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START WITH THE EVIDENCE: Addressing weaker demand and the wage gap is key to recovery
TO understand how to achieve a sustained recovery from the Great Recession, we need to understand its causes.
First, overall demand for goods and services is much weaker, both in Europe and the United States, than it was in the go-go years before the recession.
Second, most of the economic gains in the US in recent years have gone to the rich, while the middle class has fallen behind in relative terms. In Europe, concerns about domestic income inequality are compounded by angst about inequality between countries, as Germany roars ahead while the southern periphery stalls.
Progressive economists argue that the weakening of unions in the US, together with tax policies favouring the rich, slowed middle-class income growth, while traditional transfer programmes were cut back. With incomes stagnant, households were encouraged to borrow, especially against home equity, to maintain consumption.
Rising house prices gave people the illusion that increasing wealth backed their borrowing. But, now that house prices have collapsed and credit is unavailable to underwater households, demand has plummeted.
The key to recovery is to tax the rich, increase transfers and restore worker incomes by enhancing union bargaining power and raising minimum wages.
But countries like Germany that reformed labour laws to create more flexibility for employers, and did not raise wages rapidly, seem to be in better economic shape than countries like France and Spain, where labour was better protected.
So consider an alternative explanation: starting in the early 1970s, advanced economies found it increasingly difficult to grow. Countries like the US and the United Kingdom eventually responded by deregulating their economies.
Greater competition and the adoption of new technologies increased the demand for, and incomes of, highly skilled, talented, and educated workers doing non-routine jobs like consulting. More routine, once well-paying, jobs done by the unskilled or the moderately educated were automated or outsourced.
The short-sighted political response to the anxieties of those falling behind was to ease their access to credit. Faced with little regulatory restraint, banks overdosed on risky loans.
While differing on the root causes of inequality (at least in the US), the progressive and alternative narratives agree about its consequences.
The alternative narrative has more to say. Continental Europe did not deregulate as much, and preferred to seek growth in greater economic integration. But the price for protecting workers and firms was slower growth and higher unemployment.
While inequality did not increase as much as in the US, job prospects were terrible for the young and unemployed, who were left out of the protected system.
The advent of the euro was a seeming boon, because it reduced borrowing costs and allowed countries to create jobs through debt-financed spending. The crisis ended that spending, leaving the heavy spenders indebted and uncompetitive.
The important exception is Germany, accustomed to low borrowing costs even before it entered the eurozone. Germany had to contend with historically high unemployment, stemming from reunification with a sick East Germany.
In the euro's initial years, Germany had no option but to reduce worker protections, limit wage increases and reduce pensions as it tried to increase employment. Germany's labour costs fell relative to the rest of the eurozone, and its exports and gross domestic product growth exploded.
The alternative view suggests different remedies. The US should focus on helping to tailor the education and skills of the people being left behind to the available jobs.
Rather than paying for any necessary spending by raising tax rates on the rich, which would hurt entrepreneurship, more thoughtful across-the-board tax reform is needed.
For the uncompetitive parts of the eurozone, structural reforms can no longer be postponed. But it is not politically feasible to do everything, including painful fiscal tightening, immediately.
In a nutshell, the fundamental eurozone dilemma is: the periphery needs financing as it adjusts, while Germany, pointing to the post-euro experience, says that it cannot trust countries to reform once they get the money.
The Germans have been insisting on institutional change, more centralised eurozone control over periphery banks and government budgets in exchange for expanded access to financing for the periphery. Yet, institutional change will take time, for it requires careful structuring and broader public support.
Europe may be better off with stop-gap measures. If confidence in Italy or Spain deteriorates again, the eurozone may have to resort to the traditional bridge between weak credibility and low-cost financing: a temporary International Monetary Fund-style monitored reform programme.
Such programmes cannot dispense with the need for government resolve, as Greece's travails demonstrate. And governments hate the implied loss of sovereignty and face.
As a reformed Europe starts growing, parts of it may experience US-style inequality. But growth can provide the resources to address that.
Far worse for Europe would be to avoid serious reform and lapse into egalitarian and genteel decline. Japan, not the US, is the example to avoid. Project Syndicate