With its unitary fiscal system, the US can fund an increase in borrowing that the EU cannot, writes Richard Gillis

THERE WAS a time, a few short months ago, when the credit crisis was talked of as just an American thing. This week, as government leaders from around the world meet at a potentially historic global summit in Washington, that particular school of thought seems as much a part of economic history as the barter system.

So painful have been the global aftershocks of the credit crunch that French president Nicolas Sarkozy has called for nothing less than a new Bretton Woods Agreement, the 1944 meeting which led to the creation of the International Monetary Fund and other global institutions.

British prime minister Gordon Brown has talked of this being a "decisive moment for the world economy". Across the world, government intervention is back in fashion: European governments have so far committed over €2 trillion in cash injections, bank deposit guarantees, inter-bank loan coverage and partial or full nationalisations. Last week there was agreement to more than double the EU's own crisis fund to €25 billion.

The outcome of the Washington meeting is likely to shape the financial and economic landscape, but according to Niall Ferguson, one of the world's foremost economic historians, it is in Europe not America that the most fundamental change will take place.

"The US can cope with this fiscal shock in a way that the European Union simply can't," says Ferguson, author of The Ascent of Money, and holder of senior academic positions at Harvard, Stanford and Oxford universities. "The current crisis is the biggest test of European economic unity ever."

The United States, he says, has a single unitary fiscal system that can support a substantial increase in public borrowing in the form of finance payouts, costing trillions of dollars. "The European Union only has a partially unitary monetary system - the euro - and no unitary fiscal system worth talking about. So what we've seen, and Ireland led the way, has been a series of individual actions by governments trying to prop up their banks."

The problem for countries like Ireland, says Ferguson, is that to finance a bailout purely from their national tax base is way harder than anything the United States has to contend with. "It is going to be a big stress on the euro zone in particular."

The economic and political lesson of the 1990s he says, is that it takes a crisis to force Europe into greater integration: it was after the collapse of the ERM that European monetary union emerged.

"The trouble is this crisis is not going to produce greater fiscal centralisation because it's just too politically difficult. It's more likely that the European Union is going to be strained and stressed: this is the big test of the euro itself," says Ferguson. If the fiscal system is diverged, then the job of keeping the euro is going to be much harder. "We are going to see whether it's possible to have monetary union without fiscal union in the face of this crisis. I don't think it's clear that it is."

As budget deficits increase across the world, the greatest burden will fall on smaller economies. "The Celtic Tiger is going to look like a mangy cat this time next year," says Ferguson, whose opinion is based on the fragility of the Republic's economic base. "It's a painful truth that smaller economies tend to suffer disproportionately in the bad times. Places like Ireland are great places to be when capital is flowing around the world, globalisation is in full swing, and everybody agrees that free trade is desirable."

But now, he says, it's every man for himself, and it's the bigger economies that have the resources to fall back on. "I noticed the other day that the worst-performing stock market in the world this year is the Belgian stock market, but the second worst was Ireland's, and I'm afraid there is more pain to come."

The global summit is part of a greater appetite for regulation of the financial markets, a trend that worries Ferguson. There is a real danger, he says, that a simplistic view of the world will take hold, which sees a choice between free but unstable markets and state-controlled but stable markets.

"In truth state control of the financial system has been tried in the past and has failed," he says. He cites the unhappy experience of the 1970s when state intervention into capital and exchange markets did little to prevent the worst stock market crash since the Depression, with double-digit inflation and a secondary banking crisis. In the 1980s Japan's government also moved to prop up its banks, which resulted in what he calls "zombie finance", where banks are on a life-support system, "not dead, but not alive either" and the economy stagnated. The greatest threat posed by regulation is the risk of deflation, which is a real possibility for the United States and even more so in Europe. "You end up with banks propped up by state funding but are not able to fulfil their proper financial service."

An interesting aspect of the Washington summit will be how leaders now judge the usefulness of monetary policy to deal with the current crisis. The effect of unprecedented rate cuts, such as those seen in Britain over the past week, are being undermined by the clogs in the interbank credit system. As a result, a swing toward fiscal policy is being called for on both sides of the Atlantic.

Mario Draghi, governor of the Bank of Italy, pre-empted the summit by calling for greater focus on fiscal tools. And Barack Obama's inaugural address as president is set to be followed swiftly by a "Big Bang" of tax cuts and public spending, according to his chief of staff Rahm Emmanuel.

At the very least, says Ferguson, the way in which monetary policy is measured will change forever, with stock markets and house prices coming under much greater scrutiny: "The idea that you just target a single inflation rate looks absurd now," he says.