Europe-bashing is a fashionable pastime. Conventional wisdom views Europe as a sickly shadow of an economic powerhouse, flailing to keep pace with the sprightly US. Persistent growth differentials between the two economies are explained with reference to US exceptionalism and ‘Eurosclerosis’. The explanatory power of fiscal policy divergence, particularly in crisis episodes, is often overlooked.

Undeniably, the US has a structurally higher gross domestic product growth rate. Since 2005, the euro area growth has averaged 1.3% (1.4% for the European Union as a whole) compared with 2.1% in the US. Higher rates of immigration, unified capital markets and higher US productivity growth explain a large part of the gap. However, when measuring the US-euro area GDP growth gap since 2005 as the sum of the absolute differences in annual growth rates, more than a quarter of the gap is concentrated in just two crisis years: 2009 and 2020.

These years coincide with highly divergent net fiscal positions in the two economies. This suggests that the capacity of the US to act quickly in crises, smoothing economic cycles through discretionary federal support during crisis times – when fiscal policy is most binding – is relevant in contextualising US exceptionalism. The US, as a federation, has the institutional architecture to facilitate rapid centralised counter-cyclical policy. In Europe, by contrast, the absence of a centralised transfer mechanism leaves counter-cyclical fiscal policy in the hands of member states, where its intensity often varies inversely with its necessity.

Crisis management and growth differentials

The conventional measure of fiscal largesse is the cyclically adjusted primary balance. This metric expresses net borrowing or saving, excluding interest payments and adjusted for the economic cycle, as a percentage of potential GDP. It tells us the extent to which a fiscal stance is contractionary or expansionary after adjusting for the business cycle, stripping out the automatic response of revenues and spending to economic conditions – negative figures imply a looser fiscal stance and vice versa. Since 2005, the US has run an average annual CAPB of -3.9%. The figure in the euro area is -0.31%.

However, sustained fiscal largess cannot explain the growth differential. Changes in the fiscal stance – rather than levels – affect annual growth rates. These year-on-year differences in discretionary fiscal stance – annual CAPB changes – are the fiscal impulse. They are plotted alongside GDP growth in Figure 1.

Our modelling suggests that each additional 1 percentage point of potential GDP in US fiscal impulse relative to the euro area is associated with a 0.4pp widening of the growth differential. Importantly, this relationship is dominated by the effects of crisis years, particularly 2020 and to a lesser extent, 2009; Figure 1 illustrates this effect. Running our model with these years excluded the estimated association between fiscal impulse and growth differential becomes statistically indistinguishable from 0. This result is consistent with the idea that fiscal policy has the highest impact during a recession, such that crisis response dominates in the effect of fiscal policy on growth differentials.

Figure 1. Crisis effects dominate

US versus euro area GDP growth and fiscal impulse

Source: European Central Bank; Federal Reserve; World Bank; International Monetary Fund; European Commission; OMFIF analysis

Note: euro area figure rather than whole-of-EU figures used due to data availability. Fiscal impulse defined as −ΔCAPB (positive = expansionary).

The speed of the fiscal response to crisis also matters and US crisis-time fiscal policy is characterised not only by scale, but also rapidity. In response to Covid, just two days after the worst single day decline in US equity markets since 1987, the US federal government had passed a stimulus package worth $192bn, around 0.9% of 2019 GDP. Four months later, they passed the Coronavirus Aid, Relief and Economic Security (CARES) Act – worth $2.2tn, more than 10% of 2019 GDP. By the end of 2020, across five legislative packages, $3.8tn of fiscal support had been approved, with direct stimulus measures roughly equivalent to Germany’s 2020 GDP.

By contrast, the European Commission’s Support to mitigate Unemployment Risks in an Emergency (SURE) programme was agreed by the European Council on 19 May 2020, 62 days after the first major round of US stimulus. SURE authorised up to €100bn of EU financial assistance in the form of loans to member states, or 0.8% of euro area GDP (0.7% of total EU GDP). It was more than a year until the subsequent approval of the Next Generation EU fund, an €800bn package of loans and grants to member states financed by joint borrowing at the EU level.

Although member states responded with national stimulus programmes, their scale varied with heterogeneous fiscal space and their sum was dwarfed by the size of US stimulus. The euro area ran a CAPB of -2.1% of potential GDP in 2020, versus a CAPB of -8.5% in the US. Put simply, after stripping out the automatic effects of the cycle on tax receipts and spending, the US discretionary fiscal stance was more than four times as expansionary as the euro area’s.

Architecture and caricature

Centralised fiscal transfer mechanisms are not a panacea, but they are the obviously lacking component in the 21-country monetary union, and 27-country political union. Theoreticians since the 1960s have posited the need for fiscal levers to offset asymmetric shocks in a currency union. Although NGEU was too late to mitigate the worst effects of the Covid crisis, it is a workable template demonstrating that despite the constraints of Europe’s institutional architecture, it can take decisive actions towards meaningful fiscal capacity. European policy-makers seeking a post-Eurosclerosis narrative of the European economy should push to continue collective borrowing under an NGEU successor programme, bolstering the capacity of the Commission to take more rapid stabilisation measures during the next crisis.

Although the European economy lacks some of the structural economic advantages of the US, it is not preordained to lag. With the fiscal component in focus, the neat caricature of Eurosclerosis versus US exceptionalism becomes a partial account at best, obscuring the role that institutional architecture plays in determining fiscal capacity, and explaining outcome divergence.

Conor Perry is an Economist at OMFIF.

Explore Europe’s place in a divided world in further detail in the next edition of the Bulletin, publishing on 3 February.

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