Free exchange

One expensive euro

On efforts to understand the world economy

MOST of the time, American economic trends closely track those in Europe and vice-versa. When growth in one slows so does growth in the other. When one's economy tanks so does the other's, as in late 2008. And when recovery begins in one, so too does a rebound begin in the other, as in mid-2009. Sort of. In fact, America managed slightly better growth in the early years of the Great Recession than did the euro area. The overall divergence in recovery paths widened slowly through 2010, but as of 2011 the gap has grown much larger. For a simple reason: America's economy has trundled on growing at a fairly steady pace over the past two years while the euro-zone economy has been stuck in recession.

The contrast only seems to be growing starker. Forecasters now reckon that the American economy may have grown at close to a 4% annual pace in the first quarter of 2013. Meanwhile, the euro area's recession once again appears to be deepening; the latest PMI data are particularly bleak. In March, manufacturing activity declined across the euro area, from Germany to Greece. Through February, unemployment continued to worsen, albeit at a slowing pace. The March figures now coming in suggest the early-2013 slowdown in job loss has probably come to an end.

At the moment there is little reason to expect America to fall below recent trend growth in 2013 and little hope that the euro-area will escape recession. If we take America's performance as a good estimate of potential rich-country growth (rather than, more likely, a very conservative lower bound), then we can take this growing Atlantic divergence as a measure of policy-induced macroeconomic failure: in other words, the gap in output and welfare that Europeans are needlessly costing themselves by behaving foolishly. Were they only behaving as foolishly as Americans, they could be doing substantially better.

As of the fourth quarter of 2012, real output in America was about 2.5% above the level of the fourth quarter of 2007 and it is rising. In the euro area, by contrast, real output was about 2.5% below the end-2007 level, and falling. Had the euro-area economy followed the American path, its members would have produced about €110 billion in additional output in the fourth quarter of 2012. We can expect that sum to grow for at least the next few quarters. And remember, that's a flow, not a stock. Cumulative losses relative to the American trend, since the end of 2007, topped €500 billion as of the end of last year. Though we don't yet have first quarter figures, we can reasonably assume that the true shortfall is now close to €700 billion. The figure looks even worse when one considers that America still has an estimated output gap of about 6% of GDP. And don't forget that the euro zone is an economy that drove itself to the brink of crisis, most recently, over a funding shortfall of €17 billion. That €700 billion works out to over €2,000 for every man, woman, and child in the euro area. That kind of money could come in handy given the euro area's interest in balancing budgets.

So the question is: what explains the difference between the American trend and the European one? "The crisis, duh", while an accurate answer is a little too vague to be helpful.

Back in late 2011, The Economist published a briefing on the dark waters into which the euro zone appeared to be heading, based on lessons learned from the Depression. The Depression, the piece argued, emerged from a nasty feedback loop. Some heavily indebted economies, like Germany, faced pressure to begin running large current account surpluses in order to pay back loans. The gold standard prevented devaluation, however, and instead forced countries into import-crushing downturns to generate the needed surplus. Other economies, unwilling to allow their current accounts to swing to large deficits lest they suffer gold outflows, tightened monetary policy in response, running themselves into the ground and making Germany's situation intolerable. At the same time, economic downturns squeezed banks, leading to waves of bank failures. The gold standard helped transmit banking panic. Capital outflows placed pressure on central banks to raise interest rates (to hang on to gold reserves), which increased the odds of bank failure, which accelerated the pace of outflows. The result was economic collapse and catastrophe, broken only by the end of the gold standard and which even then left political chaos in its wake.

There are obvious parallels to the euro-area crisis. The single currency entails many of the same constraints as the gold standard. Had no lessons at all been learned from the 1930s, the euro area's economic trajectory would surely have more closely resembled that of the Depression, perhaps made somewhat less serious by modern safety nets and mature (perhaps that's the wrong word) democratic governments. It still might; Matt O'Brien updates the Depression story here. But today's policymakers do know more about how not to fight crises than their 1930s counterparts. That difference in knowledge is the reason the euro area is falling hundreds of billions short of an achievable output path rather then several trillion. And so I think there might be a different and more effective way to describe what's happening in Europe.

Let's say that America's output path represents "intellectual potential". The gap between a Depression-like path for America's economy and its actual path represents a gain attributable to the macroeconomic knowledge attained since the 1930s. I, like many others, think that the American economy could be doing even better—could in fact be operating at estimated potential. But policymakers lack an intellectual consensus on how to get there. Thus, intellectual potential.

Europe is falling short of intellectual potential. This shortfall isn't "structural" in the usual sense; it has only emerged over the past two years or so. It could be due to a "Great Forgetting" in the euro area—a systematic loss of macroeconomic knowledge isolated to one corner of the global economy—but that seems unlikely, and the European Central Bank's refusal to give in to liquidationism suggests the lessons of the Depression have not leaked out of Mario Draghi's brain.

No, the gap instead corresponds to the euro area's failure to implement an institutional framework capable of delivering intellectual potential. There are a number of different ways that it could tweak its framework to do so. But none of them appear to be politically manageable. That such large costs might materialise as a result of the euro's adoption has always been a possibility, but only now are they being realised. Thanks to the American counterexample, they are being realised very, very visibly. (This story is a little crude—one might ask whether Europe could duplicate America's shale bonanza, for instance—but to a first approximation it works.)

The gold standard was a powerful idea which delivered unquantifiable benefits and unquantifiable costs. The powerful fear of the unknown kept the gold standard intact even as the costs of Depression mounted. But once the dominoes began falling, they fell quickly. Even America, with enormous gold reserves and therefore, seemingly, a strong interest in maintaining the standard, only remained on gold for two more years after the system began to unravel in 1931. The threat that disaster might befall any euro member to drop out may continue to keep economies in line. But America represents a wild card that wasn't present in 1931: a very large and very rich economy not on the prevailing standard and not suffering for it. The gap between the euro zone and America is the counterfactual, the but-for path, that helps illustrate just how damaging the single currency has been. Leave the euro area and you may not immediately spring back to that alternate path, leaders around the periphery may think, but at least you'll stop sinking, and you can sell your wares to the world's healthy economies at a steep discount relative to your neighbours.

I had been surprised at how long euro-area residents seemed content to suffer through the continent's economic mess. But maybe I shouldn't have been; until recently, it wasn't obvious that other large, rich economies could manage much better. Now it is, and it will become more obvious every quarter. Perhaps the American example will motivate euro-area leaders to change course. If not, the temptation to abandon a sinking ship will only grow.

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