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.
Europe’s political leaders are getting increasingly desperate, especially since the European Central Bank’s aggressively expansionary monetary policy is proving ineffective. The more money the ECB prints, the worse the euro-zone economy performs.
The desperation is now at such a level that even the president of the ECB, Mario Draghi, is calling for EU governments to start big spending programs. Writes Benjamin Fox at EU Observer:
The European Central Bank (ECB) is preparing to step up its attempts to breathe life into the eurozone’s stagnant economy. During a speech in the US on Friday (22 August), ECB chief Mario Draghi called on eurozone treasuries to take fresh steps to stimulate demand amid signs that the bloc’s tepid recovery is stalling. “It may be useful to have a discussion on the overall fiscal stance of the euro area,” Draghi told delegates at a meeting of financiers in Jackson Hole, Wyoming, adding that governments should shift towards “a more growth-friendly overall fiscal stance.” “The risks of ‘doing too little’…outweigh those of ‘doing too much’”, he added.
Some trivia first. If you want to be rich, you have a condo on Manhattan. If you actually are rich, you have an oceanfront property in West Palm Beach. If you are genuinely wealthy you have a second home in Jackson Hole. The only people who live in Jackson Hole permanently are dyed-in-the-wool Wyomingites like former Vice President Dick Cheney (a very nice man whom I have had the honor of meeting a couple of times). It is a cold place with short, mildly warm summers and long, unforgiving winters. It is also breathtakingly beautiful.
Now for the real story… There is no doubt that Draghi is beyond worried. He should be: his monetary policy is useless. Europe is in the liquidity trap, and the European Central Bank’s expansionist monetary policy is part of the reason for this. For almost a year now Draghi has pushed the ECB to arrogantly violate the principles upon which the Bank was founded. He has printed money at a pace that by comparison almost makes Ben Bernanke look like a monetarist scrooge. More importantly, the ECB has de facto bailed out euro-zone countries even though that is very much against the statutes upon which the bank was founded. They have pushed interest rates through the floor, punishing banks for overnight lending to the bank, and they have a formal Quantitative Easing program in their back pocket.
Furthermore, the ECB was an active party in the austerity programs designed to save Europe’s welfare states in the midst of the crisis. Those programs exacerbated the crisis by suppressing activity in the private sector in order to make the welfare states look fiscally sustainable. Now Draghi is asking the same governments that he helped bully into austerity to stop trying to save their welfare states and instead be concerned with GDP growth.
Superficially this sounds like an opening toward a fiscal policy that uses private-sector metrics to measure its success. However, it is highly doubtful that Draghi and, especially, the governments of the EU’s member states, would be ready to actually do what is needed to get the European economy growing again. The first part of such a strategy would be to a combination of tax cuts and reforms to reduce and eventually eliminate the massive, redistributive entitlement programs that constitute Europe’s welfare states.
The second thing needed is a monetary policy that does not provide those same welfare states with a large supply of liquidity. The more cheap money welfare states have access to, the less inclined their governments are going to be to want to reform away their entitlement programs. On the contrary, they are going to want to preserve those programs as best they can.
Therefore, the last thing the ECB wants to do right now is to launch a QE program. Which, as the EU Observer story reports, is exactly what the ECB has in mind:
The Frankfurt-based bank is preparing to belatedly follow the lead of the US Federal Reserve and the Bank of England by launching its own programme of quantitative easing (QE) – creating money to buy financial assets.
This comes on the heels of the Bank’s new policy to increase credit supply to commercial banks on the condition that they in turn increase lending to non-financial corporations. The bizarre part of this is that in an economy that is stagnant at best, contracting at worst, there is no demand for more credit among non-financial corporations. It really does not matter if banks throw money after manufacturers, trucking companies, real estate developers… they are not going to expand their businesses unless there is someone there to buy their goods and services. If there is no buyer out there, why waste time and money on producing the product – and why take on debt to do it?
I have reported in numerous articles recently on how the European economy is not going anywhere. Growth is anemic with a negative outlook. Unemployment is stuck at almost twice the U.S. level and the overall fiscal situation of EU member states has not improved one iota despite more than three years of harsh, welfare-state saving austerity.
As yet more evidence of a stagnant Europe, Eurostat’s flash inflation estimate for August says prices increased by 0.3 percent on an annual basis. This is a further weakening of inflation and reinforces my point that unless the European economy starts moving again, it will find itself in actual deflation very soon. But the macroeconomic consequences of deflation set in earlier than formal deflation, as economic agents build it into their expectations. It looks very much as if that has now happened.
Deflation is dangerous, but it is not a problem in itself. It is a very serious symptom of an economy in depression. It is important to follow the causal chain backward and understand how the macroeconomic system brings about deflation. This blog provides that analysis; very few others attempt to do so. Ambrose Evans-Pritchard over at the good British newspaper Guardian has demonstrated good insight, and a recent article by David Brady and Michael Spence of the Hoover Institution provided some very important perspectives. But so far insights about the systemic nature of the crisis are not very widely spread.
The only advice being dispensed with some consistency is, as mentioned, the one about more government spending. Dan Steinbock of the India, China and America Institute is an example of the growing choir behind that idea. He does so, however, in a somewhat convoluted fashion. In an opinion piece for the EU Observer he discusses the macroeconomic differences between Europe and America, though in a fashion that almost makes you believe he is a regular reader of this blog:
Half a decade after the financial crisis, the United States is recovering, but Europe is suffering a lost decade. Why? In the second quarter, the US economy grew at a seasonally adjusted annual rate of 4 percent, surpassing expectations. In the same time period, economic growth in the eurozone slowed to a halt (0.2%), well before the impact of the sanctions imposed on and by Russia over Ukraine. Germany’s economy contracted (-0.6%). France’s continued to stagnate (-0.1%) and Italy’s took a dive (-0.8%). How did this new status quo come about?
He is correct about the American economy widening its gap vs. Europe, he is correct about the Italian economy, about the French economy, and about the stagnant nature of the euro-zone economy. What he does not get right is his answer to the question why the European economy has once again ground to a halt:
[In] the eurozone, real GDP growth contracted last year and shrank in the ongoing second quarter, while inflation plunged to a 4.5 year low. Europe’s core economies performed dismally. In Germany, foreign trade and investment were the weak spots. The country could still achieve close to 2 percent growth in 2014-2016 until growth is likely to decelerate to 1.5 percent by late decade. In France, President Francois Hollande has already pledged €30 billion in tax breaks and hopes to cut public spending by €50 billion by 2017. Nevertheless, French growth stayed in 0.1-0.2 percent in the 1st quarter.
Then Steinbock proceeds to make a brave attempt to explain the depth of the European economic crisis:
Fiscal austerity and falling consumer confidence are preventing domestic demand from rebounding, while investment and jobs linger in the private sector. Pierre Gattaz, head of the largest employers union in France, has called the economic situation “catastrophic.” As France is at a standstill, Paris has all but scrapped the target to shrink its deficit. … The new stance is to avoid an explicit confrontation with Germany, but to redefine austerity vis-à-vis budgetary reforms.
It is unclear what Steinbock means by this. He appears to miss the point that there are two kinds of austerity: that which aims to save government and that which aims to grow the private sector. The two are mutually exclusive, both in theory and in practice. One might suspect that Steinbock refers to the government-first version, since that is the prevailing version in Europe. However, that makes it even more unclear what Steinbock has in mind when he talks about “budgetary reforms” – an educated guess would be the relaxation of the Stability and Growth Pact so that the French government, among others, can spend more frivolously.
Such a relaxation would not contribute anything for the better. All it would do is open for more government spending. Steinbock does not make entirely clear whether or not he recommends more government spending. His article, however, seems to lean in favor of that, and I strongly disagree with him on that point for reasons I have explained on many occasions. Let’s just summarize by noting that if Europe is going to replace government-first austerity with government-first spending, then it opens up an entirely new dimension of the continent’s crisis. That dimension is in itself so ominous it requires its own detailed analysis.
Europe’s version of austerity has been designed exclusively to save the continent’s big welfare states in very tough economic times. By raising taxes and cutting spending, governments in Greece, Spain, Italy and other EU member states have hoped to make their welfare states more slim-fit and compatible with a smaller tax base. The metric they have used for their austerity policies is not that the private sector would grow as a result – on the contrary, private-sector activity has been of no concern under government-first austerity. Unemployment has skyrocketed, private-sector activity has plummeted and Europe is in worse shape today than it was in 2011, right before the Great Big Austerity Purge of 2012.
The criticism of austerity was massive, but not in the legitimate form we would expect: instead of pointing to the complete neglect of private-sector activity, Europe’s austerity critics have focused entirely on the spending cuts to entitlement programs. While such cuts are necessary for Europe’s future, they cannot be executed in a panic-style fashion – they should be structural and remove, not shrink, spending programs. Furthermore, they cannot be combined with tax hikes: when you take away people’s entitlements you need to cut, not raise, taxes so they can afford to replace the entitlements with private-funded solutions. Tax hikes, needless to say, drain dry the private sector and exacerbate the recession that produced the need for austerity in the first place.
This is a very simple analysis of what is going on in Europe. It is simple yet accurate: my predictions throughout 2012, 2013 and so far through 2014 have been that there will be no recovery in Europe unless and until they replace government-first austerity with private-sector austerity. This means, plain and simple, that you stop using government-saving metrics as measurement of austerity success and instead focus on the growth of the private sector. This will rule out tax hikes and dictate very different types of spending cuts, namely those that permanently terminate government spending programs.
Unfortunately, this aspect of austerity is absent in Europe. All that is heard is criticism from socialists who want to keep the tax hikes but combine them with more government spending. A continuation, in other words, of what originally caused the current economic crisis (that’s right – it was not a financial crisis). These socialists won big in the French elections two years ago, gaining both the Elysee Palace and a majority in the national parliament. However, faced with the harsh economic realities of the Great Recession, they soon found that spending-as-usual was not a very good idea. At the same time, they have rightly seen the problems with the kind of government-first austerity that has been common fiscal practice in Europe. Now that their own agenda is proving to be as destructive as government-first austerity, France’s socialists do not know which way to turn anymore. This has led to a political crisis of surprisingly large proportions. Reports the EU Observer:
French Prime Minister Manuel Valls on Monday (25 August) tendered his government’s resignation after more leftist ministers voiced criticism to what is being perceived as German-imposed austerity. The embattled French President, Francois Hollande, whose popularity ratings are only 17 percent, accepted the resignation and tasked Valls to form a new cabinet by Tuesday, the Elysee palace said in a press release. “The head of state has asked him [Valls] to form a team in line with the orientation he has defined for our country,” the statement added – a reference to further budget cuts needed for France to rein in its public deficit.
From the perspective of the European Union, France has been the bad boy in the classroom, not getting with the government-first austerity programs that have worked so well in Greece (lost one fifth of its GDP) and Spain (second highest youth unemployment in the EU). Hollande’s main problem is that by not getting his economy back growing again he is jeopardizing the future of the euro, in two ways. First, perpetual stagnation with zero GDP growth has forced the European Central Bank into a reckless money-supply policy with negative interest rates on bank deposits and a de facto endless commitment to printing money. This alone is reason for the euro to sink, and the only remedy would be that the economies of the euro zone started growing again. Secondly, by exacerbating the recession in France, and by failing endemically to deliver on his promises of more growth and more jobs, Hollande is setting himself up to lose the 2017 presidential election to Marine Le Pen. First on her agenda is to pull France out of the euro; if the zone loses its second-biggest economy, what reasons are there for smaller economies like Greece to stay?
This is why he has now shifted policy foot, from the spending-as-usual strategy of 2012 to government-first austerity. But since neither is good for the private sector, frustration is rising within the ranks of France’s socialists to a point where it could cause a crippling political crisis. Euractiv again:
The rebel minister, Arnaud Montebourg, who had held the economy portfolio until Monday, over the weekend criticised his Socialist government for being too German-friendly. “France is a free country which shouldn’t be aligning itself with the obsessions of the German right,” he said at a Socialist rally on Sunday, urging a “just and sane resistance”. The day before, he gave an interview to Le Monde in which he claimed that Germany had “imposed” a policy of austerity across Europe and that other countries should speak out against it. Two more ministers, Benoit Hamon in charge of education and culture minister Aurelie Fillipetti, also rallied around Montebourg and said they will not seek a post in the new cabinet. In a resignation letter addressed to Hollande and Valls, Fillipetti accused them of betraying their voters and abandoning left-wing policies, at a time when the populist National Front is gaining ground everywhere. According to Le Parisien, Valls forced Hollande to let go of Montebourg by telling him “it’s either him or me.”
Ironically, the main difference between the socialist economic policies and those of the National Front is that the latter want to reintroduce the franc while the former want to stay with the euro. Other than that, the National Front wants to preserve the welfare state, though significantly cut down on the number of non-Europeans who are allowed to benefit from it. The socialists also want to preserve the welfare state, but also open the door for more non-European immigration.
In short, the differences between socialist and nationalist economic policy is limited to nuances. Needless to say, neither will help France back to growth and prosperity.
Meanwhile, according to the Euractiv story there is mounting pressure from outside France on President Hollande to stick with the government-first austerity program:
[The] government turmoil is also a sign of diverging views on how to tackle the country’s economic woes. French unemployment is at nearly 11 percent and growth in 2014 is forecast to be of only 0.5 percent. Meanwhile, French officials have already said the deficit will again surpass EU’s 3 percent target, and are negotiating another delay with the European Commission. The commission declined to comment on the new developments in France, with a spokeswoman saying they are “aware” and “in contact” with the French government. German chancellor Angela Merkel on Monday during a visit to Spain declined to comment directly about the change in government, but said she wishes “the French president success with his reform agenda.” Both Merkel and Spanish PM Mariano Rajoy defended the need for further austerity and economic reforms, saying this boosted economic growth.
Growth – where? What growth is he talking about? But more important than the erroneous statement that the European economy is benefiting from attempts to save the welfare state, France is now becoming the focal point of more than just the future of the current European version of austerity. The struggle between socialists and competing brands of statism is a concentrate of a more general political trend in Europe. The way France goes, the way Europe will go. While the outcome of the statist competition will make a difference to immigration policy, it won’t change the general course of the economy. Both factions, nationalists and socialists, want to keep the welfare state and therefore preserve the very cause of Europe’s economic stagnation (which by the way is now in its sixth year).
Europe needs a libertarian renaissance. Its entrepreneurs, investors and workers need to stand up together and say “Laissez-nous faire!” with one voice. Then, and only then, will they elevate Europe back to where she belongs, namely at the top of the world’s prosperity league.
As I keep saying, there are no reasons for Europe’s households and entrepreneurs to be optimistic about the future. Therefore, they are not going to spend more money. They are going to drive their economy into the deep, long ditch of deflation, depression and permanent stagnation.
Eurozone private business growth slowed more than expected in August, despite widespread price cutting, as manufacturing and service industry activity both dwindled, a survey showed on Thursday (21 August).
This is an important, but hardly surprising measurement of what is really going on in the European economy. When buyers do not respond positively to price cuts, it means either of two things:
- They cannot afford to increase spending; or
- They are so pessimistic about the future that they hold on for dear life to whatever cash they have.
A less likely explanation is that they speculate, planning their purchases for a future point in time when prices are expected to be even lower. For this to be true there would have to be other signs of improving economic activity, signs indicating that, primarily, households can afford to spend money in the first place. But the European economy does not exhibit any such signs.
First of all, the cuts in entitlement programs may have wound down with some austerity measures coming to an end. But there is only a partial austerity cease-fire, with Greece, Spain, Italy, France and Sweden continuing contractionary budget measures. Austerity measures designed to save the welfare state in the midst of an economic crisis inject a great deal of uncertainty among consumers, as they can no longer trust the welfare state with keeping its entitlement promises. More of household earnings is used to build barriers against an uncertain future, causing consumer spending – the largest item in the economy – to stall or fall.
So long as austerity remains a threat to the European economy, consumers are going to hesitate.
Secondly, employment is not growing. People’s outlook on the ability to support themselves in the future is not improving. Youth unemployment is stuck at one quarter of all young being unemployed, total unemployment is almost at eleven percent and neither is budging. So long as there is no improved prospects for jobs, those who have jobs will not feel increasingly secure in their jobs, and the large segments of the population who are out of work have no more money to spend than what government provides through unemployment benefits (often hit by austerity).
Third, the European Central Bank may be flooding the euro zone with cheap money, but that is not going to help increase economic activity. Its negative interest rates on bank deposits only leaves liquidity slushing around in the banking system, making banks increasingly desperate to put the money to work. But because of the two aforementioned problems there has been no net addition of demand for credit in the European economy. While the liquidity makes no good difference in the real sector, it may find its way into financial speculation. That is a different and troubling story; the point here is that monetary policy is completely exhausted and can no longer help move the economy forward. Since the fiscal policy instruments of the European economy are entirely devoted to government-saving austerity, there is no clout left in the economic policy arsenal. The Europeans are left to fend for themselves, mired in uncertainty and stuck having to fund the world’s largest government.
In other words, there is no reason to be surprised by the lack of demand response to declining prices. There are, however, a lot of reasons to be worried about Europe’s future. Euractiv again:
Economic growth ground to a halt in the second quarter, dragged down by a shrinking economy in Germany and a stagnant France … Markit’s Composite Purchasing Managers’ Index (PMI) will provide gloomy reading for the European Central Bank (ECB), suggesting its two biggest economies are struggling like smaller members. Based on surveys of thousands of companies across the region and a good indicator of overall growth, the Composite Flash PMI fell to 52.8 from July’s 53.8, far short of expectations in a Reuters poll for a modest dip to 53.4.
Technically, any index number above 50 means purchasing managers are still expanding purchases. However, since the second-order trend is negative – the increase is flattening out – it is only a matter of a little bit of time before the PMI index itself goes negative. Shall we say three months? The Euractiv story gives good reasons for that:
Markit said the data point to third-quarter economic growth of 0.3%, matching predictions from a Reuters poll last week. “We are not seeing a recovery taking real hold as yet. We are not seeing anything where we look at it and think ‘yes, this is the point where the eurozone has come out of all its difficulties’,” said Rob Dobson, senior economist at Markit.
Again, an economist whose thinking is upside down. The right question to ask is not when the European economy is going to recover. The right question to ask is: what reasons does the European economy have to recover in the first place? In the emerging deflation climate, and with the economy stuck in the liquidity trap where monetary policy is completely impotent, Europe’s households and entrepreneurs have no reasons to change their current, basically depressed economic behavior.
Deflation is the most worrying part of their crisis. Says Euractiv:
Consumer prices in the eurozone rose just 0.4% on the year in July, the weakest annual rise since October 2009 at the height of the financial crisis, and well within the ECB’s “danger zone” of below 1%. Worryingly, according to the composite output price index firms cut prices for the 29th month – and at a faster rate than in July. … Also of concern, suggesting factories do not expect things to improve anytime soon, manufacturing headcount fell at the fastest rate in nine months.
This is not a protracted recession. This is a new normal, a state of permanent stagnation.
A state of industrial poverty.
A week ago Eurostat reported:
In June 2014 compared with May 2014, seasonally adjusted industrial production fell by 0.3% in the euro area (EA18) and by 0.1% in the EU28, according to estimates from Eurostat, the statistical office of the European Union. In May 2014 industrial production decreased by 1.1% in both zones. In June 2014 compared with June 2013, industrial production remained stable in the euro area and rose by 0.7% in the EU28.
In other words, more evidence that the European economy is stuck in a state of stagnation. If we translate “industrial production” into “manufacturing”, then we get the following interesting numbers from Eurostat:
Manufacturing employment has remained relatively stable over the past decade, obviously with a downturn during the earlier years of the Great Recession. However, the interesting part is the relation between changes in employment and changes in value added. When value added is falling faster than employment, it means employers are losing money and need to compensate by reducing employment, cutting wages or shutting down production facilities. The first two options become one if employment reductions are big enough to make a substantial difference in production costs, but if cutting employment is the only measure, the capital stock remains unchanged.
Closing facilities is a way to reduce fixed production capacity, though more drastic than a straightforward reduction in employment.
The violent changes in gross value added indicate that manufacturers made some pretty hard downsizing during the early years of the Great Recession. Once they had reduced their fixed and variable production capacity (capital and labor) they were able to improve profitability again. That improvement, however, was only transitional, as the growth in value added returned to zero and even negative territory in 2012. The lack of increase in employment during this period reinforces the conclusion that the upswing was structural, not related to an economic recovery.
Employment, meanwhile, has remained steady. The question is what the most recent uptick means – is it the sign of a steady recovery or is it the result of corrections to manufacturing capacity in response to the decline in value added during 2012? Given the overall state of the European economy, my answer is that we are witnessing once again a structural effect on value added: more efficient allocation of production and measures taken to increase labor productivity.
Data from another industry point in the same direction:
Eurostat’s data for the European construction industry reinforces the impression that there is no recovery under way. Here the value added line is dark red, and theoretically indicates an increase in profitability. However, it is not dissimilar from the one that happened in 2-12, and since there is no uptick in the employment trend.
When there is an upward trend in construction, it is a sign of a steady economic recovery. This is happening in the U.S. economy, but, as we can see, not in Europe.
When do you stop talking about an economy as being in a recession, and when do you start talking about it as being in a state of permanent stagnation? How many years of microscopic growth does it take before economic stagnation becomes the new normal to people?
Since 2012 I have said that Europe is in a state of permanent economic stagnation. So far I am the only one making that analysis, but hopefully my new book will change that. After all, the real world economy provide pieces of evidence almost on a daily basis, showing that I am right. Today, e.g., the EU Observer explains:
France has all but abandoned a target to shrink its deficit, as the eurozone endured a turbulent day that raised the prospect of a triple-dip recession. Figures published by Eurostat on Thursday (14 August) indicated that the eurozone economy flatlined between April and June, while the EU-28 saw 0.2 percent growth.
I reported on this last week. These numbers are not surprising: the European economy simply has no reason to recover.
The EU Observer again:
Germany, France, and Italy … account for around two thirds of the eurozone’s output. Germany’s output fell by 0.2 percent, the same as Italy, which announced its second quarter figures last week. France recorded zero growth for the second successive quarter, while finance minister Michel Sapin suggested that the country’s deficit would exceed 4 percent this year, missing its European Commission-sanctioned 3.8 percent target.
And that target is a step back from the Stability and Growth Pact, which stipulated a deficit cap of three percent of GDP. It also puts a 60-percent-of-GDP cap on government debt, but that part seems to have been forgotten a long, long time ago.
What is really going on here is a slow but steady erosion of the Stability and Growth Pact. Over the past 6-8 months there have been a number of “suggestions” circulating the European political scene, about abolishing or at least comprehensively reforming the Pact. The general idea is that the Pact is getting in the way of government spending, needed to pull the European economy out of the recession.
No such government spending is needed. The European economy is standing still not because there is too little government spending, but because there is too much. I do not believe, however, that this insight will penetrate the policy-making circles of the European Union any time soon.
Back to the EU Observer:
In an article in Le Monde on Thursday (14 August), [French finance minister] Sapin abandoned the target, commenting that “It is better to admit what is than to hope for what won’t be.” France would cut its deficit “at an appropriate pace,” he added in a radio interview with Europe 1. … Sapin’s admission is another setback for beleaguered President Francois Hollande, who made hitting the 3 percent deficit target spelt out in the EU’s stability and growth pact by 2013 one of his key election pledges in 2012. Paris has now revised down its growth forecast from 1 percent to 0.5 percent over the whole of 2014, and cut its projection for 2015 to 1 percent from 1.7 percent.
Let me make this point again: instead of asking when the European economy is going to get back to growth again, it is time to ask if the European economy has any reason at all to get back to growth. As I explain in my new book, there is no such reason so long as the welfare state remains in place.
The eurozone economy flatlined between April and June, while the EU-28 saw 0.2 percent growth, Eurostat confirmed Thursday. Latvia recorded 1 percent growth, the eurozone’s fastest rate, followed by Spain, Portugal and Slovakia. Germany’s output fell by 0.2 percent. The UK and Hungary were the strongest performers outside the eurozone.
These numbers, predictable as they are, report growth in the second quarter for 2014 over the first quarter. They are also adjusted for seasons, workdays and inflation. This puts a great deal of distance between these numbers and actual economic activity, kind of like the difference between plain coffee and a decaf cappuccino. The best numbers to analyze are those that are still inflation-adjusted, but nothing more, and to look at annual growth quarter-to-quarter, in other words second quarter 2014 over second quarter 2013. This is not going to happen, though, until Eurostat releases non-seasonally adjusted numbers from Q2. Until then we will have to do with the cappuccino version, but we can at least put the caffein back in it by calculating annual growth quarter to quarter.
When we make this adjustment, the negative news reported by the EU Observer are put in a better context:
Again, the U.S. economy is moving forward in a reasonably paced recovery. So is the United Kingdom, which is noteworthy since the U.K. has kept its taxes at the low end of what the European Union allows. This is now paying off.
Once again, the growth rate for the EU, when Britain is subtracted, puts economic stagnation on full display. (The growth rates for EU-less-UK are almost identical to those of the euro zone.) As yet more evidence of this stagnation, the French economy grew at an annual rate of 0.11 percent, down from 0.79 percent in the first quarter and 0.77 percent in the last quarter of 2013. Italy continued a year-long trend of negative growth.
Eurostat has not yet published a full roster of member-state GDP data for Q2 2014, so we will certainly have opportunity to return to these numbers. For now, though, let us conclude that not even the cappuccino massage of raw macroeconomic data can hide the fact that the European economy is in a solid state of stagnation.
My book Industrial Poverty: Yesterday Sweden, Today Europe, Tomorrow America will be officially available as hardcopy and e-book on September 10. This book basically asks a two-step question: Has the industrialized world entered a state of permanent economic stagnation? If so, is the state of stagnation self-inflicted?
I suggest that the answer is affirmative on both accounts. The consequence is dire for the two largest economies in the world:
- Europe is stuck in a depression that is leaving one in five young man and woman with no other option than to live off welfare;
- While the U.S. economy is improving, it is a recovery that leaves a lot to be wished for, primarily in terms of job creation and economically sustainable consumer spending.
The United States will continue to move, slowly, in the right direction, but without structural reforms to end large entitlement systems it will be very difficult to achieve more than 2-2.5 percent growth per year. That is just about enough to maintain a constant standard of living on an inter-generational basis.
A growing number of economists are expressing concerns about what will come after the Great Recession. One of them is Stanley Fischer, the number two guy at the Federal Reserve. From the New York Times:
Sounding a somber note even as the economic outlook in the United States brightens, the Federal Reserve’s No. 2 official acknowledged on Monday that global growth had been “disappointing” and warned of fundamental headwinds that might temper future gains. … Stanley Fischer … noted that although the weak recovery might simply be fallout from the financial crisis and the recession, “it is also possible that the underperformance reflects a more structural, longer-term shift in the global economy.” In a speech delivered on Monday in Stockholm at a conference organized by the Swedish Ministry of Finance, Mr. Fischer also conceded that economists and policy makers had been repeatedly disappointed as the expected level of growth failed to materialize.
My book is timely, in other words… To be perfectly honest, the reason why “economists and policy makers had been repeatedly disappointed” during the Great Recession is precisely that they do not primarily think in structural – or institutional – terms. One reason is the over-reliance on traditional econometric methods, which work well so long as there is no major upset to the overall structure of the economy. Another reason is the downgrading of genuine economic theory: today’s average graduate student in economics probably will never read an original text by theory-based scholars like Keynes, von Mises, Hayek, Lerner, Harrod or even Milton Friedman. Today’s academic economics puts the cart before the horse, deciding what tools to use first and then finding a list of problems those tool may apply to. What does not make the list is not of interest.
This is, obviously, an exaggerated stylization, but it is not more than that. Instead of using methodology that asks how soon the European economy will return to business as usual, economists need to begin to ask what reason, if any, the European economy has to return to full employment and growth. I have made my contribution. Stanley Fischer is opening for the same type of non-traditional analysis. Here is what he said, directly from the Federal Reserve website:
[The] Great Recession is a near-worldwide phenomenon, with the consequences of which many advanced economies–among them Sweden–continue to struggle. Its depth and breadth appear to have changed the economic environment in many ways and to have left the road ahead unclear. … There has been a steady, if unspectacular, climb in global growth since the financial crisis. For example, based on recent IMF data from the World Economic Outlook, which uses purchasing power parity weights, world growth averaged 3percent during the first fouryears of the recovery and as of July was expected to be 3.4 percent this year. The IMF expects global growth to reach 4 percent next year–a rate about equal to its estimate for long-run growth. This global average reflects a forecast of steady improvement in the performance of output in the advanced economies where growth averaged less than 1 percent during the initial phase of the recovery to an expected 2-1/2 percent by 2015.
Again, the best we can hope for is growth that – as I explain in my book – keeps our standard of living from a continuous decline. But let us also keep in mind that if we are going to expect Europe to grow by 2-2.5 percent next year, a minor miracle has to happen. A true end to welfare-state saving austerity would be a big step in that direction, but so far we have not seen more than verbal commitments to that. But even as this European version of austerity ends, it will take quite a while before the economy will recover. Confidence, like Rome, is not built in a day, and therefore I predict that Fischer will be too optimistic about Europe.
As we return to Stanley Fischer, he stresses the tepid nature of the global recovery:
With few exceptions, growth in the advanced economies has underperformed expectations of growth as economies exited from recession. Year after year we have had to explain from mid-year on why the global growth rate has been lower than predicted as little as two quarters back. Indeed, research done by my colleagues at the Federal Reserve comparing previous cases of severe recessions suggests that, even conditional on the depth and duration of the Great Recession and its association with a banking and financial crisis, the recoveries in the advanced economies have been well below average.
Which is yet more evidence that my argument that this is a structural crisis is valid. But not only that: the structural crisis is of a kind that traditional economics has not yet grasped. The culprit is the welfare state, the depressing effect of which slowly emerged up to four decades ago. However, unlike other long-term trend suggestions, such as the Kondratiev cycle, my hypothesis about the welfare state has a realistic microeconomic underpinning. More on that at some other point; for now, back to Stanley Fischer:
In the emerging market economies, the initial recovery was more in line with historical experience, but recently the pace of growth has been disappointing in those economies as well. This slowing is broad based–with performance in Emerging Asia, importantly China, stepping down sharply from the post-crisis surge, to rates significantly below the average pace in the decade before the crisis. A similar stepdown has been seen recently for other regions including Latin America. These disappointments in output performance have not only led to repeated downward revisions of forecasts for short-term growth, but also to a general reassessment of longer-run growth.
Does the welfare-state explanation apply to the emerging economies as well? In some cases the answer is yes, with South Africa and Argentina as leading examples. I am not familiar enough with the Chinese economy to be able to tell what role the welfare state plays there, but I would be surprised if their talk from time to time about fighting social stratification has not led to an expansion of a government-based redistribution system.
But it really does not matter if the Chinese are expanding their welfare state, or are wrestling with a financial bubble. Neither is going to change the European economy, which – as we go back to the New York Times story – is showing yet more signs of perennial stagnation:
A report on Monday by the Organization for Economic Cooperation and Development warned that German economic growth might be slowing. Germany has been one of Europe’s rare bright spots, continuing to prosper even as countries on the periphery like Greece, Portugal and Spain struggle after the debt crisis of 2010-12.
Let’s take a closer look at that report on Friday. For now, let’s just note that it is good to see that more and more economists are taking a broader, less conventional look at the economy. Just as I do…