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Why Europe is going round in vicious circles

ONE of the most puzzling things about economic performance is why it differs so much. Some countries over some periods can do no wrong; others can do nothing right.

Think of the US in the 1920s - all was go, go, go. Then revisit the US of the 1930s; it was unshiftable slump leading to the heavy regulatory interventions and the protectionism that made matters worse for the US and the rest of the world.

Or, since the War, think of Japan from the mid-1950s to the mid-1970s; and then again from 1990 onwards. A miracle of rapid, unstoppable growth in the first; an apparently hopeless stagnation in the second. Or ourselves and continental Europe: in the 1960s and 1970s they could nothing wrong and we were the basket case of the western world, yet in the 1980s and 1990s the roles have been reversed.

How can this be? We all have access to the same ideas about managing the economy, the same technology, the same world capital market, to the same sorts of skills in our labour forces. Why do we not all copy best practice?

The answer must lie in "institutions" - the way people organise themselves politically to deal with the threats from their environment. All this was brought home to me recently when reading the new book by Sir John Hoskyns (Just In Time) about the first few years of Mrs Thatcher's government when he was her political adviser in No 10. To explain to himself the nature of Britain's problem he constructed a "wiring diagram" of the economy's difficulties, all of which fed back to make the others worse.

Thus for example union power worsened unemployment, which made governments more inclined to print money and run larger deficits; the resulting inflation made unions more militant and their membership larger for protection against it; wage controls were then brought in to control inflation, but these merely strengthened unions further since unions could defy controls where individuals were powerless. Apparently to cure anything you had to change everything.

Well, hindsight is a wonderful thing and what we now know is that curing one bit can then expose the next bit in the interlocking disease, in a series of steps that build confidence in the process. First, inflation fell; then the unions were curbed; then the nationalised industries were privatised; and so on.

Once people have experienced the first part, they realise they never want to slip back into the morass and they become eager for parts two, three and four. Having completed these, a virtuous circle has replaced the previous vicious one. The people, once bitten, twice shy, revel in the new success and watch carefully for any signs of backsliding towards the old disease. Labour finally learnt this lesson and we got New Labour - full of faults but basically cautious in bringing back the Old Labour disease and ready to retreat from its excesses, like Mr Brown last week.

Economists have for years had a reasonable grasp of the causes of inflation and of growth. Inflation comes from government monetary incontinence, often fed by fiscal deficits - hence inflation is monetary in origin. Growth comes from allowing capitalist innovation to flourish with a minimum of interference and taxation - good "supply-side" policy. In the early Thatcher years policy programmes were drawn up on each of these "fronts". But economists had thought little about political feasibility - they had hunches but no properly worked-out theory.

Hoskyns' diagram was therefore well ahead of its time. In effect its wires are all political; there are strong links between outcomes and institutions. If there is a slump, voters demand regulation, strong unions, protection and unemployment benefits (the US in the 30s) or at least the abandonment of deregulation (Japan in the 90s). In this way bad money breeds a worse supply-side and the economy spirals downwards into a stagnation equilibrium.

It can also produce inflation as a desperate policy reaction to rising unemployment; that seems to have been the case in the UK in the 60s and 70s, when there was also a belief in Keynesian methods. We thus had stagflation. However, the continent in the 90s has by contrast had only stagnation - with the death of Old Keynesianism the inflation policy reaction may have been bypassed.

Getting out of this state requires either a big shock (for the US the Second World War) or a determined reform programme (the UK in 1979) which revives popular faith in normal economics. But once popular confidence is built up the demands for protection evaporate and in their place people and businesses demand freedom - just the ticket for the supply side. Then the virtuous circle operates, the economy settles at a high-growth equilibrium.

Can we apply this theory to present-day continental Europe? If only EU countries could get into that virtuous circle - of high growth and economic freedom - we would hear less about harmonisation and majority voting on taxes and our EU relations could improve.

Smaller countries like Holland have reformed, perhaps because it is easier there to get consensus in favour of rational (copycat) action, resisting the forces of the vicious circle. France too could be reforming; while denouncing "les Anglo-Saxons", its managerial elite, helped by the centralised power of the state, may well be quietly getting on and copying them. However, Germany and Italy seem caught, UK-style, in a low-level equilibrium; any reform suggestion, such as cutting the state pension entitlements that threaten state bankruptcy 30 years out, is howled down by powerful unions.

Unfortunately Germany calls Europe's tune. We must hope for a virtuous shock that corrects its wiring and turns that tune melodious.

Patrick Minford is professor of economics at Cardiff Business School  

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