Economics usually doesn’t involve experiments, but world events occasionally create them. This happened after the global financial debacle began to unfold in 2007, as the United States and the European Union responded very differently to the ensuing recession. Data on the relative success of the two approaches now indicates that our country’s approach had better results. But as is always the case in economics, that conclusion has some qualifications.
First, let’s review what happened. A perfect storm of factors motivated excessive risk taking by financial firms, especially in mortgage lending and in trading of derivative securities. Cracks began to occur in mid-August 2007, when commercial paper markets seized up in Europe. The European Central Bank and U.S. Federal Reserve both felt compelled to pump in tens of billions of dollars over a few days.
The size of the problem became increasingly apparent, the general public took little notice (unless one was trying to buy or sell a home) until Wall Street bank Bear Stearns went bust in March 2008. From then things deteriorated rapidly until a crisis blew up in early fall, with Lehman Brothers seeking bankruptcy Sept. 15. The Fed had to intervene to prop up several financial firms, including AIG, one of the world’s largest insurers and the Troubled Asset Relief Program, or TARP, was formed.
On Main Street, credit and mortgage markets dried up; people who lost jobs or otherwise couldn’t pay their mortgages found out they were “underwater,” owing more on the mortgage than their property was worth as collateral. Mass foreclosures ensued, putting even greater pressures on housing prices.
The Bush administration went to Congress for an appropriation of funds for bailouts and included about $280 billion in economic stimulus funds in the fiscal year 2009 budget. Once Barack Obama was inaugurated president, he asked Congress to approve the second half of the TARP bailout funds requested by Bush and an additional $789 billion in stimulus, of which some 35 percent was in the form of temporary tax reductions, mostly for individuals. Although Obama’s inauguration took place four months into the fiscal year, measures he requested contributed about $240 billion to a record $1.4 trillion deficit that year.
At the same time, the Federal Reserve increased the monetary base by record amounts, pushing its targeted short-term interest rate down to a mere quarter point. Later, in its quantitative easing program, the Fed added additional money beyond that required to keep interest rates near zero.
Europe, however, reacted differently. Officials there insisted at first that this was strictly a U.S. problem and that European financial institutions and economic policies were sound. It was soon apparent that was not true and, with a several-month lag, Europe followed the United States into a financial institution crisis and economic recession.
In both areas, output and employment both fell sharply. But the European Central Bank, which conducts monetary policy for the 19 EU nations that use the common currency, hesitated to increase the money supply and lower interest rates, as the U.S. Fed did. It’s increase in liquidity was more limited. The same was true for the Bank of England, representing the largest EU economy still outside the euro system.
In fiscal matters, there was a move to austerity, cutting spending and, in some nations, increasing taxes, to limit budget deficits driven by recession. There were increases in deficits for many. Two nations, Ireland and Spain, that had followed very prudent fiscal policies until then, ballooned their national debts through huge outlays to bail out their banks. Greece, the perpetual economic sick man of Europe, approached default.
See the sharp contrast? The United States reacted to a financial crisis and resulting recession with expansionary monetary policy and, at least initially, a sharp increase in the federal deficit, although state spending shrank. Europe worked to protect itself against government deficits by expanding its money supply much less and promoting a much more austere fiscal policy.
Which was the better approach? Time now provides us with an excellent real-world economics lab.
In our country, real gross domestic product, the inflation-adjusted value of output, hit a high in the first quarter of 2008, just as things were starting to fall apart on Wall Street. GDP fell about 5 percent over the next year but then started to inch back up and passed the 2008 peak in the first quarter of 2011. Now it is about 10 percent above that earlier crest and near 15 percent above the 2009 trough.
In Europe, recovery was much slower. EU real output as a whole just last month finally got back to where it was at the high in 2008. In other words, its recovery has lagged the United States by five years and total lost production far exceeded the U.S. over the eight years.
Looking at unemployment, the picture is similar. In both areas, it started to rise as problems unfolded in 2008, but in the United States it rose more steeply. It topped at 10 percent in the U.S. in late 2009 but has declined steadily since then. Europe’s rise lagged but persisted longer, not peaking at 10.9 percent until the spring of 2013. By then, our country was down to 7.5 percent unemployment. Now we are at 5.4 percent nationally, and Europe still at 9.6 percent. Numbers of jobs, as opposed to the unemployment rate, follow a similar pattern.
The obvious lesson seems to be that stimulus is a better response to financial crisis and recession than fiscal and monetary austerity. Liberal Keynesian economists like Paul Krugman and Brad Delong are hammering this point, as is ex-Minneapolis Fed President Narayana Kocherlakota, who calls for even greater money expansion in the U.S. coupled with larger stimulus spending by Congress.
So are the “anti-Austerians” like Krugman correct? My view is that generally they are, although I am much more skeptical about the efficacy of even looser money than is Kocherlakota. And to the degree that I am a Keynesian at all, I am much more cautious than Krugman.
One does not have to believe in Keynesian economic management, however, to favor the general approach of the United States. The actions of the Bush administration and Fed of 2008 seemed more out of pragmatic scrambling for responses than deliberative economic theory.
No matter what school of thought they belong to, most economists believe a central bank should never let the money supply collapse the way the Fed did from 1929 to 1933. And it should not let an economy fall into deflation. Similarly, even if skeptical about fiscal activism, most economists recognize that major downturns in government outlays during recessions tend to make the recessions worse. The austerity approach doesn’t look particularly good right now.
But this general conclusion needs some qualification.
Presidential candidates Donald Trump’s and Bernie Sanders’ populist successes reflect, in part, a broadly-held feeling that the economy has not improved at all for many, if not most, Americans. They are right. Most of the gain in national income over the past seven years has gone to a very small fraction at the top of the income scale. Most households are not much better off, if at all. The one saving grace is low to nonexistent inflation.
In Europe, the 28-member EU has not recovered nearly as well as our country. Nor is the 19-nation Eurozone. But Germany, the champion of austerity and itself running a budget surplus, is doing very well, with unemployment below that of the United States.
Income distribution is a long-term problem, but it is still better to be producing 15 percent more goods and services than eight years ago and to have low unemployment. In Europe, differences between nations is the greater problem. But both these issues are complex enough to merit their own columns.