“Interest rates aren’t a policy instrument to protect unwise lenders from the consequences of their unwise decisions,” Bank of England Governor Mervyn King said today at a press conference unveiling the bank’s latest Inflation Report.

In fact, while noting the bank would continue to monitor markets closely, Mr. King said the turmoil heralded “a more realistic appreciation of risk, which we should welcome.” He also contends there’s no evidence, yet, that the U.S. subprime turmoil has spread across the pond to Europe: “I don’t think there is much evidence of a major change in loan performance in other markets.”

European markets have gyrated recently along with global exchanges, but so far the impact of the U.S. subprime crisis on Europe does seem limited. Germany’s taken the hardest hit, with a Frankfurt-based asset management firm closing one of its funds on Monday and a government-backed group last week providing $4.8 billion to bail out another German bank whose subprime investments went bad.

Mr. King’s comments today echo similarly sanguine ones made last week by his continental European colleagues. At a press conference following the European Central Bank’s decision to keep its key interest rate at 4%, ECB President Jean-Claude Trichet said: “I would qualify this episode as a process of re-appreciation of risks which can be interpreted as a phenomenon of normalization of risk pricing in a number of markets.” Mr. Trichet had warned for months that investors were under-pricing risk.

Mr. Trichet, declining to comment on whether the ECB would consider coming to the market’s rescue in the event of a banking crisis, referred reporters to comments made by the head of Germany’s central bank, Axel Weber. Mr Weber’s take: “Fears of a banking crisis in Germany lack foundation.”

If the Fed steps in to bail out investors/banks/funds who took on more leverage than was appropriate and, worse yet, created a liquidity/duration mis-match between their assets (MBS, CDOs, CLOs) and liabilities (investor assets, margin, repo agreements) then the message is that you can go ahead and take on too much risk and if you get in trouble you’ll get bailed out.

Market participants must know that they will be the ones to own both the upside and the downside risk of the investment decisions they make. If funds blow up so be it. If Bear Stearns goes bust, so be it. If Countrywide ends up in Chapter 11, that’s their problem and their shareholder’s problem.

The discount window is for true systemic crises that surpass rationality, such as providing liquidity following the 23% drop in equity markets on 10/19/87 or offering liquidity after 9/11/01. The events of the past few weeks have been completely predictable. In fact, many funds have predicted them — Paulson Credit Opportunities ( 40% in June and 129% YTD (no June info yet)) and BlueCorr ( 17% in July and 34% YTD) for example were created to profit from just these sorts of events.

Bill Luby introduced me to your blog, and It has become part of my daily reading habit. Very thoughtful, well-written posts. Your VIX argument was particularly well-reasoned, and I indeed hope the SPX proves to be 30% undervalued! – lol. Thanks.

I too have contended since last year that the FOMC would remain neutral for quite a while. Currently, the Fed isn’t a methadone clinic, and it’s not going to provide liquidity to a problem that has its roots in excess liquidity. What the FOMC has repeatedly implied is that the best hope for easing is a significant uptick in unemployment (an ease in “resource utilization”). Shy of that, expect neutrality.

I suspect the market will hate that next week, and stocks will continue to slide. Thanks again for the great stuff…..dk