Sick Europe and the Italian Elections

The elections in Italy prompted another round of knowing comments about how Europeans must get over their silly attachment to employment security (e.g. “Europe Stalls on Road to Economic Change”). None of the comments I saw even considered the possibility that the contractionary policies of the European Central Bank (ECB) play any role in Europe’s economic weakness.

The basic story here is fairly simple. While Alan Greenspan lowered the overnight interest rate in the United States to 1.0 percent in the summer of 2003, the ECB never lowered its overnight rate below 2.0 percent. This is in spite of the fact that inflation in the euro zone has been the same or lower than in the United States and the euro zone has consistently had higher rates of unemployment. The story does get more complicated (the Fed’s overnight rate is now 4.75 percent, compared to 2.5 percent in the euro zone), but I would argue that the ECB has consistently been more contractionary than the Fed in its policies. Everyone recognizes that the Fed can stimulate the economy with low interest rates and slow growth with high interest rates, why don’t we think that the European economy works the same way?

It is striking how commentators can make seemingly contradictory claims about Europe’s dire fate with great confidence. The basic story is that Europe’s high wages and labor market protections lead to high unemployment. This is crisis # 1 – too many workers.

Then we find crisis # 2 on the horizon, a surge in the ratio of retirees to workers, which is compounded by Europe’s slow population growth. The essence of crisis #2 is not enough workers. There are economists who will try to rationalize this picture to explain how Europe will be in crisis from both too much unemployment, while also suffering from a labor shortage, but on its face this does seem to be a stretch. (The link runs through high labor taxes discouraging work. The problem with the story is that after-tax wages, not labor taxes, determine willingness to work. The impact of high before tax wages, caused by the labor shortage, should swamp the impact of higher taxes.) In other words, the Europe critics seem to be telling completely contradictory scare stories, without even recognizing this fact.

There is another scare story that some of us have been telling that the Europe critics have largely ignored. This is about the imbalances created by housing bubbles. The United States is just one of several countries that are experiencing inflated housing prices. It is hard to gage how much of the run-up is justified and how much is due to irrational exuberance without some very careful country by country analysis, which I have not done. (For example, Ireland has had among the sharpest run-ups, but it has gone from being a relatively poor European country to ranking among the richest in the last two decades.)

However, the imbalances created by bubbles are easier to recognize. These show up in low domestic savings rates and high current account deficits. The countries that stand out on this list are the United States and Spain, with current account deficits of more than 6.0 percent of GDP, and New Zealand with a deficit of more than 9.0 percent of GDP. These deficits are unsustainable, as virtually all economists agree. The adjustments from large current account deficits to manageable deficits are almost always painful. Typically the adjustment is associated with rising inflation, and then high unemployment as central banks raise interest rates to stop inflation. (Think of increasing annual tax revenue and/or cutting government spending in the United States by $600 billion – the order of pain is comparable.)

The countries on which the Europe critics focus their wrath (France, Italy, and Germany) have small current account deficits or surpluses, meaning they don’t face the painful adjustments that loom for the Spain, the United States, and New Zealand. This means that when the adjustments actually occur, we may have a different assessment of which countries’ economies look good and which ones look bad. Until then, we will have to listen to many more tirades from the Europe critics, whose voices go virtually unanswered in the media.