The global economy is gradually becoming more disparate. The United States and Japan are pulling ahead while Europe is in a permanent state of stagnation and China is likely going to experience its first, real industrialized recession ever.
In this structurally changing world there is a need for thought leadership, both nationally and globally. We have institutions that, at least to some degree, where created for that purpose. The International Monetary Fund is a good example. Unfortunately, the IMF is not taking a lead, echoing instead much of the same analysis and arguments heard from the national governments whose macroeconomic ineptitude created this long crisis in the first place.
A good example of the Fund’s attitude is put on display in a new report where the managing director of the IMF notes that:
the IMF’s World Economic Outlook had trimmed its growth forecasts for the global economy. “In the face of what we have called the risk of a new mediocre, where growth is low and uneven, we believe that there has to be a new momentum and that is what we will be discussing with the membership in the coming days. “This new momentum—with, hopefully more growth, more jobs, better growth, better jobs—is certainly something we would call on the membership to produce,” Lagarde declared.
So what is the IMF’s idea on how to get the world economy growing again? Well, Lagarde said…
the IMF has noted growing country specificity in its analysis, where within each group of economies some countries are progressing and others are lagging behind. She said the IMF recommends action in three particular areas. Monetary policy where, particularly in the euro zone and Japan, more accommodative monetary policy is needed going forward to support the economy.
This is actually the wrong recipe. Europe is already profusely accommodating with a stretched-to-the-limit monetary expansion totally unbecoming of what the founders of the ECB had in mind. Accommodation policies are in fact so bad that the euro zone is now over-saturated with liquidity and interest rates on bank overnight lending have gone negative.
None of this has helped. There is no sign on the European horizon that real-sector activity has picked up. Instead, it looks very much as though Europe has now entered its own version of the Japanese decade. After almost 15 years of a combination of stagnation, deflation and liquidity saturation, the economy has now finally entered a recovery phase. But there is no doubt whatsoever that the very protracted monetary expansion period put a lid on real-sector activity, precisely the opposite of what was intended.
The mechanisms that brought about the Japanese decade were those that Keynes specified when he defined the liquidity trap. The mechanics of the trap are important, but a topic for a separate article. What is important here is that IMF managing director Lagarde no doubt disagrees with the Keynesian analysis and, despite lack of evidence in her favor, suggests that yet more liquidity supply would get the European economy going again. That does not bode well for the Europeans.
But what about fiscal policy? Well, says the report,
more growth-friendly measures can be put in place as outlined in the IMF’s latest Fiscal Monitor that called attention to fiscal policies adjusted to support job market reforms.
No word about the need for lower taxes, more reforms promoting private deliveries on government promises. No word on how structurally over-bloated welfare states have put an unbearable burden on the welfare state in the vast majority of the world’s industrialized nations.
The IMF should be a thought leader on these issues. Instead, it has become a service organization for countries that have become stuck in a permanent state of anemic growth, recommending 20th century solutions to 21st century problems.
Europe keeps struggling with its impossible balanced-budget endeavor.
In a desperate attempt to save the welfare state while also balancing the government budget they keep destroying economic opportunity for their entrepreneurs and households. This leads to panic-driven spending cuts combined with higher taxes, the worst alternative of all routes available to a balanced budget. The reason – and I keep emphasizing this ad nauseam – is that they desperately do not want to remove the deficit-driving spending programs.
To break out of the shackles of their self-imposed welfare-statist version of austerity, some European politicians have suggested that the EU needs to revise the rules under which member states are brought into compliance with the Union’s balanced-budget amendment. This is not viewed kindly among the Eurocrats in Brussels. From Euractiv:
The European Commission will not let EU budget discipline rules be flouted, incoming economic affairs commissioner Pierre Moscovici said on Monday (29 September), days after his former colleagues in the French government said Paris would again miss EU targets. Last year, European Union finance ministers gave Paris an extra two years to bring its budget deficit below the EU ceiling of 3% of national output after France missed a 2013 deadline in what is called the ‘excessive deficit procedure’. But earlier this month, the French government said it would not meet the new 2015 deadline either and instead would reduce its budget shortfall below 3% only in 2017.
They certainly could meet the deadline, and they could do it even faster than proposed. All they would need to do would be to chainsaw the entire government budget until what is left fits within the three-percent rule. However, they know they cannot do that, for two reasons. The first is simple macroeconomics: so long as you do not cut taxes, any spending cuts will mean government takes more from the private sector and, relatively speaking, gives less back. That reduces private-sector activity and thus exacerbates the recession.
The second reason is that when half or more of the population depend on government for survival, you can only do so many spending cuts before they set the country on fire. The solution is a predictable way out of dependency, one that gives people an opportunity to become self sufficient without suffering undue, immediate financial hardship. That excludes tax hikes and sudden spending cuts – but on the other hand it mandates structural spending cuts that permanently terminate entitlement programs.
However, this solution to their unending economic crisis keeps eluding Europe’s policy makers.
I am a strong supporter of the United States armed forces, which are the world’s most powerful force for liberty. But war and other armed conflicts are costly in more ways than one; there is a much more efficient way to break down tyranny.
The world’s largest authoritarian regime, China, is slowly but steadily reforming in the right direction. The underlying force moving China in the right direction is, plainly, economic freedom. When people are free to own property, be entrepreneurial, build wealth and pursue a lifestyle above what a state-run economy can provide, they will eventually demand political freedom as well. The Chinese leaders know this, but they also know that political freedom can be destructive if introduced before a country is ready for it. They wisely and fearfully look at what happened in Russia after the collapse of the Soviet Union, where political freedom preceded economic freedom – and economic freedom was introduced haphazardly.
But the benefits of economic freedom are not just limited to authoritarian nations. Other countries where government plays a destructively large role can also benefit substantially from a new dose of economic freedom. As I explain in my new book Industrial Poverty, Europe is going backwards as an economy because of persistent efforts by the political leadership to preserve the welfare state and all its big spending programs – not to mention its high taxes.
Economic freedom comes in many forms: deregulation, termination of spending programs, tax cuts… and free trade between sovereign nations. Often, free trade can be an inroad for economic freedom to open up heavily regulated economies. In Europe’s case, free trade with more regions of the world could give some entrepreneurs opportunity to thrive when the domestic economy is holding them back.
Therefore, it would be good if the EU could ratify its pending free trade agreements with the United States and Canada. Unfortunately, it does not look like that is about to happen, at least any time soon. And the reason is a section of the trade agreements that protects private investments under certain conditions. The EU Observer reports:
Provisions allowing companies to sue governments to protect their investments must be taken out of an EU-Canada trade agreement (Ceta), German chancellor Angela Merkel’s coalition partners have said. Speaking in the Bundestag on Thursday (25 September), Sigmar Gabriel, who leads the centre-left SPD, noted that “the chapter regarding investment protection is not approvable,” adding that “the last word hasn’t been spoken yet”.
So what is this investment protection that the European left is so passionately opposed to? Here is how the Office of the United States Trade Representative explains it:
[The U.S. government] seek to ensure that Americans investing abroad are provided the same kinds of basic legal protections that we provide in the United States to both Americans and foreigners doing business within our borders. One element we use to achieve that goal is investor-state dispute settlement (ISDS). ISDS creates a fair and transparent process, grounded in established legal principles, for resolving individual investment disputes between investors and states. … Over the last 50 years, nearly 3,200 trade and investment agreements among 180 countries have included investment provisions, and the vast majority of these agreements have included some form of ISDS. The United States entered its first bilateral investment treaty (BIT) in 1982, and is party to 50 agreements currently in force with ISDS provisions.
Another point made by the U.S. Trade Representative is that the ISDS does not allow any government regulations at all. As anyone even remotely familiar with the United States economy would know, that is absolutely false. We have our own (un-)fair share of regulations. All that the ISDS does is protect private investors from arbitrary, authoritarian government intrusions into the realm of free enterprise.
The European interpretation of ISDS is a bit less forthright. The EU Observer again:
celebrations are likely to be muted now that the [Canada-EU trade] agreement, which is widely seen as a trial run for the ongoing trade talks with the US, faces a number of obstacles before it is ratified. The mechanism, known as investor state dispute settlement (ISDS), allows companies to take legal action against governments if their decisions risk undermining their investments. Critics of ISDS claim that investor claims can prevent governments from passing legislation in fields such as environmental and social protection, enabling corporations to claim potentially unlimited damages in “arbitration panels” if their profits are adversely affected by new regulations.
The part about “unlimited damages” is patently absurd. It would require a forecast for the investment in question that credibly predicts endless profits. But you do not need to study finance or economics to realize that such forecasts simply do not exist. That would require something called “perfect foresight”, an ability of economic agents to predict the world with absolute certainty.
But as the EU Observer reports, reason and good analysis do not prevent leftist hardliners from acting according to their beliefs:
Deputies from the centre-left Socialist and Democrat group and the Liberals have indicated that ISDS would have to be left out in order for them to support Ceta, while the Green and far-left GUE factions have already come out against the treaty. … In a statement on Thursday, the European trades union congress (ETUC) said that it would not support Ceta if ISDS remained part of the agreement. The ETUC also called on officials to include a list of sectors that would not be liberalised by the agreement and for Canada to sign up to the International Labour Organisation Conventions.
The EU Commission appears to be determined to complete the trade agreement with Canada. However, the left-bound winds in the EU Parliament are a guarantee for a protracted battle. This is unfortunate, since the EU is in dire need of strengthening its economy. In lieu of advancements for economic freedom inside the EU, a couple of trans-Altantic free-trade agreements would be of great help.
In Europe, frustration is growing almost by the day over the endemic recession. Unemployment is an unending problem, especially among the young, which at least in part explains the rise of the EU skeptics all over the continent. The only solution to the perennial crisis that Europeans seem to be able to come up with is to keep growing government, an idea that would only compound the continent’s structural economic problems and send them further into the territory of industrial poverty and stagnation.
Unsurprisingly, earlier this month the European Central Bank weakened its growth forecast. There is absolutely no doubt that this was an unwelcome piece of news at the time, and frustration among the EU leadership over the stagnant economy has only been growing since then. This is especially true of the central bankers at ECB, an institution that is making increasingly risky policy decisions the longer the crisis persists. The EU Observer explains:
European Central Bank (ECB) chief Mario Draghi has said he is prepared to use more unconventional measures to spur growth in the eurozone. “We stand ready to use additional unconventional instruments within our mandate, and alter the size and/or the composition of our unconventional interventions should it become necessary to further address risks of a too-prolonged period of low inflation,” he told MEPs on Monday … He said loose monetary policy will only be stopped “when we have complied with our mandate” which is to keep inflation at close to 2 percent. Currently inflation is at 0.4 percent.
It is important to remember that the ECB was created in the late 1990s as an institution of monetary conservatism. Its policy goal was limited exclusively to the preservation of price stability. It had no authority to provide funds to governments that ran deficits in excess of the balanced-budget requirement in the EU constitution (a.k.a., the Stability and Growth Pact). It was also beyond the bank’s realm of authority to fight unemployment, which meant a ban on trying to stimulate GDP growth.
Today, the ECB has broken through every boundary on its policy mandate. It has participated in vast funding schemes for deficit-ridden states in the euro zone. It has issued a guarantee to buy an unlimited amount of Treasury bonds issued by any “troubled” euro-zone state, thus de facto making a promise for future monetary expansion way beyond what the Federal Reserve ever did during the height of its QE programs.
The ECB has also cut interest rates on overnight liquidity deposits that banks make with the ECB. These interest rate cuts have gone so deep that they are now negative: banks literally have to pay the ECB to accept deposits.
The last move reeks of desperation. But doing all this has not been enough of a monetary expansion to get the EU economy going, so the bank added a program for favorable lending that was supposed to provide funding for entrepreneurs eager to make massive expansions to their operations – all they lacked was the cash to do it.
Or so the ECB thought. The EU Observer again:
The ECB has taken a series of steps since the summer to try and boost the economy and head off deflation, including interest-rate cuts and cheap loans to banks. In early September the Frankfurt-based bank cut rates further and announced it planned to buy asset backed securities (ABS). However its lending programme was deemed to have faltered when 255 eurozone banks last week only borrowed €82 billion of the €400 billion available.
And why did they not borrow more? Well, according to Draghi banks are afraid to look less solvent than they must in the upcoming “stress tests”. There is actually a grain of truth in that: banks that borrow but cannot lend won’t make any money on the interest margin. However, what Draghi fails to mention is that banks cannot find people and businesses to lend to simply because Europe’s families and entrepreneurs live in a stagnant economy. So long as stagnation prevails there will be no prospect of profits on new business investments.
In fact, according to Eurostat national accounts data, gross fixed capital formation – the national accounts variable that reports productive business investments – has been falling almost uninterruptedly since 2008. In fixed prices the decline is 16.8 percent from ’08 to 2013.
By contrast, data from the U.S. Bureau of Economic Analysis shows that businesses in the United States increased their investments in 2013 over 2008. The increase was a marginal 1.9 percent, adjusted for inflation, but that is a major sign of health relative European business investments.
To make the difference even more clear: in Europe gross fixed capital formation has decreased in five of the past six years since the Great Depression started; in the United States it has increased in four of the past six years.
No wonder Mario Draghi is getting desperate. But he has now effectively run out of options, proving what I said already in early June: Europe is now officially in the liquidity trap. That means two things: monetary policy is completely impotent and there will be no way out unless and until legislators reform away the enormous and very burdensome welfare state. And those reforms will not happen. So long as the welfare state remains, people are massively disincentivized from working and incentivized to live on welfare. The government budget is structurally in deficit and the massive supply of liquidity in the economy makes it very cheap for government to do nothing about that deficit.
I have said it before, sometimes frustratedly, that Europe is becoming the next Latin America, an economic wasteland filled with the remains of squandered prosperity. But while parts of Latin America are rising again (think Chile and Brazil) Europe continues its slow decline. And the ECB’s desperately-cheap-money policies are not exactly helping.
Scottish voters narrowly said no to independence. This was the better outcome: an independent Scotland governed by the Scottish National Party and Labour would have build a full-fledged Scandinavian welfare state, paid for in good part with revenue from oil taxes. It would have been a bad deal for the Scottish people, especially since they were apparently planning on staying part of the EU.
By remaining part of the United Kingdom the Scotsmen will be better off the day Britain leaves the EU. British taxes are still at the lower end in Europe, its welfare state is not quite as elaborate as in, e.g., Scandinavia and there is still a tradition of individual responsibility and opportunity left there. By seceding from the EU, Britain would have a future at least as bright as that which lies ahead for the United States once we are through this laggard recovery and back in full gear again.
In fact, the list of reasons for member states to leave the EU grows longer almost by the day. The latest addition is the so called “youth guarantee”, a feeble and typically statist idea to reduce youth unemployment. From the EU Observer:
Outgoing EU commissioner for employment Laszlo Andor on Wednesday (17 September) defended EU-wide efforts to tackle youth unemployment amid critical remarks from MEPs. Andor told deputies that the so-called youth guarantee “is well on track and is already bringing results”. He noted many of the programmes in the policy are set for adoption this year. He also said national authorities expected to send the commission “concrete information” by the end of the month on the estimated number of young people who stand to benefit. Submitting and getting the commission to adopt operational programmes is important because it entitles member states access to EU funding.
This is a good summary of what the “youth guarantee” is all about. The EU taxes its citizens (visa member states) then spends the money on putting young men and women on subsidized employment. Employers get cheap labor that they could not afford without the subsidy – and cannot afford when the subsidy ends – while government can formally count the tax-sponsored “employees” as no longer unemployed.
This is a classic example of “active labor market policy”, ALMP. Like most other bad economic ideas it has its roots in Sweden, which by the way at 27.6 percent has the eighth highest rate of youth unemployment in the EU (according to Eurostat, second quarter 2014).
The EU Observer again:
So far only France and Italy fit the description. Launched last year, the guarantee is the EU’s response to persistent record high unemployment rates among the under-25s. It aims to find young people work or training within four months after graduation or after being laid off. “In principle the youth guarantee is a very positive thing for young people, but national leaders lack the political will and ambition to properly implement it,” Allan Pall, secretary general of the Brussels-based European Youth Forum, told this website.
Of course they do. The EU has created this and expects that member states share the cost for it. First Brussels strong-arms member states into jobs-destroying austerity programs – thus saving the welfare state at the expense of full employment – then Brussels comes back and tries to mandate that those same member states spend money on artificial, tax-subsidized employment for the young men and women who could not find jobs because of austerity.
Back to the EU Observer:
Meanwhile, the jobless trend remains stubborn with one in two youths still unable to land a job in either Greece or in Spain. Spain (53.8% in July 2014) now has the highest youth unemployment numbers, overtaking cash-strapped Greece (53.1% in May 2014). Italy, Croatia, Portugal, and Cyprus are not far behind. Overall EU numbers indicate that more than one in five young people still cannot find a job.
Here are the numbers from Eurostat for the EU states that so far have reported youth unemployment for the second quarter of 2014:
It is worth noting that the Greek unemployment rate has fallen almost ten percentage points in two years. A good part of the reason, though, is that young Greeks emigrate, even to such formerly deplorable economies as Romania.
Overall, the youth unemployment rate in EU-28 is 21.7 percent and 22.9 for the 18-state euro zone. By comparison, America’s youth unemployment rate has fallen to 13.5 percent, down 3.1 percentage points in a year. That is twice the reduction in the EU-28. But more importantly, of the 26 reporting EU states, seven saw youth unemployment rise in the past year, and that includes Germany. The Netherlands reported unchanged unemployment since second quarter 2013 and only eight states reported a decline bigger than that in the United States.
To further highlight the lack of an EU-wide trend of declining youth unemployment, please note that almost one in three young men and women who went from unemployment in Q2 of 2013 to a job in Q2 of 2014 lived in Britain. In Q2 of 2013 Britain was home to only 9.3 percent of all the unemployed youth in the EU, a fact that reinforces the point that Britain, with its strong currency, moderate taxes and Anglo-Saxian economic and social traditions, does not belong in the European Union. It belongs in a trans-Altantic relationship with its culturally proximate friends in North America.
As for the rest of the EU member states, they would be well advised to develop an orderly plan for dissolving the super-state structure before Marine Le Pen becomes the next French president and destroys the euro by reintroducing the franc.
The political momentum has definitely turned against a unified Europe. Exhibit #1 is the referendum in Scotland:
Travelers to Scotland, beware. In buses, pubs and street rallies, people have only one thing on their mind these days: Scottish independence. They wear bumper stickers with “Yes” or “No thanks”, dye their hair white and blue, sing folk songs and hand out leaflets. Posters are everywhere. For the yes camp, it is about a nation going its own way, breaking away from a political elite in Westminister. To “naysayers”, it is a foolish decision instigated by populists, that will ruin two nations for generations to come. Both camps are virtually equal, with pollsters saying the referendum on Thursday (18 September) can go either way. The referendum will also have an impact on other independence-minded regions in the EU, such as Catalonia in Spain and Flanders in Belgium. Scotland will set a precedent for how Brussels deals with territories breaking off from an EU member state.
Alas, Exhibit #2, the independence movement in Catalonia:
Around 1.8 million Catalans took to the streets of Barcelona on Thursday (12 September) calling for the right to vote on independence. The demonstration marks the beginning of a critical period in Barcelona-Madrid relations. Dressed in red and yellow – the national colours – people shouted “in-inde-indepedencia!” and “volem votar!” (we want to vote) while waving the Catalan independence flag. Almost a quarter of the 7.5 million Catalans celebrated Catalan National Day – La Diada – in the streets of Barcelona, according to the local police forces. The day commemorates Catalonia’s loss of independence in the War of the Spanish Succession in 1714, exactly 300 years ago. Earlier this year, the Catalan Parliament voted two-thirds in favour for a consultative referendum to be held on 9 November, asking the Catalans “whether Catalonia is a state” and “if yes, whether that state should be independent”. The central government in Madrid, however, has said that it has ”all the mechanisms in place” to prevent such a vote.
Catalonia is the most prosperous region in Spain, having paid a big price for the country’s ill-designed austerity measures. It would be foolish of the Madrid government to try to suppress the Catalonian independence movement. A much better way forward is to recognize the undercurrent of anti-EU sentiments that also fuel this independence movement. The harsh austerity policies over the past couple of years where imposed on Spain by Brussels; if Spain was independent of the EU or at least had the backbone to stand up to their mad policy ideas the Catalonians would have much less of a reason to want to secede.
Anti-EU sentiments also played a major role in Sweden, our Exhibit #3. Last Sunday’s election sent nationalist Swedish Democrats skyrocketing to a position as the nation’s third largest party. In addition to their criticism of the current immigration policies in Sweden, the SD party is the only outspoken party against Swedish EU membership. They loosely resemble other EU-critical parties, such as Exhibit #4 in Germany:
Germany’s anti-euro party Alternative for Germany (AfD) got a further boost on Sunday (14 September) entering two more state parliaments following regional votes. “We are a party that is renewing the political landscape in Germany where people turn their back to traditional parties that have lost their profile,” said AfD party head Bernd Lucke. “One can’t deny it anymore: the citizens are thirsting for political change,” he added. Preliminary results suggest the right-wing party secured around 10.6 percent of the vote in Thuringia state and 12.2 percent in Brandenburg. The two states are traditionally seen as a power base of support for Chancellor Angela Merkel’s Christian Democrats. Founded 19 months ago, the AfD manifesto calls for a scrapping of the euro in favour of the German Deutsche Mark. The eurosceptic party has strongly criticised the eurozone bailouts and opposes the concentrated power base of the EU institutions in Brussels.
So long as the economic crisis continues it will be close to impossible for pro-EU politicians to gain back the momentum. And, as I have repeated ad nauseam, the crisis will not end until they structurally reform away the welfare state. Which, again, won’t happen.
The sad part of this is that the movements trying to roll back the EU for the most part want to do it to protect their national welfare states from EU-imposed austerity. The only real exception is UKIP which fundamentally is a libertarian party. But everywhere else the goal is to localize control over fiscal policy so that they can perpetuate their own version of the standard, redistributive welfare state.
In short: the way things are going now it is a safe bet that the EU will be history long before the European welfare state.
Today my book Industrial Poverty: Yesterday Sweden, Today Europe, Tomorrow America is officially available. You can order it directly from the publisher or through Amazon. An ebook version is on its way out, too, but why wait when you can get the real thing now?
In his foreword, Cato Institute senior fellow Michael Tanner writes:
Larson provides convincing evidence that the welfare state, and misguided policy choices by Europe’s governments, turned a regular recession into a systemic economic crisis. During the seemingly prosperous first years of the European Union, few people could foresee the problems ahead, and even fewer viewed these developed countries as struggling with a form of poverty. However, during this stubborn economic recession, GDP growth in many European countries slowed (or even stopped), private consumption stalled, government spending surged, and unemployment rates among the young increased. This book helps us to better understand the current situation facing Europe today, one far more complicated than the austerity versus stimulus dichotomy that is so often imposed.
And that is the most important point I hope readers will take away from this book. Europe’s crisis is not just a recession – it is the result of decades of bad policy compounded slowly into an ultimately unbearable burden for the private sector. There is plenty of evidence for this. Europe’s decline during the Great Recession is not new, but the logical continuation of four decades of slow but inevitable stagnation. The U.S. economy is on a similar, but more recent trajectory and still has the dynamics to recovery (albeit modestly) from the recession.
With slower growth it becomes more difficult for Europeans (and Americans) to increase, and eventually maintain their high standard of living. Stagnant economies also produce less surplus that can be used for aid to poor nations, either through government or through charitable donations. Trade also suffers negatively, hitting primarily low-income nations first.
Another side of economic stagnation with global repercussions is high, persistent unemployment. More than one in five young men or women in the European Union is unemployed. Overall unemployment remains stubbornly above ten percent. While the United States is experiencing declining unemployment rates, job growth is still far from as strong as it normally would in a recovery. With unemployment remaining high, it becomes increasingly difficult for Europe to provide opportunities for immigrants from poorer parts of the world.
With the two largest economies in the world tentatively on a path to long-term stagnation, the consequences for the rest of the world could be serious, especially in terms of the ability to provide disaster relief, aid and development funds. This paper suggests that the long-term stagnation is the fault of the industrialized countries. Given that the people of the prosperous nations of the world have a moral obligation to help those in abject poverty, it is immoral to fail to address the cause of long-term stagnation.
In other words, what is happening in Europe is not just a matter for the poor 500 million souls who live there, but for the rest of the world. It is of vital importance to all of us that Europe today, and the United States very soon, get their macroeconomic act together and remove the hurdles to growth and prosperity that the welfare state has created.
Yes, the welfare state. It is the root cause of Europe’s many problems. Their crisis is, to put it plainly, self inflicted. Over its more than half-century long life, the welfare state has fundamentally transformed large parts of the economic landscape. It has changed work incentives by means of both taxes and entitlements. Income-security programs, much larger in Europe than in the United States, have weakened people’s motives for participating in the workforce. The redistributive nature of the income-tax system discourages entrepreneurship and the pursuit of high-end professional careers.
Self determination and innovation are replaced by sloth and indolence.
This is a new perspective on the European crisis, a perspective that I spend my entire book explaining. The usual question “why isn’t anyone else saying this?” is easily answered: it is only recently that we have access to enough information, enough economic data, to piece together a hypothesis about the welfare state’s long-term effects on its host economy. Especially in view of the Great Recession it is now possible to study broader economic trends and the long-term macroeconomic effects of the institutions that constitute the welfare state. In this new wealth of information, a pattern is emerging, suggesting that while the welfare state can have short-term positive effects on economic growth, its long-term effects are undeniably negative.
In particular, it now appears to be possible to identify a “point of no return” beyond which the welfare state pushes an economy over the line, from the realm of GDP growth into perennial stagnation.
For more on that, and for more on what life looks like under Industrial Poverty, buy my book today!
On Friday I reported that the European Central Bank has downgraded its growth forecast for the euro zone. This wraps up a summer of bad economic news from Europe, all together showing that there is no recovery under way. At the same time, as I have explained in a series of blogs elsewhere (Ode to the American Economy, parts one, two and three), the United States continues its sleepwalk out of the Great Recession.
The differences between the U.S. and EU economies are striking. A review of the most recent Eurostat quarterly national accounts data shows that the American economy is not only outgrowing its European counterpart, but it is also in the healthier position of being dominated by consumer spending.
Let us begin with GDP growth (using the single-currency euro zone as the proxy for Europe):
Over the past 20 years for which Eurostat provides quarterly, inflation-adjusted data, there are three episodes where the United States outgrows Europe. The first episode was the heydays of the ’90s, when our unemployment was trending below four percent. Europe was struggling with twice as high unemployment rates and, in fairness, the remaining issues with Europe’s reunification. That said, with the right fiscal policies the 18 current euro-zone countries could easily have enjoyed the same forceful growth as the U.S. economy was producing.
The second episode of faster U.S. growth comes between the Millennium and Great Recessions. Many would attribute this to the housing bubble, and I am inclined to agree to some extent. However, it is important not to forget the Bush tax cuts, which in two phases – 2001 and 2003 – created a one-two punch of multiplier and accelerator effects on economic activity.
Unfortunately, this was also a period of excessive federal spending. The U.S. government grew its budget by 6.7 percent per year, on average, from 2001 to 2009, with the heaviest spending growth allocated to the latter half of that period. Indirectly, this drew resources away from private-sector growth, which partly explains the weakening of GDP growth from the top in early 2004.
As for Europe, the bump in growth right before the Great Recession is not easily explained. As shown in the two charts below, neither consumption nor exports were strong enough to produce that bump.
The third episode of American dominance is the one we are in right now. Amazingly, at a GDP growth rate mostly below 2.5 percent per year, we are leaving Europe in the dust. The difference is easily explained: after the serious dip early in the recession, U.S. fiscal policy has basically been neutral, with only marginal movements in taxes and spending. In fact, after the American Recovery and Reinvestment Act, President Obama has been the fiscally most frugal president since before Reagan. The states have also held back their spending, and even though most states still struggle with budget problems the overall trend in taxation is weakly in favor of lower taxes.
From this viewpoint the American economy has actually for the most part benefited from the Congressional deadlock and President Obama’s passion for playing golf. Our federal government is doing the American economy a favor by doing nothing. It would of course, be better if they cut taxes, reformed away entitlement programs and deregulated, but in lieu of that it is better that they continue to do nothing while we go about our business and slowly bring this economy back to something that resembles full employment.
Europe, on the other hand, is continuing to suffer from years of government-saving austerity. Their tax hikes and spending cuts have been motivated by a desire to keep as much as possible of the welfare state through the Great Recession, with little or no regard for what happens to the private sector. The European people and their businesses are now paying the price in the form of almost zero growth, eleven percent unemployment and a grim outlook on the future.
Adding insult to this national-accounts injury, the next chart shows the role of private consumption in each of the two economies:
There is a simple way to show the importance of private consumption in an economy. Subtract GDP growth from the growth rate of private consumption per period observed, in this case quarters. Sum up the difference per period and divide by the number of periods. If the resulting number is negative, it means that GDP grows faster on average than private consumption; if it is positive the opposite is true. An economy where consumption grows at least as fast as GDP is an economy where the consumer is the key economic agent, where he enjoys a high degree of economic freedom and where, therefore, the free market is a major player in the rest of the economy. In a consumption-drivene economy, the dominating end purpose of productive economic activity is to win over consumer spending on a free market, hence private businesses have to operate as free-market entities as well.
The U.S. consumption growth ratio is 1.3, meaning that for the period observed here, private consumption growth exceeds GDP growth by 1.3 percent per quarter, on average. By contrast, the euro-zone economy has a ratio of -0.7, showing that growth is driven by other variables than private consumption.
Is that “other variable” exports? Let’s take a look:
Interestingly, since the Millennium Recession there has been no major difference in the growth rate of U.S. exports and exports from euro-zone countries. The growth rates are high, especially compared to GDP growth, which means that for the slow-growing euro-zone economy the exports sector has helped keep growth up. This explains why GDP in the euro-zone countries outgrow their own private consumption, but since strong exports growth does not translate into household spending (if it did, private consumption would grow on par with exports) this means that the euro-zone economies are increasingly dependent on foreign markets to grow at all.
With its strong private-consumption growth, the U.S. economy has a big leg up on the European economy. We are, simply, a domestically dominated economy and are much less vulnerable to ups and downs of the international business cycle. Europe’s GDP, on the other hand, basically stands and falls with spending on other continents.
Furthermore, with as big a government sector as the Europeans have, their austerity policies which raise taxes – thus diminish the private sector – and cut government spending actually depress GDP in two ends.
The compounded effect on GDP is, as shown here, rather depressing. Pun intended.
Analysts are grasping for explanations of why the European economy has once again stalled. The European Central Bank, which has lowered its forecast for GDP growth in the euro zone, suggests that this weakening is not part of a trend, but an aberration from a trend:
First, activity in the first quarter was subject to an unusual upward effect from the low number of holidays (as the entire Easter school holiday period fell in the second quarter) and from the warm winter weather that had boosted construction. Neither of these upward effects in the first quarter was sufficiently captured by seasonal or working day adjustment. As they unwound in the second quarter, this dampened growth. Second, negative calendar effects related to the more than usual number of “bridge days” around public holidays in many euro area countries may have reduced the number of effective working days in May, a factor that was not captured by the working day adjustment.
I have a lot of respect for the macroeconomists at the ECB, but frankly, this is below what we should expect of them. Calendar days and weather always vary – some claim that the bad performance of the U.S. economy in the first quarter of this year was due to the unusually cold winter. In reality, that growth dip was more than likely the result of businesses trying to adjust to the impact of Obamacare. By contrast, the slow growth numbers in the European economy are part of a trend of economic stagnation. A 30,000-foot review of what the European economy looks like is a good way to become aware of that trend.
The profession of economic has to some degree drifted away from the bigger-picture thinking that characterized its earlier days in the 20th century. While econometrics is important, there is too much emphasis on it today, drawing attention away from longer, bigger trends and the kind of institutional changes that characterize Europe today. Based on this broader analysis, my conclusion stands: Europe is not going to recover until they do something fundamental about their welfare state. Or, more bluntly: so long as taxes remain as high as they are and government provides entitlements the way it does, there is no reason for the productive people in the European economy to bring about a recovery.
The problem with short-sighted, strictly quantitative analysis is that it compels the economist to keep looking for a reason why the economy should recovery, as if it was a law of nature that there should be a recovery.
This problem is reflected in the ECB forecast paper:
Regarding the second half of 2014, while confidence indicators still stand close to their long-term average levels, their recent weakening indicates a rather modest increase in activity in the near term. The weakening of survey data takes place against the background of the recent further intensification of geopolitical tensions (see Box 4) together with uncertainty about the economic reform process in some euro area countries. All in all, the projection entails a rather moderate pick-up in activity in the second half of 2014, weaker than previously expected.
It would be interesting to see the results of a survey like this where the questions centered in on the more long-term oriented variables that focused on people’s ability and desire to plan their personal finances. I did a study like that as part of my own graduate work, and the results (reported in my doctoral thesis) were interesting yet hardly surprising. When people are faced with growing uncertainty they try to reduce their long-term economic commitments as much as possible. This results in less economic activity today without any tangible commitment to future spending.
Since I do not have the resources to study consumer and entrepreneurial confidence in Europe at the level the ECB can, I cannot firmly say that people in Europe today feel so uncertain about the future that they have permanently lowered their economic activity. However, my survey results corroborate predictions by economic theory, and the reality on the ground in Europe today points in the very same direction. In other words, so long as institutional uncertainty remains, there will be no recovery in Europe.
The ECB does not consider this aspect. Instead they once again forecast a recovery, just as assorted economists have done for about a year now:
Looking beyond the near term, and assuming no further escalation of global tensions, a gradual acceleration of real GDP growth over the projection horizon is envisaged. Real GDP growth is expected to pick up in 2015 and 2016, with the growth differentials across countries projected to decline, thanks to the progress in overcoming the fragmentation of financial markets, smaller differences in their fiscal policy paths, and the positive impact on activity from past structural reforms in several countries. The projected pick-up in activity will be mainly supported by a strengthening of domestic demand, owing to the accommodative monetary policy stance – further strengthened by the recent standard and non- standard measures – a broadly neutral fiscal stance following years of substantial fiscal tightening, and a return to neutral credit supply conditions. In addition, private consumption should benefit from a pick-up in real disposable income stemming from the favourable impact of low commodity price inflation and rising wage growth.
A key ingredient here is “smaller differences in … fiscal policy paths” and “a broadly neutral fiscal stance”. This means that the ECB is expecting an end to austerity policies across the euro zone, an expectation that has been lurking in their forecasts for some time now. But austerity has not ended, nor have the budget deficit problems that brought about austerity. The austerity artillery is not as active now as it was two years ago, but it has not gone quiet. France, e.g., is currently in a political leadership crisis because of the alleged need to continue budget-balancing measures.
France also indicates where the fiscal trend in Europe is heading. If the radical side of the French socialists could have it their way they would chart a course back to big-spending territory. But they would also couple more spending with even higher taxes, in order to avoid conflicts with the debt and deficit rules of the EU Stability and Growth Pact. While technically a “neutral” policy, the macroeconomic fallout would be a further weakening of the private sector – in other words a further weakening of GDP growth.
Another aspect that the ECB overlooks is the effects of the recalibration of the welfare state that has taken place during the austerity years. I am not going to elaborate at length on this point here, but refer instead to my new book where I discuss this phenomenon in more detail. Its macroeconomic meaning, though, is important here: the recalibration results in the welfare state taking more from the private sector, partly in the form of taxes, and giving less back in the form of lower spending. As a result, the private sector is drained, structurally, of more resources, with the inevitable result that long-term GDP growth is even weaker.
None of this is discussed in the ECB forecast paper, which means that we will very likely see more downward adjustments of their growth forecasts in the future.
There would be no problem with the ECB’s erroneous forecasts if it was not for the fact that those forecasts are used by policy makers in their decisions on taxes, government spending and monetary supply. The more of these “surprising” downward corrections by forecasters, the more of almost panic-driven decisions we will see. Alas, from EUBusiness.com:
The European Central Bank cut its forecasts for growth in the 18-country euro area this year and next, and also lowered its outlook for area-wide inflation, at a policy meeting on Thursday. The ECB is pencilling in gross domestic product (GDP) growth of 0.9 percent in 2014 and 1.6 percent in 2015, the central bank’s president Mario Draghi told a news conference. “Compared with our projections in June, the projections for real GDP growth for 2014 and 2015 have been revised downwards,” he said. The bank said inflation was expected to be 0.6 percent this year — a lower rate than the 0.7 originally forecast, Draghi said.
And therefore, the ECB decided to cut its already microscopic interest rates. Among their cuts is a push of the overnight bank lending rate further into negative territory, so that it now stands at -0.3 percent. But all these measures, aimed at injecting more cheap credit into the European economy, will fall as flat on their bellies as earlier interest-rate cuts. The problem is not that there is not enough liquidity in the economy – the problem is, as mentioned earlier, that the European economy suffers from institutional and structural ailments. Those are not fixed with monetary policy. Yet with the wrong analysis of the cause of the crisis, Europe’s policy makers will continue to prescribe the wrong medicine and the patient will continue to sink into a vegetative state of stagnation and industrial poverty.
Last Friday I explained that Europe appears to be on its way back to Big Spending country. One major reason is that the policies practiced so far during the Great Recession have proven to be sorely inadequate. Another reason is that Europe suffers from a bad case of conventional wisdom, the default position of which is that there is nothing more important in the economy than the welfare state. As a result, when austerity policies, specifically designed to save the welfare state, fail to do just that while also failing to reignite the economy, voters and political leaders turn to erstwhile solutions such as more government spending. Led there by conventional wisdom, not solid analysis, they are certain to only do more harm to an already ailing patient.
In this situation, clear and crisp crisis analysis is more important than ever. That is the only way to a working solution to the crisis. Unfortunately, the road to such solutions still runs through analytical neighborhoods where arguments about what cause the crisis sprawl in all directions. My blog article from last Friday quoted one example, Dan Steinbock of the India, China and America Institute. This week, Steinbock continues his contribution in the EU Observer::
In the United States, the global financial crisis was unleashed by real estate markets and the financial sector, which caused a dramatic contraction and massive mass unemployment.
That is a superficial explanation. The root cause was a fundamental misinterpretation of a macroeconomic trend. From the late 1970s through the Millennium recession the swings in the American business cycle gradually became weaker. This has been interpreted as a shift to more stable growth, which policy makers in the United States used as a basis for liberalizing the country’s credit markets. One part of this liberalization was an expansion of subprime mortgage lending, a reform that makes sense if the expectation is high GDP growth and as a result high growth in disposable income, then the risks associated with subprime lending are well contained. The debt-to-income ratio would not reach alarming levels, perhaps not even grow at all.
There was just one problem. The trend that was interpreted as growth stabilization was also a trend of weakening growth. In the 2000s the American economy grew at about half the pace of the ’90s. This led to a relative weakening of the ability of American households to keep up with debt payments. Therefore, it is incorrect to say that this was a financial crisis – it was a macroeconomic crisis that was mismanaged and misinterpreted by key political leaders.
It is important to keep this in mind, because it has consequences for how to get the U.S. economy out of the Great Recession. Steinbock lauds the Obama administration for its “stimulus package”, which…
included spending in infrastructure, health and energy, federal tax incentives, expansion of unemployment benefits and other social welfare provisions. It boosted innovation and supported competitiveness.
Frankly, there is no evidence of this. The bulk of the money spent through the American Recovery and Reinvestment Act went to fill revenue gaps in existing government spending programs, at the federal level as well as in the states. This borrowed money may have prevented a massive tax increase, which would have been the other conventional-wisdom option, but it certainly did not expand spending. On the contrary, what was a temporary jump in GDP growth during the stimulus spending, but as soon as it was over the growth rate reverted to pre-stimulus levels. It was not until late 2013 that the very first signs of some sort of recovery were visible. That recovery, though, which is still continuing, is far weaker than it should have been. Why? More on that in a moment. For now, back to the EU Observer, where Steinbock claims that the United States…
was able to rely on common fiscal and monetary policy. When one state got into trouble, it could turn to others for support. Of course, the crisis supported some states and hurt others, but the common institutions worked.
I have worked for state-based think tanks for eight years now, and I have carefully studied state fiscal policy for at least as long. To be perfectly honest, I have no idea what Steinbock is talking about here.
Let’s continue to listen to him, though. Maybe he makes more sense when he turns to discussing Europe:
When the 2008/9 crisis hit Europe, the core economies relied on their generous social models, but structural challenges were set aside. That ensured a timeout but boosted threats. In spring 2010, the crisis was still seen as a liquidity issue and a banking crisis. So Brussels launched its €770 billion “shock and awe” rescue package to stabilise the eurozone. As the consensus view grouped behind Brussels, I argued that the rescue package was inadequate and the austerity policy too strict. Further, it ignored multiple other crisis points. And it was likely to result in demonstrations and violence in southern Europe.
While he is correct about the political fallout of the crisis, he is far too vague on the economic variables that drove the European economy into the ditch. As I explain in my book Industrial Poverty (order your hard copy now or get your ebook version very soon!) the cause of the European crisis is to be found in the structure of the welfare state. This structural ailment is present in the American economy as well, though not as pronounced, but it explains why the Western economies experienced a growth slowdown in the 1980s (EU) and on the heels of the Millennium Recession (U.S.).
So long as the structural problem remains, there will be no recovery in the European economy. The United States has been able to recover despite the weight of government, an aspect that Steinbock misses. He does, however, make a good point about mistakes made by the European Central Bank:
[The] European Central Bank (ECB), led by its then-chief Jean-Claude Trichet, moved too slowly and hiked rates instead of cutting them. When the ECB finally reversed its approach, precious time and millions of jobs had been lost. Subsequently, Trichet’s successor, Mario Draghi, cut the rates and pledged to defend euro “at any cost.” Markets stabilised, but not without huge bailout packages, which divided the eurozone.
Trying to stuff as many explanations as possible of Europe’s perennial crisis into the same article, Steinbock then proceeds to point in many different directions at the same time:
As Barroso and his commissioners began to argue that “the worst was over,” Brussels hoped to reinforce the trust in euro and the EU and deter the rise of the eurosceptics. But hollow promises resulted in a reverse outcome. What’s worse, both Brussels and the core economies failed to provide adequate fiscal adjustment amidst the global crisis and the onset of the eurozone debt crisis, which made bad mass unemployment a lot worse and continues to penalise demand and investment. Further, neither liquidity support nor recapitalisation of the major banks has mitigated the worst insolvency risks in the region. Unlike in the US, many European economies, including Nordic ones, also continued to cut their innovation investments, thus making themselves even more vulnerable in the future. As the crisis spread to Italy and Spain, which together account for almost 30 percent of the eurozone economy, bailout packages could no longer be used. Rather, structural reforms became vital but since they were seen as a political suicide, delays replaced urgency.
Reduced spending on “innovation” is not nearly as important an explanation of the crisis as the structural fiscal imbalances of the welfare state. It is important to separate what matters from what does not matter. Otherwise, one cannot provide solutions to those who are in the position to put them to work.