international analysis and commentary

What Europe can (and can’t) learn from America’s recovery

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The global financial crisis erupted in the US in September 2008 with the collapse of Lehman Brothers. Several factors have since been identified as working together to set the basis for the crisis and for its swift and wide-ranging impact on economic activity: the burst of the housing bubble, the rush to sell high risk and complex financial products, the spread of undisclosed conflicts of interest, the failure of regulators and rating agencies to address the risky behavior of financial operators. The ensuing credit crunch deployed surprisingly severe economic effects throughout the world. Europe was particularly hard hit, given the integration of the Transatlantic financial systems and the strong economic ties across the Ocean.

Five years down the road, the US (the epicentre of the crisis) appears to be returning to rates of economic growth capable of reducing unemployment while at the same time strengthening the labor participation rate (two distinct indicators that are too often conflated or rather confused). On the contrary, Europe is still in the doldrums and even at risk of deflation.

At the outburst of the financial crisis, the gravity of the financial and economic consequences became almost immediately apparent both in the US and Europe:

1)      banks had lost confidence in each other, the interbank money market vanished, giving way to a terrible credit crunch, hampering activity and raising unemployment;

2)      asset prices plummeted, slashing wealth, reducing household purchasing power and private spending;

3)      unemployment increased significantly, further reducing private consumption;

4)      the recession, coupled with the need of rescuing some major companies and banks, pushed public finances to levels unsustainable in the long-term.

US pragmatism reacted swiftly. The key task following the fall of Lehman Brothers was to restore confidence in and across the financial system. The US Federal Reserve, which had already reduced policy interest rates to very low levels, initiated a long period of unconventional monetary policy (known as Quantitative Easing). By March 2009, just six months after the collapse of Lehman, the Fed had increased its balance sheet from $750bn of Treasury notes (which it held before the recession) to $1.75trillion of bank debt, mortgage-backed securities, and Treasury notes, to reach a peak of $2.1 trillion in June 2010. Further quantitative easing was adopted in November 2010 and in September 2012.

While expansionary monetary policy was a fundamental pre-requisite to relaunch the economy, it would do little in the medium to long-term to sustain an economy falling into recession. Therefore, the government quickly intervened with a number of fiscal incentives and to rescue a number of firms and financial institutions, considered to be vital for the country, managing to save millions of jobs. In 2008 and 2009, General Motors, Chrysler, AIG and other companies cost the American tax-payer a total of $150bn, while Fannie Mae and Freddie Mac were nationalized with a disbursement of over $200bn. The government also passed the Troubled Asset Relief Program (TARP) for a total value of $700bn, mostly to help smaller banks and restore access to credit. Oxford Economics estimates that the positive impact of monetary and fiscal stimulus on the US economy between September 2009 and the end of 2011 has been about 4.5% of GDP – that is, a very significant impact.

Other factors were at play in the economy, backed by expansive monetary and fiscal policies. The deleveraging of households, of financial corporations (the debt/GDP ratio for both sectors of the economy is now close to the level of 10 years ago) and to a lesser extent of non-financial corporations has been almost completed. In the meantime, the energy sector was also changing its structure, by adopting already available technology, now made cost efficient by high oil prices. The advent of shale gas and shale oil has allowed energy prices to fall significantly, supporting US industry competitiveness – and, along with moderate unit labor costs, it is one of the main reasons behind the recovery of US manufacturing output to pre-crisis levels. Even the construction industry, whose burst bubble had much responsibility in igniting the financial crisis, has now registered several quarters of dynamic sales for both new and existing homes.

Looking at the last five years, US policymakers adopted a  sequence of measures: unconventional monetary policy, rescue of key companies by the state, fiscal policy, deleveraging of household, financial and non-financial sectors, restoration of competitiveness through moderate energy and unit labor costs. Much of such policies led to increasing disequilibria in public finances, which were left as the last to be tackled. Whether deliberate or not, the American pragmatic problem-solving approach proved to be effective, and Europe should have a lot to learn from this “policy story”.

Unfortunately, the policy reaction in the Old Continent was far less upfront. To operate a single industrial policy for 27 member states appears to be a political nightmare. An example is the energy sector, where each country proceeds independently from the others. Investment, at historical lows and largely dependent on national-level decisions, uncoordinated tariffs, levies and taxes across member states, contradictory positions regarding exploration of shale gas as well as incentives for renewables, are all challenging exercises for the European Commission (EC).

More generally, and unlike in the US, the policy to be adopted to improve competitiveness was broadly left to each country (albeit within certain regulatory frameworks defined by the EC) to the point that already troubled Southern European countries have even seen their competitive position deteriorate and their real exchange rate re-value. Another consequence of the fragmentation of approaches across European countries is that the deleveraging of the household and banking sectors is still far from being achieved, with the debt/GDP ratios still as high as in 2009. As a result, some peripheral countries still represent a systemic (albeit tail) risk for the survival of the euro.

On the monetary policy front, the ECB has appeared to make the right decisions but with significant delays, creating a much longer credit crunch than necessary. After a few years in which it basically limited itself to lowering policy rates at a slow pace, it was only on May 10, 2010 that the Securities Markets Programme (SMP) was launched by the ECB. The SMP was followed in December 2011 by a new set of longer-term refinancing operations (LTROs) amounting to around EUR1trillion. Finally, the Outright Monetary Transactions (OMT) program was announced in September 2012, but it has never been activated, largely due to the circumstance that OMTs will only be approved if the beneficiary country has agreed to the conditionality attached to an EU/IMF lending program.

A comparison of the approaches followed by the Fed and ECB highlights that while the ECB has responded (with delay) to the crisis (SMP, LTRO and OMT), it has also worked to minimize its own risk, while the Fed opted to fill its portfolio with a large amount of toxic assets, in order to alleviate the banking sector positions. Some argue that in the euro area the situation was quite different to that in the US, given the additional concern created by the sovereign default risk of several peripheral member states. In May 2010, panic spread regarding a potential Greek insolvency, and the ECB Council decided to intervene in the sovereign bond market of troubled countries through the SMP, but we should ask ourselves whether the panic was also a consequence of its prior lack of intervention to tackle the Greek problem. While the ECB may have been idle, the answer to this broader question lies outside the ECB and at the heart of Europe’s current structure. Indeed, the ECB is constrained by its mandate. “The ECB’s unique status as the central bank of 17 sovereign countries prevents it from undertaking quantitative easing operations (…), because they would involve directly assuming the mutualization of risks and the possibility of making income transfers between such countries, without the acceptance or approval of their respective parliaments” (Malo de Molina, Director General of DG Economics).

In other words, one major lesson coming from the US is that the ECB should over time be turned into a true Central Bank, with the power to intervene on markets as the financial and economic situation requires. As mentioned above, the same lesson should be learnt for economic policy, currently much too fragmented across the continent to be effective. The time it will take Europe to implement a transition to unified (or at least coordinated) monetary and economic policies is of course dependent on how serious politicians of member countries, and ultimately the European voters, will maintain a unified Europe as a viable and common objective.

The opinions expressed in this article are those of the author and do not necessarily reflect those of Oxford Economics.