Growth in Europe and America: The tortoise and the hare / Europe’s speed restrictions

Date: 16/08/03

The tortoise and the hare

The world economy cannot continue to rely so heavily upon America

IN THE late 1990s The Economist viewed the American economy as the hare and the economies of the euro-area as the tortoise. The American hare's rapid pace of growth was, we believed, exaggerated by a large economic and financial bubble. Once that bubble burst, we expected America's economy to slow sharply, while the steadily plodding European tortoise, whose economy looked relatively free from the financial imbalances that had built up in America, would start to pull ahead. America's economy has indeed slowed sharply, and the euro area did briefly grow faster than America in 2001, but the hare has since sprinted into the lead again. Europe's sluggish growth is not only a disappointment for Europe: the persistent growth gap between America and much of the rest of the world could spell trouble for the whole global economy.

The gap between growth rates in America and the euro area has widened this year. Germany, Italy and the Netherlands are in recession and output in the euro area as a whole stagnated in the second quarter. Indeed, the euro area currently looks even sicklier than Japan, where GDP grew by an annualised 2.3% in the second quarter. But most forecasters still expect Japan's economy to grow by less than 1.5% over the next couple of years. That leaves America as the main driver of the world economy, even though the American economy is hardly in the prime of health. Much of its 2.4% growth in the second quarter came from a sharp increase in defence spending during the Iraq war, and employment continues to decline. Nevertheless, recent tax cuts are almost certain to boost growth in the second half of this year, and forecasters widely expect America's economy to outpace the economies of the euro area and Japan over the next few years.

The euro area's slower growth is surprising given that the bubble supposedly created fewer excesses (such as households over-borrowing) in Europe than in America. One explanation is that growth comparisons are distorted by America's faster population growth. GDP per head in the euro area has grown at exactly the same pace as in America over the past three years. But that isn't good enough. After America's bubble burst, the euro area economies should have grown faster. Many commentators argue that structural rigidities, such as inflexible labour markets and high tax rates, are to blame. But there are more important reasons why the euro area economies have been looking less robust than America's over the past few years. First, America has enjoyed a much bigger monetary and fiscal stimulus than the euro area, where fiscal policy has been constrained by the straitjacket of the stability and growth pact. Second, although consumer borrowing has been more modest in the euro area, its corporate borrowing and investment binge in the late 1990s was bigger than in America. and this is now cramping growth.

A hobbled hare

As a result, the world economy is still too reliant on America. Morgan Stanley calculates that America has accounted for over three-fifths of global growth since 1995. That is unsustainable. Most economists expect America's GDP to grow by 3.5-4% over the next few years. But that would imply that household saving remains low and consumer debts continue to grow at an alarming pace, storing up big problems for the future. The huge monetary and fiscal stimulus that has so far underpinned demand cannot be repeated. Moreover, suppose America's economy does rebound rapidly while other economies remain sluggish. Then, America's already massive current-account deficit will widen further as more imports are sucked in, building up a new problem.

The current-account deficit is already as large as 5% of GDP, and history suggests that deficits of this size are usually followed by big declines in the currency. A dollar crash could curb growth in Europe and Japan as well as pushing up American bond yields - and mortgage rates - as foreigners demanded a bigger risk premium. Some argue that America's current-account deficit does not matter; it simply reflects foreign investors' desire to invest in American assets. But UBS estimates that more than half of America's current-account deficit in the three months to June was financed by foreign central banks' purchases of American securities. Private investors' love affair with the dollar has already faded.

The world economy would be a lot healthier if Europe and Japan took some of the strain off America by pursuing looser monetary and fiscal policies and structural reforms to boost their growth. And America would be healthier if it grew more slowly than its potential for a few years, so allowing households to bring their finances into better balance. Without a more even sharing of growth, both the hare and the tortoise risk being run over in a nasty accident.

Europe's speed restrictions

Why have the economies of the euro area looked more sickly than America's since the stockmarket bubble burst?

EUROPEANS beat Americans hands down when it comes to grabbing the best sun loungers. Sadly, their economies are much less speedy. Germany's GDP fell by 0.2% at an annual rate in the three months to June, the third consecutive quarter of decline. Italy and the Netherlands are also in recession. Even including economies that are growing, such as Spain and Ireland, the euro area as a whole stagnated in the second quarter. By comparison, America's GDP grew by a respectable annual rate of 2.4%.

If the surge in defence spending during the Iraq war is excluded, America's GDP grew by less than 1% in the second quarter. Moreover, surveys of business and consumer confidence suggest that the euro area economies should perk up in the second half of this year - but not as rapidly as America's. In The Economist's latest poll of forecasters, every member of the panel expected significantly faster growth in America than in the euro area this year and next. For 2004, the panel is forecasting only 1.7% growth in the euro area, against 3.4% in the United States.

If this is right, America's economy will have expanded by a cumulative 8.6% in the four years since its bubble burst, compared with only 4.8% in the euro area. But these numbers exaggerate America's superior performance because its population is growing faster. Over the four years, America's GDP per head will have grown by an annual average of only 1% a year, roughly the same as in the euro area.

Yet this still leaves a puzzle. The few economists who spotted that America was experiencing a giant bubble in the late 1990s correctly forecast that its growth would slow sharply when that bubble burst. But they expected that the European economies would then start to outperform. After all, European households own far fewer shares than do their American counterparts, so consumer spending should have been hurt much less by a plunge in share prices. Likewise, it was argued, the excesses created by the stockmarket bubble, such as the level of private-sector borrowing and widespread corporate malfeasance, were less severe in the euro area. In 2001, as America dipped into recession, the euro area briefly grew faster, but since then it has lagged badly behind.

European policymakers like to blame all of the euro area's economic woes on inflexible labour markets and high taxes. These have surely played a role, but only a minor one. A more important explanation for Europe's recent poor performance is that over the past three years America has enjoyed much looser monetary and fiscal policies, which have bolstered consumer spending. Adjusting for the impact of the economic cycle (deficits widen in downturns as tax revenues shrink), America's structural budget balance has shifted from a surplus of 1% of GDP in 2000 to an estimated deficit of 4% this year. Over the same period, the euro area has seen no net fiscal stimulus. Interest rates have fallen by 5.5 percentage points in America, twice the fall in the euro area. A weaker dollar is also helping to boost American exports and company profits. The combined stimulus has helped to cushion what would otherwise have been a much steeper downturn in the United States.

The common belief that the United States experienced a much bigger bubble than the euro area is also false, so far as the corporate sector is concerned. A recent study by HSBC finds that, during the late 1990s, European companies went on an even bigger borrowing and investment binge than did corporate America. European share prices rose by just as much as those on Wall Street (and have since fallen by more). From the mid 1990s to 2000 companies' capital investment, measured in nominal terms, rose more sharply as a share of GDP in the euro area than in America. (In real terms, American capital investment rose faster, because IT equipment accounted for a bigger slice of the total, and the prices of computers fell sharply.)

Corporate financial investment also rose more sharply in Europe, largely because of the M&A boom. As a result, total corporate investment (capital and financial) in the euro area rose from 14% of GDP in 1997 to 24% in 2000, eclipsing America's investment boom.

European firms' corporate-financing gap (investment minus internal funds) rose from 4% of GDP in 1997 to a record 14% in 2000 and most of that was filled by debt rather than equity finance. Corporate debt has risen much more dramatically than in America, from 60% of GDP in 1997 to 76% in 2002. This legacy of over-borrowing and over-investment is currently holding back growth in the euro zone.

Gwyn Hacche, an economist at HSBC, suggests that one reason why the bursting of the bubble has not caused a sharper downturn in America is that the investment boom was financed largely through equity and bond markets rather than through the banking system, resulting in a wider spreading of risk. Only 17% of firms' debt is from banks, compared with 89% in the euro zone. Better still, a sizeable chunk of America's investment boom was financed by European investors who then bore the losses.

Not only did European firms over-borrow to a greater degree than their American counterparts but, since the bubble burst, they have been slower than American firms to slim their borrowing needs by slashing investment and operating costs. This is where Europe's structural rigidities have played a part. America's productivity growth rose by an impressive 3.8% in the year to the second quarter, whereas that in the euro area slowed to less than 1%, making it harder for firms to lift profits and reduce debts.

A final important source of growth in America is its housing market and its system of mortgage finance. As mortgage rates fall and house prices rise, this encourages people to refinance their home loans at lower rates and to borrow more against the higher value of their home. Such “mortgage equity withdrawal” provides cash to spend on other things. In the euro area house prices have also risen briskly in many countries in recent years (with the exception of Germany), but it is costly to refinance mortgages. Unlike their American counterparts, euro-area borrowers would typically be charged a penalty of 2-3% to pay off their mortgage early. As a result, consumer spending has not been supplemented by mortgage equity withdrawal. But this fuel for America's economy is starting to run dry.

Mortgage rates have been pushed up by rising bond yields and by uncertainties at the giant mortgage agencies Fannie Mae and Freddie Mac, causing a sharp drop in mortgage refinancing. Once the stimulus from the latest tax cuts fades, the pace of American consumer spending could slow sharply.

Europe's corporate-sector imbalances may be more severe than America's, but its consumers' finances are in far better shape, with higher saving rates and lower debts. Given that consumer spending accounts for 70% of America's GDP, this suggests that over the medium term the euro area's economies will be better placed to expand than America's. And with recent promising signs of economic reform across Europe, the area's growth in GDP per head could yet outstrip America's.

Editorial says that the world economy cannot continue to rely so heavily upon America.

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