I told you so. Obama right and Europe wrong about way out of Great Recession
- By: Larry Elliott
- Nov 23, 2015
- 5 min read
I told you so. Barack Obama is too schooled in the niceties of diplomacy to put it as bluntly. But he would be well within his rights to utter those four words when he sits around the table with Angela Merkel at the G20 summit next week.
Back in 2010, when the half-yearly gatherings of developed and developing countries were in their infancy, the G20 met in Toronto. Up until this point, the summits had shown a welcome unity, with all nations committed to the goal of avoiding a second Great Depression.
In Toronto, the consensus broke down. Obama’s view was that the recovery was fragile and that this was the time to keep the pedal to the metal. The view in Germany, supported by Britain, was that there was a need to rein in the budget deficits that had widened during the Great Recession.
At the European Central Bank, there was concern that the deep cuts in interest rates and the unorthodox policies being pursued by the Federal Reserve and the Bank of England posed a threat to price stability. Despite the onset of a five-year sovereign debt crisis that almost destroyed the euro, the ECB raised interest rates a year later.
The White House was left incredulous by this act of self-immolation, and no wonder. When the history books are written, the economic blunders Europe committed in the name of sound money will be right up there with Britain’s decision to go back on the gold standard in 1925.
Jason Furman, the chairman of Obama’s council of economic advisers, who was visiting London last week, said “there is a massive, massive shortfall” in eurozone output relative to what it would have produced with more expansionary policies. When the recession bottomed out in 2009, the unemployment rates of the US and the eurozone were pretty much identical, but in the years since the dole queues have lengthened in Europe and shortened in America. Furman has an explanation for why Europe now has an unemployment rate double that of America’s: it has nothing to do with supposed labour market rigidity and everything to do with insufficient demand.
The ECB eventually realised that raising interest rates when the economy was going backwards was not the smartest idea in the world. Five years after the Fed and the Bank of England had turned on the electronic printing presses, the ECB began its own version of quantitative easing. ECB boss Mario Draghi eventually wore down German resistance, but only after it was plain that the gap between the US and the eurozone was growing wider year by year.
A recent presentation by Peter Praet, the ECB’s chief economist, illustrated just how badly the eurozone has performed since the financial crisis. Real domestic demand in the US is now about 10% higher than it was when the Great Recession began in 2008. In Europe, despite the tentative recovery seen this year, it is still 3% lower. Over the same period, the productivity gap between the US and the eurozone has doubled in size to around 15 percentage points.
Obama is not gloating about this. On the contrary, the US uses every available forum to cajole the Europeans into adopting the sort of growth-friendly approach they spurned five years ago, because it wants it to be easier for American companies to export goods and services across the Atlantic. Furman welcomes the fact that the ECB has appreciated the seriousness of the situation, but is concerned that fiscal policy remains on an austerity setting.
The point is well made. The ECB is pumping €60bn a month into the eurozone economy and has dropped a broad hint that it will do more to support activity before the end of the year. But the ECB’s interventions don’t compare in size to the Fed’s QE programme and they were delayed by more than half a decade. The ECB waited until interest rates were low and animal spirits well and truly crushed before acting.
Draghi is aware that there are limits to what he can achieve, which is why he may be privately supporting Obama in his G20 sparring with Merkel. The US position is simple. Germany is running a whopping budget surplus, which it should run down through tax cuts and spending increases that would raise domestic demand across the eurozone. At the same time, Berlin and its allies at the European commission should cease to impose draconian measures on the struggling countries on the eurozone periphery, such as Greece, and ease up on those countries, such as France and Italy, that are not currently in crisis but soon could be in the event of a modest downturn.
Three charts in Praet’s presentation show why Washington is right on every count. The first shows bank loans to the private sector, which were growing by more than 10% before the crisis but have flatlined for the past five years. The second shows investment in the eurozone, which at the end of 2014 was 7% below its level in 2008. The third shows that the glacially slow decline in eurozone unemployment is in part the result of people giving up hope of finding work and leaving the labour force.
This is textbook Keynesian stuff. Unemployment is high, which means businesses are reluctant to invest. The lack of investment means that demand for new loans is weak. The weakness of demand for loans means that driving down the cost of borrowing through QE will have little impact. Therefore, it is up to the state to break into the vicious circle by investing itself, something it can do cheaply and –because there are so many people unemployed and businesses working well below full capacity – without the risk of inflation.
It should not be for the Americans to remind the Europeans of their own history, but sadly that does seem to be the case. In the 1930s, the countries, such as France, that stuck with the gold standard suffered the longest slumps. Those countries, such as Britain and the US, that abandoned orthodoxy sooner recovered more quickly.
Since the recession, Britain and the US have outperformed the eurozone for the same reason they did better in the 1930s: they have made fewer macro-economic blunders. The Fed and the Bank of England were more aggressive in their use of monetary policy and when it came to fiscal policy, George Osborne quietly abandoned his original deficit reduction targets when the deleterious impact of an over-aggressive austerity strategy became apparent.
Expect France and Italy to follow a similar approach. François Hollande and Matteo Renzi will swear allegiance to the god of budgetary orthodoxy while at the same time borrowing and spending a bit more than they are supposed to. They should be applauded for doing so, because this god is a false god.
Source: Theguardian.com
By: Larry Elliott
