By Michael Prowse
Debate at this weekend’s G20 meeting in Toronto is likely to focus on the rift that has opened between the US and Europe on macroeconomic policy. The US view is that governments should spend now, so as to create jobs and sustain economic growth, and save later. The European view is that fiscal consolidation is the urgent priority: governments must spend less, now and in the future.
The US had been preparing to criticise the policies of both the major surplus nations: China and Germany. But by dropping its formal dollar peg just ahead of the meeting, and announcing that the renminbi will be managed against a basket of currencies, China has deftly taken itself out of the line of fire. It has given away very little since it says it intends to keep its currency “basically stable” but attention has naturally shifted to Germany which has made no concessions. Far from loosening fiscal policy, as many US economists recommend, it is cutting spending.
Germany cannot be accused of engineering the 14 per cent depreciation of the euro in recent months. But the euro’s weakness reflects the severity of the European sovereign debt crisis. And that crisis erupted in part because Germany refused to help Greece early this year when the cost of a bailout might have been quite modest.
The upshot is that German exporters are benefiting mightily from Berlin’s reluctance to accept its obligations to its EU partners. The weaker euro, moreover, is throwing in doubt President Barrack Obama’s strategy for boosting US exports and closing the US’s current account deficit.
In normal economic times, governments that wish to stimulate economies can opt to loosen either fiscal or monetary policy. Most economists would agree that fiscal consolidation – spending cuts and/or tax increases – is not necessarily undesirable when growth is weak, provided it is compensated for with aggressive monetary easing. So in normal times, the US would not be second-guessing the Europeans’ choice of policy instrument.
The trouble is these are not normal times. The interest rates that central banks can manipulate directly are close to zero, and cannot be reduced significantly. Long-term bond yields are also very low. Hence there is very little scope for monetary easing. If countries tighten fiscal policy in these circumstances, the US argues, economic growth will falter.
It is too much of a leap of faith to believe that private consumption or business investment will spontaneously expand to fill the gap. Indeed in a climate of austerity, businesses and consumers may tighten their belts as well, sending the global economy into another recession. American policymakers recall that premature belt-tightening in the late 1930s produced just such a second dip.
So what is wrong with Europeans? Why cannot they understand this simple logic? Why are they so fixated on austerity?
At a meeting this week of the German Marshall Fund in Washington, Mr Janusz Lewandowski, the Commissioner who oversees the EU budget, offered a partial answer. In each national capital, preserving or regaining the confidence of financial markets is the absolute priority. If financial stability is not secured, they fear markets will push up bond yields, making public debts unserviceable. For the time being, therefore, job creation and economic growth are of secondary importance.
This week’s British budget illustrates just how deeply these fears are felt. The UK’s public sector deficit is about 11 per cent of GDP, not far short of Greece’s. The ratio of its public debt to GDP has more than doubled since 2007. Since the UK is not a member of the euro zone, sterling has acted as a safety value, depreciating sharply against dollar in recent months. Even so the Conservative-led coalition government announced the deepest cuts in spending – a 25 per cent reduction for almost all government departments over the next five years – since the early 1980s.
Greece, Spain and Ireland had no choice but to introduce austerity measures. The UK had greater room for manoeuvre, but chose austerity in a bid to win the confidence of financial markets and forestall the kind of short-selling of government debt that toppled Greece. Germany, even though far less vulnerable than the UK, has also opted to cut spending sharply.
There is a second reason why Europeans can’t act like Americans. Although the EU is an economic bloc of roughly the same size as the US, most member states have not yet outgrown the attitudes they acquired as small economies that were heavily dependent on export markets.
Germany is an economic power-house today but, like its smaller partners, still regards the world market as something that exists independently of its own policies. The German government is anxious to sustain the competitiveness of its own exporters. But it still does not accept that its policies will strongly influence the outlook for European growth and that this in turn will strongly influence world growth.
When Americans call on Europeans to adopt more expansionary policies they forget that eurozone member states are trapped in an unpleasant institutional transition. They are no longer independent economies with control over their own interest rates and currencies. But neither are they sufficiently integrated with each other to face financial markets as a united bloc. There is, for instance, a series of individual bond markets rather than an integrated euro bond market, backed by the combined tax-raising powers of the eurozone members. Such an integrated bond market would have depth and liquidity comparable with the US bond market, but as yet it remains a distant dream.
If the dollar were to lose its position as the principal global reserve asset, American policy makers would better understand the pressures that a still fragmented Europe faces. If the US were obliged to borrow in euros and renminbi to finance its vast public sector debt, it would be more fearful of the reactions of financial markets. In such an imaginary world, dollar depreciation would really hurt because it would increase the cost of servicing American euro and renminbi debt. Rather than blithely urging fiscal expansion, the US might then be cutting public spending just as furiously as Britain or Germany.
So what can be done? In Toronto, the G20 leaders need to discuss ways of sustaining the world economic recovery. There is no harm in warning of the dangers of austerity in Europe and in urging Germany to adopt more expansionary policies. But in the absence of evidence of an imminent double dip recession, it would be unrealistic to expect a vigorous response in nervous European capitals.
The G 20 can also usefully push for further regulatory and institutional reform. Germany has taken a lead in banning naked short selling of securities – one of the practices that put the Greek government under intense strain. The G20 should continue to search for ways to ensure more responsible behaviour in financial markets. In addition, it should throw its weight behind those in Europe who are urging deeper economic integration. If Europe is to have the capacity to respond more rationally in future crises, it needs to complete its project of creating an economic and political union.
The lesson of the Greek crisis is that a monetary union and fiscal free-for-all is a dangerous combination. The eurozone has to become a fiscal as well as a monetary union, or else disband itself. At a minimum, this requires central oversight of national budgets and automatic penalties for failing to meet deficit targets. If, in addition, the euro were to become a more significant global reserve asset, Europeans could begin to act with the confidence of a large economic player on the world stage.
Who knows: they might even begin to act more like Americans and adopt a “spend now, save later” policy, regardless of the misgivings of financial markets.