prudential co-operation is a bad joke. But when the crisis comes it will not be confined to one financial market like the collapse of Long Term Capital Management in the US in 1998. And one bank regulator (then the Fed) will not be able to resolve it. Its resolution will be all the more difficult, too, because the ECB has no direct regulatory powers. The Fed does have such powers and chairman Ben Bernanke made clear last month that he is determined to hang on to them.

Fortunately for the ECB, the German Bundesbank, also in Frankfurt, does still have a financial market regulatory role. But how good are the links between the ECB and London’s Financial Services Authority? All these structures will be stress-tested if asset repricing comes in a hurry. No wonder Trichet is worried.

• Stewart Fleming is a freelance journalist based in Brussels.

Has Jean-Claude Trichet, president of the European Central Bank (ECB), just had an "irrational exuberance" moment?