How to deal with economic downturns? The US response is to loosen monetary policy (by lowering interests rates) dramatically, and by opening up the fiscal taps until everything is drunk. In Europe, it is different. For the European Central Bank, price stability is everything. Interest rates are only changed cautiously and incrementally, always with an eye on inflation and longer-term stability. If that means tolerating lower growth today, so be it. Likewise, fiscal policy is constrained within a rules-based framework (the Stability and Growth Pact) which places a high premium on fiscal discipline, and frowns on major discretionary loosening even for the purposes of mitigating a cyclical downturn.
The reason for this different is, of course, obvious. To get a bit technical, automatic stabilizers (lower taxes from lower activity and higher spending from unemployment benefits and other income support schemes) are stronger in Europe. One way to look at it is that the large government sector acts as a cushion against a private sector downturn. And that is part and parcel of the stability culture. Think of the quintessential Danish model: if you lose your job, your replacement rate will be very high (close to 90 percent of your last wage). But this is temporary and conditional on you taking part in training schemes if you cannot find work after a certain point. The other side of this social bargain is that the labor market is rather flexible, in that there are few constraints against being fired. But it works. Instead of protecting jobs that may not be viable, it protects workers. It does not protect corporations or risk takers. It provides workers them with a decent living, but does not create a culture of dependency. Denmark has one of the lowest unemployment rates in Europe.
Now, I’m sure many on the right of the American political spectrum will lambaste this system as just another example of American socialism. And yet, these same people are quite happy to cheer the government when it tries to cushion against negative shocks in other ways, typically ad hoc ways at that. The problem is, measures such as flooding the market with liquidity can sometimes have the effect of bailing out some of the people who made out like bandits during the good times, some of the people whose untamed greed led to the current crisis. Personally, I would prefer a safety net that protected workers, and let risk takers feel what the downside looks like on occasion.
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