Monday, 6 October 2014

Europe must learn from the US

This article was published in The Malta Independent on Sunday - 05 10 2014

Europe has again defeated the US in the Ryder Cup.   In golf there is nothing we need to learn from the US.   But in the handling of the economic crisis there is much that Europe needs to learn, and fast.

Six years after the financial crisis of 2008 that nearly brought the total collapse of the international financial system as credit froze and banks were losing the trust of their depositors, the US is now flying high again.   

This week we had figures showing that the US economy has continued to add employment at a fast pace bringing the unemployment rate below 6% for the first time since the crisis.   The US dollar rate of exchange index is soaring as America becomes the world’s leading producer of energy and is in a position to start exporting it, in the process pushing down energy prices.   

The only blot on the US economic performance is that economic growth is not well distributed, with the top echelons of society grabbing most of the fruit of economic revival whilst workers’ wages remain stuck at pre-crisis levels.   But this is a process which will sort-out  itself if economic growth proceeds unabated as shortage of labour will eventually inevitably translate into higher wages without pushing up inflation, given the productivity gains accompanying economy growth and falling commodity and energy prices.

Europe, especially the Euro area, is a complete antithesis of the US success. Unemployment remains stubbornly high and a generation of youth is being lost as they cannot participate at all, or at least not to the best of their abilities, in an economy stuck in a crisis. Countries that were most hit by the crisis due to their deficit and debt levels at the point of crisis entry have undergone several rounds of crushing austerity measures but they have not much to show for it.  They are stuck in an economy that has all characteristics of deflation, with falling prices, high unemployment, lack of investment, gummed bank credit and their burden of debt is getting heavier as they are caught in a deflationary debt trap.

From Malta this view seems unreal as thank God our economy has continued to perform and indeed accelerate more in US style rather than European style.  But we are the exception to the European rule and let us not kid ourselves:  if the European crisis prolongs our economic performance will be hit too as demand for our exports of goods and services is mainly sourced from the EU.

The obvious question is what has caused this difference in results between the US and the EU, particularly the Euro area.   The problem was largely the same so why in a such an economically inter-connected world the youth in Pennsylvania are finding work, even if not well paid, whereas the youth in Portugal have no jobs?

Clearly this has been due to the different response to the crisis between the US and Europe.  

The US as a single Federal State with a Federal Congress, an elected Federal Executive and a single Treasury and Central Bank could respond more forcefully and punctually to the crisis.    Although not to the degree desired by Keynesian economists like Paul Krugman, Larry Summers  and Joseph Stiglitz, fiscal policy was complementary to the aggressive monetary policy which brought interest rates down to zero. When that was not enough the Federal Reserve made three rounds of quantitative easing buying long term government bonds and mortgage backed securities to bring down long term interest rates, giving banks space to entertain fresh credit demands and in the process stabilising and reviving the housing market.  More than anything else the US immediately addressed the capital deficiency problems of its banks, resulting from losses they suffered in the crisis, using fiscal policy to re-capitalise banks so that they could immediately become active players in the revival of economy.

The US recipe which is proving so successful was based on three pillars:
  •  Immediate re-capitalisation of Banks through TARP funds approved during the last days of the Bush administration.
  •  Fiscal stimulus given by the Obama administration soon after executive takeover.
  •   Ultra-loose monetary policy consistently operated by the Federal Reserve.

The European response was piecemeal, uncoordinated and altogether insufficient.

There was and still there is no adequate reply to the capital deficiency of European banks.   Bank stress tests undertaken in various rounds were too soft and failed to serve any purpose.   Even the current process of Asset Quality Review to be followed by aggressive stress tests is half baked.    Without a ready fund which can be used to fill up any capital deficiency holes, it is like risking starting a fire without having an extinguisher at the ready.    As in the US,  Europe needed to use fiscal policy to create such a TARP like capitalisation fund.   And the burden for such funds should have been pan-European.  No use expecting countries struggling with excessive fiscal deficits, within a currency bloc they do not control, to use more fiscal funding for  their banks’ capital deficiency.

Instead of fiscal stimulus Europe imposed harsh austerity programmes.   The word austerity was not in the US lexicon for handling the crisis.  Austerity crushes demand leading to economic contractions, larger deficits and yet more austerity.  It is a spiral which like a slippery slope is hard to break. Europe needed restructuring of the disequilibria in countries like Ireland, Portugal and Greece but this had to be compensated by creation of compensating demand in surplus countries.  Instead surplus countries like Germany also adopted austerity and balanced budgets when their excessive balance of payments surplus needed a totally opposite approach.

And lastly the only institution in the EU which has autonomous authority to work in a Federal-like manner, the ECB, was not forceful enough with loosening monetary conditions.  One can mention the interest rate increases in 2011 which were a heresy in the context they were applied and had to be immediately reversed.    When the zero-interest bound was reached the ECB could not move into quantitative easing as fast as the US Fed and only now that inflation in the Euro area overall has fallen to 0.3% (meaning that problem countries are effectively in deflation) the ECB is finding the courage to do some altogether inadequate quantitative easing.   In the process it is finding harsh criticism from German quarters who only respect the independence of the Central Bank when it suits them.

The stasis in the EU organisational structure is becoming a serious threat to its own existence.    Democracy cannot take endless rounds of austerity without at least a credible light at the end of the long and dark economic tunnel.     Inevitably such dissatisfaction will become easy prey for extremist demagogues of the left or right who promise easy solutions which will challenge the whole EU structure and stability.    Papendreou and Berlusconi were practically forced out of power from Berlin but they were losing support in their home ground in any case.   What would happen if Marine Le Pen will be the next democratically elected President of France with a popular mandate to break all the EU and Euro rules?

If the EU and the Euro are to be saved there is not much time left to revise our response to the crisis and build on the model of the US measures that proved effective.  Obviously institutional arrangements are difference and a direct copy is impossible.  But the general message is that the ECB as the only pan European institution with autonomous power that give it the flexibility to move fast and effectively, have to deliver through its monetary policy and macro-prudential mandates solutions that carry the load  that fiscal policy cannot shoulder within the current EU institutional framework.  It can be done if countries respect the ECB independence all the time not just when it suits them.

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