THE Great Recession of 2008 has morphed into the North Atlantic Recession: it is mainly Europe and the US, not the emerging markets, that have become mired in slow growth and high unemployment. And it is Europe and the US that are marching, alone and together, to the denouement of a grand debacle. A busted bubble led to a huge Keynesian stimulus that averted a much deeper recession, but that also fuelled substantial budget deficits. The response - big spending cuts - ensures that unacceptably high unemployment will continue, possibly for years.
The European Union has finally committed itself to helping its financially distressed members. It had no choice: with financial turmoil threatening to spread from small countries such as Greece and Ireland to large ones such as Italy and Spain, the euro's very survival was in growing jeopardy. Europe's leaders recognised that distressed countries' debts would become unmanageable unless their economies could grow, and that growth could not be achieved without assistance.
But, even as Europe's leaders promised help was on the way, they doubled down on the belief that noncrisis countries must cut spending. The resulting austerity will hinder Europe's growth, and thus that of its most distressed economies: after all, nothing would help Greece more than robust growth in its trading partners. And low growth will hurt tax revenues, undermining the proclaimed goal of fiscal consolidation. The discussions before the crisis illustrated how little had been done to repair economic fundamentals. The European Central Bank's (ECB's) vehement opposition to what is essential to all capitalist economies - the restructuring of failed or insolvent entities' debt - is evidence of the continuing fragility of the western banking system.
The ECB argued that taxpayers should pick up the entire tab for Greece's bad sovereign debt, for fear that any private- sector involvement would trigger a "credit event," that would force large payouts on credit-default swaps , possibly fuelling further financial turmoil. But, if that is a real ECB fear, surely it should have demanded that the banks have more capital.
Likewise, the ECB should have barred banks from the risky credit-default swaps market, where they are held hostage to rating agencies' decisions about what constitutes a "credit event". Indeed, one positive achievement by European leaders at the recent Brussels summit was to begin the process of reining in both the ECB and the power of the US ratings agencies.
Indeed, the most curious aspect of the ECB's position was its threat not to accept restructured government bonds as collateral if the rating agencies decided that the restructuring should be classified as a credit event. The whole point of restructuring was to discharge debt and make the remainder more manageable. If the bonds were acceptable as collateral before the restructuring, surely they were safer after the restructuring, and thus equally acceptable.
This episode serves as a reminder that central banks are political institutions, with a political agenda, and that independent central banks tend to be captured by the banks they are supposed to regulate.
Matters are little better on the other side of the Atlantic. Th e extreme right threatened to shut down the US government, confirming what game theory suggests: when those irrationally committed to destruction if they don't get their way, confront rational individuals, the former prevail. As a result, President Barack Obama acquiesced in an unbalanced debt-reduction strategy, with no tax rises.
Optimists argue that the short-run macroeconomic effect of the deal to raise the US's debt ceiling and prevent sovereign default will be limited - about $25bn in spending cuts in the coming year. But the payroll-tax cut was not renewed, and surely business, expecting contractionary effects down the line, will be even more loath to lend.
The end of the stimulus itself is contractionary. And with housing prices continuing to fall, economic growth faltering, and unemployment high, more stimulus is needed - to balanc e the budget as well. The single most important driver of deficit growth is weak tax revenue as a result of poor economic performance; the single best remedy would be to put the US back to work. The recent debt deal is a move in the wrong direction.
There has been much concern about financial contagion between Europe and the US. After all, the US's financial mismanagement played an important role in triggering Europe's problems, and financial turmoil in Europe would not be good for the US.
But the real problem stems from another form of contagion: bad ideas move easily across borders, and misguided economic notions have been reinforcing each other. The same will be true of the stagnation those policies bring. © Project Syndicate, 2011. www.project-syndicate.org
. Stiglitz is professor at Columbia University.