While the US calls for a coordinated macroeconomic policy reaction to the ongoing recession, France and Germany are calling for microeconomic measures to prevent the next crisis. While the US is concerned about mounting unemployment and the associated distress of millions of households, France and Germany worry about their public debts. The G20 will not be able to paper over these differences, which reflect deep divergences in the way economic policies are prepared and understood.
Denial in Europe
It all looks like France and Germany, among other European countries, failed to realise the depth of the recession and the historical hardship that it is gradually creating. Alternatively, it looks like the US authorities are needlessly panicking, sowing the seeds of an outburst of inflation and massive public debt. History will eventually tell who is right. A good bet is that the Europeans are in denial or, worse that they cynically count on the US budget deficit to pull the world out of the recession. After all, the US is where the crisis was created.
For a while, many political leaders in Europe and elsewhere, including in Asia, were soothed by the decoupling theory, according to which the crisis would not come their way. Even now that the decoupling theory is in shambles, many in high positions seem to believe that it will never be as bad in continental Europe as it is in the US. Besides believing that banks here are in better shape, they like to argue that Europe’s famed welfare systems have larger automatic stabilisers and should reassure consumers. This is not really supported by most empirical estimates, but we know that precision is not the hallmark of this corner of economic knowledge.
In fact, our poor understanding of fiscal policy effects is spilling into widespread scepticism that most measures taken by the US will not do much of a difference. Coupled with concerns about public indebtedness, this view has swayed many political leaders into doing as little as possible, essentially dishing out transfers to sensitive industries, a thinly-veiled codeword for “friends”. When influential US economists such as Robert Barro support the view that fiscal policy is basically inefficient, no argument and no evidence will ever convince the sceptics.
It is true that piling up public debt is a guaranteed implication of fiscal policy expansion, while no one really knows how much bang we will get from the bucks. It is also true that many countries had finally started to come to grip with endemic financial indiscipline when the crisis got under way. What is missing in this line of argument is the simple fact that a recession will worsen budget deficits. Containing the recession, therefore, is one way to limit the deficits. This is a lesson that, I thought, we had learnt from the Great Depression. But the debate about the New Deal is raging again. Arguments that it was ineffective are not new, and economic historians have not sorted it out. So, once again, we are in a situation where economists, as a profession, cannot come out with firm answers while individuals relish the possibility of making a clever argument. The problem is that, if clever arguments can get you a publication in a good journal, they may also confuse the laymen, including policymakers.
Why the divide? Europe’s lack of expertise in high office
Why, then, the growing divide between the US and Europe on how to respond to the recession? The size of public debts is one answer. Another answer is that the hallways of power in Washington (both in the Fed and the Treasury) are peopled with first-rate economists who happen to be of the saltwater variety who believe that fiscal policy works and have developed a clear view of what they want to see done. Several of them are also economic historians who have studied the Great Depression in great detail and concluded that, maybe, policy actions did not do as much good as is sometimes asserted, but that inaction under the Hoover administration transformed the financial crash into a full-blown recession.
Now look at the hallways of power in continental Europe, and you will not find many economists, even fewer first-rate economists, and certainly no one who can claim any in-depth knowledge of the Great Depression. Confused policymakers cannot develop a macroeconomic strategy on their own. On the other hand, microeconomic policies are more reassuring, because they do not seem to involve general equilibrium reasoning. Policymakers like partial equilibrium reasoning – because it is easier but mainly because they can believe that they understand what they do. Of course, we know that partial equilibrium is dead wrong and that you never get what you expect.
What can we expect from the G20 summit next month?
Sadly, not much, as most agree. The Franco-German idea of focusing on the next crisis by rethinking financial regulation is disastrous. For one, there is no reason to choose between macroeconomic policies and financial regulation. Both are badly needed, although fiscal action is a matter of acute urgency while financial regulation is going to be a long drawn-out process that will take years to deliver its results. In addition, financial regulation is extraordinarily complicated, as it calls for sophisticated general equilibrium reasoning. Summit meetings are ideally unsuited to the task. It is one thing to ban tax havens, which played no role in the crisis; it is another thing to design incentives that will prevent financial firms from taking risks that yield vast private returns and even larger public losses.
The US, with some support from the UK, Japan and, surprisingly, China, are highly unlikely to extract more than token fiscal policy commitments from the Europeans. Maybe this is not all that disastrous. These four countries account for about a hefty share of world GDP, so they can do a lot of good to themselves and to the rest of the world. Indeed, it is very likely that a significant portion of their fiscal expansion will feed imports from the other countries thus spreading relief internationally, especially if their currencies appreciate, but who knows? The problem is that free-riding by some countries may elicit protectionism from those that carry the burden. And that would be disastrous.