Tagged: EUROPE

Stagnant EU Industrial Activity

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:

LB 8 20 14 1

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:

LB 8 20 14 2

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.

French Economy Grinds to a Halt

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.

USA, Britain Outgrowing Europe

The EU Observer notes:

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:

LB 8 15 14

Source: Eurostat.

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.

Industrial Poverty and 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

Bad Euro Monetary Policy Continues

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.

Deflation and Economic Theory

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.

A Recipe for Economic Stagnation

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.

Comparing U.S. and EU Economies

When the good news came about the second-quarter GDP growth in the American economy, some commentators used the relatively low jobs number of 209,000 to make a case that the economy is not at all very strong.

If the spending growth that drove the GDP number were of a more transitional nature, then I would agree with them. But as I explained on Wednesday, the numbers indicate strengthening confidence among consumers and entrepreneurs. It is very likely, therefore, that this is a sustainable recovery.

Not a perfect recovery, but a sustainable one. We should be happy for it. After all, things could be much worse.

We could be Europe.

Just like us, the Europeans took a beating in 2009 when the Great Recession began. Both the U.S. and the EU economies saw unemployment rise rapidly. Deficits swept through government budgets.

On both sides of the Atlantic Ocean, politicians made the wrong choices. The Obama administration and Congress thought massive government spending could save the day. As a result, we got the American Recovery and Reinvestment Act in 2009 but had to wait until 2012 for the recovery to begin.

In Europe, political leaders took to a statist version of austerity in order to save the welfare state from disastrous budget deficits. The outcome was thoroughly bad: while the ARRA “only” delayed our recovery, the European economy actually went into an even deeper recession.

The contrast is clearly visible in Figure 1, which reports the difference in inflation-adjusted growth between the U.S. economy and the EU. Blue columns show how much higher (or lower) the U.S. GDP growth rate was compared to the EU. Grey columns show the growth difference for private consumption:

RFC LB joint blog

Some facts:

  • In nine of the 13 years covered the U.S. economy outgrew Europe;
  • American consumers increased their spending faster than European consumers in 12 out of 13 years;
  • On average consumption growth was twice as fast in America as in Europe, 2.12 percent per year compared to 1.07 percent per year.

There are other differences. Our unemployment rate is 6.2 percent; theirs is 10.3 percent. Our youth unemployment rate is trending down; theirs is basically stuck. Our federal deficit is declining while GDP is growing; the EU economy is barely growing and deficits are frustratingly persistent.

Those who complain that is not a perfect recovery should keep in mind what a perfect recovery would require: a perfect tax policy, perfect downsizing reforms of government spending and perfect deregulation.

We have none of that, so let’s celebrate the recovery we have. It is not that bad.

And as Europe reminds us, we could be stuck in an economic wasteland where the only future to hope for is one in the stagnant life of industrial poverty.

Methodological note: The GDP numbers reported in the attached chart are from the Bureau of Economic Analysis (the U.S. economy) and Eurostat (the EU). In both cases, GDP growth is reported in chain-linked, inflation-adjusted prices. The base year for the U.S. data is 2009 but 2005 for the EU numbers. This difference would normally preclude a comparison. For example, the apparent strength of European growth from 2005 to 2009 could be a statistical anomaly caused by the base year difference. However, due to limited availability of national accounts products from Eurostat, these two time series were the best comparison objects. The short time span covered is also dictated by limitations of the Eurostat database.

An Institutional Analysis of the Crisis

As an institutional economist I focus my research on the role that institutions and policy structures play in our economy. It is a fascinating niche in economics, and when combined with macroeconomics it becomes one of the most powerful analytical tools out there. So far, over the past 2.5 years, everything I have predicted about the European crisis has turned out to be correct; my upcoming book Industrial Poverty makes ample use of institutional economics and macroeconomics to show why Europe’s crisis is far more than just a protracted recession.

In economics, the institutional methodology is often pinned against econometrics, the mainstream methodological favorite. I don’t see it that way – econometrics has its place in economics – but the mainstream of the academic side of economics has given econometrics a far bigger role than it can handle. This has led to over-confidence among econometricians which, in turn, has led to a downplay or, in many cases, complete disregard for the benefits that other methodologies bring. The worst consequence of this over-reliance on econometrics was the multiplier debacle at the IMF, with serious consequences for the Greek economy. (How many young Greeks are unemployed today because their government implemented austerity policies based on IMF miscalculations?) A wider, better understanding for economic institutions and their interaction with the macroeconomy could help mainstream economists a long way toward a deeper, more complete understanding of the economy and, ultimately, toward giving better policy advice.

As an example of how institutional analysis can inform more traditional analysis, consider this interesting article on the European crisis by Economics Nobel Laureate Michael Spence and David Brady, Deputy Director of the Hoover Institution:

Governments’ inability to act decisively to address their economies’ growth, employment, and distributional challenges has emerged as a major source of concern almost everywhere. In the United States, in particular, political polarization, congressional gridlock, and irresponsible grandstanding have garnered much attention, with many worried about the economic consequences. But, as a recent analysis has shown, there is little correlation between a country’s relative economic performance in several dimensions and how “functional” its government is. In fact, in the six years since the global financial crisis erupted, the US has outperformed advanced countries in terms of growth, unemployment, productivity, and unit labor costs, despite a record-high level of political polarization at the national level.

This is true, and as I demonstrate in Industrial Poverty, a major reason for this is that the American economy is not ensnared in a welfare state like the European. We still lack a couple of major institutional components that they have: general income security and a government-run, single-payer health care system. That said, the U.S. economy is not exactly performing outstandingly either:

LB 7 28 14 2

Yes, we are currently in better shape than Europe, but we are also doing worse than ourselves 20, 30 or 40 years ago.

Let’s keep this in mind as we continue to listen to Spence and Brady – their discussion about political dysfunction is actually tied to the role of the welfare state in the economy:

[In] terms of overall relative economic performance, the US clearly is not paying a high price for political dysfunction. Without dismissing the potential value of more decisive policymaking, it seems clear that other factors must be at work. Examining them holds important lessons for a wide range of countries. Our premise is that the global integration and economic growth of a wide range of developing countries has triggered a multi-decade process of profound change. These countries’ presence in the tradable sector of the global economy is affecting relative prices of goods and factors of production, including both labor and capital.

And the government structures that aim to redistribute income and wealth within a country. High-tax economies lose out to low-tax economies. The Asian tigers have generally held tax advantages over their European competitors, but they have also held advantages on the other side of the welfare-state equation as well. By not putting in place indolence-inducing entitlement systems they have kept their work force more shaped toward high-productivity labor than is the case in the old, mature welfare states of Europe.

Why does the welfare state not change, then, in response to increased global competition? After all, Japan, China, South Korea and other Asian countries have been on the global market for decades. Enter the political dysfunction that Spence and Brady talk about. Unlike the United States, there is almost universal agreement among Europe’s legislators that the welfare state should be not only preserved but also vigorously defended in times of economic crisis. This has been the motive behind the European version of austerity, with the result that taxes have gone up, spending has gone down and the price of the welfare state for the private sector has increased, not been reduced as would be the logical response to increased global competition.

It is not entirely clear what kind of American political dysfunction Spence and Brady refer to, but if it has to do with fighting the deficit, they are absolutely on target.

In fact, probably without realizing it, Spence and Brady make an important observation about the long-term role of the welfare state:

Relatively myopic policy frameworks may have worked reasonably well in the early postwar period, when the US was dominant, and when a group of structurally similar advanced countries accounted for the vast majority of global output. But they cease working well when sustaining growth requires behavioral and structural adaptation to rapid changes in comparative advantage and the value of various types of human capital.

If understood as a general comment on the institutional structure of an economy, this argument makes a lot of sense. So long as the traditional industrialized world only had to compete with itself, it could expand its welfare states without paying a macroeconomic price for it. Gunnar Myrdal, Swedish economist and a main architect of the Scandinavian welfare-state model, confidently declared back in 1960 that the welfare state had no macroeconomic price tag attached to it. Back then, it was easy to let government sprawl in every direction imaginable without any losses in terms of growth, income and employment. That is no longer possible.

Spence and Brady then make this excellent observation of the American economy:

What, then, accounts for the US economy’s relatively good performance in the post-crisis period? The main factor is the American economy’s underlying structural flexibility. Deleveraging has occurred faster than in other countries and, more important, resources and output have quickly shifted to the tradable sector to fill the gap created by persistently weak domestic demand. This suggests that, whatever the merit of government action, what governments do not do is also important. Many countries have policies that protect sectors or jobs, thereby introducing structural rigidities. The cost of such policies rises with the need for structural change to sustain growth and employment (and to recover from unbalanced growth patterns and shocks).

The move of resources from the domestic to the foreign-trade sector is visible in national accounts data as a rise of gross exports as share of current-price GDP from 9.1 percent in 2003 to 13.5 percent in 2013. Furthermore, actual growth numbers for exports relative private consumption reinforce the point made by Spence and Brady: from 20087 to 2013 private consumption has increased by 15 percent in current prices, while gross exports have increased by more than 22 percent. For every new dollar Americans doled out on cars, food, haircuts and motel nights, foreign buyers added $1.50 to what they spend on our products.

However, let us once again remember that the adaptation of the American economy should be viewed against the backdrop of a smaller welfare state. As I have discussed on several occasions, European countries are also making big efforts at increasing exports. They are not as lucky in using foreign sales as a demand-pull mechanism for restarting their economies. One reason, again, is the rigor oeconomicus that the welfare state injects into the economy.

Spence and Brady also compare the United States to a number of other countries, noting that:

Removing structural rigidities is easier said than done. Some stem from social-protection mechanisms, focused on jobs and sectors rather than individuals and families. Others reflect policies that simply protect sectors from competition and generate rents and vested interests. In short, resistance to reform can be substantial precisely because the results have distributional effects. Such reform is not market fundamentalism. The goal is not to privatize everything or to uphold the mistaken belief that unregulated markets are self-regulating. On the contrary, government has a significant role in structural transitions. But it must also get out of the way.

In short – and my words, not theirs: reform away the welfare state. Its detrimental influence actually stretches deeper than perhaps Spence and Brady recognize: it does indeed protect large sectors from competition by simply monopolizing them. Health care is a good example, with a government monopoly spilling over on medical-technology products. Another good example is income security, where many European countries have de facto monopolized every aspect from parental-leave benefits to retirement security. Education is a third example, where the United States, despite its heavily socialized K-12 system has a very strong private sector for academic education. This sector is almost entirely absent in many European countries.

Again, it is good to see a different approach to economic analysis than the traditional one based on econometrics and often irresponsibly simplified quantitative analysis. In a situation like the European crisis, it is very important for economists and other social-science scholars (Brady is a political scientist) to broaden the analysis and focus on such variables that rarely change. Among those are economic institutions such as the welfare state, and the political and economic incentives at work in Europe to preserve it, even in the face of mounting global competition.

The Structural Crisis: More Evidence

The European crisis still seems to confuse the continent’s policy makers. After having believed for several years that austerity would both save the welfare state and increase growth, they have now slowly began walking away from the EU’s constitutionally required government deficit and debt rules. Instead, there is now growing belief in government spending as the remedy for the persistent crisis.

For the most part, the debate now seems to gravitating toward the question of how much government stimulus is needed. If the continent is indeed in a recovery mode, as some suggest it is, then there is not this big need for more government spending.

It is understandable that some believe there is a recovery under way. According to Eurostat, GDP for the EU as a whole grew by an inflation-adjusted 1.5 percent in the first quarter of 2014, over the same quarter of 2013. This is an increase from the last quarter of 2013 (1.0 percent) and in fact the fourth quarter in a row with improving growth numbers.

Technically, this represents a recovery. However, in no way does this mean that Europe is out of the crisis. To see why, let us compare GDP growth rates for EU-28 during the 2009-10 spurt to the one that started in 2013:

Q2 2009 Q3 2009 Q4 2009 Q1 2010 Q2 2010
Q1 2013 Q2 2013 Q3 2013 Q4 2013 Q1 2014
2009-10 -5.9 -4.4 -2.1 1.1 2.5
2013-14 -1.3 0.1 0.5 1.0 1.5

Early on in the Great Recession, the European economy made a rapid recovery and kept growing at more than two percent per year for four quarters straight. The rate slowly fell, though, and by the second quarter of 2011 growth was once again below two percent. By the end of that year it was below one percent, and down into negative territory in Q2 of 2012.

But should not a growth spurt count as a definitive recovery? Are not four quarters of improvement enough, especially if followed by a year of growth above two percent?

There is some merit to that argument. The problem is that the growth rates discussed here are not the kind of rates that normally would constitute a recovery, let alone a growth phase of a business cycle. Europe is in a structural crisis, which means that its growth rate is permanently lower than it was before. This is now becoming painfully evident in Eurostat’s national accounts data.

It has now been six years since the Great Recession began. For the entirety of the crisis that we have seen so far, namely 2008-2013, the average inflation-adjusted annual GDP growth rate for the European Union is a depressing -0.1 percent.

This is despite the aforementioned growth spurt.

Compare that to the six preceding years, 2002-2007: 2.4 percent. And that covers the back end of the Millennium Recession. Going back yet another six-year period to 1996-2001, we include the opening and trough of that recession, and still come out with 2.8 percent per year!

To further emphasize the structural nature of the European crisis, let us look at a long-term trend in growth. The following figure illustrates GDP growth in the EU as a six-year moving average. Starting in the fourth quarter of 2001 the average begins by covering the 1996-2001 period. The average is quarter-based to give as detailed an image as possible:

LB GDP EU28 6YR MAVG

The red trend line conveys a chilling message of structurally driven decline. In order to get Europe out of this decline and persistent crisis, economists must re-write their own books on macroeconomics. Surely, the conventional relative-price based advice from accomplished economists such as Michael Spence is still valid: a reduction in the cost of production in Spain vs. other exporting countries will eventually bring about a boost in exports. But as I have pointed out on several occasions, when that boost happens, such as in Germany or Sweden, it has very little influence on GDP growth as a whole. Modern foreign trade in industrialized economies is an isolated activity as many inputs are imported from elsewhere.

But more importantly, the presence of the welfare state throws a heavy, wet blanket over the economy. Austerity, as practiced in Europe in recent years, has added insult to injury by means of even higher taxes and even more perverted economic incentives.

As Michael Spence points out in the aforementioned article, it does not help Europe’s most troubled economies to share currency with Germany. This prevents the exchange rate adjustment needed to reflect global relative production costs. But the conventional macroeconomic wisdom also tends to downplay the growth-hampering effect that welfare states, and welfare-state saving austerity policies, have on GDP.

Spence actually opens for a recognition of this problem in another article together with political scientist David Brady. They acknowledge that modern Western governments have difficulties unifying all their policy goals, including income redistribution. However, Spencer and Brady do not go into more depth on the role that income-redistributing policies may play in causing the downward growth trend illustrated above. Their choice not to do so is understandable – their focus is elsewhere – but it also reflects somewhat of a conventional wisdom among economists: income redistribution and its institutional form, the welfare state, is just another sector of the economy.

It is not. It is the overweight on the private sector that is slowly but inevitably destroying the prosperity of the West. For more on that, stay tuned for my book Industrial Poverty. Out soon!