Stephen King: Europe may prove the tortoise can catch the hare

We all know that the hare should have beaten the tortoise. We also know, of course, that the tortoise ultimately emerged victorious. Could the same apply to the US and Europe? Everyone believes the US has a better economy – leaner, fitter, more flexible and more devoted to its shareholders. Everyone also believes that Europe hides behind its protective shell, scared of global competition, undynamic, unwilling to adjust and afraid of change.

Yet could it be that Europe, over the long haul, does better than America? Imagine the headlines in a few years' time: "Europe shows the way"; "The US is taught a transatlantic lesson"; " Europe booms during America's bust".

All of this might seem like a bizarre flight of fancy. Yet history suggests that bizarre flights of fancy have a nasty habit of turning into a new reality. For example, turn the clock back to the late 1980s. Back then, it was the Japanese hare against the American tortoise. True, America had experienced some reasonably decent growth in the late 1980s. Nothing, however, could compare with the Japanese model.

Japan enjoyed strong growth, low inflation, rapidly-rising asset prices and a microeconomic management system that, by most accounts, was the envy of the world. Japan was, apparently, set to dominate the global economic stage through the 1990s and, perhaps, into the 21st century as well.

Well, that obviously wasn't the best forecast ever made. Which is why the current US position is worrying. It is not so much that the US is another Japan – American companies would never have tolerated Japan's willingness to maintain its cost base to the extent seen throughout the 1990s. Rather, America is a concern because the boom of the late 1990s was associated with expectations of so much more. America would deliver in a way that other countries could only dream about. America had discovered the elixir of rapid, long-term growth. American financial markets had boomed only because they understood the implications of the new economy better than anyone else did.

On top of all this, the Federal Reserve began to believe the new rhetoric. By 1999 and the beginning of 2000, the central bank's main emphasis was on the extent to which the new economy was shifting up the underlying growth rate of US GDP. And if the Fed believed it, there was every reason for others to buy into the same story. This official "rubber stamping" of America's transformation simply raised expectations further into the stratosphere. Moreover, to the extent that the Fed had successfully warded off earlier external threats – the Asian crisis, the LTCM hedge fund crisis, the Brazilian crisis – investors, quite reasonably, saw the risk of significant losses fade away. Suddenly, it was possible to achieve high returns with relatively low risk.

Despite all this, it is difficult to argue that the Fed did anything wrong, at least with regard to its constitutional mandate. Its mandated goals are straightforward. It needs to ensure price stability. It needs to ensure the highest possible level of employment. And, it needs to ensure low and stable levels of long-term interest rates. Obviously, it is not always easy to achieve all three at once. To get round this, the Fed has tended to argue that stable prices are a necessary pre-condition of both a high level of employment and a low level of long-term interest rates.

Looking at the Fed's track record through the late 1990s, it is reasonable to conclude that America's central bank did a good job with regard to its mandate. Inflation was low. Employment levels were incredibly high. Long-term interest rates were, historically, at low levels, in part a product of larger than expected government budget surpluses (see chart).

It follows that America's problems today may have more to do with the central bank's mandate than with the performance of the central bank itself.

This is where the Europeans come in. The European Central Bank has to worry only about price stability. It doesn't have to think too hard either about the level of employment or the level of interest rates. This has led to a lot of criticism of the ECB's performance. It has been too "rigid", too unwilling to "go for growth", too focused on the defeat of inflation at a time when price stability has, apparently, been relatively easy to achieve. Many have argued that the world would be a better place if only the ECB had adopted the same "enlightened" policies pursued by the Fed.

Certainly, there is evidence to support this view. Since the beginning of the year, the Federal Reserve has cut interest rates on seven separate occasions in order to shore up the flagging US economy. The ECB has obliged with only one rate cut so far. And, as I argued in last week's column, there is now a strong case for the ECB to act more aggressively to support the world economy. Put another way, without the ECB's help, the world economy will be a poorer place over the next one to two years.

However, it would be wrong to characterise the ECB as being purposefully belligerent for the sake of it. The ECB's approach to economic management differs from the Fed's in terms of mandate. But the differences go deeper than that. To understand the fundamentally different philosophies of the world's two most powerful central banks, we need to go all the way back to the Roaring Twenties and the depressionary 1930s. The current Fed's view on this period is relatively straightforward. If only the Fed of the day had been prepared to cut interest rates aggressively, the depression of the 1930s might have been more limited and, possibly, could have been avoided altogether.

The ECB's underlying view carries quite a different spin. For the ECB, the excesses of the 1920s were precisely the events which gave way to the economic collapse of the 1930s. In particular, it was the Fed's interest rate cuts to secure Britain's continued commitment to the Gold Standard in the late 1920s that left America's domestic economy exposed to the subsequent boom (for a modern day equivalent, think about the Fed's rate cuts in the light of the Asian and Russian crises).

Both views are, of course, partially right. Busts don't tend to occur unless there has been a previous boom. Equally, busts are made worse if there is a lack of monetary action. The ECB has taken on board the first of these lessons. The Fed has taken on the second. To the extent, however, that neither bank has fully embraced both lessons, there is scope for continued economic instability. Put simply, it may be that the ECB is better at managing booms – it's good at taking the punch bowl away before the party really gets going – whereas the Fed is better at dealing with the subsequent hangover.

This argument, however, leaves Europe with one potential advantage over the next few years. To the extent that Europe hasn't suffered the excesses of the US, the hangover should be that much smaller.

Europe still has its problems, of course. Its companies are slow to restructure. It has still seen excesses in, for example, the telecoms sector. The German economy, in particular, has weakened at about the same time as America's over the last year or so. However, to the extent that Europe hasn't "borrowed from the future" or "mortgaged the present", it may be able to shake off the hangover from the earlier euphoria much more quickly than the US. Europe's tortoise may still be no match for the best that the US has to offer but America's over-confident hare may now find the race a lot harder than it ever imagined at the start.

The writer is managing director of economics at HSBC.