We all want to sustain the global recovery — and are not sure how (Kose and Terrones 2012). The closing years of the last two centuries present two examples of international cooperation that may give us hope.
The world economy worked well in the second half of the 20th century because the US was a hegemonic power, that is, a country that could induce other countries to cooperate in the maintenance of prosperity. The Bretton Woods system was put in place in 1944. The US extended its hand to European countries after World War II in the Marshall Plan of 1947. Europeans responded well with a plethora of international organisations that grew into what are now the EU and European Monetary Union.
The world economy also worked well at the end of the 19th century. There were rapid technical advances and rapid population growth; savings were high and these savings were invested. This was a global system, with Britain’s Empire, as well as the US, providing a market for British manufactures, producing raw materials in exchange. Within Europe, the southern periphery provided an outlet for German manufactures. Then, Britain was the hegemonic power. As Keynes said, the Bank of England was the conductor of an international orchestra. Just as, a century later, the US made it possible for many countries to industrialise and grow rapidly, in the late 19th century the UK made this possible for countries we now consider among the vanguard of prosperous nations.
In our recent book (Temin and Vines 2013), we argue that the transition from British to American hegemony was not made quickly or easily. Britain was exhausted by the war, Germany was burdened by reparations. Even though the US intervention was critical to Allied success in World War I, the US abandoned its European interests after the war. War debts led to hyperinflations in the early 1920s and this was followed by an interim period of lending to Germany in the mid 1920s and some consequent recovery. But the reparations problem had not been solved. The departure of Germany from the gold standard in the currency crisis of 1931, followed by Britain’s exit, and then by tight policies in the US, ultimately led to the Great Depression in the 1930s. The absence of a hegemon to restore cooperation and prosperity was all too evident. Massive unemployment persisted, only ending with the beginning of World War II.
We are now in a similar transition. The US squandered its leadership with two elective wars and massive tax cuts, and with low interest rates and a property boom. Countries normally raise taxes to fight wars, although seldom far enough to avoid inflation. The US went in the opposite direction, under the idea that ‘deficits don’t matter’, at the same time as tolerating a property boom, simply because inflation did not rise. Since the boom collapsed, Americans have been left wondering how to deal with their resulting fiscal debts.
Europeans started this century not with new wars, but a new currency. As a result, Germany has squandered its leadership within Europe, because the architecture of the new currency union was flawed. The idea was that international capital flows would become internal capital flows and, because of this, would cease to be an object of worry. We now know that this was wrong. The money which northern European banks lent to southern peripheral countries in Europe led to a boom there, as well as rising costs. And the money was not well used; it supported speculative property booms and consumption, rather than investment in productive tradable good industries. All went well during the ‘Great Moderation’ – the reduction in the volatility of business cycle fluctuations starting in the mid-1980s – but the system broke down during the Global Crisis. The money which banks lent to countries in the European periphery ended up as fiscal debts (once the banks had been rescued), and some of these fiscal debts have since became the obligations of the ECB. It is not clear within the Eurozone which countries will end up being responsible for resolving these fiscal debts.
Like the Great Depression, the global financial crisis of 2008 spread across the world. In early 2009, the G20 coordinated a cooperative response, but this spirit has faded. Our task now is to understand what kind of cooperation is needed. There are three problems:
- Unemployment is widespread across the industrial world.
It is mired at around 8% in America, and is nearly 12% across the Eurozone, with much higher numbers in southern Europe. It is not only foolish to continue this waste of resources, it is dangerous. Idle workers are not like idle capital or land. Workers lose skills when they are out of work for long periods of time, and young workers never learn on-the-job skills if they cannot find their first job. Deprived of their income, their chance to learn and their dignity, these workers quite naturally become angry. They join extreme political parties and vent their fury on politicians and democratic institutions alike.
- This comes about because the private sector is holding back on expenditure.
The personal sector remains burdened with housing debt in the US; in Europe banks are heavily burdened and will not lend. For the first time in living memory, investors are holding back because of uncertainties about the future in a way which is causing high unemployment and low growth to become self-fulfilling prophesies.
- Of course, fiscal debts continue to rise.
The gross debt-to-GDP ratio in the US may well go above 100% of GDP this year. This figure is approaching 90% of GDP for Europe as a whole and, again, it is much higher for countries in southern Europe.
Labour and debt
The first aim of economic policy must be to deal with the first problem – to get workers back to work as soon as possible. This is what we learned about the 1930s, and it is true of the present as well. This need to increase employment is now typically seen as conflicting with the need to deal with fiscal debt. There is a widely held view that the fiscal crisis should be solved first, just as there was a widely held view that the gold standard should come first in the early 1930s.
Dealing with debt first is the wrong way round. Countries with low demand and massive unemployment are not in a position to service and draw down their debt – just as countries with massive unemployment were not in a position to defend the gold standard. Countries need fiscal resources to sustain the unemployed at a time when tax revenues have fallen. And, as is now widely understood, austerity may end up worsening the debt position. The aims of full employment and the needs for debt reduction need to be approached together. The reduction in fiscal debts from spectacular levels, which happened after World War II, took place at a time of full employment, growth and rising tax revenues.
International cooperation is needed to make this possible. There needs to be agreement on eventually restoring international balance in Europe, and on resolving the debt overhang there. There also needs to be agreement on ensuring a stable ratio of debt to GDP in the US. Policymakers can then design programmes which will restore demand and reduce unemployment in their own economies, to direct them in the direction of the long-run goal of debt reduction. A straight line is not always the shortest path toward economic adjustments.
Indebted countries need to reduce imports and increase exports in order to enable their economies to grow when the private sector is reluctant to spend, and so to make a reduction in public debt possible. This is what happened after the Asian financial crisis. It is straightforward to do this in the US; a lower dollar will encourage exports, discourage imports and support expenditure on domestic goods. Rebuilding areas destroyed by recent hurricanes and investing in new infrastructure will provide an ample menu of domestic expenditures; education is another essential use of domestic resources. An improved external position will make increased tax revenues possible and these will both support these domestic expenditures and make a gradual repayment of fiscal debts possible.
Southern Europe also has compelling domestic needs, but there is less freedom of movement in the Eurozone with a common currency. These countries have already reduced total consumption and imports because of austerity. That austerity must now be put on hold. They need, instead, to lower costs at home and encourage a move away from imports and a rise in exports. That will only be possible if there is growing demand in Germany, and a willingness by Germany to allow costs there to rise. Germany must put its austerity on hold too – reducing government spending by around half a percent of GDP per year for the next four years will create a large Europe-wide burden. The adjustment will all take time –reducing relative costs in southern Europe by another 20% will require much time. It will be especially slow if relative costs can only change at around 4% per year, which is probably the best that can be hoped for.
And southern European governments will need to borrow more during the transition. As a result, debt forgiveness may be necessary so that northern governments bear some of the burden imposed by the over-lending of northern banks. Political risks remain high.
Alas, cooperation and foresight are in short supply. There is opposition in the US to new taxes, particularly on the wealthy. The Germans, who lent to southern Europe, are reluctant to expand their economy to ease the burden on the same southern Europeans. And countries in East Asia, including China, remain hesitant to expand demand rapidly enough to absorb goods exported by the US and Europe. There is no continent within which there is yet enough of a sense of common purpose. History shows us that leadership is possible. Our current circumstances show us that it is also necessary.
Temin, Peter and David Vines (2013), The Leaderless Economy: Why the World Economic System Fell Apart and How to Fix It, Princeton University Press.
Kose, M Ayhan and Terrones, Marco E (2012), “Uncertainty weighing on the global recovery”, VoxEU.org, 18 October.