When do you stop talking about an economy as being in a recession, and when do you start talking about it as being in a state of permanent stagnation? How many years of microscopic growth does it take before economic stagnation becomes the new normal to people?
Since 2012 I have said that Europe is in a state of permanent economic stagnation. So far I am the only one making that analysis, but hopefully my new book will change that. After all, the real world economy provide pieces of evidence almost on a daily basis, showing that I am right. Today, e.g., the EU Observer explains:
France has all but abandoned a target to shrink its deficit, as the eurozone endured a turbulent day that raised the prospect of a triple-dip recession. Figures published by Eurostat on Thursday (14 August) indicated that the eurozone economy flatlined between April and June, while the EU-28 saw 0.2 percent growth.
I reported on this last week. These numbers are not surprising: the European economy simply has no reason to recover.
The EU Observer again:
Germany, France, and Italy … account for around two thirds of the eurozone’s output. Germany’s output fell by 0.2 percent, the same as Italy, which announced its second quarter figures last week. France recorded zero growth for the second successive quarter, while finance minister Michel Sapin suggested that the country’s deficit would exceed 4 percent this year, missing its European Commission-sanctioned 3.8 percent target.
And that target is a step back from the Stability and Growth Pact, which stipulated a deficit cap of three percent of GDP. It also puts a 60-percent-of-GDP cap on government debt, but that part seems to have been forgotten a long, long time ago.
What is really going on here is a slow but steady erosion of the Stability and Growth Pact. Over the past 6-8 months there have been a number of “suggestions” circulating the European political scene, about abolishing or at least comprehensively reforming the Pact. The general idea is that the Pact is getting in the way of government spending, needed to pull the European economy out of the recession.
No such government spending is needed. The European economy is standing still not because there is too little government spending, but because there is too much. I do not believe, however, that this insight will penetrate the policy-making circles of the European Union any time soon.
Back to the EU Observer:
In an article in Le Monde on Thursday (14 August), [French finance minister] Sapin abandoned the target, commenting that “It is better to admit what is than to hope for what won’t be.” France would cut its deficit “at an appropriate pace,” he added in a radio interview with Europe 1. … Sapin’s admission is another setback for beleaguered President Francois Hollande, who made hitting the 3 percent deficit target spelt out in the EU’s stability and growth pact by 2013 one of his key election pledges in 2012. Paris has now revised down its growth forecast from 1 percent to 0.5 percent over the whole of 2014, and cut its projection for 2015 to 1 percent from 1.7 percent.
Let me make this point again: instead of asking when the European economy is going to get back to growth again, it is time to ask if the European economy has any reason at all to get back to growth. As I explain in my new book, there is no such reason so long as the welfare state remains in place.
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.
Want some euros? There is plenty of them around, and there is going to be even more. The European Central Bank is considering a massive expansion of money supply to fight deflation, which is undoubtedly the enemy of a recovery. Deflation means that falling consumer prices depress the profitability of today’s production and investments. This is the last thing you want to add to the macroeconomic mix in a recession, where profit margins are slim to begin with.
However, the ECB wants inflation for another purpose as well, namely to close the budget deficit gaps that persistently plague Europe’s welfare states. This raises two questions:
- How smart is this strategy?
- Even if it was smart, could the ECB provoke inflation just by printing money?
Let’s address the latter question first. Printing money does not necessarily help. Consider this chart:
At least in the past four years, Europe has experienced an inverse relationship between the supply of M1 money and inflation. This simple statistical observation raises a few questions regarding the ability of the European Central Bank to boost inflation by printing money. Yet, as this article from The Telegraph explains, the leadership of the ECB does not seem to have any qualms about putting the monetary printing presses to work:
Investors are betting the ECB will cut interest rates next month, paving the way for potential further steps such as a bond-buying programme, after its president Mario Draghi said on Thursday the bank was ready to act in June if updated inflation forecasts merit it, reports Bloomberg’s David Ingles.
There was a time when a statement like this from a central bank meant it was ready to act to curb inflation. Now the mindset in central banking is more or less the opposite, with Janet Yellen at the Federal Reserve seeming impervious to the worries about inflation. Admittedly, she has no choice but to continue the Fed’s QE program, but at the same time she has a history of talking dovishly about inflation. It is not inconceivable that she, while essentially being forced to continue QE, harbors a secret wish for higher inflation in the U.S. economy. If so, it is not beyond the realm of the probable that if Congress took decisive steps to rein in the federal debt, and thus eliminate a major reason for the Federal Reserve to print money, Yellen would actually continue printing money just to keep inflation up.
Her counterpart at the European Central Bank, Mario Draghi, is apparently also comfortable with trying to provoke inflation. However, both he and Janet Yellen are playing with fire. Once inflation goes beyond a certain point it grows legs of its own.
The Telegraph again:
European Central Bank President Mario Draghi strongly hinted Thursday that the eurozone’s top monetary authority could take action next month to counter persistently low inflation and strengthen the recovery … The bank’s 24-member rate council refrained from loosening its monetary policy on Thursday. But Draghi said it “would be comfortable with acting next time,” in June, when it will have new staff inflation forecasts.
And now for the question whether or not it is wise to use inflation to fight budget deficits. Buried in the article is a statement that appears to come directly from the smoke-filled back rooms in the ECB headquarters:
Low inflation is a concern because it makes it harder for people and governments to reduce debt.
It is a very safe bet that Mario Draghi, just like Janet Yellen, would like to see inflation precisely because of its effect on government revenue. If that is indeed where we are heading, then it means that influential policy makers would use inflation as a third measure to save the welfare state, after taxes and deficit spending. As you move out that scale, from taxes to inflation, the destructive force of the government-funding measure increases. If our policy makers are indeed so married to the welfare state’s entitlement programs, then we are in for a long, long ride through a landscape of economic stagnation and industrial poverty.
Not even the United States can withstand the pressure from a growing welfare state if our government resorts to inflation to pay for it.
It remains to be seen if that will happen. We still have pretty strong safety zones between us and the European disaster. Those safety zones are essentially constructed by the absence of the worst forms of entitlement programs (general income security being one of them) and a checks-and-balances government that can still fend of the worst excesses of government expansionism. This may prove enough to protect us from succumbing to a European welfare state, which essentially is a slowly detonating socioeconomic counterpart of the hydrogen bomb.
So far we have survived the – admittedly large – elements of the welfare state that we have had to deal with. However, this does not mean we are immune forever. We need to understand in depth that it was big government, not the financial industry, that brought Europe to its knees. Only then will we understand how futile, irresponsible and outright dangerous it is to let inflation loose in our economy.
If the Europeans want to create inflation, there is nothing we can or should do about it. It would mean that they have made the ultimate choice – the welfare state at all cost – but it does not mean that we must make the same choice.
We get almost daily confirmations that the world economy is not in very good shape. The American economy is limping along, with expectations of a reasonable second quarter of 2014 after the abysmal growth number for the first quarter. But with China heading for a major slowdown, possibly spiced up by a financial crisis, we have reasons to be concerned about the economic health of Pacific Asia. But worst of all is, of course, the fact that Europe’s self-inflicted economic crisis is dragging on through yet another year with at best one percent GDP growth.
The lack of any discernible, global recovery is weighing heavy on serious policy makers. One of them is Federal Reserve chairwoman Janet Yellen, who is in the difficult situation of having no choice but to continue the Fed’s Quantitative Easing program. She may or may not be a dove on inflation, but even if she was a hawk who wanted to turn off the monetary faucet right now, she really would have no choice but to stick with current policies. A story from Bloomberg.com sheds light on her situation:
Federal Reserve Chair Janet Yellen made it clear she believes the economy still requires a strong dose of stimulus five years after the recession ended because unemployment and inflation are well short of the Fed’s goals. “A high degree of monetary accommodation remains warranted,” Yellen said today in testimony to the Joint Economic Committee of Congress. “Many Americans who want a job are still unemployed,” and inflation is below the central bank’s 2 percent target, she said.
Again, Yellen does have a reputation of being an inflation dove. This would suggest that she may not at all have the concerns about Quantitative Easing that some critics have. If she is as dovish as some claim she is, QE will continue even as inflation inches closer to the two-percent target.
The irony is that according to some economic theory, QE should itself spark inflation and thus bring about its own ending. However, the transmission mechanisms from money supply to inflation are not as simple and straightforward as is often claimed; there is no real-world correspondence to the monetarist quantity theory of money. That is not to say, though, that more money does not have effects on inflation. It does, but the transmission mechanism runs instead through government. Examples of hyper-inflation in, primarily, Latin America – see, e.g., Argentina – but also in Weimar Germany have all been related to government spending. When the Treasury sells bonds to the central bank in exchange for freshly printed money, and uses that cash to fund entitlements, then we have a recipe for hyper-inflation.
Today, this is only a theoretical risk here in the United States. At this point our federal deficit is shrinking, but if forecasts of a return to growing deficits are correct, and if our dinosauric federal entitlement programs Social Security and Medicare remain unreformed, that theoretical risk will quickly turn into a real problem.
If, on the other hand, the federal government refrains from further regulatory incursions into the private sector, and if the Obama administration can work with Congress to scale back – and eventually remove – the Affordable Care Act, then the U.S. economy will keep moving at steady pace. This will reduce the need for newly printed cash to pay for government expenditures. It will buy us some time to reform our big entitlement programsand permanently reduce the need for an interventionist Federal Reserve.
Until then, though, we are going to have to let Janet Yellen push accommodating monetary policy, with all its consequences. She has no choice. Bloomberg again:
Yellen highlighted weaknesses in the labor market, such as the number of long-term unemployed, even as the economic outlook improves. The Treasury market yield curve steepened after her comments tempered expectations among some investors for a faster pace of interest-rate increases. “She wants to reiterate that there are still challenges, we’re not out of the woods yet, and it’s too early to think about starting to remove accommodation,” said Michelle Meyer, a senior U.S. economist at Bank of America Corp. in New York. “She put the labor-market recovery in historical context, which is that there are still a lot of scars left from the incredibly deep recession.”
Here is the problem. The European Central Bank is still very much committed to accommodating policies, especially with its bond buy-back guarantee where it promises to buy any amount of euro-denominated Treasury bonds that the market may want to sell. They are also considering a dedicated QE program to fight deflation. On top of that, China would probably handle a financial crisis much the same way as European and American central bankers do, namely by saturating the financial system with liquidity. With both Europe and China in money-printing mode, their currencies are going to be under depreciation pressure vs. the dollar. A termination of the Fed’s QE would catapult the dollar to new highs vs. both the euro and the renminbi. That would harm U.S. exports at a very sensitive point in the business cycle.
Long story short, while a continuation of Bernanke’s QE program reinforces Yellen’s reputation as a supporter of lax monetary policy, macroeconomic realities speak to her favor.
Of course, as the Bloomberg story explains, not everyone is going to see it this way:
Five-year yields dropped three basis points to 1.65 percent at 3:11 p.m. in New York, based on Bloomberg Bond Trader data. The 30-year bond yield increased as much as three basis points to 3.41 percent before trading at 3.4 percent. An increase in longer-term yields indicates investors see inflation accelerating, while shorter maturities are anchored by the Fed’s policy rate.
There is one question I would like to ask Yellen, namely at what point does she see monetary policy as having lost its efficiency. According to Bloomberg, she says that the benchmark interest rate…
will stay near zero for a “considerable time” after the Fed ends its bond-purchase program intended to spur growth. In March, Yellen responded to a reporter’s question by saying the rate might start to rise about six months after the Fed ends its asset purchases, a timeframe she hasn’t repeated.
If the U.S. economy continues its slow recovery, the risk continually shrinks that we end up in a liquidity trap. However, with an almost-zero benchmark interest rate we can safely conclude that nobody expects it to fall further. This in turn creates expectations of higher interest rates, just as Bloomberg reports on the 30-year rate. The major consequence of this is that the market expects the price of U.S. Treasury bonds to fall, in other words that it is going to become more difficult for the Treasury to sell its bonds.
These market expectations exist under the condition that the Federal Reserve terminates its QE program at some point. Once that happens, the market will evaluate the U.S. government’s debt on strict market terms, and their evaluation is, again, not favorable. The reason why this is not happening now is, of course, the QE program; if Yellen decided to phase out QE, the U.S. Treasury would have immediate difficulties financing the deficit.
The Obama administration does not want any of this to happen. Yellen, in turn, realizes the difficulties that rapidly rising interest rates would impose on the domestic economy. She also understands the risks to exports from a sharp rise in our exchange rate. All in all, as much as she may be an inflation dove and a fan of monetary accommodation, current fiscal-policy and macroeconomic conditions do not allow her to do anything different than what she is doing.
Last week I again cautioned that the European economy is living under a looming deflation threat. Leading politicians and Eurocrats do everything they can to deny that this threat is real, but economic facts have an irritating tendency to surface again when you least want them to. Alas, the story of deflation is gaining steam, such as with this story from Der Spiegel’s English section:
Speaking to gathered journalists at the Spring Meetings of the International Monetary Fund and the World Bank, [President of the European Central Bank] Draghi twice almost uttered a word he has been at pains to avoid. “Defla…”, Draghi began, before stopping himself and continuing with the term “low inflation.” Yet despite Draghi’s efforts, the specter of deflation was omnipresent in Washington during the meetings. And it is one that is making central bank heads and government officials nervous across the globe. The IMF in particular is alarmed, with Fund economists warning that there is currently up to a 20 percent risk of a euro zone-wide deflation.
That is of course a bit hard to quantify, of course, but the warning from the IMF is well worth listening to. Once deflation sets in, economic behavior changes in many key areas. Consumption is slowed down because consumers can make money off saving their cash and wait for prices to be lower next year; worker compensation will grow more slowly as businesses no longer have to make sure their valued employees can keep up with inflation; productive investments become more expensive because future sales will bring in less per-unit revenue than today’s production; finally, governments start having budget problems again as spending and income grow more slowly, thus slowing down income and sales tax revenues.
Deflation is about the last thing Europe needs right now. So what do leading economists and politicians intend to do to prevent it? Back to Der Spiegel:
IMF head Christine Lagarde has called on European central bankers to “further loosen monetary policy” to address the danger.
As of right now, M1 money supply in the euro zone is growing at almost six percent per year. By contrast, current-price GDP for the euro zone is at best growing at 1.5 percent per year. This means, plain and simple, that the growth of high-powered money is four times faster than growth in demand for that money among the general public.
How much more money would Lagarde like to see the ECB print before she thinks the deflation threat is over?
It looks like someone needs to teach her about the liquidity trap. Perhaps IMF chief economist Olivier Blanchard could give her one of his old textbooks?
Der Spiegel again:
Ever since the Great Depression at the beginning of the 1930s, deflation has been seen as one of the most dangerous illnesses that can befall an economy. Several countries at the time fell victim to a downward spiral consisting of falling prices, rapidly rising unemployment and shrinking economic output — a morass that took years to escape. … Japan provides a more recent example, where the economy has been largely stagnant for years amid falling prices.
Unlike the 1930s, and unlike Japan, Europe has yet one more explosive ingredient in its deflation mix: the welfare state. Europe has been wrestling with budget deficits for five years now, subjecting itself to repeated fiscal austerity whippings that (as I explain in my upcoming book Industrial Poverty) has made the economic crisis far worse than it otherwise would have been. If deflation sets in, tax revenues will fall yet again, while the enormous costs of the welfare state will remain as welfare rolls remain swollen to the breaking point.
What will Europe’s political leaders do when deflation causes a loss of tax revenue?
Der Spiegel does not ask this question. They do, however, notice how ECB officials frantically try to avoid talking about deflation:
The inflation rate in the common currency zone sank to 0.5 percent in March, dangerously close to zero and far away from the ECB’s target of 2 percent. Still, both Draghi and Jens Weidmann, head of Germany’s central bank, the Bundesbank, continue to insist that there is no reason to worry at present. At the IMF Spring Meetings, Draghi said “we see no statistical or model-based evidence of a self-feeding, broad based falling of prices. … In other words, we have no evidence that people are postponing spending waiting for lower prices.”
It is hard to see how Draghi could reach that conclusion. National accounts data from Eurostat indicate that if the Europeans are lucky, private consumption both in the euro zone and in EU as a whole will grow at a maximum of one percent, adjusted for inflation, in 2014. This is no real change for the better from 2013.
Apparently, as Der Spiegel explains, Draghi does not even believe his own words:
A measure is even being considered that has long been seen as taboo: quantitative easing. QE, as it is known, involves central banks buying up significant amounts of securities as a way of pumping money into the markets and thus stimulating both the economy and inflation. Other central banks, particularly the US Federal Reserve, have used the method in recent years to combat the effects of the financial crisis. But in the euro zone, many monetary policy purists, such as Bundesbank head Weidmann, are wary of the solution. The concern is that such a flood of liquidity could encourage governments and companies to delay necessary structural reforms.
This is verbal vanity. The ECB has already made a pledge to buy any amount of treasury bonds from anyone eager to sell. While this pledge is technically limited to countries with “troubled” government finances, it de facto means that if the financial markets pressure a country onto the “troubled” list, the ECB will extend its bond-buying guarantee to cover that country as well. Therefore, the ECB has de facto already written a blank QE check to the bond market and a step from pledge to practice would not raise that many eyebrows.
The question, of course, is if it can help fight off deflation. QE would encourage more government spending – debt spending – which is the most inefficient way to get an economy rolling again. Every other variable on the right side of the classic national-accounts identity Y=C+I+G+NX (where of course G represents government spending) is preferable as a driving force toward a recovery.
Needless to say, Europe must escape the deflation threat, but it must happen in such a way that there is a sustainable recovery on the other side. Printing money to stimulate government spending is a recipe for perpetuating the current crisis. Instead, Europe should try reforming away its welfare state. That would open 40-50 percent of the economy to new entrepreneurs, cost savings, innovation and lots of new jobs.
Europe’s political leadership keeps trumpeting out that their austerity policies actually worked. They are closely backed by their media outlets. Alas, the following story in the EU Observer:
Cash-strapped Greece recorded its first primary budget surplus in a generation last year, according to data released by Eurostat on Wednesday (23 April). Excluding interest on its debt repayments and a number of one-off measures to prop up its banks, Athens recorded a surplus of €1.5 billion, worth the equivalent of 0.8% of its economic output in 2013. Despite this, Greece still recorded an overall deficit figure of 12.7 percent, up by 4 percent on the previous year as the crisis-hit country endured a sixth straight year of recession.
As always, it is completely wrong to use the government budget as some sort of health indicator for how an economy is performing. To illustrate how dicey that can be, let us go over some numbers on the Greek economy.
First, GDP growth, measured as growth over the same quarter in the previous year:
If economic growth was any indicator, the jury would still be out on the Greek economy. It is somewhat of a relief that the contraction of the economy (“negative growth”) is slowing down – the figure for the last quarter of 2013 was -2.3 percent – but there were also two “spikes” of improvement during the ongoing recession, one in late 2009 and one in 2011.
The slowdown of the contraction that began in 2012 is still ongoing, though, which could mean that the Greek economy may actually start growing again some time in 2014. The question is what is behind this improvement. Since austerity policies are still being enforced, fiscal policy is suppressing domestic spending. Therefore, a good bet is that the “leveling out” of the long decline in Greek GDP is driven by an improvement in exports. Not surprisingly, Eurostat data show that Greek exports increased three quarters in a row during 2013. This is the longest period of improvement in exports since 2010.
If activity is improving in the exports industry, it would naturally translate into better GDP numbers, albeit limited compared to a sustained recovery in private consumption. QED. It would also translate into an improvement of government finances, as tax revenue would rise from growing corporate income. However, this improvement is probably not going to be strong enough to lift the Greek government budget to balance, thus it won’t help them end austerity.
So what, then, do Greek government finances actually look like?
If amplitude is a measure of stability, things do not look good for the Greek government. However, what the European press and its political leaders are raving about is the improvement of the budget deficit displayed as the very last data point in the chart above. There, the consolidated government budget is in a deficit of “only” 2.86 percent of GDP. If this came on top of the weak but visible trend of smaller deficits from 2009 and on, there would be a reason to believe in a recovery. However, two variables call for a reality check: first, the exceptional dip in the second quarter, plunging the deficit into 30.4 percent of GDP; secondly, and much more importantly, the fact that the Greek GDP is still shrinking.
If the deficit improves as a ratio of a shrinking GDP, it means that tax revenues are shrinking as you improve your deficit ratio. This in turn means that you are making very drastic changes to tax rates as well as spending: tax rates have to go up and spending has to decline.
In other words, the only way to accomplish an improvement in the Greek deficit is to keep austerity in place. This in turn keeps the depression lid on domestic economic activity. So long as that lid is in place there is no chance for an improvement in overall economic activity.
In addition to GDP growth there is one variable that mercilessly tells the true story of how an economy is actually doing:
If the Greek GDP is indeed nearing a point where it will no longer shrink, and if the reason is a surge in exports, then the leveling out of the employment ratio is the best the Greeks are going to see for the foreseeable future. Their exports industry cannot pull the economy out of the recession anymore than it could pull Denmark out of its very deep recession in the late ’80s, or Sweden in the mid-’90s. So long as austerity remains in place, depression will still keep its tight grip on the Greek economy.
But just to make it worse… even if austerity was lifted, the Greeks would have little reason to expect a rapid return to better days. To see why, let us return to the EU Observer story:
The surplus [in the Greek budget], which was achieved a year ahead of the schedule set out in Greece’s rescue programme, means that it is entitled to further debt relief on its €240 billion bailout. Talks on debt relief, which is likely to involve lengthening the maturity of Greece’s loans to up to 50 years, will start among eurozone finance ministers following May’s European elections.
All the EU is doing here is kicking the can down the road. They are extending the Greek welfare state’s credit line over and over again. All the bailout programs really achieve is a recalibration of the welfare state, with higher taxes, lower spending and overall a more intrusive government that takes more from the private sector – at a lower level of private-sector activity.
And this is precisely the point here. The goal with austerity policies in Greece is to balance the Greek government’s budget. The goal is not to restore full employment; the goal is not to return to high levels of GDP growth; the goal is not to reduce the ranks of welfare and unemployment benefit recipients. No, the goal is to balance the budget. If the Greek government accomplishes that, they will be rewarded by the EU with more, longer-maturity loans.
In a “normal” welfare state the budget balances at something akin to full employment. However, that changes once a welfare state ratchets down into the depths of a protracted recession, such as the one Sweden experienced in the early ’90s and Europe has been struggling with since 2009. Austerity raises the tax ratio on GDP in order to make sure that government can pay for its spending obligations; spending cuts mitigate some of those tax increases. As taxes go up and spending shrinks, the government budget eventually clears, but at a GDP that provides much fewer jobs than before. In other words, after a long period of austerity, government can pay for its expenses without having as many taxpayers as before.
Once the economy starts improving, tax revenues will go up earlier in the recovery than they otherwise would. Since spending has been adjusted downward, this means in effect that government will begin over-taxing the economy way before it reaches full employment. In the Greek case, if austerity actually works the consolidated government will find itself running a surplus at an employment ratio 10-12 percentage points below what it was before the recession.
Excess taxation thwarts private economic activity. Taxes themselves discourage productive investments and spending, but so long as government spends the tax money there is at least some return that mitigates the loss to the private sector. Taxation for a budget surplus, however, means that literally nothing is coming back into the economy. Every tax dollar is a full loss of economic activity, meaning that the budget surplus indiscriminately prevents the creation of new jobs.
The economy gets stuck at a low rate of employment. This is a perspective on the Greek economy that nobody outside of this blog is pointing to. Yet there is ample evidence that this is exactly what will happen – unless the Greek government replaces austerity with a long series of permanent, well-designed tax cuts.
There is historic experience to show that such policies could work very well. There is also historic experience to show that if you do not cut taxes, you perpetuate the depression you are in. For more on this, please be patient and wait for my book Industrial Poverty, out in late August.
What is the difference between a turtle and the European economy? The turtle is moving fast forward. There are no lights in the tunnel either, especially when we take into consideration the situation in the big French economy. The socialist government came into power on promises to get the economy going, turn the tide on employment and get the austerity dementors from Brussels off the back of the French people. They have not delivered on a single one of their promises, and even though it takes time for new economic policies to sink in, the French socialist government is closing in on two years in office and should at least be able to produce some credible signs of recovery. But that is not the case. On the contrary, whatever blip on the radar they have been able to produce is succumbing under their tax increases and even more stifling regulatory incursions into the private sector:
The rather tepid growth record of the French economy is having a real impact on its government’s relations to Brussels. With the tax base (GDP) barely growing at half a percent per year, it is arithmetically impossible for the government in Paris to close its budget gap. As a result, Euractiv.co, reports:
France is again seeking an extension from the EU on the deadline to reduce its national deficit. European Parliament President Martin Schulz supports the idea but the German government is insisting on adherence to the guidelines of the European Stability Pact. EurActiv Germany reports. In a speech earlier this week, French President François Hollande made it clear he would attempt to renegotiate Brussels’ demands to reduce the French deficit to under 3% of GDP by 2015. The new finance minister, Michel Sapin, also intends to renegotiate the timeline with the European Commission. “The government will have to convince Europe that France’s contribution to competitiveness, to growth, must be taken into account with respect to our commitments,” Holland said on 31 March. But the EU has already given the country two extra years to comply with the Stability Pact’s deficit limit of 3% of GDP.
This is raising tensions over the Stability and Growth Pact, effectively the legal deficit-cap instrument in the EU constitution:
On Thursday (3 April) in Frankfurt, ECB President Mario Draghi again stressed how important it was for eurozone countries to honour their fiscal commitments within the EU. On Friday morning, European Parliament (EP) President Martin Schulz, spoke in favour of meeting French demands. Schulz is the European Socialists’ candidate in the upcoming European elections. Speaking on BFM-TV in France, he said the country must be given more time to comply with the Maastricht criteria. The rules of the Stability and Growth Pact, with its debt limit of 3% must “be reconsidered”, said Schulz. Norbert Barthle is Bundestag spokesman on budgetary policy for Merkel’s Christian Democratic Union (CDU). In his view, another postponement of the deadline should only take place under clear conditions which state that France will really put its budget back on course. The chairman of the Bavarian Christian Social Union (CSU) political group in the EP, Markus Ferber strongly criticised Schulz’s demands to soften the terms of the Stability and Growth Pact: “While the CDU and the CSU have been acting as a fire brigade to extinguish the euro debt-crisis, Martin Schulz is adding new fuel to the growing fire.”
Schulz is the socialist candidate for president of the EU Commission, with a strong statist agenda in his hand. His desire to water down the Stability and Growth Pact has nothing to do with concern for the French economy – it is primarily motivated by a desire to give government the room to grow without any real limits.
Secondarily, Schulz is vehemently against the austerity policies that the EU-ECB-IMF troika has been forcing on some EU states. I share his resistance, but for entirely different reasons. While Schulz sees austerity as an impediment on government growth, I view it – or at least its European iteration – as a macroeconomic poison pill. It is a good idea to stop austerity policies, but the replacement should absolutely not be more government. The French government is way too big, but this is also the case in Europe in general – which is why there is no recovery in sight. On the contrary, stagnation is the new normal. In the last quarter of 2013, industry activity in the EU-28 and euro-18 areas were as follows in key sectors, measured in gross value added (one of three ways of measuring GDP):
- Manufacturing grew 1.7 percent over the same quarter in 2012; 1.3 percent in the euro area;
- Construction declined 0.4 percent, the 11th quarter in a row with declining activity in this sector; in the euro area the decline was 1.7 percent, the 22nd negative quarter in a row!
- Finance and insurance contracted 0.9 percent in EU-28, 1.1 percent in euro-18.
Measured as employment, the numbers do not look better:
- Manufacturing employment contracted 0.7 percent in the fourth quarter of 2013, the eighth straight quarter with a decline; the decline was 1.2 percent in euro-18;
- Construction saw employment shrink by 1.4 percent, the 22nd straight negative quarter; the decline was a notable 2.9 percent in euro-18, marking the 23rd quarter in a row with declining construction employment;
- The financial-insurance industry basically stood still at +0.1 percent (-0.3 percent in euro-18).
(All numbers are from Eurostat.)
Things may turn around when we get the numbers from Q1 of 2014, but I see no substantial reason to expect a sustained recovery. On the contrary, everything points to continued stagnation, in France as well as in Europe. This does not bode well for the future of the continent – perhaps the EuropeanS should get used to scenes like this one:
There is an ongoing debate here in the United States about our federal debt. Obviously, we cannot keep raising the debt-to-GDP ratio, and although the federal deficit has shrunk dramatically in the past couple of years, there is a strong likelihood that we will return to growing deficits some time beyond 2018. This obviously means that the debt will accelerate again; what will happen to the debt ratio is a question for future inquiry.
As things look now, the U.S. economy is slowly rising out of the recession at growth rates 2-3 times what the Europeans are seeing. That is somewhat good news when it comes to our debt ratio, a variable that has more than symbolic meaning. Countries with high debt-to-GDP ratios pay more on their debts than countries with low ratios. The reason is simple: a country with a low debt ratio is more likely to have enough of a tax base to both fund its current spending and meet its debt obligations. GDP, obviously, is the broadest possible tax base, so the larger it is relative government debt, the safer it is to buy a country’s Treasury bonds.
The next step in this reasoning would be to ask if the debt ratio itself has any relation to GDP growth itself. In other words, does the burden of government debt on an economy slow down its growth? If the answer is yes, then rising debt creates a vicious circle including higher interest rates, the need for higher taxes and stagnant growth.
Many would say that this vicious circle obviously exists and that no further investigation into the matter is needed. However, those who say so disregard the fact that the United States, with a debt ratio above 100 percent of GDP (we cannot count just the debt “held by the public” because all debt costs money one way or the other) has a faster-growing GDP than the EU does, where the aggregate debt-to-GDP ratio for all 28 member states is 87 percent.
Therefore, as always it is good to take a look at some data. The following figure reports Eurostat data for 27 EU member states (excluding Croatia which became a member just this year) over the period 2000-2013. The data is broken down to quarterly levels and not adjusted seasonally (this vouches for “genuine” observations). The left vertical axis reports debt-to-GDP ratios while the right axis reports inflation-adjusted GDP growth numbers, quarterly over the same quarter the previous year. Since this gives us a very large number of pairs of observations, the data is organized into deciles. Each contains 148 pairs of observations – debt ratio and GDP growth for the same quarter – except for the last decile which contains 149 observations. Each decile reports average numbers for each variable for that decile:
*) The astute observer will notice that I am only reporting 1,481 observation pairs when 27 countries observed over 14 years, four times per year, should actually produce 1,512 observation pairs. The lower number reported here is due to two factors: only one data series is available for the fourth quarter of 2013, and both series for Malta are missing for the first few quarters.
While this is not an actual econometric study (that would take a lot more time than I have on my hand for this blog) the analysis nevertheless reports an interesting correlation. First, when the debt ratio rises above 60 percent, growth slows notably. The 60-percent debt level is often referred to in the public debate over government debt as a threshold governments should not cross. I have sometimes dismissed this level as arbitrarily chosen, and I maintain that any simple focus on this ratio for legislative purposes is indeed arbitrary. In fact, if we look at the other end of the spectrum a debt level below 40 percent appears to have very strong positive effects on growth. If we are going to have legislation about a debt ratio cap, then why not use 40 percent?
That said, the observed correlation calls for deeper investigation. Unlike some simplistic pundits (you know who you are…) I am not going to draw the immediate conclusion that high debt ratios cause low growth. Let us remember that GDP is the denominator of the debt ratio; if the denominator grows slowly for any reason, and government keeps deficit-spending as usual, then the debt ratio is going to rise for purely arithmetical reasons. However, as mentioned earlier, large deficits themselves can very well drag down GDP growth, raising the debt ratio for causal reasons.
More on that later.For now, let’s conclude this little exercise with two questions that I hope to answer soon:
1. Is there a correlation between large debt and big government spending? If so, the low growth in high-debt-ratio countries could have its explanation.
2. What happens if we delay one of the two variables one quarter? This classic, basic statistical method could tell us a lot about the causes and effects between debt and growth. I am going to take a stab at it as soon as time allows.
Needless to say, any future inquiry would have to include the United States. This one does not, simply because the raw data used here did not include U.S. numbers. Now that I have this data in a configured file of my own it is easy to add U.S. data.