The EU, the US and the Great Recession

Are we coming out of the Great Recession of 2008-10? On the face of it, the news is positive: there are signs of renewed health in France, Germany and Japan - and though the UK, Spain and the USA are still in bad shape, most pundits are optimistic that they too will soon recover.

Rapid action by the Fed and the Bank of England (BoE) in 2007-08 prevented what might have been a banking crisis from turning into a global financial collapse. Banks 'too large to fail' were effectively underwritten by governments, and a combination of monetary and fiscal instruments was used to stop the Great Recession from becoming something far worse.

China, by bucking the economic trend and growing at nearly 8% annually this year, may not yet be the engine of the world economy, but it is emerging as a major player.

Monetary policy complements fiscal

The US has led the pack in producing a huge fiscal stimulus package worth about 6% of GDP (although spread out over several years). If Keynes has been vindicated, so too, it would appear, has Milton Freidman.

Ben Bernanke in at the Fed and his UK counterpart, Mervyn King, have concocted powerful and sophisticated remedies, injecting liquidity into the market and buying gilts to push down long-term interest rates (ie, quantitative easing). They have done so sufficiently quickly to prevent meltdown.

Even Monsieur Trichet has convinced his colleagues at the ECB of the need to loosen the monetary strings by cutting base rate to 1% in June 2009 and flooding the market with €440bn in August. Ironically, while the ECB was far less pro-active than it might have been, the signs are that it is the Eurozone which will recover first, before the US and the UK.

Why this apparent paradox? Perhaps it is because the Eurozone economies were less financially vulnerable and industrially stronger than their Anglo-Saxon cousins. But it is early days yet, and a fraction of a percentage of growth during the last quarter does not guarantee that the Eurozone will soon be bounding along at 3-4% per year. Indeed, such a result would be little short of miraculous given the abysmal growth record of the core Eurozone countries over the past decade.

What would Keynes have thought?

One wonders how Keynes himself would have viewed the current situation. Doubtless he would have favoured the rapid reaction of the Fed and the BoE to the threat of financial collapse.

One may rue the fact that more has not been done to support house buyers, small business people or workers on the dole - but had the banking system collapsed, the worldwide impact would have been nothing short of catastrophic.

Quantitative easing, too, would have found favour with Keynes who insisted that only by fully loosening monetary policy could fiscal policy be rendered truly effective (arguably, a point ignored in Japan until relatively recently.)

So too would de Larosiere-style regulation, as indeed the massive fiscal impulse given to aggregate demand by policy makers in the US and China. But Keynes would have paused to remind us - as Richard Koo's recent book does - that, like banks, firms and households first deleverage and restore the health of their own accounts before embarking on a new spending spree.

Indeed, Keynes might have argued that it will be some years before consumers spend at the same pre-recession rate and that, in consequence, private investors may take some years to invest massively in production capacity.

It is perhaps too easily forgotten that the main lesson of the 1930s was that it took rearmament and a major war to get the advanced economies moving again.

The real Keynesian lesson

The main Keynesian lesson is, after all, not about the details of fiscal fine tuning and the lags involved - it is quite simply that when capitalists stop investing for a prolonged period, it is the State which must take up the slack.

And today, just as in the 1930s, there is no shortage of productive state investment opportunities. Simply to meet the 2020 carbon emission targets will require a Herculean effort: new energy sources must be exploited; the housing stock must be insulated; transport infrastructure must be modernised; and the private motor car must either be made greatly more efficient or else banished altogether.

The list goes on; it certainly cannot be argued that the private sector left to its own devices will green the planet - the State's role is arguably more vital to securing our survival today than it was 80 years ago.

From recession to stagnation

Moreover, despite some recent goods news about the current recession, the large OECD economies are far from being on the path to vigorous growth.

Two pessimistic scenarios are possible: either the recovery will be W-shaped (a second dip will take place), or else we shall experience a Japanese style 'recovery', namely, two decades of near-zero growth.

Consider the US data - and bear in mind that it is still the locomotive of the world economy. Even if the US recession ended in the fourth quarter of 2009, (09,Q4) it would be the deepest recession since the 1930s.

US job losses which in 2007 averaged 150,000 per month are currently at twice that level and unemployment is forecast to top 10% in late 2009. And although the 'auto scrappage' scheme has apparently been of benefit, it will soon come to an end.

Looking beyond 09/Q3, the outlook for consumption hinges on the strength of the labour market and its ability to support real income growth.

The picture is not encouraging as the accompanying figure makes clear. US net disposable income has declined dramatically. Corporate 'downsizing', unemployment growth and stagnant real wages will prolong this trend, as will the fact that US households - which until recently spent more than they earned - are rebuilding their savings. Moreover, the value of real estate (households' main store of wealth) continues to decline and house repossessions mount. Private spending will not soon return to its pre-recession levels.

Thanks to the Euro, but no thanks to our politicians

In the EU, we can be thankful for the Eurozone. It has protected the weakest from an Icelandic-style run on the currency - think of what might have happened to the punt, peseta or the drachma were we still in a pre-EMU world.

Most importantly, is has protected Europeans from a repeat of the competitive devaluations of the 1930s.

Unlike the 1930s when successive rounds of devaluation were the result of government policy, this time they would have been induced by market expectations - as in the case of the UK where sterling took a far bigger hit in 2008 than in 1992.

That's the good news. The bad news for the EU is that its political class appears to have learned very little from the recession. While German's Peer Steinbrueck is right today in calling for salary caps on bonuses and greater prudential regulation, his statement in late 2008 that an 'economic rescue packages … that would saddle a generation with debt' came straight from the neo-liberal hymn sheet; similarly, Angela Merkel has steadfastly ignored Sarkozy's appeal for rethinking the economic governance of the Eurozone.

Changing the structure of Eurozone governance

The Stability and Growth Pact (even in its new clothes) is now dead.

It should be patently obvious that 'automatic fiscal stabilisers' operating at member-state level plus the 'broad policy guidelines' are not strong enough to counter world-wide financial collapse or prolonged OECD-wide recession.

The belief that micro-policies alone (competition, flexible labour markets) suffice to boost Eurozone productivity is ill-founded.

The Eurozone needs a massive package of infrastructure investment to become truly green, modern and competitive. Anchoring Eurozone governance to a single supranational pillar, the ECB, is no substitute for European economic governance which features a Federal Treasury.

A Eurozone Treasury - instead of deploying a small budget to be balanced annually in the best tradition of the corner grocer's shop - would have a genuine budget equivalent to 4-5% of combined GDP, the power to spend it counter-cyclically, the power to tax member states progressively and to issue Euro-Treasury bonds; in short, it would act in a similar way to the Federal Treasury in the United States.

Just as it is inconceivable that the US could emerge from recession without both a Central Bank and a Treasury, so it is with the Eurozone. And while we're at it, why not have a basic Eurozone state pension so that citizens can feel that the EU really benefits them?

If the Eurozone countries miss this opportunity to redesign their economic governance, they will have learned nothing from the Great Recession. Indeed, the Great Recession may well return to haunt us all.

The writer is Research Professor at the University of London, SOAS (george@irvin.com)