Belgium is one of Europe’s most troubled welfare states, though its problems have been overshadowed by the macroeconomic disasters along the Mediterranean. Its fiscal problems are older than most EU member states, and it was the first country to attract sociological interest based on the fact that there were families – regular working class families – where three generations were perennially unemployed.
Today, Belgium is attracting interest because of a new report from the International Monetary Fund. The EU Observer reports:
The Belgian government is planning “many welcome measures to address the critical macroeconomic challenges facing the Belgian economy”, but it can do more, the International Monetary Fund (IMF) said on Monday (15 December). On the same day Belgian unions organised a general national strike, the IMF presented its findings from a ten-day mission to the country. “The planned reforms of social security and budgetary measures are a step in the right direction”, the IMF wrote.
As with other welfare states in Europe, Belgium suffers from disturbingly low growth. As a result, tax revenues cannot keep up with entitlement spending and the budget deficit becomes structural. GDP growth has been as disappointing in the Belgian economy over the past few years as it has elsewhere in Europe (annual growth rates, reported quarterly):
The Great Recession took a big toll on the Belgian government’s finances. Its budget went from a 156 million euro surplus in 2007 to a 19.1 billion euro deficit in 2009, equal to 5.6 percent of GDP.
From there, the deficit has declined slowly but steadily, reaching the EU’s magic three-percent of GDP mark in 2013. Due to the almost clinical absence of GDP growth, the decline has been accomplished by means of welfare-state saving austerity. As the EU Observer explains, these policies are likely to continue, with some tax reshuffling to spice it up:
The centre-right government of Charles Michel, the first coalition without socialists since 1988, started work in October. It plans spending cuts and increasing the pension age from 65 to 67 by 2030. However, the IMF says that Belgium should also reform its tax system. … when it comes to labour tax, Belgium ranks top with a rate of over 40 percent. The IMF suggests that labour tax should be lowered and compensated with a higher tax on capital.
As the figure above clearly shows, there is no recovery under way in Europe. Belgium is no exception, which makes the IMF advice a problematic ingredient in the Belgian fiscal policy mix. More than anything, Belgium needs tax cuts, not a redistribution of the tax burden. It also needs massive, structural reforms to its welfare-state entitlements system, encouraging work and discouraging indolence. None of this is on the horizon, which makes it a safe bet to predict that the Belgian economy will not return to historic growth levels in the foreseeable future.
Since 2012 I have been predicting that Europe will transition from the downslope of the Great Recession into a state of long-term “stable stagnation” – a state best described as industrial poverty. (I define it here.) For the past 12-18 months GDP and other data have shown that the downslope is ending, and that the state of stagnation now has Europe in a firm grip. Weak signs of an economic recovery in Greece and Spain do not contradict this observation: the two countries hit the hardest by the recession are simply adjusting to the aftermath of some of the hardest austerity policies on record.
One of the characteristics of the crisis downslope was a barrage of credit downgrades of governments in EU member states – and Greece was far from alone here. Spain, Portugal and Ireland suffered five downgrades each, starting in 2009, sending Spanish treasury bonds to the financial junk yard by 2012. Italy was downgraded three times, starting in 2011, and France lost its AAA rating with Standard & Poor in January 2012. In November that year Moody’s downgraded France, followed by Fitch in July of 2013 and yet another downgrade by S&P in November last year.
Now Fitch is at it again. After having reduced France to AA+ in July last year the rating institute has now decided to kick the French down another notch. Explains Fitch:
When it placed the ratings on RWN in October, Fitch commented that it would likely downgrade the ratings by one notch in the absence of a material improvement in the trajectory of public debt dynamics following the European Commission’s (EC) opinion on France’s 2015 budget. Since that review, the government has announced additional budget saving measures of EUR3.6bn (0.17% of GDP) for 2015, which will push down next year’s official headline fiscal deficit target to 4.1% of GDP from the previous forecast of 4.3%.
The reason why Fitch focuses on the French government’s budget deficit is the prevailing notion that a big deficit is bad for the economy. In reality, the biggest threat is that a deficit will weaken or eventually destroy the ability of government to pay its obligations through welfare-state entitlements. Austerity policies in Europe have been aimed at closing deficits in order to save welfare states from pending default on entitlements: the idea has, simply speaking, been to make the welfare states more “affordable”. The affordability is measured in terms of budget balancing – a deficit is taken as a sign that the welfare state cannot support its spending obligations.
It is not entirely clear whether or not Fitch and others factor this into their ratings. The outcome, however, of their analysis is precisely that: a welfare state that is chronically unable to fund its entitlements will sooner or later be downgraded.
This is what has just happened to France. Back to the Fitch report:
The 2015 budget involves a significant slippage against prior budget deficit targets. The government now projects the general government budget deficit at 4.4% in 2014 (up from 3.8% in the April Stability Programme with the slippage led by weaker than expected growth and inflation) and 4.1% in 2015 (previously 3.0%), representing no improvement from the 4.1% of GDP achieved in 2013. It has postponed its commitment to meet the headline EU fiscal deficit threshold of at most 3% of GDP from 2015 until 2017.
And this despite enacted as well as announced increases in the tax burden on the French economy. As I noted a week ago:
In other words, no stronger growth outlook, no sustainable improvement in business investments or job creation. As a matter of fact, a closer look at the measures that Mr. Sapin refers to reveals a frail, temporary improvement that will not put France on the right side in any meaningful macroeconomic category
Even the part of the deficit that the government can reduce is largely due to a reduction in the annual EU membership fee. There is no underlying macroeconomic improvement behind the small deficit decline. With this in mind it is easy to see why the Fitch report expresses concern about the future of the French economy:
The weak outlook for the French economy impairs the prospects for fiscal consolidation and stabilising the public debt ratio. The French economy underperformed Fitch’s and the government’s expectations in 1H14 as it struggled to find any growth momentum, in common with a number of other eurozone countries. Underlying trends remained weak despite the economy growing more strongly than expected in 3Q, when inventories and public spending provided an uplift.
And, as if to top off the analysis:
Fitch’s near-term GDP growth projections are unchanged from the October review of 0.4% in 2014 and 0.8% in 2015, down from 0.7% and 1.2% previously. Continued high unemployment at 10.5% is also weighing on economic and fiscal prospects. The on-going period of weak economic performance, which started from 2012, increases the uncertainty over medium-term growth prospects. The French economy is expected to grow less than the eurozone average this year for the first time in four years.
And that is quite an achievement, given the notoriously weak growth in the euro zone.
Overall, this is yet more evidence of long-term stagnation in Europe. The bottom line: don’t ask when Europe will recover – ask what reason the European economy has to recover.
The one good thing about the rising levels of frustration in Europe over the crisis, is that the public debate is being enriched with voices whose message might actually make a difference for the better. Today, a group of leading German economists has decided to speak up against the lax monetary policies of the ECB. This is a welcome contribution, but their contribution would be stronger and more to the point if they also learned a thing or two about what has actually brought Europe into the macroeconomic ditch.
Reports Benjamin Fox for the EU Observer:
The European Central Bank’s (ECB) plans to pump more cheap credit into banks risk undermining the long-term health of the eurozone, according to Germany’s leading economic expert group. The ECB’s “extensive quantitative easing measures” posed “risks for long-term economic growth in the euro area, not least by dampening the member states’ willingness to implement reforms and consolidate their public finances”, the German Council of Economic Experts (GCEE) said in its annual report, published on Wednesday (12 November).
That monetary expansion is indeed a problem. In September 2014 the M1 money supply in the euro zone had grown by 6.5 percent over September 2013. Over the past 12 months the annual growth rate has averaged 5.86 percent, showing that monetary expansion in the euro zone is actually increasing. In fact, adjusted for the large expansions in M1 euro supply that resulted from an expansion of the monetary union, the current expansion rate appears to be the highest in the history of the euro (though that is just a preliminary observation – I am not completely done with the simulation).
If current-price GDP was growing at the same rate, then all the new money supply would be absorbed by transactions demand for money. But the euro-zone GDP is practically standing still, which means that all the new money supply is directed into the financial sector (theoretically known as “speculative demand for money”). That is where the real danger is in this situation.
Unfortunately, the German economists are not primarily worried that the ECB is destabilizing the European financial system. Their concern is instead that lax monetary policy discourages fiscal discipline among euro-zone governments. They appear to be stuck in the state of misinformation where budget deficits are keeping the euro-zone economy from recovering.
Benjamin Fox again:
The Bundesbank is also uncomfortable about the ECB’s increasingly activist role in the bond and securities markets. … But the German call for the Frankfurt-based bank to limit its intervention remains a minority position. Most governments in and outside the eurozone, together with the International Monetary Fund, want the ECB to provide increased monetary stimulus. Last week the Organisation for Economic Co-operation and Development (OECD) also urged the bank to “employ all monetary, fiscal and structural reform policies at their disposal” to stimulate growth in the currency bloc, including a “commitment to sizeable asset purchases (“quantitative easing”) until inflation is back on track”.
Can any economist at the ECB, the IMF or the OECD please explain how the ECB’s money pumping is going to create inflation in any other way than the traditional monetary kind? Nothing in either my academic training as an economist or my 14 years of practicing economics as a Ph.D. gives me the slightest clue how this is supposed to work.
In fact, the only inflation I can see coming out of this would be strictly monetary – and that is not what anyone in Europe wants. Monetary inflation, unlike inflation caused by rising economic activity, can run amok deep into the double digits, as it has in Argentina and Venezuela.
It is good that leading German economists are worried about the ECB’s activities. Time now for them to take the next step and study the true structure of the economic crisis.
Europe keeps struggling with its impossible balanced-budget endeavor.
In a desperate attempt to save the welfare state while also balancing the government budget they keep destroying economic opportunity for their entrepreneurs and households. This leads to panic-driven spending cuts combined with higher taxes, the worst alternative of all routes available to a balanced budget. The reason – and I keep emphasizing this ad nauseam – is that they desperately do not want to remove the deficit-driving spending programs.
To break out of the shackles of their self-imposed welfare-statist version of austerity, some European politicians have suggested that the EU needs to revise the rules under which member states are brought into compliance with the Union’s balanced-budget amendment. This is not viewed kindly among the Eurocrats in Brussels. From Euractiv:
The European Commission will not let EU budget discipline rules be flouted, incoming economic affairs commissioner Pierre Moscovici said on Monday (29 September), days after his former colleagues in the French government said Paris would again miss EU targets. Last year, European Union finance ministers gave Paris an extra two years to bring its budget deficit below the EU ceiling of 3% of national output after France missed a 2013 deadline in what is called the ‘excessive deficit procedure’. But earlier this month, the French government said it would not meet the new 2015 deadline either and instead would reduce its budget shortfall below 3% only in 2017.
They certainly could meet the deadline, and they could do it even faster than proposed. All they would need to do would be to chainsaw the entire government budget until what is left fits within the three-percent rule. However, they know they cannot do that, for two reasons. The first is simple macroeconomics: so long as you do not cut taxes, any spending cuts will mean government takes more from the private sector and, relatively speaking, gives less back. That reduces private-sector activity and thus exacerbates the recession.
The second reason is that when half or more of the population depend on government for survival, you can only do so many spending cuts before they set the country on fire. The solution is a predictable way out of dependency, one that gives people an opportunity to become self sufficient without suffering undue, immediate financial hardship. That excludes tax hikes and sudden spending cuts – but on the other hand it mandates structural spending cuts that permanently terminate entitlement programs.
However, this solution to their unending economic crisis keeps eluding Europe’s policy makers.
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.