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.
So what is really happening to the U.S. economy? Is it in recovery mode, or did the very negative growth numbers for the first quarter signal a new recession? Is the European economy in a recover phase, or not?
While I have firmly said “no” on the European recovery question, there is no doubt that economists in general will wrestle with these questions for at least the remainder of 2014. The past few years have been particularly challenging for economists, especially those whose days are spent on mainstream, econometrics-based forecasting. In an excellent article for the Wall Street Journal, republished by the Hoover Institution, financial economist John Cochrane shows just how challenging those years have been.
Put bluntly, over the course of the Great Recession, leading macroeconomists have missed the target in their predictions of GDP growth by so much that if they tried to send a space chip to Mars it would go to Jupiter instead.
Fortunately, economists do not build space ships. But major errors in macroeconomic forecasting are a serious matter. Politicians decide fiscal policy based on those forecasts. In Greece, for example, the government followed advice on tax increases and spending cuts from leading economists at the International Monetary Fund (IMF). The IMF economists had grossly under-estimated the negative reactions in the private sector to government spending cuts.
The error, concentrated to a so called fiscal multiplier, was of such dimensions that one fifth of all young in Greece are now unemployed indirectly as a result of that forecasting error.
As I have reported before, IMF chief economist Olivier Blanchard, a highly respectable economist, issued a full mea-culpa paper soon after they discovered the error. The paper is a stark but honorable warning to other economists to be more cautious about forecasting the future – and about offering legislative advice.
As a macroeconomist I have great difficulty discouraging anyone from listening to advice from economists. Generally, we do well on the policy side. But the Great Recession has challenged a lot of widely held beliefs in economics, among them the belief that econometrics – currently the technical core of economic forecasting – is the supreme tool for predicting the future.
Unorthodox economists like yours truly have long criticized mainstream economists for relying too much on so called rigorous quantitative tools. As Cochrane’s article shows, this debate is gaining strength, and it is a safe bet that it will continue for a long time. In fact, I believe it will constitute the groundwork for major reforms to macroeconomics, both in theory and in methodology, over the next decade or two.
We need those reforms, and we all need to pull our load to make them happen. I do not pretend to have a big voice, but my new book, Industrial Poverty, about the European crisis, will be my first contribution to the conversation.
Politicians, businesses and other members of the general public depend on us knowing what we do. If we are not willing to reconsider our theory, our methodology and everything else all the way down to our forecasting methods, then economists will ultimately be responsible for more surprises in the future, like the one with the U.S. growth numbers, or the one that has been unfolding in Europe over the past five years.
Here is the first in a four-part series on austerity, its theory, its application and its consequences:
In the May European Parliamentary elections voters expressed strong anti-EU sentiment. This sentiment was split into two main channels, one patriotic-nationalist and one socialist. Europe’s leftist political leaders have aggressively seized the momentum, emboldened in good part by strong showings in national elections in recent years (Greece, France and Italy to mention three). They are now seeking to set a new tone in Europe’s fiscal policy, with the Stability and Growth Pact in their crosshairs.
It is important to understand what this means. The socialist desire to overhaul Europe’s fiscal rules are not driven by a concern for the European economy and its permanent crisis. Instead, their goal is to do away with restrictions on deficit spending so they can get back to their favorite political pastime: growing government. They are, however, cleverly using the lack of economic recovery to their advantage.
Before we get to the details of this, let us first note that – just as I have said over and over again – there is no recovery underway in Europe:
Eurozone business activity slipped for the second month running in June, a closely watched survey showed on Monday, with France leading the fall and possibly heading to recession. Suggesting a modest recovery could be stalling, Markit Economics said its Eurozone Composite Purchasing Managers Index (PMI) for June, a leading indicator of overall economic activity, slipped to 52.8 points from 53.5 in May. The data showed that growth remained robust in Germany, despite weakening slightly, but that the downturn deepened in France, the country generating the most worry in the 18-member currency bloc. “Once again, the bad news in June came largely from France,” said Holger Schmieding, chief economist at Berenberg Bank. Business activity in France slumped to 48.0 points from 49.3 points, pushing even lower below the 50-point line which marks the difference between expansion and shrinkage of the economy.
France is the second largest economy in the euro zone, with 21.5 percent of the zone’s total GDP. It is also the second largest economy in the EU, measured in euros, edging out Britain by eight percent. For this reason alone, a downturn in France is going to affect the entire euro area and, though obviously to a lesser degree, the entire EU economy.
However, as the EU Business story continues, we learn that France is not the only culprit here:
The June PMI rounded off the strongest quarter for three years, but a concern is that a second consecutive monthly fall in the index signals that the eurozone recovery is losing momentum,” Williamson said. The currency bloc excluding heavyweights France and Germany “is seeing the strongest growth momentum at the moment, highlighting how the periphery is recovering,” he added. Germany’s PMI stood well into expansion territory, but at 54.2 points, slightly lower than 56.1 points reached the previous month. “Despite the further drop in the overall Eurozone composite PMI, the index remains comfortably in growth territory,” said Martin van Vliet of ING. But the PMI slip “vindicates the ECB’s recent decision to implement further monetary easing and will keep fears of a Japanification of Europe firmly alive,” he said.
See I told you so. I stand firmly behind my long-term prediction that Europe’s crisis is not a protracted recession but a permanent state of economic affairs. Europe is in a permanent state of stagnation and will remain there for as long as they insist on keeping their welfare states.
This is where the surging socialists come back into the picture. The last thing they would do is admit that government is too big. Instead, they are now hard at work to do away with the restrictions on deficit spending that the EU Constitution has put in place, also known as the Stability and Growth Pact. Or, as explained in a story from the EU Observer:
The European Commission and government ministers will re-assess the bloc’s rules on deficit and debt limits by the end of 2014, the eurozone’s lead official has said. But Dutch finance minister Jeroen Dijsselbloem, who chairs the monthly meeting of the eurozone’s 18 finance ministers, insisted that the terms be kept to for now. “All the ministers stressed the importance to stick to the rules as they are now,” he told a news conference in Luxembourg on Thursday (19 June). “At the end of the year… we will look at whether we can make them less complex.” The EU’s stability and growth pact requires governments to keep budget deficits below 3 percent and debt levels to 60 percent. It has also been stiffened in the wake of the eurozone debt crisis to make it easier for the commission to impose reforms and, ultimately sanctions, on reluctant governments. But the effectiveness of the regime has been called into question this week. Germany’s economy minister Sigmar Gabriel appeared to distance himself from his country’s long-standing commitment to budgetary austerity on Monday, commenting that “no one wants higher debt, but we can only cut the deficit by slowly returning to economic growth.” Critics say that the 3 percent deficit limit enshrines austerity and prevents governments from putting in place stimulus measures to ease the pain of economic recession and boost demand.
It is interesting to compare this to statements from the IMF earlier this month. The IMF does not - at least not explicitly – want to give room for expanded government spending. But government expansionism is the underlying agenda when the EU Commission and other political leaders in Europe start questioning the debt and deficit rules if the Stability and Growth Pact. According to the prevailing wisdom among Europe’s leftists the Pact has driven austerity which in turn has reduced government spending. While they are correct in that regard, they do not mention that the same austerity measures have increased the presence of government in the other end, namely in the form of higher taxes. They obviously do not have a problem with higher taxes, but to them it is politically more advantageous to point solely at the spending side of the equation.
In short, the new leftist attack on the Pact’s debt and deficit rules seeks to cast the rules as not only having damaged the European welfare state but also as preventing future government expansion:
The Italian premier [Democratic Socialist Matteo Renzi] is a key player in delicate negotiations among EU leaders on the next president of the European Commission, who also needs the EP’s endorsement. The assembly’s socialist group, where the PD is the largest delegation, has expressed readiness to support Merkel’s candidate – former Luxembourg premier Jean-Claude Juncker – if he accepts a looser interpretation of EU budget rules. “Whoever is running to lead the EU commission should first tell us what he intends to do for growth and jobs. Rules must be applied with a minimum of common sense,” Renzi said last week, while his point man for the EU presidency, undersecretary Sandro Gozi, suggested that the EU had “worried a lot about the Stability Pact”, forgetting that “its full name is ‘Stability and Growth Pact’, not just ‘Stability Pact’”.
Interestingly, the left has gained such a momentum in their attack on the Stability and Growth Pact that they are beginning to rock support for it even among its core supporters. The EU Observer again:
On Monday, German Vice-Chancellor Sigmar Gabriel echoed Italian arguments by suggesting that countries adopting reforms that are costly in the short term, but beneficial in the long run, could win some form of budget discipline exemption. But his proposal was immediately shot down by Merkel’s right-hand man, Finance Minister Wolfgang Schaeuble. Daniel Gros, the German-born director of the Centre for European Policy Studies (CEPS), a Brussels think-tank, thinks Renzi could get his way as long as he delivers on his domestic reform pledges. “If he manages not just to announce them, but also get them approved by parliament and implemented on the ground, he would have a lot of cards in hands,” Gros says. He agrees it is a question of reinterpreting, rather than changing EU budget rules.
Renzi has made it clear that he wants to see increased budget flexibility under EU rules, a condition for him to back Jean-Claude Juncker as the next European Commission president. The Italian PM wants productive investments to be removed from deficit calculations. Padoan said this month that reforms undertaken should be factored in the way budget deficits are calculated.
There is no mistaking the confidence behind the left’s attempts at doing away with the Stability and Growth Pact, or at least disarming it. So far it has been political kätzerei in Germany to even raise questions about the debt and deficit rules. But as another story from Euractiv reports, that is beginning to change:
German Economic Affairs Minister Sigmar Gabriel has advocated giving crisis-ridden countries more time to get their budgets in order, triggering a debate in Germany and rumours of a divide within Germany’s grand coalition over its course for EU stability policy. … “We are in agreement: There is no necessity to change the Stability Pact,” said German Chancellor Angela Merkel in Berlin on Wednesday (18 June). The Chancellor and Economic Affairs Minister Sigmar Gabriel deflected accusations on Wednesday that there is a rift within the German government over changes to Europe’s Stability and Growth Pact. The two were clear that they are in agreement over the fact that the pact does not need to be altered. Rumours of dissent came on Monday (16 June) after Gabriel said countries should be given more time to fix their budgets in exchange for carrying out reforms, while speaking in Toulouse, France. Countries like France and Italy have been struggling with the strict conditions of the Stability Pact for some time now and continue to call for more flexibility and time. Gabriel’s initiative seeks to accommodate these concerns, a proposal that originally came from the family of social democratic parties in Europe. The French and Italian governments are run by parties belonging to this group.
The problem with the left’s aggressive assault on the Pact is not that the Pact itself is good. It is not. It is constructed by artificially defined debt and deficit limits with no real macroeconomic merit to them. No, the problem is that the left wants to be able to grow government even more, in an economy that already has the largest government sector in the world. Doing so would only reinforce Europe’s stagnation, its transformation into an economic wasteland – and its future as the world’s most notorious example of industrial poverty.
Big news. The IMF wants Europe to focus less on saving government from a crisis that government created, and to focus more on getting the economy growing again. From a practical viewpoint this is a small step, but it is nevertheless a step in the right direction.
Politically, though, it is a big leap forward. Two years after the Year of the Fiscal Plague in Europe, the public debate on how to get the continent growing again is beginning to turn in the right direction.
The EU’s rules on cutting national budget deficits discourage public investment and “imply procyclicality,” prolonging the effects of a recession, a senior IMF official has said. Speaking on Tuesday (10 June) at the Brussels Economic Forum, Reza Moghadam said that reducing national debt piles should be the focus of the EU’s governance regime, adding that the rules featured “too many operational targets” and a “labyrinth of rules that is difficult to communicate.” “Debt dynamics i.e., the evolution of the debt-GDP ratio, should be the single fiscal anchor, and a measure of the structural balance the single operational target,” said Moghadam, who heads the Fund’s European department.
Let’s slow down a second and see what he is actually saying. When the Great Recession broke out full force in 2009 the IMF teamed up with the EU and the European Central Bank to form an austerity troika. Their fiscal crosshairs were fixed on Greece and other countries with large and uncontrollable budget deficits. The troika put Greece through two very tough austerity programs, with a total fiscal value of eleven percent of GDP.
Imagine government spending cuts of $800 billion and tax increases of $1 trillion in the United States, executed in less than three years. This is approximately the composition of the austerity packages imposed on the Greek economy in 2010-2012. No doubt it had negative effects on macroeconomic activity – especially the tax increases. But the econometricians at the IMF were convinced that they knew what they were doing.
Until the fall of 2012. I have not been able to establish exactly what made the IMF rethink its Greek austerity strategy, but that does not really matter. What is important is that their chief economist, Olivier Blanchard, stepped in and published an impressive mea-culpa paper in January 2013. The gist of the paper was an elaborate explanation of how the IMF’s econometricians had under-estimated the negative effects on the economy from contractionary fiscal measures – in plain English spending cuts and tax increases.
The under-estimation may seem small for anyone reading the paper, but when translated into jobs lost and reduction in GDP the effects of the IMF’s mistake look completely different. It is entirely possible that the erroneous estimation of the fiscal multiplier is responsible for as much as eight of the 20 percent of the Greek GDP that has vanished since 2008 thanks to austerity.
This means that by doing sloppy macroeconomics, some econometricians at the IMF have inflicted painful harm on millions of Greeks and destroyed economic opportunities for large groups of young in Greece. I am not even going to try to estimate how large the responsibility of the IMF is for Greece’s 60-percent youth unemployment, but there is no doubt that the Fund is the main fiscal-policy culprit in this real-time Greek tragedy.
Despite the hard facts and inescapable truth of the huge econometric mistake, the IMF in general, and chief economist Olivier Blanchard in particular, deserve kudos for accepting responsibility and doing their best to avoid this happening again. Their new proposal for simplified fiscal-policy rules in the EU is a step in this direction, and it is the right step to take.
Back to the EU Observer story:
“The rules are still overlapping, over specified and detract focus from the overall aim of debt sustainability,” he said. The bloc’s stability pact drafted in the early 1990s, and reinforced by the EU’s new governance regime, requires governments to keep to a maximum deficit of 3 percent and a debt to GDP ratio of 60 percent. However, six years after the start of the financial crisis, the average debt burden has swelled to just under 90 percent of economic output, although years of prolonged budget austerity has succeeded in reducing the average deficit exactly to the 3 percent limit.
Yes, because that was the only goal of austerity. The troika – especially the EU and the ECB – did not care what happened to the rest of the economy. All they wanted was a balanced budget. The consequences not only for Greece, but for Italy, Spain, Portugal, Ireland, France, the Netherlands, Belgium and even the Czech Republic have been enormous in terms of lost jobs, higher taxes, stifled entrepreneurship, forfeited growth…
I believe this is what the IMF is beginning to realize. The European Parliament election results in May put the entire political establishment in Europe on notice, and the IMF watched and learned. They have connected the dots: austerity has made life worse in Europe; when voters see their future be depressed by zero growth, high unemployment and a rat race of costlier government and lost private-sector opportunities, they turn to desperate political solutions.
When people are looking ahead and all they see is an economic wasteland, they will follow the first banner that claims to lead them around that wasteland. Fascists and communists have learned to prey on the desperation that has taken a firm grip on Europe’s families. But the prospect of a President Le Pen in 2017 – a President Le Pen that pulls France out of the euro – has dialed up the panic meter yet another notch.
In short: the IMF now wants Europe’s governments to replace the balanced-budget goal with fiscal policy goals that, in their view, could make life better for the average European family. The hope is that they will then regain confidence in the EU project and reject extremist alternatives. I do not believe they can pull it off, especially since they appear to want to preserve, even open for a restoration of, the European welfare state.
EU Observer again:
[Critics] … argue that the [current fiscal] regime is inflexible and forces governments to slash public spending when it is most needed at the height of a recession. “Fiscal frameworks actively discourage investment….and imply pro-cyclicality and tightening at the most difficult times,” commented Morghadam, who noted that “they had to be de facto suspended during the crisis.” Procyclical policies are seen as those which accentuate economic or financial conditions, as opposed to counter-cyclical measures which can stimulate economic output through infrastructure spending during a recession.
All of this, taken piece by piece, is correct. The problem is the implied conclusion, namely that you can do counter-cyclical fiscal policy with the big government Europe has. You cannot do that. The confectionary measures at the top of a business cycle simply become too large, too fast. The reason is that taxes and entitlements are constructed in such a way that they redistribute income and resources between citizens on a structural basis. If you use this structure as a measure to stabilize a business cycle you will inevitably reinforce the work-discouraging features of high marginal income taxes at the top of the cycle, but you won’t weaken work-discouraging entitlements at the same point in time. The combination of work-discouraging incentives then accelerate the downturn.
Long story short, if you attempt to use a modern welfare state is not suited for countercyclical fiscal policy, you will end up with weaker growth periods and stronger recessions. Exactly the pattern we have seen over the past quarter-century or so in Europe, and to a lesser degree over the past 15 years in the United States.
The only viable route forward for Europe – and long-term for the United States as well – is to do away with the welfare state. Until we get there, though, this rule change, proposed by the IMF, would be a small step in the right direction. It would ease the austerity pressure, take focus away from attempts at saving government and putting the political spotlight on the need to restore the private sector of the European economy.