EU Economic Standstill in Details

Today it is time to review in more detail the latest national accounts data from Eurostat. A disaggregation of the spending side of GDP reinforces my long-standing statement: the European economy is in a state of long-term stagnation.

To the numbers. We begin with private consumption, which is the driving force of all economic activity. It is not only a national-accounts category, but an indicator of how free and prosperous private citizens are to satisfy their own needs on their own terms. It is a necessary but not sufficient condition for economic freedom that private consumption is the dominant absorption category.

Once consumer spending starts ticking up solidly, we can safely say there is a recovery under way. However, little is happening on the consumption front: over the past eight quarters (ending with Q3 2014) the private-consumption growth rate for the EU has been 0.3 percent per year. While the increase was stronger in 2014 than in 2013, only half of the EU member states experienced a growth in consumer spending of two percent or more in the last year. The three largest euro-zone countries, Germany, France and Italy, were all at 1.2 percent or less.

One bright spot in the consumption data: Greece, Spain and Portugal, the three member states that have been hit the hardest by statist austerity, now have an annual consumption growth rate well above 2.5 percent. Portugal has been above two percent for three quarters in a row; a closer look at these three countries is merited.

Overall, though, the statist-austerity policies during the Great Recession have caused a structural shift in the European economy that may be hard to reverse. From having been a consumer-based economy with strong exports, the EU has now basically been transformed into an exports-driven economy. On average, gross exports is larger as share of GDP than private consumption.

In theory, one could argue that this is a sign of free-market trade where people and businesses choose to buy what they want and need from abroad instead. I would be inclined to agree – but only in theory. In practice, if households and businesses freely made their choices on a global market, then rising exports would correlate with rising imports and, most importantly, rising private consumption. However, that is not the case in Europe. On average for the 28 EU member states,

  • Exports has increased from an unweighted average of 59 percent of GDP in 2007 to an unweighted average of 70 percent in 2014;
  • Net exports has also increases, from zero in 2007 (indicating trade balance) to six percent of GDP in 2014 (indicating a massive trade surplus).

If the rising exports had been a sign of increased participation in global trade on free-market terms, then either of two things would have happened: consumption would have increased as share of GDP or imports would have increased on par with exports. In reality, neither has happened, which leads to one of two conclusions:

  1. There has been a massive increase in corporate investments, which if true would indicate growing confidence in the future among Europe’s businesses; or
  2. Exports is the only category of the economy that is allowed to grow because it is not subject to the tight spending restrictions imposed by austerity.

Gross fixed capital formation, or “investments” as it is often casually referred to, was an unweighted average of 26 percent in the EU member states in 2007. Seven years later it had fallen to 21 percent. This is clearly a vote of no confidence from corporate Europe. Therefore, only one explanation remains: the discrepancy between on the one hand the rise in gross and net exports and, on the other hand, stagnant private consumption and a declining investment share, is the result of a fiscal policy driven by statist austerity.

The purpose of fiscal policy in Europe since at least the beginning of the Great Recession has been to balance the government budget at any cost. If this statist austerity leads to a painful decline in household consumption or corporate investments, then so be it. As shown by the numbers reported here, years of statist austerity have depressed corporate activity. In fixed prices, gross fixed capital formation in the EU has not increased since 2011:

  • In the third quarter of 2011 businesses invested for 607.8 billion euros;
  • In the third quarter of 2014 they invested for 602 billion euros.

The bottom line here is that the only form of economic activity that brings any kind of growth to the European economy is – you guessed it – exports. But it is not just any exports. It is exports outside of the EU. How do we know that? Because of the following two tables. First, the average annual private-consumption growth rate, reported quarterly, for the past eight quarters (ending Q3 2014):

Private consumption growth
Lithuania 4.4% France 0.2%
Latvia 4.3% Denmark 0.0%
Estonia 4.0% Ireland -0.2%
Romania 2.2% Bulgaria -0.2%
Sweden 2.1% Austria -0.3%
Malta 2.0% Finland -0.4%
United Kingdom 1.7% Portugal -0.5%
Poland 1.7% Spain -0.8%
Luxembourg 1.6% Netherlands -1.1%
Germany 0.8% Greece -1.4%
Hungary 0.6% Croatia -1.5%
Belgium 0.5% Italy -1.8%
Czech Republic 0.4% Slovenia -2.1%
Slovakia 0.3% Cyprus -3.5%

With private consumption growing at less than one percent in 19 out of 28 countries, households in the EU do not form a good market for foreign exporters.

Things a not really better in the category of business investments:

Gross fixed capital formation
Ireland 7.5% Latvia -0.2%
Hungary 7.4% Slovakia -0.9%
Lithuania 6.4% France -1.1%
Malta 5.1% Czech Republic -1.5%
United Kingdom 4.5% Netherlands -1.7%
Poland 3.3% Spain -2.1%
Slovenia 2.0% Croatia -2.5%
Sweden 1.7% Luxembourg -2.5%
Estonia 1.7% Portugal -3.7%
Denmark 1.4% Italy -4.5%
Germany 0.9% Finland -5.2%
Bulgaria 0.5% Romania -6.0%
Belgium -0.1% Greece -7.3%
Austria -0.1% Cyprus -14.3%

What this means, in plain English, is that the European economy still is not pulling itself out of its recession.

But is it not possible that things have changed recently? After all, the time series analyzed here end with the third quarter of 2014. There is always that possibility, but one indication that the answer is negative is the latest report on euro-zone inflation. From EU Business:

Eurozone consumer prices fell by a record 0.6 percent in January, EU data showed Friday, confirming deflation could be taking hold and putting pressure on a historic bond-buying plan by the ECB to deliver. The drop from minus 0.2 percent in December appears to back the European Central Bank’s decision last week to launch a bond-buying spree to drive up prices. Plummeting world oil prices were largely to blame for the fall in the 19-country eurozone, already beset by weak economic growth and high unemployment, the EU’s data agency Eurostat said.

If the EU governments let declining oil prices trickle down to consumers – and avoid raising taxes in response – there could be a positive reaction in private consumption. However, lower gasoline and home heating costs will not be enough to turn around the European economy.

More on that later, though. For now, the conclusion is that Europe is going nowhere.

Weak Growth – No Recovery

Recently Eurostat released national accounts data for the third quarter of 2014. Here is a review of those numbers in the context of historical GDP data. All growth rates are in 2005 chained prices.

First, the growth rates of 28-member EY and 18-member euro zone:

EU EURO

The real annual growth rate of the EU-28 GDP is 1.51 percent, compared to 1.34 percent in Q2 of 2014 and 1.61 percent in Q1. Euro-zone growth is markedly lower – for first, second and third quarters of last year, respectively: 1.08, 0.65 and 0.79 percent. The difference between the euro zone and the EU-28 is primarily the work of a recovery in the British economy. In the three quarters of 2014, Britain saw its GDP growth at 1.8, 3.6 and 3.2 percent, respectively. If we subtract the U.K. economy from the EU-28 GDP, the European growth rates for 2014 fall to (with actual rates in parentheses) 1.58 (1.61), 0.89 (1.34) and 1.17 (1.51) percent. A distinct difference, in other words.

As the aforementioned numbers report, there is not much to be joyful of inside the euro zone. There are member states with strong growth, but they tend to be of marginal importance for the entire zone. In the third quarter of 2014 the strongest-growing euro-zone countries were Luxembourg (3.99 percent over Q3 2013), Malta (3.82) and Ireland (3.54). By contrast, the three largest euro economies have a tough time growing at all: Germany (1.24 percent over Q3 2013) and France (0.24) kept their nose above water, while third-largest Italy saw its GDP decline by half a percent.

Here is the growth history of the three largest euro-zone economies:

Italy France Germany

We will have to wait and see what the new Greek government will do to the future of the euro and the confidence of private-sector agents in the European economy. With Syriza teaming up with a distinctly nationalist party, the message out of Athens could not be stronger: Greece is off on a new course, and it won’t be with the best interests of the euro zone in mind.

There is a lot more to be said about these GDP numbers. It will be very interesting to look at what sectors are driving whatever growth there is – and which ones are contracting. I suspect that exports will play a larger role than domestic demand. Hopefully I am wrong, because if I am correct it means that there is still no change in overall private-sector confidence in the euro zone. But that remains to be seen; I will return to this dissemination of Europe’s national accounts as soon as possible.

The New Left and Europe’s Future

Only a couple of days after the European Central Bank raised white flag and finally gave up its attempts at defending the euro as a strong, global currency, Greek voters drove their own dagger through the heart of the euro. Reports The Telegraph:

Greece set itself on a collision course with the rest of Europe on Sunday night after handing a stunning general election victory to a far-Left party that has pledged to reject austerity and cancel the country’s billions of pounds in debt. In a resounding rebuff to the country’s loss of financial sovereignty, With 92 per cent of the vote counted, Greeks gave Syriza 36.3 percent of the vote – 8.5 points more than conservative New Democracy party of Prime Minister Antonis Samaras.

That is about six percent more than most polls predicted. But even worse than their voter share is how the parliamentary system distributes mandates. The Telegraph again:

It means they will be able to send between 149 and 151 MPs to the 300-seat parliament, putting them tantalisingly close to an outright majority. The final result was too close to call – if they win 150 seats or fewer, they will have to form a coalition with one of several minor parties. … Syriza is now likely to become the first anti-austerity party in Europe to form a government. … The election victory threatens renewed turmoil in global markets and throws Greece’s continued membership of the euro zone into question. All eyes will be on the opening of world financial markets on Monday, although fears of a “Grexit” – Greece having to leave the euro – and a potential collapse of the currency has been less fraught than during Greece’s last general election in 2012.

It does not quite work that way. The euro is under compounded pressure from many different elements, one being the Greek economic crisis. The actions by the ECB themselves have done at least as much to undermine the euro: its pledge last year to buy all treasury bonds from euro-zone governments that the market wanted to sell was a de facto promise to monetize euro-denominated government debt. The EU constitution, in particular its Stability and Growth Pact, explicitly forbids debt and deficit monetization. By so blatantly violating the constitution, the ECB undermined its own credibility.

Now the ECB has announced that in addition to debt monetization, it will monetize new deficit. That was the essence of the message this past Thursday. The anti-constitutionality of its own policies was thereby solidified; when the Federal Reserve ran its multi-year Quantitative Easing program it never violated anything other than sound economic principles. If the ECB so readily violates the Stability and Growth Pact, then who is to say it won’t violate any other of its firmly declared policy goals? When euro-zone inflation eventually climbs back to two percent – the ECB’s target value – how can global investors trust the ECB to then turn on anti-inflationary policies?

Part of the reason for the Stability and Growth Pact was that the architects of the European Union wanted to avoid runaway monetary policy, a phenomenon Europeans were all too familiar with from the 1960s and ’70s. Debt and deficit monetization is a safe way to such runaway money printing. What reasons do we have, now, to believe that the ECB will stick to its anti-inflationary pledge when the two-percent inflation day comes?

This long-winded explanation is needed as a background to the effects that the Syriza victory may have on the euro. I am the first to conclude that those effects will be clearly and unequivocally negative, but as a stand-alone problem for the ECB the Greek hard-left turn is not enough. In a manner of speaking, the ECB is jeopardizing the future of the euro by having weakened the currency with reckless monetary expansionism to the point where a single member-state election can throw the future of the entire currency union into doubt.

Exactly how the end of the euro will play out remains to be seen. What we do know, though, is that Thursday’s deficit-monetization announcement and the Greek election victory together put the euro under lethal pressure. The deficit-monetization pledge is effectively a blank check to countries like Greece to go back to the spend-to-the-end heydays. Since the ECB now believes that more deficit spending is good for the economy, it has handed Syriza an outstanding argument for abandoning the so-deeply hated austerity policies that the ECB, the EU and the IMF have imposed on the country. The Telegraph again:

[Syriza], a motley collection of communists, Maoists and socialists, wants to roll back five years of austerity policies and cancel a large part of Greece’s 320 billion euro debt, which at more than 175 per cent of GDP is the world’s second highest proportional to the size of the economy after Japan. … If they fulfil the threats, Greece’s membership of the euro zone could be in peril. Mr Tsipras has toned down the anti-euro rhetoric he used during Greece’s last election in 2012 and now insists he wants Greece to stay in the euro zone. Austerity policies imposed by the EU and International Monetary Fund have produced deep suffering, with the economy contracting by a quarter, youth unemployment rising to 50 per cent and 200,000 Greeks leaving the country.

Youth unemployment was up to 60 percent at the very depth of the depression. Just a detail. The Telegraph concludes by noting that:

Mr Tsipras has pledged to reverse many of the reforms that the hated “troika” of the EU, IMF and European Central Bank have imposed, including privatisations of state assets, cuts to pensions and a reduction of the minimum wage. But the creditors have insisted they will hold Greece to account and expect it to stick to its austerity programmes, heralding a potentially explosive showdown.

Again, with the ECB’s own Quantitative Easing program it becomes politically and logically impossible for the Bank and its two “troika” partners to maintain that Greece should continue with austerity. You cannot laud government deficit spending with one side of your mouth while criticizing it with the other.

As a strictly macroeconomic event, the ECB’s capitulation on austerity is not bad for Greece. The policies were not designed to lift the economy out of the ditch. They were designed to make big government more affordable to a shrinking private-sector economy. However, a return to government spending on credit is probably the only policy strategy that could possibly have even worse long-term effects than statist austerity.

Unfortunately, it looks like that is exactly where Greece is heading. Syriza’s “vision” of reversing years of welfare-state spending cuts is getting a lot of support from various corners of Europe’s punditry scene. For example, in an opinion piece at Euractiv.com, Marianna Fotaki, professor of business ethics at University of Warwick, England, claims that the Syriza victory gives Europe a chance to “rediscover its social responsibility”:

Greece’s entire economy accounts for three per cent of the eurozone’s output, but its national debt totals 360 billion or 175 per cent of the country’s GDP and poses a continuous threat to its survival. While the crippling debt cannot realistically be paid back in full, the troika of the EU, European Central Bank, and IMF insist that the drastic cuts in public spending must continue. But if Syriza is successful – as the polls suggest – it promises to renegotiate the terms of the bailout and ask for substantial debt forgiveness, which could change the terms of the debate about the future of the European project.

As I explained recently, so called “debt forgiveness” means that private-sector investors lose the same amount of money. The banks that received such generous bailouts earlier in the Great Recession had made substantial investments in Greek government debt. Would Professor Fotaki like to see those same banks lose even more money? With the new bank-rescue feature introduced as the Cyprus Bank Heist, such losses would lead to confiscation of the savings that regular families have deposited in their savings accounts.

Would professor Fotaki consider that that to be an ethically acceptable consequence of her desired Greek debt “forgiveness”?

Professor Fotaki then goes on a long tirade to make the case for more income redistribution within the euro zone:

The immense social cost of the austerity policies demanded by the troika has put in question the political and social objectives of an ‘ever closer union’ proclaimed in the EU founding documents. … Since the economic crisis of 2007 … GDP per capita and gross disposable household incomes have declined across the EU and have not yet returned to their pre-crisis levels in many countries. Unemployment is at record high levels, with Greece and Spain topping the numbers of long-term unemployed youth. There are also deep inequalities within the eurozone. Strong economies that are major exporters have benefitted from free trade, and the fixed exchange rate mechanism protecting their goods from price fluctuations. But the euro has hurt the least competitive economies by depriving them of a currency flexibility that could have been used to respond to the crisis. Without substantial transfers between weaker and stronger economies, which accounts for only 1.13 per cent of the EU’s budget at present, there is no effective mechanism for risk sharing among the member states and for addressing the consequences of the crisis in the eurozone.

In other words, Europe’s welfare statists will continue to blame the common currency for the consequences of statist austerity. But while professor Fotaki does have a point that the euro zone is not nearly an optimal currency area, the problems that she blames on the euro zone are not the fault of the common currency. Big government is a problem wherever it exists; in the case of the euro zone, big government has caused substantial deficits that, in turn, the European political leadership did not want to accept – and the European constitution did not allow. To battle those deficits the EU, the ECB and the IMF imposed harsh austerity policies on Greece among several other countries. But countries can subject themselves to those policies without being part of a currency union: Denmark in the 1980s is one example, Sweden in the ’90s another. (I have an entire chapter on the Swedish ’90s crisis in my book Industrial Poverty.) The problem is the structurally unaffordable welfare state, not the currency union.

Professor Fotaki again:

The member states that benefitted from the common currency should lead in offering meaningful support, rather than decimating their weaker members in a time of crisis by forcing austerity measures upon them. This is not denying the responsibility for reckless borrowing resting with the successive Greek governments and their supporters. However, the logic of a collective punishment of the most vulnerable groups of the population, must be rejected.

What seems to be so difficult to understand here is that austerity, as designed for Greece, was not aimed at terminating the programs that those vulnerable groups life off. It was designed to make those programs fit a smaller tax base. If Europe’s political leaders had wanted to terminate those programs and leave the poor out to dry, they would simply have terminated the programs. But their goal was instead to make the welfare state more affordable.

It is an undeniable fact that the politicians and economists who imposed statist austerity on Greece did so without being aware of the vastly negative consequences that those policies would have for the Greek economy. For example, the IMF grossly miscalculated the contractionary effects of austerity on the Greek economy, a miscalculation their chief economist Olivier Blanchard – the honorable man and scholar he is – has since explained and taken responsibility for.

Nevertheless, the macroeconomic miscalculations and misunderstandings that have surrounded statist austerity since 2010 (when it was first imposed on Greece) do not change the fact that the goal of said austerity policies was to reduce the size of government to fit a smaller economy. That was a disastrous intention, as shown by experience from the Great Recession – but it was nevertheless their goal. However, as professor Fotaki demonstrates with her own rhetoric, this point is lost on the welfare statists whose only intention now is to restore the welfare state to its pre-crisis glory:

The old poor and the rapidly growing new poor comprise significant sections of Greek society: 20 per cent of children live in poverty, while Greece’s unemployment rate has topped 20 per cent for four consecutive years now and reached almost 27 per cent in 2013. With youth unemployment above 50 per cent, many well-educated people have left the country. There is no access to free health care and the weak social safety net from before the crisis has all but disappeared. The dramatic welfare retrenchment combined with unemployment has led to austerity induced suicides and people searching for food in garbage cans in cities.

There is nothing wrong factually in this. The Greek people have suffered enormously under the heavy hand of austerity, simply because the policies that aim to save the welfare state for them also move the goal post: higher taxes and spending cuts drain the private sector of money, shrinking the very tax base that statist austerity tries to match the welfare state with.

The problem is in what the welfare statists want to do about the present situation. What will be accomplished by increasing entitlement spending again? Greek taxpayers certainly cannot afford it. Is Greece going to get back to deficit-funded spending again? Professor Fotaki gives us a clue to her answer in the opening of her article: debt forgiveness. She wants Greece to unilaterally write down its debt and for creditors to accept the write-down without protest.

The meaning of this is clear. Greece should be able to restore its welfare state to even more unaffordable levels without the constraints and restrictions imposed by economic reality. This is a passioned plea for a new debt crisis: who will lend money to a government that will unilaterally write down its debt whenever it feels it cannot pay back what it owes?

This kind of rhetoric from the emboldened European left rings of the same contempt for free-market Capitalism that once led to the creation of the modern welfare state. The welfare state, in turn, brought about debt crises in many European countries during the 1980s and ’90s, in response to which the EU created its Stability and Growth Pact. But the welfare states remained and gradually eroded the solidity of the Pact. When the 2008 financial crisis hit, the European economy would have absorbed it and shrugged it off as yet another recession – just as it did in the early ’90s – had not the welfare state been there. Welfare-state created debt and deficits had already stretched the euro-zone economy thin; all it took to sink Europe into industrial poverty and permanent stagnation was a quickly unfolding recession.

Ironically, the state of stagnation has been reinforced by austerity policies that were designed in compliance with the Stability and Growth Pact; by complying with the Pact, those policies, it was said, would secure the macroeconomic future of the euro zone and keep the euro strong. Now those policies have led the ECB to a point where it has destroyed the future of its own currency.

The Day When the ECB Gave Up

And so it begins:

The European Central Bank will plough €1.1 trillion into the eurozone economy in a last-ditch attempt to breath [sic] life into the European economy. At its monthly governing council on Thursday (January 22), the bank’s governing council agreed to start buying up to €60bn of government bonds from March in an unprecedented quantitative easing programme.

How is this supposed to happen? Private spending would accelerate if interest rates went down, but that will happen if and only if the interest rate on treasury bonds falls as a result of this new ECB spending program. That, in turn, can only happen if demand for treasury bonds increased enough to overcome the risk premium associated with euro-zone member states.

However, the risk premium was supposed to go away with the bond purchase program that the ECB announced last summer. Back then the bank pledged an open-ended purchase program for treasury bonds issued by troubled euro-zone countries: everyone and anyone who owned a treasury bond issued by, say, Greece would be guaranteed to get his money back by selling it to the ECB. This guarantee, then, would bring down interest rates and stimulate private-sector activity.

But this did not happen. The bond buy-back program may have had a marginally visible effect on interest rates, but it certainly was not enough to encourage any sustained upswing in private-sector activity.

When that did not work the ECB pushed bank-lending interest rates through the floor by lowering the rate on overnight bank deposits to -0.2 percent. That had no effect whatsoever on private-sector activity. So after having opened two liquidity flood gates on the European economy, without coming even close to achieving desired results, the ECB has now decided to open the third flood gate.

Well, if you try the same thing enough times over and over again, then eventually it might actually work…

Back to the EU Observer story:

The programme is open-ended, and will run until September 2016 at the earliest. Speaking at a press conference following the governing council meeting, ECB president Mario Draghi said that the bond-buying programme would remain in place “until we see a sustained adjustment in the path of inflation which is consistent with our aim of achieving inflation rates below, but close to, 2%” … The Frankfurt-based bank hopes to boost inflation and drive down the value of the euro against other major currencies in a bid to make the bloc’s exports more attractive.

This is a tried-and-failed strategy. Every time a country depreciates or devalues its currency to boost exports, the main result is an increase in profits among large, dominant and already-established manufacturing businesses. Those profits, in turn, are free of charge for the businesses: all they have to do is keep manufacturing the very same products, without investments toward improved competition.

If this currency-based exports rebate is maintained long enough, the result will be a decay in productivity in exporting businesses. They have no profit-based reason to make new investments – quite the contrary. Any investments toward enhanced competitiveness will divert funds from the free-cash profits.

But what will the businesses use their cash for? Financial investments. This in turn will flood the domestic economy with even more liquidity than was already injected into it by the central bank’s aggressive monetary policy. More and more money will chase fewer and fewer profitable investments. In the meantime, little to nothing is going to happen in the real sector; the only moving part will be credit-driven consumption of durable goods like cars, and private real estate. But that will require a rapid build-up of private-sector debt, which in turn is a recipe for – yet another – future financial crisis.

Overall, as I have explained before, this QE program will notch the euro yet another inch or two toward its grave. And just to make sure there is enough certainty about where the euro is heading, the other day the the EU Observer reported that Greece may be allowed to exit its tough austerity program – without having solved its underlying macroeconomic problems:

A legal opinion by the EU top court and comments by the EU economics commissioner about the end of the bailout troika have come just days before elections in Greece, where troika-imposed austerity is a central issue. … EU economics commissioner Pierre Moscovici on Monday (19 January) … said the “troika should be replaced with a more democratically legitimate and more accountable structure based around European institutions with enhanced parliamentary control”. Moscovici added that the troika “was useful and necessary” at the height of the crisis, “but now I think we need another step.” His comments come just a week after a legal opinion by the general advocate of the European Court of Justice said that the European Central Bank should not oversee reforms of countries it helps via Outright Monetary Transactions, a bond-buying scheme coupled with structural reforms modelled on what the troika has done in bailed-out countries.

In other words, the ECB can no longer come with cash in one hand and demands for austerity in the other. It has to choose either. Since the ECB has chosen to come with money, this means an end to austerity demands.

In reality this is a carte blanche to euro-zone governments in, e.g., Greece to get back to the old days of spending. The ECB promises to buy its treasury bonds, the austerity protesters in, e.g., Syriza have in the public opinion won the argument over austerity, and the ECB is desperate to see some kind of life sign in the European economy. This is a perfect storm for a massive increase in government spending.

This is, of course, exactly the wrong recipe for the European economy. Nevertheless, this is how the game is set up. More government spending, more money printing – until the euro is in so bad shape that it collapses into junk status and goes the same way the Reichsmark did in Weimar Germany.

The cold, hard, bottom line here is that government spending, bankrolled with monetary printing presses, does not create productive economic activity. All it does is dig the economy further into the same hole into which it has been slowly sinking for the past six years.

The ECB has given up. They are not even trying to play defense anymore.

This is the beginning of the end of the euro.

Euro-QE Would Be Big Mistake

How much time does the euro have left? That question was put on its edge last week when the Swiss National Bank decided it was no longer going to anchor the Swiss franc to the iceberg-bound euro ship. It was a wise decision for a number of reasons, the most compelling one being that the euro faces insurmountable challenges in the years ahead.

In fact, the Swiss decision was de facto a death spell for Europe’s currency union. More specifically, I noted that the euro

survived the Greek depression of 2012 by a razor-thin margin. Now it faces three very serious threats to its own survival. The first is the upcoming Greek elections, where anti-austerity, anti-euro, pro-Hugo Chavez Syriza looks like winners. Should they emerge victorious they could very well initiate a Greek exit from the currency union. The euro would survive that, and the German government has a contingency plan in place to stabilize the euro. But then there is the Greek government debt… Syriza has openly declared that they want “debt forgiveness” for governments throughout Europe. If the drachma is reintroduced, it will very likely plummet vs. the euro, making it exceptionally difficult for Syriza to repay its loans to the EU and the ECB. A default is within the realm of the probable; remember the Greek “debt write down” three years ago.

If all the problems for the euro were tied to Greece, the currency would indeed have a future. But there are so many other challenges ahead for the common currency that nothing short of a miracle – or unprecedented political manipulation – can keep it alive through the next three years.

The biggest short-term problem – Greece aside – is the pending announcement by the ECB of its own Quantitative Easing program. Reuters reports:

The European Central Bank will announce a 600 billion euro sovereign bond buying program this week, money market traders polled by Reuters say, but they also believe this will not be enough to bring inflation up to target. In the past two months traders have consistently predicted that the ECB would undertake quantitative easing, considered the bank’s final weapon against deflation. Eighteen of 20 in Monday’s poll said the bank would announce QE on Thursday.

This highly anticipated European QE program must be viewed in its proper macroeconomic context. It is going to be very different from the American QE program. For starters, the balance between liquidity supply and liquidity demand was very different in the U.S. economy than it is in the euro zone today. After its initial plunge into the Great Recession the American economy slowly but relentlessly worked its way back to growth again. Since climbing back to growth in 2010 the U.S. GDP has grown at a rate slightly above two percent per year. This is not something to throw a party over, but it has allowed the economy to absorb much of the liquidity that the Federal Reserve has pumped into the economy.

By being able to absorb liquidity, the U.S. economy has avoided getting caught in the liquidity trap. Growth rates have been good enough to motivate businesses to increase investment-driven credit demand; households have gotten back to buying homes and automobiles (car and truck sales in 2014 were almost as good as in pre-recession 2006).

The European economy does not absorb liquidity. It is stagnant, and has been so for three years now. The ECB has pushed its bank deposit rate to -0.2 percent, in other words it is punishing banks for not lending enough money to its customers. Despite this ample supply of credit there are no signs of a recovery in the euro zone, with GDP growth having reached the one-percent rate once in three years.

In other words, the positive outlook on the future that motivates American entrepreneurs and households to absorb liquidity through credit is notably absent in the European economy. When the ECB now evidently plans to pump even more liquidity out in the economy, it appears to not understand how significant this difference is between the euro zone and the United States.

Or, to be fair, with all its highly educated economists onboard, the ECB most certainly understands what role liquidity demand plays in an economy. Its pending decision to launch a QE program appears instead to be based in open ignorance of the lack of liquidity demand.

Which leads us to ask why they would ignore it.

The answer to this question is in the declared purpose of the QE program. If it is aimed at buying treasury bonds, then the QE program clearly is not designed to re-ignite the economy, an argument otherwise used. If QE is supposed to monetize government deficits, then its purpose is really to secure the continued existence of the European welfare state. If that is the purpose, then the only safe prediction is that there will be no end to QE before the welfare state ends.

That, in turn, means the ECB would be stuck monetizing deficits for the rest of the life of the euro. Which, under such circumstances, would be a relatively short period of time…

More on this on Thursday, when the ECB is expected to announce its QE program. Stay tuned.

Europeans Are Still Unemployed

The production of macroeconomic data from the European Union for the last two quarters of 2014 is a bit slow. The main source, Eurostat, took until last week to release GDP data for the third quarter, though that was under ESA 2010 standards. We are still waiting for the “modernized” versions to be released.

According to the “older” series, which I reported on last week, economic stagnation continues to hold Europe in an unforgiving chokehold. A look at unemployment statistics – which is updated faster than national accounts data – confirms this picture:

EU US U

Regardless of what configuration Europe is given – the EU as a whole or the euro zone – its unemployment rate is not where it should be. Before the Great Recession, U.S. unemployment was almost half of what it was in Europe; after a brief period of declining jobless rates, Europe experienced a long period of unrelenting increase. In fact, as Figure 1 shows, European unemployment has been creeping upward for five years, from mid-2008 to mid-2013.

It remains to be seen if 2013 actually was the peak, and if 2014 represents the beginning of a long-term decline. There is no underlying trend in GDP or any of its individual components to hint of a real recovery. Here, the European economy stands in stark contrast to the U.S. economy, where unemployment has been falling, albeit slowly, since 2010.

All is not dark as night in Europe, though. Some countries have seen a drastic decline in unemployment since the peak. Measured from the first quarter of 2013 through the third quarter of 2014, the unemployment rates in…

Hungary fell by more than a third;

Lithuania declined by almost one third;

Estonia, Poland and Portugal have plummeted by about one quarter;

Bulgaria, Czech Republic and the U.K. are down by just over one fifth.

Despite these reductions, rates are still disturbingly high in many countries. Here are the EU member states with an unemployment rate higher than the U.S. rate of 6.2 percent:

Unemployment, EU States, Q3 2014
Greece 25.6 Slovenia 9.3
Spain 23.7 Lithuania 9.1
Cyprus 16.1 Belgium 8.7
Croatia 15.7 Poland 8.2
Portugal 13.3 Estonia 7.5
Slovakia 12.9 Finland 7.5
Italy 11.8 Hungary 7.4
Ireland 11.3 Sweden 7.2
Bulgaria 10.8 Denmark 6.5
Latvia 10.6 Romania 6.5
France 9.9 Netherlands 6.4

While it is good to see that “only” a quarter of all Greeks were unemployed in Q3 2014, as opposed to 28 percent a year ago, it should also be noted that unemployment was lower in 2012 when their economy was plunging like the Titanic after she hit the iceberg. In Q3 2012 the Greek unemployment rate was 25 percent exactly.

Spain, with Europe’s second-highest unemployment rate, saw its peak in early 2013 at 26.9 percent. They are now back where they were in 2012, but the decline is very, very slow.

Cyprus is actually still in the phase where unemployment is increasing. It is unclear if the same is true for Croatia, where unemployment has been fluctuating between 14 and 18 percent – averaging 16.6 – over the past three years. What is clear, though, is that there is no downward trend in the Croatian unemployment rate.

Fifth on the list is Portugal, where unemployment topped at 17.8 percent in Q1 2013 and has been moving down very slowly since then. To their credit, the Portuguese have seen a slow improvement in GDP growth, from an annual, inflation-adjusted rate of -1.4 percent in Q2 2013 to one percent in Q3 2014. Greece and Spain have seen similar improvements:

2013Q2 2013Q3 2013Q4 2014Q1 2014Q2 2014Q3
Greece -4.2% -2.6% -3.1% -0.4% 0.4% 1.9%
Spain -1.5% -0.5% -0.1% 0.7% 1.3% 1.7%

The Spanish improvement is predominantly driven by exports. The same is ostensibly true for Greece and Portugal as well, in which case the case for a lasting improvement is basically non-existent. A more detailed examination of national accounts data will give us a more detailed picture (stay tuned).

The small decline in Europe’s notoriously high unemployment reported above is far too weak, far to little to indicate anything beyond a temporary easing of the social and economic pressure that comes with large segments of the labor force being unemployed for years.

Swiss Predict Euro Demise

This week the Swiss central bank did the right thing and let go of the Swiss franc’s peg to the euro. The result was a massive appreciation of the franc, primarily vs. the euro. Though the move was not entirely unexpected, there have been a lot of speculations as to why the Swiss did it now.

The answer is not very complicated. The Swiss have grown increasingly uncomfortable with the fixed exchange rate vs. the euro, especially since the ECB:

a) pledged to buy every single treasury bond from every single euro-zone country; and

b) started pumping money out in the hot air to “stimulate spending” in the perennially stagnant euro zone.

International investors, rightly interpreting these reckless measures as the ECB playing desperate defense against the tides of macroeconomics, have taken refuge in the Swiss financial markets. To defend the peg against the euro, the Swiss National Bank (SNB) has been forced to print unhealthy amounts of new money.

There finally came a point where the SNB gave up on defending the peg. When they did they effectively acknowledged that major global financial investors have called it right: the future of the euro is limited.

More on the actual threats to the euro in a moment. First, let us take a look at a couple of interesting factoids that help explain what the SNB did this week.

In order to defend a fixed exchange rate, a central bank must constantly buy and sell its own currency on the international currency market. In this case the Swiss franc was in higher demand than the euro, which forced the SNB to sell large amounts of Swiss francs on the currency market. To do so, they had to print large amounts of money, far more than is needed to keep the Swiss economy fully liquid. Figure 1 below illustrates the excess increase in Swiss money supply over the past few years; first, though, let us note that current-price GDP has been growing virtually on par in Switzerland and the euro zone:

  • Average current-price GDP growth in the euro zone, from 2008 through 2013, was 1.2 percent;
  • Average current-price GDP growth in Switzerland, from 2008 through 2013, was 1.9 percent.

This is a notable difference, but not nearly enough to explain why the SNB has been printing money much more fiercely than the ECB. Figure 1 illustrates the money growth parity in Switzerland and in the euro zone – defined as M1 growth rate less current-price GDP growth:

Euro CHF

In other words, when we subtract current-price GDP growth from M1 money supply growth, we find that the Swiss M1 growth parity has far exceeded the euro parity since 2008. Since current-price GDP growth represents growth in transactions demand for money – i.e., money to keep the economy monetized and liquid – any growth in money supply beyond current-price GDP is a sign of either of two phenomena: irresponsible funding of government debt, or a desperate attempt at keeping currency speculators and financial investors at bay.

The euro-zone’s excess M1 growth is the result of the former; the Swiss parity is the result  of the latter.

During 2014 the SNB has cut down on money printing – annualized M1 growth rates per month have been less than four percent – and thereby signaled that it would, sooner or later, give up on its exchange-rate peg vs. the euro.

That has now happened. Speculators are free to rake in their currency-appreciation gains, but more importantly: investors have established their concerns about the future of the euro. Which brings us back to the limited life span of that currency. Once launched as the new gold standard of the world, the euro has fallen from the skies, badly wounded by reckless money printing.

It survived the Greek depression of 2012 by a razor-thin margin. Now it faces three very serious threats to its own survival. The first is the upcoming Greek elections, where anti-austerity, anti-euro, pro-Hugo Chavez Syriza looks like winners. Should they emerge victorious they could very well initiate a Greek exit from the currency union. The euro would survive that, and the German government has a contingency plan in place to stabilize the euro. But then there is the Greek government debt… Syriza has openly declared that they want “debt forgiveness” for governments throughout Europe. If the drachma is reintroduced, it will very likely plummet vs. the euro, making it exceptionally difficult for Syriza to repay its loans to the EU and the ECB. A default is within the realm of the probable; remember the Greek “debt write down” three years ago.

If Greece can get away from its debt vs. the EU and the ECB by exiting the euro, it sets a precedent for other heavily indebted countries on the southern rim of the currency area. That creates a standing threat of further destabilization of the euro – and weakens the reliability of the currency.

The second reason why the euro has a limited future lies in the ECB’s intentions to launch a formal Quantitative Easing program. De facto already in place with the treasury purchase guarantee, this formalization would involve the ECB directly in funding the issuance of new government debt (the current pledge is “only” about buying existing debt). This effectively removes any incentives that national governments have in place to keep any tabs on their borrowing.

The Stability and Growth Pact formally enforces a deficit cap of three percent of GDP, but that pact has already hit an iceberg it can’t recover from. The Pact, namely, bans euro zone countries from bailing out each other – something the Germans violated years ago by helping the EU and the ECB to bail out Spain, Greece and Portugal – and it also prevents the ECB from, yes, Quantitative Easing.

With two of the three pillars of the Pact already destroyed, what reasons do euro-zone governments have to abide by the third pillar, especially if the ECB is going to bankroll all the debt  those governments may want to issue?

The third reason for a limited euro future is the French 2017 presidential election. If Marine Le Pen wins, she will pull France out of the currency union. With the second largest economy exiting there is no longer a reason for anyone else to stay in.

Switzerland once again serves as a safe haven for global investors. But the end of QE here in the United States, together with our slow but steady recovery, allows the dollar to shoulder some of that burden. The more the euro shakes and rattles, the stronger the dollar will become.

It is basically a done deal that the euro will end. All we can hope for is that it will be a peaceful exit under stable, predictable circumstances.

Europe’s Long Economic Decline

Earlier this week I explained how Europe has, institutionally, set itself up for a long-term decline in growth. The Stability and Growth Pact should take a lot of blame for this, as it comes with a built-in bias in favor of contractionary fiscal policy. But it is not just any type of contractionary policy that is favored by the Stability and Growth Pact: it is contractionary policy aimed at balancing the government budget – regardless of all other policy goals.

To be clear, there are two types of contractionary fiscal policy:

  • So called “statist austerity” aims at balancing the government budget with the explicit or implicit purpose to keep government spending programs as intact as possible under tighter economic conditions;
  • So called “free market austerity” where the goal is to shrink government spending with the explicit purpose of permanently reducing the size of government.

The two forms employ different policy strategies. Statist austerity can include tax increases; the balance between spending cuts and tax hikes is determined primarily by practical and political considerations. These considerations typically supersede economic analysis: the execution of statist austerity typically takes place over a short period of time and upon short notice, such as looming panic among global investors over a government’s believed ineptitude in balancing the budget.

Free market austerity, on the other hand, aims solely at permanently shifting the balance between the private sector and government. This can be achieved if and only if:

a) government spending is permanently reduced; and

b) taxes are reduced proportionately to the reduction in spending.

As a result, the combination of changes in taxes and spending is entirely different than what is required under statist austerity. In terms of outcomes, the effects of free-market austerity on GDP growth are radically different from the effects of statist austerity: under the latter government actually increases its net claim on the economy, while under the former the private sector is given ample opportunity to expand.

By dictating budget-balancing requirements, the Stability and Growth Pact de facto mandates statist austerity in Europe. The logical outcome of this should be a long-term decline in GDP growth. There is lots of economic theory to draw on for this conclusion.

Predictably…:

Figure 1

LB Europe 1 15

The growth rate reported in this figure is of the sliding-average kind (without a forecasting side), which shifts focus from periodic observations to trend observations. As the polynomial (third order) trend line indicates, the long-term path is unequivocally downward. In addition, growth peaks get weaker and shorter.

Perhaps the best evidence of the connection between the Stability and Growth Pact and this long-term trend can be found in the downturn after 2010. Annual growth in the fourth quarter of 2010 was 2.2 percent; a year later it was 0.2 percent and by Q4 2012 euro-zone GDP was shrinking by a full percent. It did not return to growth until the latter half of 2013, and then only at tepid rates below half a percent.

In fact, over the past three years – 12 quarters – euro-zone GDP growth has only been above one percent one single quarter. That was in Q1 2014. For Q3 2014 it expanded by a tiny 0.8 percent on an annual basis.

The relation between the institutional structure and the long-term decline in GDP growth is one of the most important reasons why I have come to the conclusion that Europe is stuck in a state of permanent economic stagnation – a state of industrial poverty – which it will not recover from until it reforms away its institutional barriers to a real economic recovery.

Europe Invented Statist Austerity

In December I took a first look at the European Commission’s “Report on Public Finances”, with the intention of returning to this important document later. It has been almost a month, longer than I expected, but here we are.

In my first review of the report I explained that the strict focus by Europe’s political leadership on government finances has led to a systemic error in their fiscal policy priorities:

Austerity, as designed and executed in Europe, was aimed not at shrinking government but making it affordable to an economy in crisis. The end result was a permanent downward adjustment of growth, employment and prosperity. In order to get their economy out of this perennial state of stagnation, Europe’s leaders need to understand thoroughly the relations between government and the private sector.

This is a kind of prioritization that has guided European fiscal policy for two decades now. Under the Stability and Growth Pact, EU member states in general are forced to adopt a fiscal policy that inherently has a contractionary – austerity – bias. But it is not the kind of austerity that reduces the size of government. It is the kind that tries to shrink a budget deficit in order to keep government finances in good order and save the welfare state from insolvency.

So long as contractionary fiscal policy – austerity – is focused on balancing the budget and saving the welfare state, it won’t reduce the size of government. For that, it takes specifically designed austerity measures. Those measures are indeed possible, even desirable, but they cannot be launched unless government is allowed by its own constitution to prioritize less government over a balanced budget.

Unfortunately, the Stability and Growth Pact does not permit that member states prioritize shrinking government over budget balancing. Instead, the Stability and Growth Pact forces them to always pay attention to deficits and debt, but never worry about running too large surpluses. Part A of the Pact caps government deficits at three percent of GDP and debt at 60 percent of GDP. At the same time, there are no caps on budget surpluses; since a surplus is excess taxation, and since excess taxation drains the private sector for money in favor of a government savings account, this means that governments can drain the private sector for all the money it wants to without violating the European constitution.

Unlike a budget surplus, which is contractionary in nature, a budget deficit is, at least in theory, always stimulative. However, by capping deficits the European constitution restricts the stimulative side of fiscal policy, while at the same time leaving the contractionary end unrestricted.

In addition to the technical aspects of this contractionary bias, there is also the political mindset that is born from a legislative construct of this kind. Lawmakers and elected cabinet members – primarily treasury secretaries – are concerned with avoiding deficits, thus quick to resort to contractionary policy measures, but pay little attention to the need for counter-cyclical policies. Over time, this political mindset becomes “one” with the Stability and Growth Pact to the extent where parliaments do not think twice of passing budgets that impose harsh contractionary measures in order to balance a budget.

Think Europe in 2012. And read chapters 4a and 4b in my book Industrial Poverty to get an idea of how deep roots in Europe’s legislative mindsets that this “gut reaction” bias toward contractionary measures has actually grown.

With its contractionary bias, Europe’s fiscal policy has permanently downshifted growth in Europe. This in turn has perpetuated the budget problems that said contractionary policies were intended to solve. It left the European economy fragile and frail, vulnerable to a tough recession. All it took was the downturn in 2008-09 with its spike in deficits – and once the fiscal-policy gut reaction kicked in, there was nowhere to go for Europe other than into the dungeon of budget-balancing contractionary measures; statist-driven austerity; mass unemployment; and perpetual budget problems.

Never did Europe’s leaders think twice of trying to actually release its member states from the shackles of the Stability and Growth Pact. Never did they think twice of permitting a widespread downward adjustment of the size of government.

The Commission’s “Report on Public Finances” cements this statist approach to contractionary fiscal policy. It has an entire section that suggests further collaboration and coordination among EU member states on the fiscal policy front. So long as the Stability and Growth Pact remains in place, such coordination would be a thoroughly bad idea. All that such coordination would accomplish is to cement statist austerity as the prevailing “fiscal policy wisdom” ruling the economy that feeds 500 million people.

I will return in more detail to this report. In the meantime, do take a minute and read my paper Fiscal Policy and Budget Balancing: The European Experience. It is part of a five-paper series of discussion papers on the ups and downs of a balanced-budget amendment to the United States constitution.