by Bob Hancké, Political Economist at the London School of Economics and Political Science

Something strange is happening in the European economy. Those countries that, on the whole, did the right thing over the last ten to fifteen years by sorting out their domestic economies, and produce competitive exports goods, are staring into a dark tunnel, while the country that built its growth on debt and speculation – the UK – may be coming out of the recession. Germany’s 2009 drop in GDP is going to be the highest on the continent (leaving aside the Baltics and a few other semi-suicidal Central European economies); the UK government, meanwhile, is increasingly looking right in its forecasts of positive growth in 2010. 

It’s too early to tell if this is actually going to happen. I am not very impressed by the pervasive talk of ‘green shoots’ in the economy, and it is not entirely clear what exactly medium-term growth in the UK would be based on. The recovery has been primarily based on government-financed macro-economic policy and a massive devaluation in sterling, not on a resurgent vibrant economy. My fear is that while the UK is doing the right thing in the short run, its problems lie in the long-run adjustment of the economy. I don’t quite see how the industries where the UK was strongest internationally – first and foremost the financial sector, of course – are offering a viable long-term economic strategy, and I am equally sceptical about the ability of the UK to rediscover its old industrial roots and start churning out sophisticated complex engineering goods. And the high levels of public and private debt will curtail any ambitions about public or private investment for many years to come. 

If I am right about this, the UK is in for a protracted period of low growth, punctuated by mild recessions – exactly what made Japan lose almost two decades. Think of the curve over time as a slow decline, followed by a long period of stagnation at a relatively low level, with small annual blips above and below this trend line, playing out over at least ten years – or longer, if that’s what it takes to restore financial balances and build competitive export sectors. 

Germany faces a very different predicament. It has been overly reliant on exports for growth, and with global demand slumping, that creates its own problems. In addition, its fiscal policy is too little (and often too late), so relief from that corner is going to be minor. And because Germany is directly or indirectly the main trading partner of all other places in Europe, a slump in Germany rapidly reproduces itself over the entire continent. The upshot: German companies adjust by becoming more competitive, while the macro-economy keeps on sagging. But that, too, looks like Japan in the 1990s: a morose economy with a highly competitive export sector, but which discovers that you cannot compete your way out of a serious recession. 

It might all not be as bad as this: the UK may well be turning the corner, slowly, and north-west Europe, including Germany, may go through a short, sharp V-like recession, and start picking up again, on the UK’s and the US’ coattails by late 2010. But if it is, the textbooks on economic policy-making will have to be rewritten: what we thought we learned from the Japanese experience over the last twenty years should take a far more central place than it has up until now.