Paul Krugman, the PrincetonUniversity economist and blogger, recently summarized divergingtransatlantic trends as follows: “Better here,worse there.” It is a shocking observation: as recently as in 2009, Europeanpoliticians and commentators lambasted the USfor being at the root of the financial turmoil and hailedthe euro for protecting the continent from it.
Unfortunately for Europe’s boosters,the facts are unambiguous. According to theEuropean Commission, US per capita GDP is expected to return to its 2007 level nextyear, whereas it is expected to remain 3% below that level in the eurozone.
Likewise, unemployment was roughly the same on both sidesof the Atlantic in 2009-2010, but it is now almost four percentage points lowerin the US. Capital expenditure in the US is recovering more strongly, andexports are picking up. Even inflation is likely to be lower in America than inEurope this year.
The one area where Europe is postingbetter results is public finances. In 2012, the aggregate fiscal deficit in theeurozone 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 theprice of misguided austerity. The other is that the US, too, will eventuallyface its day of fiscal reckoning, and thatEurope 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 animportant part of the story. In the aftermath of the Great Recession, the USand Europe (including the United Kingdom) adopted opposite strategies.President Barack Obama’s administration and the US Federal Reserve gavepriority to healing the private sector. After expeditiouslyrestoring confidence in the banks by forcing them to undergo severe stresstests, they gave households time to repair their balance sheets. The task foreconomic policy was to compensate for the resulting shortfall in private demanduntil households eventually recovered. Fiscal consolidation was put on hold(although some did occur, owing to the balanced-budget rules of most USstates), and monetary policy was geared toward flattening the yield curve.
Europe, by contrast, put early emphasis on restoring fiscalsustainability, 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 toconsume, although, in Spain and elsewhere, many were over-indebted. And labor-hoarding was encouraged at the expense of productivityand profitability.
As a result, Europe emerged from the recession with toomany zombie banks, wounded households, and struggling companies. In Germany,the private economy was fit enough to recover, but this was less true insouthern Europe or even France.
The UK, which has not suffered directly from the eurocrisis, is an interesting test, for it also followed the European strategy.Instead of the productivity surge experienced in the US, it has gone through asort of productivity holiday, with serious consequences. The Bank of England’slatest Inflation Report reckons that UK productivityis 10% below pre-crisis trends, owing to low investment and a slowdown of the Schumpeterian process of creativedestruction. As in continental Europe, productivity has suffered from acombination 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 outputmakes fiscal adjustment even more compulsory; but, on the demand side, a weakprivate economy lacks the resilience needed to weatherfiscal retrenchment.
At this stage, struggling European countries evidentlycannot afford to put public-sector adjustment on holdto concentrate on private-sector balance sheets. Nor should they takeinspiration from America’s “fiscal cliff” theater.Nonetheless, the US approach holds three lessons.
First, banking-sector repair should be policymakers’ toppriority wherever it has not been completed. Second, the pace of consolidationshould remain moderate as long as private demand remains constrained bydeleveraging or credit restrictions. Finally, attention should be paid to thebalance between fiscal tightening and supply-side reforms: wheneverappropriate, more priority should be given to the latter than has been the caseso far.