As if the diplomatic spat over Iraq weren't bad enough, relations between the US and Europe are being slowly poisoned by divergent economic policies. Indeed, the differences between the two sides' economic strategies are as sharp as they have been in two decades.
At first glance, the depth of this "policy gap" seems surprising. The economic outlook for the rest of this year and for next has improved recently both in the US and Europe. Moreover, the US and Europe face a similar challenge: encouraging economic recovery. But their governments' actions -- or lack of action -- make it seem as if neither side can see the problems faced by the other.
When the euro was introduced, most EU members -- Germany, in particular -- looked forward to managing their economic policies with more autonomy and less US pressure. Thus, today's framework, with its unique mix of joint monetary policy and national responsibility for fiscal policy, was not constructed to facilitate macroeconomic coordination with the US.
But the perception of many American observers was different. They saw the central implication of the euro as requiring Europe to junk its supposed role as a "free rider" in the international economy, one that left the US shouldering the burden of policy adjustments to promote global growth. Europe would inevitably be forced to coordinate its policies with America.
These two views were on a head-on collision course, and now they've stuck. Tensions hidden during the long Clinton-era boom rose throughout 2001, when America tried to address its economic downturn by rapidly easing its monetary and fiscal policies. As big budget deficits returned, so did European skepticism about the sustainability of America's mounting external deficit and the overvalued dollar.
American critics, meanwhile, saw the euro area as overly cautious for cutting interest rates slowly and maintaining the fiscal constraints of the Stability and Growth Pact. Initially, the Europeans underestimated the slowdown they confronted. Subsequently, they were constrained by the limits to their fiscal reactions embodied in the Maastricht Treaty; the large economies of Continental Europe had not done enough budgetary consolidation during the years of good growth. Both monetary and fiscal policies facilitated growth, but Europe did not help much to redress America's external imbalance.
Of course, area that uses the euro is so large that it can no longer deny some responsibility for stimulating global growth. But US efforts to encourage Europeans to adopt their pragmatic and discretionary approach to economic policy inevitably lead to frustration: the issues confronting the European economies are different from those facing the US -- as are perceptions about the challenges.
In fact, the main reasons for the massive swing in US public finances -- from surplus in 2000 to a deficit of more than 4 percent in for this fiscal year -- have little to do with stabilization. Aside from the costs of the Iraq war and other security concerns, along with lapses in earlier spending controls, US tax cuts have structural and distributional rather than short-term aims. A short-term stimulus would not have bestowed the largest benefits upon the most affluent, whose spending is less sensitive to taxes.
The cuts should sustain private demand this year and next, but at the cost of postponing improvements in private saving and indebtedness. Although the dollar has been depreciating for a year, continuing growth in US demand, the current account deficit will likely remain above 5 percent of GDP. As the deficit widens, dollar depreciation will likely resume, despite laggard performances by the world's other major economies.
Will the US accept a prolonged slowdown after next year, and could Europe make a greater contribution to global growth? Probably not. The counterpart to the US emphasis on self-reliance rather than direct public assistance is that employment must be maintained at high levels -- regardless of the party in power -- whereas most European countries have been prepared to accept unemployment rates of 8 percent or more. So the US is likely to opt for growth.
Despite three years of weak growth, the gap between potential and actual output in Continental Europe's largest economies is currently smaller than in the US. Income tax cuts to stimulate demand for labor and investment are desirable, given high rates in Europe's largest economies.
But tax cuts that must soon be reversed -- due mainly to demographic pressure on public pensions and healthcare -- are unlikely to stimulate demand as consumers lose confidence in government's ability to control deficits. Europe needs structural reforms and tighter fiscal management, not inflation.
The EU is finally accelerating its implementation of structural reforms, but the starting point has become less favorable and political resistance too entrenched, as illustrated by the recent conflicts over reforms of French pensions and the German labor market. Continued dollar depreciation as well as slower US growth would undermine EU exports, the one relatively successful component of demand in Europe.
The divergence in policy and its time horizon will be papered over by the improved outlook for growth in both Europe and the US for the next year or so. But the medium-term outlook is one of transatlantic confrontation, potentially as divisive as the disputes over the Iraq war.
If so, the ongoing Doha round of international trade negotiations could be first to suffer. Protectionism will be harder to resist on both sides of the Atlantic. The US cannot afford a continuing massive drain of demand through an external deficit, while complaints about loss of competitiveness will intensify in the EU. It strains the imagination to think that the coming macroeconomic confrontation could subside quickly or quietly.
Niels Thygesen is professor of international economics at the University of Copenhagen and a member of the Center for European Policy Studies Policy Group in Brussels.
Copyright: Project Syndicate
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