Financial TV has displayed (or reflected) some confusion lately over U.S. and European policies. Europe seems to be adopting “austerity” measures–why haven’t we heard the term ‘root canal’ lately?–while our administration is advocating stimulus for Europe and even more stimulus for the U.S. What’s wrong? Doesn’t economic theory provide the answer and shouldn’t the answer be the same here as in Euroland?
The first step in sorting this out is to acknowledge that the problem to be fixed is not exactly the same in Euroland and the United States. We both need stimulus to boost a weak recovery. We both have growing budget deficits and debt levels that should be reduced. However, the budget and debt piper to be paid has shown up in Europe already, beginning in Greece and affecting all 16 members of the Eurozone through the impact on the Euro.
Stimulus to promote growth in Europe may be needed and be important; deficit reduction in Europe is urgent. We all know from management literature and practice that, like it or not, the urgent must be dealt with before getting to the important.
Deficit reduction and bending the debt growth curve down is also extremely important for the United States. However, it’s not yet as urgent as in Europe. Maybe it’s luck; maybe the dollar’s role as a reserve currency has something to do with it. In addition, we see signs that our recovery may be losing steam, deflation increasingly seems more likely than inflation, and the dollar is rising rather than falling against most currencies, if not against gold.
Meanwhile, in the United States, the impression of an inflationary money growth is finally, but gradually, giving way to recognition that the money supply just isn’t growing that fast. A monetarist looking at graphs of M1 and M2 money growth in the United States over the past year or so would surely worry that monetary policy has been too tight rather than too easy as most people assume.
A massive build-up of excess reserves in the banking system is a sign of banker fear and uncertainty–as was the case in the mid-1930s–rather than a current inflationary threat. If the Fed heeded calls to “mop up” those excess reserves while banks continue to regard them as needed precautionary balances, the consequences would likely be similar to the consequences of that same action in the mid-1930s–that is, not good. It may well be that raising taxes in the middle of what came to be called the great depression did more harm that raising reserve requirements, but so what? They both, along with other policy mistakes, helped turn a great recession into a great depression. Guess what? We don’t have to pick and choose; we should avoid both mistakes.
Euroland is right to place deficit reduction at the top of its priority list. We should place it close to the top. We should be careful, however. Europe’s austerity program, will weaken European demand for U.S. goods and make the weakening economy more variable. We are right to urge them to stimulate their economy only if they can do so without triggering a renewed debt crisis. I don’t think we should risk that outcome.