The divergent paths of the US and Europe

Olivier Blanchard, 10 June 2003

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Will there be an economic recovery soon, as the G8 leaders promise us? Many economic stars are indeed aligned right, both in the US and in Europe. Oil prices are coming down from their Iraq war highs, and under plausible scenarios, may well be heading for more of a fall. Investors all over the world are emerging from their Brazil-Enron-Iraq war jitters, and the risk premium is falling, leading to higher stock prices, and lower yields on long bonds. The overhang of the excess capital accumulated during the crazy 1990s has now been mostly worked out. Investment rates have been low for three years in a row, and only a few sectors still suffer from excessive capital accumulation. Firms are now ready to invest again.

This is all good news. But here, the similarities between Europe and the US come to an end. Monetary and fiscal policy are working at full throttle in the US; they are muzzled in Europe. In the US, Greenspan did his job in 2001 and 2002, aggressively cutting rates. And when monetary policy could not do much more, the Bush administration took the relay. It did so with relish: the budget has gone from a surplus of 1.4% of GDP in 2000 to a forecast deficit of 4.6% in 2003, a 6% swing—of which about 5% is due to changes in policy rather than the weak economy. This may be fiscally irresponsible (and, together with the tax cuts put in place for the future, it indeed surely is), but, in the short run, it surely is an enormous boost to demand.

In Europe, the ECB has been much more careful. True, it had to establish credibility, but the result is still a smaller and slower decrease in interest rates, the last cut notwithstanding. Fiscal policy is constrained by the Stability and Growth Pact. The budget for the Euro area has gone from a surplus of 0.1% in 2000 to a forecast deficit of 2.4% for 2003, nearly all of it due to the weak economy, not to changes in fiscal policy. Governments are now tinkering at the margin, cheating a bit, and getting reprimanded by Brussels. But, in the best of scenarios, what will happen is likely to fall short of the major short-run fiscal expansion Europe may well need. (The secret of success is here: increase deficits in the short-run, while improving the long-run outlook through serious pension reforms. Governments are trying to do the second; they should feel freer to do the first.)

And the world is going through a major exchange rate realignment. The dollar is depreciating, the euro appreciating. There is indeed a deep and sad irony to the current depreciation of the dollar. The depreciation is the price the US has to pay for its past sins, for its large current account deficit which foreign investors are no longer willing to finance, at least at the pace of 4% or more of US GDP. The irony is that this dollar adjustment is unambiguously good news for the US, and unambiguously bad news for Europe.

For the US, it means a boost to exports, and a further increase in demand, a further push for recovery. It also means a bit more inflation, but, in today's world, a bit more inflation is good, not bad. For Europe, it means lower competitiveness, and further contraction. The effects are far from negligible. The best estimates are that a 10% Euro appreciation lead to a decrease in demand and output of 0.6% of Euro GDP. So far the appreciation is close to 30% from the lows of two years ago, and there is every reason to think that there is more to come: The Euro is the only currency against which the dollar can depreciate. (The last thing Japan needs is an appreciation of the yen.) It will take more than what we have seen so far to return the US current account deficit to reasonable proportions.

And with contraction and euro appreciation comes deflation. Europe is already flirting with deflation; this may well be the tipping factor. And, as the now ten-year old Japanese slump tells us, Europe surely does not want to go there.

So, the G8 are half right. Between falling oil prices, aggressive fiscal and monetary policies and the dollar depreciation, it is hard to see what stands in the way of a strong recovery in the US. But this does not translate to Europe. There, monetary caution, self imposed fiscal constraints, and the euro appreciation, all lead to clear dangers, deflation and a prolonged slump. The slump is not preordained; many fundamentals are right, and a simple change in mood may lift Europe into recovery. But this is the time for strong contingency plans, for ambitious macroeconomic policies. I do not see them coming.

Topics: Global economy, Monetary policy
Tags: economic recovery, Europe, monetary and fiscal policy, US

Chief economist, IMF, on leave from MIT