European Affairs

This gap between the economic fundamentals and the market's expectations, which on some levels is probably at its widest since the Great Depression of the 1930s, will not persist indefinitely. As 2003 unfolds, the gap will close.

But the billion-dollar question is which will yield - stock markets, by rallying, or the economic fundamentals, by deteriorating? Normally, one would expect it to be the markets: It is generally the economic fundamentals, rather than markets, that drive economic performance.

These are not, however, normal times. The fall in stock markets has sharply reduced wealth, which tends to depress expenditure. In addition to this direct effect, plunging stock markets can also reduce spending by damaging consumer and business confidence. Such effects can on occasion be savage, reaching a threshold point at which confidence crumbles. Thus, there is a risk that plunging markets bring about the very recession that they fear.

This scenario is on the minds of investors everywhere - in the United States, Europe and Asia alike. But equally on their minds is that, while the U.S. authorities have taken major action to reduce its likelihood by stimulating their economy, Europe has done much less. There is a widely expressed fear that Europe's policymakers have failed to take out the necessary macroeconomic insurance - that they are "behind the curve."

To be fair, there are things that can be said in favor of Europe's policy stance. First, the excessive investment and stock market boom from which markets are now reeling was more a U.S. than a European affair. But if investors had confidence in Europe, its stock markets should have held up, rather than falling in line with - and in some cases more than - stock prices in the United States.

Second, the two major hits to confidence, the terrorist attacks of September 11 and the corporate governance scandals, were also principally U.S. events. But again, their consequences were not confined to the United States. They were transmitted, with disturbing speed and virulence, to Europe, where business fixed investment, in particular, nose-dived.

One of the main reasons why investors have punished Europe more than might seem warranted by these shocks emanating from the United States is that they are contrasting how differently policymakers have reacted on the two sides of the Atlantic.

As a result of a mixture of good management and good fortune, the United States has, through monetary and fiscal means, stimulated its economy by 3.5 to four percent of GDP over the last year or so. And the U.S. consumer has responded strongly to this encouragement, acting as spender of last resort not just for the world's largest economy, but also for the world as whole.

U.S. equity markets, however, have not responded to this policy stimulus with anything like the same enthusiasm. So, with U.S. personal sector balance sheets increasingly exposed to the downdraft of ever-lower stock prices and wealth, and the impact of some of the macroeconomic stimulus now beginning to wane, there is a risk that the U.S. economy could yet slide back into recession.

A slowdown in the U.S. economy would inevitably have an impact on Europe. So investors look with concern at the stance of macroeconomic policy in Europe, which, by contrast with the United States, has delivered only about a quarter as much stimulus - and all on the monetary side through interest rate cuts by the European Central Bank.

That may indeed prove sufficient to ensure that the European economy grows satisfactorily next year; but the concern expressed widely throughout the investor community is that Europe is wide open to damage from any subsequent shocks to confidence, whether originating at home or transmitted from abroad.

Now of course the reasons for keeping Europe's macroeconomic policy on a steady course are well rehearsed. On the monetary policy side, the ECB is charged only with ensuring price stability: concern with growth is not part of its mandate.

Admittedly, the Bank has been prepared to allow its conservative 2 percent inflation target to be exceeded: but only by half a percentage point and only after a protracted period when inflation was below target. Two basic questions are therefore being asked about the ECB's judgment.

The first, a technical one, concerns the interest rate that is consistent with inflation control. The ECB clearly considers that, until European governments make further progress with structural reform, particularly in the areas of labor market and social policies, faster economic growth would push inflation unacceptably higher.

But many investors consider - and this is supported by research - that the ECB is underestimating the progress that has already been made with structural reform in Europe. Research conducted by Lehman Brothers suggests, for example, that the ECB could safely reduce interest rates by up to 50 basis points (0.5 percentage points) without jeopardizing the achievement of its inflation target, and at least some investors share this view.

Second, and more compelling for many investors, is the insurance argument. Shocks to confidence, especially in a troubled environment such as the present, can hit suddenly and hard, leading firms and consumers sharply to reduce their expenditure. Although it is clearly a value judgment, most investors would, in today's environment, prefer to see the ECB err on the side of supporting growth further, even at the risk of somewhat higher inflation, as an insurance policy against unexpectedly weak growth.

Similarly most investors, in comparing recent U.S. and European fiscal policymaking, consider that Europe is displaying an inertia that looks out of synch with global risks. Admittedly, here too, there are arguments for caution. Budget deficits do matter, especially during periods of high resource utilization. They crowd out private sector expenditure and push up market interest rates.

Over the last two decades, each one percent of GDP increase in the public debt raised 10-year bond yields significantly, perhaps by around 80 basis points for the typical G7 economy. Certainly, therefore, the euro area cannot afford to be complacent about its public debt, which as a proportion of GDP is some 12 points higher than in the United States.

So the basic idea of the European Union's Maastricht Treaty, and of its successor, the Stability and Growth Pact, clearly makes sense. The aim is to constrain spendthrift politicians from gaining political advantage by ramping up government expenditure, leaving their successors to clean up the mess.

If, however, deficit limitation goes so far as to constrain the automatic widening of the deficit in times of weak economic activity, fiscal policy becomes pro-cyclical, amplifying rather than diminishing the slowdown. The Great Depression is the notorious example.

On the face of it, the deficit limit of three percent of GDP imposed by the Stability and Growth Pact seemed wide enough to avoid fiscal policy becoming pro-cyclical. But that limit presupposed that countries would have gotten their deficits into balance before the first post-Pact recession arrived.

In the event, the continuing costs of German unification and the persistent lack of dynamism in

Europe have helped to keep the major European countries in deficit. As a result, the full margin originally envisaged (between a zero deficit and one of three percent of GDP) has not been available to them. So the pressure, in Germany especially, to push ahead with deficit limitation despite the economic slowdown is seen by nearly all investors as unwise.

It would be sensible to suspend the Pact's three percent limit until durable growth has self-evidently recommenced, and only then to resume deficit reduction - preferably in a framework of cyclically adjusted figures. The cyclically adjusted European deficit of between one and two percent of GDP is not a disaster and is no greater than the likely U.S. figure.

Paradoxically, however, the U.S. figure is attracting less attention because the United States has no statutory limitation on its deficit. Certainly investors are not currently punishing the U.S. bond market for what has been a very sharp swing in the U.S. fiscal position.

In short, while it is the prerogative of a country's policymakers to decide where to draw the key economic tradeoff between growth and inflation, as well as the balance between expenditure and taxation, investors are questioning whether Europe's institutional policy framework, as well as the mindset of its policymakers, are appropriately framed to deal in a timely manner with a serious crisis of confidence, should that eventuate.

In addition, however, there is increasing talk of what is seen, in the United States at least, as an element of hypocrisy in European policymaking, which is souring already-strained Transatlantic relations. European policymakers perennially talk disapprovingly of America's large current account deficit, now at nearly five percent of GDP, and contrast it unfavorably with Europe's balanced position.

But they make considerably less play of the benefit that Europe has reaped from booming exports to the United States. Had the United States not had such surging imports and quiescent exports, Europe would have grown significantly more slowly, and its unemployment would have been higher.

European policymakers argue that the U.S. current account deficit cannot carry on indefinitely, and, if history is any guide, they are right. There is scarcely an investor who doubts that there will come a point, some day, when the market will, through marking down the dollar, lead the United States to import less and export more. This will indeed help to redress the U.S. current account position.

But much of the counterpart to that adjustment will be seen in Europe, which will thereby import more and export less. When this happens then, unless Europe's domestic demand accelerates significantly, Europe risks being pushed into yet slower growth, if not outright recession.

In the minds of most investors, therefore, Europe is not setting its macroeconomic policy appropriately in the light of prevailing risks. They see Europe as too preoccupied with inflation, at the expense of growth; they fear that it has not taken out enough insurance against a possible further downturn in business and consumer confidence; and they worry about an over-dependence on exports to the United States. It is hardly surprising, therefore, that they are punishing Europe's markets at least as severely as they are punishing those in the United States.


This article was published in European Affairs: Volume number III, Issue number IV in the Fall of 2002.