Lessons From Europe’s Long Recession
Five years after the onset of its worst recession, the European Union’s economic recovery remains painfully slow. Has anything been learned from this dismal performance about how governments can combat severe recessions? The answer is yes -- but sadly, the clearest lessons are the ones governments seem least likely to apply.
It would be hard to deny that Europe’s record has been awful. Over the past four years, gross domestic product in the euro area has grown by less than 3 percent; output fell slightly in 2012 and again this year. European unemployment still stands at more than 12 percent. The latest forecasts from the Organization for Economic Cooperation and Development predict growth of just 1 percent next year and 1.6 percent in 2015. It’s an outlook that makes the sluggish U.S. recovery look brisk.
Still, there remains a dispute about the proper role of policy -- especially fiscal policy -- in such times.
Many economists argue that Europe’s governments tried too hard and too soon to reduce their budget deficits after the recession began. Governments committed themselves early on to fiscal stringency, either because their euro-area partners forced them to or because they chose to go for “expansionary austerity”: the theory that budget discipline will restore market confidence and hence revive growth.
The term “expansionary austerity,” always something of an oxymoron, is now out of favor, because there’s been little or no expansion. But this doesn’t quite clinch the argument. Advocates of tight fiscal discipline continue to claim that things would have been even worse if budgets hadn’t been cut.
They may have a point, especially when it comes to the most heavily stressed peripheral members of the euro area. Unable to borrow from financial markets and, crucially, denied adequate fiscal support by their EU partners, these countries had no real choice: Either cut spending and raise taxes, whatever the economic consequences, or default on their debts. For some, this brutal dilemma hasn’t yet gone away. Greece still faces it; so might Portugal.
The U.K. is a telling case because it is not part of the euro area and thus had more fiscal freedom. Yet it chose to be a champion of expansionary austerity. Earlier this year, Finance Minister George Osborne said signs of a strengthening recovery had proved him right.
Not quite. The U.K. still has a lot of ground to make up. Its comparative success in reducing unemployment -- now at 7.6 percent, the lowest in three years -- is due to an alarming and unexplained collapse in productivity growth. Though it’s impossible to be sure, the U.K. would probably have recovered sooner and faster if the government hadn’t tried so hard to cut borrowing.
The same goes for the weakest euro-area economies, except that in their case more government spending would have depended on the willingness of the EU to provide it. Therein lies the first clear lesson of the limping EU recovery: EU institutions should be reformed to provide at least the possibility of fiscal stimulus if it’s deemed necessary. The lack of nationally differentiated monetary policies within the euro area only underscores this need, because fiscal policy is all there is.
A second lesson, no more popular than the first, is the need for closer cooperation on bank resolution. A single-currency area needs a proper banking union, with a single deposit-insurance program and a single resolution mechanism for failing banks. Without it, the fatal link between fear of bank failure and government insolvency remains. That toxic connection is holding back the euro economy even now.
Again, however, too many governments are reluctant -- and for much the same reason as before. A banking union so broadly conceived is, in effect, a kind of fiscal union, and Germany and its economic-policy allies are set against any further pooling of fiscal risk.
The third and clearest lesson of Europe’s lame recovery should arouse no controversy at all. It’s Public Finance 101: Guard against fiscal stress before the fact. Developing the option of fiscal accommodation in downturns requires moderate levels of public debt at the outset. In booms, therefore, governments should run surpluses, not cut taxes or embark on grandiose spending plans, as they’re often tempted to do. Surging economic growth is the occasion for hard-nosed fiscal restraint. Then, when recession strikes, policy can be eased to support demand without alarming markets or testing partners’ goodwill.
What are the chances of that idea catching on? Europe is so far from booming that it’s too soon to say -- but the signs aren’t good. Europe is settling on an old-school fiscal orthodoxy that turns modern economics on its head: Tighten fiscal policy in recessions and be relaxed about budgetary discipline as things improve.
It’s downright perverse. Ill-timed austerity not only slows a recovery, but it also could make the next recession, when it comes, even worse. Economists of almost all persuasions realize this. Too bad for Europeans that their leaders seem not to.
To contact the senior editor responsible for Bloomberg View’s editorials: David Shipley at email@example.com.