The Transatlantic macroeconomic divergence

BRUSSELS — With Europe finally beginning to catch up to the United States in vaccinating its population, both sides of the Atlantic seem set for a strong economic recovery. But macroeconomic policies are diverging in ways that could create serious problems in the future.

Fiscal policy has already diverged. The US is on course to run a public of around 15 per cent of GDP for two years (2020 and 2021). The scale of next year’s deficit remains to be seen, but bringing it down to single-digit figures would constitute an unprecedented contraction. Add to that President Joe Biden’s proposed $2 trillion American Jobs Plan, which his administration is still negotiating with lawmakers, and it seems highly unlikely that the US fiscal stance will suddenly tighten in 2022.

In the eurozone, governments also ramped up spending during the COVID-19 crisis, but not nearly as much. Expenditure added up to 7-8 per cent of GDP in 2020 and 2021, no small share, but just half that of the US.

Moreover, according to the European Commission’s Spring 2021 Economic Forecast, the deficit should fall to below 4 per cent of GDP in 2022, again, probably half the likely US value. Most European countries plan to return soon to the prudence that enabled the eurozone to achieve an average deficit of close to zero in 2019, just before the pandemic hit.

At first sight, this fiscal-policy divergence might be puzzling. After all, the US is set to recover its pre-crisis GDP first, suggesting that it is less in need of stimulus. But a closer look reveals a clear reason for the split, namely, how well fiscal spending was targeted.

In most European countries, short-time working schemes provided the funds companies needed to keep workers on their payroll, even if public-health measures left them with little actual work to do for months. By contrast, the US federal government provided checks to everybody below a certain (relatively high) income level, regardless of whether they kept their jobs, in addition to increased benefits for the unemployed.

As a result of these divergent approaches, the pandemic affected European and US labour markets very differently. In Europe, the situation was not particularly tumultuous: recorded unemployment increased by less than one percentage point, even though hours worked declined significantly.

In the US, hours worked declined by a similar amount, but unemployment was far from stable. Tens of millions of workers were laid off early last year, when pandemic lockdowns began. In recent months, as vaccination has progressed and restrictions have been lifted, millions have been rehired. But some 7 million jobs still need to be restored for the US economy to return to full employment.

The US and Europe are also taking different monetary-policy approaches. To be sure, monetary policy officially remains fully accommodative everywhere. But the underlying conditions, and actual policy, are beginning to diverge, as central banks decided when and how to begin tightening.

For the US Federal Reserve, the plan is to maintain a very accommodative stance, including large asset purchases, until actual inflation exceeds its target of near 2 per cent. In a sense, this line has already been crossed: headline inflation is above 4 per cent, and even core inflation, with volatile energy and food prices stripped out, recently surpassed 3 per cent. But the Fed expects this increase to be temporary, so it has decided not to begin tightening immediately. In fact, the Fed has officially committed to “mitigate shortfalls of employment…from its maximum level”, Fed-speak for running the economy “hot”.

But the Fed’s actions are not quite in line with its official stance. The most recent “dot plot”, which maps out the Federal Open Market Committee members’ expectations for where interest rates could be headed in the future, implies that rates might rise as early as next year. Already, the Fed has begun stealthily tightening monetary policy.

In recent months, the Fed has engaged in large repurchase operations, whereby it has sold forward around $800 billion of Treasury securities, much more than it has bought on the cash market. In other words, one arm of the Fed is, through reverse repos, de facto undoing the other arm’s bond purchases. This approach enables the Fed to claim not to be tightening policy at a time when unemployment is still high, even as, for all intents and purposes, it does just that.

The discrepancy between the Fed’s official stance and actual policies has naturally increased uncertainty about the future course of inflation in the US, a topic that has already invited heated discussion. Some financial-market indicators now place the likelihood that inflation will exceed 3 per cent over the next five years at nearly 40 per cent.

Meanwhile, the European Central Bank (ECB) remains committed to ensuring price stability. This means getting inflation to rise, not fall. While headline inflation reached 2 per cent for the first time in years this past May, core inflation remains stuck just below 1 per cent. With the ECB aiming to push inflation closer to 2 per cent, the ECB has little choice but to continue buying bonds at a rapid pace. And no interest-rate hike is in sight.

So, while fiscal and monetary policy technically remain expansionary on both sides of the Atlantic, the US and the eurozone are clearly on different macroeconomic-policy tracks. Whereas the US is embracing fiscal expansion, but surreptitiously pursuing monetary tightening, the eurozone is eager to return to fiscal prudence, while maintaining monetary accommodation.

By itself, this divergence is not particularly newsworthy. Nobody is shocked to hear that different economic conditions and priorities lead to different policy approaches. But the potential longer-term effects should not be underestimated. If both economies stay on their current path, it would strengthen the US dollar, reinforce America’s tendency to run large external deficits, and make growth in Europe even more export-dependent. This is a recipe for trade tensions, and for an abrupt end to the Biden era’s transatlantic honeymoon.

Daniel Gros is a member of the board and a distinguished fellow at the Centre for European Policy Studies. Copyright: Project Syndicate, 2021. 

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