Europe's flagging response to the financial crisis

Since the 1980s, many of the largest economies in the EU have developed unenviable reputations for protracted economic downturns followed by sluggish recoveries. The current downturn is set to repeat this pattern – in exaggerated form. There are two reasons. One is that Europeans have consistently underestimated the impact of the crisis on their economies. The other is that their willingness to push through supply-side reforms may be weakening. Many EU member-states could therefore end up suffering a steeper and more prolonged downturn than the US, and see a more sluggish recovery.

When the financial crisis erupted in 2007, many Europeans were quick to treat the event as a morality tale. Americans, they believed, were paying for their profligacy and for their heartless model of capitalism. Schadenfreude was sustained by the belief that the crisis would not significantly affect most EU countries – with the exception of American ‘outposts’ such as Britain. But the rapid deterioration in economic data has exposed the fallacy of this belief. Countries across the EU are now in recession. And Germany, which has been living within its means for years, is contracting even faster than the debt-laden ‘Anglosphere’.

Yet the macroeconomic policy response across much of Europe remains timid. True, the European Central Bank has cut interest rates by 275 basis points since October 2008. And all EU countries have adopted fiscal stimulus programmes. Some of these have been larger than is generally recognised: if welfare payments to the unemployed are included, Germany’s fiscal stimulus is one of the largest in the OECD. But the scale of the overall macroeconomic stimulus across the EU remains far smaller than in the US. And it is too modest to offset the likely decline in GDP (activity is set to contract by 3 per cent or more in 2009).

Europe’s economic prospects over the next two years will be determined by what happens on the demand side. Over the longer term, however, supply-side factors will be paramount. Since 2000, supply-side reforms across the EU have been guided by the Lisbon agenda – a wide-ranging programme to raise productivity and employment (the two key determinants of long-term growth). The CER’s latest Lisbon scorecard, which tracks progress on the agenda, concludes that while there are still wide variations in reform efforts across EU countries, there does seem to have been some convergence in the direction of reform.

But for how much longer? One risk is that the intellectual case for supply-side reforms may be more difficult to make following the financial crisis. The Lisbon agenda was, after all, a conscious attempt to inject US dynamism into European economies. Now, critics argue, the freewheeling model of US capitalism has been entirely discredited. The American model of lightly regulated finance caused the deepest global economic crisis since the 1930s – and the US’s economic performance has been exposed as a mirage. The lesson? Europeans have nothing to learn from the US and the Lisbon agenda should be ditched. It is not hard to see why such logic might be compelling to Europeans who have long feared that market liberalisation would weaken their cherished social welfare systems. But at a time when many people are reading American capitalism’s last rites, Europeans should be more judicious. The US was mistaken to have allowed parts of its financial sector to thrive with little or no regulatory oversight. But it does not follow that there is nothing in the US worth emulating. It is still one of the most productive economies in the world. And Europeans do not need more regulated labour markets than they already have.

Is there any evidence that the financial crisis has weakened governments’ commitment to supply-side reforms? It is not yet clear. Most continue to pay lip service to the Lisbon agenda. Many have even been submitting proposals to the Commission for renewing the agenda after 2010. But it is becoming harder to square some politicians’ denunciations of American capitalism with their continued support for a programme of market liberalisation. France’s President Nicolas Sarkozy, for example, has declared the end of laissez-faire. The crisis, he claims, signals “the return of the state and the end of the ideology of public powerlessness”.

Even if governments remain fully signed up to the Lisbon agenda in principle, the financial crisis is generating domestic pressures that many are finding hard to resist. To date, the most visible effects have been on the EU’s single market. The Commission has its work cut out to ensure that state rescues of ailing banks and car companies do not distort the single market. Banks are being leant upon by politicians to lend at home rather than abroad. And British workers have held wild cat strikes to protest against the use of foreign contract workers. Strains on the single market are likely to increase as economic activity contracts.

Weakening economies, allied to an increasingly tense social climate, are also likely to slow reform efforts within EU countries. Domestically weakened governments may still push through reforms in areas where the perceived political costs are low. Some of these measures – for example, cuts in non-wage labour costs – could even make long-term sense. But governments are unlikely to go out of their way to embrace reforms which might stoke opposition from special interest groups. They are likely, for example, to shy away from relaxing labour market legislation or from introducing more competition in services markets.

So EU governments risk making two mistakes. They are not doing enough to offset the current contraction in private sector spending. At the same time, some of their interventions on the supply side will do little to lift growth over the longer term – and could even lower it. If EU countries fail to adopt a better mix of macro- and micro-economic policies, they will suffer a worse recession than the US, take longer to recover, and will have a lower rate of long-term growth. Five years hence, talk of the crisis of US capitalism may sound distinctly dated.