Macro-Economic Situation and Prospects for Growth in the US and Europe

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*The New Atlantic Capitalism Project is supported by the European Commission. However, the sole
responsibility for the text lies with the author(s) and the Commission is not responsible for any use that may be
made of the information contained herein





Macro-Economic Situation and Prospects for Growth in the US and Europe

Background note for the 1
st
meeting of the High Level Group “New Atlantic
Capitalism”*
Warsaw, 6-7 December 2010

Eulalia Rubio, Notre Europe
November 2010

This background note is meant to provide material for the discussions at the High Level
Group “New Atlantic Capitalism” being held in Warsaw on 6-7 December 2010. It is
structured in two sections. Section one describes the current state of the US and the European
economies and examines the strength of the recovery with the help of the most recent IMF
and OECD outlook reports
1
. Section two put forward some general reflections on the
prospects for growth in these two economies over the next decade
2
.
SECTION 1- MACRO-ECONOMIC SITUATION OF THE US AND EUROPE

Two years after the Lehman Brothers’ collapse, the two largest advanced economies find
themselves in a distinct but comparable situation. In the US, output has recovered thanks to an
unprecedented massive macroeconomic policy stimulus. However, the expansion is far
weaker than in previous recessions due to low household consumption, stubbornly high
unemployment rates and fragile financial and real estate sectors. Besides, the effect of the
government fiscal stimulus is diminishing while the prospects for new expansionary policies
have been severely reduced after the 2010 elections. In Europe, growth has resumed in 2010,
mostly thanks to a German export-driven rebound. Yet, output growth is also appreciably
below pre-crisis levels and remains dependent on foreign demand. More worryingly, the (still
unfinished) Euro area sovereign debt crisis and the wave of fiscal consolidation that this has
spurred represent a serious threat to Europe’s recovery.

Over all, the situation in both economies is similar in that the path to recovery remains fragile.
There is in particular much uncertainty on the impact of recent policy strategies adopted on
either side of the Atlantic (mostly based on fiscal austerity in Europe and on expansionary
monetary policy in the US). In addition to that, political attention and public debates have
been so far focused on the short-term - i.e., on whether or not we can avoid a double-dip
recession. Little attention has been paid to the long-term prospects for growth.

1. The United States


1
IMF World Economic Outlook and IMF Regional Economic Outlooks for Western Hemisphere and Europe of
October 2010, OECD Economic Outlook of 18 November 2010
2
The reflections put forward in this second section are partly based on a conversation with Tommaso Padoa-
Schioppa.

*The New Atlantic Capitalism Project is supported by the European Commission. However, the sole
responsibility for the text lies with the author(s) and the Commission is not responsible for any use that may be
made of the information contained herein




After vigorous growth during the second half of 2009 and early 2010, the US economy has
slowed considerably in the second and third quarter of 2010. Much of this slowdown is due to
sluggish household consumption – which is by far the biggest component of the US GDP.
There are several factors that explain the low levels of private consumption. First, household
net wealth has deteriorated sharply, with house prices falling by around 25-30 percent since
the burst of the housing bubble. Second, unemployment remains at high levels. It is currently
at 9,6 percent of the total workforce, with unemployment duration and the percent of long-
term unemployed being at historic highs. Finally, banks are still reluctant to lend to
consumers as they are still deleveraging and struggle to restore balance sheets.

In contrast to private consumption, private investment has rebounded strongly. Indeed, both
the IMF and the OECD expect gross fixed capital formation to be the principal driver of
domestic demand in the near future, as inventory accumulation slows. As concerning public
consumption, while it had a positive impact on 2009, a smaller effect is expected for 2010,
and its impact on growth is expected to turn negative in 2011 with the introduction of fiscal
consolidation measures.
The current account deficit narrowed considerably in the years after the crisis (from 6% of
GDP in 2006 to 2,7% in 2009). For the coming years, it is expected to remain at about 3% in
2010 and 2011 as the recovery of private investment will be financed mainly by domestic
savings (private and public). In a context of jobless recovery and sluggish private
consumption, inflation is projected to be low, and the IMF event points to a tail risk of
deflation.
Table 1- United States: Main Macro-Economic Indicators

IMF forecasts OECD forecasts
2008 2009 2010 2011 2010 2011
Private consumption

-0,3 -1,2 1,5 2 1,7 2,4
Public consumption

2.5 1,9 1,5 -1,2 1,1 1,0
Gross Fixed Capital Formation

-4,5 -14,8 2,2 6,4 3,4 7,2
Final Domestic Demand

-0,6 -3,1 1,6 2,1 1,8 2,8
Stockbuilding

-0,5 -0,7 1,4 0,1 1,6 -0,1
Total domestic demand

-1,1 -3,6 3 2,2 3,4 2,7
Net exports

1,2 1,3 -0,5 0 -0,7 -0,6
Real GDP
0 -2,6 2,6 2,3 2,7 2,2

Consumer Price Index

3,8 -3 1,4 1,0 1,6 1,1
Unemployment rate

5,8 9,3 9,7 9,6 9,7 9,
Government Fiscal Balance

-6,7 -12,9 -11,1 -9,7 -10,5 -8,8
Gross Gov Debt as % GDP 71,7 84,3
92,7 99,3 - -
Current Account Balance -4,7 -2,7
-3,2 -2,6 -3,4 -3,7

According to both the IMF and the OECD, the most likely prospect for the US economy is a
continued but slow recovery for 2010 and 2011. They are, however, some downside risks.
First, there is much uncertainty concerning the future trends of private consumption. The

*The New Atlantic Capitalism Project is supported by the European Commission. However, the sole
responsibility for the text lies with the author(s) and the Commission is not responsible for any use that may be
made of the information contained herein




household saving rate has risen to about 6 percent in the second quarter of 2010 and, given the
unusually low saving levels before the crisis and the loss in net wealth, the desire to save is
likely to remain elevated relative to pre-crisis levels. Besides, unemployment levels are likely

to remain high for a long time, partly as a result of the negative interaction between large
sectoral and geographical skill mismatches and housing conditions hampering labor mobility
3
.

Second, the real estate market remains fragile. Tax measures temporarily increased activity
during the second quarter of 2010 but housing demand fell and prices receded after the
expiration of these measures. Although this was anticipated, the drop was larger than
expected, renewing fears of a ‘double-dip’ recession in the US housing market. This would
have consequences not only for households but also for small and medium-size banks,
inhibiting the recovery of credit conditions.
Finally, despite considerable efforts to improve financial stabilization, the banking system
remains vulnerable. In particular, capital will probably need to be raised to meet higher
regulatory requirements set up in recent reforms, and this may have a short-term impact on
credit dynamics and economic activity.
2. Europe
The European economy has recovered modestly during 2010, in spite of the various episodes
of turbulences in sovereign debt markets. In the Euro area, activity has expanded thanks to the
resurgence of exports, especially in Germany, although export growth has been broadly
matched by a rise in imports. With few exceptions (Germany, Finland, Slovakia and Slovenia)
growth rates in the euro area have been much lower than in the US, and the same can be said
for the UK (1,7% growth in 2010, 2,0 in 2011).
Table 2- Euro Area: Main Macro-Economic Indicators

IMF forecasts OECD forecasts
2008 2009 2010 2011 2010 2011
Private consumption

0,4 -1,1 0,6 0,9 0,6 1,0
Public consumption

2,3 2,4 1,2 -0,2 1,0 0,0
Gross Fixed Capital Formation

-0,8 -11,3 -0,1 1,6 -1,1 1,6
Final Domestic Demand

0,5 -2,6 0,6 0,8 0,3 0,9
Stockbuilding

-0,1 -0,8 0,5 0,1 0,6 0,1
Total domestic demand

0,4 -3,4 1,0 0,9 0,9 1,0
Net exports

0,1 -0,7 0,7 0,7 0,8 0,7
Real GDP
0,5 -4,1 1,7 1,5 1,7 1,7

Consumer Price Index

3,3 0,3 1,6 1,5 0,9 1,2
Unemployment rate

9,4 10,1 10,0 9,9 9,6


3
As the states with largest skill mismatches are also those with most depressed housing markets, an unemployed
individual willing to move faces important capital losses from trading his house in the depressed state for
another in a more prosperous region (see IMF Regional Economic Outlook of Western Hemisphere, p. 5).

*The New Atlantic Capitalism Project is supported by the European Commission. However, the sole
responsibility for the text lies with the author(s) and the Commission is not responsible for any use that may be
made of the information contained herein




Government Fiscal Balance

-1,9 -6,3 -6,5 -5,1 -6,3 -4,6
Gross Gov Debt as % GDP
69,5 79,0 84,1 87,0
Current Account Balance
-0,7 -0,4 0,2 0,5 -0,2 0,3

The Euro area growth rate hides pronounced differences across the region. In Germany,
economic activity has strongly rebounded thanks to robust manufacturing exports but also to
an improvement in both private consumption and investment. In France, growth has been
modest as private consumption is weakened by high unemployment and the withdrawal of
public measures. In Italy, both exports and investment have picked up during the first half of
2010 but recovery is expected to be subdued as persistent competitiveness problems limit the
scope for export growth and planned fiscal consolidation is likely to weaken private demand.
Finally, growth in the so-called “peripheral economies” (Portugal, Ireland, Greece and Spain)
has remained negative or very low.
The prospects for the Euro area are very much dependent on the fate of peripheral countries.
At the moment of writing this note, Ireland is preparing a formal request of aid from the
European Financial Stability Fund and there are rumors that Portugal will follow soon. At the
same time, the Greek government has just announced that the deficit for 2010 will be higher
than expected. This suggests that the IMF and OECD predictions for these countries might be
too optimistic. Indeed, peripheral countries find themselves in a negative spiral of low or
negative growth rates, tightened fiscal policies and increasing deficits, and it is not clear how
they are going to break this vicious circle and regain growth.

Another downside risk comes from the banking sector. Both the IMF and the OECD raise
concerns on the strength of the European banking system and its ability to provide credit as
demand picks up. More worryingly, both the Greek and the recent Irish crises have put into
evidence the potential negative spillovers between sovereign debt markets and the banking
system. If the Greek crisis showed that a sovereign debt crisis might have negative
consequences for banks (given the large amount of government papers they hold), the recent
Irish episode proves that the reverse is also true; that is, European government budgets are
vulnerable to banking crisis, given their formal or informal commitment to bailout banks.
Apart from that, the Euro area prospects are also dependent on what happens in Germany. A
higher-than-expected activity in Germany could boost private demand in the whole Euro are
given the substantial trade and production linkages. However, German prospects are very
much conditioned to the strength of global growth, which could well be weaker than
predicted.
Table 3 – Selected Euro Area Economies: Real GDP, Current Account Balance, Fiscal
Balance and Unemployment
Real GDP
1
Current Account
Balance
1
Gov. Fiscal
Balance
1
Unemployment
Rate
2
2010 2011 2010 2011 2010 2011 2010 2011
Germany

3,3 2,0 6,1 5,8 -4,5 -3,7 6,9 6,3
France

1,6 1,6 -1,8 -1,8 -8,0 -6,0 9,3 9,1
Italy

1,0 1,0 -2,9 -2,7 -5,1 -4,3 8,6 8,5

*The New Atlantic Capitalism Project is supported by the European Commission. However, the sole
responsibility for the text lies with the author(s) and the Commission is not responsible for any use that may be
made of the information contained herein




Greece

-4,0 -2,6 -10,8 -7,7 -7,9 -7,3 12,2 14,5
Ireland

-0,3 2,3 -2,7 -1,1 -17,7 -11,2 13,6 13,6
Portugal

1,1 0,0 -10,0 -9,2 -7,3 -5,2 10,7 11,4
Spain

-0,3 0,7 -5,2 -4,8 -9,3 -6,9 19,8 19,1
(Sources:
1
IMF,
2
OECD)

In Central and Eastern Europe (CEE), growth has gained strength, thanks to a rebound in
exports. Domestic demand, however, remains weak in most countries (only in Poland it has
recovered to pre-crisis levels). CEE countries have differed remarkably in their exposure to
the crisis and their capacities to cope with it, to the extent that many observers consider that it
is now harder to speak of a region called ‘Eastern Europe’
4
. Indeed, two clusters of countries
can be distinguished: those with relatively strong private and public sector balances, which
were able to create a competitive export basis during the pre-crisis period (Poland, Czech
Republic) are having strong recoveries, while those that had experienced unsustainable credit
booms (Bulgaria, Latvia) or had vulnerable public sector balances (Hungary, Romania) are
struggling to recover.
Looking ahead, the prospects for the CEE countries are good if compared with those of
advanced Europe. Nevertheless, CEE recovery is dependent on what happens in the Euro
area. A new sovereign debt crisis would depress growth in the euro area, and this would
impact negatively the CEE countries through lower exports. Lower growth in the Euro area
could also increase stress in the banking sector and reduce capital flows to the CEE countries,
thus delaying the revival of credit growth and domestic demand, or even fuelling a
depreciation of some currencies. The IMF even alerts on a risk of sovereign crisis contagion,
which would have very negative consequences for the most indebted CEE countries.

Table 4 – Selected Central and Eastern European Countries: Real GDP, Real Domestic
Demand Growth, Current Account Balance and Gov. Fiscal Balance
Real GDP Real Domestic
Demand Growth

Current Account
Balance

Gov. Fiscal
Balance

2010 2011 2010 2010 2010 2010 2010 2011
Poland

1,7 3,4 2,7 3,7 -2,4 -7,4 -7,4 -6,7
Czech Republic

-4,1 2,0 0,8 2,2 -1,2 -5,4 -5,4 -5,6
Hungary

-6,3 0,6 -5,3 0,4 0,5 -4,2 -4,2 -4,5
Bulgaria

0,0 2,0 -4,9 2,4 -3,0 -4,9 -4,9 -4,2
Romania

-7,1 -1,9 -2,7 1,5 -5,1 -6,8 -6,8 -4,4
Latvia

-18,0 -1,0 -1,6 5,2 5,5 -11,9 -11,9 -7,6
(Source: IMF)

3. US and Europe: divergent policy strategies and large uncertainty
During 2008 and 2009, the US and the European public authorities reacted similarly to the
global financial and economic crisis. In both continents, governments made massive capital
injections to fragile banks and implemented stimulus packages in order to avoid another Great
Depression, while monetary authorities provided additional stimulus by offering liquidity


4
“Eastern Europe: Wrongly Labeled”, The Economist, 9 January 2010, pp 27-28.

*The New Atlantic Capitalism Project is supported by the European Commission. However, the sole
responsibility for the text lies with the author(s) and the Commission is not responsible for any use that may be
made of the information contained herein




support and reducing interest rates
5
. Since 2010, however, there is a growing divide in the
policy strategies adopted on either side of the Atlantic.

Europeans are much keener to restore monetary and fiscal discipline, fearing that maintaining
macro-economic stimulus would further destabilize the economy. In particular, the turmoil in
sovereign debt markets has translated into a general switch towards fiscal consolidation across
Europe. Ambitious measures to drastically reduce the budget have been implemented in those
countries facing market severe pressure (Ireland, Spain, Greece, Portugal) but fiscal
consolidation agendas have been also announced in countries having no urgent need to reduce
the deficit, with the United Kingdom being the most illustrative example.

Americans are less concerned by the longer-term risk of delaying an exit from stimulus
policies. The status of the dollar as international reserve currency makes them less vulnerable
to sovereign debt market crisis, and partly because of this, they have maintained a more
expansionary fiscal policy than its Europeans counterparts. Recently, anticipating the phasing
out of fiscal stimulus, the FED has taken the lead in efforts to bolster the economy by
launching an additional quantitative easing program worth $600 billion to promote growth
(the so-called “QE2”).
Both the impact of fiscal consolidation in Europe and expansionary monetary policy in the US
is uncertain. The European move to fiscal consolidation is based on the assumption that fiscal
consolidation will boost private actors’ confidence and thus contribute to sustainable growth
in consumption and investment (the so-called “expansionary fiscal contractions” hypothesis).
Yet, fiscal consolidation typically has a negative effect on aggregate demand and, as a recent
IMF analysis shows, this negative effect has historically been cushioned by reductions in
interest rates and/or increases in exports thanks to currency devaluations
6
. In current
circumstances, with interest rates close to zero and with many countries pursuing fiscal
consolidation at the same time, adopting an austerity-based growth strategy is clearly a risky
bet.
In the US, QE2 could boost growth through three channels: a) by reducing long-term interest,
leading to an increase in real asset prices, b) by rising inflation expectations, which would
translate into lower real interest rates and c) by exercising a downside pressure to the Dollar’s
exchange rate, thus making exports easier. In practice, however, the knowledge about the
effects of QE through these three channels is limited. Besides, there are elements to doubt on
the efficacy of these three channels in current circumstances. First, long-term interest rates are
already very low and therefore no substantial impact can be expected in this respect. Second,
given the excess capacity in the US economy, quantitative easing may be unable to change
inflation expectations. Finally, an effect on the Dollar’s exchange rate would only have
positive effects in the long-run while in the short-run it may result into retaliation from third
countries.


5
Although at the beginning the ECB was reluctant to lower interest rates; indeed, they were raised in June 2008
in response to rising commodity prices.
6
« Will it hurt? Macroeconomic effects of fiscal consolidation”, IMF World Economic Outlook October 2010,
chapter 3.

*The New Atlantic Capitalism Project is supported by the European Commission. However, the sole
responsibility for the text lies with the author(s) and the Commission is not responsible for any use that may be
made of the information contained herein





SECTION 2 - LOOKING FORWARD: WHAT PROSPECTS FOR LONG-TERM GROWTH?

So far, we have described the current state of the US and the European economies and the
political strategies adopted on either continent. These are all useful elements to assess the
risks of a ‘double dip’ recession in 2011. Yet, while this is a relevant issue, it is not the most
important one. Growth is a matter of years or decades, not of quarters. What will happen in
the US and Europe in 2011 is important, but a more fundamental question is what the growth
prospects are for the next decade in these two regions. In other words, how can advanced
economies generate strong, inclusive growth in the coming decade, in the context of an
emerging economic world order?
1. A new geography of growth
The resilience of emerging and developing countries during the current economic crisis has
exposed the realignment of the world economy which has taken place over the last decade. In
effect, while the 1990s proved to be another ‘lost decade’ for the developing world (with
growth hampered by financial crisis and political instability), during the 2000s many
developing countries enjoyed its first decade of strong growth in many years.

Particularly remarkable was the trend followed by a group of poor and middle-income
economies which grew at more than twice the average growth rate of advanced economies
over the last decade. This includes countries such as China, India or Brazil but also smaller
economies such as Vietnam, Chile, South Africa or many Central and Eastern European
countries. A recent OECD report
7
classifies these countries as “converging countries” and
distinguishes them from “struggling countries” (countries whose growth performance has
been irregular over the last decade, even if strong at times) and “poor countries” (countries
whose incomes per capita have stagnated or declined). While in the 1990s there were 12
countries which qualified as ‘converging’ countries, in the 2000s the converging group
included 65 countries.
Table 5- Number of countries according to their income and rate of growth per capita (OECD
classification, based on World Bank)
1990s 2000s
Affluent countries

34 40
Converging countries

12 65
Struggling countries

66 38
Poor countries

55 25


7
OECD, Perspective s on Global Development 2010: Shifting Wealth

*The New Atlantic Capitalism Project is supported by the European Commission. However, the sole
responsibility for the text lies with the author(s) and the Commission is not responsible for any use that may be
made of the information contained herein




Total

167 168
Source: OECD, Perspectives on Global Development, 2010, p.37.

The current crisis has not stopped this process of economic realignment. While advanced
economies’ GDP contracted by 3,2 percent in 2009, emerging and developing economies
posted growth of 2,5 percent and their average growth is expected to be 7,1 percent in 2010

(OECD 2010). The greatest rebound is expected in developing Asia. Average growth rates in
this region are expected to be around 8-9 percent in the coming years.

Table 6- IMF growth forecasts, 2010-2015

2010 2011 2015
United States

2,6 2,3 2,6
Euro Area

1,7 1,5 1,7
Central and Eastern Europe

3,7 3,1 4,1
Latin America and the
Caribbean
5,7 4,0 3,9
Developing Asia

9.4 8,4 8,5
China

10,5 9,6 9,5
India

9,7 8,4 8,1
Source: IMF (2010)
All seems to indicate that growth in emerging economies will remain higher than that in
advanced economies in the coming decade. This is not only due to the different impact of the
crisis on these two types of economies, but because of the different nature of growth they
have. Emerging economies are in a phase of ‘catching up’: so far, they have mostly relied on
exports to grow, but after two decades of prosperity their domestic markets are in a process of
expansion. Private consumption will therefore be strong in the coming years as driven by a
change in living standards. This contrasts with the situation in affluent economies, where
private consumption is likely to remain sluggish due not only of the correction of pre-crisis
excesses (i.e. highly US indebted households needing to save more and consume less) but also
because consumption is based on purchases of ‘postponable items, and thus highly sensitive
to uncertainties or financial market conditions.
2. An open question: How to create strong, sustainable and inclusive growth in the US
and Europe in the coming decade?
As seen in the previous section, the prospects for advanced economies are gloomy. There are
hints to believe that we are heading towards a decade of low growth. A period of continuous
slow growth is always undesirable but in current times, with soaring public deficits and debts,
it might very dangerous. This is particularly the case for highly indebted countries facing
severe market pressures (Greece, Portugal, Ireland, Spain). These countries need to generate
growth to improve their fiscal balances and debt-to-GDP ratios. These ratios will decline if
the denominator ‘growth’ rises, otherwise there is no stability program that can really bring
them out of the target of the markets losing confidence


*The New Atlantic Capitalism Project is supported by the European Commission. However, the sole
responsibility for the text lies with the author(s) and the Commission is not responsible for any use that may be
made of the information contained herein




Advanced economies are thus confronted to the dilemma of having to combine fiscal
consolidation with growth. The dilemma is more acute in Europe than in the US, but
Europeans have an advantage with respect to Americans: As Europe is a composite of
advanced and emerging economies, there is a potential for growth from strengthening the
links between these two types of economies (in other words, from deepening the EU internal
market). Another solution for Europe could be to reverse the scheme of the last years – in
which stability came from Brussels and growth from member states. As stabilization is now
imposed by market pressures to national governments, the EU could take the lead in
stimulating growth by for instance launching an ambitious plan to finance long-term
investments in areas such as energy, transport, research or the environment. This would
require increasing the amount of resources at disposal of the EU institutions, either by
creating an EU-wide tax or by allowing the EU to borrow money on international markets.

A more general question for Europeans and Americans is what type of strategy should be
pursued to stimulate growth. As said above, private consumption is expected to remain low.
If growth cannot come from domestic demand, the alternative is to increase exports towards
emerging countries. Given the differences in costs, the natural option for advanced economies
is to compete on the quality of the products. However, this will not be easy, as emerging
economies are increasingly better in producing higher-technology goods. Besides, given their
fiscal balances, they are in a better position to invest in human capital, research and
innovation in the coming years
Finally, there is the question of how to make future growth both sustainable and inclusive. As
pointed out by the IMF and the OECD, if the prospects for low growth materialize public
expenditure programs would have to be scaled back or taxes be increased. Can we avoid this
situation? If not, can we think on ‘smart’ strategies to make spending cuts and/or tax reforms,
that is, strategies capable of boosting growth at the short-term while at the same time
promoting inclusive and sustainable growth in the long run?