Europe is still dreaming of inflation. The EU Observer explains:
The eurozone edged out of a four-month period of deflation in April, according to the EU’s statistical agency. An estimate by Eurostat released on Thursday (30 April) found that consumer prices were flat in April 2015, up from -0.1% in March. Prices had fallen for four consecutive months since December.
Inflation data can be confusing. To make it simple yet still accurate, let us compare two “views” of inflation. They both report the so called Harmonized Index of Consumer Prices; the first looks at changes month to month, as reported in Figure 1:
According to this measurement, consumer prices are actually rising in the euro zone, by more than one percent in April.
However, inflation is not measured as month-to-month changes in a price index. It is measured on an annual basis. The measurement can be either calendar year or annual comparisons month by month. In the latter case the usual procedure is to remove seasonal variations from the data in order to obtain a smoother curve reflecting long-term changes in prices.
This method is dubious as it places a filter between the observer and the reality he is trying to understand. I avoid seasonally adjusted data in general as much as ever possible, and inflation data is no exception.
On the contrary, sometimes the seasonally un-adjusted data can reveal anomalies in trends that help explain current events. The following inflation data, based on the same index numbers as Figure 1, is a good example:
When reported on an annual basis, inflation in the euro zone suddenly looks quite different. The downward trend is unmistakably bound for deflation territory (and the trend line here is a third-degree polynomial function, so if there were any changes in the trend we would see them). Reasonably, prices do not plunge into deflation as fast as they do through the inflation part of the chart; once inflation hits zero the down bound trend will weaken drastically, even vanish altogether. However, not only is this a somewhat uncertain prediction – the knowledge among economists about deflation is very limited compared to their knowledge about inflation – but it is also important to keep in mind that even if prices stop plunging there is no reason to believe they will start rising again.
But what about that little uptick at the end of the curve? What about the observed positive price change for April as reported by the EU Observer above?
Here is where we have the true advantage of looking at “real” numbers, not seasonally adjusted ones. Because the data we analyze has not been smoothened out by seasonal adjustments, we have access to all the real-world kinks and crooks in the inflation curve.
Let us compare the period leading up to the little uptick in March of 2015 to the period January to June 2013:
The 2013 excerpt ends with June and an inflation rate of 1.75 percent. For July that year inflation was 1.72 percent, in other words basically the same.
After that, the rate started declining again.
For 2014/15, April is the first month beyond the excerpt. In accordance with the events of the first half of 2013, it is logical that inflation has not yet turned downward again. But it would be rather surprising if there was some sort of rebound in prices back into inflation territory at this point. There simply are no macroeconomic reasons for a rebound to happen.
And at the end of the day, that is where you find the meat and potatoes of this issue. Traditional macroeconomic analysis centers in on GDP growth, consumer spending, private-sector job creation, business investments… If there is no upward movement in those variables, it is very difficult to find any reason why there would be inflation in the economy, especially over time.
There is one exception: pure monetary inflation. The kind they have in Venezuela and Argentina.
Surely nobody in the euro zone would want that? Thought so. Which brings us back to the point just made: there will be no sustained trend of inflation in Europe until the real sector picks up and starts growing again.
Greece keeps pushing the currency union envelope. Mr. Tsipras, the socialist prime minister, is driven by his ideological convictions and therefore plays a different game than the leaders in Brussels with whom he is negotiating to keep his country afloat. The problem for the European leadership is that it seems incapable of understanding what role Tsipras’s ideology plays for his actions – Tsipras wants full independence for Greece so he can build his version of the socialist dreamland that now-defunct Venezuelan president Hugo Chavez created.
Rational arguments such as “property rights no longer exist in Venezuela” or “they have 60 percent inflation” and “crime is rampant and there is a shortage of almost every daily necessity” do not work on ideologues like Tsipras. That is the very problem with them. Therefore, you cannot reason with them as though they were swayed by the same type of “sensible” arguments that you are. But more importantly: so long as the EU leadership does not understand that politicians like Tsipras are ideologically opposed to everything that the EU stands for, they will not be able to have a rational conversation. There will be constant discords, where the EU leaders try to set goals that will help Greece stay inside the euro zone – and ultimately the EU – while Tsipras and others like him (think euro skeptics in Italy and Spain) will try to create circumstances that allow them to get what they want, namely out of the euro zone (and eventually the EU).
The biggest danger with this discord is that once the euro zone starts breaking apart, the retreat from the common currency will be disorderly. There is no doubt that the Bundesbank in Germany has a contingency plan for that disorderly dissolution, but it is far from certain that their plan will work. There are so many uncertain factors in this game that an even reasonably confident prediction is out of the question.
That said, there are some fixed points that can be put in the context of macroeconomic reasoning. That in turn should at least provide some insight into the best and worst case scenarios.
Before we get there, though, an update on the Greek situation, as reported by the EU Observer:
The stand-off between Greece and its lenders deepened over the weekend ahead of a meeting of euro finance ministers on Friday (24 April), with both sides exchanging barbs over the risk of a Greek default and its consequences for the eurozone. On Friday, Eurogroup president Jeroen Dijsselbloem said both parties should avoid “a game of chicken to see who can stick it out longer. We have a joint interest to reach an agreement quickly”.
An agreement about what? If Greece secedes from the euro it can, at least theoretically, run away from its bailout-related deals. In practice, the EU would still want to enforce loan contract, but it is much more difficult with a country that has a currency of its own – a currency that in all likelihood will be depreciating rapidly.
As for the IMF, Greece would have to deal with them separately, but it could do so much more so on its own terms once outside of the euro zone.
In fairness, though, it looks like the full extent of the Greek situation is beginning to dawn on at least some EU leaders. The EU Observer again:
EU and International Monetary Fund (IMF) leaders warned that Greece had to make quick progress to finalise a list of reforms that would enable it to receive a €7.2 billion loan. But they hinted that a Greek default could be managed by the eurozone. “More work, I say much more work is needed now. And it’s urgent,” said European Central Bank (ECB) chief Mario Draghi in Washington, where he was attending the IMF’s Spring meeting. “We are better equipped than we were in 2012, 2011, and 2010,” he added, referring to the years when fears of a eurozone break-up were at a high. “Having said that, we are certainly entering into uncharted waters if the crisis were to precipitate, and it is very premature to make any speculation about it,” Draghi also said.
So what would happen if Greece seceded from the euro? Well, the EU Observer article brushes on that subject:
Greek finance minister Yanis Varaoufakis, for his part, warned that his country’s exit would cause major problems for the rest of the region. “Some claim that the rest of Europe has been ring-fenced from Greece and that the ECB has tools at its disposal to amputate Greece, if need be, cauterize the wound and allow the rest of the eurozone to carry on,” he said on Spain’s La Sexta channel “Once the idea enters peoples’ minds that monetary union is not forever, speculation begins … who’s next? That question is the solvent of any monetary union. Sooner or later it’s going to start raising interest rates, political tensions, capital flight.”
This is a key statement. Some would interpret it as Greek leverage in negotiations with Brussels. However, the correct way to read it is as a blunt warning of what is to come: sooner or later Greece will leave the currency union, and it will do so like the men who escaped Alcatraz in 1962. Once someone has done what everyone thought was impossible, then just as Mr. Varaoufakis says, the only question on everyone’s mind will be: who’s next?
British Member of the European Parliament for the UKIP, Mr. Nigel Farage, made a great point recently when appearing on BBC (at about 2:25 into the video): the initial effect of a Greek currency secession is going to be a boost in growth as the currency depreciates. This growth spurt will inspire other struggling euro-zone states to consider a return to their national currency. Once the secession movement gets off ground, it is uncertain how many states will actually reintroduce their national currency, but it would be reasonable to expect a first round of secession to sweep from Athens to Lisbon.
The short-term financial turmoil aside, the most likely effect will be a southern European currency war. The four countries that have historically had weak currencies will find themselves returning to that position, only with an even deeper macroeconomic ditch to climb out of. The only moving part of their economies is, actually, exports, which will get a boost from a rapid currency depreciation. At the same time, that depreciation will be a major conduit for imported inflation, which in turn will eat its way into the economy a bit after the exports boom has gained momentum. The more the currency depreciates, the stronger the imported-inflation effect will be.
Inflation will have major consequences for the government budget. Depending on what type of inflation indexation is built into the welfare state’s entitlement programs, the cost of government spending will rise more or less with inflation. While inflation can also be beneficial to the revenue side of the state budget, it negatively influences the purchasing power of households and generally (but not always) depresses business profitability. As a result, domestic economic activity slows down, causing the tax base to stagnate.
And this is where the major test comes for currency secessionists: how will they handle their budget problems? With weak currencies they will have a hard time selling their treasury bonds on the international market; they can load up their banks – a likely scenario in Greece where a Syriza government could even go as far as to nationalize banks – but as the Great Recession demonstrated, leaning on banks for funding a government deficit is a particularly bad idea. When banks are overloaded with bad government debt in the midst of a macroeconomic crisis, then suddenly it is 2009 again.
Very briefly, then: once the euro zone starts falling apart the first ones to leave will face very difficult challenges. That is not to say that the remaining euro zone countries will have a better life – it is very likely that the euro zone itself won’t survive the 2017 French presidential election – but once the Southern Rim has left the euro zone the remaining countries will have a somewhat easier time following an orderly retreat plan. In fact, it would not be surprising if Germany, Austria and the BeNeLux countries remained in a “core” currency union – a Gross-Deutsch Mark, if you will. That currency could actually become a stabilizing point for a post-euro EU.
Still, even with an anchor currency in the heart of the EU, an implosion of the euro will have major negative effects for the European economy. What will those effects look like? That is a subject for another article.
For more than a year the European economy has been in deflation territory. To reverse that trend the European Central Bank launched its Quantitative Easing program, aimed at flooding the euro zone with liquidity. According to crude monetary theory this will drive up prices in line with the so called quantity theory of money; few if any central bankers would admit that their take on money supply and inflation is this simple, but the only other explanation is so far-fetched that even the quantity theory of money makes sense.
The alternative theory says that the reason why businesses are not investing in Europe is that there is not enough cheap risk capital available in the economy. For this theory to work, though, the cost of borrowing that businesses face would have to have been exceptionally high during the recession. In fact, the exact opposite is true: since the Great Recession started the composite cost of borrowing for non-financial corporations in the euro zone has been in the 2-4 percent bracket. Right before the recession it topped out above ten percent.
In other words, the has been an abundance of liquidity available for anyone and everyone willing – and qualified – to borrow.
But if your business outlook says flat sales, at best, you are not going to take on new loans. And flat sales or worse has been the forecast story for European businesses for six years now.
What does this have to do with inflation? Well, low economic activity means low demand and low utilization of productive capacity. As a result, there is no upward pressure on prices and therefore no real-sector inflation in the economy. Whatever inflation may be looming in the near European future has a monetary origin.
Does this mean that the primitive quantity theory of money is correct? No, it does not. The quantity theory rests on a rigid structure of assumptions regarding the operation of a free market, both in terms of the flexibility of real-sector resources and of free-market prices. The most confounding part of the quantity theory of money is that the economy axiomatically always reverts back to full employment; then, and only then, can monetary inflation occur.
Europe is about to line up with several other countries proving that monetary inflation is just as possible – if not more possible – in a stagnant economy. In fact, when stagnation and low capacity utilization is combined with monetary inflation, there is a macroeconomic venom brewing. The worst response to this situation is one where key decision makers assume that the monetary inflation they see is actually real-sector inflation.
Somewhat surprisingly, that mistake is made by Ambrose Evans-Pritchard, who is without a doubt Europe’s best political commentator. But in his latest column in The Telegraph, Mr. Evans-Pritchard allows his otherwise astute analytical abilities to lead him astray:
Be thankful for small mercies. The world economy is no longer in a liquidity trap. The slide into deflation has, for now, run its course. The broad M3 money supply in the US has been soaring at an annual rate of 8.2pc over the past six months, harbinger of a reflationary boomlet by year’s end. Europe is catching up fast. A dynamic measure of eurozone M3 known as Divisia – tracked by the Bruegel Institute in Brussels – is back to growth levels last seen in 2007.
But GDP growth, business investments, employment and capacity utilization are far from 2007 levels. While inflation back then was a real-sector phenomenon, it is not founded in real-sector activity today.
And that should have us all worried. Evans-Pritchard included:
History may judge that the European Central Bank launched quantitative easing when the cycle was already turning, but Italy’s debt trajectory needs all the help it can get. The full force of monetary expansion – not to be confused with liquidity, which can move in the opposite direction – will kick in just as the one-off effects of cheap oil are washed out of the price data.
I know Mr. Evans-Pritchard is British, but that does not mean he has to entertain an erstwhile concept of liquidity. Just a small comment. Back to his column, where his discussion of inflation is taking a somewhat odd turn:
Inflation will soon be flirting with 2pc across the Atlantic world. Within a year, the global economic landscape will look entirely different, with an emphasis on the word “look”. In my view this will prove to be mini-cyclical in a world of “secular stagnation” and deficient demand, but mini-cycles can be powerful. Mr Stein said total loans in the US are now growing at a faster rate (six-month annualised) than during the five-year build-up to the Lehman crisis.
Again, all macroeconomic indicators point to a continuation of a ho-hum recovery here in the United States, the March GDP numbers notwithstanding. At the same time, practically nothing says that Europe will enjoy anything near a U.S. growth period any time soon. Therefore, it is wrong to compare the inflation rates in Europe and the United States as if they are apples and apples. They are not. Our inflation here in the United States is the result of a steady rise in economic activity, a tightening of available capacity in infrastructure and other capital stock and even a glimpse of labor shortage in some sectors.
In other words, traditional causes of inflation. Europe, on the other hand, still suffers from almost twice the unemployment rate, with GDP growth at half or less the rate of ours. To really drive home the point about Europe’s abundant, idling economic resources, let us once again repeat the point that the cost of borrowing for non-financial corporations is down to 2-4 percent (after topping 10 percent before the Great Recession).
There is in other words no demand-driven push on prices to rise in Europe. This means monetary inflation, and there is an abundance of evidence from the past century on just how destructive and unstable such inflation can be.
Mr. Evans-Pritchard does not see this. Instead, he is worried about monetary tightening in the United States and its possible global effects:
“The risk is that the Fed will have to raise rates much more quickly than the markets expect. This is what happened in 1994,” he said. That episode set off a bond rout. Yields on 10-year US Treasuries rose 260 basis points over 15 months, resetting the global price of money. It detonated Mexico’s Tequila crisis. Bonds are even more vulnerable to a reflation shock today. You need a very strong nerve to buy German 10-year Bunds at the current yield of 0.16pc, or French bonds at 0.43pc, at time when EMU money data no longer look remotely “Japanese”.
Just one second here… No longer remotely “Japanese”? GDP growth for 2014 in the euro zone (19 countries) was 0.89 percent, and 1.3 percent in the EU as a whole. How is that not “Japanese” data??
Yet on some points Mr. Evans-Pritchard does see the underlying real-sector dimension of the inflation issue:
[The U.S. labor market] is turning. The quit rate – a gauge of willingness to look for a better job – is nearing 2pc, the level when employers must build pay-moats to keep workers. It is true that the US economy gave a good imitation of hitting a brick wall in the first quarter. Retail sales have fallen for three months, the worst drop since 2009. The Atlanta Fed’s snap indicator – GDPNow – suggests that growth dropped to stall speed in March. The rise in non-farm payrolls slumped 126,000 in March, half expectations. Yet economies do not fall out of sky. The US has already survived the biggest fiscal squeeze since demobilisation after the Korean War without falling into recession.
And again, some sectors and states are already in tight labor supply. Try hire a Hooters waitress for less than $15/hr in North Dakota. Some trucking companies are pushing annual driver compensation north of $70,000.
But perhaps the problem, at the end of the day, is that analysts and commentators focus on too many variables at the same time. You can certainly look at the economy from an almost infinite number of angles and get different stories out of each one of them, but in reality some angles only show symptoms while others capture the causes. Mr. Evans-Pritchard stretches his analysis a bit thin, going into asset prices and a roster of secondary data, elevating those numbers to the same prominence as – actually higher prominence than – real-sector growth data.
In reality, asset prices depend on real-sector growth data; tainted by speculative expectations, they only give an imperfect image of where the economy is really heading.
When we look at the European and American economies from the angle of real-sector activity, we do again see the gaping difference between a growth, moderately healthy United States and a stagnant, industrially poor Europe. The former has a sound form of inflation on its way; the latter is experiencing the beginning of a dangerous episode of monetary inflation.
That said, I still recommend you all to keep reading Ambrose Evans-Pritchard. He is intelligent and thorough and he has no problem presenting unpopular views if he believes they are merited.
For the people who live in the European Union, daily life offers challenges in the form of zero growth, high unemployment, lack of opportunity and a gloomy outlook on the future. For a macroeconomist, however, the EU is a formidable experiment that must not be left undocumented. The union was constructed based on the European tradition of welfare statism, right when the welfare state as a socio-economic construct was beginning to show clear signs of macroeconomic ailment. For unknown reasons – though probably ideological preferences played a good part – the architects of the EU misinterpreted the symptoms of macroeconomic ailment such as persistent budget deficits. They saw them as expressions of irresponsible budget policies and therefore institutionalized budget-balancing guidelines for member-state fiscal policies. Those guidelines became the EU’s own constitutional balanced-budget requirement, also known as the Stability and Growth Pact.
The Stability and Growth Pact was created essentially to secure the fiscal sustainability of the European welfare state. The problem is that the welfare state in itself is not fiscally sustainable. A wealth of literature (which I am currently working my way through as part of my next book project) and a plethora of compelling data together convincingly show that the welfare state is in fact the fiscal venom that causes governments to go into structural deficits. So far, though, the political leaders of the European Union have not understood that their practice of the Stability and Growth Pact – known as statist austerity – has driven the European economy into a permanent recession. Their governments, consuming up to half of GDP, are subjected to spending cuts and in turn subject the private sector to higher taxes, which in turn causes the private sector to contract its activity or at the very least keep it constant.
As statist austerity causes GDP to stagnate, the welfare state’s budget problems are exacerbated. More people request assistance from its entitlement programs, while fewer people pay taxes. The budget problems that statist austerity was aimed at solving – again in order to make the welfare state look fiscally sustainable – actually cause a new round of budget problems. In response, austerity-minded governments tighten the fiscal belt yet another notch.
All in order to make the welfare state more affordable to a shrinking economy. In other words, saving the welfare state is the prime directive of European fiscal policy.
American fiscal policy has a different purpose. It aims to help the economy grow and lower unemployment. Granted, far from everything that comes out of U.S. fiscal policy is helpful in that respect, but at least the basic course of direction is right. Therefore, when representatives of the United States Treasury look at Europe and try to figure out what on Earth is going on over there, it is hardly surprising that some eyebrows go up and some foreheads are wrinkled.
The United States warned Europe on Thursday (9 April) against relying too much on exports for growth, and urged officials to make more use of fiscal policy, saying stronger demand was essential. In its semiannual report on foreign-exchanges policies to Congress, the US Treasury Department gave a preview of the positions it will press on foreign policymakers during next week’s International Monetary Fund meetings in Washington. The world cannot rely on the United States to be the “only engine of demand,” the report insisted. It urged nations to use all tools available to accelerate growth and not rely only on their central banks to boost recovery.
Before we get to the accolades, a technical comment. Exports is also “demand”, though from foreign buyers. The Treasury economists should know better and use the term “domestic demand”.
Now for the accolades. It is refreshing and reassuring to see that the Obama administration’s Treasury understands how the economy works. This is not a sarcastic comment – this is a genuine word of appreciation. Europe, by contrast, is filled to the brim with economists and other fiscal-policy decision makers whose actions and decisions prove that they have basically no comprehension of macroeconomics whatsoever. An economy is driven by its demand side: household spending and business investments from the private side, and government spending. Since consumer spending is 65-75 percent of a well-functioning economy, the confidence and prosperity of the general population is quintessential to the survival, growth and prosperity of any nation.
Furthermore, businesses invest because they ultimately will sell something to the general public. Therefore, confident households create confident businesses. A strong, forward-looking economy spends 15-20 percent of GDP on business investments.
Without growth in these two private-sector spending categories, there will be no growth in the economy as a whole. The economists of the U.S. Treasury know this, and they operate based on this basic, common-sense macroeconomic knowledge. Their criticism of Europe’s governments for not understanding the same thing is highly valid and echoes, in fact, what I have been saying on this blog for three years.
But there is one more aspect to this that the Treasury economists have not brought up – at least not as quoted by Euractiv. Let’s get back to their story:
The report singled out Europe’s biggest economy, saying “stronger demand growth in Germany is absolutely essential, as it has been persistently weak.” The US Treasury argues that policy makers in the euro area need to use fiscal policies to complement the monetary stimulus that the European Central Bank is providing. … While growth in Europe has shown some recent signs of picking up, the region remains the sick man of the global economy.
The problem for the Europeans is that they cannot do this. They cannot use fiscal policy to stimulate aggregate demand, because if they do they have to abandon statist austerity. Welfare states would again be allowed to go into deficits.
There are many reasons why the Europeans cannot let that happen. The first and most immediate reason is called “Greece”. The EU is in a very tense showdown with the socialist Greek government over repayments of loans – loans that in turn were given as part of EU-enforced statist austerity. If the EU now abandoned its austerity policies, the Greeks would rightly ask “what about us??” and the 25-percent drop in GDP that followed the harsh implementation of statist austerity in the country.
Another reason for the EU to stick to its austerity guns is the long-term concern for the welfare state’s fiscal sustainability. The Europeans are almost unanimously behind their welfare states and they are willing to sacrifice enormously for their ideologically driven big government. They have convinced themselves that the welfare state is not, has not been, and will not be the cause of their macroeconomic ailment. Therefore, they will try as best they can to defend the indefensible, namely the fiscal sustainability of the welfare state; that defense will take priority over any measures to help the private sector grow and thrive.
For these reasons, and others, there is no hope for a growth-oriented fiscal policy in Europe.
Apparently, the realization that something is structurally wrong is beginning to set in on some key policy makers. Euractiv again:
Speaking ahead of next week’s meetings, IMF managing director Christine Lagarde also warned that global recovery remained ‘moderate and uneven’ with too many parts of the world not doing enough to enact reforms even as risks to financial stability are rising. Mediocre economic growth could become the “new reality,” leaving millions stuck without jobs and increasing the risks to global financial stability, she insisted.
Ms. Lagarde and others interested in the systemic roots of this growth crisis are more than welcome to read my book Industrial Poverty about the structural problems in the European economy.
Again, it is encouraging to see American government officials notice and basically correctly analyze the differences between Europe and the United States. What is needed now is that those officials speak up about why the Europeans are ailing, and what the consequences will be for them and the world economy if they insist on protecting their welfare states at all cost.
Perhaps a President Rand Paul can take it up a notch…
When a welfare state runs out of taxpayers’ money they run a so called structural budget deficit. That is a deficit that does not go away with strong growth but remains in the government budget, theoretically forever, in practice over a period of time longer than at least one business cycle.
A structural deficit forces government to borrow continuously, i.e., to make borrowing a permanent revenue source on par with taxation. As I explained recently, of 14 member states in the European Union ten suffer from structural deficits when GDP growth is measured in current prices. When inflation is removed from the growth data, all 14 countries run significant structural deficits.
Since this deficit analysis was limited by the availability of consistent data (only 14 states) it is not possible to firmly conclude anything about the EU as a whole. However, if 14 states, selected merely because of data availability, run structural deficits, then the likelihood is pretty high that the remaining 14 EU member states have similar problems with structural deficits.
Structural deficits create a major problem for the countries whose governments have to borrow the money. The ongoing borrowing need depresses market demand for their bonds, eventually driving some countries with extreme deficits – think Greece of Spain – to have to pay massive interest premiums on their treasury bonds in order to attract buyers. To fix this, the European Central Bank came up with its own version of the American Quantitative Easing program: the central bank buys the bonds that the free market does not like.
Quantitative Easing was a bad idea in the United States, as it allowed the federal government to continue spending money without reining in its increasingly uncontrollable welfare state. In Europe, the idea is even worse: the European welfare state is more “mature” than the American, making its structural deficit problems even more serious. Therefore, the QE program will feed a government that is even farther away from being able to pay for its ongoing expenses than the U.S. government is.
Against this background, it is astounding to read the following article at EUBusiness.com:
The European Central Bank said Thursday it is increasingly confident that its controversial bond purchase programme is helping boost the eurozone’s economic recovery, even as a top official expressed doubts about its effectiveness. In the minutes of the governing council’s meeting on March 4 and 5 released on Thursday, the ECB said that “members generally shared the assessment that significant positive effects … could already be seen” from the new bond purchase programme known as quantitative easing (QE).
First of all, the QE policy is not even a quarter of a year old yet. It would not be possible to identify causalities even if we tried with an economic microscope. Secondly, even if there are visible effects, they would be limited to lower interest rates. While it is true that the ECB has entered negative interest territory and decided to stay there for a while, it is important to remember that the negative interest rate became reality long before the QE program did. Furthermore, ultra-low interest rates do not fix Europe’s macroeconomic problems anymore than they have fixed Japan’s decades-long problems.
According to EUBusiness.com there is no shortage of critics of the QE program:
[Some] prominent ECB members — notably the head of the German central bank or Bundesbank Jens Weidmann and ECB executive board member Sabine Lautenschlaeger — have repeatedly expressed doubts about the need and impact of such a programme. Lautenschlaeger told a German magazine on Thursday that she had “doubts whether the economic effects of the purchase programme will reach the desired magnitude.” And she warned that the current very low level of interest rates could lead to the formation of asset price bubbles. Before joining the ECB’s executive board, Lautenschlaeger was vice president of the German central bank and she shares the same scepticism as Weidmann.
But the monetary Eurocrats seem to be dead set on finding something positive to report. EUBusiness.com again:
Nevertheless, at the governing council’s last policy meeting in Nicosia, Cyprus, in March, there appeared to be agreement that QE was indeed helping to ease financial market conditions and the cost of external finance for companies, the minutes showed. Coupled with recent positive economic data and signs of a turnaround in inflation, “this provided grounds for ‘prudent optimism’ regarding the scenario of a gradual recovery and a return of inflation rates to levels closer to 2.0 percent,” the minutes stated.
This is actually disingenuous. Corporate borrowing costs have been declining since the Great Recession started. They started falling because banks still wanted to lend to non-financial corporations, but the non-financial corporations refused to take on more debt. They were simply far too pessimistic about the future of the European economy.
In short: low corporate borrowing costs have absolutely nothing to do with QE.
All in all, it sounds like the ECB is desperately trying to grab for positive news. this makes them prone to overlook the risks associated with QE, one of them being that governments simply decide not to do much more about their notorious deficits. This means, simply, letting the structural deficits remain as they are, whereupon the underlying problem in the European economy – an over-bloated welfare state – remains unsolved.
In my book Industrial Poverty I diagnose the European economic crisis as being a permanent state of economic stagnation, caused by a fiscally unsustainable welfare state. The deficits that plague the continent’s welfare states are caused by a structural imbalance between tax revenue growth and growth in government spending. In other words, the deficits that the EU-IMF-ECB troika and member-state governments have been fighting so hard over the past 5-6 years are actually in large part structural.
As I explain in this paper, you cannot fight structural deficits with business-cycle policy measures. That is what the Europeans have tried to do for half a decade now, to no avail. In fact, their problems have only gotten worse, with no recovery in sight.
Today I am happy to report on yet another depressing angle of the crisis. A structural budget deficit is a deficit that a government cannot pay for over a long period of time. While there is no set-in-stone definition of a structural deficit, the conventional definition has been that it is the deficit that remains when the economy is operating at full employment. However, the definition of full employment changes over time; what was considered serious unemployment in the 1980s is now acceptable as full employment in many countries. With that change, obviously the definition of the structural deficit would change as well, even though government has done nothing to reduce the deficit.
A better definition of a structural deficit is one that still rises above the regular business cycle but at the same time is independent of the level of employment. In the aforementioned paper I suggested a definition based on, at minimum, ten years of economic performance: a ten-year long trend in government spending (or a specific share thereof) is compared to a ten-year long trend in tax-base growth. If spending outgrows the tax base, then the government is having to deal with a structural deficit; if the tax base grows faster than spending, then there is a structural surplus in the government budget.
To get a good idea of whether or not Europe has a structural-deficit problem, I pulled the following numbers from the Eurostat database:
Government spending defined as welfare-state spending: housing and community development; health; culture, religion and recreation; education; and social protection; and
Current-price and inflation-adjusted growth in GDP.
Not all member states report these numbers down to the level needed for a ten-year trend study; in addition to 13 EU member states I also pulled data for Norway, which turned out to be interesting.
The results are as follows (time period 2004-2013). A ratio of 100 means a perfect growth balance where welfare-state spending is growing on par with the tax base; an index number below 100 is a structural deficit while an index number higher than 100 represents a structural surplus. For current-price GDP, four of the 14 countries actually run a surplus:
|CURRENT PRICE STRUCTURAL|
While the Polish government’s broadest possible tax base is growing by 120.5 euros per 100 euros of welfare-state spending, the Portuguese tax base only grows by 53 cents per euro of growth in welfare-state spending.
This indicates structural deficits in ten of these 14 countries. It does not mean that there is an actual deficit of this magnitude, but it means that the economy of these ten countries is unable to sustain the spending that goes out through their entitlement programs.
But that aside, it looks kind of good, doesn’t it, to have such a prominent welfare state as Sweden in the structural surplus category. Does that not mean that the welfare state can be paid for?
Let us answer that question with a look at the same spending numbers, but now compared to inflation-adjusted GDP:
|REAL GROWTH STRUCTURAL|
All of a sudden, Poland can only pay for 61.8 cents of every euro they spend on welfare-state programs. Sweden cannot pay for half of its welfare state. But worst of all: welfare-state spending in Portugal and Italy is so structurally under-funded that it outgrows the tax base by more than a euro, per euro in increased spending!
This means, in a nutshell, that the Portuguese and Italian governments draw taxes from a shrinking tax base to pay for what is undoubtedly an out-of-control welfare state.
Even if the actual growth of their tax revenues does not track the growth of GDP at all times, the GDP growth rate provides the most comprehensive picture of what the economy – and thereby taxpayers – could afford in terms of welfare-state spending. The bottom line for today, therefore, is that governments of welfare states from all corners of Europe are lucky if they see their tax revenues grow half as fast as their spending. And that is regardless of where the business cycle is: again, these numbers cover the period from 2004 through 2013.
As the Germans, the Greeks and the European Union leadership try to hash out a reasonable plan for Greece to secede from the currency union, the underlying question remains: has Europe managed to deal with the structural problems that brought many of its member states to their fiscal knees?
More specifically: are the problems that have sent Greece into a depression and possibly out of the euro zone unique to Greece – or are they just more concentrated there than elsewhere in Europe?
The answer to this question, presented in my book Industrial Poverty, is that the Greek crisis is merely a concentrate of an endemic European problem: a welfare state that is structurally and permanently too costly for the private sector to pay for. So long as the Europeans keep their welfare state they will continue to dwell in economic stagnation, with chronic problems of growth and budget deficits.
Over the past year countless forecasts of a strong recovery – or even a moderate recovery – in the European economy have been proven wrong. There are two reasons for this: economists normally rely on econometrics when they make their forecasts, a methodology that is not well tuned for large institutional and structural problems in the economy; and the focus on – obsession with – econometrics leads economists to ignore long-term structural trends in the economy.
Europe’s crisis is a structural one, caused by a long trend of weakening growth and increasingly persistent budget deficits. The over-arching problem, again, is the structure of entitlements imposed on the economy by the welfare state, a fact that is visible in the following, rather compelling data.
Figure 1 reports data on GDP growth and government deficits as share of GDP. The data is from 12 European welfare states, selected first and foremost based on data availability. The 12 states are then observed over a period of 48 quarters, fourth quarter of 2002 through third quarter of 2014, for annual, inflation-adjusted GDP growth and the deficit-GDP ratio. The result is a clearly visible correlation between the deficit ratio and GDP growth:
The better the deficit-to-GDP ratio, the stronger is GDP growth.
Now, let’s not rush to conclusions here. The immediate reaction among crude Austrians and crude Keynesians would be, respectively:
- “Yes, this proves that austerity is king!”
- “No, this can’t be – everybody knows that deficit spending is king!”
Truth is, neither side is correct. The reason why budget surpluses, or small deficits, correlate with high growth and deficits with slow or no growth, is as simple as it is independent of political-economic theory. Put simply, modern, mature welfare states are so big and difficult to pay for that a budget deficit is the normal state of affairs. Since the welfare state also depresses growth, by means of high taxes and sloth-inducing entitlements, it creates a combination of deficits and low growth.
Under unusual circumstances, high growth combines with surpluses not because government spending is low, but because GDP growth is high. In other words, observations of surpluses in Figure 1 are due entirely to a fortunate period of strong growth.
To further reinforce the point that growth is the only way to a reduced deficit in modern welfare states, consider Figure 2:
Note how the deficit-to-GDP ratio improves from 2005-2006. The reason is an improvement in GDP growth that started already in 2003. Next, note how GDP growth stagnates and starts declining in 2007 and how the deficit ratio follows downward in 2008. The upturn in the deficit ratio does not come until 2010, a year after GDP started improving.
In a nutshell: it is growth, not austerity, that fixes European budgets. (The same holds true, obviously, for the United States as well.) In absence of growth the budget deficits overwhelm their host economies and pile up more and more unsustainable debt.
Earlier this week I summed up some recent observations of macroeconomic differences between the United States and Europe. Those differences, which explain why the euro has plunged from $1.39 in May last year to its current $1.06, are not going to go away any time soon. I recently did an overview of the fundamentals that constitute the strength of the U.S. economy (see part 1, part 2, part 3 and part 4); today’s article takes a closer look at the European economy.*
As the latest national-accounts data from Eurostat reports, the European economy remains in a state of de facto stagnation. According to inflation-adjusted numbers, GDP growth for 2014 stood at 1.3 percent; while much better than 0.04 percent for 2013, a closer examination shows that it is neither impressive nor sustainable.
Unlike the growth in the U.S. economy, which originates in sustained growth of domestic, private-sector activity, Europe’s increase in growth is driven primarily by exports. In 2013 exports from the European Union grew by 2.16 percent in inflation-adjusted numbers, a number that increased to 3.53 percent in 2014.
There is a sharp contrast between these growth numbers and those for private consumption: -0.1 percent in 2013 turned into growth of 1.29 percent in 2014, hardly an impressive number.
To further emphasize the role of exports for Europe, consider the strong correlation between exports and business investments, vs. the apparent absence of consumption-investment correlation:
Since private consumption barely moves, businesses have no reason to invest for the domestic market. They therefore tailor their business expansions – to the extent such expansions take place – to fluctuations in foreign markets.
The dependency on exports is even more apparent at the member-state level. Over the past two years, exports has been the leading absorption variable in 17 of the 26 countries included here (Ireland and Luxembourg have not yet reported fourth-quarter data). In five of the countries exports was the only absorption category that shows any growth; in Spain private consumption barely squeezed into positive territory:
|Consumption||Investm.||Govt cons.||Exports||GDP avg|
The long-term trend of growing dependency on exports is visible across the board in the EU. From 2011 to 2014 (4th quarters), exports share of GDP increased in 23 of the 26 member states included here.
While there is nothing wrong inherently with growing exports, there is a problem when an economy almost entirely depends on exports. Contrary to prevailing wisdom among, primarily, European economists there is no lasting positive “multiplier” effect from exports to the rest of the economy – except, as mentioned, the business investments that relate specifically to exports.
The lack of positive multiplier effects from exports to, e.g., private consumption is reinforced by the fact that government spending is the strongest or second-strongest growth variable in 15 of the 26 countries. This is remarkable: for all of EU-28 government absorption grew at an annual rate of 0.6 percent per year over the 2013-2014 eight quarters. The fact that this was enough to finish second speaks volumes to the overall weakness of the European economy.
So long as this weakness remains, there will be no reversal of the long-term decline of EU economy.
*) Eurostat, 2005 chain-linked national accounts data.
I normally do not write about momentary events, such as the daily fluctuations on the international currency market. But today’s exchange rate between the dollar and the euro, which according to Bloomberg happens to be $1.06 per euro right now, is worth a broader analysis. The trend toward euro-dollar parity has gained a fair amount of attention in the media, and rightly so: when the euro was launched a decade and a half ago it was sold as a stellar currency, backed by some kind of European integrity, and certainty way above that flimsy greenback.
Reality turned out different. The euro and the dollar would have reached parity many years ago had it not been for the excessive money printing during Bernanke’s QE programs. But now that the Federal Reserve has cooled down its printing presses and the European Central Bank, on their end, have cranked up theirs, it is only logical that the two currencies are re-evaluated on the global currency market.
Immediately, one could question the case for parity based on the fact that the Federal Reserve Board of Governors meet tomorrow, Wednesday and likely will throw some cold water on the surge of the dollar. However, a postponed interest-rate hike will not make much of a difference over time: while only about three percent of all short-term rate changes are related to real-sector events, long-term trends are determined by the macroeconomic performance of the two economies. From this perspective, euro-dollar parity is a historic event. Its underlying cause is a long-term, widening gap between GDP growth, consumer spending, business investments and job creation in the United States and in Europe.
I have on several occasions analyzed the differences between the European and American economies. This is a good time for a quick recap. To begin with, the American economy is a much stronger job-producing machine than the European economy:
Our job creation record in this recovery is not exactly stellar, but our unemployment is nevertheless almost half of what it is in the euro zone. The EU as a whole is doing microscopically better than the euro zone, but that is almost entirely thanks to the comparatively positive trend in the British economy.
The American advantage in terms of job creation originates in a still-overall business friendly institutional framework. On the one hand, the Obama administration has a penchant for regulations; on the other hand this president has a comparatively modest spending record – far better than his predecessor – which has allowed Congress to combine largely unchanged taxes with an expansion of private-sector business opportunities. As a result, GDP growth is comparatively strong here:
It is important to understand the driving forces behind growth. If it is private consumption and business investments, it means that the private sector is doing well. In my recent blog series “State of the U.S. Economy” I pointed to these variables as being essential to the growth of our economy. What is particularly interesting is the visibly stronger confidence in business investments.
Therefore, we can safely conclude that we have a growth period in the U.S. economy that is well grounded and could last for a couple of more years.
The European economy, on the other hand, is not as lucky. Whatever growth they have appears to be driven by exports more than anything else. Private consumption is not playing a key role here:
The differences are striking in terms of private-consumption growth. Americans are now back at a level of consumption where they can maintain their standard of living and even start getting ahead a little bit. In Europe, by contrast, the standard of living has been declining consistently for over a decade: consumption growth has been below the Industrial Poverty threshold since the Millennium Recession.*
This points to a fundamental weakness in the European economy. While government has assumed more responsibilities for people’s lives in Europe than here – and as a result has a higher level of spending – it is important to understand that this does not compensate for lack of private-consumption growth. Government spending in Europe has been held back by welfare-statist austerity policies for a good six years now, which only pours more salt in the growth-stopping wounds on the European economy.
For all the macroeconomic reasons reported above, Europe will not return to growth any time soon. The American economy will continue to grow at moderate rates for another couple of years, during which we will see a reversal of the exchange rate between the euro and the dollar.
*) For an explanation of the two-percent growth threshold in private consumption, see my book Industrial Poverty, specifically the section about applying Okun’s Law to private consumption.
Two years ago Caritas, the charity arm of the Catholic church, published a study of the socio-economic effects of the European crisis. They reported:
The prioritisation by the EU and its Member States of economic policies at the expense of social policies during the current crisis is having a devastating impact on people – especially in the five countries worst affected – according to a new study published today by Caritas Europa. The … failure of the EU and its Member States to provide concrete support on the scale required to assist those experiencing difficulties, to protect essential public services and create employment is likely to prolong the crisis.
Their report presented…
a picture of a Europe in which social risks are increasing, social systems are being tested and individuals and families are under stress. The report strongly challenges current official attempts to suggest that the worst of the economic crisis is over. It highlights the extremely negative impact of austerity policies on the lives of vulnerable people, and reveals that many others are being driven into poverty for the first time.
This was, again, two years ago. Since then, things have gotten worse, which Caritas reflects in its 2015 study of the European crisis. Sadly, the report not only accurately presents the socio-economic disaster in southern Europe, but it also makes requests for a bigger welfare state.
Starting with the effects of the crisis, Caritas points to widespread cuts in income-security entitlements and health care, especially in the worst-off countries like Greece, Italy, Rumania, Portugal and Cyprus:
[From] 2011, social expenditure declined … and social challenges have grown further during the second dip of the recession … for example, in a number of countries the number of long-term unemployed losing their entitlements has increased, the level or duration of benefits has been reduced, eligibility rules have been tightened to increase incentives to take up work and this has also led to excluding beneficiaries from some [entitlement programs].
The study also criticizes the hand of austerity that has been particularly heavy on southern Europe:
[The] policy of requiring countries with the weakest social protection systems to impose fiscal consolidation and successive rounds of austerity measures within very short timetables is placing the burden of adjustments on the shoulders of those who did not create the crisis in Europe and are least able to bear the burden.
[Austerity] policies pursued during the crisis in Europe and the structural reforms aimed at economic and budgetary stabilisation have had negative effects with regard to social justice in most countries
This is the problem facing Europe in the next few years. An economic crisis hit; governments responded by slashing welfare-state entitlements and raising taxes; people respond by getting angry – not over the crisis, but over lost entitlements. As a result, socialist parties are gaining strength from Paris to Lisbon, from Athens to Madrid, pushing an agenda of restored entitlements. Caritas reinforces this movement by suggesting that “social justice” – a politically undefinable concept – should be the guideline for post-austerity policy.
A battle cry for more social justice is a battle cry for higher taxes and more income redistribution. Or, as Caritas puts it, “the impacts [of austerity] have not been shouldered equally”. If by “equally” they mean “spread out evenly across the citizenry”, then yes, they are entirely correct. But the reason for this is – obviously – that only a select segment of the population receives entitlements from the welfare state. That is the very reason for the welfare state’s existence.
Caritas and other advocates of social justice would respond that this is a moot point: those who earn the least cannot afford lose the entitlements they have. Others have money, they contend.
If the argument about the frugality of welfare-state entitlements were applied to the United States, it would not stand up to scrutiny. Michael Tanner and Charles Hughes have proven this beyond the shadow of a doubt. Things are a bit different in Europe, though, as Caritas actually show in their study. However, this does not mean that austerity could have been executed differently. More burden on those who do not receive entitlements automatically means higher taxes; as I show in my book Industrial Poverty austerity based on tax increases has even worse macroeconomic effects than austerity biased toward spending cuts. This means, in a nutshell, that if austerity had been profiled according to some “social justice” scale, it would have deprived even more Europeans of jobs and entrepreneurial opportunities.
Plain and simple: Europe must not fall for the temptation of “social justice”. It must charter a course away from collectivism and government “solutions”. The way to the future goes through fundamental, structural reforms toward a permanently smaller government.