Five years ago, when Lehman Brothers failed, the same shock hit the US and the EU. It was US-made, but deep financial integration between the two sides of the Atlantic implied that European banks suffered from it as much as US banks.
Today, however, Europe is lagging the US by a significant margin. GDP in the EU is and is expected to remain for a year at least below the 2007 peak, while the US economy is safely above it. The European employment recession was much milder than the US one, but Europe continues to destroy jobs, whereas the US is its third year of job creation. Finally business investment recovered a bit in Europe, then contracted again, while it is on the rise in the US.
Why is it that reactions to the same shock differ so much? In part this is an old story that started in the 1980s when Europe’s relative catching up stalled. But there is more. To its long-term growth challenge, Europe has added a short-term one and they now interact perversely with each-other, creating a serious risk of vicious circle.
The reason is that Europe made three mistakes in the management of the crisis. The first was to underestimate its banking problem. Financial intermediation is of central importance for growth and productivity, especially when, in the aftermath of crises, reallocation of labour and capital across sectors and firms has to take place, and especially in very bank-based economies such as the European ones. When banks are ill, the economy suffers.
Japan in the 1990s illustrated the dangers of procrastination in dealing with banking sector weaknesses. The US learned the lesson. In 2008-2009 it tackled its banking problem aggressively. Back then, many doubted the medicine would be effective. But it was. Five years into the crisis, banks in the US are healthy, while Europe has too many weak ones.
Banking weakness is probably one of the reasons why Europe has not recorded significant productivity gains in the last five years, limiting its potential output, while the US in the aftermath of the 2008 shock experienced a productivity surge. Certainly finance is only one of the factors behind this poor performance, but it is one that contributes to lowering investment and the replacement of less efficient firms by more efficient ones.
The second mistake was to ignore that its crisis is for sure a debt crisis, but not only a public debt crisis. It is also a private debt crisis. This is true of the US, where the household sector was heavily indebted, but also of several European countries. Europe’s household debt problem may have been less serious than the US one, but it also had a corporate debt problem. Soon after the 2009 recession, Europe’s choice was to focus on the public debt problem. It is legitimately proud of having gone further than the US on this front. But thanks to personal bankruptcy procedure and a faster nominal GDP growth rate, the US has managed to reduce private debt while it has increased in Europe. Overall, since 2007 the US has piled up less debt in proportion of GDP. Furthermore, its private debt-to-GDP ratio is now in safe territory, which implies that households can spend instead of saving.
With a functional financial system and financially sound households and firms, the US economy is now better able than that of the EU to undergo a period of fiscal adjustment. True, one never knows what the US political system will be able (or unable) to deliver. But from an economic standpoint at least, it was better to frontload private deleveraging and to delay the public one.
The third mistake was the management of the euro crisis. It is a problem of its own that does not require extensive discussion here. The important point is that as long as relative prices between the north and the south of the euro area remain distorted, this is bound to affect the reallocation of capital and labour to productive sectors and the emergence of new firms. Again, this is a hindrance to recovery. Rebalancing between north and south is taking place for sure, but its pace is too slow and this affects the growth potential.
It is thus not one problem that prevents Europe from growing. It is a perverse interaction between several simultaneous ones – a banking one, a deleveraging one and a rebalancing one – that also contribute to a fourth one, low productivity.
For those whose interest is to draw lessons from experiences in other regions of the world, the comparison between the two continents is telling enough. For the Europeans, who inhabit one of these two continents, observations on the effectiveness of policies are less important than action. Europe still has the capacity to correct its mistakes and improve its record. This requires to set the priorities right.
The first one is financial repair. The coming creation of a banking union is a unique opportunity to complete the strengthening of European banks. This requires comprehensive action – recapitalisation for solvent banks, resolution for insolvent ones – before the European Central Bank takes over from national supervisors. Corresponding fiscal costs should be recognised, even if this acknowledgement increases public debts. Other initiatives should also be taken to ensure that credit can flow to firms that are too small to access bond markets.
The second priority is to foster reallocation of capital and labour across firms and sectors. Financial repair will help, if accompanied by reforms that favour the mobility of production factors. Incentives to such reforms should be put in place.
The third priority is to choose the right pace of fiscal consolidation. The issue is not whether to embrace or reject austerity, but to adopt the right timing for the unavoidable consolidation of public finances. The fiscal framework that Europe has devoted so much effort to put in place should be used to make commitment for tomorrow enforceable.
The fourth priority is to accelerate relative price rebalancing in the euro area. This requires more wage and price increases in the North and less in the South, keeping price stability in the euro area as a whole.