The Relentless Growth of Debt

The Great Recession has been a rockier ride for the economies of the Western world than any other economic crisis since the Great Depression. We are still not out of it, and there is no way of telling when Europe will recover – if ever. While the U.S. economy continues its moderate recovery, there are still no credible signs of a turnaround in Europe, where there is almost no GDP growth and very slow growth in consumer spending.

It is entirely understandable that the Europeans have not yet seen the light in the tunnel. Their focus during the recession has been to bring down government budget deficits, prioritizing a balanced budget over any other economic goal. But underneath the efforts to balance the budget there is another, less visible but nevertheless unrelenting agenda: to save the European welfare state.

The EU has propagated for, and imposed, austerity policies upon member states not because a balanced budget is inherently good, but because it makes the welfare state look fiscally unsustainable. During the 1980s, when Lady Thatcher led Britain back to the 20th century, Europe’s conservatives used budget deficits as an argument against big, redistributing entitlement programs. They had a point: government debt as share of GDP has been growing all over the Western world for almost half a century now. The following tables illustrate this. They report data from CESIFO, a German research institute, with the numbers illustrating a relationship between government debt as share of GDP in two different years. For example, in the first table, the number reported for Japan is 6.04 under the column title “1970 to 1990″. This means that the Japanese government’s debt in 1990, as share of GDP, was 6.04 times higher than it was in 1970. In other words, if the Japanese government’s debt in 1970 was ten percent of GDP, it would be 60.4 percent of GDP in 1990.

Consequently, any report of a number larger than 1.00 means that the debt ratio in that country has increased:

Debt ratios

Country selection is based entirely on data availability; not all countries have reported comparable data for the periods in question. However, for each period, the selection shows the same consistent trend of growing government debt. In the first period, from 1970 to 1990, debt grew in eleven of 13 countries. In the second period, 1975-1995, debt grew in 14 out of 16 countries. In period three, 1980-2000, 14 out of 17 countries experienced debt growth. Finally, in the fourth period debt grew in 22 out of 28 countries.

The unrelenting growth in debt is closely associated with the welfare state. A good example: the Danish record-breaking growth in debt between 1975 and 1995 originates in an out-of-control expansion of entitlement programs in the 1970s and early ’80s. In the late ’80s Denmark went through a very painful period of austerity, with massive tax increases that in some ways crippled private consumption. Debt growth stopped, though, and in the early ’90s focus shifted toward tax cuts. As a result, the Danish debt ratio declined from 1995 through 2005.

Does the Danish example show that the welfare state is compatible with economic growth and prosperity? No, it does not. More on that in a later article. For now, enjoy the debt ratios and consider what they tell us about our generation’s sense of entitlement, especially vs. future generations.

Wishful Recovery Thinking in Europe

Don’t get me wrong – I would be thrilled if Europe could enter a phase of solid growth and sustained recovery. But having studied the European crisis in depth over the past two years (with a book due out in July) I also know what it takes for that economy to recover. So far I do not see anything that tells me it is happening, and I certainly do not see the political open-mindedness needed for the Eurocrats to enable a recovery. On the contrary, I see Europe’s political leaders play “Where’s Waldo?” with the economic recovery. On February 25, the EU Observer declared:

The EU’s economic recovery will gather speed in 2014 and 2015, the European Commission predicted on Tuesday (25 February), indicating that the worst of the economic storm which hit Europe is over. “Recovery is gaining ground in Europe,” economic affairs commissioner Olli Rehn told reporters at the European Parliament in Strasbourg, saying that the EU economy would grow by 1.5 percent in 2014 and 2 percent in 2015. The recovery would be driven, in the main, by increased domestic demand and consumption, as Europeans and businesses become more confident about their economic prospects, he added.

Then today, EUBusiness.com reports:

The European Central Bank on Thursday raised slightly its growth forecast for the euro area this year, but trimmed its forecast for inflation. ECB president Mario Draghi told a news conference that the central bank is pencilling in economic growth of 1.2 percent in 2014, 1.5 percent in 2015 and 1.8 percent in 2016. That represent a fractional upward revision of 0.1 percentage point for 2014, compared with the ECB’s previous projections published in December, Draghi said.

Of these two sources, it would be wise to trust neither. They have both presented spiced-up growth forecasts more times in the past few years than anyone cares to keep track of. But there is no doubt that of these two institutions the ECB possesses the better tools to be fairly accurate.

That said, there are a few items in the way of a recovery, even at the very modest numbers that the ECB foresees. According to the EU Business article, the central bank predicts that

External demand would benefit from the global recovery gradually gaining strength. Domestic demand was expected to benefit from improving confidence, the accommodative monetary policy stance and falling oil prices which should lift real disposable incomes. “Domestic demand should also benefit from a less restrictive fiscal policy stance in the coming years and from gradually improving credit supply conditions,” the ECB said.

The phrase “in the coming years” is critical. So far there has not really been any change in fiscal-policy preferences in the EU generally. Greece is still under austerity pressure, and the French government has gone on a fiscal rampage through the economy, spearheaded by outright confiscatory income taxes. If the EU declared an unequivocal austerity cease-fire, then the member states would stand a chance of getting somewhere down the road of a recovery.

As things are now, it is simply not credible to forecast a recovery. Unemployment numbers point toward a state of stagnation at best, and as I explained on February 17, a more comprehensive look at the European economy suggests stagnation, not recovery.

Since then, Eurostat has released quarterly GDP growth rates for the last quarter of 2013. For the EU-28 there is a little bit of good news: growth was 1.1 percent, adjusted for inflation, over the fourth quarter in 2012. It is the highest quarterly growth rate in more than two years, but it does not give us a full picture of what is actually happening on the ground. Eurostat has so far only released state-specific data for 18 of the EU’s 28 member states, but practically every one of those states reports an increase in year-to-year growth for the fourth quarter of 2013 compared to the third quarter of 2013.

Taken together with the less-disastrous numbers for the third quarter, the fourth-quarter numbers could be interpreted as an emerging recovery trend. However, as this figure shows, EU GDP growth has fluctuated rather violently over the past few years, and even sustained above two percent for a while, without any trend emerging toward an economic recovery:


If, as the ECB says, the recovery depends primarily on a better global economy, then we are back to the case of an exports-driven turnaround for the European economy. As I explained last summer, it is practically impossible for exports to pull a modern economy out of its slump.

But even more important than this is the fact that the Europeans have re-calibrated their welfare states. The in-depth meaning of this will have to wait until another article; the short story is that government budgets in many European countries now balance at a lower activity level. As a result, it takes less growth in GDP to generate a budget surplus, a surplus that constitutes a net drainage of money from the private sector to government – where it is not spent. This puts a dampener on GDP growth, and it also leaves more workers idle as it takes fewer workers to produce the taxes that government needs.

The re-calibration of the welfare state is a result of austerity and an important reason why Europe is facing stagnation, not a recovery.

Tax Hikes in Sweden a Bad Idea

The Swedish Treasury secretary, Anders Borg, has been in office now for seven years. He is one of the longest lasting masters of government funds in the free world. I’ve had a lot of criticism for him over the years, but I also want to acknowledge that he has done some things right, at least given the circumstances.

Mr. Borg came into office after the 2006 parliamentary election, and was very soon hurled into the Great Recession. I really don’t envy his job: Swedish law mandates that the government prioritizes a balanced budget, annually, above all other economic policy goals. This is an easy priority to comply with in good times, but once a recession strikes government revenue takes a nose dive. In the elaborate European welfare states, government spending increases precisely when revenue declines. In other words, government budgets are built to open major deficits in recessions.

Like all other Treasury secretaries in a similar situation, Mr. Borg chose to fight the deficit. Early on, his fiscal policy was clumsy and came with ill-conceived spending cuts. His budgets were poorly written, sometimes with outright embarrassing analytical flaws. Over time, though, things got better on the analytical side and Mr. Borg persisted in pushing for a Swedish version of the Earned Income Tax Credit. As I explain at length in a chapter in my book Ending the Welfare State, the EITC is an inefficient way of cutting people’s tax burdens, primarily because it creates very steep marginal tax effects for low-income families. That said, in a country that has a history of having the world’s highest taxes it is better to introduce an EITC of sorts than to do nothing.

In the last year or two Mr. Borg has taken yet another step toward a more comprehensive fiscal policy. He has cited Keynesian theory as the source of inspiration for his fiscal policy. Last year he emphasized, several times, the need for fiscal stimulus to get the Swedish economy going. He pointed to a further expansion of the Swedish EITC as an example.

Today Mr. Borg still abides by a crude, textbook version of the Keynesian-Neoclassical synthesis. He still wants to counter swings in the business cycle with active, stabilizing fiscal policy. There is nothing wrong in this, except for two things: Mr. Borg is still determined to defend the indefensible welfare state – and you would have to accept the fact that Sweden is now out of its recession and heading for some kind of macroeconomic over-heating.

Leaving the indefensibility of the welfare state aside for now, the notion that Sweden is in a growth period is of bigger interest than it might seem at first. In claiming that he sees a recovery in the economy, Mr. Borg echoes similar sentiments from Eurocrats in Brussels. But just as it is wrong to say that Greece is on a macroeconomic rebound, it is simply bizarre to say that Sweden is out of the recession.

Let us look at some data from Eurostat to see where Sweden really is today:

  • The Swedish unemployment rate is currently reported by Swedish statistical agencies as 7.7 percent. According to Eurostat it has been at eight percent since 2010 with no real trend in either direction.
  • Youth unemployment is also trendless. After topping out at 26.7 percent during the crisis it is now steady around 24 percent.
  • GDP growth is equally unimpressive. In the third quarter of 2013 the Swedish economy grew by 0.7 percent over the same quarter in 2012. The average annual growth rate for the last four quarters is 0.8 percent.

These are not numbers that indicate any kind of over-heating in an economy. There is not even a hint of recovery here. Okun’s law says that an economy needs to grow at more than two percent per year to bring down unemployment; so far, the Swedish economy cannot even get to half that rate.

The only variable with any kind of positive trend is private consumption. In the third quarter of 2013 Swedish households increased their spending by 2.1 percent, adjusted for inflation, over the same quarter in 2012. This was the fifth quarter in a row with accelerating consumption growth, which could be taken as a sign of economic recovery. However, if we remove spending on housing from these numbers the average growth rate declines to approximately European average. The reason why we need to make this adjustment is that Swedish households are spending exceptional amounts on housing: there is practically no production of new homes, and population growth is among the highest in the industrialized world (due to large immigration from non-Western countries). As a result, Swedish households have been forced to basically mortgage the rest of their lives, with debt-to-disposable-income ratios in excess of 180 percent. By comparison, when the American housing bubble burst in 2008, the average U.S. household had a debt of 130 percent of their disposable income.

In short: what seems like a trend of recovery in Sweden’s private consumption is in reality a debt-driven housing spending spree. It cannot and will not bring the economy back to growth.

The saddest part of this is that Mr. Borg wants to quell an overheated economy that does not exist, by raising taxes. All that this will do is perpetuate the current situation with high unemployment, almost no growth – and dangerously indebted households. In fact, by raising taxes Mr. Borg could provoke an acute debt crisis: by taking more from the private sector he raises the likelihood that private disposable income will cease to grow in the next year or two. As this happens, the ratio of household debt to disposable income will rise again, but since it is now the denominator that is stagnating, the risk of bank panic is higher than if the numerator was accelerating.

In short: Mr. Borg could provoke a meltdown on the Swedish real estate market.

Again, I applaud Mr. Borg for wanting to build his fiscal policy on an analytical foundation. His problem is that he does not give himself enough time to do the analysis (and he certainly does not have access to adequate brainpower at the Treasury Department in Stockholm…). A growth period in need of any kind of fiscal-policy moderation would look more like the Swedish economy in the 1980s when unemployment was at two percent.

Yes, two percent.

In a way, the fact that Mr. Borg does not want to wait for full employment before he takes to growth-quelling policy measures is an indication of how the past couple of decades have changed people’s perception of the macroeconomic normal. This is not just the case in Sweden, but in Europe in general.

We have to watch out here in the United States so we don’t fall for the same illusion.

EU Stagnation: More Evidence

The search for a European economic recovery continues. On February 4 British newspaper The Guardian reported that while there were somewhat disappointing news out of the United States, the European should be seeing some lights in the tunnel:

The Dow has fallen close to 5% since its all time high at the end of the year, dropping in part on fears that China’s growth is slowing and amid signs of more economic woes in emerging markets. There was stringer manufacturing data in Europe, where Greece’s factory sector was shown to have finally returned to growth for the first time in more than four years, fuelling hopes that the country’s long slump could be easing. The news of rising orders and activity for Greece’s manufacturers came amid evidence of a manufacturing recovery continuing in much of the eurozone.

We have heard these news about a European recovery several times recently, and previously it has turned out to be a macroeconomic henhouse made out of a feather. To check whether or not this is true this time, let us review some Eurostat national accounts data.

Since we do not yet have annual numbers for the European economies for 2013, quarterly data will have to do. That is not a bad idea, though, because if calibrated correctly they can give us a fine-tuned picture of what is happening on the ground. Thus, using quarterly national accounts data, adjusted for inflation, we find the following:

1. GDP growth in the 28 member states of the EU together was 0.4 percent in the third quarter of 2013 over the third quarter of 2012. This is the first positive growth number since the first quarter of 2012 (0.7 percent) which is worth noticing. At the same time, the euro zone exhibited zero growth in the third quarter of last year, admittedly an improvement over five straight quarters with shrinking GDP but hardly anything to write home about. The difference between the two growth rates suggests that it is better to stay out of the euro zone than to be part of it. Sure enough, if we isolate growth rates for the third quarter of 2013 (again over third quarter 2012) we find that out of the eleven EU member states that have a growth rate in excess of one percent, only three – Germany, Ireland and Luxembourg – are part of the euro zone. For example, the British economy outgrew the German, if only by a tenth of a percent. The explanation of this is most likely that the EU-ECB-IMF troika has targeted euro-zone countries for harsh austerity measures, allowing the non-euro EU states to more or less escape the tough fiscal repression. Greece is a good example, with a GDP growth rate of -3.0 percent. A positive side to this number is that it is the smallest quarterly GDP contraction in at least two years, but it also means that all talk about the Greek economy being in a recovery phase is nonsense.

2. Eurostat does not compile data on household consumption in the form of year-to-year quarterly consumption growth. However, they do report it for 23 member states. Of those, seven report a growth rate of one percent or more, while nine report shrinking private consumption. The unweighted average growth rate is 0.5 percent, which goes well with the GDP growth rate in the EU-28 (in normally functioning economies private consumption is the single largest contributor to GDP). Again looking at Greece, it ranks lowest of the 23 with consumption contracting 3.9 percent in the third quarter of 2013 over the same quarter 2012. Again, this is better than previous quarters: we have to go back to the third quarter of 2011 to find a less depressing figure (-2.5 percent). This is of course a good sign in itself, and we could add that the contraction rate fell throughout 2013 (with fourth-quarter numbers still not reported). That said, we could be looking at the same type of temporary relief as the third quarter of 2011 delivered: the first and second quarters of that year saw major contraction rates in private consumption (-12.3 and -6.5 percent, respectively). I don’t think that is the case, because overall it seems like the European economy in general, and the Greek economy in particular, are leaving the depression phase they have been in over the past few years. That, however, does not mean that they are heading for a recovery – far more likely is that we are witnessing the emergence of long-term economic stagnation.

3. Now for the manufacturing numbers. EU-28 saw a 0.4 percent growth rate in the third quarter of 2013, with the euro zone at 0.1 percent. With Eurostat figures from 24 of the 28 EU states we can conclude that there are vast differences between individual member states. Six states saw manufacturing grow at more than two percent; another eight experienced a growth rate of zero to one percent. In ten states manufacturing declined, led by Cyprus (-5.4 percent), Croatia (-5.4) and – yes – Greece (-5.2). Admittedly, one quarter figure does not a full story make, but the Greek situation does not improve much if we look back through the past few quarters. Before the significant decline in the third quarter, Greece saw four straight quarters of growing manufacturing. The average for those quarters was 2.3 percent, which does not compare well to the nine percent quarterly average loss in the four quarters prior to that growth period. In other words, while there has been some comeback for Greek manufacturing since early 2012, the nosedive in the third quarter shows that it is far too early to draw any definitive conclusions.

More than being a sign of a recovery, these Eurostat numbers reinforce the point I have made earlier that the Greek economy is transitioning from depression to stagnation. The same is true for the rest of Europe.

Beyond that, it is interesting to note the emerging difference between the euro-zone countries and members of the EU that still maintain their own currencies. Again, the better performance in non-euro EU states is probably not related to exchange-rate fluctuations benefitting foreign trade, the difference. Instead, it is a matter of austerity enforcement: the ECB obviously has no direct influence over non-euro states, which leaves the fiscal policy in somewhat better shape there.

OECD Wrong on European Crisis

The Great Recession continues to baffle economists around the world. Some have actually admitted that their academic research has been wrong – kudos to the economists at IMF for leading the pack – while others continue to stumble around in the dark. A story in The Guardian gives an example of economists in the latter category:

A failure to spot the severity of the eurozone crisis and the impact of the meltdown of the global banking system led to consistent forecasting errors in recent years, the Organisation for Economic Co-operation and Development admitted on Tuesday. The Paris-based organisation said it repeatedly overestimated growth prospects for countries around the world between 2007 and 2012. The OECD revised down forecasts at the onset of the financial crisis, but by an insufficient degree, it said. “Forecasts were revised down consistently and very rapidly when the financial crisis erupted, but growth out-turns nonetheless still proved substantially weaker than had been projected,” it said in a paper exploring its forecasting record in recent years.

Technically they under-estimated the effects of the credit losses that financial institutions suffered, but not for the reasons the OECD believes. Their forecasting mistake is instead founded in a two-pronged misunderstanding of the true nature of the crisis. First, they fail to realize that this was a welfare-state crisis, created by a slow but relentless growth in the burden of government on Europe’s economies. The weight of the government’s fiscal obesity eventually became so heavy on taxpayers, and the disincentives toward work and investment so strong, that it did not take much to nudge the economy into a deep, severe crisis.

The welfare state’s role in the crisis was enhanced by the fact that in the years leading up to the crisis Europe’s banks bought a trillion euros worth of Treasury bonds, a good chunk of which was from countries that soon turned out to be junk-status borrowers. This seriously aggravated the balance sheets of banks that were already struggling with credit losses.

If they had not been forced to deal with the junkification of Greek, Spanish, Portuguese and Irish government bonds, the banks would have been able to manage and endure the private-sector credit losses. But the unlimited irresponsibility of spendoholic legislators escalated a recession into a crisis.

The second prong of the OECD’s forecasting mistake has to do with austerity. Humbly put, nobody outside of my office grasped the truly negative impact of austerity as early as I did; the only ones who have caught up are IMF economists. On the other hand, their analysis of the role of the multiplier has, frankly, been intriguing. Nevertheless, by not understanding that austerity is always negative for macroeconomic activity, the OECD has missed the forecasting mark even more than by just misunderstanding the relation between the welfare state and the financial sector.

All in all, there is still a lot to be said on what has happened in Europe these past few years, and what implications that has for the future of Europe as well as for America. I am impatiently looking forward to the July release date of my book Industrial Poverty which provides a thorough analysis of the crisis.

Interestingly, as we return to The Guardian, the OECD denies my point about austerity:

The OECD said a failure to understand the impact of austerity policies in various countries did not appear to be a major driver of forecasting inaccuracies. It said the OECD became better at factoring in the impact of austerity amid little space for further monetary loosening as the crisis continued. Overall, “fiscal consolidation is not significantly negatively related to the forecast errors”.

This is a blatant refutation of what the leading economists at the IMF concluded over a year ago. The IMF paper is compelling and based directly on observed forecasting errors. Their main point is that the multiplier effect of one dollar’s worth of government spending cuts is stronger than the multiplier of one dollar’s worth of government spending increases. They show good evidence for this conclusion, evidence that the OECD ignores entirely.

Furthermore, as I report in my forthcoming book there is a wide range of literature on austerity and its effects, and that literature has one thing in common: politicians always under-estimate either of two things: the negative effects of austerity, or the persistent problems with pulling out of a recession by means of austerity.

But there is yet another point where the OECD is wrong. If the financial-sector problems were to blame for the depth and the length of this recession, then why is it that the credit losses happened several years ago, that the bank bailouts have been essentially wrapped up and that, thanks in part to the European Central Bank’s easy monetary policy, there are no longer any credit worries in the European banking system – and Europe is still sinking into higher unemployment and more budget problems??

The underlying presumption in the OECD’s focus on the financial system is again that this was a financial crisis, nothing else. But if that was the case, we would have entered the crisis with sky high interest rates; the banking system would have signaled systemic credit defaults by drying up credit and raising interest rates to the sky before the macroeconomic downturn began. But none of that happened. Interest rates in Spain, Greece and other troubled EU member states started rising only after the recession had escalated into a crisis!

What does this tell us? To answer that question, let us take one more step into the technicalities of macroeconomics. The reason why interest rates went up was not that the financial sector raised the price of credit. The reason was that Treasury bonds in Europe’s big-government states were sent to the financial junk yard. The reason why the Greek government has had to pay ten times higher interest rates than, e.g., the Swiss government is that the Swiss government has never defaulted on its loans while the Greek government forced its creditors to write off part of their loans.

In short: when interest rates started rising in Europe, it was because of unimaginable budget deficits, i.e., a crisis in the welfare state, not the financial system.

One last weirdo from the OECD:

“The macroeconomic models available at the time of the crisis typically ignored the banking system and failed to allow for the possibility that bank capital shortages and credit rationing might impact on macroeconomic developments,” it said.

Credit rationing? At a time when the central bank has flooded every corner of the economy with liquidity?? Europe’s banks hold trillions of dollars in government bonds, and in theory they could go to the ECB and, under the ECB’s bond buyback guarantee, demand cash right now for them. That would be free money for the banks who could then lend it out to whoever they wanted to lend to, and almost be guaranteed to make good money.

In reality, the rationing is not on the supply side of the credit market. It is on the demand side where there are not enough credit-worthy households and businesses to gobble up Europe’s rapidly growing money supply. The fact that the OECD fails to see this adds to my conclusion that they have not done their homework on the Great Recession.

Again: this is a welfare-state crisis, not a financial crisis.

Eurocrats Frustrated over Crisis

I recently noted that the Greek economy has begun a transition from depression to stagnation. A couple of days ago an EU Observer report reinforced my point:

Greece came under renewed pressure to reach a deal with creditors on the latest round of cuts and economic reforms at a meeting of eurozone finance ministers in Brussels on Monday (28 January). Troika officials representing Greece’s creditors began their latest review of the implementation of the country’s €240 billion rescue in September. But they are still to approve the next tranche of a rescue loan, with offficials [sic] indicating that an agreement was unlikely to be reached before the end of February.

There you have it: austerity is not over. As I noted in the aforementioned article, the implosion of the Greek economy is tapering off not because the austerity measures have somehow worked – because they have not – but because the private sector of the Greek economy has reduced itself to its bare bones. Consumers basically have nothing more to cut away. The businesses that are still up and running have slimmed down to pure survival mode. What looks like the end of a depression is really the emergence of industrial poverty.

But even under these harsh conditions and grim future outlook for the Greek people, the austerity-thumping Eurocracy is not satisfied. The EU Observer again:

The review “is taking too long,” Jeroen Dijsselbloem, the Dutch finance minister and chairman of the “Eurogroup,” said. “It’s been going on since September-October, and I think it’s in the joint interest of us and the Greek government to finalise it as soon as possible.” Dijsselbloem also told reporters that any further discussions aimed at tackling an estimated €11 billion shortfall in Greece’s finances in 2014 are on hold. “We’ve made it quite clear that we’re not going to come back to it until there is a final positive conclusion to the review,” he noted. “We call on Greece and the troika to do the utmost to conclude the negotiations,” he added.

There are echoes of frustration in Dijsselbloem’s words. Not only is the Greek economy basically going nowhere (except into the shadow realm of industrial poverty and perpetual stagnation) but the rest of Europe is also, at best, at a standstill. Even if Eurocrats in general practice political denial as best they can, even they have to see the macroeconomic writing on the wall.

But even if Greece were to manage to turn its economy around, it would not be able to pull out of its stagnation. The EU Observer again:

The Greek government is not facing an imminent cash-flow crisis, but says it has no political room to implement any more spending cuts. The Greek government says its economy will emerge from six years of recession in 2014, and record a primary budget surplus of 1.6 percent of GDP in the process. It also says that a primary surplus should see its creditors reduce the country’s debt burden as part of the bailout agreement. For his part, Greek finance minister Yannis Stournaras said he hoped a deal could be reached next month, paving the way for the release of more financial aid in March.

The budget surplus is the work of austerity, not a macroeconomic recovery. By completely recalibrating the welfare state for a lower economic activity level, the Greek government has made sure that should the economy ever recover, it will have a budget surplus even before unemployment falls below 25 percent. That surplus, in turn, will have a depressing effect on the private sector much in the same way as austerity does, namely by exacting excess taxation.

Again, the root cause of Europe’s economic ailment is the welfare state. It is also the elephant in the room that nobody wants to talk about. So I will continue to do so.

EU Downgrades Growth Forecast

In recent months desperate Eurocrats have tried to talk up the European economy. They have predicted that austerity is over, that growth is returning and that hard-hit middle class families have seen the worst of it.

All along, I have pointed to the facts, which speak quite a different language. And lo and behold:

The EU economy will remain flat in 2013, EU economic affairs commissioner Olli Rehn said on Tuesday (5 November), as he downgraded the bloc’s growth forecasts for 2014 and 2015. Although the EU economy grew by 0.3 percent in the second quarter of 2013, offsetting an identical decline between January and March, the commission is not expecting any further growth in the remaining six months of the year.

That 0.3-percent growth number is incorrect, unless it is quarter-to-quarter. Eurostat’s latest quarterly GDP data tells us that measured year to year in the second quarter, the EU-27 economy did not grow at all, but contracted instead by 0.2 percent.

The euro area fared worse, contracting by 0.5 percent. Furthermore:

GDP Growth in the EU, 2013Q2
Latvia 4.3% Belgium 0.1%
Lithuania 3.8% Bulgaria -0.2%
Malta 3.6% EU-27 -0.2%
Luxembourg 2.4% Euro-17 -0.5%
Romania 1.5% Finland -0.7%
Poland 1.2% Croatia -0.7%
Estonia 1.0% Ireland -1.2%
Slovakia 0.9% Czech Republic -1.3%
United Kingdom 0.9% Spain -1.7%
Germany 0.9% Netherlands -1.7%
Sweden 0.6% Slovenia -1.7%
Denmark 0.6% Portugal -2.5%
Hungary 0.5% Italy -2.6%
France 0.4% Greece -3.8%
Austria 0.2% Cyprus -5.9%

There are several important pieces of information in this table. To begin with, the only countries that exhibit any recovery-strength growth are small outlying states like Latvia, Lithuania and Malta, or a tiny, mono-industrial economy like Luxembourg. The engines of the European economy, namely Germany, the United Kingdom and France, are not even at one percent growth.

Seven EU states have a GDP growth rate above one percent, while nine states have a GDP that is shrinking by more than one percent. In the latter category we find the austerity-devastated states on the southern rim: Spain, Portugal, Italy, Greece and Cyprus.

The Greek GDP loss is currently at a rate of 3.8 percent per year, on top of the 25 percent they have lost since the crisis began. That country is nothing short of a macroeconomic horror story.

With these observations, let us get back to the EU Observer story:

Rehn said all 28 of the EU’s member states would achieve economic growth by 2015.  He said the European economy had “reached a turning point” although he cautioned that “it is too early to declare victory: unemployment remains at unacceptably high levels.”

That is an understatement, especially when it comes to youth unemployment which is at or above 20 percent in 20 EU member states. Over the past year youth unemployment has grown in 14 EU states and remained constant or fallen in 14 others (including rookie member Croatia). The average change in the first group is an increase of 2.75 percent while the average reduction rate in the second group is 1.95 percent.

These numbers will not get better until the European economy is back in growth mode. Consider this figure and its clear message on the correlation between growth and youth unemployment:


The fact that the EU Commission is now downgrading its growth forecast for 2014 and 2015 is a big reason to worry what is coming ahead. If there will be no substantial trend change for the better in terms of youth unemployment, Europe is going to lose its young. Period. By 2015 this crisis will be seven years old, going on its eighth year. With just a little bit of bad luck it might outdo the 1930s as the economically most devastating period in modern history.

More Fiscal Trouble in Germany

Two days ago I reported on France’s rising unemployment  and the potential for a large-scale repetition of the Greek crisis. I concluded that so long as the French economy continues to lose up to one percent of its taxpayers to unemployment every year, the government does not stand a chance at balancing its budget. Any attempts at doing so will one way or the other set a downward macroeconomic spiral in motion that, as Greece has demonstrated, can continue to the next Big Bang.

Unlike its southern neighbor Spain, France still has time to save itself from the Greek tragedy. However, their room to take appropriate action is limited by three factors:

1. The mere size of government as it is today heavily stifles private entrepreneurship. Even if the French government did nothing from hereon to try to balance its budget, the French economy would have a long, slow and frail journey to growth, full employment and rising prosperity. This makes it very difficult to defend continuing EU-imposed budget-balancing measures.

2. The socialist ideology of President Hollande, the prime minister and his cabinet prevents the current French government from thinking clearly about alternatives to big-government intervention whenever there is a problem. Since the only sustainable path out of France’s crisis goes through reforms to reduce the size of government, the people that French voters elected to lead the country are ideologically predisposed to reject such a solution. Even if they tried to develop the right kind of solutions it is highly unlikely that they would get very far before their voters, party grassroots and left-leaning media would cry foul and call them ideological hypocrites. Unfortunately, that alone can be a strong deterrent against the right kind of reforms.

3. A rescue plan to have France evade the Greek dungeon would require that most of the rest of the euro-area economy is in reasonably good shape.

Even if lightning struck twice and the French socialists managed to get their act together, the third condition will stand in their way like a concrete road block. Made in Germany. Behold this report from the EU Observer:

In December 2012, leaders from 25 EU countries all signed up to a pact championed by German Chancellor Angela Merkel. The so-called fiscal compact is supposed to discipline countries into spending within their means and reducing their budget deficits and overall debt. In Germany, the “debt brake” will fully come into force in 2019, when the federal state and the regions (laender) are legally bound to stop making new debt.

This is a charade of royal proportions. The EU has had a ban on member-state debt beyond three percent of GDP since 1992, Effectively, the Stability and Growth Pact, which has been in place over two decades now, has made “excessive” debt illegal. As we all know, that has not prevented EU member states from building excessive debt. But that does not prevent the Eurocracy from making what is already illegal, really illegal.

Back to the EU Observer, which reports some worrying signs from inside the German government conglomerate:

Germany is in a much better position when it comes to deficits and debts than its southern neighbours. But still the federal government currently has a debt running at 75 percent of the gross domestic product – above the 60 percent threshold enshrined in EU rules. But in the multi-layered German state, cities fear it will be they who will ultimately foot the bill for Germany’s exemplary balance sheet.

This is crucial:

Ulrich Maly, the mayor of Nuremberg, told journalists in Berlin on Tueday (1 October) that more and more tasks are being moved from federal and regional to the local level, but without any extra funding. … As head of the association representing 3,400 German towns and cities, Maly tabled a series of requests to the upcoming German government, warning of the unfair burden being placed on townhalls in reducing the country’s budget deficit and debt.

Let’s take this in slow motion. The federal government creates a welfare state, then asks states and local governments to participate in the execution of the welfare state’s entitlement programs. To encourage full participation from lower jurisdictions the federal government sends them money. States and local governments get used to the cash and think nothing more of it. Until the day comes when the federal government has made more spending promises than its taxpayers can afford.

All of a sudden the federal government has to make choice:

a) Do they raise taxes? or

b) Do they reduce spending?

The German government tried alternative (a) but tax-paying voters put an end to that. That is in no way surprising, and incumbent prime minister Angela Merkel is trying hard to avoid tax hikes. But choosing alternative (b) is tougher than one might think. Merkel could just slash spending across the board, but if she did she would be accused of wanting to dismantle the German welfare state. That is a battle she does not want to take, probably because she – like most of today’s European “conservatives” – has embraced the welfare state and wants to keep it.

Merkel avoids a battle over the welfare state if she can come across as not cutting any entitlement programs. But since the entitlement programs are the cost drivers for the German government – just as they are for any welfare-state government – she cannot fend off the deficit wolves without somehow reducing the cost of those same entitlements.

Her solution: pass on more obligations to local governments, so the federal government does not have worry about them. But don’t increase spending – have the cities do more with the same or even less money. That way you look like you are protecting the welfare state while also balancing the federal budget.

Does this seem cynical? Understandable. After all, it is cynical. But this is the way politics works when our elected officials set up policy goals that are entirely incompatible, and where the pursuit of one goal, such as the welfare state, hampers the pursuit of another goal, in this case the balanced budget.

This does not stop Merkel’s political opponents from exploiting the apparent inconsistency in her policies. The EU Observer again:

With social expenditure – such as for the integration of disabled people or kindergardens [sic] – taking up over half of cities’ budgets, the question will be “what kind of country do we want,” the Social Democrat said. “The debt brake will put political choices in the spotlight. It will be a question of what we can still afford if we’re supposed to make no new debt. Do we want inclusion of disabled people – which will cost several billion euros – or do we abandon this human right?”

This would be the perfect point to explain to the German people that not even their economy can carry the welfare state any farther. The addition of new entitlements on the top of already existing ones, while people expect existing entitlements to grow, is a formidably bad idea. It goes to show that to the statist there is no such thing as a government big enough.

But it also goes to show how illiterate the backers of the welfare state actually are when it comes to basic macroeconomics. They choose to believe whatever they need to believe in order to motivate a sustained, even growing, welfare state.

And just to show how desperate the situation is getting in Germany, the EU Observer introduces us to…

Eva Lohse, a member of Merkel’s Christian Democratic Union and mayor of Ludwigshafen, … [Lohse] warned that the townhall has virtually no money left for infrastructure projects. “Reducing deficits and debt actually means that somebody else is doing it, not that the task is gone. So whoever does it also needs to have the proper funding for it. We have bridges crumbling down in the middle of our towns – this is unacceptable,” Lohse said.

In effect, there is a glaring lack of understanding of basic macroeconomics on both sides of the ideological aisle in German politics. This lack of insight will delay or entirely rule out appropriate policy solutions. Both the “conservatives” and the social-democrats in Germany will continue to try and preserve the welfare state while balancing the budget in the midst of zero or negative GDP growth. This is a recipe for decline, putting Germany in the same category of struggling welfare states as France, namely one step behind Spain and two steps behind Greece.

Germany still enjoys a lot of economic strength, but with the country’s fiscal policy makers focused on the unworkable combination of the welfare state and a balanced budget that strength can evaporate quickly. Right now, the case for German economic decline is actually stronger than the case for Germany economic recovery. And with German economic decline other euro-zone countries are in grave danger. Greece and Spain won’t get more bailouts, and France and other less-disaster-stricken economies will not have the same strong support anymore from trade with Germany as they have had historically.

Inevitably, our conclusion from this must be that Europe is continuing its slide into the cold, dark dungeon of industrial poverty.

The Welfare-State Debt Game

As I have reported recently, the European crisis is still cooking. Despite five years of austerity, deficits have not gone away. They are so persistent, in fact, that the European Central Bank has been forced to create an unlimited bond buyback program for troubled welfare states: whatever amounts of Greek, Italian, Spanish, Portuguese or any other euro-denominated Treasury bond anyone wants to sell, the ECB promises to buy them without the buyer losing any money.

This program is not making the welfare-state debt crisis easier, but worsening it. Its ultimate consequence could be high and persistent inflation; in order to see why, let us begin with acknowledging another consequence, namely that you can now buy 100,000 euros worth of ten-year Greek Treasury bonds, get 10,290 euros in interest over a year and then be guaranteed to get your money back as if you had bought a Swiss Treasury bond at 1.09 percent. Two weeks ago I explained the potential consequences of this bond buyback program:

In short: there will come a point when the international bond market will test the ECB’s cash-for-bonds promise. Just to give an idea of how much money the ECB could be forced to print, here is a list of government debt by the most troubled euro zone countries: Government debt 2012

Italy 1,988 bn
Ireland 192 bn
France 1,833 bn
Spain 884 bn
Portugal 204 bn
TOTAL 5,101 bn

Greece, notably, does not report its government debt to Eurostat. Nevertheless, here alone we are talking about five trillion euros worth of government debt. If the ECB had to execute on its bonds buyback program for only ten percent of that, it would have to rapidly print 500 billion euros. To put this in perspective, according to the latest monetary statistical report from the ECB, M-1 money supply in the euro zone is 5.3 trillion euros. Of this, 884 billion euros is currency in circulation while the rest is overnight deposits. If the ECB had to print money to meet a run on the bonds in the countries listed above, it would find itself having to expand the M-1 money supply by up to ten percent in a very short time window (theoretically over night). This is to be compared to the 7.7 average annual growth rate of M-1 in May, June and July of 2013.

For all you statists out there, this means increasing growth in M-1 money supply from 7.7 percent to 17.7 percent. By comparison, the Federal Reserve has increased the U.S. M-1 money supply by an average of 11.5 percent per year over the past 12 months (measured month past year to month current year). The growth rate has dropped in recent months, though, falling to 9.1 percent in August.

A temporary boost in euro money supply to stave off a run-on-the-Treasury wave of bond sales would hurl the euro boat into very rocky waters for some time, but if the buyback program really works as intended, the relentless cash pumping by the ECB will eventually calm things down. The problem for the ECB – just as for the Federal Reserve – is that it is a lot harder to reduce money supply than to increase it. Basically, once the cash is out there in private hands, people are not voluntarily going to give it back to the government.

That is, if the buyback program works as intended. It is a very risky program, especially if it would be extended to other euro-zone countries as well. France alone has 1.8 trillion euros in debt, and even though they are technically not covered by the bond buyback program at this time, they could be the next link in the euro chain to come under stress. Their ridiculous tax policies of late will guarantee very weak GDP performance in the next couple of years. I would be very surprised, frankly, if the French economy manages to grow, on average, in 2013 and 2014.

With zero GDP growth, or worse, tax revenues will not grow as the French government intended. They are still wrestling with a deficit – their taxpayers simply cannot keep up with the cost of the welfare state – and with the new, socialist-imposed extra tax burden that deficit is going to be even more persistent.

Since president Hollande and his socialst cohorts in the French National Assembly have pledged to end austerity, they have opened the door for more government spending. This obviously adds insult to injury for an economy already under great stress. It is therefore increasingly likely that the ECB will have to extend its bond buyback program to cover frog-issued bonds as well.

Given the size of the French economy, and debt, this would put the buyback program to the test. Not immediately, but eventually. Today France is paying lower interest rates on its national debt than the United States, but the trend is upward. After almost two years of declining interest rate costs, early this year the trend shifted direction. Interest rates have been going up since February of this year, and the ten-year French Treasury bond now pays almost a half a percent more than it did this past spring.

When the Spanish government started having problems with selling its bonds, it had to increase the interest rate from four to six percent in less than a year. That is a 50-percent spike in the yield demanded by investors, and at the time back in 2011 it took both the ECB and the Spanish government by surprise. Let’s hope no one is surprised if France finds itself in a similar situation 12-18 months from now.

If the ECB thus finds itself saddled with the responsibility to – at least in theory – have cash ready for almost seven trillion euros worth of government debt, it will have to abandon its prime goal, namely price stability. While the United States has proven that you can increase money supply five, six even eight  times faster than GDP without causing high inflation, this does not mean that there is no inflation threat attached to money printing. However,

  • if the freshly printed money goes out to the private sector in the form of reckless lending – as in China – then there is an inflation price to pay (the Chinese are looking at six or more percent inflation this year); or
  • if the fresh new cash goes into the hands of entitlement recipients, thus feeding private consumption without a corresponding increase in private productive activity,

then high, persistent inflation is knocking on the door.

If the ECB starts buying back Treasury bonds en masse, the latter effect could kick in:

1. Troubled governments know that the ECB will guarantee their bonds, thus significantly reducing their incentives to shrink their deficits;

2. The ECB has attached austerity demands to the buyback program, but those demands have proven totally ineffective against government deficits, thus practically voiding those austerity demands of meaning;

3. Persistent, high and socially stressful unemployment has shifted the fiscal balance in troubled welfare states on a permanent basis, with fewer taxpayers and more entitlement takers; in order to maintain political and social stability national politicians will avoid more cuts in the welfare state;

4. As the welfare state’s spending programs remain and more people join them as a result of the economic crisis, government spending will rise while tax revenues are stalled or even decline.

By allowing an increasing share of the population to live on entitlements, Europe’s troubled welfare-state governments will create an imbalance between productive and improductive economic activity strong enough to drive up inflation.

Add to this the imported inflation that inevitably comes in from other countries when the ECB’s new, massive money supply eventually weakens the currency.

The involvement of the ECB in trying to keep Europe’s welfare states afloat is troubling for many reasons. The prospect of the bond buyback program bringing about inflation is not a very healthy one. But for every year that goes by without the EU doing anything to reform away its welfare states, the scenario outline here, which is somewhat speculative today, moves closer and closer to becoming reality.

Another View of the Lost Continent

I have been warning for a long time that Europe is in long-term decline, losing its position alongside North America, Australia and North East Asia as the world’s most prosperous regions. I have warned that Europe is turning into an economic wasteland and explained that nothing is going to change so long as the governments of Europe’s welfare states continue to use austerity to defend their big, redistributive entitlement systems.

This trend of stagnation and decline is not new to the current economic crisis – in some countries it began showing itself as early as the 1980s – but the last five years have put enough nails in Europe’s prosperity coffin to transform the continent into a new South America.

I have been pointing to this serious, structural decline for almost two years now. So far, my warnings have not been heard very widely, but now some people are beginning to see the same pattern. One example is Dan Steinbock, research director at the India, China and America Institute, who just published an opinion piece in the EU Observer. He starts out with a somewhat hopeful observation:

The second quarter GDP figures for the Euro-area economies indicated growth, for the first time in 18 months. Some fund managers and market observers argue that positive new developments could unleash a long-term rally for the continent.

And those fund managers are wrong. Taxes have gone up and government spending has gone down. The private sector has to replace what government is no longer spending money on, with higher-taxed incomes, while still maintaining all its other spending. How is that a recipe for a “long-term rally”?

Steinbock seems to want to agree, at least in part, with the fund managers:

While there are some signs of possible recovery, Europe’s debt crisis has not gone away. … The US economy may soon be ready for a gradual, multi-year exit from QE. Southern Europe certainly is not. And yet, current forecasts portray 2013 as the magical year when everything will turn for the better.

Go back and look at forecasts over the past 3-4 years. Eurostat, OECD and others have consistently been over-optimistic as to where the European economy was heading. The main reason is that they think austerity is good for the economy. So long as they believe that they are going to continue to portray every “next year” as the one where the flowers start blooming again in Europe.

The reason why economists continue to miss the forecasting mark is that they have not done their theoretical homework. They know how to run all kinds of regressions, up and down, sideways, inside out, even in zero gravity, but they treat the economic system as mechanical pieces in hydraulic interaction, not the complex social, cultural and moral system it really is.

Steinbock again:

In the past year or so, the backlash against austerity in Southern Europe has resulted in policy shifts, which, in turn, have supported greater stability, less severe contractions and an improved sentiment across the region. None of these gains indicate a major turnaround, but alleviation of single-minded austerity measures that have added to European challenges.

Again, he is too optimistic. The Greeks are still pushing more austerity measures, and Portugal is in political turmoil over more austerity. Not to mention France – which Steinbock does:

Despite the shift from the conservative Sarkozy to the socialist François Hollande, the competitiveness of France continues to erode. While Paris is slowly moving toward reforms, it is lingering in contraction and can hope for weak growth in 2014, at best.

May I recommend this article, which I published two days ago.

Back to Steinbock, who continues his somewhat optimistic review before eventually turning pessimistic:

Italy has been ridden by contraction for nine consecutive quarters. Enrico Letta’s government has been strong enough to stay in power, but too weak to achieve major changes. The more flexible approach to austerity across the Eurozone has benefited Italy and may allow Rome’s exit from the excessive deficit procedure (EDP) in 2014. But Italy suffers from structural challenges, which translate to continued decline of industrial production and the end of the Letta government by 2014. After half a decade of recession, Spanish conditions are now bad but not devastating, as the austerity obsession has given way to more realistic policies. … In Portugal, the recession will continue until 2014, which means that unemployment will remain close to 20 percent. In July, the resignation of two ministers led to a new cabinet. Greater flexibility in austerity measures and rising sentiment are softening the contraction impact.

Let’s not get ahead of ourselves here. The prime fiscal policy directive in Europe, and especially in Spain, Portugal, Italy, France and Greece, is still to balance that pesky government budget. This means that all other policy goals, such as growth in GDP, reduced unemployment or increased private consumption, are ranked below that goal. Every policy measure is evaluated first and foremost on its potential for bringing down the deficit, and only secondarily on whether or not it can help the economy grow.

Whatever leniency Steinbock is detecting in terms of austerity is more political trickery than signs of a real change in fiscal policy. This means that the economies in Southern Europe will still be under great pressure.

Steinbock then turns to Greece, which, he says…

will be in recession well over the mid-2010s, despite additional funding by Brussels. Unemployment is over 26 percent. Political turmoil is likely to increase toward 2013/2014. A government collapse could pave way to the radical left coalition Syriza, as the leading political party.

Probably. But don’t disregard the possibility that Golden Dawn will team up with the Greek military and force an equally radical political change onto the country.

And now for the more pessimistic, bigger view of the Lost Continent:

[The] Eurozone is suffering a lost decade, which could have been avoided with more sensible policies. During the past half a decade, prosperity levels, as measured by per capita incomes, have stagnated or fallen across Southern Europe. In this way, they have amplified the historical trend line. … By the end of the 2010s, a new hierarchy will prevail in Southern Europe. In France, per capita income is likely to be slightly behind that of Germany. In turn, income per capita in Italy (80% of French GDP per capita) and Spain (70%) will fall behind. Before the global recession, prosperity levels in Greece and Spain were not that different. However, the past half a decade has been devastating in Greece. By the end of the 2010s, Greek per capita income will be close to that in Portugal. In these two countries, prosperity will be barely half of that in France.

This is a bit vague, as Steinbock does not explicitly define the term “prosperity”. It appears to be per-capita GDP, in which case it makes a great deal of sense to compare countries. However, even more important than the relative growth in GDP is the performance of each country: the Greek loss of 25 percent of its GDP in a matter of a few years is completely devastating and unheard of in the Post-World War II industrialized world. It is examples like Greece that can teach us something about what we should and should not try to do to fix an economic crisis.

Steinbock’s main point, again, is that economists are overly optimistic in forecasting Europe’s future. This is a point worth repeating, and the consequences of erroneous forecasts definitely deserve a mention:

At Brussels, the current forecasts – including projections of per capita income, debt, unemployment – are predicated on the idea that 2013 is the year of the great turnaround, when debt will start to decline, recovery will broaden, per capita incomes will climb and high unemployment rates are expected to decrease by some 20 percent by 2018. These gains are anticipated, even despite the impact of aging populations on productivity and growth, and thus on prosperity. In reality, Southern Europe is coping with long-term erosion, which has been compounded by excessive reliance on austerity, at the expense of fiscal support, pro-growth policies and structural reforms. There is no easy way out anymore.

That is entirely correct. The solution lies in those “structural reforms”, the most important of which means dismantling the welfare state – it is the only way out of the prosperity shadow-realm where Europe now finds itself.