Tagged: EUROPE

Euro-QE Would Be Big Mistake

How much time does the euro have left? That question was put on its edge last week when the Swiss National Bank decided it was no longer going to anchor the Swiss franc to the iceberg-bound euro ship. It was a wise decision for a number of reasons, the most compelling one being that the euro faces insurmountable challenges in the years ahead.

In fact, the Swiss decision was de facto a death spell for Europe’s currency union. More specifically, I noted that the euro

survived the Greek depression of 2012 by a razor-thin margin. Now it faces three very serious threats to its own survival. The first is the upcoming Greek elections, where anti-austerity, anti-euro, pro-Hugo Chavez Syriza looks like winners. Should they emerge victorious they could very well initiate a Greek exit from the currency union. The euro would survive that, and the German government has a contingency plan in place to stabilize the euro. But then there is the Greek government debt… Syriza has openly declared that they want “debt forgiveness” for governments throughout Europe. If the drachma is reintroduced, it will very likely plummet vs. the euro, making it exceptionally difficult for Syriza to repay its loans to the EU and the ECB. A default is within the realm of the probable; remember the Greek “debt write down” three years ago.

If all the problems for the euro were tied to Greece, the currency would indeed have a future. But there are so many other challenges ahead for the common currency that nothing short of a miracle – or unprecedented political manipulation – can keep it alive through the next three years.

The biggest short-term problem – Greece aside – is the pending announcement by the ECB of its own Quantitative Easing program. Reuters reports:

The European Central Bank will announce a 600 billion euro sovereign bond buying program this week, money market traders polled by Reuters say, but they also believe this will not be enough to bring inflation up to target. In the past two months traders have consistently predicted that the ECB would undertake quantitative easing, considered the bank’s final weapon against deflation. Eighteen of 20 in Monday’s poll said the bank would announce QE on Thursday.

This highly anticipated European QE program must be viewed in its proper macroeconomic context. It is going to be very different from the American QE program. For starters, the balance between liquidity supply and liquidity demand was very different in the U.S. economy than it is in the euro zone today. After its initial plunge into the Great Recession the American economy slowly but relentlessly worked its way back to growth again. Since climbing back to growth in 2010 the U.S. GDP has grown at a rate slightly above two percent per year. This is not something to throw a party over, but it has allowed the economy to absorb much of the liquidity that the Federal Reserve has pumped into the economy.

By being able to absorb liquidity, the U.S. economy has avoided getting caught in the liquidity trap. Growth rates have been good enough to motivate businesses to increase investment-driven credit demand; households have gotten back to buying homes and automobiles (car and truck sales in 2014 were almost as good as in pre-recession 2006).

The European economy does not absorb liquidity. It is stagnant, and has been so for three years now. The ECB has pushed its bank deposit rate to -0.2 percent, in other words it is punishing banks for not lending enough money to its customers. Despite this ample supply of credit there are no signs of a recovery in the euro zone, with GDP growth having reached the one-percent rate once in three years.

In other words, the positive outlook on the future that motivates American entrepreneurs and households to absorb liquidity through credit is notably absent in the European economy. When the ECB now evidently plans to pump even more liquidity out in the economy, it appears to not understand how significant this difference is between the euro zone and the United States.

Or, to be fair, with all its highly educated economists onboard, the ECB most certainly understands what role liquidity demand plays in an economy. Its pending decision to launch a QE program appears instead to be based in open ignorance of the lack of liquidity demand.

Which leads us to ask why they would ignore it.

The answer to this question is in the declared purpose of the QE program. If it is aimed at buying treasury bonds, then the QE program clearly is not designed to re-ignite the economy, an argument otherwise used. If QE is supposed to monetize government deficits, then its purpose is really to secure the continued existence of the European welfare state. If that is the purpose, then the only safe prediction is that there will be no end to QE before the welfare state ends.

That, in turn, means the ECB would be stuck monetizing deficits for the rest of the life of the euro. Which, under such circumstances, would be a relatively short period of time…

More on this on Thursday, when the ECB is expected to announce its QE program. Stay tuned.

Europeans Are Still Unemployed

The production of macroeconomic data from the European Union for the last two quarters of 2014 is a bit slow. The main source, Eurostat, took until last week to release GDP data for the third quarter, though that was under ESA 2010 standards. We are still waiting for the “modernized” versions to be released.

According to the “older” series, which I reported on last week, economic stagnation continues to hold Europe in an unforgiving chokehold. A look at unemployment statistics – which is updated faster than national accounts data – confirms this picture:

EU US U

Regardless of what configuration Europe is given – the EU as a whole or the euro zone – its unemployment rate is not where it should be. Before the Great Recession, U.S. unemployment was almost half of what it was in Europe; after a brief period of declining jobless rates, Europe experienced a long period of unrelenting increase. In fact, as Figure 1 shows, European unemployment has been creeping upward for five years, from mid-2008 to mid-2013.

It remains to be seen if 2013 actually was the peak, and if 2014 represents the beginning of a long-term decline. There is no underlying trend in GDP or any of its individual components to hint of a real recovery. Here, the European economy stands in stark contrast to the U.S. economy, where unemployment has been falling, albeit slowly, since 2010.

All is not dark as night in Europe, though. Some countries have seen a drastic decline in unemployment since the peak. Measured from the first quarter of 2013 through the third quarter of 2014, the unemployment rates in…

Hungary fell by more than a third;

Lithuania declined by almost one third;

Estonia, Poland and Portugal have plummeted by about one quarter;

Bulgaria, Czech Republic and the U.K. are down by just over one fifth.

Despite these reductions, rates are still disturbingly high in many countries. Here are the EU member states with an unemployment rate higher than the U.S. rate of 6.2 percent:

Unemployment, EU States, Q3 2014
Greece 25.6 Slovenia 9.3
Spain 23.7 Lithuania 9.1
Cyprus 16.1 Belgium 8.7
Croatia 15.7 Poland 8.2
Portugal 13.3 Estonia 7.5
Slovakia 12.9 Finland 7.5
Italy 11.8 Hungary 7.4
Ireland 11.3 Sweden 7.2
Bulgaria 10.8 Denmark 6.5
Latvia 10.6 Romania 6.5
France 9.9 Netherlands 6.4

While it is good to see that “only” a quarter of all Greeks were unemployed in Q3 2014, as opposed to 28 percent a year ago, it should also be noted that unemployment was lower in 2012 when their economy was plunging like the Titanic after she hit the iceberg. In Q3 2012 the Greek unemployment rate was 25 percent exactly.

Spain, with Europe’s second-highest unemployment rate, saw its peak in early 2013 at 26.9 percent. They are now back where they were in 2012, but the decline is very, very slow.

Cyprus is actually still in the phase where unemployment is increasing. It is unclear if the same is true for Croatia, where unemployment has been fluctuating between 14 and 18 percent – averaging 16.6 – over the past three years. What is clear, though, is that there is no downward trend in the Croatian unemployment rate.

Fifth on the list is Portugal, where unemployment topped at 17.8 percent in Q1 2013 and has been moving down very slowly since then. To their credit, the Portuguese have seen a slow improvement in GDP growth, from an annual, inflation-adjusted rate of -1.4 percent in Q2 2013 to one percent in Q3 2014. Greece and Spain have seen similar improvements:

2013Q2 2013Q3 2013Q4 2014Q1 2014Q2 2014Q3
Greece -4.2% -2.6% -3.1% -0.4% 0.4% 1.9%
Spain -1.5% -0.5% -0.1% 0.7% 1.3% 1.7%

The Spanish improvement is predominantly driven by exports. The same is ostensibly true for Greece and Portugal as well, in which case the case for a lasting improvement is basically non-existent. A more detailed examination of national accounts data will give us a more detailed picture (stay tuned).

The small decline in Europe’s notoriously high unemployment reported above is far too weak, far to little to indicate anything beyond a temporary easing of the social and economic pressure that comes with large segments of the labor force being unemployed for years.

Swiss Predict Euro Demise

This week the Swiss central bank did the right thing and let go of the Swiss franc’s peg to the euro. The result was a massive appreciation of the franc, primarily vs. the euro. Though the move was not entirely unexpected, there have been a lot of speculations as to why the Swiss did it now.

The answer is not very complicated. The Swiss have grown increasingly uncomfortable with the fixed exchange rate vs. the euro, especially since the ECB:

a) pledged to buy every single treasury bond from every single euro-zone country; and

b) started pumping money out in the hot air to “stimulate spending” in the perennially stagnant euro zone.

International investors, rightly interpreting these reckless measures as the ECB playing desperate defense against the tides of macroeconomics, have taken refuge in the Swiss financial markets. To defend the peg against the euro, the Swiss National Bank (SNB) has been forced to print unhealthy amounts of new money.

There finally came a point where the SNB gave up on defending the peg. When they did they effectively acknowledged that major global financial investors have called it right: the future of the euro is limited.

More on the actual threats to the euro in a moment. First, let us take a look at a couple of interesting factoids that help explain what the SNB did this week.

In order to defend a fixed exchange rate, a central bank must constantly buy and sell its own currency on the international currency market. In this case the Swiss franc was in higher demand than the euro, which forced the SNB to sell large amounts of Swiss francs on the currency market. To do so, they had to print large amounts of money, far more than is needed to keep the Swiss economy fully liquid. Figure 1 below illustrates the excess increase in Swiss money supply over the past few years; first, though, let us note that current-price GDP has been growing virtually on par in Switzerland and the euro zone:

  • Average current-price GDP growth in the euro zone, from 2008 through 2013, was 1.2 percent;
  • Average current-price GDP growth in Switzerland, from 2008 through 2013, was 1.9 percent.

This is a notable difference, but not nearly enough to explain why the SNB has been printing money much more fiercely than the ECB. Figure 1 illustrates the money growth parity in Switzerland and in the euro zone – defined as M1 growth rate less current-price GDP growth:

Euro CHF

In other words, when we subtract current-price GDP growth from M1 money supply growth, we find that the Swiss M1 growth parity has far exceeded the euro parity since 2008. Since current-price GDP growth represents growth in transactions demand for money – i.e., money to keep the economy monetized and liquid – any growth in money supply beyond current-price GDP is a sign of either of two phenomena: irresponsible funding of government debt, or a desperate attempt at keeping currency speculators and financial investors at bay.

The euro-zone’s excess M1 growth is the result of the former; the Swiss parity is the result  of the latter.

During 2014 the SNB has cut down on money printing – annualized M1 growth rates per month have been less than four percent – and thereby signaled that it would, sooner or later, give up on its exchange-rate peg vs. the euro.

That has now happened. Speculators are free to rake in their currency-appreciation gains, but more importantly: investors have established their concerns about the future of the euro. Which brings us back to the limited life span of that currency. Once launched as the new gold standard of the world, the euro has fallen from the skies, badly wounded by reckless money printing.

It survived the Greek depression of 2012 by a razor-thin margin. Now it faces three very serious threats to its own survival. The first is the upcoming Greek elections, where anti-austerity, anti-euro, pro-Hugo Chavez Syriza looks like winners. Should they emerge victorious they could very well initiate a Greek exit from the currency union. The euro would survive that, and the German government has a contingency plan in place to stabilize the euro. But then there is the Greek government debt… Syriza has openly declared that they want “debt forgiveness” for governments throughout Europe. If the drachma is reintroduced, it will very likely plummet vs. the euro, making it exceptionally difficult for Syriza to repay its loans to the EU and the ECB. A default is within the realm of the probable; remember the Greek “debt write down” three years ago.

If Greece can get away from its debt vs. the EU and the ECB by exiting the euro, it sets a precedent for other heavily indebted countries on the southern rim of the currency area. That creates a standing threat of further destabilization of the euro – and weakens the reliability of the currency.

The second reason why the euro has a limited future lies in the ECB’s intentions to launch a formal Quantitative Easing program. De facto already in place with the treasury purchase guarantee, this formalization would involve the ECB directly in funding the issuance of new government debt (the current pledge is “only” about buying existing debt). This effectively removes any incentives that national governments have in place to keep any tabs on their borrowing.

The Stability and Growth Pact formally enforces a deficit cap of three percent of GDP, but that pact has already hit an iceberg it can’t recover from. The Pact, namely, bans euro zone countries from bailing out each other – something the Germans violated years ago by helping the EU and the ECB to bail out Spain, Greece and Portugal – and it also prevents the ECB from, yes, Quantitative Easing.

With two of the three pillars of the Pact already destroyed, what reasons do euro-zone governments have to abide by the third pillar, especially if the ECB is going to bankroll all the debt  those governments may want to issue?

The third reason for a limited euro future is the French 2017 presidential election. If Marine Le Pen wins, she will pull France out of the currency union. With the second largest economy exiting there is no longer a reason for anyone else to stay in.

Switzerland once again serves as a safe haven for global investors. But the end of QE here in the United States, together with our slow but steady recovery, allows the dollar to shoulder some of that burden. The more the euro shakes and rattles, the stronger the dollar will become.

It is basically a done deal that the euro will end. All we can hope for is that it will be a peaceful exit under stable, predictable circumstances.

Europe’s Long Economic Decline

Earlier this week I explained how Europe has, institutionally, set itself up for a long-term decline in growth. The Stability and Growth Pact should take a lot of blame for this, as it comes with a built-in bias in favor of contractionary fiscal policy. But it is not just any type of contractionary policy that is favored by the Stability and Growth Pact: it is contractionary policy aimed at balancing the government budget – regardless of all other policy goals.

To be clear, there are two types of contractionary fiscal policy:

  • So called “statist austerity” aims at balancing the government budget with the explicit or implicit purpose to keep government spending programs as intact as possible under tighter economic conditions;
  • So called “free market austerity” where the goal is to shrink government spending with the explicit purpose of permanently reducing the size of government.

The two forms employ different policy strategies. Statist austerity can include tax increases; the balance between spending cuts and tax hikes is determined primarily by practical and political considerations. These considerations typically supersede economic analysis: the execution of statist austerity typically takes place over a short period of time and upon short notice, such as looming panic among global investors over a government’s believed ineptitude in balancing the budget.

Free market austerity, on the other hand, aims solely at permanently shifting the balance between the private sector and government. This can be achieved if and only if:

a) government spending is permanently reduced; and

b) taxes are reduced proportionately to the reduction in spending.

As a result, the combination of changes in taxes and spending is entirely different than what is required under statist austerity. In terms of outcomes, the effects of free-market austerity on GDP growth are radically different from the effects of statist austerity: under the latter government actually increases its net claim on the economy, while under the former the private sector is given ample opportunity to expand.

By dictating budget-balancing requirements, the Stability and Growth Pact de facto mandates statist austerity in Europe. The logical outcome of this should be a long-term decline in GDP growth. There is lots of economic theory to draw on for this conclusion.

Predictably…:

Figure 1

LB Europe 1 15

The growth rate reported in this figure is of the sliding-average kind (without a forecasting side), which shifts focus from periodic observations to trend observations. As the polynomial (third order) trend line indicates, the long-term path is unequivocally downward. In addition, growth peaks get weaker and shorter.

Perhaps the best evidence of the connection between the Stability and Growth Pact and this long-term trend can be found in the downturn after 2010. Annual growth in the fourth quarter of 2010 was 2.2 percent; a year later it was 0.2 percent and by Q4 2012 euro-zone GDP was shrinking by a full percent. It did not return to growth until the latter half of 2013, and then only at tepid rates below half a percent.

In fact, over the past three years – 12 quarters – euro-zone GDP growth has only been above one percent one single quarter. That was in Q1 2014. For Q3 2014 it expanded by a tiny 0.8 percent on an annual basis.

The relation between the institutional structure and the long-term decline in GDP growth is one of the most important reasons why I have come to the conclusion that Europe is stuck in a state of permanent economic stagnation – a state of industrial poverty – which it will not recover from until it reforms away its institutional barriers to a real economic recovery.

Europe Invented Statist Austerity

In December I took a first look at the European Commission’s “Report on Public Finances”, with the intention of returning to this important document later. It has been almost a month, longer than I expected, but here we are.

In my first review of the report I explained that the strict focus by Europe’s political leadership on government finances has led to a systemic error in their fiscal policy priorities:

Austerity, as designed and executed in Europe, was aimed not at shrinking government but making it affordable to an economy in crisis. The end result was a permanent downward adjustment of growth, employment and prosperity. In order to get their economy out of this perennial state of stagnation, Europe’s leaders need to understand thoroughly the relations between government and the private sector.

This is a kind of prioritization that has guided European fiscal policy for two decades now. Under the Stability and Growth Pact, EU member states in general are forced to adopt a fiscal policy that inherently has a contractionary – austerity – bias. But it is not the kind of austerity that reduces the size of government. It is the kind that tries to shrink a budget deficit in order to keep government finances in good order and save the welfare state from insolvency.

So long as contractionary fiscal policy – austerity – is focused on balancing the budget and saving the welfare state, it won’t reduce the size of government. For that, it takes specifically designed austerity measures. Those measures are indeed possible, even desirable, but they cannot be launched unless government is allowed by its own constitution to prioritize less government over a balanced budget.

Unfortunately, the Stability and Growth Pact does not permit that member states prioritize shrinking government over budget balancing. Instead, the Stability and Growth Pact forces them to always pay attention to deficits and debt, but never worry about running too large surpluses. Part A of the Pact caps government deficits at three percent of GDP and debt at 60 percent of GDP. At the same time, there are no caps on budget surpluses; since a surplus is excess taxation, and since excess taxation drains the private sector for money in favor of a government savings account, this means that governments can drain the private sector for all the money it wants to without violating the European constitution.

Unlike a budget surplus, which is contractionary in nature, a budget deficit is, at least in theory, always stimulative. However, by capping deficits the European constitution restricts the stimulative side of fiscal policy, while at the same time leaving the contractionary end unrestricted.

In addition to the technical aspects of this contractionary bias, there is also the political mindset that is born from a legislative construct of this kind. Lawmakers and elected cabinet members – primarily treasury secretaries – are concerned with avoiding deficits, thus quick to resort to contractionary policy measures, but pay little attention to the need for counter-cyclical policies. Over time, this political mindset becomes “one” with the Stability and Growth Pact to the extent where parliaments do not think twice of passing budgets that impose harsh contractionary measures in order to balance a budget.

Think Europe in 2012. And read chapters 4a and 4b in my book Industrial Poverty to get an idea of how deep roots in Europe’s legislative mindsets that this “gut reaction” bias toward contractionary measures has actually grown.

With its contractionary bias, Europe’s fiscal policy has permanently downshifted growth in Europe. This in turn has perpetuated the budget problems that said contractionary policies were intended to solve. It left the European economy fragile and frail, vulnerable to a tough recession. All it took was the downturn in 2008-09 with its spike in deficits – and once the fiscal-policy gut reaction kicked in, there was nowhere to go for Europe other than into the dungeon of budget-balancing contractionary measures; statist-driven austerity; mass unemployment; and perpetual budget problems.

Never did Europe’s leaders think twice of trying to actually release its member states from the shackles of the Stability and Growth Pact. Never did they think twice of permitting a widespread downward adjustment of the size of government.

The Commission’s “Report on Public Finances” cements this statist approach to contractionary fiscal policy. It has an entire section that suggests further collaboration and coordination among EU member states on the fiscal policy front. So long as the Stability and Growth Pact remains in place, such coordination would be a thoroughly bad idea. All that such coordination would accomplish is to cement statist austerity as the prevailing “fiscal policy wisdom” ruling the economy that feeds 500 million people.

I will return in more detail to this report. In the meantime, do take a minute and read my paper Fiscal Policy and Budget Balancing: The European Experience. It is part of a five-paper series of discussion papers on the ups and downs of a balanced-budget amendment to the United States constitution.

Monetary Madness in Europe

On Monday, in an analysis of the ECB’s declared intentions to monetize government deficits and the apparent desire to get the wheels going again in the European economy, I wrote that:

Unless the ECB is planning to buy bonds directly from European consumers, there is no direct connection between Draghi’s bond purchases and consumer spending. If he is hoping to depress interest rates even further and thereby stimulate consumption, then he has very little to play with. In most euro-zone countries interest rates are plunging toward zero – credit is practically available for free.

My comment about consumers was a bit tongue-in-cheek; it should be apparent to everyone, I thought, that handing out cash to consumers is not the way to go if you want more growth, more jobs and more prosperity.

Apparently, I had missed out on just how desperate – or economically ignorant – well-educated people can get. Alas, from Der Spiegel:

It sounds at first like a crazy thought experiment: One morning, every resident of the euro zone comes home to find a check in their mailbox worth over €500 euros ($597) and possibly as much as €3,000. A gift, just like that, sent by the European Central Bank (ECB) in Frankfurt. The scenario is less absurd than it may sound. Indeed, many serious academics and financial experts are demanding exactly that. They want ECB chief Mario Draghi to fire up the printing presses and hand out money directly to the people.

This is being done on a daily basis. Tens of millions of working-age Europeans receive cash directly from government through all sorts of cash entitlements. In 2012 the governments of the 28 EU states handed out 2.37 trillion euros in cash benefits to its citizens. That was an increase of 288 billion euros, or 12.1 percent, over 2008.

In Spain the increase was 15.8 percent, while the economy was in complete tailspin. Greek cash entitlement handouts grew by 11.7 percent; during the same time period the Greek economy shrank by one fifth in real terms.

What some thinkers in Europe are now proposing is, for all intents and purposes, the same kind of cash entitlement program, only with a short-cut administration process: instead of governments borrowing the money from the ECB and then handing it out as entitlements, the ECB should simply send the checks directly to people.

It has not worked when done the traditional way; but shame on those who give up on a hopeless idea – maybe if we print just a little bit more money, and send it to just a little bit more people, then all of a sudden the free cash won’t have the same work-discouraging effect it currently has. If we just churn out a bit more newly printed money, we will find that sweet spot when people start spending like mad dogs.

Yep.

Back to Der Spiegel:

Currently, the inflation rate is barely above zero and fears of a horror deflation scenario of the kind seen during the Great Depression in the United States are haunting the euro zone. … In this desperate situation, an increasing number of economists and finance professionals are promoting the concept of “helicopter money,” tantamount to dispersing cash across the country by way of helicopter. The idea, which even Nobel Prize-winning economist Milton Friedman once found attractive, has triggered ferocious debates between central bank officials in Europe and academics.

In addition to the fact that proponents of this ludicrous idea won’t learn from existing examples, there is also the tiny little nagging thing called the Stability and Growth Pact – Europe’s constitutional debt and deficit control mechanism. The Pact consists of three parts:

1. Government debt cannot exceed 60 percent of GDP and government deficit cannot exceed three percent of GDP;

2. Member states cannot bail out each other in times of deep deficits; and

3. The ECB is banned from monetizing debt and deficits.

For a long time, member states have almost made a habit out of breaking the first rule. In recent years that has led to intervention from the EU, the ECB and the IMF, also known as the Troika, which has imposed serious austerity programs on those countries. The effect has, at best, been temporary and minor.

Germany broke the second rule when it participated in a bailout of Greece, and the ECB has been stretching the third rule time and time again by its participation in member-state bailouts. If this cash entitlement program goes into effect, it will drive a dagger through the heart of the last, remaining piece of the Stability and Growth Pact.

Der Spiegel is not too concerned with the consequences of the Pact falling apart. Instead, their article centers in on the fight against deflation, a battle that the ECB is not winning:

Draghi and his fellow central bank leaders have exhausted all traditional means for combatting deflation. The failure of these efforts can be easily explained. Thus far, central banks have primarily provided funding to financial institutions. The ECB provided banks with loans at low interest rates or purchased risky securities from them in the hope that they would in turn issue more loans to companies and consumers. The problem is that many households and firms are so far in debt already that they are eschewing any new credit, meaning the money isn’t ultimately making its way to the real economy as hoped.

And the bright minds at the ECB headquarters in Frankfurt did not realize this before they bing lending to banks? Of course they did. They just refused to see the causality between a recession, high household debt and the inability of said households to afford more debt.

Somehow they must have thought that if only you print money fast enough, credit scores won’t matter.

Anyway. Back to the helicopter cash idea and its prominent backers in the highly sophisticated world of advanced economic thinking:

In response to this development, Sylvain Broyer, the chief European economist for French investment bank Natixis, says, “It would make much more sense to take the money the ECB wants to deploy in the fight against deflation and distribute it directly to the people.” Draghi has calculated expenditures of a trillion euros for his emergency program, funds that would be sufficient to provide each euro zone citizen with a gift of around €3,000. Daniel Stelter, founder of the Berlin-based think tank Beyond the Obvious and a former corporate consultant at Boston Consulting, has even called for giving €5,000 to €10,000 to each citizen.

If this is such a good idea, why stop there? Why not crank it up to 50,000 euros? A hundred grand? What is keeping them back?

As an addition to the magnanimous disregard for basic economic theory that is fueling the monetary helicopter:

Many academics have based their calculations on experiences in the United States, where the government has in the past provided cash gifts to taxpayers in the form of rebates in order to shore up the economy.

It is one thing to let people keep more of what they have already earned. It is an entirely different thing to give them what they have not earned. When people get a tax refund they have already been productive, they have already participated in the production of total output in the economy. When people are given a handout they have not earned, they do not participate in that same production process, partially or entirely.

Cash handouts discourage workforce participation. It does not matter if it is a one-time event or a permanent entitlement program: the effect is the same, differing only in how long it lasts. When people reduce their workforce participation they increase their demand for other entitlements as well. That effect is small for temporary cash handouts, but consider what will happen in low-income families if, as a pundit quoted above suggested, the ECB gave away 5,000 or 10,000 euros per resident. A family of four would suddenly have 20-40,000 in extra cash.

How likely is it that both parents in that family will continue to work for the next year, when they just got more cash than one of them earns in a year (after tax)?

More cash in consumer hands and less workforce participation is a recipe for rising prices. Which, one should note, is just the intention behind this program. European economists and politicians are paralyzed with fear over the imminent threat of deflation. They will do whatever it takes to get inflation up to the two percent where the ECB would like it to be.

The problem is that if they succeed in causing inflation, it is going to be a rapid spike, i.e., an upward adjustment of prices very early in the spending cycle that the ECB would stimulate with its cash entitlement program. Retailers and manufacturers, squeezed by seven years of economic stagnation, will be quick to raise prices when they see a reason to do so. The price jump will eat up a large share of the consumption stimulus that helicopter proponents expect. As a result, the effect on jobs will be modest, if even visible.

Because of the inflation bump there will not be any lasting effect of this stimulus. It will be a blip on the GDP radar. The risk, however, is that the higher prices linger, thus putting pressure on money wages across Europe. It probably would not be a serious issue, but it would most likely eradicate any remaining stimulative effects of the helicopter entitlement program.

In other words, it is hard to find reliable transmission mechanisms to take the European economy from where it is today to a recovery simply by doing a one-time cash carpet bombing of the economy.

ECB Plans Deficit Monetization

When the euro was introduced more than 15 years ago it was marketed as the rock-solid currency that would beat the sterling, the U.S. dollar and the Swiss franc as the world’s safe haven for investors.

Part of the foundation for that ambitious, but not unattainable, goal was the convergence criteria that were supposed to align fiscal policy in all euro-zone countries. Those criteria, which went into effect in 1993, were elevated to constitutional status and still guide fiscal policy in the form of the Stability and Growth Pact. One of the three pillars of the pact was a ban on deficit monetization: the European Central Bank was not allowed to print money to buy up treasury bonds.

During the Great Recession the first two pillars of the Pact have crumbled; now the third one is about to fall apart as well. From the EU Observer:

The euro has begun 2015 at its lowest level in more than eight years, as markets expect the European Central Bank to present plans to buy government bonds in the coming weeks. The single currency was trading at $1.19 on Monday (5 January), its lowest rate since 2006, after ECB president Mario Draghi gave an interview stating that the bank was preparing a programme to buy up government securities in its latest bid to stimulate greater consumer demand and avoid deflation.

Unless the ECB is planning to buy bonds directly from European consumers, there is no direct connection between Draghi’s bond purchases and consumer spending. If he is hoping to depress interest rates even further and thereby stimulate consumption, then he has very little to play with. In most euro-zone countries interest rates are plunging toward zero – credit is practically available for free.

The problem is not lack of liquidity. The problem is lack of faith in the future. More on that in a moment. Now back to the EU Observer:

Speaking to German daily Handelsblatt on Friday (2 January), Draghi said the ECB was preparing to expand its stimulus programmes beyond offering cheap loans to banks and buying private sector bonds. “We are in technical preparations to adjust the size, speed and compositions of our measures in early 2015,” said Draghi, who will convene the next meeting of the bank’s Governing Council, where the support of a majority of its 25 members would be needed for a decision to be taken, on 22 January.

That will be four days before the Greek elections, which could bring the euro-secessionist Syriza to power. Syriza is a leftist hard-liner party with Venezuela’s defunct president Hugo Chavez as their political and economic role model. They would not think twice of reintroducing the drachma if they had enough political clout to do it.

By promising to buy up government bonds, the ECB could make a direct appeal to Greek voters – or at least to an incoming Syriza prime minister – that the ECB will buy all their government debt if only they choose to stay in the currency union. That, in turn, will basically give a new Syriza government the bargaining chip they need vs. Brussels to end austerity and return to the spending-as-usual policies that reigned before the Great Depression.

Precisely the situation the Stability and Growth Pact was supposed to prevent.

And again, as always, there is the change in tone among forecasters – the same kind of change that has become so frequent in recent years:

Draghi added that the risk of negative inflation had increased … Eurostat’s monthly inflation data to be published on Wednesday is likely to show that prices fell by 0.1 percent in December, the first decline since 2009. … Market analysts are forecasting another difficult year for the single currency bloc, predicting that the euro will continue to weaken against the dollar over the course of 2015, as a result of a combination of very low inflation and weak economic performance. … The eurozone economy is forecast to have grown by a mere 0.8 percent in 2014, and to grow by a meagre 1.2 percent in 2015, well below the US.

Unless there is a radical change in fiscal and welfare-state policies across the euro zone, its GDP won’t even grow by one percent for 2015.

A bond-buying program by the ECB won’t change that. All it will do is allow governments to return to deficit spending, which is not a desirable alternative to the austerity policies of the past few years. Europe needs structural reforms in the direction of free markets, limited government, low taxes and cheap energy. Nothing else will help.

Stagnant Europe Entering 2015

Welcome back to The Liberty Bullhorn – the starting point of economic freedom on the internet!

While this year is promising for many, especially Americans who have a steadily improving job market to search for new opportunities, the outlook on the new year is hardly better in Europe today than it was a year ago. As far as Europe is concerned, 2014 went down in history as the year of squandered hopes for a recovery. I have lost track of all the forecasts that predicted “the” recovery take-off during last year, though it would be valuable for future reference to collect all the “squandered hopes” forecasts. There is a lot to be learned from the serial failures of econometrics-based forecasting during 2014.

The reason why Europe is nowhere near a recovery is that its political leadership is doing absolutely nothing to address the fundamental structural problem of their economy. The welfare state is still in place and its austerity policies have been driven by an urge to save the welfare state – make it slimmer and more affordable – so that it can fit inside a smaller economy with high unemployment and weak tax revenues. But it is precisely these efforts that have escalated the current crisis to a level where – as I explain in my book – it has now become a permanent state of economic affairs.

So long as Europe’s leaders refuse to acknowledge the nature of the economic crisis, they will continue to inject the patient with the medicine that perpetuates the illness.

There are some lights in the tunnel, for sure. The Greek economy has, of late, shown signs of transitioning from an almost unreal ratcheting down into an economic depression to a state that is at least a little bit promising. Its vital macroeconomic signs indicate stagnation rather than decline, which is hardly something to write home about, but good news for people who on average have lost 25 percent of their income, their jobs, and their standard of living since the beginning of the Great Recession.

Sadly, just as the Greeks were being given an opportunity to catch their breath, their elected officials went ahead and caused an early parliamentary election to be held in late January. If current opinion polls are correct, the next prime minister will be Mr. Tsirpas of the Syriza party – a radical socialist group that considers deceased Venezuelan president Hugo Chavez and his authoritarian government a good role model.

Greece does not need an economic model that has caused high unemployment, eradicated property rights and brought about 63 percent inflation. Greece needs major free-market reforms, thoughtfully executed and coupled with growth-generating tax cuts.

But Greece is not the only EU member state that is struggling. France is going nowhere, and going there fast. The socialists in charge in Paris stick to their tax-to-the-max policies, which is part of the reason why the country is going into 2015 with record-high unemployment. Economic forecasters, perhaps burned by last year’s irresponsibly positive predictions, now expect a 0.4-percent increase in real GDP for 2015. That is much more realistic.

Overall, when predicting Europe’s future, one should not ask “when is the economy going to recover?” but “what reasons do the European economy have to start growing again?”.

Again, there is not much positive to look forward to for our European friends. However, it is better to talk about things the way they are, and then find a solution to the problems thus identified, than to pretend that everything is really not what it really is.

Europe has a lot of potential. It could join us here in America and restore prosperity, hope and opportunity for the entire industrialized world. If Europe chooses to do so, we have a future to look forward to that is almost unimaginably positive.

If, on the other hand, Europe’s political leaders stick to their statist guns, their continent will continue on its current path to becoming the next Latin America. It will no longer be even close to comparison with the United States, whose economy will continue its ho-hum economic recovery through 2015 and 2016. Beyond that, it depends entirely on who is elected president next year. If it is a Republican friendly to Capitalism, like Rand Paul or Mitt Romney, we will know for certain that there will be good, growth-promoting tax and spending reforms. A more mainstream-oriented Jeb Bush or Chris Christie would also be good, but not only second-tier good.

Even a fiscally conservative Democrat would be preferable to the kind of leadership they have in Europe.

Hopefully, there can be some libertarian-inspired change for the better in Britain thanks to the seemingly unstoppable UKIP. Maybe – just maybe – that could inspire a surge of support for libertarian ideas elsewhere in Europe.

EU Still Wrong on Economic Crisis

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

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

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

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

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

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

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

Austerity, as designed and executed in Europe, was aimed not at shrinking government but making it affordable to an economy in crisis. The end result was a permanent downward adjustment of growth, employment and prosperity. In order to get their economy out of this perennial state of stagnation, Europe’s leaders need to understand thoroughly the relations between government and the private sector.

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

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

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

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

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

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

Europe’s Shortsighted Fiscal Policy

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

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

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

First out is an article from Euractiv a month ago:

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

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

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

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

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

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

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

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

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

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

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

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

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

Think Eastern Europe under Soviet rule.