Analysts are grasping for explanations of why the European economy has once again stalled. The European Central Bank, which has lowered its forecast for GDP growth in the euro zone, suggests that this weakening is not part of a trend, but an aberration from a trend:
First, activity in the first quarter was subject to an unusual upward effect from the low number of holidays (as the entire Easter school holiday period fell in the second quarter) and from the warm winter weather that had boosted construction. Neither of these upward effects in the first quarter was sufficiently captured by seasonal or working day adjustment. As they unwound in the second quarter, this dampened growth. Second, negative calendar effects related to the more than usual number of “bridge days” around public holidays in many euro area countries may have reduced the number of effective working days in May, a factor that was not captured by the working day adjustment.
I have a lot of respect for the macroeconomists at the ECB, but frankly, this is below what we should expect of them. Calendar days and weather always vary – some claim that the bad performance of the U.S. economy in the first quarter of this year was due to the unusually cold winter. In reality, that growth dip was more than likely the result of businesses trying to adjust to the impact of Obamacare. By contrast, the slow growth numbers in the European economy are part of a trend of economic stagnation. A 30,000-foot review of what the European economy looks like is a good way to become aware of that trend.
The profession of economic has to some degree drifted away from the bigger-picture thinking that characterized its earlier days in the 20th century. While econometrics is important, there is too much emphasis on it today, drawing attention away from longer, bigger trends and the kind of institutional changes that characterize Europe today. Based on this broader analysis, my conclusion stands: Europe is not going to recover until they do something fundamental about their welfare state. Or, more bluntly: so long as taxes remain as high as they are and government provides entitlements the way it does, there is no reason for the productive people in the European economy to bring about a recovery.
The problem with short-sighted, strictly quantitative analysis is that it compels the economist to keep looking for a reason why the economy should recovery, as if it was a law of nature that there should be a recovery.
This problem is reflected in the ECB forecast paper:
Regarding the second half of 2014, while confidence indicators still stand close to their long-term average levels, their recent weakening indicates a rather modest increase in activity in the near term. The weakening of survey data takes place against the background of the recent further intensification of geopolitical tensions (see Box 4) together with uncertainty about the economic reform process in some euro area countries. All in all, the projection entails a rather moderate pick-up in activity in the second half of 2014, weaker than previously expected.
It would be interesting to see the results of a survey like this where the questions centered in on the more long-term oriented variables that focused on people’s ability and desire to plan their personal finances. I did a study like that as part of my own graduate work, and the results (reported in my doctoral thesis) were interesting yet hardly surprising. When people are faced with growing uncertainty they try to reduce their long-term economic commitments as much as possible. This results in less economic activity today without any tangible commitment to future spending.
Since I do not have the resources to study consumer and entrepreneurial confidence in Europe at the level the ECB can, I cannot firmly say that people in Europe today feel so uncertain about the future that they have permanently lowered their economic activity. However, my survey results corroborate predictions by economic theory, and the reality on the ground in Europe today points in the very same direction. In other words, so long as institutional uncertainty remains, there will be no recovery in Europe.
The ECB does not consider this aspect. Instead they once again forecast a recovery, just as assorted economists have done for about a year now:
Looking beyond the near term, and assuming no further escalation of global tensions, a gradual acceleration of real GDP growth over the projection horizon is envisaged. Real GDP growth is expected to pick up in 2015 and 2016, with the growth differentials across countries projected to decline, thanks to the progress in overcoming the fragmentation of financial markets, smaller differences in their fiscal policy paths, and the positive impact on activity from past structural reforms in several countries. The projected pick-up in activity will be mainly supported by a strengthening of domestic demand, owing to the accommodative monetary policy stance – further strengthened by the recent standard and non- standard measures – a broadly neutral fiscal stance following years of substantial fiscal tightening, and a return to neutral credit supply conditions. In addition, private consumption should benefit from a pick-up in real disposable income stemming from the favourable impact of low commodity price inflation and rising wage growth.
A key ingredient here is “smaller differences in … fiscal policy paths” and “a broadly neutral fiscal stance”. This means that the ECB is expecting an end to austerity policies across the euro zone, an expectation that has been lurking in their forecasts for some time now. But austerity has not ended, nor have the budget deficit problems that brought about austerity. The austerity artillery is not as active now as it was two years ago, but it has not gone quiet. France, e.g., is currently in a political leadership crisis because of the alleged need to continue budget-balancing measures.
France also indicates where the fiscal trend in Europe is heading. If the radical side of the French socialists could have it their way they would chart a course back to big-spending territory. But they would also couple more spending with even higher taxes, in order to avoid conflicts with the debt and deficit rules of the EU Stability and Growth Pact. While technically a “neutral” policy, the macroeconomic fallout would be a further weakening of the private sector – in other words a further weakening of GDP growth.
Another aspect that the ECB overlooks is the effects of the recalibration of the welfare state that has taken place during the austerity years. I am not going to elaborate at length on this point here, but refer instead to my new book where I discuss this phenomenon in more detail. Its macroeconomic meaning, though, is important here: the recalibration results in the welfare state taking more from the private sector, partly in the form of taxes, and giving less back in the form of lower spending. As a result, the private sector is drained, structurally, of more resources, with the inevitable result that long-term GDP growth is even weaker.
None of this is discussed in the ECB forecast paper, which means that we will very likely see more downward adjustments of their growth forecasts in the future.
There would be no problem with the ECB’s erroneous forecasts if it was not for the fact that those forecasts are used by policy makers in their decisions on taxes, government spending and monetary supply. The more of these “surprising” downward corrections by forecasters, the more of almost panic-driven decisions we will see. Alas, from EUBusiness.com:
The European Central Bank cut its forecasts for growth in the 18-country euro area this year and next, and also lowered its outlook for area-wide inflation, at a policy meeting on Thursday. The ECB is pencilling in gross domestic product (GDP) growth of 0.9 percent in 2014 and 1.6 percent in 2015, the central bank’s president Mario Draghi told a news conference. “Compared with our projections in June, the projections for real GDP growth for 2014 and 2015 have been revised downwards,” he said. The bank said inflation was expected to be 0.6 percent this year — a lower rate than the 0.7 originally forecast, Draghi said.
And therefore, the ECB decided to cut its already microscopic interest rates. Among their cuts is a push of the overnight bank lending rate further into negative territory, so that it now stands at -0.3 percent. But all these measures, aimed at injecting more cheap credit into the European economy, will fall as flat on their bellies as earlier interest-rate cuts. The problem is not that there is not enough liquidity in the economy – the problem is, as mentioned earlier, that the European economy suffers from institutional and structural ailments. Those are not fixed with monetary policy. Yet with the wrong analysis of the cause of the crisis, Europe’s policy makers will continue to prescribe the wrong medicine and the patient will continue to sink into a vegetative state of stagnation and industrial poverty.
Last Friday I explained that Europe appears to be on its way back to Big Spending country. One major reason is that the policies practiced so far during the Great Recession have proven to be sorely inadequate. Another reason is that Europe suffers from a bad case of conventional wisdom, the default position of which is that there is nothing more important in the economy than the welfare state. As a result, when austerity policies, specifically designed to save the welfare state, fail to do just that while also failing to reignite the economy, voters and political leaders turn to erstwhile solutions such as more government spending. Led there by conventional wisdom, not solid analysis, they are certain to only do more harm to an already ailing patient.
In this situation, clear and crisp crisis analysis is more important than ever. That is the only way to a working solution to the crisis. Unfortunately, the road to such solutions still runs through analytical neighborhoods where arguments about what cause the crisis sprawl in all directions. My blog article from last Friday quoted one example, Dan Steinbock of the India, China and America Institute. This week, Steinbock continues his contribution in the EU Observer::
In the United States, the global financial crisis was unleashed by real estate markets and the financial sector, which caused a dramatic contraction and massive mass unemployment.
That is a superficial explanation. The root cause was a fundamental misinterpretation of a macroeconomic trend. From the late 1970s through the Millennium recession the swings in the American business cycle gradually became weaker. This has been interpreted as a shift to more stable growth, which policy makers in the United States used as a basis for liberalizing the country’s credit markets. One part of this liberalization was an expansion of subprime mortgage lending, a reform that makes sense if the expectation is high GDP growth and as a result high growth in disposable income, then the risks associated with subprime lending are well contained. The debt-to-income ratio would not reach alarming levels, perhaps not even grow at all.
There was just one problem. The trend that was interpreted as growth stabilization was also a trend of weakening growth. In the 2000s the American economy grew at about half the pace of the ’90s. This led to a relative weakening of the ability of American households to keep up with debt payments. Therefore, it is incorrect to say that this was a financial crisis – it was a macroeconomic crisis that was mismanaged and misinterpreted by key political leaders.
It is important to keep this in mind, because it has consequences for how to get the U.S. economy out of the Great Recession. Steinbock lauds the Obama administration for its “stimulus package”, which…
included spending in infrastructure, health and energy, federal tax incentives, expansion of unemployment benefits and other social welfare provisions. It boosted innovation and supported competitiveness.
Frankly, there is no evidence of this. The bulk of the money spent through the American Recovery and Reinvestment Act went to fill revenue gaps in existing government spending programs, at the federal level as well as in the states. This borrowed money may have prevented a massive tax increase, which would have been the other conventional-wisdom option, but it certainly did not expand spending. On the contrary, what was a temporary jump in GDP growth during the stimulus spending, but as soon as it was over the growth rate reverted to pre-stimulus levels. It was not until late 2013 that the very first signs of some sort of recovery were visible. That recovery, though, which is still continuing, is far weaker than it should have been. Why? More on that in a moment. For now, back to the EU Observer, where Steinbock claims that the United States…
was able to rely on common fiscal and monetary policy. When one state got into trouble, it could turn to others for support. Of course, the crisis supported some states and hurt others, but the common institutions worked.
I have worked for state-based think tanks for eight years now, and I have carefully studied state fiscal policy for at least as long. To be perfectly honest, I have no idea what Steinbock is talking about here.
Let’s continue to listen to him, though. Maybe he makes more sense when he turns to discussing Europe:
When the 2008/9 crisis hit Europe, the core economies relied on their generous social models, but structural challenges were set aside. That ensured a timeout but boosted threats. In spring 2010, the crisis was still seen as a liquidity issue and a banking crisis. So Brussels launched its €770 billion “shock and awe” rescue package to stabilise the eurozone. As the consensus view grouped behind Brussels, I argued that the rescue package was inadequate and the austerity policy too strict. Further, it ignored multiple other crisis points. And it was likely to result in demonstrations and violence in southern Europe.
While he is correct about the political fallout of the crisis, he is far too vague on the economic variables that drove the European economy into the ditch. As I explain in my book Industrial Poverty (order your hard copy now or get your ebook version very soon!) the cause of the European crisis is to be found in the structure of the welfare state. This structural ailment is present in the American economy as well, though not as pronounced, but it explains why the Western economies experienced a growth slowdown in the 1980s (EU) and on the heels of the Millennium Recession (U.S.).
So long as the structural problem remains, there will be no recovery in the European economy. The United States has been able to recover despite the weight of government, an aspect that Steinbock misses. He does, however, make a good point about mistakes made by the European Central Bank:
[The] European Central Bank (ECB), led by its then-chief Jean-Claude Trichet, moved too slowly and hiked rates instead of cutting them. When the ECB finally reversed its approach, precious time and millions of jobs had been lost. Subsequently, Trichet’s successor, Mario Draghi, cut the rates and pledged to defend euro “at any cost.” Markets stabilised, but not without huge bailout packages, which divided the eurozone.
Trying to stuff as many explanations as possible of Europe’s perennial crisis into the same article, Steinbock then proceeds to point in many different directions at the same time:
As Barroso and his commissioners began to argue that “the worst was over,” Brussels hoped to reinforce the trust in euro and the EU and deter the rise of the eurosceptics. But hollow promises resulted in a reverse outcome. What’s worse, both Brussels and the core economies failed to provide adequate fiscal adjustment amidst the global crisis and the onset of the eurozone debt crisis, which made bad mass unemployment a lot worse and continues to penalise demand and investment. Further, neither liquidity support nor recapitalisation of the major banks has mitigated the worst insolvency risks in the region. Unlike in the US, many European economies, including Nordic ones, also continued to cut their innovation investments, thus making themselves even more vulnerable in the future. As the crisis spread to Italy and Spain, which together account for almost 30 percent of the eurozone economy, bailout packages could no longer be used. Rather, structural reforms became vital but since they were seen as a political suicide, delays replaced urgency.
Reduced spending on “innovation” is not nearly as important an explanation of the crisis as the structural fiscal imbalances of the welfare state. It is important to separate what matters from what does not matter. Otherwise, one cannot provide solutions to those who are in the position to put them to work.
Europe’s version of austerity has been designed exclusively to save the continent’s big welfare states in very tough economic times. By raising taxes and cutting spending, governments in Greece, Spain, Italy and other EU member states have hoped to make their welfare states more slim-fit and compatible with a smaller tax base. The metric they have used for their austerity policies is not that the private sector would grow as a result – on the contrary, private-sector activity has been of no concern under government-first austerity. Unemployment has skyrocketed, private-sector activity has plummeted and Europe is in worse shape today than it was in 2011, right before the Great Big Austerity Purge of 2012.
The criticism of austerity was massive, but not in the legitimate form we would expect: instead of pointing to the complete neglect of private-sector activity, Europe’s austerity critics have focused entirely on the spending cuts to entitlement programs. While such cuts are necessary for Europe’s future, they cannot be executed in a panic-style fashion – they should be structural and remove, not shrink, spending programs. Furthermore, they cannot be combined with tax hikes: when you take away people’s entitlements you need to cut, not raise, taxes so they can afford to replace the entitlements with private-funded solutions. Tax hikes, needless to say, drain dry the private sector and exacerbate the recession that produced the need for austerity in the first place.
This is a very simple analysis of what is going on in Europe. It is simple yet accurate: my predictions throughout 2012, 2013 and so far through 2014 have been that there will be no recovery in Europe unless and until they replace government-first austerity with private-sector austerity. This means, plain and simple, that you stop using government-saving metrics as measurement of austerity success and instead focus on the growth of the private sector. This will rule out tax hikes and dictate very different types of spending cuts, namely those that permanently terminate government spending programs.
Unfortunately, this aspect of austerity is absent in Europe. All that is heard is criticism from socialists who want to keep the tax hikes but combine them with more government spending. A continuation, in other words, of what originally caused the current economic crisis (that’s right – it was not a financial crisis). These socialists won big in the French elections two years ago, gaining both the Elysee Palace and a majority in the national parliament. However, faced with the harsh economic realities of the Great Recession, they soon found that spending-as-usual was not a very good idea. At the same time, they have rightly seen the problems with the kind of government-first austerity that has been common fiscal practice in Europe. Now that their own agenda is proving to be as destructive as government-first austerity, France’s socialists do not know which way to turn anymore. This has led to a political crisis of surprisingly large proportions. Reports the EU Observer:
French Prime Minister Manuel Valls on Monday (25 August) tendered his government’s resignation after more leftist ministers voiced criticism to what is being perceived as German-imposed austerity. The embattled French President, Francois Hollande, whose popularity ratings are only 17 percent, accepted the resignation and tasked Valls to form a new cabinet by Tuesday, the Elysee palace said in a press release. “The head of state has asked him [Valls] to form a team in line with the orientation he has defined for our country,” the statement added – a reference to further budget cuts needed for France to rein in its public deficit.
From the perspective of the European Union, France has been the bad boy in the classroom, not getting with the government-first austerity programs that have worked so well in Greece (lost one fifth of its GDP) and Spain (second highest youth unemployment in the EU). Hollande’s main problem is that by not getting his economy back growing again he is jeopardizing the future of the euro, in two ways. First, perpetual stagnation with zero GDP growth has forced the European Central Bank into a reckless money-supply policy with negative interest rates on bank deposits and a de facto endless commitment to printing money. This alone is reason for the euro to sink, and the only remedy would be that the economies of the euro zone started growing again. Secondly, by exacerbating the recession in France, and by failing endemically to deliver on his promises of more growth and more jobs, Hollande is setting himself up to lose the 2017 presidential election to Marine Le Pen. First on her agenda is to pull France out of the euro; if the zone loses its second-biggest economy, what reasons are there for smaller economies like Greece to stay?
This is why he has now shifted policy foot, from the spending-as-usual strategy of 2012 to government-first austerity. But since neither is good for the private sector, frustration is rising within the ranks of France’s socialists to a point where it could cause a crippling political crisis. Euractiv again:
The rebel minister, Arnaud Montebourg, who had held the economy portfolio until Monday, over the weekend criticised his Socialist government for being too German-friendly. “France is a free country which shouldn’t be aligning itself with the obsessions of the German right,” he said at a Socialist rally on Sunday, urging a “just and sane resistance”. The day before, he gave an interview to Le Monde in which he claimed that Germany had “imposed” a policy of austerity across Europe and that other countries should speak out against it. Two more ministers, Benoit Hamon in charge of education and culture minister Aurelie Fillipetti, also rallied around Montebourg and said they will not seek a post in the new cabinet. In a resignation letter addressed to Hollande and Valls, Fillipetti accused them of betraying their voters and abandoning left-wing policies, at a time when the populist National Front is gaining ground everywhere. According to Le Parisien, Valls forced Hollande to let go of Montebourg by telling him “it’s either him or me.”
Ironically, the main difference between the socialist economic policies and those of the National Front is that the latter want to reintroduce the franc while the former want to stay with the euro. Other than that, the National Front wants to preserve the welfare state, though significantly cut down on the number of non-Europeans who are allowed to benefit from it. The socialists also want to preserve the welfare state, but also open the door for more non-European immigration.
In short, the differences between socialist and nationalist economic policy is limited to nuances. Needless to say, neither will help France back to growth and prosperity.
Meanwhile, according to the Euractiv story there is mounting pressure from outside France on President Hollande to stick with the government-first austerity program:
[The] government turmoil is also a sign of diverging views on how to tackle the country’s economic woes. French unemployment is at nearly 11 percent and growth in 2014 is forecast to be of only 0.5 percent. Meanwhile, French officials have already said the deficit will again surpass EU’s 3 percent target, and are negotiating another delay with the European Commission. The commission declined to comment on the new developments in France, with a spokeswoman saying they are “aware” and “in contact” with the French government. German chancellor Angela Merkel on Monday during a visit to Spain declined to comment directly about the change in government, but said she wishes “the French president success with his reform agenda.” Both Merkel and Spanish PM Mariano Rajoy defended the need for further austerity and economic reforms, saying this boosted economic growth.
Growth – where? What growth is he talking about? But more important than the erroneous statement that the European economy is benefiting from attempts to save the welfare state, France is now becoming the focal point of more than just the future of the current European version of austerity. The struggle between socialists and competing brands of statism is a concentrate of a more general political trend in Europe. The way France goes, the way Europe will go. While the outcome of the statist competition will make a difference to immigration policy, it won’t change the general course of the economy. Both factions, nationalists and socialists, want to keep the welfare state and therefore preserve the very cause of Europe’s economic stagnation (which by the way is now in its sixth year).
Europe needs a libertarian renaissance. Its entrepreneurs, investors and workers need to stand up together and say “Laissez-nous faire!” with one voice. Then, and only then, will they elevate Europe back to where she belongs, namely at the top of the world’s prosperity league.
There is yet more evidence that Europe, unlike the United States, is going to remain in a state of economic stagnation for a while longer. The EU Observer reports:
Italy has slipped back into recession putting pressure on Prime Minister Matteo Renzi to fulfil promises to see through major structural reform to boost growth. The Italian economy, the third largest in the eurozone, shrank 0.2 percent in the second [quarter], the country’s national statistics office said Wednesday (6 August).
The only quarterly number that Eurostat has released so far is the one adjusted for seasons and workdays, a number I would rarely use. However, it has its merits, too, as it comes as close as you can to linking GDP to the abstracted performance of economic agents. Compared to the same quarter 2013, this number shows a 0.3-percent drop in GDP over the same quarter 2013. Going back two years, the total decline is 2.5 percent. While the bulk of that decline took place in 2013, the country is still suffering from government-saving austerity programs designed to bring Italy into compliance with EU debt and deficit mandates.
But it is not over yet for Italy, not by a long shot. EU Observer again:
Finance minister Pier Carlo Padoan defended the government’s reform plans and said the country would not now need a corrective mini budget to stay on the right side of the EU’s fiscal rules. “The (GDP) figure is negative, but there are also positive elements. Industrial production is much better and consumer spending is continuing to increase, albeit slowly,” said Padoan
This statement is revealing of the purpose behind austerity. Everywhere in Europe, political leaders measure the success of austerity in terms of government fiscal balances; the metric never includes GDP growth. Greece is the prime example of this, where government-saving austerity peeled away one fifth of GDP in fixed prices. The Spanish encounter with austerity exemplifies similarly warped policy goal setting.
In addition, the finance minister’s statement about consumer spending is downright false. While there are no second-quarter Eurostat numbers yet on the spending of Italian consumers, first-quarter numbers are downright troubling. From Q1 2012 to Q1 2014, Italy’s consumer spending declined four percent. Over the last year, Q1 2013 to Q1 2014, the decline was a modest half-percent, but that is still a decline – not an increase.
Even if the GDP and consumption numbers indicate that the decline in Italian economic activity is coming to an end, there are no real signs of a sustainable uptick. It would be foolish to expect anything else, as the main fiscal-policy priority of the Italian government remains the same: save the welfare state. As we go back to the EU Observer, we get even more indications that nothing is really going to change for the better in the Italian economy:
The Italian PM has been among those calling the loudest for flexibility in the interpretation of the rules that govern debt and deficits in the eurozone. However other partners and the EU commission have indicated they wanted to see more structural reform undertaken first. The commission reiterated this on Wednesday and noted that Italy had already been told that it should stick to its budget plans. The other leader calling for flexibility and support from its EU partners is France’s Francois Hollande. In an interview with Le Monde recently, the French president urged Germany and the European Central Bank to do more to boost growth.
1. The Italian prime minister’s call for more flexibility in the interpretation of the EU’s stability and growth pact is really nothing more than a request to be allowed to increase government spending. It echoes what the socialist French president has been demanding for almost two years. However, the last thing Europe needs is more government spending.
2. When European political leaders talk about “structural reform” they do not refer to the kind of reforms actually needed, namely an orderly phase-out of the welfare state. Their take on “structural” is entirely regulatory and focused mostly on the labor market. But regulations do not build a structure – they are part of it, but they are not a structure in themselves. Furthermore, it is pointless to relax labor-market regulations without permanent tax cuts and terminations of government spending programs. Deregulation is supposed to make it easier for employers to hire and fire, but if there is no more demand for labor after the deregulation than before, there won’t be any more jobs out there.
3. It is rather amusing to see how the French president is urging others, outside of his domain, to do more for economic growth. In essence, he is telling the Germans to run their economy better, so he can continue to raise hate-the-rich taxes and drive even more entrepreneurs and hard-working high-end professionals out of France.
In conclusion, there still is no case for an economic recovery in Europe. The continent is now on its sixth year of stagnation, and in some countries an outright depression. Monetary policy has now taken the entire euro zone into the liquidity trap while fiscal policy remains stubbornly fixated on government-saving austerity policies.
Youth unemployment remains stuck above 22 percent in the EU, and above 23 percent in the euro zone. An entire generation is lost.
As painful as it is to say it, Europe is turning into an economic wasteland. It is entirely self-inflicted and if the Europeans want get out of their permanent crisis, they have the solution in their hands.
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.
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.
I got some really positive feedback on my first austerity video. Thank you! The topic is timely, especially with reference to the crisis in Europe. After the elections in May when statist parties on the left gained seats in the European Parliament, the debate over how to handle the perennial economic slump has intensified. Austerity critics have become more vocal, and the funniest part of that is that they do not even realize that the kind of austerity they criticize is really the kind I define as “Government-First” austerity in my video.
This is telling of what the debate over austerity in Europe is really about, and who the participants are. Proponents of the European version of austerity are not out to reduce the size of government, but to make sure government – the welfare state to be precise – survives the recession as unharmed as possible. As I point out on the video, if they had a “Limited Government” purpose behind their austerity they would use private-sector growth, or lack thereof, as their metrics for whether or not austerity was successful. But since private-sector activity has been plunging in the countries hit worst by the European version of austerity, it is clear that the purpose behind austerity as applied in the EU is of the “Government First” kind.
This puts an absurd light on far-leftist criticism of austerity. Since there are no limited-government proponents on the scene in the European debate, statists are bashing statists over not using the right tools to save the welfare state. With the noise from their fight rising, it is becoming increasingly likely that my predictions for Europe’s future will come true: the continent is bound for a new form of stagnation. So long as Europe does not dispose of the welfare state, they will end up right there, in the economic wasteland of industrial poverty.
The harder the far left works to end government-first austerity, the farther to the left they will pull economic policy in Europe. Instead of trying to balance government budgets as a means toward saving the welfare state, the far left does not even want to have to worry about the budget. Their attacks on the EU’s constitutional stability and growth pact are symptomatic of this.
Austerity criticism is not limited to the EU level. Wherever socialists have made headway in national parliamentary elections they raise their anti-austerity voices. Italy is a case in point, as illustrated by an article in the EU Observer:
The EU is at a “crossroads” between accepting a long period of austerity and high unemployment or taking steps to boost an economic recovery, Italian prime minister Matteo Renzi has warned. Speaking in national parliament on Tuesday (24 June), Renzi told deputies that “high priests and prophets of austerity” were stifling the European economy. Renzi’s government takes control of the EU’s six month rotating presidency next week and has indicated that migration and the bloc’s stability and growth pact will be its main policy priorities. The Italian prime minister has led calls for the pact’s rules on budget deficits to be interpreted in a way that encourages more public investment.
In other words, what they want to be able to do is to spend more on government-run, tax-funded education, on more roads, mass transit and so called research and development programs. They also want to pour more money into non-fossil energy, the kind of complete waste that has been Germany’s failed attempt at replacing nuclear energy with “renewable” energy sources. (Out of utter panic over rising energy prices, Germany is now building coal power plants almost as fast as the Chinese.)
None of that spending would help the economy grow. If you tax the private sector into oblivion, it does not matter if it can ship its products on four-lane highways or six-lane highways. There won’t be anyone there to buy their products in the first place. It matters even less if the energy that manufacturers would use is from sometimes-producing wind turbines or sometimes-producing solar panels. If the energy is too expensive to make manufacturing competitive, nobody is going to want to buy it in the first place.
Europe does not need more government. It does not need more government-first austerity either. It needs limited-government austerity. And soon. Otherwise, it is basically over for Europe as a first-world continent.
Here is the first in a four-part series on austerity, its theory, its application and its consequences:
Europe’s political leaders are showing more and more signs of discomfort – not to say emerging panic – over an economic crisis that just won’t go away. My diagnosis is that this is a permanent crisis, brought upon Europe by its fiscally obese and unsustainable welfare state. (Make sure to get my book Industrial Poverty when it comes out August 28!) By consequence, it is therefore not possible for Europe to get out of the crisis unless they first roll back and eventually fully dismantle their welfare state.
Not everyone agrees. As the EU Observer reports, the social affairs commissioner of the EU – compare him to the U.S. Secretary of Health and Human Services – is getting mighty frustrated with the crisis and calls for a restoration of the welfare state:
The EU’s social affairs commissioner on Friday (13 June) lashed out at the EU’s response to the economic crisis. Lazlo Andor, in a speech delivered in Berlin, said debt-curbing policies designed to resolve the sovereign debt crisis have wrecked Europe’s social welfare model. “Austerity policies in many cases actually aggravated the economic crisis,” he said.
Has he been sneak-peeking on this blog? Apparently, because he cannot have read my articles in full. If he had, he would know that there are two answers to his frustration over austerity and the crisis. On the one hand, yes, the spending cuts have slashed entitlement programs and made it tougher to get by on government handouts. On the other hand, though, the current European austerity model has raised taxes on businesses and households. This has stifled economic growth and thus made it harder for people to get out of their government dependency.
The reason for this is that austerity, as designed and carried out during the crisis in Europe, has had the purpose of balancing the government budget – even at the cost of depressed private-sector activity. Other forms of austerity, applied back in the late 20th century, had other goals, among them to inspire growth in the private sector. The difference is monumental for the outcome of an austerity strategy.
Europe has been under the statist version of austerity, the purpose of which is to balance the government budget and therefore restore fiscal sustainability in government. The reason for this, in turn, is that as Europe’s political leaders designed a response to the crisis, it never occurred to them that the very existence of a welfare state could have something to do with the crisis.
Back to the EU Observer:
He described the EU’s economic and monetary union (EMU) as flawed from the start, forcing troubled member states to make deep cuts in the private and public sectors via internal devaluation. “Internal devaluation has resulted in high unemployment, falling household incomes and rising poverty – literally misery for tens of millions of people,” he said.
This is a technical level of macroeconomics. What Commissioner Andor is saying is actually that Greece would have been better off when the crisis began if they had been able to devalue their own currency – the drachma – vs the Deutsch mark. However, that is a way to grossly simplify the problem: the argument rests on the assumption that Greece fell into a depression because of bad terms of trade vs. Germany. But the fact of the matter is that Greece was in trouble for years before the outbreak of the Great Recession, with deficit and debt problems resulting not from insufficient exports capacity (which is what Commissioner Andor alludes to) but from a vast system of entitlement programs that promised a lot more to their recipients than taxpayers could afford.
The EU Observer again:
[The] EMU is gripped by a social and economic paradox. “On the one hand, we introduce social legislation to improve labour standards and create fair competition in the EU. On the other hand, we settle with a monetary union which, in the long run, deepens asymmetries in the community and erodes the fiscal base for national welfare states,” he said.
There you go. No blame on the welfare state, all blame on admittedly dysfunctional EU institutions. But the role of the EU did not become acute until the economic crisis had escalated to depression-level conditions in some southern EU states. It was not until the Troika (EU-ECB-IMF) went to work in 2010-11 that the venom of ill-designed austerity went to work deep inside the economies of Greece, Spain, Portugal and Italy. By then, the crisis had already started, it had escalated and caused runaway unemployment and rampant deficits.
So long as Commissioner Andor persists in believing that the welfare state is the victim, not the culprit, in this crisis, the crisis will prevail.
Commissioner Andor’s complete ignorance on this item is revealed as the EU Observer story reaches its crescendo:
A possible way out, he says, is to disperse some money from national coffers through so-called “fiscal transfers” between member states using the euro. Some of the pooled money would be used, in part, to fund a European Unemployment scheme to better prop up domestic demand, says Andor.
How many entitlement programs, and how many levels of government, do you have to involve before government expansionists understand that pouring more gasoline on the fire is not going to put out the flames?
In last week’s elections, did Europe’s voters plant the seeds of a post-EU Europe? The question has surfaced in response to the strong showing of Euroskeptics and outright anti-EU parties across the continent. While most observers of European politics are still at loss trying to comprehend the fact that some of their fellow citizens actually don’t like the EU, some sharp-minded analysts see the writing on the wall for what it actually is. In addition to Yours Truly, you can always trust Daily Telegraph columnist Ambrose Evans-Pritchard. Again, he has elevated himself above the murmur. Starting with Britain, he gradually expands his perspective, laying out a credible scenario for Europe’s future:
If Europe’s policy elites could not quite believe it before, they must now know beyond much doubt that they have lost Britain. This island is no longer part of the European project in any meaningful sense. British defenders of the status quo were knouted on Sunday. UKIP won 27.5pc of the vote … Margaret Thatcher’s Tory children are scarcely more friendly to the EU enterprise.
This is an important observation. The British vote shows two things: first, that British democracy, unlike continental Europe’s, still has not succumbed to Europhoristic centralism – on the contrary, Brits still believe in their traditions and their way of governing themselves; secondly, classical Anglo-Saxian liberalism still has a voice in Britain.
The second point carries more weight than perhaps even the Brits themselves realize. Deep down, UKIP’s ideology is a mild version of what we here in America refer to as “libertarianism”, namely a solid refutation of all government beyond a small set of strictly contained and enumerated core functions. A UKIP prime minister would never pursue the termination of the British welfare state, but he would most likely revive some of Thatcher’s legacy, a legacy that has been carefully squandered by the Conservatives.
Britain needs more Thatcherism. Europe could use a big dose of it as well. Hopefully, an invigorated UKIP can deliver that, with the right cooperation in the European Parliament.
Back to Evans-Pritchard:
Britain’s decision to stay out of monetary union at Maastricht sowed the seeds of separation, as pro-Europeans fully understood at the time, though almost nobody expected EMU officialdom to clinch the argument so emphatically by running the currency bloc into the ground with 1930s Gold Standard policies and youth unemployment levels above 50pc in Spain and Greece, and above 40pc in Italy. European leaders must henceforth calculate that the British people will vote to leave the EU altogether unless offered an entirely new dispensation: tariff-free access to the single market along the lines already enjoyed by Turkey or Tunisia; and deliverance from half the Acquis Communautaire, that 170,000-page edifice of directives and regulations that drains away sovereignty, and is never repealed.
In a nutshell, Evans-Pritchard is saying that the euro was doomed without Britain’s participation – a statement that is only partially correct. The structural imbalance of the euro project goes deeper than that. But more on that later. Evans-Pritchard refers to reckless austerity policies as having removed the fiscal and, especially, monetary policy foundations for a sound, strong common currency. He is right about austerity, as regular readers of this blog know; the Liberty Bullhorn contains more analysis of Europe’s austerity policies and their consequences than any other website in the world.
But even if we disregard the structural imbalances built into the euro project, it is important to note that the ECB has exacerbated the crisis by frivolously printing money right, left, up and down to save credit-crashing welfare states from fiscal ruin. If there is one single policy move that really drove the pole through the heart of the euro, it was the ECB’s decision to bail out its worst-rated welfare states. That open-ended commitment to print money reduced the euro from Deutsch Mark status to something of a business-class Drakhma.
Evans-Pritchard also makes a note of the ever-growing regulatory burden on EU’s member states. In this category, the EU is competing with the Obama administration, though in the latter case things have slowed down considerably in the last couple of years. Also, it is increasingly likely that the next president of the United States will have libertarian roots – probably stronger than those of UKIP leader Nigel Farage – which will vouch for a historic regulatory rollback. For that to happen in Britain, the country has to leave the EU.
Which, again, is probably going to happen in the next few years. Now for the broader perspective, and Evans-Pritchard’s analysis of where France is heading:
It is a fair bet that EU leaders would search for an amicable formula, letting Britain go its own way while remaining a semi-detached or merely titular member of the EU. Let us call it the Holy Roman Empire solution. Yet Britain is the least of their problems. The much greater shock is the “Seisme” in France, as Le Figaro calls it, where Marine Le Pen’s Front National swept 73 electoral departments, while President Francois Hollande’s socialists were reduced to two. … It is widely claimed that the Front is eurosceptic only on the surface. Perhaps, but when I asked Mrs. Le Pen what she would do no her first day in office if she ever reached the Elysee Palace, her reply was trenchant. She would instruct the French Treasury to draft plans for the immediate restoration of the franc… She vowed to confront Europe’s leaders with a stark choice at their first meeting: either to work with France for a “sortie concertee” or coordinated EMU break-up, or resist and let “financial Armageddon” run its course. … She said there can be no compromise with monetary union, deeming it impossible to remain a self-governing nation within the structures of EMU, and impossible to carry out the reflation policies necessary to defeat the economic slump.
Given that the Front National has suffered no notable setback in national voter support over the past decade, but instead gradually grown stronger, the prospect of a Madame President Le Pen is one that both Europe and the United States should get used to. Therefore, as Evans-Pritchard rightly explains, it is also time to get used to the prospect of Europe returning to national currencies.
The one point in this that I disagree with is that reflation is the way out of the recession. More on that in a moment. First, one more point from Evans-Pritchard, this one about the future of the euro with rising Euro-skepticism among voters:
The euro will inevitably lurch from crisis to crisis without some form of fiscal union and debt pooling. Yet voters have just let forth a primordial scream against any further transfers of power.
Indeed. So long as there is any form of government involved in the economy, there has to be a fiscal policy tied to that currency. Furthermore, so long as there is a welfare state there will be government deficits, either in recessions or on a structural basis as has been the case in Europe and the United States for decades now. Such deficits will be denominated in a currency, and that currency has to be the same that the government accepts for, e.g., tax payments, as well as the same currency that they use to pay out entitlements. In other words, there has to be a jurisdictional overlap between a currency and a fiscal government, or else the currency inevitably becomes unstable.
Some of these points were made by economists, among them Robert Mundell, already 15 years ago, before the euro was minted. However, they were drowned out by the Europhoria that dominated most of the ’90s in Europe, leaving the continent with a fundamentally unsustainable imbalance between monetary and fiscal policy.
So long as national government deficits were of manageable levels the imbalance did not have any notable political or macroeconomic consequences. As I describe in my forthcoming book Industrial Poverty, this was the case between the Millennium and Great Recessions. However, as soon as budgetary sink holes opened up around Europe from 2008 and on, the imbalance became a true problem.
The full explanation of this requires an intricate but fascinating macroeconomic analysis. I am working on it separately, hoping to share it later this year. In the meantime, let’s acknowledge that Evans-Pritchard hits it right on the nail: the mounting voter resistance to more EU power is a game changer for both the EU and the future of the euro currency. What is missing from his column is the right economic conclusion, namely that dismantling the welfare state – not reflation – is the way forward for Europe. But that is a minor point. Do take a moment and read the rest of his entertaining yet sharply analytical column.