The U.S. economy might be on the verge of a double-dip recession, while Europe is paralyzed by a massive debt crisis afflicting the governments on the periphery of the eurozone. Alarming as they are, both of these stories are just part of an even gloomier overall economic picture of the West.
The latest data on manufacturing and job creation in the United States indicate that the recovery is faltering. In May, the number of jobs added by companies rose by 38,000, down from 179,000 in April. Overall, the U.S. economy is now expected to grow at only 2 to 3 percent this year—in sharp contrast with the initial forecasts of solid 4 percent growth.
The news from Europe is not encouraging, either. The debt crisis in Portugal, Italy, Ireland, Greece, and Spain—known collectively as the PIIGS—might be entering its terminal stages, as Greece’s debt is downgraded deeper into junk status. Unless Greece receives another installment of roughly $17.3 billion from the EU and the IMF by the end of this month, it will face a default within a matter of weeks.
Since the mid-1970s, productivity growth of Western economies has slowed dramatically. The U.S. economy grew at an average rate of 3.8 percent in the period of 1946-1973, yet growth rates since then have averaged 2.7 percent, causing median incomes effectively to stagnate.
The economist Tyler Cowen has made the case in The Great Stagnation that this slowdown is a result of America’s running out of its “low-hanging fruit”: free land, technological breakthroughs, and a smart yet uneducated labor force. Western Europe has endured a similar experience whereby it has never regained the growth rates it enjoyed during the three postwar decades, known in France as the “trente glorieuses.”
Living in what is at least for now a lower growth world requires an adjustment of spending habits. However, both American and European fiscal institutions have behaved as if the economic slowdown never occurred and that regaining the pre-1970s growth rates was only a question of time. Unsurprisingly, this set the West on an unsustainable fiscal path.
In the past decades, the two fastest growing sectors of the American economy, for instance, have been health care and education. While neither of them is run solely by the government, their growth was made possible by government spending and entitlement programs. This would not have been a problem if the growth in those sectors had resulted in a healthier and better-skilled labor force. Unfortunately, that has not been the case. If anything, the quality of an average college graduate’s education is worse today than 30 years ago. Furthermore, any link between the increase in health care spending and Americans’ enjoying longer, healthier lives is extremely tenuous to say the least.
While not necessarily fueling the growth of their health care or education systems, the Europeans have devised elaborate ways of harming their economies. The euro has been a political project from the start. It has never been justified in economic terms, and the early warnings from the likes of Milton Friedman and Martin Feldstein were ignored. Since its inception in 1999, this monetary arrangement has created a real-estate bubble in Ireland and great fiscal and external imbalances in the Mediterranean countries, which would almost certainly have benefited from looser monetary policy.
Today, countries like Greece or Portugal are asked to go through a very painful process of rapid fiscal tightening and internal devaluation only to avoid their default and exit from the eurozone. The reason for this policy is that a wave of sovereign defaults by the PIIGS would trigger a banking crisis in France and in Germany, which hold most of the debt. Such a crisis could have an impact on the global economy beyond the scope of the recession we saw in the aftermath of the failure of Lehman Brothers.
The efforts to consolidate public finance in Greece and elsewhere are likely to come to nothing. In modern history, countries that have been able to deal successfully with imbalances of the size that are plaguing the Mediterranean have done so through a combination of debt restructuring and currency devaluation. To pretend, as European leaders do, that this time is different is both naïve and harmful for the future of European economies.
So what’s the best way forward? Besides tackling the threat of a double-dip recession and a potentially devastating banking crisis in Europe, the West needs to learn how to live within its means in a modest-growth world. By the standards of the past 200 years, the growth rates enjoyed in the 30-year period following World War II may turn out to have been an anomaly.
If normal growth is the likely state of affairs in the decades to come, politicians on both sides of the Atlantic need to take it into account when devising their spending plans. In the United States as in Europe, that means curbing the growth of entitlement programs and rethinking what role government-provided welfare can be reasonably expected to play. Politicians will need to become prudent, modest, and more frank about what governments are able to do, and at what cost.
Many of our current predicaments result from the simple fact that politicians have refused to face reality. They either pretended that Western societies were becoming wealthier than they actually were, or thought that grand political schemes—such as a common European currency—were going to boost growth miraculously.
Both of those approaches—denial and hubris—have failed spectacularly and led to costs that are much greater than the direct effects of the under-lying productivity slowdown. The prospects of living in a world of only modest economic growth are not exciting. But as our current economic woes suggest, there is an almost limitless potential for ill-advised policies to make things worse.
Dalibor Rohac is a research fellow at the Legatum Institute in London.