Europe’s political leaders are getting increasingly desperate, especially since the European Central Bank’s aggressively expansionary monetary policy is proving ineffective. The more money the ECB prints, the worse the euro-zone economy performs.
The desperation is now at such a level that even the president of the ECB, Mario Draghi, is calling for EU governments to start big spending programs. Writes Benjamin Fox at EU Observer:
The European Central Bank (ECB) is preparing to step up its attempts to breathe life into the eurozone’s stagnant economy. During a speech in the US on Friday (22 August), ECB chief Mario Draghi called on eurozone treasuries to take fresh steps to stimulate demand amid signs that the bloc’s tepid recovery is stalling. “It may be useful to have a discussion on the overall fiscal stance of the euro area,” Draghi told delegates at a meeting of financiers in Jackson Hole, Wyoming, adding that governments should shift towards “a more growth-friendly overall fiscal stance.” “The risks of ‘doing too little’…outweigh those of ‘doing too much’”, he added.
Some trivia first. If you want to be rich, you have a condo on Manhattan. If you actually are rich, you have an oceanfront property in West Palm Beach. If you are genuinely wealthy you have a second home in Jackson Hole. The only people who live in Jackson Hole permanently are dyed-in-the-wool Wyomingites like former Vice President Dick Cheney (a very nice man whom I have had the honor of meeting a couple of times). It is a cold place with short, mildly warm summers and long, unforgiving winters. It is also breathtakingly beautiful.
Now for the real story… There is no doubt that Draghi is beyond worried. He should be: his monetary policy is useless. Europe is in the liquidity trap, and the European Central Bank’s expansionist monetary policy is part of the reason for this. For almost a year now Draghi has pushed the ECB to arrogantly violate the principles upon which the Bank was founded. He has printed money at a pace that by comparison almost makes Ben Bernanke look like a monetarist scrooge. More importantly, the ECB has de facto bailed out euro-zone countries even though that is very much against the statutes upon which the bank was founded. They have pushed interest rates through the floor, punishing banks for overnight lending to the bank, and they have a formal Quantitative Easing program in their back pocket.
Furthermore, the ECB was an active party in the austerity programs designed to save Europe’s welfare states in the midst of the crisis. Those programs exacerbated the crisis by suppressing activity in the private sector in order to make the welfare states look fiscally sustainable. Now Draghi is asking the same governments that he helped bully into austerity to stop trying to save their welfare states and instead be concerned with GDP growth.
Superficially this sounds like an opening toward a fiscal policy that uses private-sector metrics to measure its success. However, it is highly doubtful that Draghi and, especially, the governments of the EU’s member states, would be ready to actually do what is needed to get the European economy growing again. The first part of such a strategy would be to a combination of tax cuts and reforms to reduce and eventually eliminate the massive, redistributive entitlement programs that constitute Europe’s welfare states.
The second thing needed is a monetary policy that does not provide those same welfare states with a large supply of liquidity. The more cheap money welfare states have access to, the less inclined their governments are going to be to want to reform away their entitlement programs. On the contrary, they are going to want to preserve those programs as best they can.
Therefore, the last thing the ECB wants to do right now is to launch a QE program. Which, as the EU Observer story reports, is exactly what the ECB has in mind:
The Frankfurt-based bank is preparing to belatedly follow the lead of the US Federal Reserve and the Bank of England by launching its own programme of quantitative easing (QE) – creating money to buy financial assets.
This comes on the heels of the Bank’s new policy to increase credit supply to commercial banks on the condition that they in turn increase lending to non-financial corporations. The bizarre part of this is that in an economy that is stagnant at best, contracting at worst, there is no demand for more credit among non-financial corporations. It really does not matter if banks throw money after manufacturers, trucking companies, real estate developers… they are not going to expand their businesses unless there is someone there to buy their goods and services. If there is no buyer out there, why waste time and money on producing the product – and why take on debt to do it?
I have reported in numerous articles recently on how the European economy is not going anywhere. Growth is anemic with a negative outlook. Unemployment is stuck at almost twice the U.S. level and the overall fiscal situation of EU member states has not improved one iota despite more than three years of harsh, welfare-state saving austerity.
As yet more evidence of a stagnant Europe, Eurostat’s flash inflation estimate for August says prices increased by 0.3 percent on an annual basis. This is a further weakening of inflation and reinforces my point that unless the European economy starts moving again, it will find itself in actual deflation very soon. But the macroeconomic consequences of deflation set in earlier than formal deflation, as economic agents build it into their expectations. It looks very much as if that has now happened.
Deflation is dangerous, but it is not a problem in itself. It is a very serious symptom of an economy in depression. It is important to follow the causal chain backward and understand how the macroeconomic system brings about deflation. This blog provides that analysis; very few others attempt to do so. Ambrose Evans-Pritchard over at the good British newspaper Guardian has demonstrated good insight, and a recent article by David Brady and Michael Spence of the Hoover Institution provided some very important perspectives. But so far insights about the systemic nature of the crisis are not very widely spread.
The only advice being dispensed with some consistency is, as mentioned, the one about more government spending. Dan Steinbock of the India, China and America Institute is an example of the growing choir behind that idea. He does so, however, in a somewhat convoluted fashion. In an opinion piece for the EU Observer he discusses the macroeconomic differences between Europe and America, though in a fashion that almost makes you believe he is a regular reader of this blog:
Half a decade after the financial crisis, the United States is recovering, but Europe is suffering a lost decade. Why? In the second quarter, the US economy grew at a seasonally adjusted annual rate of 4 percent, surpassing expectations. In the same time period, economic growth in the eurozone slowed to a halt (0.2%), well before the impact of the sanctions imposed on and by Russia over Ukraine. Germany’s economy contracted (-0.6%). France’s continued to stagnate (-0.1%) and Italy’s took a dive (-0.8%). How did this new status quo come about?
He is correct about the American economy widening its gap vs. Europe, he is correct about the Italian economy, about the French economy, and about the stagnant nature of the euro-zone economy. What he does not get right is his answer to the question why the European economy has once again ground to a halt:
[In] the eurozone, real GDP growth contracted last year and shrank in the ongoing second quarter, while inflation plunged to a 4.5 year low. Europe’s core economies performed dismally. In Germany, foreign trade and investment were the weak spots. The country could still achieve close to 2 percent growth in 2014-2016 until growth is likely to decelerate to 1.5 percent by late decade. In France, President Francois Hollande has already pledged €30 billion in tax breaks and hopes to cut public spending by €50 billion by 2017. Nevertheless, French growth stayed in 0.1-0.2 percent in the 1st quarter.
Then Steinbock proceeds to make a brave attempt to explain the depth of the European economic crisis:
Fiscal austerity and falling consumer confidence are preventing domestic demand from rebounding, while investment and jobs linger in the private sector. Pierre Gattaz, head of the largest employers union in France, has called the economic situation “catastrophic.” As France is at a standstill, Paris has all but scrapped the target to shrink its deficit. … The new stance is to avoid an explicit confrontation with Germany, but to redefine austerity vis-à-vis budgetary reforms.
It is unclear what Steinbock means by this. He appears to miss the point that there are two kinds of austerity: that which aims to save government and that which aims to grow the private sector. The two are mutually exclusive, both in theory and in practice. One might suspect that Steinbock refers to the government-first version, since that is the prevailing version in Europe. However, that makes it even more unclear what Steinbock has in mind when he talks about “budgetary reforms” – an educated guess would be the relaxation of the Stability and Growth Pact so that the French government, among others, can spend more frivolously.
Such a relaxation would not contribute anything for the better. All it would do is open for more government spending. Steinbock does not make entirely clear whether or not he recommends more government spending. His article, however, seems to lean in favor of that, and I strongly disagree with him on that point for reasons I have explained on many occasions. Let’s just summarize by noting that if Europe is going to replace government-first austerity with government-first spending, then it opens up an entirely new dimension of the continent’s crisis. That dimension is in itself so ominous it requires its own detailed analysis.
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.
As I keep saying, there are no reasons for Europe’s households and entrepreneurs to be optimistic about the future. Therefore, they are not going to spend more money. They are going to drive their economy into the deep, long ditch of deflation, depression and permanent stagnation.
Eurozone private business growth slowed more than expected in August, despite widespread price cutting, as manufacturing and service industry activity both dwindled, a survey showed on Thursday (21 August).
This is an important, but hardly surprising measurement of what is really going on in the European economy. When buyers do not respond positively to price cuts, it means either of two things:
- They cannot afford to increase spending; or
- They are so pessimistic about the future that they hold on for dear life to whatever cash they have.
A less likely explanation is that they speculate, planning their purchases for a future point in time when prices are expected to be even lower. For this to be true there would have to be other signs of improving economic activity, signs indicating that, primarily, households can afford to spend money in the first place. But the European economy does not exhibit any such signs.
First of all, the cuts in entitlement programs may have wound down with some austerity measures coming to an end. But there is only a partial austerity cease-fire, with Greece, Spain, Italy, France and Sweden continuing contractionary budget measures. Austerity measures designed to save the welfare state in the midst of an economic crisis inject a great deal of uncertainty among consumers, as they can no longer trust the welfare state with keeping its entitlement promises. More of household earnings is used to build barriers against an uncertain future, causing consumer spending – the largest item in the economy – to stall or fall.
So long as austerity remains a threat to the European economy, consumers are going to hesitate.
Secondly, employment is not growing. People’s outlook on the ability to support themselves in the future is not improving. Youth unemployment is stuck at one quarter of all young being unemployed, total unemployment is almost at eleven percent and neither is budging. So long as there is no improved prospects for jobs, those who have jobs will not feel increasingly secure in their jobs, and the large segments of the population who are out of work have no more money to spend than what government provides through unemployment benefits (often hit by austerity).
Third, the European Central Bank may be flooding the euro zone with cheap money, but that is not going to help increase economic activity. Its negative interest rates on bank deposits only leaves liquidity slushing around in the banking system, making banks increasingly desperate to put the money to work. But because of the two aforementioned problems there has been no net addition of demand for credit in the European economy. While the liquidity makes no good difference in the real sector, it may find its way into financial speculation. That is a different and troubling story; the point here is that monetary policy is completely exhausted and can no longer help move the economy forward. Since the fiscal policy instruments of the European economy are entirely devoted to government-saving austerity, there is no clout left in the economic policy arsenal. The Europeans are left to fend for themselves, mired in uncertainty and stuck having to fund the world’s largest government.
In other words, there is no reason to be surprised by the lack of demand response to declining prices. There are, however, a lot of reasons to be worried about Europe’s future. Euractiv again:
Economic growth ground to a halt in the second quarter, dragged down by a shrinking economy in Germany and a stagnant France … Markit’s Composite Purchasing Managers’ Index (PMI) will provide gloomy reading for the European Central Bank (ECB), suggesting its two biggest economies are struggling like smaller members. Based on surveys of thousands of companies across the region and a good indicator of overall growth, the Composite Flash PMI fell to 52.8 from July’s 53.8, far short of expectations in a Reuters poll for a modest dip to 53.4.
Technically, any index number above 50 means purchasing managers are still expanding purchases. However, since the second-order trend is negative – the increase is flattening out – it is only a matter of a little bit of time before the PMI index itself goes negative. Shall we say three months? The Euractiv story gives good reasons for that:
Markit said the data point to third-quarter economic growth of 0.3%, matching predictions from a Reuters poll last week. “We are not seeing a recovery taking real hold as yet. We are not seeing anything where we look at it and think ‘yes, this is the point where the eurozone has come out of all its difficulties’,” said Rob Dobson, senior economist at Markit.
Again, an economist whose thinking is upside down. The right question to ask is not when the European economy is going to recover. The right question to ask is: what reasons does the European economy have to recover in the first place? In the emerging deflation climate, and with the economy stuck in the liquidity trap where monetary policy is completely impotent, Europe’s households and entrepreneurs have no reasons to change their current, basically depressed economic behavior.
Deflation is the most worrying part of their crisis. Says Euractiv:
Consumer prices in the eurozone rose just 0.4% on the year in July, the weakest annual rise since October 2009 at the height of the financial crisis, and well within the ECB’s “danger zone” of below 1%. Worryingly, according to the composite output price index firms cut prices for the 29th month – and at a faster rate than in July. … Also of concern, suggesting factories do not expect things to improve anytime soon, manufacturing headcount fell at the fastest rate in nine months.
This is not a protracted recession. This is a new normal, a state of permanent stagnation.
A state of industrial poverty.
A week ago Eurostat reported:
In June 2014 compared with May 2014, seasonally adjusted industrial production fell by 0.3% in the euro area (EA18) and by 0.1% in the EU28, according to estimates from Eurostat, the statistical office of the European Union. In May 2014 industrial production decreased by 1.1% in both zones. In June 2014 compared with June 2013, industrial production remained stable in the euro area and rose by 0.7% in the EU28.
In other words, more evidence that the European economy is stuck in a state of stagnation. If we translate “industrial production” into “manufacturing”, then we get the following interesting numbers from Eurostat:
Manufacturing employment has remained relatively stable over the past decade, obviously with a downturn during the earlier years of the Great Recession. However, the interesting part is the relation between changes in employment and changes in value added. When value added is falling faster than employment, it means employers are losing money and need to compensate by reducing employment, cutting wages or shutting down production facilities. The first two options become one if employment reductions are big enough to make a substantial difference in production costs, but if cutting employment is the only measure, the capital stock remains unchanged.
Closing facilities is a way to reduce fixed production capacity, though more drastic than a straightforward reduction in employment.
The violent changes in gross value added indicate that manufacturers made some pretty hard downsizing during the early years of the Great Recession. Once they had reduced their fixed and variable production capacity (capital and labor) they were able to improve profitability again. That improvement, however, was only transitional, as the growth in value added returned to zero and even negative territory in 2012. The lack of increase in employment during this period reinforces the conclusion that the upswing was structural, not related to an economic recovery.
Employment, meanwhile, has remained steady. The question is what the most recent uptick means – is it the sign of a steady recovery or is it the result of corrections to manufacturing capacity in response to the decline in value added during 2012? Given the overall state of the European economy, my answer is that we are witnessing once again a structural effect on value added: more efficient allocation of production and measures taken to increase labor productivity.
Data from another industry point in the same direction:
Eurostat’s data for the European construction industry reinforces the impression that there is no recovery under way. Here the value added line is dark red, and theoretically indicates an increase in profitability. However, it is not dissimilar from the one that happened in 2-12, and since there is no uptick in the employment trend.
When there is an upward trend in construction, it is a sign of a steady economic recovery. This is happening in the U.S. economy, but, as we can see, not in Europe.
When do you stop talking about an economy as being in a recession, and when do you start talking about it as being in a state of permanent stagnation? How many years of microscopic growth does it take before economic stagnation becomes the new normal to people?
Since 2012 I have said that Europe is in a state of permanent economic stagnation. So far I am the only one making that analysis, but hopefully my new book will change that. After all, the real world economy provide pieces of evidence almost on a daily basis, showing that I am right. Today, e.g., the EU Observer explains:
France has all but abandoned a target to shrink its deficit, as the eurozone endured a turbulent day that raised the prospect of a triple-dip recession. Figures published by Eurostat on Thursday (14 August) indicated that the eurozone economy flatlined between April and June, while the EU-28 saw 0.2 percent growth.
I reported on this last week. These numbers are not surprising: the European economy simply has no reason to recover.
The EU Observer again:
Germany, France, and Italy … account for around two thirds of the eurozone’s output. Germany’s output fell by 0.2 percent, the same as Italy, which announced its second quarter figures last week. France recorded zero growth for the second successive quarter, while finance minister Michel Sapin suggested that the country’s deficit would exceed 4 percent this year, missing its European Commission-sanctioned 3.8 percent target.
And that target is a step back from the Stability and Growth Pact, which stipulated a deficit cap of three percent of GDP. It also puts a 60-percent-of-GDP cap on government debt, but that part seems to have been forgotten a long, long time ago.
What is really going on here is a slow but steady erosion of the Stability and Growth Pact. Over the past 6-8 months there have been a number of “suggestions” circulating the European political scene, about abolishing or at least comprehensively reforming the Pact. The general idea is that the Pact is getting in the way of government spending, needed to pull the European economy out of the recession.
No such government spending is needed. The European economy is standing still not because there is too little government spending, but because there is too much. I do not believe, however, that this insight will penetrate the policy-making circles of the European Union any time soon.
Back to the EU Observer:
In an article in Le Monde on Thursday (14 August), [French finance minister] Sapin abandoned the target, commenting that “It is better to admit what is than to hope for what won’t be.” France would cut its deficit “at an appropriate pace,” he added in a radio interview with Europe 1. … Sapin’s admission is another setback for beleaguered President Francois Hollande, who made hitting the 3 percent deficit target spelt out in the EU’s stability and growth pact by 2013 one of his key election pledges in 2012. Paris has now revised down its growth forecast from 1 percent to 0.5 percent over the whole of 2014, and cut its projection for 2015 to 1 percent from 1.7 percent.
Let me make this point again: instead of asking when the European economy is going to get back to growth again, it is time to ask if the European economy has any reason at all to get back to growth. As I explain in my new book, there is no such reason so long as the welfare state remains in place.
The eurozone economy flatlined between April and June, while the EU-28 saw 0.2 percent growth, Eurostat confirmed Thursday. Latvia recorded 1 percent growth, the eurozone’s fastest rate, followed by Spain, Portugal and Slovakia. Germany’s output fell by 0.2 percent. The UK and Hungary were the strongest performers outside the eurozone.
These numbers, predictable as they are, report growth in the second quarter for 2014 over the first quarter. They are also adjusted for seasons, workdays and inflation. This puts a great deal of distance between these numbers and actual economic activity, kind of like the difference between plain coffee and a decaf cappuccino. The best numbers to analyze are those that are still inflation-adjusted, but nothing more, and to look at annual growth quarter-to-quarter, in other words second quarter 2014 over second quarter 2013. This is not going to happen, though, until Eurostat releases non-seasonally adjusted numbers from Q2. Until then we will have to do with the cappuccino version, but we can at least put the caffein back in it by calculating annual growth quarter to quarter.
When we make this adjustment, the negative news reported by the EU Observer are put in a better context:
Again, the U.S. economy is moving forward in a reasonably paced recovery. So is the United Kingdom, which is noteworthy since the U.K. has kept its taxes at the low end of what the European Union allows. This is now paying off.
Once again, the growth rate for the EU, when Britain is subtracted, puts economic stagnation on full display. (The growth rates for EU-less-UK are almost identical to those of the euro zone.) As yet more evidence of this stagnation, the French economy grew at an annual rate of 0.11 percent, down from 0.79 percent in the first quarter and 0.77 percent in the last quarter of 2013. Italy continued a year-long trend of negative growth.
Eurostat has not yet published a full roster of member-state GDP data for Q2 2014, so we will certainly have opportunity to return to these numbers. For now, though, let us conclude that not even the cappuccino massage of raw macroeconomic data can hide the fact that the European economy is in a solid state of stagnation.
My book Industrial Poverty: Yesterday Sweden, Today Europe, Tomorrow America will be officially available as hardcopy and e-book on September 10. This book basically asks a two-step question: Has the industrialized world entered a state of permanent economic stagnation? If so, is the state of stagnation self-inflicted?
I suggest that the answer is affirmative on both accounts. The consequence is dire for the two largest economies in the world:
- Europe is stuck in a depression that is leaving one in five young man and woman with no other option than to live off welfare;
- While the U.S. economy is improving, it is a recovery that leaves a lot to be wished for, primarily in terms of job creation and economically sustainable consumer spending.
The United States will continue to move, slowly, in the right direction, but without structural reforms to end large entitlement systems it will be very difficult to achieve more than 2-2.5 percent growth per year. That is just about enough to maintain a constant standard of living on an inter-generational basis.
A growing number of economists are expressing concerns about what will come after the Great Recession. One of them is Stanley Fischer, the number two guy at the Federal Reserve. From the New York Times:
Sounding a somber note even as the economic outlook in the United States brightens, the Federal Reserve’s No. 2 official acknowledged on Monday that global growth had been “disappointing” and warned of fundamental headwinds that might temper future gains. … Stanley Fischer … noted that although the weak recovery might simply be fallout from the financial crisis and the recession, “it is also possible that the underperformance reflects a more structural, longer-term shift in the global economy.” In a speech delivered on Monday in Stockholm at a conference organized by the Swedish Ministry of Finance, Mr. Fischer also conceded that economists and policy makers had been repeatedly disappointed as the expected level of growth failed to materialize.
My book is timely, in other words… To be perfectly honest, the reason why “economists and policy makers had been repeatedly disappointed” during the Great Recession is precisely that they do not primarily think in structural – or institutional – terms. One reason is the over-reliance on traditional econometric methods, which work well so long as there is no major upset to the overall structure of the economy. Another reason is the downgrading of genuine economic theory: today’s average graduate student in economics probably will never read an original text by theory-based scholars like Keynes, von Mises, Hayek, Lerner, Harrod or even Milton Friedman. Today’s academic economics puts the cart before the horse, deciding what tools to use first and then finding a list of problems those tool may apply to. What does not make the list is not of interest.
This is, obviously, an exaggerated stylization, but it is not more than that. Instead of using methodology that asks how soon the European economy will return to business as usual, economists need to begin to ask what reason, if any, the European economy has to return to full employment and growth. I have made my contribution. Stanley Fischer is opening for the same type of non-traditional analysis. Here is what he said, directly from the Federal Reserve website:
[The] Great Recession is a near-worldwide phenomenon, with the consequences of which many advanced economies–among them Sweden–continue to struggle. Its depth and breadth appear to have changed the economic environment in many ways and to have left the road ahead unclear. … There has been a steady, if unspectacular, climb in global growth since the financial crisis. For example, based on recent IMF data from the World Economic Outlook, which uses purchasing power parity weights, world growth averaged 3percent during the first fouryears of the recovery and as of July was expected to be 3.4 percent this year. The IMF expects global growth to reach 4 percent next year–a rate about equal to its estimate for long-run growth. This global average reflects a forecast of steady improvement in the performance of output in the advanced economies where growth averaged less than 1 percent during the initial phase of the recovery to an expected 2-1/2 percent by 2015.
Again, the best we can hope for is growth that – as I explain in my book – keeps our standard of living from a continuous decline. But let us also keep in mind that if we are going to expect Europe to grow by 2-2.5 percent next year, a minor miracle has to happen. A true end to welfare-state saving austerity would be a big step in that direction, but so far we have not seen more than verbal commitments to that. But even as this European version of austerity ends, it will take quite a while before the economy will recover. Confidence, like Rome, is not built in a day, and therefore I predict that Fischer will be too optimistic about Europe.
As we return to Stanley Fischer, he stresses the tepid nature of the global recovery:
With few exceptions, growth in the advanced economies has underperformed expectations of growth as economies exited from recession. Year after year we have had to explain from mid-year on why the global growth rate has been lower than predicted as little as two quarters back. Indeed, research done by my colleagues at the Federal Reserve comparing previous cases of severe recessions suggests that, even conditional on the depth and duration of the Great Recession and its association with a banking and financial crisis, the recoveries in the advanced economies have been well below average.
Which is yet more evidence that my argument that this is a structural crisis is valid. But not only that: the structural crisis is of a kind that traditional economics has not yet grasped. The culprit is the welfare state, the depressing effect of which slowly emerged up to four decades ago. However, unlike other long-term trend suggestions, such as the Kondratiev cycle, my hypothesis about the welfare state has a realistic microeconomic underpinning. More on that at some other point; for now, back to Stanley Fischer:
In the emerging market economies, the initial recovery was more in line with historical experience, but recently the pace of growth has been disappointing in those economies as well. This slowing is broad based–with performance in Emerging Asia, importantly China, stepping down sharply from the post-crisis surge, to rates significantly below the average pace in the decade before the crisis. A similar stepdown has been seen recently for other regions including Latin America. These disappointments in output performance have not only led to repeated downward revisions of forecasts for short-term growth, but also to a general reassessment of longer-run growth.
Does the welfare-state explanation apply to the emerging economies as well? In some cases the answer is yes, with South Africa and Argentina as leading examples. I am not familiar enough with the Chinese economy to be able to tell what role the welfare state plays there, but I would be surprised if their talk from time to time about fighting social stratification has not led to an expansion of a government-based redistribution system.
But it really does not matter if the Chinese are expanding their welfare state, or are wrestling with a financial bubble. Neither is going to change the European economy, which – as we go back to the New York Times story – is showing yet more signs of perennial stagnation:
A report on Monday by the Organization for Economic Cooperation and Development warned that German economic growth might be slowing. Germany has been one of Europe’s rare bright spots, continuing to prosper even as countries on the periphery like Greece, Portugal and Spain struggle after the debt crisis of 2010-12.
Let’s take a closer look at that report on Friday. For now, let’s just note that it is good to see that more and more economists are taking a broader, less conventional look at the economy. Just as I do…
The prevailing wisdom in some economics circles, primarily those adherent to orthodox Austrian and monetarist theory, is that an expansion of the money supply automatically causes inflation. The last few years have proven the hardline monetarist view wrong, with massive money supply expansion in the United States and accelerating money printing in the euro zone. That does, however, not mean that there is no connection whatsoever between money supply and inflation. There is, but the money needs a transmission mechanism from the banks – literally – to the real sector where prices are set.
In South America government entitlements serve that role as a transmission mechanism. In Argentina, e.g., there is a job guarantee effectively making government everyone’s employer of last resort. Together with other entitlements this has caused government spending to rise to unsustainable levels while eroding (my means of sloth and indolence) the tax base supposed to pay for those entitlements. Instead of reforming away its entitlement state, the government led by socialist president Cristina Kirchner pumps newly printed money into the government budget.
With consumer demand kept up by entitlements and productive activity kept down by the same entitlements (among other business-stifling measures) imports have increased. The massive money printing weakens the currency, causing imported inflation to compound a problem caused by domestic excess demand. Tradingeconomics.com reports the Argentinian CPI-based inflation rate at just above ten percent, though at least one other source put it above 13 percent. It is worth, though, to take any number coming out of Argentina with a grain of salt, as president Kirchner has been accused of trying to tamper with the country’s national accounts data.
Regardless of the fine print of Argentina’s inflation numbers, their economy exemplifies how excessive money printing can indeed cause inflation. One person who should definitely keep the Argentinian lesson in mind is Mario Draghi, president of the European Central Bank. Despite the restrictions put in place on the ECB when the bank was created, Draghi is pushing hard for a very expansive monetary policy. His money printing ambitions take many different forms, big and small. On Thursday August 7, e.g., in an official ECB statement, Draghi explained the ECB Governing Council’s latest policy decision:
Based on our regular economic and monetary analyses, we decided to keep the key ECB interest rates unchanged. The available information remains consistent with our assessment of a continued moderate and uneven recovery of the euro area economy, with low rates of inflation and subdued monetary and credit dynamics.
In a brief press release the same day, the ECB announced that:
the interest rate on the main refinancing operations and the interest rates on the marginal lending facility and the deposit facility will remain unchanged at 0.15%, 0.40% and -0.10% respectively.
The latest M1 money supply data from the ECB shows an annual growth rate of 5.4 percent. This is actually a reduction from a bit over a year ago when they were pumping massive amounts of euros into saving Spain and Greece from collapse. However, back then the M1 growth rate relative real GDP growth was approximately four to one, meaning money supply expanded four times faster than transactions money demand. The U.S. economy has seen similar excess growth rates for a while, though with GDP growth picking up and the Federal Reserve tapering off its Quantitative Easing policy, the U.S. rate is declining.
The exact opposite is happening in Europe. With GDP growth at best reaching one percent per year, the euro-zone excess growth rate in M1 is now at 5:1. Of every five new euros printed, one is absorbed by the economy to serve as liquidity for spending, investment, labor compensation and tax-payment purposes. The remaining four dollars go into the financial system as excess liquidity. With the ECB’s overnight lending rate for banks at -0.1 percent, that means a dangerous rise in excess liquidity in the banking system.
It could also lead to an Argentine-style monetary inflation rally. For now, though, the ECB hopes that consumers and businesses will absorb all the money slushing around in the financial system. Back to Draghi:
The targeted longer-term refinancing operations (TLTROs) that are to take place over the coming months will enhance our accommodative monetary policy stance. These operations will provide long-term funding at attractive terms and conditions over a period of up to four years for all banks that meet certain benchmarks applicable to their lending to the real economy. … Looking ahead, we will maintain a high degree of monetary accommodation. Concerning our forward guidance, the key ECB interest rates will remain at present levels for an extended period of time in view of the current outlook for inflation.
Where would the demand for these loans come from? Other than random blips on the national accounts radar, there is no real movement in either business investments or consumer spending in Europe. The only way Draghi and the European banks can push new loans on entrepreneurs and households is to lower credit qualification requirements. That, in turn, exposes banks to significantly higher default risks, without stimulating private-sector activity more than on the margin.
Thus, in order to put their relentlessly expanding liquidity supply to work, the ECB has to go for other measures. And this is where Argentina comes back into the picture. Draghi again:
[The ECB] Governing Council is unanimous in its commitment to also using unconventional instruments within its mandate, should it become necessary to further address risks of too prolonged a period of low inflation. We are strongly determined to safeguard the firm anchoring of inflation expectations over the medium to long term. … the annual rate of change of MFI loans to the private sector remained negative in June and the necessary balance sheet adjustments in the public and private sectors are likely to continue to dampen the pace of the economic recovery.
Let us translate this into plain English. The point about “unconventional instruments” means that the ECB will do whatever it takes to drive up inflation to two percent. This includes using U.S.-style QE measures to prop up deficit-struggling member states. Which opens the door to Argentina. Unlike the United States, the European economy does not have the resiliency to get out from underneath bad fiscal policy and onerous governments. Furthermore, despite our overly generous welfare systems we do not have Europe’s massive income security structure which flood households with work-free cash.
Compared to the U.S. situation, Europe is at significantly higher the risk of monetary inflation. I would not want to keep my investments in Europe when the ECB starts pumping money directly into government budgets.
The last part of Draghi’s speech reinforces my concerns:
To restore sound public finances, euro area countries should proceed in line with the Stability and Growth Pact and should not unravel the progress made with fiscal consolidation. Fiscal consolidation should be designed in a growth-friendly way. A full and consistent implementation of the euro area’s existing fiscal and macroeconomic surveillance framework is key to bringing down high public debt ratios, to raising potential growth and to increasing the euro area’s resilience to shocks.
It is precisely the pursuit of welfare-state saving austerity that has brought the European economy to its knees. So long as the short-term budget balance is more important than GDP growth, consumer spending or reduced unemployment, policy makers at the ECB as well as in the EU leadership and member-state governments will continue to keep the European economy in its increasingly perennial state of stagnation. If they push hard enough on fiscal consolidation, in other words if they add QE to their current policy mix, stagnation will become stagflation.
In economics, a lot of academic research is focused on high-end sophisticated quantitative methods. Many economists who work in public policy consider such research more or less useless. I agree only to some extent. There is a lot of technically advanced research that informs us in the interface between politics and academia. Right now, e.g., I am reading highly technical and theoretical research in price theory for a paper that develops new policy applications.
That said, the technical experts in economics have run away with the discipline. Far more resources are spent on advanced mathematical research and sophisticated statistical methods than can ever be merited by real-world applicability. This technical overkill has led to two problems in the practice of economics: econometricians make errors in forecasting and economists ignore problems that do not easily lend themselves to high-end technical analysis.
The more I read of economics literature, and the more time I spend in the public policy interface of politics and economics, the more convinced I am that economics needs a thought revolution. I find myself relying on erstwhile thinkers and basic macroeconomic theory developed early in the 20th century, because I have had much more use of it than more modern, less theoretical research.
One example of where I find the basics very useful is in the understanding of why there is such a difference in inflation patterns in Europe and the United States. While U.S. inflation is slowly trending up toward two percent, Europe is moving steadily into deflation territory. From The Guardian:
Eurozone inflation fell to its lowest level in almost five years in July, bringing the threat of a dangerous deflationary spiral closer. The annual rate of inflation fell unexpectedly to 0.4% from 0.5% in June, dragged lower by accelerating falls in food, alcohol and tobacco prices. Energy prices also fell sharply, by 1%, compared with a 0.1% rise in June. It was the lowest level of annual inflation since October 2009, when prices were in negative territory.
I have warned about deflation several times. It is not hard to predict deflation in Europe:
1. Government consumes 40-50 percent of the economy;
2. Austrian theory explains how government misallocates resources, thus lowers overall economic activity;
3. When the recession hit in 2008-09, growth was already so weak that the European economy lacked the resiliency needed to recover;
4. Austerity, designed to save the welfare state, has further depressed private-sector activity, just as Keynesian theory predicts;
5. More recently the ECB has flooded the euro zone with money in a desperate attempt to revive business investments;
6. Since austerity has left the private sector more heavily taxed, with even weaker support from government, businesses and consumers are even less inclined to spend money and take on new loans than before austerity;
7. When real-sector activity is depressed, the monetary sector cannot revive economic activity even when it pushes private-sector loan interest rates into negative territory, as the ECB has done.
No matter how hard the ECB tries, it is not going to restart the European economy. Instead, it has firmly planted the euro zone in the liquidity trap where monetary policy is useless.
As for inflation, the only kind that Europe could see in this situation is the monetary kind. That is important to keep in mind, especially since there is probably a widespread desire for inflation among Europe’s political leadership. There, inflation is considered a blessing because it drives up tax revenues. But monetary inflation would have such detrimental consequences for the economy that nobody should sit around and wish for it to happen.
I honestly believe that Europe’s politicians and central bankers share that thought – they want real-sector driven inflation but unlike their peers in the United States they don’t know how to get the real sector going.
The Guardian again:
Peter Vanden Houte, chief eurozone economist at ING, said the threat of eurozone deflation was likely to persist. “[July's] figures don’t give any assurance that the eurozone is already out of the deflation danger zone,” he said. … The fear is that weak price pressures could ultimately trigger a dangerous deflationary spiral, where consumers and businesses damage their domestic economies by putting off spending amid expectations that prices will fall further still.
Exactly right. Both Keynes and the Austrians point to this, in different forms. But more importantly, the first thing you need to do when you are in a liquidity trap, on he verge of deflation, is to quit printing money. Deflation and growing money supply reinforce the depression effect of deflation itself. When liquidity is abundantly available, and prices of what you would buy with that liquidity are falling, you may borrow the money, but you put it in the bank. As prices continue to fall, your liquidity gains in net value; if the net gain exceeds the interest rate (not hard when interest rates are practically zero), you make money off borrowing and not spending.
I borrow $100 today to buy a bicycle. The interest rate is one percent and deflation is two percent. Tomorrow I pay one dollar to the bank but only $98 for the bike. I can use an extra dollar in “profit” toward paying back the loan. The longer I wait with buying the bike, the larger my “profit” will be. In other words, I have a speculative incentive to depress economic activity further.
If the interest rate is higher than deflation, I will borrow the money but buy the bike it immediately. The only way, though, that the interest rate can go up is if the ECB tightens liquidity supply in the euro zone. That, however, won’t happen any time soon. The Guardian reminds us of how the ECB took the euro zone into negative interest rate territory:
Policymakers at the European Central Bank (ECB) took action in June to stave off the threat of deflation and breathe some life into the currency bloc’s flagging economy. The main interest rate was cut to a record low of 0.15% and a €400bn (£317bn) package of cheap funding for banks was announced, with the condition that the money be used to lend to companies outside the financial sector, and not for mortgages. The ECB also announced it would in effect charge banks to deposit money, by imposing a negative rate of interest of -0.1% on deposits. The hope is that it will encourage banks to lend more to consumers and businesses, boosting the wider economy.
Fortunately, the ECB has announced that it will hold off on further monetary “stimulus” for now. Perhaps the weaker euro, which the Guardian also mentions, will inject a little bit of import-price inflation into the European economy. That would weaken the deflation trend, but it is unlikely that it will do enough to lift the euro zone our of the liquidity trap.
Overall, economic theory and the current course of the European economy together suggest that the continent’s economy is going to continue its journey into the shadow realm of deflation and permanent stagnation.
In the meantime, the U.S. economy will continue to grow, with a healthy dose of low, real-sector driven inflation. The differences between the eastern and western shores of the Atlantic Ocean will also continue to grow. The sharp contrast emerging will be one between thriving free-market based capitalism and stagnant welfare-state based socialism.
Take your pick.
As I explained last week, the American economy is pulling ahead of Europe. One major reason why this is happening is that our welfare state, big and onerous as it is, has not quite yet grown to the point where it brings the private sector to a grinding halt. Our consumers and entrepreneurs still have enough breathing room to pursue happiness and prosperity.
It is a safe bet that Europe will continue to slide behind. More evidence of this is in this Euractiv.com report:
Germany, France and Italy have agreed on closer cooperation in the areas of energy, transport and digital infrastructure. At a meeting in Berlin on Wednesday (July 30), German Minister of State for Europe Michael Roth, French State Secretary of Europe Harlem Désir and Italian State Secretary of European Affairs, Sandro Gozi agreed on the shared goals. In an explanatory paper, the three Europe ministers emphasised the importance of bridging investment gaps. “It is necessary that we fully exploit existing instruments like the EU structural funds, loans from the European Investment Bank and project bonds,” said Roth. But it is also important to be ready to test new, suitable instruments – regardless whether public or private, he added.
The prevailing political doctrine, in other words, is that more government spending is needed in Europe. The only problem the statists have is that they do not know how to fund that new spending, and that is perhaps the only silver lining in this. After the tax hikes that came with the past few years of austerity, Europe can catch its breath for a while.
This emphasis on government spending is part of a trend that gained momentum with the socialist gains in the EU elections in May. Consequently, it is not surprising that, according to Euractiv, these European politicians…
also emphasised the desire to more strongly address high youth unemployment in many EU member states. Europe should not be reduced to a functioning internal market and a common currency, Roth explained. “Europe is also, and above all, a community of values and solidarity.” Germany, France and Italy have set common goals of fulfilling targets for sustainable growth and improving employment opportunities, said Roth. Above all, this applied to the younger generation, he added.
By using terms like “values” and “solidarity” instead of “freedom” and “opportunity”, Europe’s political leaders declare again that government is the key player in bringing the continent’s economy out of its perennial slump. When government designs policies based on “values” it means imposing ideas of income redistribution on taxpayers, who are then asked to give up some of their money for someone who has not earned it. When government pursues “solidarity” it wants to eradicate differences between individuals in terms of economic outcomes. Jack’s hard work should not give Jack more than what Joe can achieve through sloth and indolence.
There is another interesting angle to this. Euractiv again:
To free up new sources of cash, the European Commission would like to expand project bonds for large infrastructure projects. According to the Commission, these funds will be granted to private investors such as banks and pension funds to support cross-border infrastructure like power grids, roads and railways. The credit quality of loans will be improved through the acquisition of guarantees.
As I have explained numerous times on this blog, a major component of the so called financial crisis was the early and rapid credit decline of Europe’s welfare states. In the years leading up to the crisis, financial institutions in Europe had rapidly expanded their investments in European government debt. As the credit worthiness of those welfare states fell, so did the solidity of bank portfolios. Spanish, Irish, Portuguese, French, Italian and – not to forget – Greek treasury bonds were reduced from practically no credit risk to more or less junk status. As a result, bank balance sheets tumbled, and a real financial crisis emerged – not as a cause of the economic crisis, but as a result of it.
Now governments in Europe want private investors to once again trust them with their money.
Apparently, Europe has learned nothing from the crisis. Instead both voters and political leaders demand more of the very same economic ingredients that caused the crisis in the first place: entitlements, high taxes and unsustainable welfare states.
Europe has turned into an economic wasteland. So long as its politicians keep protecting the welfare state at any cost, the European continent will sink deeper and deeper into perennial industrial poverty.