President Obama and 'Headwinds' from Europe
Here we go again. Over the weekend, the President once more blamed “headwinds” from Europe for the United States economy’s poor recent performance. The President’s insistence on using Europe as a scapegoat is particularly frustrating because it breeds misunderstanding of both the European dilemma and the nature of our own challenges.
First, many countries either inside of the euro zone (or highly dependent on it) have performed far better than the United States over the past few years. If exposure to Europe were the main “headwind” holding back growth in the U.S., it would not be possible to explain these countries’ success. The recession in Europe is clearly weighing on multinational corporations’ earnings, but many of these products are produced in Europe, which means the decline accounts for a very small share of U.S. national income.
In the first quarter of 2012, the U.S. economy expanded at a 1.5% annual rate, about half as fast as the trend growth rate for the past forty years and exceptionally low in the context of the level of unemployment. “Recoveries” should be periods of catch-up when the economy grows faster than it would at full employment to make up for the past contraction. For example, in the Congressional Budget Office (CBO) baseline economic outlook, the economy is expected to grow by 4.7% between 2014 and 2015 to reach full employment by 2018. If the economy continues to grow at between 1% and 2%, unemployment will remain above 8% indefinitely.
Entering 2012, the export of goods to the European Union (the 27-member EU, which includes 10 counties that do not use the euro currency) totaled $268 billion, or 1.77% of U.S. GDP. A decline of 25% (far higher than what’s anticipated) would slow U.S. growth by just 0.4%. The maximum headwind from Europe that one could reasonably estimate for the second quarter would be about 0.1%. It’s clear that President Obama would rather people focus on the news headlines, where fears about the euro zone’s disintegration are a daily feature, and not the underlying arithmetic.
Consider the case of Sweden, where the economy expanded at a 5.7% annual rate in the second quarter of 2012 (a 1.4% quarterly rate, compared to a 0.4% quarterly rate in the U.S.). Sweden is a member of the European Union but retains its own currency. Entering 2012, exports to the euro zone – just the 17 nations that use the euro currency – was equal to 17.5% of Sweden’s GDP, or more than 10-times the U.S. exposure. Moreover, advanced economies inside the euro zone like Germany and Finland actually grew faster in the first quarter (and in the previous year) than the U.S. Less advanced euro zone economies like Estonia also grew much faster. The U.S. exposure to Europe explains a very small fraction of our slow growth, and the relative success of European economies helps to emphasize this point.
Secondly, the President’s efforts to contrast U.S. policies to those of Europe deserve further scrutiny. The key takeaway from the crisis in Greece, Spain, and elsewhere, is that entrenched interests and constituencies dependent on government payments are not willing to surrender their hard-fought gains against the backdrop of broader budget instability. Calls for “austerity” have generated riots in the street, political brinksmanship, and socialist electoral resurgence. The Greek government is unable to cut spending to comply with the terms of its bailout; Spain cannot enact reform to eliminate the lifetime employment rules and national wage bargaining that are directly linked to its 24.8% unemployment rate; and France just elected a Socialist President focused on lowering the retirement age. In short, and as is so often the case, increasing the size of government also increases the strength of connected constituencies.
The President argues that the decisive action taken in 2009 helped the U.S. avoid Europe’s current fate. More likely, it (and the lack of action on long-term U.S. budget reforms since) has increased the chances that the U.S will share in Europe’s fate. By increasing the size of government (e.g. strengthening the hand of public employees’ unions through fiscal transfers to states and creating new entitlements), the President has not only made a fiscal crisis more probable, he has also made the population less able (or prepared) to deal with its implications. Protests against structural reforms to labor markets or increases in the retirement age are generally animated by a sense that “the rich” should be the ones sacrificing rather than middle class workers. It was no accident that in France, President Hollande’s pledge for more stimulus and a lower retirement age was matched by a call for an increase in the top tax rates to 75%. It is not simply anger over budget cuts that drive people to the streets, but also resentment of those who seem able to avoid having to make a similar sacrifice.
Every year the U.S. waits to address the budget gap, the larger the spending cuts will have to be to solve the problem. Today, a 4% of GDP cut would be worth 32% of GDP in ten years as the savings accumulate over time. Waiting is likely to prove especially hazardous for the U.S. given that the long-term budget problem is so intimately tied to paying for retirees’ public pensions and, particularly, their health care. As shown in the table below, the IMF estimates the size of the U.S. fiscal problem as several times larger than Italy’s and about 70% larger than Greece’s and Spain’s when including age-related spending. Within ten years, the politics of reform will be even worse than the arithmetic.
