Morgan Stanley warns of 'catastrophic event'

as ECB fights Federal Reserve

The
clash between the European Central Bank and the US Federal Reserve over
monetary strategy is causing serious strains in the global financial
system and could lead to a replay of Europe's exchange rate crisis in
the 1990s, a team of bankers has warned.

"We see
striking similarities between the transatlantic tensions that built up
in the early 1990s and those that are accumulating again today. The
outcome of the 1992 deadlock was a major currency crisis and a
recession in Europe," said a report by Morgan Stanley's European
experts.

	Jean-Claude Trichet is taking a hard line on rates

Just
as then, Washington has slashed rates to bail out the banks and prevent
an economic hard-landing, while Frankfurt has stuck to its hawkish line
- ignoring angry protests from politicians and squeals of pain from
Europe's export industry.

Indeed, the ECB has let the de facto interest rate - Euribor - rise by over 100 basis points since the credit crisis began.

Just
as then, the dollar has plummeted far enough to cause worldwide alarm.
In August 1992 it fell to 1.35 against the Deutsche Mark: this time it
has fallen even further to the equivalent of 1.25. It is potentially
worse for Europe this time because the yen and yuan have also fallen to
near record lows. So has sterling.

Morgan Stanley doubts that Europe's monetary union
will break up under pressure, but it warns that corked pressures will
have to find release one way or another.

This
will most likely occur through property slumps and banking purges in
the vulnerable countries of the Club Med region and the euro-satellite
states of Eastern Europe.

"The tensions will not
disappear into thin air. They will find fault lines on the periphery of
Europe. Painful macro adjustments are likely to take place. Pegs to the
euro could be questioned," said the report, written by Eric Chaney,
Carlos Caceres, and Pasquale Diana.

The point of
maximum stress could occur in coming months if the ECB carries out the
threat this month by Jean-Claude Trichet to raise rates. It will be
worse yet - for Europe - if the Fed backs away from expected
tightening. "This could trigger another 'catastrophic' event," warned
Morgan Stanley.

The markets have priced in two US
rates rises later this year following a series of "hawkish" comments by
Fed chief Ben Bernanke and other US officials, but this may have been a
misjudgment.

An article in the Washington Post by
veteran columnist Robert Novak suggested that Mr Bernanke is concerned
that runaway oil costs will cause a slump in growth, viewing inflation
as the lesser threat. He is irked by the ECB's talk of further monetary
tightening at such a dangerous juncture.

	Ben Bernanke is reported to be irked by the ECB's approach

The
contrasting approaches in Washington and Frankfurt make some sense.
America's flexible structure allows it to adjust quickly to shocks.
Europe's more rigid system leaves it with "sticky" prices that take
longer to fall back as growth slows.

Morgan Stanley
says the current account deficits of Spain (10.5pc of GDP), Portugal
(10.5pc), and Greece (14pc) would never have been able to reach such
extreme levels before the launch of the euro.

EMU
has shielded them from punishment by the markets, but this has allowed
them to store up serious trouble. By contrast, Germany now has a huge
surplus of 7.7pc of GDP.

The imbalances appear to
be getting worse. The latest food and oil spike has pushed eurozone
inflation to a record 3.7pc, with big variations by country. Spanish
inflation is rising at 4.7pc even though the country is now in the grip
of a full-blown property crash. It is still falling further behind
Germany. The squeeze required to claw back lost competitiveness will be
"politically unpalatable".

Morgan Stanley said the
biggest risk lies in the arc of countries from the Baltics to the Black
Sea where credit growth has been roaring at 40pc to 50pc a year.
Current account deficits have reached 23pc of GDP in Latvia, and 22pc
in Bulgaria. In Hungary and Romania, over 55pc of household debt is in
euros or Swiss francs.

Swedish, Austrian, Greek and
Italian banks have provided much of the funding for the credit booms. A
crunch is looming in 2009 when a wave of maturities fall due. "Could
the funding dry up? We think it could," said the bank.