Previewing Obama's European Trip #2: U.S.–European Economic Relations

Note: Even though the economy will be only one point on the crowded agenda for the November 20 U.S.-EU Summit, the meeting will take place at a crucial moment for policy coordination. While discordant exit strategies from the crisis and the U.S. choice for aggressive monetary stimulus will be on the table at the G-20 Summit in Seoul on November 11 and at other fora, the divergent approaches also open a very specific rift between Europe and the United States that needs to be discussed in Lisbon.

The golden age of transatlantic economic cooperation: 2008-2009

The U.S.-EU Summit in Lisbon will take place in what is widely considered a period of tension in global economic policy coordination, including between Europe and the U.S. The slowdown of the American economy in the last six months, the shift towards a very stimulative monetary policy (especially through quantitative easing to increase money supply) and the related weakening of the dollar are calling into question the basis of international coordination in exiting the crisis.

Current macroeconomic divergences between the EU and the U.S. are particularly evident against the background of intense policy cooperation that characterized the response to the global financial crisis in the fall of 2008 and the following months. Assessments of transatlantic policy coordination commonly identify the 12 months after the Lehman crisis as a ‘golden age’ of transatlantic cooperation. During this period, it was clearly acknowledged in the U.S. and Europe that interdependencies were too large for national or regional policies to be optimal unless international spillovers were taken into account. Strengthening global governance became a real emergency, especially in the financial field. The role of multilateral institutions and relations was openly acknowledged by the U.S. and by the EU. At the peak of the crisis there were concerns that recent progress in trade liberalization and integration might be stalled or even reversed, but any significant outbreak of protectionism has been hitherto avoided in transatlantic trade.

Monetary policy cooperation reached a high watermark in the fall of 2008 when coordinated interest rate cuts were enacted, bank deposit guarantees were harmonized, liquidity and capital were rapidly made available to the banking systems and other financial institutions. Information sharing among central banks was intensified through the Global Economy meetings of governors and various other Basel and Bank for International Settlements (BIS) committees. During the liquidity crisis a relevant role was played by the network of temporary currency swaps or repos set up bilaterally by the European Central Bank (ECB) and the Federal Reserve, which has since involved other central banks around the world.

Economic cooperation also benefitted from positive institutional developments that launched a new age in global governance. By the time G20 leaders met in London in April 2009, coordinated monetary and financial responses were accompanied by a convergent analysis on the need for fiscal stimulus. This approach, which took into account Government expenditure for automatic stabilizers, was not that different on the two sides of the Atlantic.

The marked deterioration of Transatlantic cooperation: late 2009 to present

The agreement on economic policies has weakened markedly since late 2009 and worsened further in 2010. In contrast to the American position of sustained fiscal stimulus, the Europeans have put emphasis on the need to consolidate public finances. The difference in the policy agendas became particularly visible at the Toronto G20 Summit in June 2010. Further significant divergences emerged in the conduct of monetary policy. Divergent policies can be acceptable, or even desirable, when the fundamental conditions of the economies are themselves divergent. However, policies still need to be coordinated and made consistent with medium term balancing, if only to avoid uncertainty and the resulting severe market reactions. Currently the U.S. suffers from a more sizable slack and a wider structural current account imbalance (and thus deficit) than Europe, where the current account is nearly balanced (notwithstanding wide variations within the group of countries). Policy stimulus is therefore seen as more necessary in the U.S. than in Europe, but it is also potentially more conducive to external imbalances.

Europeans are much more determined to restore monetary and fiscal discipline, fearing that injecting macro-economic stimulus by increasing liquidity and deficits would further destabilize the economy. Americans, on the other hand, seem to be less concerned by the longer-term risk of delaying an exit from stimulus policies and are relying heavily on extraordinary monetary easing. Policy divergences like these may have serious consequences, and they are already impacting the stability of the euro-dollar exchange rate and may ultimately affect the efficacy of economic policies in both areas.

Since the deficit is currently twice as high in the U.S. as in the EU, Americans expect much of the stimulus to come from U.S. monetary policy. In fact, the Federal Reserve has repeatedly been in favor of extending credit easing, while the ECB has shown concern about the need to reign in the exceptional accommodative measures of the past months. Market expectations for different monetary policy measures brought about significant swings in the euro-dollar exchange rate: in 2009 the dollar depreciated by 20 percent between June 6 (when it was 1.1917) and November 4 (when it was 1.4216). Monetary uncertainty can affect the scope and the efficacy of economic policies in the U.S. and Europe, both by reinforcing the restrictive impact of fiscal austerity in Europe through currency appreciation and by aggravating sustainability concerns regarding the U.S. government’s tolerance for a looser fiscal policy.

An old rule of international economics theory is that when you fail in coordinating economic policies you bicker about currencies, and when you fail to find an agreement on currencies you end up with a trade war. This eventuality seems very remote, but its message must be taken into consideration as a backdrop for the need for intensified U.S.-EU coordination, especially for reciprocal and credible commitments to spur growth and to lower external imbalances.

America and Europe: from accidental allies to antagonists?

One optimistic interpretation of the rift between the U.S. and the EU policies holds that the current divergences are based on short term, or cyclical, differences in the economic situation in the two areas. Therefore the division will be gradually overcome by economic developments and by a more lucid reassessment of the benefits of stricter cooperation. Consequently, the U.S.-EU Summit in Lisbon would be a crucial appointment for a much needed frank discussion on the benefits of transatlantic coordination on the heels of the G20 Seoul meeting on November 11.

A more disenchanted vision would attribute the coordinated U.S. and European responses during the golden phase of 2008-9 to the similarity of the challenges faced, rather than to any real commitment to coordination. The dramatic urgency of the financial crisis and the resulting and uniform fall in economic activity could not but induce the EU and the U.S. to implement the same response to the same economic challenge. But soon afterwards, when the fundamental conditions of the economy changed across the Atlantic, the “accidental cooperation” ceased to exist. While U.S. GDP rebounded faster in 2009 than European GDP, in 2010 the sustainability of the U.S. recovery appeared less solid than the European one. As economic challenges started to diversify across the Atlantic, policy responses returned to the same uncoordinated character of the decade preceding 2008. This second analysis implies that the U.S. and EU have to find a new and more solid basis for policy coordination.

A more cautious interpretation lies between the optimist-pessimist divide: the awareness of the benefits of coordination may be strong and clear both in the U.S. and in the EU, but both policy actors need to honestly address some new fundamental questions. These include the reduced weight of the U.S. and the EU in global governance, the relation between growth and fiscal sustainability and the need for U.S.-EU economic policies to also be orientated toward externally balanced growth.

Three fundamental questions for the Transatlantic couple

The first question centers on the still central, but very much changed, role of transatlantic relations in global economic governance after the crisis. The significant transformation of global governance stemming from the new role played by emerging countries can be illustrated by four examples. First, the G20 has replaced the G7/8 as the principal global governance group at the heads of state and government as well as at the central bank governor level. Second, monetary policy coordination is now centered on the Global Economy Meeting (which comprises thirty four central bankers) rather than the G10. Third, Financial Stability Board membership has been extended far beyond the borders of the G7. Fourth, the IMF is undergoing a process of reweighting between developed and emerging economies. Although less easy to pinpoint, the quantitative impulse to the global economic cycle deriving from the emerging economies is largely more determinant than it was before 2007. Against this backdrop, the EU and U.S. policy divergences look less striking and less justifiable than previously considered. For example, no assessment of the euro-dollar level—and therefore of the currency strategies in the U.S. and in the Euro area—should disregard the role of the currencies of the emerging economies and, obviously, the renminbi. If the U.S. and the EU were able to take into account the new global setting, they would likely find more reasons for policy convergence than for divergence.

The second question concerns the compatibility of growth and fiscal sustainability. Fiscal tightening will become broader in 2011 and driven by discretionary measures in both advanced and emerging economies. However, public debt ratios are still rising rapidly in advanced economies, and fiscal risks remain elevated. Though confidence in the Keynesian effects of fiscal policy is more widely accepted in the U.S. than in the EU, where citizens are closer to the Ricardian view (whereby the effectiveness of current government expenditures is neutralized by expected future increases in taxes), both in the EU and in the U.S. there is increasing awareness of the inevitability in the coming years of a long term, restrictive fiscal policy. A common question for the EU and the U.S. related to the reduced role of public consumption is “where will the demand come from?” The common answer has to do with the emerging countries recording particularly high surpluses in their current accounts while domestic demand is still low.

The third question is related to the internalization of global rebalancing in national or regional policies. The recent monetary strategy of the Federal Reserve has raised doubts in the EU about the American commitment not to transfer the burden of rebalancing abroad through an uncoordinated appreciation of the Euro. At the same time, the Euro zone countries’ difficulties in tackling the serious problems within their currency area is also a source of severe instability that could reverberate across the Atlantic, as happened last spring. These policy behaviors must be urgently measured in terms of U.S.-EU coordination. The traditional strategy of “putting the national house in order” is a second-best solution that will ultimately prove self-defeating.

Avoid muddling through in Lisbon

Provided they credibly commit themselves to more balanced growth domestically and externally, Europe and the U.S. have a common interest in a determined effort to put the issue of global rebalancing back on the table and to pursue an ambitious agreement in the WTO Doha Round that could support exports and global growth. In order to do this they will have to commit explicitly to fiscal stability at home, growth enhancing reforms and, obviously, to rejecting any temptation of protectionism in transatlantic trade.

Therefore the U.S.-EU summit of November 20 is a unique opportunity to contain the deterioration of transatlantic coordination. Protectionism must be openly rebuffed with new commitments on transatlantic trade, in particular in the area of emerging technologies, with the specific goal to avoid future barriers. Cooperation on innovation may become a new strategy to support the economic recovery and the creation of jobs and growth in both economic areas. Finally, even though the Summit is not the prime forum for monetary coordination, it is of paramount importance to convey a credible commitment to ensure that monetary and currency policies find their orientation in long term stability. With that commitment, a return to the ‘golden age’ will be not only necessary, but possible.