We Shouldn’t be Surprised by Signs of an Early European Recovery

A common American assumption has been that the US economy would recover earlier and faster than that of the European Union. Therefore, the preliminary results for the second quarter of 2009, which showed that Germany and France grew by 0.3 percent over the first quarter of 2009, delivered a surprise. Well, this should not have been a surprise. The most telling comparison is between the two big European economies, Germany and France, on the one hand, and the United States and the United Kingdom, on the other, as the United States and the United Kingdom are in similar economic situations.

1. The United States prides itself on the enactment this year of a great stimulus package. But how stimulating has it been? The most relevant measure of stimulus is probably the increase in the budget deficit as a share of GDP. Using the IMF forecast for 2009, the budget deficit as a share of GDP has increased from 2008 to 2009 by 2.8 percent in France and 4.6 percent in Germany, compared with 4.5 percent in the United Kingdom and 7.5 percent in the United States. The stimulus seems sufficient everywhere. Leszek Balcerowicz, the former governor of the National Bank of Poland and member of the board of directors of the Peterson Institute, has questioned whether a stimulus of more than 2–3 percent of GDP can be effective, arguing that worries about fiscal sustainability accompanying a large budget deficit are likely to restrain economic actors. This seems to have happened in Sweden in the crisis in 1992–93. Such concerns are currently rampant in the United States and United Kingdom. The quality of a stimulus depends on speed and multiplier effects. Social transfers have the advantage of providing immediate stimulus, and they are the dominant form of stimulus in Europe. Jacob Kirkegaard, my colleague here at the Peterson Institute, has particularly emphasized the importance of these natural stabilizers in Europe as social transfers rise with hardship. In the United States, by contrast, most of the stimulus package will be delivered in 2010 and 2011. The European natural stabilizers go predominantly directly to consumption supporting demand. While unemployment is rising to similar levels of 10 percent of the active labor force both in America and Europe, the jobless rate is likely to have a more negative impact on consumption in the United States with its much lower unemployment allowances.
2. Accounting for about 70 percent of GDP in Western economies, consumption is the main determinant of economic growth, and consumption is the main drawback faced by the American economy. In the United States, consumption fell by 1.8 percent in the second quarter of 2009 over the first quarter, while it increased by 0.7 percent in France. Two factors are now depressing consumption: rising saving rates and declining wealth. The low saving rates are largely an Anglo-American problem, as they had shrunk to 1–2 percent of disposable income in the United States and the United Kingdom. Now the household saving rate is rising in these countries and it has reached 6.2 percent of US disposable household income in May. In Germany, on the contrary, the saving rate has persistently lingered above 10 percent, and the French savings ratio is even higher at 15–16 percent of disposable household incomes. In both countries, the saving rate has remained constant and does not depress consumption. Another reflection of the differing saving rates is that the eurozone countries have much lower consumer debt levels than the United States and the United Kingdom, which means that the consumer retrenchment or deleveraging will be much less in the eurozone than in the United States and the United Kingdom. Presumably, the different development of the saving rate is the main explanation of the surprisingly good European performance.
3. In both the United States and the United Kingdom, real estate prices have fallen very substantially, reducing household wealth. The only other European countries that are facing such a problem are Ireland and Spain. Germany did not have any real estate boom in the last decade and consequently no bust or decline in housing prices. In France, the real estate rise and decline are limited. Moreover, stock ownership is much more common in the United States than in France or Germany, and French and German pensions are almost immune to changes in the stock market. Thus, the wealth effect on demand is almost nil in Germany and small in France, while it is substantial in both the United States and the United Kingdom. This is probably the second most important factor behind European resurgence.

Naturally, investment and foreign trade are also important, and they are the most cyclical factors influencing the economy. In general, Europe has higher investment rates than the United States and is more dependent on foreign trade. Both these factors should aggravate the business cycle in Europe. Yet, the countervailing savings and wealth effects are probably having the greatest impact at the present stage of the business cycle. Exports are now recovering around the world, and they will add more dynamism to the European economies than to the US economy, which has actually benefited from rising net exports while drawing down its current account deficit in the midst of the crisis. Exchange rate shifts are an important joker in the pack.

Thus, on the basis of natural stabilizers, savings development, and wealth effects, ceteris paribus, it would be natural for the US and UK economies to underperform for a couple of years.