Paul Krugman, the Princeton University economist and blogger, recently summarized diverging transatlantic trends as follows: “Better here, worse there.” It is a shocking observation: as recently as in 2009, European politicians and commentators lambasted the US for being at the root of the financial turmoil and hailed the euro for protecting the continent from it.
Unfortunately for Europe’s boosters, the facts are unambiguous. According to the European Commission, US per capita GDP is expected to return to its 2007 level next year, whereas it is expected to remain 3% below that level in the eurozone.
Likewise, unemployment was roughly the same on both sides of the Atlantic in 2009-2010, but it is now almost four percentage points lower in the US. Capital expenditure in the US is recovering more strongly, and exports are picking up. Even inflation is likely to be lower in America than in Europe this year.
The one area where Europe is posting better results is public finances. In 2012, the aggregate fiscal deficit in the eurozone is expected to be slightly above 3% of GDP, compared to more than 8% in the US.
There are two competing explanations for Europe’s relative malaise. One is the claim that Europe is paying the price of misguided austerity. The other is that the US, too, will eventually face its day of fiscal reckoning, and that Europe had no choice but to start it earlier: as the euro crisis demonstrates, things would have been worse had austerity been postponed.
There is truth in both views, but both overlook an important part of the story. In the aftermath of the Great Recession, the US and Europe (including the United Kingdom) adopted opposite strategies. President Barack Obama’s administration and the US Federal Reserve gave priority to healing the private sector. After expeditiously restoring confidence in the banks by forcing them to undergo severe stress tests, they gave households time to repair their balance sheets. The task for economic policy was to compensate for the resulting shortfall in private demand until households eventually recovered. Fiscal consolidation was put on hold (although some did occur, owing to the balanced-budget rules of most US states), and monetary policy was geared toward flattening the yield curve.
Europe, by contrast, put early emphasis on restoring fiscal sustainability, but neglected its private-sector maladies. As early as the second half of 2009 – that is, before bond markets got nervous – policymakers’ top priority was to find the exit from fiscal stimulus. Private-sector problems were overlooked on the way out. Banks, for example, were said to be in good shape, whereas several were barely solvent. Households were assumed to be ready to consume, although, in Spain and elsewhere, many were over-indebted. And labor-hoarding was encouraged at the expense of productivity and profitability.
As a result, Europe emerged from the recession with too many zombie banks, wounded households, and struggling companies. In Germany, the private economy was fit enough to recover, but this was less true in southern Europe or even France.
The UK, which has not suffered directly from the euro crisis, is an interesting test, for it also followed the European strategy. Instead of the productivity surge experienced in the US, it has gone through a sort of productivity holiday, with serious consequences. The Bank of England’s latest Inflation Report reckons that UK productivity is 10% below pre-crisis trends, owing to low investment and a slowdown of the Schumpeterian process of creative destruction. As in continental Europe, productivity has suffered from a combination of insufficient profitability and dysfunctional capital markets. Unit labor costs have risen, and potential output growth has fallen.
Neglect of the private sector has left Europe in a sad quandary. On the supply side, permanently lower output makes fiscal adjustment even more compulsory; but, on the demand side, a weak private economy lacks the resilience needed to weather fiscal retrenchment.
At this stage, struggling European countries evidently cannot afford to put public-sector adjustment on hold to concentrate on private-sector balance sheets. Nor should they take inspiration from America’s “fiscal cliff” theater. Nonetheless, the US approach holds three lessons.
First, banking-sector repair should be policymakers’ top priority wherever it has not been completed. Second, the pace of consolidation should remain moderate as long as private demand remains constrained by deleveraging or credit restrictions. Finally, attention should be paid to the balance between fiscal tightening and supply-side reforms: whenever appropriate, more priority should be given to the latter than has been the case so far.