For the past three months, markets have been worrying about the future of countries in the European Union, and more particularly within the zone that uses the euro. The euro has fallen consistently against the dollar and euro denominated bond yields of southern European countries have risen to heights at which financing budget deficits becomes painfully expensive. Yet as policy responses on both sides of the Atlantic have evolved, one thing has become clear: Europe is not the problem markets think it is, and the U.S. economy looks much shakier than markets currently believe.
U.S. commentators, at least from the conservative side of the aisle, have always tended to sneer at the European Union. There’s no question that its bureaucracy is even more irresponsible and unaccountable than that in Washington D.C. and the constitutional barriers against that bureaucracy’s self-aggrandizement instincts are much too weak. When I dealt with it fifteen years ago it was also significantly more corrupt than its U.S. counterpart, although I have the impression that U.S. standards have since deteriorated to equalize matters.
As for the European economies themselves, they generally involve about 10% more of GDP than in the United States being absorbed by the government, partly in better (and more efficient) healthcare provision, but also in a greater degree of income redistribution and an overgrown welfare state. There is a certain offset from lower European defense spending, but overall government’s drag on the economy is significantly greater in Europe.
Nevertheless, in certain respects the European system works better. This is notably the case in monetary policy, where the constitution of the European Central Bank and its links to the German Bundesbank make it more immune to meddling than the over-politicized Fed. Europe’s expansion of money supply was less during the bubble than the Fed’s, its interest rate floor has been 1%, rather than zero, and it has been notably less enthusiastic than the Fed in buying rubbish when trouble intervened, attempting to sterilize its purchases through repurchase agreements rather than simply running out and buying mortgage-backed junk in trillion-dollar lots.
At June 18, the ECB’s balance sheet totaled 2.12 trillion euros ($2.54 trillion) compared with the Fed’s $2.39 trillion in an economy which at $1.20 = 1 euro is just about the same size. That comparison shows nothing; however of the ECB’s balance sheet 1.25 trillion euros ($1.5 trillion) represented lending to Eurozone banks and government securities, considerably less than the Fed’s equivalent figure of $2.07 trillion. Since the Eurozone is currently in mid-crisis whereas the U.S. banking crisis is a year in the past, the ECB has thus been notably more conservative than the Fed in the use of its balance sheet as well as in its monetary policy.
However the most notable economic policy area in which the EU differs from the U.S. is its attitude to fiscal “stimulus” and budget deficits. Even at the height of the 2008 banking crisis, when some EU countries such as Britain under its Labour government were widening their budget deficits, the social democrat German finance minister Peer Steinbruck referred to the stimulus policy as “crass Keynesianism.” Unlike in previous economic crises like the 1930s, when electorates tended to turn towards big government, this time in Europe they have turned away from it, with both Germany and Britain electing center-right coalitions within the past year.
The result of recent electoral changes and of the Greek crisis has been a big move in Europe towards fiscal austerity. Greece, Portugal and Spain were more or less forced to cut their budget deficits. However Germany, which introduced a deficit reduction package last week and France, which increased its state sector retirement age to 60, were in little danger of a market “run” on their government bonds, so their move to fiscal austerity has been largely voluntary. Now Britain has introduced the largest budget cuts in a generation, aiming to get close to balancing the government’s budget by 2015. All these countries have taken an axe to their public sectors in terms of employment levels, pay and pensions, reducing state-sector entitlements that had become bloated by a decade of moderate economic expansion and fiscal laxity.
Keynesians are now arguing that Europe’s austerity packages will plunge the continent back into recession. President Obama penned an official letter to this effect prior to this weekend’s meeting of the G20 leaders of the world’s major economies, and was reinforced by Larry Summers and Treasury Secretary Tim Geithner in a Wall Street Journal op-ed. Obama is right to be worried. If the Keynesians are right, Europe’s budget cutters, by pushing the United States’ largest market back into recession, will damage the United States’ embryonic recovery. If however the Keynesians are wrong, and Europe does not plunge back into recession, then the U.S. with its titanic budget deficit will become an isolated example of fiscal laxity, damaging its credit rating. Since the U.S. makes an excellent return on seignorage from the dollars it provides to the world economy and to fearful Chinese central banks, causing the world’s bankers to focus on the dollar’s problems could push the country even further into downturn.
My vote would be for the Keynesians being wrong, and being proved so pretty quickly, partly because of the markets’ dinging of the euro in recent months. For the southern European countries in real trouble, reducing their deficits will increase the availability of capital to their economies, as markets come to have confidence in their long term viability (that may not apply to Greece, the worst of the miscreants, but there an EU bailout will have a similar effect – free money always helps matters.) For Britain and France, fiscal retrenchment will also increase the amount of capital available to those countries’ business sectors, at a time when banks’ natural preference is to invest only in government bonds, funding those purchases with short-term deposits and picking up large returns from the universal steep yield curves.
For Germany, the benefits of immediate reduction the fiscal deficit are less, because Germany is in fine shape economically, with a recovery that is already on track. However for Germany and for all the other EU countries, the reduction in the value of the euro will provide a very welcome boost to exports. Countries like Spain, which have become uncompetitive with their Eurozone partners, will benefit least, but Germany should benefit most of all because its export sectors are already highly competitive and should gain market share. If the ECB and the Bank of England begin to raise interest rates, as seems very possible, the yield curve attractions of government bond investment will disappear, banks will once more be forced into the difficult business of lending to small companies and European consumers will further rebuild their personal balance sheets through saving.
The main laggards in the race to rebalance budgets are thus the United States and Japan (apart from India, something of a special case and still a relatively small economy.) In Japan, the new prime minister Naoto Kan has made noises about moving towards fiscal balance, but appears to wish to do so by raising consumption taxes rather than by trimming back Japan’s excessive government expenditure. If he follows this preference, the positive effect on the private sector will be less marked than from spending cuts, since money released by lower borrowing will be reabsorbed through extra tax. Increasing the consumption tax in order to reduce the deficit failed in Japan in 1997; it is unlikely to be very successful today, although reducing investor anxiety over Japan’s gigantic debt burden will certainly provide long-term benefits.
As for the United States, President Obama and the current Congress appear committed to continuing their Keynesian “stimulus” polices. These have already failed in their ostensible purpose of increasing employment — the damaging effect of the huge deficits on bank lending to the small-business private sector appears to have negated any benefit from preserving public sector union jobs. With the dollar strengthening against the euro and interest rates far below the rate of inflation, the balance of payments deficit and savings dearth have both worsened, returning towards their unsustainable levels of 2007. Now housing appears to be weakening once more, with the ending at the end of March of the Fed purchases of mortgage backed debt and at the end of April of the $8,000 subsidy to homebuyers. There must thus be a substantial risk of a double dip recession, not in the world as a whole, but in the United States, where both fiscal and monetary policies have for several years been hopelessly misguided.
No doubt the other G20 leaders attempted to explain this problem to President Obama at their meeting. On past form, they are unlikely to have succeeded in doing so. Meanwhile it is the United States and to a lesser extent Japan, not Europe, that have the greatest economic problems currently. With the help of some draconian and courageous budget management, Europe is recovering just fine.
-0-
(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)