Earlier this week I explained how Europe has, institutionally, set itself up for a long-term decline in growth. The Stability and Growth Pact should take a lot of blame for this, as it comes with a built-in bias in favor of contractionary fiscal policy. But it is not just any type of contractionary policy that is favored by the Stability and Growth Pact: it is contractionary policy aimed at balancing the government budget – regardless of all other policy goals.
To be clear, there are two types of contractionary fiscal policy:
- So called “statist austerity” aims at balancing the government budget with the explicit or implicit purpose to keep government spending programs as intact as possible under tighter economic conditions;
- So called “free market austerity” where the goal is to shrink government spending with the explicit purpose of permanently reducing the size of government.
The two forms employ different policy strategies. Statist austerity can include tax increases; the balance between spending cuts and tax hikes is determined primarily by practical and political considerations. These considerations typically supersede economic analysis: the execution of statist austerity typically takes place over a short period of time and upon short notice, such as looming panic among global investors over a government’s believed ineptitude in balancing the budget.
Free market austerity, on the other hand, aims solely at permanently shifting the balance between the private sector and government. This can be achieved if and only if:
a) government spending is permanently reduced; and
b) taxes are reduced proportionately to the reduction in spending.
As a result, the combination of changes in taxes and spending is entirely different than what is required under statist austerity. In terms of outcomes, the effects of free-market austerity on GDP growth are radically different from the effects of statist austerity: under the latter government actually increases its net claim on the economy, while under the former the private sector is given ample opportunity to expand.
By dictating budget-balancing requirements, the Stability and Growth Pact de facto mandates statist austerity in Europe. The logical outcome of this should be a long-term decline in GDP growth. There is lots of economic theory to draw on for this conclusion.
The growth rate reported in this figure is of the sliding-average kind (without a forecasting side), which shifts focus from periodic observations to trend observations. As the polynomial (third order) trend line indicates, the long-term path is unequivocally downward. In addition, growth peaks get weaker and shorter.
Perhaps the best evidence of the connection between the Stability and Growth Pact and this long-term trend can be found in the downturn after 2010. Annual growth in the fourth quarter of 2010 was 2.2 percent; a year later it was 0.2 percent and by Q4 2012 euro-zone GDP was shrinking by a full percent. It did not return to growth until the latter half of 2013, and then only at tepid rates below half a percent.
In fact, over the past three years – 12 quarters – euro-zone GDP growth has only been above one percent one single quarter. That was in Q1 2014. For Q3 2014 it expanded by a tiny 0.8 percent on an annual basis.
The relation between the institutional structure and the long-term decline in GDP growth is one of the most important reasons why I have come to the conclusion that Europe is stuck in a state of permanent economic stagnation – a state of industrial poverty – which it will not recover from until it reforms away its institutional barriers to a real economic recovery.
In December I took a first look at the European Commission’s “Report on Public Finances”, with the intention of returning to this important document later. It has been almost a month, longer than I expected, but here we are.
In my first review of the report I explained that the strict focus by Europe’s political leadership on government finances has led to a systemic error in their fiscal policy priorities:
Austerity, as designed and executed in Europe, was aimed not at shrinking government but making it affordable to an economy in crisis. The end result was a permanent downward adjustment of growth, employment and prosperity. In order to get their economy out of this perennial state of stagnation, Europe’s leaders need to understand thoroughly the relations between government and the private sector.
This is a kind of prioritization that has guided European fiscal policy for two decades now. Under the Stability and Growth Pact, EU member states in general are forced to adopt a fiscal policy that inherently has a contractionary – austerity – bias. But it is not the kind of austerity that reduces the size of government. It is the kind that tries to shrink a budget deficit in order to keep government finances in good order and save the welfare state from insolvency.
So long as contractionary fiscal policy – austerity – is focused on balancing the budget and saving the welfare state, it won’t reduce the size of government. For that, it takes specifically designed austerity measures. Those measures are indeed possible, even desirable, but they cannot be launched unless government is allowed by its own constitution to prioritize less government over a balanced budget.
Unfortunately, the Stability and Growth Pact does not permit that member states prioritize shrinking government over budget balancing. Instead, the Stability and Growth Pact forces them to always pay attention to deficits and debt, but never worry about running too large surpluses. Part A of the Pact caps government deficits at three percent of GDP and debt at 60 percent of GDP. At the same time, there are no caps on budget surpluses; since a surplus is excess taxation, and since excess taxation drains the private sector for money in favor of a government savings account, this means that governments can drain the private sector for all the money it wants to without violating the European constitution.
Unlike a budget surplus, which is contractionary in nature, a budget deficit is, at least in theory, always stimulative. However, by capping deficits the European constitution restricts the stimulative side of fiscal policy, while at the same time leaving the contractionary end unrestricted.
In addition to the technical aspects of this contractionary bias, there is also the political mindset that is born from a legislative construct of this kind. Lawmakers and elected cabinet members – primarily treasury secretaries – are concerned with avoiding deficits, thus quick to resort to contractionary policy measures, but pay little attention to the need for counter-cyclical policies. Over time, this political mindset becomes “one” with the Stability and Growth Pact to the extent where parliaments do not think twice of passing budgets that impose harsh contractionary measures in order to balance a budget.
Think Europe in 2012. And read chapters 4a and 4b in my book Industrial Poverty to get an idea of how deep roots in Europe’s legislative mindsets that this “gut reaction” bias toward contractionary measures has actually grown.
With its contractionary bias, Europe’s fiscal policy has permanently downshifted growth in Europe. This in turn has perpetuated the budget problems that said contractionary policies were intended to solve. It left the European economy fragile and frail, vulnerable to a tough recession. All it took was the downturn in 2008-09 with its spike in deficits – and once the fiscal-policy gut reaction kicked in, there was nowhere to go for Europe other than into the dungeon of budget-balancing contractionary measures; statist-driven austerity; mass unemployment; and perpetual budget problems.
Never did Europe’s leaders think twice of trying to actually release its member states from the shackles of the Stability and Growth Pact. Never did they think twice of permitting a widespread downward adjustment of the size of government.
The Commission’s “Report on Public Finances” cements this statist approach to contractionary fiscal policy. It has an entire section that suggests further collaboration and coordination among EU member states on the fiscal policy front. So long as the Stability and Growth Pact remains in place, such coordination would be a thoroughly bad idea. All that such coordination would accomplish is to cement statist austerity as the prevailing “fiscal policy wisdom” ruling the economy that feeds 500 million people.
I will return in more detail to this report. In the meantime, do take a minute and read my paper Fiscal Policy and Budget Balancing: The European Experience. It is part of a five-paper series of discussion papers on the ups and downs of a balanced-budget amendment to the United States constitution.
The truth about the European economic crisis is spreading. The latest evidence of this growing awareness is in an annual report by the European Commission. Called “Report on Public Finances”, the report expresses grave concerns about the present state as well as the economic future of the European Union. It is a long and detailed report, worthy of a detailed analysis. This article takes a very first look, with focus on the main conclusions of the report.
Those conclusions reveal how frustrated the Commission has become over Europe’s persistent economic stagnation:
The challenging economic times are not yet over. The economic recovery has not lived up to the expectations that existed earlier on the year and growth projections have been revised downwards in most EU Member States. Today, the risk of persistent low growth, close to zero inflation and high unemployment has become a primary concern. Six years on from the onset of the crisis, it is urgent to revitalise growth across the EU and to generate a new momentum for the economic recovery.
Yet only two paragraphs down, the Commission reveals that they have not left the old fiscal paradigm that caused the crisis in the first place:
The aggregate fiscal picture for the EU and the euro area is now considerably more favourable, thanks to the commendably large consolidation efforts made in the past. … this has allowed Member States to slow the pace of adjustment. The aggregate fiscal stance is now expected to be broadly neutral in 2014 and 2015, both in the EU and the euro area. This will reduce one of the drags on growth and should therefore be welcomed.
If Europe is ever to recover; if they will ever avoid decades upon decades of economic stagnation and industrial poverty; the government of the EU must understand the macroeconomic mechanics behind this persistent crisis. To see where they go wrong, let us go through their argument in two steps.
a) “The aggregate fiscal picture for the EU and the euro area is now considerably more favourable, thanks to the commendably large consolidation efforts made in the past.” There are two analytical errors in this sentence. The first is the definition of “fiscal picture” which obviously is limited to government finances. But this is precisely the same error in the thought process that led to today’s bad macroeconomic situation in Europe: government finances are not isolated from the rest of the economy, and any changes to spending and taxes will affect the rest of the economy over a considerable period of time. The belief that government finances are in some separate silo in the economy led to the devastating wave of ill-designed attempts at saving Europe’s welfare states in 2012.
Austerity, as designed and executed in Europe, was aimed not at shrinking government but making it affordable to an economy in crisis. The end result was a permanent downward adjustment of growth, employment and prosperity. In order to get their economy out of this perennial state of stagnation, Europe’s leaders need to understand thoroughly the relations between government and the private sector.
b) “The aggregate fiscal stance is now expected to be broadly neutral in 2014 and 2015, both in the EU and the euro area. This will reduce one of the drags on growth and should therefore be welcomed.” Here the Commission says that if a government runs a deficit, it causes a “drag” on macroeconomic activity. This is yet another major misunderstanding of how a modern, monetary economy works.
Erstwhile theory prescribed that a government borrowing money pushes interest rates up, thus crowding out private businesses from the credit market. But that prescription rested on the notion that money supply was entirely controlled by the central bank; in a modern monetary economy money supply is controlled by the financial industry, with the central bank as one of many players. Its role is to indicate interest rate levels, but neither to set the interest rate nor to exercise monopolistic control on the supply of liquidity.
A modern monetary economy thus provides enough liquidity to allow governments to borrow, while still having enough liquidity available for private investments. In fact, it is rather simple to prove that the antiquated crowding-out theory is wrong. All you need to do is look at the trend in interest rates before, during and after the opening of the Great Recession, and compare those time periods to government borrowing. In a nutshell: as soon as the crisis opened in 2008 interest rates plummeted, at the same time as government borrowing exploded.
This clearly indicates that the decline in macroeconomic activity was not caused by government deficits; it was the ill-advised attempt at closing budget gaps and restore the fiscal soundness of Europe’s welfare states that caused the drag. And still causes the drag.
In other words, there is nothing new under the European sun. That is unfortunate, not to say troubling, but on one front things have gotten better: the awareness of the depth of the problems in Europe is beginning to sink in among key decision makers. What matters now is to educate them on the right path out of the crisis.
There is a lot more to be said about the Commission’s public finance report. Let’s return to it on Saturday.
In a few articles recently I have pointed to some evidence of an emerging economic recovery in Spain and Greece. This is not a return to anything like normal macroeconomic conditions, but more a stagnation at a depressed level of economic activity. To call it a “recovery” is a stretch, but given the desperate circumstances of the past few years, an end to the depression is almost like a recovery.
The transition from a depression with plunging GDP, vanishing jobs and overall an economy in tailspin, to stagnation where nothing gets neither better nor worse, is in fact a verification of my long-standing theory. Europe has entered a new era of permanent stagnation – an era best described as industrial poverty – and is slowly but steadily becoming a second-tier economy on the global stage. The path into that dull future is paved with decisions made by political leaders, both at the EU level and in national governments. While they do have the power to actually return Europe to global prosperity leadership, they choose not to use that power. Instead, their economic policies continue to destroy the opportunities for growth, prosperity and full employment.
In fact, Europe’s leaders have the opportunity on a daily basis to choose which way to go. The difference is made in their responses to the economic situation in individual EU member states. Let us look at two examples.
First out is an article from Euractiv a month ago:
Greece is “highly unlikely” to end its eurozone bailout programme without some new form of assistance that will require it to meet targets, a senior EU official said on Monday (3 November). “A completely clean exit is highly unlikely,” the official told reporters, on condition of anonymity. “We will have to explore what other options there are. Whatever options we may be adopting, it will be a contractual relationship between the euro area institutions and the Greek authorities,” the official said.
How will the EU, the European Central Bank and the International Monetary Fund respond to this? Will they continue to impose the same austerity mandates that they began forcing upon Greece four years ago? Back to Euractiv:
The eurozone and IMF bailout support of €240 billion began in May 2010. Greece is in negotiation with EU institutions and the International Monetary Fund ahead of the expiry of its bailout package with the European Union on 31 December. Athens has said it wants its bailout to finish when EU funding stops, though the IMF is scheduled to stay through to early 2016. The EU official said he expected eurozone ministers and Greece to decide on how best to help Athens at a meeting of finance ministers in Brussels on 8 December.
If the EU decides to continue with the same type of bailout program, thus continuing to demand government spending cuts and tax hikes, then their response to this particular situation will continue the economic policies that keep Europe on its current path into perpetual industrial poverty.
The second example, France, also presents Europe’s political leadership with a fork-in-the-road kind of choice. From the EU Observer:
France’s finance minister cut the country’s deficit forecast for 2015 on Wednesday (3 November) adding that Paris will be well within the EU’s 3 percent limit by 2017. Michel Sapin told a press conference that he had revised France’s expected deficit down to 4.1 percent from the 4.3 percent previously forecast, as a consequence of extra savings worth €3.6 billion announced by Sapin in October.
That sounds good, but what is the reason for this improved forecast – and, as always with optimistic outlooks in Europe, can we trust it?
The extra money does not come from additional spending cuts but instead from lower interest expenses from servicing France’s debts, a reduction in its contributions to the EU budget, and extra tax revenues from a clampdown on tax evasion and a new tax on second homes. “We have revised the 2015 deficit … without touching the fundamentals of French economic policy,” Sapin told reporters.
This also means they have done their debt revision without seeing a change for the better in “the fundamentals” of the French economy. In other words, no stronger growth outlook, no sustainable improvement in business investments or job creation. As a matter of fact, a closer look at the measures that Mr. Sapin refers to reveals a frail, temporary improvement that will not put France on the right side in any meaningful macroeconomic category:
- A lower interest rate on French government debt is almost entirely the work of the European Central Bank and its irresponsible money-printing; the French are paying lower interest rates on ten-year treasury bonds than we do here in the United States, but that will last only for as long as investors remain confident in the ECB’s version of Quantitative Easing; interest rates will quickly start rising again once that confidence is shattered – and it will be shattered as soon as investors realize that, unlike in the United States, the European economy will not start growing again;
- Reduced French EU contributions come at the expense of other countries and likely won’t last very long; as soon as other countries have grown impatient with the French, they will force Paris to increase its contributions again; besides, this “reduced EU contributions” thing is basically just an accounting trick – effectively it means that the EU has reduced their demands on how much France needs to cut its deficit to be “compliant”;
- A new second-home tax is a tax increase to which taxpayers will make the necessary adjustments; they will move from owning a home to renting one or to extended-stay vacations at luxury hotels; once that adjustment reaches a critical point the French government will have lost the new revenue and their hopes of being “compliant” with the EU deficit requirement will fade away.
If the French government spent all the political and legislative efforts that went into these measures, on structural reforms to the French government, then France would be en route to a major improvement in growth, jobs creation, business investments and the standard of living of their citizens. But that is not going to happen. All they do is try to comply with the same old statist rules that have forced them to balance their budget – and save their welfare state – instead of promoting the prosperity of their people.
There is a painful shortsightedness in European fiscal policy, one that almost entirely prevents the political leadership of that continent to look beyond the next fiscal year. It is time for them to stop, raise their eyes to the horizon and think about where they want their continent to be ten years from now.
If they don’t, I can surely say where they are going to be: in an era of industrial poverty, colored by three shades of grey, where children are destined to – at best – live a life no better than what their parents could accomplish. Think Argentina since the decline and fall of their 15 years of global economic fame.
Think Eastern Europe under Soviet rule.
Usually when my regular workload intensifies I find it hard to get time to put meaningful content up on this blog. However, recently that has not been the case. Instead, my predictions from the past two years – and especially from my book Industrial Poverty – are now cashing in, yielding bundles and barrels of content material. What I have been saying since 2012 is now dawning on political leader after political leader in Europe, namely that the continent simply is not going to recover.
Yesterday, British Prime Minister David Cameron joined the chorus of alarmed, baffled, concerned and desperate European political leaders who, with rising anxiety in their voices, try to determine why their continent’s economy is going nowhere. Cameron got plenty of room in The Guardian:
Six years on from the financial crash that brought the world to its knees, red warning lights are once again flashing on the dashboard of the global economy.
For the zillionth time – it was not a financial crisis. There. I had to make that point again. Back to Prime Minister Cameron:
As I met world leaders at the G20 in Brisbane, the problems were plain to see. The eurozone is teetering on the brink of a possible third recession, with high unemployment, falling growth and the real risk of falling prices too. Emerging markets, which were the driver of growth in the early stages of the recovery, are now slowing down. … The British economy, by contrast, is growing. After the difficult decisions of recent years we are the fastest growing in the G7, with record numbers of new businesses, the largest ever annual fall in unemployment, and employment up 1.75 million in four years: more than in the rest of the EU put together.
Back in August I noted that the U.S. and U.K. economies were outgrowing the rest of Europe. We will soon have the definitive numbers for the third quarter, but until then we can basically take Cameron’s word for it that Britain is way ahead of the rest of Europe.
Cameron then turns to the dark clouds on the global economic horizon, pointing out that the economic stagnation in the euro zone is showing up in Britain’s foreign trade statistics. And then he makes an interesting observation:
As the global economy faces greater uncertainty, it is more important than ever that we send a clear message to the world that Britain is not going to waver on dealing with its debts. This stability is vital in attracting the business and international investment that delivers growth and jobs, and which keeps long-term interest rates low. So we will stick to our plan on the deficit and continue to use monetary policy to support growth without adding to borrowing or debt.
This sounds like a generic political statement, formulated to put out specific words in a specific order to appeal to the subconscious mind of the voter. But it is more than that: this is a poke in the side of Germany and other euro-zone countries who cannot get their economies going. Cameron’s point is, plainly, that Britain has been successful in separating its fiscal and monetary policies from the European mainstream – and that Britain will continue to pursue its own, independent economic policies.
No doubt, this is an attempt at appealing to UKIP supporters, but it is also an acknowledgment of a reality where the EU is stuck in the ditch of economic stagnation and Britain will not – and cannot – let itself be held back by that same organization.
In fact, as Cameron continues, he carves out an even sharper independent profile for himself and his country:
Our long-term plan is backing business by scrapping red tape, cutting taxes, building world-class skills and supporting exports to emerging markets. Underpinning all of this is our radical programme of investment in infrastructure. … We are making the biggest investment in roads since the 1970s and the biggest in rail since Victorian times, connecting 40,000 premises to superfast broadband every week, and starting an energy revolution with the first new nuclear plant in a generation, the world’s first green investment bank and the largest production of offshore wind on the planet.
We’ll see how that energy policy works in the end. American energy prices are falling, thanks in part to an expansion of oil and natural gas production on private land. But again – Cameron’s point is that Britain stands out among European countries, that the leading euro-zone economies are in permanent stagnation and that Britain is not going to fold into the ranks of European mediocrity.
David Cameron is not the best option for Britain. He is, fundamentally, a traditional British Europhile. But the fact that he talks so forcefully about the uniqueness of British economic policies and economic performance is a clear indication of which way Britain is heading, and why. His article simply confirms how strong the euroskeptics are in Britain and thereby the high probability that Nigel Farage of the UKIP will be their next Prime Minister.
Let us hope that Cameron continues with his moderately successful fiscal policies. If he can make an example out of Britain to the rest of Europe, he can embolden Euroskeptics elsewhere in the EU. Eventually, their strength – given that they are of the UKIP kind and not aggressive nationalists – will bring an end to the stifling statism that has become endemic in austerity-ridden eurozone welfare states.
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.
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.
There is good news today from the Bureau of Economic Analysis, which reports that U.S. GDP…
increased at an annual rate of 4.0 percent in the second quarter of 2014, according to the “advance” estimate released by the Bureau of Economic Analysis. In the first quarter, real GDP decreased 2.1 percent (revised). The Bureau emphasized that the second-quarter advance estimate released today is based on source data that are incomplete or subject to further revision by the source agency
This is good news, indeed, even with the caveat that there will be revisions to the number by the end of August when more complete data has been processed. As a reminder of how big those revisions can be, consider that the estimates for the first quarter of this year ranged from -2.1 to -2.9 percent. That was an unusually large margin of error. Early estimates, like this four-percent growth figure for the second quarter, are based on limited data and matched with forecasting models that “fill in the blanks”. Those models, in turn, are based on historic trends in industrial activity throughout the U.S. economy. When real economic activity deviates from long-term, historic trends – either because of a protracted recession or because of an ongoing structural change to the economy – the part of preliminary GDP estimates that comes from forecasting models is suddenly more uncertain.
In a nutshell, while there is an underlying trend of recovery, that trend is not strong and confident enough to yield highly accurate preliminary GDP estimates. But even if there is an unusually large downward adjustment of this figure, we are still going to have satisfactory growth going in this economy.
So what is behind this good GDP news? Back to the BEA news release:
This upturn in the percent change in real GDP primarily reflected upturns in private inventory investment and in exports, an acceleration in PCE [private consumption], an upturn in state and local government spending, an acceleration in nonresidential fixed investment, and an upturn in residential fixed investment that were partly offset by an acceleration in imports.
In other words, the BEA sees an across-the-board increase in economic activity. This is very good, even though we could have done without the rise in state and local government spending. However, once the more complete numbers are out in about a month, there will be opportunity for a detailed examination of the actual growth drivers. However, the BEA gives some hints:
Real personal consumption expenditures increased 2.5 percent in the second quarter, compared with an increase of 1.2 percent in the first. Durable goods increased 14.0 percent, compared with an increase of 3.2 percent. Nondurable goods increased 2.5 percent; it was unchanged in the first quarter.
The rise in durable-goods consumption is particularly notable, as it is often associated with long-term spending or financing commitments by consumers. This could actually indicate a deeper, more lasting trend of growth, driven by strengthening consumer confidence. If so, we will see much more of GDP in the 3-percent growth bracket. That would be highly welcome, especially since the average GDP growth for the U.S. economy in the 2000s barely exceeded an inflation-adjusted 1.5 percent per year.
But before we all jump up and down with joy, keep in mind again that growth in the first quarter was a solid negative 2.1 percent. I attribute that, at least in part, to the uncertainty around Obamacare. Businesses have now adjusted to it, consumers are absorbing the cost and accommodating to it. That does not mean Obamacare has not had negative effects on the economy; wait and see what happens to health care costs, employment in the health sector and spending on medical technology.
Another indicator that the economy may be on a reinforcing rebound is the 5.3-percent increase in non-residential construction, an indication that businesses expect activity to grow on a long-term basis. Business equipment investment corroborates this, with a solid seven-percent growth (it decreased in the first quarter). Residential construction growth was even stronger, at 7.5 percent.
All in all, what has been a tepid recovery looks better today. A couple of key variables indicate reinforced confidence among consumers as well as businesses. If the Obama administration sits still and does nothing, they will make the best contribution possible to this. No more big spending programs, please. (Let’s not forget that Obama has been more fiscally conservative than any recent Republican president, Reagan included.) If Republicans take the Senate in November, there will be even more reasons to believe in a sustained recovery.
In addition to continued growth in jobs and earnings, a solid trend of growing GDP will also reduce the risk of monetarily driven inflation in the United States. From this perspective it is particularly reassuring that consumer spending on durable goods is growing, as is spending on both residential and commercial construction. All these activities rely heavily on credit, and that includes, of course, the mortgages needed to buy new homes. Excess liquidity that has been slushing around in the U.S. banking system will now go to work where it is needed.
This particular aspect of the recovery is usually under-estimated by economists. Let’s briefly compare our situation to what is happening in Europe. There, too, business credit is growing, but not for the same reason as here. EUBusiness.com reports:
Banks in the eurozone eased credit standards for loans to businesses in the second quarter for the first time since 2007, the European Central Bank said Wednesday. Announcing the upbeat results of its quarterly euro area bank lending survey, the ECB said it had also become easier for private households to get loans as confidence returned to the sector.
This is nonsense. The EU economy may be breaking into positive growth numbers, but it is closer to one than two percent annually. The best evidence of this is a very slow growth rate in private consumption. This is not enough to shore up confidence and make people crowd to the banks, desperate for loans. The same is true for businesses, whose investment growth is nowhere near American levels.
Instead of a desperately needed real-sector recovery, the increase in lending in the euro zone is a direct effect of the negative interest rates that the European Central Bank has introduced on bank over-night deposits. This measure, which de facto marked Europe’s entry into the liquidity trap, penalizes banks if they deposit excess liquidity to accounts with the ECB. Faced with a penalty from the ECB, banks have apparently decided to aggressively market loans to businesses and households.
The fact that they decide to lower credit standards right away, right as they start their loan marketing campaign, is a good indicator of cause and effect in this: if households and businesses were recovering solidly from the Great Recession, they would qualify for loans at existing standards; the fact that banks have to lower credit standards in order to sell loans to customers means that the aggregate credit profile of the European bank customer has not changed recently. That in turn means that people and businesses make roughly the same amount of money, have approximately the same employment and sales outlook on the future, and that job prospects and markets are not growing.
In other words, without the ECB’s negative interest rate and without banks lowering credit standards, there would be no increase in bank lending in Europe.
Because there is no recovery, an increase in lending to the private sector could result in monetarily driven inflation. More on that some other time, though. For now, let’s celebrate yet another U.S. macroeconomic victory over Europe.
As an institutional economist I focus my research on the role that institutions and policy structures play in our economy. It is a fascinating niche in economics, and when combined with macroeconomics it becomes one of the most powerful analytical tools out there. So far, over the past 2.5 years, everything I have predicted about the European crisis has turned out to be correct; my upcoming book Industrial Poverty makes ample use of institutional economics and macroeconomics to show why Europe’s crisis is far more than just a protracted recession.
In economics, the institutional methodology is often pinned against econometrics, the mainstream methodological favorite. I don’t see it that way – econometrics has its place in economics – but the mainstream of the academic side of economics has given econometrics a far bigger role than it can handle. This has led to over-confidence among econometricians which, in turn, has led to a downplay or, in many cases, complete disregard for the benefits that other methodologies bring. The worst consequence of this over-reliance on econometrics was the multiplier debacle at the IMF, with serious consequences for the Greek economy. (How many young Greeks are unemployed today because their government implemented austerity policies based on IMF miscalculations?) A wider, better understanding for economic institutions and their interaction with the macroeconomy could help mainstream economists a long way toward a deeper, more complete understanding of the economy and, ultimately, toward giving better policy advice.
As an example of how institutional analysis can inform more traditional analysis, consider this interesting article on the European crisis by Economics Nobel Laureate Michael Spence and David Brady, Deputy Director of the Hoover Institution:
Governments’ inability to act decisively to address their economies’ growth, employment, and distributional challenges has emerged as a major source of concern almost everywhere. In the United States, in particular, political polarization, congressional gridlock, and irresponsible grandstanding have garnered much attention, with many worried about the economic consequences. But, as a recent analysis has shown, there is little correlation between a country’s relative economic performance in several dimensions and how “functional” its government is. In fact, in the six years since the global financial crisis erupted, the US has outperformed advanced countries in terms of growth, unemployment, productivity, and unit labor costs, despite a record-high level of political polarization at the national level.
This is true, and as I demonstrate in Industrial Poverty, a major reason for this is that the American economy is not ensnared in a welfare state like the European. We still lack a couple of major institutional components that they have: general income security and a government-run, single-payer health care system. That said, the U.S. economy is not exactly performing outstandingly either:
Yes, we are currently in better shape than Europe, but we are also doing worse than ourselves 20, 30 or 40 years ago.
Let’s keep this in mind as we continue to listen to Spence and Brady – their discussion about political dysfunction is actually tied to the role of the welfare state in the economy:
[In] terms of overall relative economic performance, the US clearly is not paying a high price for political dysfunction. Without dismissing the potential value of more decisive policymaking, it seems clear that other factors must be at work. Examining them holds important lessons for a wide range of countries. Our premise is that the global integration and economic growth of a wide range of developing countries has triggered a multi-decade process of profound change. These countries’ presence in the tradable sector of the global economy is affecting relative prices of goods and factors of production, including both labor and capital.
And the government structures that aim to redistribute income and wealth within a country. High-tax economies lose out to low-tax economies. The Asian tigers have generally held tax advantages over their European competitors, but they have also held advantages on the other side of the welfare-state equation as well. By not putting in place indolence-inducing entitlement systems they have kept their work force more shaped toward high-productivity labor than is the case in the old, mature welfare states of Europe.
Why does the welfare state not change, then, in response to increased global competition? After all, Japan, China, South Korea and other Asian countries have been on the global market for decades. Enter the political dysfunction that Spence and Brady talk about. Unlike the United States, there is almost universal agreement among Europe’s legislators that the welfare state should be not only preserved but also vigorously defended in times of economic crisis. This has been the motive behind the European version of austerity, with the result that taxes have gone up, spending has gone down and the price of the welfare state for the private sector has increased, not been reduced as would be the logical response to increased global competition.
It is not entirely clear what kind of American political dysfunction Spence and Brady refer to, but if it has to do with fighting the deficit, they are absolutely on target.
In fact, probably without realizing it, Spence and Brady make an important observation about the long-term role of the welfare state:
Relatively myopic policy frameworks may have worked reasonably well in the early postwar period, when the US was dominant, and when a group of structurally similar advanced countries accounted for the vast majority of global output. But they cease working well when sustaining growth requires behavioral and structural adaptation to rapid changes in comparative advantage and the value of various types of human capital.
If understood as a general comment on the institutional structure of an economy, this argument makes a lot of sense. So long as the traditional industrialized world only had to compete with itself, it could expand its welfare states without paying a macroeconomic price for it. Gunnar Myrdal, Swedish economist and a main architect of the Scandinavian welfare-state model, confidently declared back in 1960 that the welfare state had no macroeconomic price tag attached to it. Back then, it was easy to let government sprawl in every direction imaginable without any losses in terms of growth, income and employment. That is no longer possible.
Spence and Brady then make this excellent observation of the American economy:
What, then, accounts for the US economy’s relatively good performance in the post-crisis period? The main factor is the American economy’s underlying structural flexibility. Deleveraging has occurred faster than in other countries and, more important, resources and output have quickly shifted to the tradable sector to fill the gap created by persistently weak domestic demand. This suggests that, whatever the merit of government action, what governments do not do is also important. Many countries have policies that protect sectors or jobs, thereby introducing structural rigidities. The cost of such policies rises with the need for structural change to sustain growth and employment (and to recover from unbalanced growth patterns and shocks).
The move of resources from the domestic to the foreign-trade sector is visible in national accounts data as a rise of gross exports as share of current-price GDP from 9.1 percent in 2003 to 13.5 percent in 2013. Furthermore, actual growth numbers for exports relative private consumption reinforce the point made by Spence and Brady: from 20087 to 2013 private consumption has increased by 15 percent in current prices, while gross exports have increased by more than 22 percent. For every new dollar Americans doled out on cars, food, haircuts and motel nights, foreign buyers added $1.50 to what they spend on our products.
However, let us once again remember that the adaptation of the American economy should be viewed against the backdrop of a smaller welfare state. As I have discussed on several occasions, European countries are also making big efforts at increasing exports. They are not as lucky in using foreign sales as a demand-pull mechanism for restarting their economies. One reason, again, is the rigor oeconomicus that the welfare state injects into the economy.
Spence and Brady also compare the United States to a number of other countries, noting that:
Removing structural rigidities is easier said than done. Some stem from social-protection mechanisms, focused on jobs and sectors rather than individuals and families. Others reflect policies that simply protect sectors from competition and generate rents and vested interests. In short, resistance to reform can be substantial precisely because the results have distributional effects. Such reform is not market fundamentalism. The goal is not to privatize everything or to uphold the mistaken belief that unregulated markets are self-regulating. On the contrary, government has a significant role in structural transitions. But it must also get out of the way.
In short – and my words, not theirs: reform away the welfare state. Its detrimental influence actually stretches deeper than perhaps Spence and Brady recognize: it does indeed protect large sectors from competition by simply monopolizing them. Health care is a good example, with a government monopoly spilling over on medical-technology products. Another good example is income security, where many European countries have de facto monopolized every aspect from parental-leave benefits to retirement security. Education is a third example, where the United States, despite its heavily socialized K-12 system has a very strong private sector for academic education. This sector is almost entirely absent in many European countries.
Again, it is good to see a different approach to economic analysis than the traditional one based on econometrics and often irresponsibly simplified quantitative analysis. In a situation like the European crisis, it is very important for economists and other social-science scholars (Brady is a political scientist) to broaden the analysis and focus on such variables that rarely change. Among those are economic institutions such as the welfare state, and the political and economic incentives at work in Europe to preserve it, even in the face of mounting global competition.
The European Parliament elections in May conveyed a somewhat schizophrenic voter message. At the end of the day, though, the inevitable outcome is a strong gain for the left. Socialists were emboldened, as were their fellow statist nationalists. Both flanks are pushing for a number of policy reforms that, taken together, could very well mark the beginning of the end of the European Union as we know it. On the left, more and more voices demand a restoration of Europe’s austerity-tarnished welfare state. Some of those demands come in the form of attacks on the Stability and Growth Pact, which dictates budget deficit caps for all EU member states, attacks that are motivated by the desire to rebuild the welfare state.
Europe’s left turn seems to continue at the state level, and with it the criticism of the prevailing austerity doctrine. The most recent example is from Slovenia. Euractiv reports:
Center-left political novice Miro Cerar led his party to victory in Slovenia’s election … (13 July), indicating he would rewrite a reform package agreed upon with the European Union to fix the euro zone member’s depleted finances. The result will test investor nerves, given Cerar’s hostility to some of the big-ticket privatization programmes that the EU says are key to a long-term fix for Slovenia, which narrowly avoided having to seek an international bailout for its banks last year.
Selling off government-owned businesses is a way to temporarily reduce the budget deficit:
Cerar’s government will now oversee a raft of crisis measures agreed upon with the EU, in order to reduce Slovenia’s budget deficit and remake an economy heavily controlled by the state. Cerar, however, opposes the sale of telecoms provider Telekom Slovenia and the international airport, Aerodrom Ljubljana, fuelling investor fears of backsliding. … He said his cabinet would immediately consider which companies would remain in state hands and what to do with the rest. … The outgoing government suspended the privatization process this month pending the formation of a new government, which is not expected before mid-September. Cerar will have to find other ways to raise cash if he is to meet to targets agreed to with the EU, in order to slash Slovenia’s budget deficit to 3% of output by 2015, from a forecast 4.2% this year.
The Slovenians better make up their minds on this issue. According to the EU Observer, the EU and the ECB are not budging on the Stability and Growth Pact:
ECB boss Mario Draghi urged EU leaders not to meddle with the bloc’s rules on debt and deficits on Monday, warning that it could turn the tide on much needed economic reforms.
It remains to be seen to what extent the emboldened left in the European Parliament can influence the way the EU Commission interprets the Stability and Growth Pact. So far, though, the Draghi view is also that of the Commission.
And just to add to the schizophrenia of current European politics, Draghi added a curious remark:
Addressing MEPs on the Parliament’s economic affairs committee in Strasbourg (14 July), Draghi said structural reforms combined with government spending cuts and lower taxes were the only route to restoring economic stability. “There should be a profound structural reform process,” he said, adding that “there is no other way”. “We should take great care not to roll back this important achievement, or to water down its implementation to an extent that it would no longer be seen as a credible framework,” he said.
The combination of less government spending and lower taxes is almost the antithesis of what the EU and the ECB have been preaching to euro-zone member states in the past few years. The austerity packages they have forced on member states have been of the government-first kind, aimed at balancing budgets to make welfare states more fiscally sustainable.
This type of austerity relies at least partly on tax increases. A combination of less taxes and less spending is in fact not austerity at all – it is a policy for government roll-back. If Draghi really means this, he is the first major EU figure to step forward and promote such a structural change to the Euoropean economy.
It is unlikely, though, that Draghi will get much support for any kind of permanent reduction of government. There is far too much power to be had in making the Stability and Growth Pact more flexible. Not only does it allow statist politicians to save their welfare states, but it also opens for a classic form of “Italian governance”. The EU Observer again:
Italian prime minister Matteo Renzi, whose government holds the EU’s six month presidency, has led calls for the pact’s rules to be applied with more flexibility to allow governments to increase public investment programmes. The demand was rejected by Draghi who stated that “the present rules already contain enough flexibility”. “If a rule is a rule then it has to be complied with,” he said, commenting that “I’m not sure I get – perhaps because I lack political skills – the chemistry of flexibility being essential to make a rule credible”.
It’s simple. The flexibility that Renzi wants is simply a way to apply a general law selectively. That, in turn, gives elected officials more power, as they can oversee the “flexible” application and choose who will get and exception and who will not. Inevitably, the choice will be made based at least in part on the size of the brown envelopes that exchange hands under the negotiation tables in Brussels.
Between corruption and the welfare state, big government has enough supporters to stay right where it is in Europe. Furthermore, regardless of what kind of interpretation of the Stability and Growth Pact that will set the tone in the next few years, it is going to be there as a power tool for the EU over the member states. The left’s desire for more flexibility is just a desire to put more direct power in the hands of bureaucrats and legislatures.