When I was writing this article, the US House of Representatives had just approved a $ 1.9 billion budgetary stimulus package to support the recovery of the American economy from the crisis caused by the Covid-19 pandemic, one of the largest packages in the US history. And at the same time, the Financial Times published an editorial criticizing the modest recovery plans launched at European level, when compared to the plans on the other side of the Atlantic.¹

The Covid-19 pandemic was the biggest shock of the post-World War II period for developed economies: the EU and U.S. economies shrank 14.2% and 9.5% in the second quarter of 2020. In addition to the size, this type of shock was also unprecedented, creating problems as regards policies to address it. Modern macroeconomic policy is based on the economic cycle stabilization paradigm, stimulating during recessions and “tightening” during expansions. It quickly became clear that this approach would not be the most appropriate to deal with a public health crisis that required controlled shutdown of entire sectors of the economy. Traditional stimulus measures become counterproductive, as they stimulate precisely the economic activity that economies were doing their most to slow down. The objective of economic policy moved from “stimulus” to “relief”, in order to try to minimize the impact on those that depended the most on closed sectors, and to preserve the productive structure of these sectors.

With very low or even negative interest rates, the main central banks found themselves limited in terms of conventional policy and reactivated many of the extraordinary measures that had been put in place during the Great Recession. Its action was swift and may have prevented that shock from triggering a financial crisis in March 2020. But monetary policy had reached already its limits, along with the fact that it is not easily targeted at those sectors of society that were being most affected by the crisis. Most of the “relief” had to come from fiscal policy.

Figure 1 shows the “total relief” offered by several countries as a % of GDP. The intervention is classified into two types: direct expenditure and contingent liabilities. Direct expenditure consists of resources directly injected into the economy by governments, normally directed at families (direct transfers, unemployment support programs, etc.), with contingent liabilities consisting of guarantees or loans granted by governments, normally directed at companies.

The figure shows that although European countries like Germany and Italy offered substantial relief, they were generally much more moderate in terms of direct stimuli than the USA. This difference is to be expected, up to a certain extent, considering that European countries tend to have much more generous security and social protection systems, which means that part of that relief comes from automatic stabilizers and does not require the discretionary measures referred to in Figure 1. Furthermore, European economies tend to be less dynamic than the American economy in terms of job creation and job destruction. This explains why unemployment in the USA increased much more than in Europe, but fell also fallen rapidly. These two facts help explaining the differential aspects of the crisis response, and why European governments have focused much more on supporting companies and preserving jobs that would not have been quickly recovered should they have been destroyed.

Although the pandemic is not yet fully controlled, vaccination campaigns are in full swing and attention is now focused on the reopening of economies and on the policies that prove necessary to ensure that they recover in a sustainable manner. Unlike the aforementioned relief policies, these will be rather traditional stimulus policies. In the US, the proposed $ 1.9 billion package has yet to be approved by the Senate. In the EU, the recovery will be supported by the Next Generation EU, with € 750 billion to be distributed among member states from 2021 to 2023.

Figure 1

The size and type of such packages has been at the core of economic policy debate on both sides of the Atlantic. In the US, some argue that the package is too big, and the reasons pointed out are the following: the relief policies discussed in the previous paragraphs have led to an increase in household disposable income, 15% above the pre-pandemic value. Disposable income has increased abnormally not only as a result of these policies, but also given that part of the economy is closed and households cannot spend that additional income on goods and services they would normally buy (tourism, eating out, etc.). ). There is, therefore, an “accumulated demand” for goods and services, which does not materialize because the economy is still closed. After the reopening, there will be enough disposable income to generate a large increase in aggregate demand and recovery will rest on this. Therefore, a large fiscal stimulus is necessary, but it can cause problems: it leads to large increase in public debt, which is already at historically high levels (130% of GDP), and possibly to a huge inflation rate increase.

In Europe, on the other hand, and given that relief policies were more modest, household disposable income fell, and is now 3% below its pre-pandemic value (and with bigger drops in some member states). Therefore, there are no expectations that “accumulated demand” may sustain the recovery. The situation in terms of private investment is even more shocking: a 10% drop in the EU, compared to 1.7% in the USA. These two facts lead several analysts to believe that the ‘output gap’ in the EU is much higher than that of the USA, and that budgetary intervention is much more necessary, which calls into question the (relatively) small size of the European recovery package. (see Figure 2, which compares the total GDP declines in 2020 to the proposed recovery packages).

An under-ambitious European recovery policy could have many political consequences that go far beyond macroeconomics. There is a causal relationship between economic stagnation and the rise of populist movements, which occurs in different times in history and regions of the world.² It follows that avoiding a situation of anaemic recovery, as witnessed after the Great Recession, and guaranteeing a prosperous recovery for all (especially those most affected by this shock) may be essential to guarantee the survival of the European Union itself. 

Figure 2

¹ “Europe should go big on fiscal policy too”, Financial Times, 22 February 2021

² See, for example, Colantone & Stanig (2019) “The Surge of Economic Nationalism in Western Europe”, Journal of Economic Perspectives.

* The views in this article are those of the author and do not reflect the positions of the Federal Reserve Bank of St. Louis or the Federal Reserve System.