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EU Still Wrong on Economic Crisis

The truth about the European economic crisis is spreading. The latest evidence of this growing awareness is in an annual report by the European Commission. Called “Report on Public Finances”, the report expresses grave concerns about the present state as well as the economic future of the European Union. It is a long and detailed report, worthy of a detailed analysis. This article takes a very first look, with focus on the main conclusions of the report.

Those conclusions reveal how frustrated the Commission has become over Europe’s persistent economic stagnation:

The challenging economic times are not yet over. The economic recovery has not lived up to the expectations that existed earlier on the year and growth projections have been revised downwards in most EU Member States. Today, the risk of persistent low growth, close to zero inflation and high unemployment has become a primary concern. Six years on from the onset of the crisis, it is urgent to revitalise growth across the EU and to generate a new momentum for the economic recovery.

Yet only two paragraphs down, the Commission reveals that they have not left the old fiscal paradigm that caused the crisis in the first place:

The aggregate fiscal picture for the EU and the euro area is now considerably more favourable, thanks to the commendably large consolidation efforts made in the past. … this has allowed Member States to slow the pace of adjustment. The aggregate fiscal stance is now expected to be broadly neutral in 2014 and 2015, both in the EU and the euro area. This will reduce one of the drags on growth and should therefore be welcomed.

If Europe is ever to recover; if they will ever avoid decades upon decades of economic stagnation and industrial poverty; the government of the EU must understand the macroeconomic mechanics behind this persistent crisis. To see where they go wrong, let us go through their argument in two steps.

a) “The aggregate fiscal picture for the EU and the euro area is now considerably more favourable, thanks to the commendably large consolidation efforts made in the past.” There are two analytical errors in this sentence. The first is the definition of “fiscal picture” which obviously is limited to government finances. But this is precisely the same error in the thought process that led to today’s bad macroeconomic situation in Europe: government finances are not isolated from the rest of the economy, and any changes to spending and taxes will affect the rest of the economy over a considerable period of time. The belief that government finances are in some separate silo in the economy led to the devastating wave of ill-designed attempts at saving Europe’s welfare states in 2012.

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.

b) “The aggregate fiscal stance is now expected to be broadly neutral in 2014 and 2015, both in the EU and the euro area. This will reduce one of the drags on growth and should therefore be welcomed.” Here the Commission says that if a government runs a deficit, it causes a “drag” on macroeconomic activity. This is yet another major misunderstanding of how a modern, monetary economy works.

Erstwhile theory prescribed that a government borrowing money pushes interest rates up, thus crowding out private businesses from the credit market. But that prescription rested on the notion that money supply was entirely controlled by the central bank; in a modern monetary economy money supply is controlled by the financial industry, with the central bank as one of many players. Its role is to indicate interest rate levels, but neither to set the interest rate nor to exercise monopolistic control on the supply of liquidity.

A modern monetary economy thus provides enough liquidity to allow governments to borrow, while still having enough liquidity available for private investments. In fact, it is rather simple to prove that the antiquated crowding-out theory is wrong. All you need to do is look at the trend in interest rates before, during and after the opening of the Great Recession, and compare those time periods to government borrowing. In a nutshell: as soon as the crisis opened in 2008 interest rates plummeted, at the same time as government borrowing exploded.

This clearly indicates that the decline in macroeconomic activity was not caused by government deficits; it was the ill-advised attempt at closing budget gaps and restore the fiscal soundness of Europe’s welfare states that caused the drag. And still causes the drag.

In other words, there is nothing new under the European sun. That is unfortunate, not to say troubling, but on one front things have gotten better: the awareness of the depth of the problems in Europe is beginning to sink in among key decision makers. What matters now is to educate them on the right path out of the crisis.

 There is a lot more to be said about the Commission’s public finance report. Let’s return to it on Saturday.

Deficit Problems in Belgium

Belgium is one of Europe’s most troubled welfare states, though its problems have been overshadowed by the macroeconomic disasters along the Mediterranean. Its fiscal problems are older than most EU member states, and it was the first country to attract sociological interest based on the fact that there were families – regular working class families – where three generations were perennially unemployed.

Today, Belgium is attracting interest because of a new report from the International Monetary Fund. The EU Observer reports:

The Belgian government is planning “many welcome measures to address the critical macroeconomic challenges facing the Belgian economy”, but it can do more, the International Monetary Fund (IMF) said on Monday (15 December). On the same day Belgian unions organised a general national strike, the IMF presented its findings from a ten-day mission to the country. “The planned reforms of social security and budgetary measures are a step in the right direction”, the IMF wrote.

As with other welfare states in Europe, Belgium suffers from disturbingly low growth. As a result, tax revenues cannot keep up with entitlement spending and the budget deficit becomes structural. GDP growth has been as disappointing in the Belgian economy over the past few years as it has elsewhere in Europe (annual growth rates, reported quarterly):

LB Belgium

The Great Recession took a big toll on the Belgian government’s finances. Its budget went from a 156 million euro surplus in 2007 to a 19.1 billion euro deficit in 2009, equal to 5.6 percent of GDP.

From there, the deficit has declined slowly but steadily, reaching the EU’s magic three-percent of GDP mark in 2013. Due to the almost clinical absence of GDP growth, the decline has been accomplished by means of welfare-state saving austerity. As the EU Observer explains, these policies are likely to continue, with some tax reshuffling to spice it up:

The centre-right government of Charles Michel, the first coalition without socialists since 1988, started work in October. It plans spending cuts and increasing the pension age from 65 to 67 by 2030. However, the IMF says that Belgium should also reform its tax system. … when it comes to labour tax, Belgium ranks top with a rate of over 40 percent. The IMF suggests that labour tax should be lowered and compensated with a higher tax on capital.

As the figure above clearly shows, there is no recovery under way in Europe. Belgium is no exception, which makes the IMF advice a problematic ingredient in the Belgian fiscal policy mix. More than anything, Belgium needs tax cuts, not a redistribution of the tax burden. It also needs massive, structural reforms to its welfare-state entitlements system, encouraging work and discouraging indolence. None of this is on the horizon, which makes it a safe bet to predict that the Belgian economy will not return to historic growth levels in the foreseeable future.

Greece in Peril Again

I spent some time traveling Eastern Europe before the Berlin Wall came down. I have many vivid memories of my trips, such as the very low-tech cars they all were so proud of. But I was also impressed with some things, like the breakfast on the overnight train through East Germany – a gourmet experience you could not even get in first-class intercontinental flights at that time. Or the beauty of Prag and Budapest, two of Europe’s most prominent, historic cities.

Perhaps the most painful experience was the sense of perennial economic stagnation. It was almost as though they all lived in a 1950s time capsule, from the enormous, inefficient and highly polluting industrial “combinates” to the design and quality of furniture and home electronics (to the extent it even existed).

Children grew up to the same standard of living that their parents experienced. And their children had nothing more optimistic to look forward to.

Fast forward a quarter century. The Great Recession is hurricaning its way through the European economy. Panic-driven tax increases, combined with spending cuts designed not to shrink government, but to preserve the welfare state, add insult to injury in country after country. The entire continent falls into the dungeon of economic stagnation.

Year after year go by without any discernible improvement on the horizon. All of a sudden, half-a-billion people have no reason to believe in a better tomorrow.

To me, and to anyone who had the opportunity to see first hand what life was like in Communist Europe, this is a painful deja-vu experience. One generation after the fall of the Berlin Wall and the opening of unlimited opportunities to hundreds of millions of people from Saxony to Sakhalin, new skies have descended over the former Soviet empire. The part of it that remained under the Russian sphere now struggle with political instability and an economy that seems to be moving backwards.

The countries that chose the European Union for their future are not in much better shape. They are now part of a bigger economy that may have elevated them to a higher standard of living, but is now keeping them from further growth. If anything, people all over Europe now have to worry that their children and grandchildren will not be able to lead a more prosperous life than they have.

A new era – the same stagnation.

Industrial poverty, for short.

The insights of this long-term trend are slowly spreading. While 2014 has been the year of dashed hopes for a recovery, it looks like 2015 might be the year of painful insights. Those are coming little by little, slowly spreading from writer to writer, from analyst to analyst. A good example of someone who seems to be joining the ranks of the frustrated yet insightful is Peter Kohli, who writes for NASDAQ about Greece:

On November 13th, I wrote an article on this website on how to take advantage of a possible turnaround in the Greek economy, because of certain positive reports I had read. However, it seems that things have changed rather quickly and that the Presidential elections there have been moved up to next week, beginning on December 17th.

The lack of steady economic recovery is taking a political toll on the country. This is not surprising – the channels between politics and the economy are strong in Europe’s welfare states, where government is promising to cater to almost every need people may have. During the fall from relative prosperity in 2007 to the dark, frustrating dungeons of economic depression in 2012, Greek voters expressed their very deeply felt dissatisfaction with their government by voting for two radical and fundamentally anti-democratic parties: Syriza with its Hugo Chavez-style bolivarian socialist platform, and Golden Dawn, the first openly Nazi party to take seats in a European parliament since the 1930s.

Earlier this year it looked like there might be a recovery under way in Greece. However, as more data came online, it quickly became clear that this was merely a transition from depression to stagnation, an insight that very likely has made its way into the hallways of Greek political power. Alas, the election concerns that Kohli writes about. Back to his article:

Ordinarily this would not be a problem, except that there are no candidates for the post yet. In Greece, the election of a president is done by the legislators, who need a supermajority – which they don’t have. If after three successive elections they fail to install a candidate, a general election will be called, and here is where the real problem lies. Currently, the far left anti-austerity party, Syriza, is way ahead in the polls and they are promising to basically roll back nearly all the plans to put the country back on the path of prosperity instituted by the current government.

Well, that path is not exactly a path. It is more of a picture on the wall. But that is a minor point here. Let’s listen to Kohli’s conclusion:

This sent shivers down the spines of many investors, causing the ATHEX Composite Index (GD) to plummet 12.78% on December 9th, another 1% the following day, and then down a further 7.35% the next. Subsequently, the only single-country Greece ETF (GREK), has been hit hard and is down a whopping 39.28% YTD. After making some significant positive steps, I thought the Greeks were on their way back, but this is another Greek tragedy in the making.

It is indeed. If the Greeks do elect Syriza, there is a not-insignificant risk of two major crises forming a perfect storm:

  • The attempt to roll back austerity will lead to the only thing worse than those policies, namely reckless tax hikes; an abandonment of EU-imposed austerity could also lead to a Greek euro exit, with currency free-fall and massive inflation as a result; the economy would be hurled back into depression; and
  • The Nazis in Golden Dawn will not tolerate a government they would consider to be downright Communist; with their penchant for “creative” extra-parliamentary politics, and their deep support among the armed forces and the police, this would pose a direct threat to Greek democracy.

Europe needs to choose between the welfare state and prosperity. Irrefutable evidence shows they cannot get both. The question is: what will it take for them to realize the terms of the choice? The Greek situation may be extreme, but it is extreme in quantity, not in quality. The architecture for a similar development is present in several other European countries: Spain, Portugal, France…

French Government Downgraded

Since 2012 I have been predicting that Europe will transition from the downslope of the Great Recession into a state of long-term “stable stagnation” – a state best described as industrial poverty. (I define it here.) For the past 12-18 months GDP and other data have shown that the downslope is ending, and that the state of stagnation now has Europe in a firm grip. Weak signs of an economic recovery in Greece and Spain do not contradict this observation: the two countries hit the hardest by the recession are simply adjusting to the aftermath of some of the hardest austerity policies on record.

One of the characteristics of the crisis downslope was a barrage of credit downgrades of governments in EU member states – and Greece was far from alone here. Spain, Portugal and Ireland suffered five downgrades each, starting in 2009, sending Spanish treasury bonds to the financial junk yard by 2012. Italy was downgraded three times, starting in 2011, and France lost its AAA rating with Standard & Poor in January 2012. In November that year Moody’s downgraded France, followed by Fitch in July of 2013 and yet another downgrade by S&P in November last year.

Now Fitch is at it again. After having reduced France to AA+ in July last year the rating institute has now decided to kick the French down another notch. Explains Fitch:

When it placed the ratings on RWN in October, Fitch commented that it would likely downgrade the ratings by one notch in the absence of a material improvement in the trajectory of public debt dynamics following the European Commission’s (EC) opinion on France’s 2015 budget. Since that review, the government has announced additional budget saving measures of EUR3.6bn (0.17% of GDP) for 2015, which will push down next year’s official headline fiscal deficit target to 4.1% of GDP from the previous forecast of 4.3%.

The reason why Fitch focuses on the French government’s budget deficit is the prevailing notion that a big deficit is bad for the economy. In reality, the biggest threat is that a deficit will weaken or eventually destroy the ability of government to pay its obligations through welfare-state entitlements. Austerity policies in Europe have been aimed at closing deficits in order to save welfare states from pending default on entitlements: the idea has, simply speaking, been to make the welfare states more “affordable”. The affordability is measured in terms of budget balancing – a deficit is taken as a sign that the welfare state cannot support its spending obligations.

It is not entirely clear whether or not Fitch and others factor this into their ratings. The outcome, however, of their analysis is precisely that: a welfare state that is chronically unable to fund its entitlements will sooner or later be downgraded.

This is what has just happened to France. Back to the Fitch report:

The 2015 budget involves a significant slippage against prior budget deficit targets. The government now projects the general government budget deficit at 4.4% in 2014 (up from 3.8% in the April Stability Programme with the slippage led by weaker than expected growth and inflation) and 4.1% in 2015 (previously 3.0%), representing no improvement from the 4.1% of GDP achieved in 2013. It has postponed its commitment to meet the headline EU fiscal deficit threshold of at most 3% of GDP from 2015 until 2017.

And this despite enacted as well as announced increases in the tax burden on the French economy. As I noted a week ago:

In other words, no stronger growth outlook, no sustainable improvement in business investments or job creation. As a matter of fact, a closer look at the measures that Mr. Sapin refers to reveals a frail, temporary improvement that will not put France on the right side in any meaningful macroeconomic category

Even the part of the deficit that the government can reduce is largely due to a reduction in the annual EU membership fee. There is no underlying macroeconomic improvement behind the small deficit decline. With this in mind it is easy to see why the Fitch report expresses concern about the future of the French economy:

The weak outlook for the French economy impairs the prospects for fiscal consolidation and stabilising the public debt ratio. The French economy underperformed Fitch’s and the government’s expectations in 1H14 as it struggled to find any growth momentum, in common with a number of other eurozone countries. Underlying trends remained weak despite the economy growing more strongly than expected in 3Q, when inventories and public spending provided an uplift.

And, as if to top off the analysis:

Fitch’s near-term GDP growth projections are unchanged from the October review of 0.4% in 2014 and 0.8% in 2015, down from 0.7% and 1.2% previously. Continued high unemployment at 10.5% is also weighing on economic and fiscal prospects. The on-going period of weak economic performance, which started from 2012, increases the uncertainty over medium-term growth prospects. The French economy is expected to grow less than the eurozone average this year for the first time in four years.

And that is quite an achievement, given the notoriously weak growth in the euro zone.

Overall, this is yet more evidence of long-term stagnation in Europe. The bottom line: don’t ask when Europe will recover – ask what reason the European economy has to recover.

On Growth and Income Differences

The question of income inequality keeps popping up. In a new study, the Organization of Economic Cooperation and Development, OECD, a tax-funded think tank in Paris, France, suggests that income inequality reduces GDP growth. Their results, which differ from a vast body of previous research, suggest that for the average OECD country there is significant GDP growth to be gained from reduced income inequality:

The impact of inequality on growth turns out to be sizeable. Based on the estimated coefficients in column 1, for example, lowering inequality by 1 Gini point would translate in an increase in cumulative growth of 0.8 percentage points in the following 5 years (or 0.15 points per year).

The statistical work behind these results appears to be solid, suggesting that it is time for the industrialized world to focus its legislative efforts on reducing income inequality – and thereby gain growth in return.

There is no doubt that this test is a technical and statistical improvement on some previous studies. However, when boiled down to its core the study looks for correlations between income differences – measured as the Gini coefficient – and GDP growth over a five-year period. While the data covered is from a longer period than that, the chronological starting point is 1985. From that point on, says the study, income inequality has increased and growth has slowed down.

I reported similar findings on growth in my recent book. For Europe as well as for the United States there was a shift toward lower growth during or immediately after the 1970s. I attribute this downshift to the fact that virtually all Europe’s welfare states at that time had reached a size of 40 percent or more of GDP. Sweden was one of the first countries to hit this mark, late in the 1960s, and starting in the early 1970s Sweden has had persistent growth problems. It got so bad that by the end of the 1980s they had to completely overhaul their pay-as-you-go retirement system, which by then had been in place for less than 30 years.

Herein lies a good part of the problem with the OECD study. They find a negative correlation between income differences and GDP growth and assume that the correlation comes with a causality from the former to the latter. But the causal relation could just as well be the opposite. The downshift in growth coincides, as mentioned, with a government sector that is larger than, up until then, it had ever been in the free world.

As the OECD report reveals, it is difficult if not impossible to explain, coherently and with theoretical consistency, why larger income differences would cause a decline in growth. The so called “endogenous fiscal policy” theory takes a stab at that, suggesting that larger income differences lead voters to elect redistribution-minded legislators. They in turn create redistribution programs that, says the theory, are distortionary – or growth-hampering – by nature. The OECD report claims to find evidence (section 3.3) that redistribution does not affect growth, a statement that actually is evidence that there is no causality at all from income differences to economic growth.

Put differently: you cannot have it both ways. On the one hand the OECD says that income differences cause a decline in growth; on the one hand they say that changing those differences does not affect growth.

This inconsistency in the report indicates that at the end of the day, the causality from income differences to growth simply does not exist. A more plausible hypothesis is that their correlation – the original one which focuses on market income – is evidence of another causal structure. In the 1960s and ’70s government grew to reach or exceed 40 percent of GDP. Up until roughly that point the private sector had been able to cope with, and adjust to, the continuous rise in taxes and perversion of economic incentives caused by expanding welfare state entitlements. Then there came a point where the cost of adjusting to government growth exceeded the losses from cutting down on business activity or scrapping plans to expand. Labor-related taxes – primarily payroll taxes to pay for various tax-funded income security systems – combined with the proliferation of hire-and-fire regulation on the labor market created an onerous fixed-cost instep for small businesses. As a result, large, existing corporations could dodge productivity-enhancing competition.

All taken together, these institutional changes to the European and (though to a lesser extent) the U.S. economies put a wet blanket over the economy. Growth slowed down permanently. Job creation stagnated, at least in Europe.

And here comes the tie back to income differences. When the economy is not growing as well as it used to, lower-end jobs become dead-end careers with little prospect of a reasonable income development. A slowdown in GDP growth is an indication that productivity is not evolving quite as fast as it used to. A relative slowdown in productivity is also negative for lower-end jobs, thus slowing growth in their income.

In short: the negative correlation between income differences and GDP growth is indicative of a causality from the latter to the former. Slower growth causes income differences, not the other way around.

Again, for a more detailed understanding of why the Western world has experienced a decline in GDP growth since the 1979s, see my book on the European crisis.

Europe’s Shortsighted Fiscal Policy

In a few articles recently I have pointed to some evidence of an emerging economic recovery in Spain and Greece. This is not a return to anything like normal macroeconomic conditions, but more a stagnation at a depressed level of economic activity. To call it a “recovery” is a stretch, but given the desperate circumstances of the past few years, an end to the depression is almost like a recovery.

The transition from a depression with plunging GDP, vanishing jobs and overall an economy in tailspin, to stagnation where nothing gets neither better nor worse, is in fact a verification of my long-standing theory. Europe has entered a new era of permanent stagnation – an era best described as industrial poverty – and is slowly but steadily becoming a second-tier economy on the global stage. The path into that dull future is paved with decisions made by political leaders, both at the EU level and in national governments. While they do have the power to actually return Europe to global prosperity leadership, they choose not to use that power. Instead, their economic policies continue to destroy the opportunities for growth, prosperity and full employment.

In fact, Europe’s leaders have the opportunity on a daily basis to choose which way to go. The difference is made in their responses to the economic situation in individual EU member states. Let us look at two examples.

First out is an article from Euractiv a month ago:

Greece is “highly unlikely” to end its eurozone bailout programme without some new form of assistance that will require it to meet targets, a senior EU official said on Monday (3 November). “A completely clean exit is highly unlikely,” the official told reporters, on condition of anonymity. “We will have to explore what other options there are. Whatever options we may be adopting, it will be a contractual relationship between the euro area institutions and the Greek authorities,” the official said.

How will the EU, the European Central Bank and the International Monetary Fund respond to this? Will they continue to impose the same austerity mandates that they began forcing upon Greece four years ago? Back to Euractiv:

The eurozone and IMF bailout support of €240 billion began in May 2010. Greece is in negotiation with EU institutions and the International Monetary Fund ahead of the expiry of its bailout package with the European Union on 31 December. Athens has said it wants its bailout to finish when EU funding stops, though the IMF is scheduled to stay through to early 2016. The EU official said he expected eurozone ministers and Greece to decide on how best to help Athens at a meeting of finance ministers in Brussels on 8 December.

If the EU decides to continue with the same type of bailout program, thus continuing to demand government spending cuts and tax hikes, then their response to this particular situation will continue the economic policies that keep Europe on its current path into perpetual industrial poverty.

The second example, France, also presents Europe’s political leadership with a fork-in-the-road kind of choice. From the EU Observer:

France’s finance minister cut the country’s deficit forecast for 2015 on Wednesday (3 November) adding that Paris will be well within the EU’s 3 percent limit by 2017. Michel Sapin told a press conference that he had revised France’s expected deficit down to 4.1 percent from the 4.3 percent previously forecast, as a consequence of extra savings worth €3.6 billion announced by Sapin in October.

That sounds good, but what is the reason for this improved forecast – and, as always with optimistic outlooks in Europe, can we trust it?

The extra money does not come from additional spending cuts but instead from lower interest expenses from servicing France’s debts, a reduction in its contributions to the EU budget, and extra tax revenues from a clampdown on tax evasion and a new tax on second homes. “We have revised the 2015 deficit … without touching the fundamentals of French economic policy,” Sapin told reporters.

This also means they have done their debt revision without seeing a change for the better in “the fundamentals” of the French economy. In other words, no stronger growth outlook, no sustainable improvement in business investments or job creation. As a matter of fact, a closer look at the measures that Mr. Sapin refers to reveals a frail, temporary improvement that will not put France on the right side in any meaningful macroeconomic category:

  • A lower interest rate on French government debt is almost entirely the work of the European Central Bank and its irresponsible money-printing; the French are paying lower interest rates on ten-year treasury bonds than we do here in the United States, but that will last only for as long as investors remain confident in the ECB’s version of Quantitative Easing; interest rates will quickly start rising again once that confidence is shattered – and it will be shattered as soon as investors realize that, unlike in the United States, the European economy will not start growing again;
  • Reduced French EU contributions come at the expense of other countries and likely won’t last very long; as soon as other countries have grown impatient with the French, they will force Paris to increase its contributions again; besides, this “reduced EU contributions” thing is basically just an accounting trick – effectively it means that the EU has reduced their demands on how much France needs to cut its deficit to be “compliant”;
  • A new second-home tax is a tax increase to which taxpayers will make the necessary adjustments; they will move from owning a home to renting one or to extended-stay vacations at luxury hotels; once that adjustment reaches a critical point the French government will have lost the new revenue and their hopes of being “compliant” with the EU deficit requirement will fade away.

If the French government spent all the political and legislative efforts that went into these measures, on structural reforms to the French government, then France would be en route to a major improvement in growth, jobs creation, business investments and the standard of living of their citizens. But that is not going to happen. All they do is try to comply with the same old statist rules that have forced them to balance their budget – and save their welfare state – instead of promoting the prosperity of their people.

There is a painful shortsightedness in European fiscal policy, one that almost entirely prevents the political leadership of that continent to look beyond the next fiscal year. It is time for them to stop, raise their eyes to the horizon and think about where they want their continent to be ten years from now.

If they don’t, I can surely say where they are going to be: in an era of industrial poverty, colored by three shades of grey, where children are destined to – at best – live a life no better than what their parents could accomplish. Think Argentina since the decline and fall of their 15 years of global economic fame.

Think Eastern Europe under Soviet rule.

Political Turbulence in Sweden

The new Swedish prime minister who took office after the September elections announced on Wednesday that he is calling extra elections. They will be held in March, as early as the constitution allows. This will be the first time in more than half a century that Sweden has held an extra-ordinary general election, and the announcement has caused quite a bit of political turmoil.

This is a dramatic situation, and yet another sign that Sweden is in some relatively deep trouble. As a background, let me explain the two reasons why the extra-ordinary election will be held.

The first is superficially a constitutional rule de facto forcing an incumbent prime minister to resign if he cannot win parliamentary support for his annual budget. However, underneath the rule was a clash between two different approaches to economic policy. On the one hand, the incumbent prime minister’s green-socialist coalition wanted to raise a number of taxes; on the other hand the opposition alliance, consisting of four center-right parties that governed Sweden up to the September elections, wanted a continuation of their moderately better tax and spending policies. The parliamentary majority lined up behind the center-right alliance budget bill.

One ingredient in this was that the green-socialist coalition wanted to raise payroll taxes on workers below the age of 25. While technically a “return” of the rate to where it was before the alliance government cut it, there have been credible estimates that this increase would cost tens of thousands of young people their jobs. More importantly, it would bar hundreds of thousands of them from finding jobs in the future.

On top of this tax increase the green-socialist coalition wanted to open a new “trainee” program for young people in the nation’s socialized health care system. In short, their plan was to tax away private-sector jobs for young men and women and then, by means of conditioned unemployment benefits, coerce them into the “trainee” program.

In short, the difference between the center-right alliance and the green-socialist coalition was a difference between a modestly market-oriented approach to fiscal policy and a doubling down on heavy-handed statism. The parliamentary came down in favor of the former, leading the prime minister to give up hopes on pushing his cabinet’s budget through the Riksdag.

The second reason for the new election has to do with the Swedish Democrats, a “third party” in the parliament. With 13 percent of the votes in September, the SD became the third largest party in the Riksdag. The green-socialist coalition has sternly declared that they do not want to engage in any talks whatsoever with the SD, the reason being the SD’s more restrictive policies on immigration. Beyond that issue, though, the SD is essentially a traditional European social-democrat party, which should appeal both to the green-socialist coalition and the center-right alliance (which is basically as committed to defending the Swedish welfare state as the socialists are).

Because of their refusal to even talk to the SD, the green-socialist coalition turned the SD into a political enemy. When the SD found that there were only moderate differences between the green-socialist coalition’s budget and the bill put forward by the center-right alliance, they decided to let their disdain for the green party (a sentiment that the greens have carefully reciprocated) become the deciding factor when they came to the budget vote in the Riksdag. Determined to put an end to a coalition where the greens had a lot of influence, the SD cast their votes for the budget bill from the center-right alliance.

The prime minister, himself a social democrat, responded as many had predicted, namely by calling an extra-ordinary election.

There is no doubt that Sweden is politically less stable now than it did a couple of days ago, and there are some reasons to see it that way. The Riksdag, the parliament, is essentially in legislative deadlock after the budget vote. Even though the alliance alternative won the vote and its budget became the law of the land, they cannot actually implement their policies until they have parliamentary majority. By contrast, the green-socialist coalition can no longer seek parliamentary approval of their policies without risking yet another embarrassing defeat.

 It is too early to predict what the March election will bring. But don’t be surprised if the biggest party of the center-right alliance reaches out to the Swedish Democrats. The SD has a potential of 15-18 percent in the new election and could therefore become so big that the moderates could form a government with them alone. Today, many commentators and analysts would consider this unthinkable, but as I will explain in a later article, there are several reasons why this is actually one of the most probable outcomes of the March elections.

Until then, Sweden will be in a state of uncertainty. Keep your money out of that country but do keep your eyes on it.

A Picture of a Broken Promise

Whenever government creates an entitlement, it makes a promise to its citizens. The promise is defined in terms of a cash value, or an in-kind service of a certain quality; in terms of duration and of who is, or can become, eligible.

Over time, people adjust their lives to these promises. They come to rely on government being there for them when it really matters, and therefore stop – or never start – saving for contingencies such as unemployment or major health care expenses. Their incentives to stop providing for unforeseen events are reinforced by the taxes that go toward paying for government’s promises.

There you have it, in a nutshell: the welfare state.

In the early years of its existence, the welfare state provided for people with relative ease. Many adults still lived by the old creed of keeping current expenses moderate in order to have enough in the bank for most of what life could throw at them. Taxes were also relatively moderate, allowing people the cash margins to do the saving they still thought they needed.

Over time, though, it became harder and harder for government to keep its welfare-state promises. The incentives structure that government had created began sinking in to the fabric of the economy. Not only did people cut down on their savings, thus relying more on the welfare state, but they also responded to the higher taxes by working less.

Dependency on government increased while independence decreased. This created a trend where the ability of government to pay for its promises was slowly but inevitably eroded. The cost of its promises crept upward, beyond what the creators of the welfare state had originally imagined; work disincentives eroded tax revenues, also beyond what the architects of the welfare state had pictured.

In the early 1970s most of Europe’s welfare states hit a point where the cost of the welfare state began rising above what the private sector of the economy could afford. Various accommodating measures were taken, varying from higher taxes and benefits cuts – as in Denmark – to supply-side tax cuts aimed at accelerating growth in tax revenue – as in Sweden. (Notably, the Reagan tax cuts were coupled with seven-percent-per-year federal spending growth, a clear indication that the supply-side policies were there to fund government, not part of a strategy to reduce the size of government.) But these were merely stopgap measures; inevitably, the welfare state overwhelmed the private sector with its entitlement costs, its high taxes, its incentives toward a lifestyle of government dependency.

The crisis of 2008 was the straw that broke the camel’s back. Europe’s welfare states plunged into the dungeon of economic stagnation and began their march into a new era of industrial poverty.

For more on that part of the story, see my book on the European crisis. For now, though, there is another aspect of the crisis of the welfare state that deserves attention. In response to the overwhelming cost of the welfare state, most of Europe’s countries have resorted to a kind of austerity not yet known to Americans. They cut government spending and raise taxes not to reduce the size of government, but to resize their welfare states to slim-fit them into a smaller economy (make them more “affordable” as Michael Tanner so aptly put it in his foreword to my book). The metrics for whether or not austerity has succeeded have nothing to do with how the private sector is doing – they are all focused on whether or not the welfare state will survive.

The primary measurement of survivability is whether or not the budget deficit has been reduced.

In order to get there, though, most European governments have had to cut deeply into their welfare state programs. That would be fine under the right circumstances – if people were given tax cuts corresponding to the spending cuts and thus a chance to buy the same services on a private market. But in the European, statist version of austerity, reduced spending means cutting the size of government without giving more room to the private sector. As much as this sounds like a contradiction in terms, consider the fact that while spending is reduced, taxes remain high or go up even higher.

As a direct result of this statist version of austerity, government breaks its promises to its citizens, and does it on many fronts at the same time. This is now statistically visible.

Broadly speaking, welfare-state spending consists of two parts: cash benefits and in-kind benefits. The latter is health care, elderly care, child care and similar services. Both these two categories can then be subdivided into means-tested and non-means tested benefits.

When a government is faced with the need to cut spending, and its motive for cutting spending is to save as much as possible of the welfare state, it will make its cuts based on two criteria:

  • what cuts will give the most bang for the political and legislative effort; and
  • what cuts will stir up the least political protests among voters.

These two criteria do not always work in tandem, and it varies from country to country, from government to government, which one weighs more heavily. However, as a general rule it is easier to cut in-kind benefits than cash benefits: while people see the reduction in cash benefits immediately, it takes a while for them to experience the reduced quality or availability of services such as health and child care.

We can see this rule at work in Europe. In countries that have been hit hard by statist austerity, there were tough cuts to in-kind benefits spending (Eurostat data; changes to annual total spending; current prices):

2004 2005 2006 2007 2008 2009 2010 2011 2012
Greece 7.8% 13.1% 9.6% 3.8% 13.8% 6.0% -1.9% -11.6% -21.9%
Spain 7.8% 10.8% 9.7% 7.1% 10.6% 6.1% -0.1% -0.2% -6.7%
Italy 9.7% 6.2% 5.7% 0.7% 6.8% 1.9% 2.5% -1.1% -1.7%
Cyprus -3.1% 14.0% 17.6% 9.9% 11.3% 16.6% 0.9% 0.1% -10.4%
Hungary 6.2% 16.6% 2.2% 6.6% 1.4% -12.7% 6.6% -2.5% -10.0%
Portugal 3.2% 5.2% 2.3% 0.8% 3.4% 8.4% -1.2% -11.1% -1.5%

By contrast, countries that have not suffered as hard statist austerity measures:

2004 2005 2006 2007 2008 2009 2010 2011 2012
Finland 6.9% 6.1% 5.5% 5.7% 10.9% 4.8% 4.1% 5.9% 6.0%
Belgium 8.8% 4.5% 3.2% 7.4% 9.4% 7.5% 2.9% 5.1% 4.6%
Denmark 4.7% 4.6% 5.5% 8.4% 6.0% 8.2% 4.5% -1.3% 2.0%
Germany -1.7% 4.1% 2.7% 3.3% 4.3% 12.8% 3.3% 2.1% 2.7%
Netherlands 2.0% 4.3% 23.1% 8.0% 6.3% 7.4% 3.0% 2.7% 4.0%

Now compare the cuts to in-kind benefits in “austerity countries” to what they did with cash benefits:

2004 2005 2006 2007 2008 2009 2010 2011 2012
Greece 8.5% 8.4% 6.7% 9.1% 7.7% 7.3% -0.6% 0.7% 5.6%
Spain 7.6% 8.5% 6.9% 9.4% 8.9% 12.8% 1.8% 3.1% 0.3%
France 4.4% 4.5% 1.6% 4.1% 3.7% 3.1% 3.4% 3.0% 3.7%
Italy 3.6% 3.0% 4.7% 4.7% 4.8% 4.7% 2.6% 2.0% 2.2%
Cyprus 9.1% 8.0% 6.9% 5.4% 12.7% 8.0% 10.4% 7.2% 3.1%
Hungary 9.6% 12.3% 4.3% 15.5% 10.0% -10.6% 2.0% 0.7% 0.0%
Portugal 9.5% 6.8% 6.0% 4.4% 4.7% 7.5% 3.5% 1.2% -1.7%

What is the lesson from all this? There is, again, the broader, long-term lesson of a future in economic stagnation and a life in industrial poverty. But already today there are tangible consequences felt by citizens whom welfare statists often refer to as “vulnerable”. They have first been lured into dependency on government, then – when austerity strikes – they are left without access to services monopolized by government.

When the welfare state breaks its promises, having the right to health care is one thing; getting health care when needed is a totally different matter.

More Signs of Spanish Recovery

It is very easy to establish that Europe’s economy is stuck in a state of deep, solid stagnation. As I have explained recently, you have to look carefully to find any exceptions to that rule. However, those exceptions exist in the form of Greece and Spain. So far neither country has reached a state of real recovery – so far their economies have elevated themselves out of the deepest part of a depression, but their economies have so far only risen to the same state of stagnation that has slowly but steadily spread to the entire continent.

That is not to say Spain and Greece can’t do better. They can. To find out more about their economies I decided to review the value-added side of their economies. For those of you who are not macroeconomic nerds, there are three ways to calculate GDP: the income approach, the expenditure approach and the value added approach. The third is the least commonly used one, mostly because it does not say very much about the two major forms of activity in an economy such as the European: private consumption and government spending. However, value added can tell us a great deal about what industries are flourishing and which ones are doing poorly.

The following four industries represent almost 40 percent of the Greek economy:

VA Greece

Correction: the industry labeled “Tourism etc” should really be “Wholesale trade, tourism etc”.

This is unfortunately not the image of an economy in steady recovery. Manufacturing, which is only responsible for nine percent of the added value in the Greek economy, is definitely in a state of stagnation; if all the talk about an exports renaissance in Europe were true, Greek manufacturing would be surging.

Instead, it is “Wholesale trade, tourism, etc” that is on a clear trajectory to recovery.  Producing 22 percent of the value added, this industry is labor intensive and close to consumers. The sustained improvement in activity is encouraging and has a potential for spreading its upturn to other sectors. First and foremost, it could mean that the young in Greece, whose chances of finding a job – any job – is the worst in the industrialized world, might regain some sort of faith in the future. That would be good for the long-term stability of both the economy and the Greek democracy.

That said, the figure of the Greek economy also shows that the other major industries are still in decline – or at least were in decline through the second quarter of this year. Greece needs a lot more to regain some of its status as an industrialized economy with a future.

Things look a bit different in Spain:

VA Spain

Together, these four industries are responsible for 46 percent of the total value produced in the Spanish economy. The three recovering industries represent 38 percent of total value added, a share big enough to positively affect the rest of the economy.

Adding to the cautious optimism about the Spanish economy is the fact that the growth rate of value added in two of the three recovering industries is actually accelerating. Manufacturing saw accelerating growth in five consecutive quarters:

2013Q1 2013Q2 2013Q3 2013Q4 2014Q1 2014Q2
Professional -1.61% -0.80% 0.23% 1.97% 1.49% 2.23%
Wholesale, Tourism etc -2.45% -0.64% 1.07% 1.35% 1.69% 2.83%
Manufacturing -3.33% -0.71% -0.08% 0.76% 1.83% 1.29%
Construction -7.89% -8.46% -7.68% -6.87% -7.71% -3.15%

It deserves to be repeated that in total, the Spanish economy is still very much in recession mode. Austerity is still a real fiscal-policy threat, and the declining euro-zone interest rates pose a threat in terms of renewed financial speculation. However, the sectorial recovery has enough momentum that if it is allowed to continue, it will give the Spanish economy a reasonable shield against moderate negative shocks.

That said, should austerity again come to define fiscal policy at the levels it saw in 2012, there is a substantial risk that the recovering industries will fall back into recession mode. They will then pull the entire economy back down into the hole of depression.

Bottom line: Greece is far from out of its depression, farther than a cursory analysis would show. Spain on the other hand is worth watching closely.

Bad Euro Economy Worries OECD

The European economic stagnation is now becoming a concern for the rest of the world. The OECD – Organization for Economic Cooperation and Development – is sounding the alarm in their latest Economic Outlook. From their news release:

The Economic Outlook draws attention to a global economy stuck in low gear, with growth in trade and investment under-performing historic averages and diverging demand patterns across countries and regions, both in advanced and emerging economies.

Put bluntly, the EU with its 500 million residents and supposedly first-world standard of living is spreading its stagnation to other countries and continents. An economy that is not growing is not growing its imports; it offers fewer, and less profitable, investment opportunities than a growing economy.

Many emerging economies have their own problems to deal with, from a heavy-handed government in India and clumsy deregulation in China to dangerous political corruption and violence in South Africa. But there is no doubt that entrepreneurs in those countries who can participate in global trade would be much more able to make a difference for the better if they had a growing global market on which to sell their products. While the U.S. economy sticks to its lazy recovery – the latest job numbers are moderately good but not exciting – the Japanese upturn is still fledgling. But the big drag on the global economy is, no doubt, Europe.

The OECD notes this…

“We are far from being on the road to a healthy recovery. There is a growing risk of stagnation in the euro zone that could have impacts worldwide, while Japan has fallen into a technical recession,” OECD Secretary-General Angel Gurria said.

…but when it comes to prescriptions for what to do about this, the OECD falls short. Before we get there, though, it is important to note one aspect of the OECD report that hints of what kind of solutions they may be prescribing:

The euro area is projected to grow by 0.8% in 2014, before slight acceleration to a 1.1% rate in 2015 and a 1.7% rate in 2016. A prolonged stagnation in the euro area could drag down global growth and have knock-on effects on other economies through trade and financial links.  A scenario in the Outlook shows how a negative shock could lead an extended period of very low growth and very low euro inflation, resulting in unemployment remaining at its current unacceptably high level.

I have lost count of all forecasts over the past two years that predict a rising GDP growth rate for the euro zone or the EU as a whole. The reason why so many economists make these predictions is that they base their modeling on the standard notion that every economy eventually, long term, gravitates back toward full-employment equilibrium. They are no doubt mystified by the protracted nature of the current European crisis, but instead of rethinking the fundamentals of their forecasting they stick to their default, which is a long-term full-employment equilibrium.

This is, however, not a regular crisis that allows itself to be analyzed in terms of standard macroeconomic models. It is a structural crisis, systemic in nature and by default perennial in duration. Its cause is a permanent imbalance between government-promised entitlements and the ability of the private sector to pay for those entitlements. This imbalance will remain forever unless Europe’s legislators actively reform away entitlements and alleviate the burden of the welfare state on the shoulders of the private sector.

In short: it does not take another negative shock to keep there European economy depressed forever. All it takes is absence of drastic structural reform.

That, however, is not what the OECD is prescribing:

“With the euro zone outlook weak and vulnerable to further bad news, a stronger policy response is needed, particularly to boost demand,” said OECD Chief Economist Catherine L Mann. “That will mean more action by the European Central Bank and more supportive fiscal policy, so that there is space for deeper structural reforms to take hold. A Europe that is doing poorly is bad news for everyone.”

More action from the ECB? Let’s look at some recent annual growth rates in euro-zone M1 money supply, courtesy of the European Central Bank, and current-price GDP growth, courtesy of Eurostat:

M1 Euro Growth 2

Current-price GDP growth represents growth in money demand. The liquidity pumped out by the ECB in excess of that goes straight into the financial system where, to be a bit crude, it will slush around in search of profitable investment opportunities.

For example, in 2013 the ECB printed €7.36 for every €1.00 in increased current-price GDP. Technically this adds €245 billion of liquidity into the financial system. The result of this monetary policy, zero to negative interest rates, has not made a bit of a difference to the euro-zone economy.

As for the fiscal-policy part of the OECD recommendations, this would take a complete abandonment of welfare-state saving austerity. Are the Europeans ready to do that? And more importantly: are they ready to use active fiscal policy to roll back government and provide more growth room to the private sector?

So far, neither the EU Commission nor key member-state governments have showed any inclination in that direction. But I am not even sure the OECD actually would recommend the right kind of fiscal policy; the farthest they would go is probably a traditional mainstream-Keynesian fiscal stimulus. That would only serve to preserve status quo.

With all this in mind, though, it is good that the OECD is now waking up to the European crisis. Next step is to lead them to the right conclusion as to the nature of that crisis