The Future of the Euro

The economic problems in Europe make themselves known in many different ways. Among them, a weakening of the euro. TorFX reports, via EUBusiness.com:

While the Euro recovered losses sustained in the wake of Portugal’s mini-banking crisis earlier in the month, the common currency put on a fairly lacklustre performance last week. The Euro dropped to a fresh 22-month low against the Pound and struggled against the US Dollar as investors speculated on the prospect of the European Central Bank bringing in additional stimulus measures.

It is important to keep in mind that exchange rates swing very frequently and sometimes violently, only to return to long-term stability. However, there is more than a short-term message in a 22-month low for the euro. Four variables are aligning to make the euro’s future difficult:

1. The negative interest rate. The ECB is penalizing banks for depositing excess liquidity with the bank’s overnight accounts. Even the moderately skilled speculator knows that a negative interest rate means he will have less money on Friday than he had on Monday, which of course drives investors to other currencies. The British pound comes to mind, as does the U.S. dollar. The problem for Europe is that once it has dug itself into a hole with the negative interest rate, it is mighty hard for the ECB to get out of there without any macroeconomic gains to show for it. The argument for the negative interest rate is that it will “encourage” more lending to non-financial corporations – business investments, for short. But businesses do not want to invest unless they have credible reasons to believe they will be able to pay back the loans. That really does not change because interest rates drop from almost zero to zero.

Bottom line: the ECB has entered the liquidity trap and will be stuck there for a long time to come, negative interest rate and all. This weakens the currency, especially over the short term.

2.  Deflation. Part of the reason for the ECB’s move into negative interest territory is the spreading fear of deflation. The past few years have shown that a rapid expansion of the money supply has no effect on inflation, either in Europe or in the United States. Therefore, the ECB cannot reasonably be hoping to cause monetary inflation with a desperate move like negative interest rates. Its hope is instead hitched to a rise in business investments which would cause inflation through traditional, Phillips-curve style excess-demand effects.

Bottom line: not gonna happen. As mentioned earlier, businesses are not borrowing at almost-zero interest rates – why would they borrow at zero rates? There is no profit-promising activity in other parts of the economy, and there won’t be, as our next point explains.

3. Austerity and government debt. Ever since the Great Recession began, Europe has used austerity not to reduce the size of government, but to preserve the welfare state. This has led to perennially slow or non-existent GDP growth and high, perennial unemployment. This has two consequences that spell trouble for the euro over the longer term. The first is that persistent lack of economic activity discourages business investments per se. Austerity, European style, includes tax hikes which constitute further government incursions into the private sector. The perpetuation of European austerity therefore means the perpetuation of low levels of business activity. The second consequence is that even if economic activity picks up, because, e.g., a long-term rise in exports (unlikely to happen) there is so much excess capacity in the economy that there will be no excess-demand driven inflation for a year, maybe even two. The excess supply, of course, consists of massive amounts of un-demanded liquidity slushing around in the European economy, and perennially high unemployment, including 20+ percent youth unemployment in a majority of EU member states.

Bottom line: political preferences to preserve the welfare state will keep macroeconomic activity low. Long-term outlook is continued stagnation. No support for a return to interest rates above liquidity-trap levels.

4. Continued recovery in the United States. Despite dismal growth numbers for the first quarter, the long-term outlook for the U.S. economy is moderately positive. We have not applied the destructive European version of austerity, even though its tax-hiking component makes it a wet dream for many statists. Furthermore, Obama has been surprisingly restrained on the spending side of the federal budget, being far more fiscally conservative than, e.g., Ronald Reagan. This has created reasonably good space for U.S. businesses to grow. There are caveats, though, such as the implementation of Obamacare, which in all likelihood contributed to  the negative GDP number in the first quarter of this year. There has also been a regulatory barrage from the Obama administration that has stifled a lot of business activity, although it has subsided somewhat in the last year and a half. But even a moderately positive business climate makes the U.S. economy notably stronger than its European competitor.

Bottom line: a slowly strengthening dollar will attract investments that otherwise would have gone to the euro zone, putting further downward pressure on the euro.

There is actually a fifth variable, which is entirely political. If Marine Le Pen gets elected president in France in 2017 she will pull her country out of the euro. That means goodnight and farewell for the common currency. Long-term minded investors would be wise to keep this in mind.

All in all, the case for the euro is not good. Stagnation at best, weakening more likely, with the probability of its demise slowly gaining strength.

More Tensions over Stability Pact

The European Parliament elections in May conveyed a somewhat schizophrenic voter message. At the end of the day, though, the inevitable outcome is a strong gain for the left. Socialists were emboldened, as were their fellow statist nationalists. Both flanks are pushing for a number of policy reforms that, taken together, could very well mark the beginning of the end of the European Union as we know it. On the left, more and more voices demand a restoration of Europe’s austerity-tarnished welfare state. Some of those demands come in the form of attacks on the Stability and Growth Pact, which dictates budget deficit caps for all EU member states, attacks that are motivated by the desire to rebuild the welfare state.

Europe’s left turn seems to continue at the state level, and with it the criticism of the prevailing austerity doctrine. The most recent example is from Slovenia. Euractiv reports:

Center-left political novice Miro Cerar led his party to victory in Slovenia’s election … (13 July), indicating he would rewrite a reform package agreed upon with the European Union to fix the euro zone member’s depleted finances. The result will test investor nerves, given Cerar’s hostility to some of the big-ticket privatization programmes that the EU says are key to a long-term fix for Slovenia, which narrowly avoided having to seek an international bailout for its banks last year.

Selling off government-owned businesses is a way to temporarily reduce the budget deficit:

Cerar’s government will now oversee a raft of crisis measures agreed upon with the EU, in order to reduce Slovenia’s budget deficit and remake an economy heavily controlled by the state. Cerar, however, opposes the sale of telecoms provider Telekom Slovenia and the international airport, Aerodrom Ljubljana, fuelling investor fears of backsliding. … He said his cabinet would immediately consider which companies would remain in state hands and what to do with the rest. … The outgoing government suspended the privatization process this month pending the formation of a new government, which is not expected before mid-September. Cerar will have to find other ways to raise cash if he is to meet to targets agreed to with the EU, in order to slash Slovenia’s budget deficit to 3% of output by 2015, from a forecast 4.2% this year.

The Slovenians better make up their minds on this issue. According to the EU Observer, the EU and the ECB are not budging on the Stability and Growth Pact:

ECB boss Mario Draghi urged EU leaders not to meddle with the bloc’s rules on debt and deficits on Monday, warning that it could turn the tide on much needed economic reforms.

It remains to be seen to what extent the emboldened left in the European Parliament can influence the way the EU Commission interprets the Stability and Growth Pact. So far, though, the Draghi view is also that of the Commission.

And just to add to the schizophrenia of current European politics, Draghi added a curious remark:

Addressing MEPs on the Parliament’s economic affairs committee in Strasbourg (14 July), Draghi said structural reforms combined with government spending cuts and lower taxes were the only route to restoring economic stability. “There should be a profound structural reform process,” he said, adding that “there is no other way”. “We should take great care not to roll back this important achievement, or to water down its implementation to an extent that it would no longer be seen as a credible framework,” he said.

The combination of less government spending and lower taxes is almost the antithesis of what the EU and the ECB have been preaching to euro-zone member states in the past few years. The austerity packages they have forced on member states have been of the government-first kind, aimed at balancing budgets to make welfare states more fiscally sustainable.

This type of austerity relies at least partly on tax increases. A combination of less taxes and less spending is in fact not austerity at all – it is a policy for government roll-back. If Draghi really means this, he is the first major EU figure to step forward and promote such a structural change to the Euoropean economy.

It is unlikely, though, that Draghi will get much support for any kind of permanent reduction of government. There is far too much power to be had in making the Stability and Growth Pact more flexible. Not only does it allow statist politicians to save their welfare states, but it also opens for a classic form of “Italian governance”. The EU Observer again:

Italian prime minister Matteo Renzi, whose government holds the EU’s six month presidency, has led calls for the pact’s rules to be applied with more flexibility to allow governments to increase public investment programmes. The demand was rejected by Draghi who stated that “the present rules already contain enough flexibility”. “If a rule is a rule then it has to be complied with,” he said, commenting that “I’m not sure I get – perhaps because I lack political skills – the chemistry of flexibility being essential to make a rule credible”.

It’s simple. The flexibility that Renzi wants is simply a way to apply a general law selectively. That, in turn, gives elected officials more power, as they can oversee the “flexible” application and choose who will get and exception and who will not. Inevitably, the choice will be made based at least in part on the size of the brown envelopes that exchange hands under the negotiation tables in Brussels.

Between corruption and the welfare state, big government has enough supporters to stay right where it is in Europe. Furthermore, regardless of what kind of interpretation of the Stability and Growth Pact that will set the tone in the next few years, it is going to be there as a power tool for the EU over the member states. The left’s desire for more flexibility is just a desire to put more direct power in the hands of bureaucrats and legislatures.

The Global Socialist Rebound

There is no bigger threat to economic freedom than an authoritarian government. It destroys property rights and economic incentives. It crushes the pillars of entrepreneurship and makes it practically impossible for people to make an honorable living on their own. Gradually, an authoritarian government destroys free-market capitalism, and when the destruction has reached a critical point the most obvious economic result is the inevitable decline in the standard of living for all.

Misery replaces opportunity. Poverty replaces prosperity. Government dependency replaces self determination.

There is nothing new in this. The history of the 20th century is filled to the brim with evidence of the destructive effects of authoritarianism, including its devastating power to destroy well-functioning economies and the prosperity they produce. It would be logical to conclude that we have learned the lessons of the Soviet empire, of the collapse of collectivist economic projects in Latin America and of the slow but unrelenting stagnation of Europe’s welfare states.

You would expect that those lessons would be loud and clear, available to everyone.

Unfortunately, that is not the case. Socialism is on a worldwide rebound. It is not new: already eight years ago I warned about the resurrection of communism in Europe. At that time it was a topic that nobody really paid any attention to. This is understandable. The economy was in pretty good shape, both in the United States and in Europe – in other words there was no reason to worry about depression-driven support for extremism of the kind we can witness in Europe today. The terror attacks of 9/11 were in fresh memory, as were the attacks in London in the summer of 2005. The only extremism that made its way into the public debate had an islamist trademark.

Nevertheless, my warning was timely. Communism and its ideological affiliates have been on the rise for a long time. After a decade in disarray following the fall of the Soviet empire, socialists regained strength and confidence after 9/11. In addition to their support for Saddam Hussein’s regime and opposition to any efforts to topple it, they started lining up their political assets in parliamentary democracies to advance their ideology on democratic terms. In the mid-2000s, the global left was becoming politically savvy thanks in part to idolized authoritarians like Hugo Chavez in Venezuela.

Today, socialism has made dangerous inroads on several fronts around the world. The socialist power structure that Chavez put in place is still in charge of Venezuela, and perhaps even more radical now than under his reign. The “Chavista” version of Latin American socialism has spun off at least two other authoritarian leaders in the region, Evo Morales in Bolivia and Rafael Correa in Ecuador. In a separate but parallel advancement of socialism in Latin America, Cristina Kirchner has driven Argentina into the same ditch on the left side of the road as the gentlemen Chavez, Morales and Correa have done with their countries.

In Europe, the last few years of serious economic crisis has pushed large groups of voters into the arms of socialist parties. It is a remarkably broad phenomenon that has made Chavez-admiring Syriza one of the largest parties in Greece; it led to the sweeping French socialist election victories a couple of years ago; in September it will probably carry the surging left-wing coalition in Sweden to a strong election victory (on a message that the world’s highest taxes are not high enough!).

Even the nationalist movement in Europe is a form of socialism. Hungary’s Fidesz and Jobbik adhere to the same economic collectivism as do Golden Dawn in Greece, Front National in France and an assortment of smaller, nationalist parties in the Netherlands, Belgium, Germany, Denmark and Sweden. The difference between socialists and nationalists in Europe is, essentially, that the former want to expand the welfare state with no inhibitions while the latter want to reserve the services of the welfare state for the people of their individual countries, and not share them with immigrants from – primarily – Africa and the Middle East.

(Disclaimer: UKIP, Britain’s patriotic movement, is basically a libertarian party. They are opposed to the welfare state and to immigration aimed at living off it, but unlike continental and Scandinavian nationalist parties they also want to ultimately dismantle the welfare state. As such they are rather alone on the European political scene. Now back to our regular broadcast.)

The rebound of socialism is not limited to Europe and Latin America. The Obama administration was carried into office by a warped belief that government can take care of people from cradle to grave. Obama and his fervent supporters soon found that Americans still have a strong sense of individualism and skepticism toward government as a partner through life. It is fair to say that on a broad scale, Obama’s aggressive statist agenda has peaked and so has collectivism in America. The question is how we as a country will downsize government, and whether or not it will happen on fiscally sustainable terms.

Others are not so lucky. South Africa is a good example. After two decades of European-inspired welfare statism, South African voters have grown a bit weary of the ANC. Their hold on power is not yet in jeopardy, but it has weakened in recent years. As I have explained in numerous articles, the reasons for this weakened support for the ANC are obvious to any sober observer of the South African economy. Poverty is pandemic among black South Africans and has slowly but steadily spread to colored and white South Africans as well. Unemployment and crime have become permanent phenomena, especially – but not exclusively – in the large areas of the country that still live in abject poverty.

Despite 20 years of promises, the ANC has delivered precisely what socialism always delivers: decline, deprivation and despair. As a result, many South Africans are turning to alternative political movements, and one of the first to capitalize on this is Julius Malema. The former president of the ANC’s youth league has formed his own political movement, an outright communist party that pervertedly calls itself the “Economic Freedom Fighters”.  Here is some of what they want to do to South Africa:

A supposition that the South African economy can be transformed to address the massive unemployment, poverty and inequality crisis without transfer of wealth from those who currently own it to the people as a whole is illusory. The transfer of wealth from the minority should fundamentally focus on the commanding heights of the economy. This should include minerals, metals, banks, energy production, and telecommunications and retain the ownership of central transport and logistics modes such as Transnet, Sasol, Mittal Steel, Eskom, Telkom and all harbours and airports.

They have similar plans for agricultural land, with the intent to redistribute it from current owners and users to others, ostensibly based on racial preferences. The miserable consequences of land expropriation in Zimbabwe have apparently not deterred them. Nor has the economic disaster created by Chavez in Venezuela, where government has gotten itself involved in everything from utilities to the production and distribution of food. Not surprisingly, Julius Malema, South Africa’s premier communist, wants to do the same.

A communist government is just about the last thing South Africa needs. By the same token, Europe is absolutely not in any need of more collectivist policies. Latin America’s socialist experiments must end now, so the continent can reap the harvests of its full economic potential under economic freedom.

Currently, much of the global socialist rebound is currently flying under the radar of freedom-minded scholars, activists and politicians. Let’s hope that changes.

Economics and the Great Recession

So what is really happening to the U.S. economy? Is it in recovery mode, or did the very negative growth numbers for the first quarter signal a new recession? Is the European economy in a recover phase, or not?

While I have firmly said “no” on the European recovery question, there is no doubt that economists in general will wrestle with these questions for at least the remainder of 2014. The past few years have been particularly challenging for economists, especially those whose days are spent on mainstream, econometrics-based forecasting. In an excellent article for the Wall Street Journal, republished by the Hoover Institution, financial economist John Cochrane shows just how challenging those years have been.

Put bluntly, over the course of the Great Recession, leading macroeconomists have missed the target in their predictions of GDP growth by so much that if they tried to send a space chip to Mars it would go to Jupiter instead.

Fortunately, economists do not build space ships. But major errors in macroeconomic forecasting are a serious matter. Politicians decide fiscal policy based on those forecasts. In Greece, for example, the government followed advice on tax increases and spending cuts from leading economists at the International Monetary Fund (IMF). The IMF economists had grossly under-estimated the negative reactions in the private sector to government spending cuts.

The error, concentrated to a so called fiscal multiplier, was of such dimensions that one fifth of all young in Greece are now unemployed indirectly as a result of that forecasting error.

As I have reported before, IMF chief economist Olivier Blanchard, a highly respectable economist, issued a full mea-culpa paper soon after they discovered the error. The paper is a stark but honorable warning to other economists to be more cautious about forecasting the future – and about offering legislative advice.

As a macroeconomist I have great difficulty discouraging anyone from listening to advice from economists. Generally, we do well on the policy side. But the Great Recession has challenged a lot of widely held beliefs in economics, among them the belief that econometrics – currently the technical core of economic forecasting – is the supreme tool for predicting the future.

Unorthodox economists like yours truly have long criticized mainstream economists for relying too much on so called rigorous quantitative tools. As Cochrane’s article shows, this debate is gaining strength, and it is a safe bet that it will continue for a long time. In fact, I believe it will constitute the groundwork for major reforms to macroeconomics, both in theory and in methodology, over the next decade or two.

We need those reforms, and we all need to pull our load to make them happen. I do not pretend to have a big voice, but my new book, Industrial Poverty, about the European crisis, will be my first contribution to the conversation.

Politicians, businesses and other members of the general public depend on us knowing what we do. If we are not willing to reconsider our theory, our methodology and everything else all the way down to our forecasting methods, then economists will ultimately be responsible for more surprises in the future, like the one with the U.S. growth numbers, or the one that has been unfolding in Europe over the past five years.

Another Attack on Tax Competition

From a macroeconomic viewpoint Illinois is one of the worst-performing U.S. states. A big reason is the high taxes, by U.S. comparison, that drive jobs and businesses to other states. Illinois has raised its taxes more times than I care to count, with a “temporary” income-tax increase in 2011 that (huge surprise) has turned out to be permanent. States neighboring Illinois have been quick to capitalize on The Prairie State’s suicidal tax policy, with some crafty people in Indiana putting up this billboard at the state line:

LB 7 9 14 image

The image is not mine. It was the thumbnail for a policy paper by the Illinois Policy Institute, a hard-working free-market think tank in Chicago. I chose to borrow it because it illustrates the campaign by Indiana to attract tax-weary Illinoisans. In doing so, Indiana participates in one of the most important economic activities of our time: tax competition. Since there is completely free movement of people and capital across state lines in the United States, the decisions by families and businesses where to reside and work is governed to a relatively large degree by factors such as the tax burden. High-tax states (count Illinois among them) lose jobs and investments to low-tax states.

Politicians who want to build big governments can then sell their welfare states to taxpayers as best they can – if taxpayers prefer to keep more of their own money, and pay for more of their own consumption directly out of their own pocket, then they can choose to do so.

Tax competition fulfills two major purposes. (For an excellent introduction to tax competition, please visit this site over at Center for Freedom and Prosperity.) The first purpose is to keep the free-market sector of the economy alive. When people make decisions to move, look for jobs or invest based in part on differences in taxation, it keeps us as economic agents on alert. We do not slouch on the job, we watch for better opportunities and thereby take responsibility for ourselves and those who depend on us.

The second purpose is to put a cap on the growth, and ideally size, of government. If people can vote with their feet – or money – then government will at some point have to reconsider its plans to expand with yet more tax hikes.

Which explains why there is such widespread contempt for tax competition among lawmakers, both in the United States and in Europe. The latest expression of that contempt comes from (another huge surprise) France, where socialist politicians want to do away with tax competition altogether, at least within the EU. Reports Euractiv:

Paris has long backed the idea of an across-the-board harmonisation of EU member states’ tax systems. According to French government advisors, this must begin by a common tax base for the European banking sector, EurActiv France reports. … Those in favour of harmonisation have a mountain to climb, but have not backed away from the challenge.

Fortunately, there is still a shred of common sense to be shared among some in Europe:

Experts across Europe oppose a common tax system on the basis that competition between tax systems is positive and forces governments to be more efficient.

This, however, has not prevented government expansionists from making the most absurd arguments for abolishing tax competition. Euractiv again:

France has one of the highest levels of income tax in Europe and the government argues that low tax rates prevent the smooth working of the European Common Market. Earlier this year French President François Hollande said he wanted “harmonisation with our largest neighbours by 2020.” In a report titled Tax Harmonisation in Europe: Moving Forward, the [French government's economic advisory council] CAE proposed three ways to tackle the negative effects of fiscal competition.

The very idea that low tax rates prevent “the smooth working” of the free market in the EU is patently absurd. The argument is based on the notion that when tax rates are the same everywhere, businesses make decisions based not on taxes but on “real” business matters. But that notion disregards the fact that government is an active player in the economy, and that its services – while provided inefficiently under a coercion-based monopoly – are like most other services in the economy. I can choose to buy tax-paid services from the New York state government, or from the state of Wyoming, just as I can choose to bank with Warren Federal Credit Union or First Interstate Bank, or to buy my insurance products from Farmers, GEICO or any other insurance company.

Since government is an active player in our economy, it must be subjected to the same free-market conditions as the rest of us, as far as that is possible.

However, as we go back to the Euractiv piece we learn that this is not a concept that European statists are willing to entertain:

The first measure is to continue efforts for a common consolidated corporate tax base (CCCTB). Harmonising tax systems would make “fiscal competition more transparent and healthier,” says Agnès Bénassy-Quéré. According to Alain Trannoy, an economist who co-wrote the report, a CCCTB should be based on “reinforced cooperation or with some countries like Germany, France, the Benelux states and Italy, in order to create a snowball effect in different Eurozone countries.” Harmonising tax bases would also reduce the risks of optimisation, when multinationals transfer their revenues from one country to another in order to benefit from lower corporate tax. “Corporate tax is an important element, but there is no point if tax bases are not harmonised,” said Alain Trannoy.

And now for the three-dollar bill question: once these high-tax EU states succeed in creating a high-tax cartel, what is going to happen with the tax rates?

a) They will go up,

b) They will go up, or

c) They will go up.

You may choose whichever answer you want, so long as your choice is harmonized with the answers you do not choose.

Euractiv again:

According to the authors, the Banking Union, which was adopted in April, needs to go further in the area of taxation. This can be done with a Single Financial Activity Tax (FAT) in Europe. They also advocate a minimum corporate income tax for the banking sector, the receipts of which should be reinvested into infrastructure and long term investments and “form the first building block of a euro area budget.”

And there you have it. The real purpose behind this is to build yet another level of government spending. While it sounds noble to invest in “infrastructure” and the like, this is, after all Europe. Therefore, it is a safe bet to foresee that if this new level of government were ever to be created, its spending would go primarily toward yet more entitlement programs in an even more complex welfare state. Let’s keep in mind that there are already politicians on the left flank of European politics who are pushing hard for harmonized entitlement programs across the EU. What better venue for that harmonization than a full-fledged, EU-level welfare state?

And as we all immediately understand, the world’s largest welfare state, which has not solved all the alleged problems of inequality and poverty it was created to solve, must therefore obviously become a lot bigger.

Out there, on the outer left rim of unabridged statism, the question “when is government big enough?” simply does not have an answer. With the next EU Commissioner for Economic Affairs likely being a socialist, this unanswered question is going to have serious consequences for Europe. Its current journey into industrial poverty, paved by the world’s most sloth-inducing entitlement systems and fueled by the world’s highest taxes, apparently is not going fast enough.

Spain: A Macroeconomic Assessment

We keep hearing from the soothsayers who suggest Europe is in the recovery phase of a protracted recession. The latest to join the chorus is the British newspaper The Guardian:

Spain’s economic recovery was underlined as its manufacturing sector recorded its greatest activity in seven years, but the financial crisis has left its mark with separate figures showing a sharp rise in people leaving the country. A snapshot of the state of Spanish factories combining output, orders and employment showed activity rose to a seven-year high in June. The Markit PMI increased to 54.6 from 52.9 in July – with a reading above 50 indicating expansion. That puts growth in Spain’s manufacturing sector ahead of Germany, France and Italy and is further evidence that its economy is outperforming the eurozone as whole.

To begin with, it is not very hard to outperform the euro zone, where GDP growth is as close to zero as anything can be. Private consumption is exceptionally weak, and even the OECD has been forced to downgrade its previously optimistic growth forecast for the EU.

But more importantly, a rise in an index is not a rise in actual economic activity. For that to happen, there must be a change for the better in national accounts data. More on that in a moment – first we return to the Guardian story:

The struggling Spanish car industry in particular is showing signs of recovery thanks in part to a government incentive scheme, now in its sixth year, for people to upgrade their vehicles. Christian Schulz, senior economist at Berenberg bank, said Spain was benefiting from the reforms that it put in place in response to the financial crisis. “If we add similarly impressive readings for the Spanish services sector, we can safely conclude that Spain is reaping the rewards of its tough labour market reforms of 2012 and is becoming a mainstay of eurozone growth,” he said.

The program referred to is one where government offers 1,000 euros toward the down payment on a new car that costs no more than 25,000 euros, provided the buyer trades in a 7-10-year-old, less fuel efficient car. According to at least one report this has contributed to the sales of 300,000 cars in Spain in the last couple of years.

There are a couple of problems with programs like these. First of all, they create a sense of entitlement among consumers, who learn to expect their government to chip in. Today it is toward cars, tomorrow - who knows? Homes? Furniture? Haircuts?

Secondly, it skews the car market. People buy smaller cars than they otherwise would, sending signals of demand to car manufacturers that are not based on free-market conditions but government subsidies. When those subsidies end because they are too costly for government, manufacturers will be left there with production capacity designed not based on the free market, but on defaulted government promises.

Third, the rebate increases the purchasing power of consumers who would otherwise not be able to afford a car. As a direct result, consumers can get approved for car loans with weaker ability to repay them than if there had been no tax-paid incentives program. What happens when those consumers default on their loans?

It remains to be seen how important this program is for the weak but nevertheless increase in private consumption that we can see in Spain’s GDP numbers.

LB7714Spain2

Adjusted for inflation, Spanish private consumption fell for 13 quarters in a row, from third quarter 2010 to third quarter 2013. In the fourth quarter of last year and the first this year, households increased their spending by, respectively, one and two percent.

Does this signal a recovery? It is too early to tell, especially since there was a similar spike in early 2010. But it is entirely likely that the car-buyer incentives program has artificially boosted the shift in consumer spending from decline to increase. This means that the reversal from worse to better – at least in consumer spending – is the result of government spending. Since Spanish government finances are in bad shape due to the economic depression, this only means that the macroeconomic problems that the Spanish government is trying to solve are just being shuffled around.

There is more evidence of this. In the figure above, the strongest growth is not in private consumption but in exports. In the past 17 quarters, since the beginning of 2010, Spanish gross exports have increased by an annual rate of 6.7 percent on average. By contrast, private consumption contracted by an annual average of 1.3 percent over the same period. This marks a shift in importance for GDP, with private consumption slightly declining as growth driver, and exports rising in its place.

Arithmetically, this makes a lot of sense. A variable that constitutes a small share of GDP grows rapidly for a long period of time. At some point it ceases to be a small variable and instead becomes important for GDP. When it does, its effect on GDP increases, accelerating GDP growth while exports still grow at the same pace as before.

However, this is a problem from a macroeconomic viewpoint. The Spaniards are not getting wealthier from the exports boom. Private consumption is not moving anywhere, and when it seems to be increasing it is ostensibly because of a government subsidy in one particular area. (There is also a home buyer’s program, but let’s not even get into that today…)

But it is not just private consumption that shows that there is no real domestic recovery in Spain:

LB7714Spain

While, as the green line shows, the exports share of GDP has been growing steadily during the Great Recession, the orange line shows that business investments have been on a steady decline (again as share of GDP). And this decline is all the more dramatic: Spanish businesses have decreased their investments, in fixed prices, for five straight years now.

Yes – five straight years. Since the first quarter of 2009 there is not a single quarter with growth in business investments. Measured in fixed prices, the amount that Spanish businesses spent on investments in the first quarter of 2014 was only two thirds of what they spent in the first quarter of 2009. This has happened while, again, exports have been growing solidly.

So long as businesses do not reverse the downward trend in investments on a sustained basis, there can be no recovery in the Spanish economy. Growing exports will not generate a recovery, especially not when the growth is concentrated to manufacturing. Modern manufacturers in Europe often import parts and assemble them on European soil. This means that growing exports are followed by growing imports of manufacturing inputs – in essence a passing-through of products that does not have any positive repercussions for the rest of the economy.

In January I explained that Germany has precisely this problem. If the exports were a sign of recovery in other EU countries, there would be hope for a recovery across Europe. But that is not the case: everywhere you look in Europe, private consumption and other domestic-spending variables are growing very reluctantly, if at all. The exports that the Euroepans are so happy about are, in other words, bound for other continents, without having any real positive effect on the European economy itself.

Europe will not return to growth, prosperity and full employment until its political leadership realizes what the problem is: the big, burdensome welfare state and its high taxes and anti-productive set of incentives that steer people away from self sufficiency and straight into life long career of sloth, indolence and government dependency.

EU Economy Going Nowhere

There is no better macroeconomic “health indicator” for an economy than private consumption. Not only is it the largest part of GDP, but private consumption also reflects well the overall sentiment of households. Since households are important spenders, taxpayers and workers all baked into one type of economic unit, the growth rate of private consumption is the best quick-check “wellness test” of an economy. (A more detailed understanding of the shape of an economy obviously requires a more detailed macroeconomic and microeconomic analysis.)

Since I have recently reported on how the European economic recovery has not materialized, I figured it would only be fair to perform a quick-check macroeconomic “wellness test”. Alas, I pulled private consumption data from Eurostat, and I made sure to get inflation-adjusted figures based on a price that is relatively distant in time. (If the index year is close in time there can be growth distortions based on the mere proximity to “year zero”.) I also selected quarterly data, which is not commonly used for this purpose. My motivation, though, is that if the quarterly data is not seasonally adjusted it allows for a more frequent communication of household sentiments.

You would expect this type of data to be available from every EU member state for every quarter you might want it. I often encounter that attitude from consumers of public policy research: somehow they assume that every piece of statistical information anyone could ever want is readily available within two clicks into the internet. That is not the case, though, and the reason is simple. Quality statistical material requires careful data collection, according to detailed and very rigid collection methods; it requires methodologically rigorous processing according to standards defined not just for this piece of information, but for every comparable piece of information in the world.

There are other methodological restrictions on statistical information that contribute to the production cost. We should actually take this as a sign of quality for the data we have access to; I always get suspicious when scholars claim to have produced large sets of quantitative information in short periods of time – it often leads to bombastic conclusions that later prove to be little more than a house of cards built on clay feet.

Anyway. Back to the European economy. For reasons of high quality standards and therefore reasonably high production costs for national accounts data, not every EU member state reports the kind of consumption data analyzed here. Figure 1 below reports real private consumption growth in 24 EU member states from 2002 through 2013:

Figure 1

C pr EU 24

The growth rates, again, are inflation-adjusted rates per quarter, over the same quarter the year before. This means that the blue line reports a rolling annual growth rate, updated quarterly. As such it helps us pinpoint business cycle swings with good accuracy. The  most obvious example is that private consumption nosedives in the second quarter of 2008: after having averaged an acceptable two percent per year from 2003 through 2007, private consumption literally came to a standstill over the next five years. From 2008 through 2012 the average growth rate was zero percent.

The difference may not seem like much, but for two reasons it would be wrong to draw that conclusion. First, a one-percent reduction in private consumption equals a decline in spending worth a bit over two million jobs in the EU-28 economy. This does not mean that two million Europeans automatically lose their jobs if households cut spending by one percent – the economy is more dynamic than that. But it does mean that if private businesses lose sales over a sustained period of time they cannot afford to keep all of their employees. At the macroeconomic level this eventually translates into, roughly, two million jobs per one percent private consumption (measured in current prices).

In other words, even seemingly small fluctuations in household spending can have major effects on the economy.

Secondly, sluggish private consumption means that the economy is not evolving. If the growth rate falls below two percent, then at least in theory consumers are no longer improving their standard of living. I explain in detail how this works in my book Industrial Poverty (out August 28); a very brief explanation is that it takes a certain level of sustained spending to maintain one’s standard of living. As products get better and other factors affect the quality of our consumption, we have to grow our outlays by a certain minimum rate just to make sure we keep our standard of living intact.

For the first half of the 12 years reported in Figure 1, households in the 24 selected EU member states managed to maintain their standard of living; on the other hand, for the second half of the period they did not maintain that standard. With an average growth rate of zero (adjusted for inflation) the theoretical loss of standard of living was two percent per year.

In addition to creating unemployment, this protracted sluggishness in household spending is a long-term prosperity downgrade for Europe’s consumers. What is even worse is that there are still no signs of a return to higher growth rates. While 2013 saw an average .8 percent growth in the EU-24 we discuss here, that came on the heels of ytwo years of negative growth (-0.6 percent). There was a similar, and bigger, uptick in 2010 (1.5 percent) that proved to be an anomaly compared to the two years before and after.

Furthermore, data for the first quarter of 2014, which is available for 20 of the 24 EU member states, shows a rise in inflation-adjusted private consumption in three countries only. While it is good to see a rise in Greece and Spain, which have been the hardest hit by the crisis (Austria is the third) this is far too isolated and far too small to be the turnaround many economists have hoped for.

More importantly, this is where the use of quarterly data can spook the careless observer. Spanish private consumption, which is up by 3.1 percent in the first quarter of this year, has a pattern of growing every other quarter. Since it was down 1.3 percent in the last quarter of 2013, this only means that the economy is on track with its historic path (which, sadly, means zero growth over the 16 quarters in 2010-2013). The rise in Greek private spending is part of a similar pattern, coming on the heels of a 2010-2013 average of -1.1 percent.

Bottom line, then, is that European households are unwilling or, more likely, unable to unleash that spending spree the European economy needs so badly. This should not surprise any regular reader of this blog, but it will in all likelihood be a surprise to those who live in the illusion that big government and the welfare state are the blessings that prosperity is built from.