TCS Daily

Europe's Economy in the Eye of a Storm

By Desmond Lachman - March 1, 2005 12:00 AM

One has to pity the European economy. Not only is it riddled with well-known structural rigidities that depress Europe's long-run economic growth potential. It is also saddled with a macro-economic policy straightjacket that makes it difficult to use policy to cushion the economy from demand and supply shocks. In normal times, this lack of policy flexibility would not be of much moment. However, in today's world of unprecedented global payment imbalances and highly unstable oil prices, it has to be a matter for serious concern.

The contrast between the United States and Europe in terms of macro-economic policy flexibility could not be starker. Whereas the US Federal Reserve is not bound by any explicit inflation target and is enjoined by the Humphrey-Hawkins Bill to simultaneously aim at full employment, price stability, and economic growth, the European Central Bank is mandated to aim at price stability alone. The ECB chooses to do so by rigidly aiming at keeping headline inflation at close to 2 percent.

Similarly, whereas there are no legislative constraints on the US government's room for fiscal policy maneuver, the individual member government's of the European Union are bound by the Fiscal Stability Pact to aim at keeping their budget deficits from exceeding 3 percent of GDP. This is true irrespective of the state of the economic cycle, which encourages a pro-cyclical fiscal policy at a time of economic weakness.

Recent experience underlines the advantages of US policy flexibility. In the wake of the stock market meltdown in early 2000 and the events of September 11, 2001, the Federal Reserve cut interest rates by 550 basis points over an eighteen-month period. At the same time, the budget was allowed to move from a 2 percent of GDP in 2000 surplus to a 3 ½ percent of GDP deficit by 2004, thereby providing the economy with additional large-scale policy stimulus. Absent such massive policy stimulus, there can be little doubt that the US economy would have experienced the same sort of recession that has accompanied the bursting of asset price bubbles in other countries.

In the period ahead, the lack of policy flexibility in Europe could weigh heavily upon the European economy, as it is likely to have to simultaneously confront two distinct external shocks. The first of these shocks could arise from the needed halving of the US external current account deficit from its present level of around 6 percent of GDP to a more sustainable 3 percent of GDP. The second of these shocks could occur from an international oil price remaining well in excess of US$40 a barrel as a consequence of continued Middle-East instability.

As the US external current account deficit adjusts, the rest of the world will have to live with lesser exports and greater imports than before. This will be true irrespective of whether the US external adjustment is effected through a further depreciation of the dollar or through a correction of the US budget deficit, as many European policymakers would seem to prefer.

In a world where the US adjustment were evenly spread amongst countries, the fact that the US accounts for about one quarter of world output would imply that Europe's external accounts would have to weaken by around 1 percentage point of GDP. However, in a world where many Asian countries actively pursue policies that thwart external adjustment, Europe's economy could be subjected to an external shock well in excess of 1 percentage point of GDP.

A large shock to the European economy emanating from the US external adjustment would be particularly unfortunate at this juncture, since exports have been the dominant engine of European growth. It would also not help that such a shock would be coinciding with high international oil prices that must be expected to sap vitality from European consumer demand.

In view of the likely external shock to which the European economy will be subjected in the period ahead, the question must be asked whether Europe can afford both the straightjacket of the Fiscal Stability Pact and a monetary policy that is backward looking and solely focused on a headline inflation target.

One might well ask whether a Fiscal Stability Pact that at least took into account the state of the economic cycle in setting fiscal policy targets would not serve Europe better? More importantly, one might ask whether the ECB should not be taking a leaf out of the Federal Reserve's book and be more pre-emptive in setting monetary policy? Should the ECB not do so with the explicit goal of supporting economic growth at a time of anticipated weakness, while still aiming at keeping core inflation well contained?

The author is Resident Fellow at the American Enterprise Institute.


TCS Daily Archives