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.
Of all the countries around the world that have tried to embrace the European welfare state, Argentina is perhaps the most tragic example. From the 1920s through the 1950s the Argentine economy was one of the strongest in the world, and there were years when Argentina attracted more immigrants from Europe than the United States did. But what could have become a formidable economic powerhouse caved in to the ideas of the welfare state. As the economy began declining, social and economic stability evaporated and Argentina suffered decades of political turmoil.
The long-term suffering of the Argentine people, and of many other South American countries, is a stark warning to today’s Europeans: their continent could become the same tragedy in the 21st century that South America was in the last century. Unfortunately, the Europeans refuse to hear the warning bells from recent history, so we might just as well pile on yet another story, on top of the ones already published about the crumbling Argentine economy and what brought it down. This one is from Bloomberg.com:
Argentina reduced government subsidies on natural gas and water by an average 20 percent in a bid to narrow the largest fiscal deficit in more than a decade. The government could save as much as 13 billion pesos ($1.6 billion) and will use proceeds to cover utility company costs and finance social spending, Economy Minister Axel Kicillof and Planning Minister Julio De Vido said today at a press conference in Buenos Aires. The cuts won’t apply to industrial users.
And the reason for the big deficit?
President Cristina Fernandez de Kirchner has boosted social spending since taking office in 2007 and left utility rates largely unchanged amid average annual inflation of about 25 percent, straining the finances of power distribution companies and leading to periodic blackouts.
If you live in California (which, thank my tax God, I don’t) you recognize this behavior. Back in the ’90s the state of California wanted to compassionately make sure that everyone could always pay their utility bills. So they regulated the price that utility companies could sell power for to households, but imposed no price regulations on the market where utility companies buy power from power producers. As a fourth-grader could have figured out, if the regulated price in the retail end was too low, on average utility companies would be buying power at a market price that exceeded the retail price they could charge.
The result? Rolling black-outs, no investments to improve either power production or power delivery, and in the end mounting costs for everyone in the back end when the entire power infrastructure needed massive upgrades anyway. (It did not help that California at the time was falling for the global warming delusion and chasing low-cost, fossil-based fuel out of the state.)
Now, Argentina finds itself in the exact same situation. But even more importantly, the Argentine government’s focus on entitlement spending is a stark parallel to Europe. Utility price regulation, which varies from country to country in Europe, is just another form of welfare-state intervention into the private sector. When coupled with the general plethora of entitlement programs that normally comes with welfare states, the subsidy becomes just another entitlement.
As Argentina demonstrates, this has consequences when government runs into fiscal trouble. Just like every welfare state the Argentine version combines spending determined by political preferences with revenues determined by a private sector, i.e., struggling entrepreneurs and tax-burdened consumers. Entitlement spending has a strong tendency to outgrow its revenues – in fact, I am working on an article for an academic journal defining a law that shows that welfare-state entitlement programs inevitably outspend their revenue – but politicians favoring the welfare state never realize that this is actually happening. Inevitably, therefore, they run into deficit problems, but since the politicians do not see this coming they are caught by surprise and react with fiscal panic.
There are three ways that fiscally panicking politicians can respond:
1. Buy time. This means, borrowing as much as they can. When they cannot borrow any more money by flooding the world with their Treasury bonds, they print money and have the central bank buy the Treasury bonds instead. If this happens in an economy with a stable financial system and a limited system of cash entitlements, the money printing will not cause high inflation. If on the other hand cash entitlements are comparatively important for daily consumer spending, then printing money to fund them opens a dangerous transmission mechanism for the money supply to cause high inflation.
2. Raise taxes. No longer a viable option, other than marginally. There is a fair amount of research that shows that voters in both Europe and North America grew tired of constantly rising taxes already back in the 1970s. Since then, an increasing share of the growth in government spending has been deficit-funded. The same is true in Argentina.
3. Cut spending. Since most politicians in our modern welfare states want to preserve the welfare state one way or the other, they do not want to eliminate entitlement programs. But when tax revenues do not grow as fast as they would want it to they are forced to downsize the welfare state to fit within a tighter revenue framework. This means chipping away at entitlements that people have gotten used to and based on which they plan their family finances.
For common-sense minded economists and politicians this means a good opportunity to prudently reform away the welfare state. “Just cutting spending, damn it” is not the way forward, but a structurally sound phase-out model can do wonders.
Leftists, on the other hand, go even deeper into panic. Bloomberg.com again:
Argentina, which has subsidized utilities since 2003, wants to cut aid from about 5 percent of gross domestic product to 2 percent of GDP and make higher income earners pay more for their utilities, Cabinet Chief Jorge Capitanich said March 12. “In 2003 the need for subsidies was clear,” Kicillof said in reference to the period after the nation’s $95 billion default and economic crisis. “Argentina isn’t ending subsidies, just redistributing them.” For Argentine households, the increase in their gas bill may rise as much as 161 percent for the biggest consumers and 306 percent for water bills, according to a presentation distributed by the Planning Ministry.
“The Planning Ministry”… Why not just adopt the Soviet acronym GOSPLAN and get it over with? Humor aside, though, it is worth noting that the families who are now hit with enormous price increases still have to pay the same amount of taxes as before.
The way out, again, is not to restore the subsidies. The way out is to end the entitlement programs and return purchasing power to the private sector so that those who have grown dependent on government can actually support themselves. This, of course, won’t happen in Argentina. What will happen there instead is that consumers now will respond by cutting spending elsewhere, thus reducing economic activity in general. This has repercussions for the tax base, which again will take government by surprise. And the entire process is repeated, with the difference that it starts from an already lower level of economic activity.
Europe is not in as bad a shape as Argentina is. But if they continue down the current path of using spending cuts and tax increases to save the welfare state in tough times, they will perpetuate their own crisis – and thereby perpetuate the need for spending cuts and tax increases.
The end station? An economic wasteland where children grow up to be poorer than their parents. That is, in effect, where Argentina is today, and has been for a long time. Sweden has been there for a good two decades and other European countries are beginning to see that same economic wasteland on the horizon.
Never bark at the big dog. The big dog is always right.
If your goal is to restore growth and full employment in a crisis-ridden economy, don’t use austerity. It does not work. I have explained this for two years now – in blogs, research papers and numerous debates – and I am pleased to say that my work has been recognized. One step forward on that front is my book, out in July. But more important than the recognition of my work is the constant reminders of austerity failure that reality provides. In addition to raw, statistical evidence of decline and stagnation all over Europe, the German government is now de facto conceding defeat on the austerity front. From British newspaper The Guardian:
Germany has signalled it is preparing a third rescue package for Greece – provided the debt-stricken country implements “rigorous” austerity measures blamed for record levels of unemployment and a dramatic drop in GDP. The new loan, outlined in a five-page position paper by Berlin’s finance ministry, would be worth between €10bn to €20bn (£8bn-16bn), according to the German weekly Der Spiegel, which was leaked the document. Such an amount would chime with comments made by the German finance minister, Wolfgang Schäuble, who, in a separate interview due to be published on Monday insisted that any additional aid required by Athens would be “far smaller” than the €240bn it had received so far.
So how can the German government be admitting it has lost the austerity fight against the economic crisis, when it actually demands more austerity by the Greek government? Simple: the German government together with assorted Eurocrats from Brussels have sold last two fiscal-disaster packages as “the” fix for the crisis. If only Greece agreed to this-or-that austerity measure, and then got a loan, then the Greek economy would be on a fast track to a recovery.
By now proposing not a second, but a third bailout for the Hellenic welfare-state wasteland the German government is de facto admitting that the prior two packages did not at all deliver as promised.
Which, of course, is an outstanding reason to try the same policies a third time while expecting a different outcome…
The Guardian again:
The renewed help follows revelations of clandestine talks between Schäuble and leading EU figures over how to deal with Greece, which despite receiving the biggest bailout in global financial history, continues to remain the weakest link in the eurozone. The talks, said to have taken place on the sidelines of a Eurogroup meeting of eurozone finance ministers last week, are believed to have focused on the need to cover an impending shortfall in the country’s financing and the reluctance Athens is displaying to enforce long overdue structural reforms.
It is a bit unclear what the “structural” element of those reforms would be, but if the history of Greek bailouts is any indication we can safely assume that the “reforms” would be higher taxes and lower entitlement spending. While less spending is highly desirable, it has to come in the form of predictable reductions – and they have to be coupled with targeted tax cuts that give those dependent on government a fighting chance to provide for themselves once the government handouts are gone.
Such reforms are not rocket science. Two years ago I put together five such proposals in a book. I would not expect the Greek government to have read it, or that any Eurocrat would have seen it… but the basic idea – permanent spending cuts coupled with targeted tax cuts – is so common-sensical that you would expect someone in Europe to propose it as a guideline for getting Greece, and Europe, out of its crisis.
So far, though, I have not seen a single proposal for “structural reform” in Greece along these lines.
Perhaps it is understandable, at the end of the day, why no such ideas are floating around in the public debate. After all, the end result is a dismantling of the welfare state, an idea as alien to Europeans as a monarchy is to Americans. But so long as Europe’s political leaders remain married to the welfare state, they will also have to continue to come up with non-solutions to the crisis. One of those solutions is another debt write-down. The Guardian again:
Most of the debt overhang now haunting the country belongs to European governments and at 176% of GDP – up from 120% of national output at the start of the crisis – is not only a barrier to investment but widely regarded as being at the root of its economic woes. “They are missing the point: Greece does not need a third bailout, it needs debt restructuring,” said the shadow development minister and economics professor, Giorgos Stathakis. “Even in the IMF, logical people agree there is no way we can have any more fiscal adjustment when the whole thing has reached its limits,” he said. “There is simply no room for further cuts and further taxes and that is what they are going to ask for.”
It is precisely this attitude that traps Greece in a perpetual crisis. Its plunge into industrial poverty over the past five years was not caused by a financial crisis, as public economic mythology suggests. The plunge was the work of the welfare state, which over a long period of time had drained the private sector of money, entrepreneurship, investments and productivity. When the global recession hit, the excessive cost of the welfare state was exposed full force. Trying first and foremost to save the welfare state, Eurocrats from the EU and the ECB joined forces with economists from the IMF to squeeze even more taxes out of the private sector. At the same time, the rapidly growing crowds of unemployed and poor were deprived of more and more of the only thing that had kept them going: welfare-state handouts.
The result was that those who saw their handouts shrink were even less able to find a job than they had been before. Rising taxes killed the job market for them.
At the core, the Greek crisis is one of a welfare state that costs vastly more than the private sector of the Greek economy can afford, even on a good day. The debt that the good professor and fellow economist Stathakis wants to have forgiven is the result of this historic mess of irresponsible entitlements and burdensome taxes.
If Greece does not fix its welfare-state problem, it does not matter how much debt that is forgiven. It will continue to accumulate more debt, and then what? Another round of debt forgiveness?
Again, this basic insight is missing from the European discussion on what to do with Greece. Even the IMF is apparently concentrating on the debt burden, suggesting, according to the Guardian, that “without additional debt relief by eurozone governments, Greece’s debt burden could smother the country’s economy.” That is exactly wrong: the economy is being smothered by the welfare state, which austerity measures are aimed at saving.
At least there is some common sense in the debate. The Guardian concludes:
China, Brazil, Argentina, India, Egypt and Switzerland have been among the countries expressing grave doubts that the assistance would work, arguing that Greece might end up worse off after the austerity programme.
Thank you for that. Let’s now hope that more people see this and that we can get some traction for a reform program that combines entitlement phase-out with targeted tax cuts. It is the only way to save Greece from generations of industrial poverty – and it is the only way to save the rest of Europe from the same fate.
On Monday I explained that Greece has begun a transition from depression to stagnation. The transition is visible in macroeconomic data: the decline in GDP and private consumption, both of which have been going on for years, are not as fast anymore, and unemployment seems to be plateauing. Government debt is still growing, though, especially when measured as a ratio to GDP. In the second quarter of 2013, the latest number available, the quarter-to-quarter increase in the ratio was faster than it was in any of the three preceding quarters.
The transition from depression to stagnation is largely made possible by two factors. First, the Greeks have lost one quarter of their economy, which includes an enormous drop in standard of living. Most Greeks have had to forfeit consumption that people in other industrialized countries take for granted. What remains is essentially the bare-bones kind of consumption that you realistically cannot sustain without in an industrialized country. At this “core consumption” level of economic activity, it is harder for people to cut away anything more. As a result, they will increase their efforts to protect what they have left.
Secondly, years of austerity has recalibrated the Greek welfare state. The reason why it ran enormous deficits for years is that its tax rates could not produce enough revenue for the spending that the welfare state required. This was a problem before the Great Recession but it exploded into pure urgency as the crisis started unfolding. Instead of trying to turn around the implosion of the economy, the EU and the Greek government decided to recalibrate the welfare state: taxes were raised to produce more revenue at a lower GDP, and spending programs were cut to spend less at that same lower GDP. Each new austerity program effectively constituted another recalibration. Eventually, during last year, the recalibration efforts caught up with the imploding GDP, and austerity tapered off.
Once you release an economy from its austerity stranglehold it will transition from decline to stagnation. However, it will not recover – other than marginally – for one very simple reason: the welfare state is now recalibrated to balance the budget at an abysmally low activity level. Therefore, as soon as economic activity picks up the government budget will suck in excessive amounts of money from the private sector, creating substantial surpluses early on in the recovery. Politicians who have fought the people to subject them to round after round of austerity will not be inclined to cut taxes; they will see the surpluses as yet another sign that “austerity worked”. While they throw victory parties, the economy continues to putter along at permanently higher unemployment and a permanently lower standard of living.
This is exactly what happened in Sweden in the ’90s (I have an entire chapter on that crisis in my upcoming book Industrial Poverty) and the Greek situation is not much different.
Yet despite glaring evidence to the contrary, there are people out there who willingly and eagerly claim that in the austerity war on the crisis, austerity won. In an opinion piece for the EU Observer, Derk Jan Eppink, Member of the EU Parliament from Belgium and vice president of the Parliament’s Conservatives and Reformists group, has this to say:
Irish Premier Enda Kenny has announced his country will exit its bailout programme in December. When he took office in 2011, Ireland’s budget deficit was over 30 percent of GDP. Narrowing it to projections of 7.3 percent this year and 4.8 percent next, Kenny has restored market confidence in Dublin’s ability to sort out its long-term debts. Investors are again willing to buy Irish bonds, raising funds and lowering borrowing costs. In mid-2011, interest on Irish debt stood at 15 percent. Now it is below 4 percent and Ireland has raised sufficient cash balances to cover all its debt payments next year. Standard & Poor’s and Fitch have both returned their Irish rating to investment grade. Without repairing its ability to manage its debts, Ireland’s government could not function for very long as a provider of essential public services. Irish recovery could not have happened without the fiscal consolidation which commentators attack as “austerity.”
It is interesting to notice what metrics Mr. Eppink uses to measure the Irish “success”. The austerity program has recalibrated the Irish welfare state to produce a budget balance at a vastly lower activity level than before the crisis. This means that the Irish government has no incentive to run a fiscal policy that brings the economy back to its higher activity levels; as in the Greek case, its tax-and-spend ratios will actually discourage private-sector growth beyond what is needed for the newly calibrated budget balance.
What this means in practice is easy to see in Eurostat employment numbers. Irish unemployment has fallen over the past two years, with total unemployment down from 15.1 percent in January 2012 to 12.3 percent in November 2013; during the same period of time youth unemployment declined from 31.1 percent to 24.8 percent. This looks like a solid recovery, especially since one in four unemployed aged 15-24 is no longer unemployed. However, if we cross-check these numbers with the employment ratio we get a somewhat different picture:
In the years before the crisis the employment ratio for 15-64 year-olds was 65-70 percent; in the third quarters of 2010, 2011, 2012 and 2013 it has averaged 59.7 percent, with no visible trend either up or down;
In the years before the crisis Irish unemployment for the group aged 15-24 was 45-55 percent; in the third quarters of 2010, 2011, 2012 and 2013 it has averaged 30.9 percent, with no visible trend either up or down.
It is troubling when unemployment falls but employment ratios remain steady. It means that people are either leaving Ireland in desperation or, more likely, that they are leaving the work force. A closer look at the enrollment in various income-security programs would probably give a detailed answer. (I will try to return to that later.)
A glance at GDP data also indicates stagnation rather than recovery. In the third quarter of 2013 the Irish seasonally adjusted, constant-price GDP grew by 1.7 percent over the same quarter in 2012. However, the four preceding quarters GDP contracted. There was more growth in the Irish economy in 2011 than what appears to be the case in 2013. Private consumption has been falling six of the last eight quarters, with entirely negative numbers thus far for 2013.
There is only one conclusion to draw from these numbers: there is no Irish recovery under way. If anything, the end of the Irish austerity campaign has marked the starting point of economic stagnation for the Irish economy just as it has in Greece.
Most of this blog’s focus is on the European crisis, for two reasons: first, Europe is ahead of America on the downslope into industrial poverty, and we can learn a great deal from their terrible mistakes; and secondly, we are beginning to see the contours of what Europe will look like on the other side of the crisis, and it is not pretty. In fact, a Europe where fascism and totalitarianism get a bigger playground is a Europe that could very well destabilize an already volatile world.
For the most part, we are doing better here in the United States. Our economy is in better shape than the European, especially the euro zone, and our political system is more resilient and stable than what the Europeans are living with. But that does not mean we cannot screw it up here; if the Europeans could squander a half-century long streak of growing prosperity by committing themselves to poor policy judgments, then there is in fact a moderate risk that we might do the same.
As I mentioned earlier, the fight over funding the federal government was not a sign of weakness, but a sign of the strength of the American democracy. The problem with the fight was not that it took place, but that Republicans and Democrats agreed to reopen the federal government without reaching a deal on how to handle the debt. From now to January, the U.S. Treasury is once again free to borrow money on overtime. Stubborn spenders in the White House and Congress evaded the deficit problem, agreed to punt for a few months and let ObamaCare go into effect.
Long term, this may have been a good outcome for the Republicans as voters now get to feel the full impact of ObamaCare on their lives. However, from a macroeconomic viewpoint it was not at all what we needed. The deficit punting is going to feed expectations of a future debt default – and expectations of inflation.
Global investors are already worried about the U.S. debt. They have forced the federal government to pay more for its debt than what some European countries pay. The reason for this is in good part that the European Central Bank has created a very risky bond buyback program, where it promises to purchase any euro-denominated bond issued by a debt-troubled Eurozone country. While a bad idea long-term, this program has calmed investors for now – and it has made investors believe that countries in the turbulent eurozone are less likely to default on their debt than the United States is – even though their immediate debt crisis actually is worse than ours.
There is, however, one problem that we may see emerging here before it gets to Europe: inflation. The default-related risk premium that investors demand on U.S. Treasury bonds will probably increase in the next couple of months as investors factor in the leadership transition at the Federal Reserve. As I explained recently, Ben Bernanke’s successor Janet Yellen appears to be more lenient toward inflation than her two most recent predecessors. The basis for her leniency seems to be the continued existence of a large federal budget deficit. She has been quoted as preferring higher inflation to tightening the Fed’s funding of the budget deficit.
In other words, Congress and President Obama would have to do even less to balance the budget.
Higher inflation would benefit the federal government in the short run as some tax revenues would increase faster. The Wyoming state government would not benefit as much directly from inflation, primarily because we do not have a multi-bracket income tax. However, there is an indirect gain: higher inflation is normally associated with a weaker exchange rate for the U.S. dollar, which would benefit natural resources exporters and boost severance tax revenues.
This makes inflation an attractive escape route for spendoholic politicians who simply cannot bring themselves onto a route toward smaller government. Congress should be very observant here, and hear the warnings that others are issuing – not just us “inflation hawks” in the economics profession, at think tanks and on public-policy blogs. A good place to go to is China, whose government has recently shown an increased interest in U.S. Treasury bonds. As of July 2012, China (including Hong Kong) owned approximately 7.9 percent of the federal debt. However, in the past year they have purchased one-fifth of the new external debt issued by the Treasury, boosting their total debt share to almost 8.5 percent.
This increased Chinese investment comes at the same time that China is having serious domestic debt problems. Their GDP growth is slowing down – quarterly numbers indicate slower growth in China than in the United States – while their inflation rate is notably high. This is a substantial change from past high-growth decades.
Here is the kicker. A rise in the U.S. inflation rate would exacerbate the Chinese recession problems: with a dollar depreciation, U.S. exporters will compete more strongly on the global market and Chinese manufacturing costs will rise relative to American manufacturers.
By expanding their holding in U.S. Treasury bonds, the Chinese achieve two goals. They prop up the dollar vs. their own currency and they increase their political leverage vs. Congress. The other day we got a sign of their attempts at the latter: the Chinese government’s own credit rating agency downgraded the U.S. government to A-.
While not a credible downgrade from a strict market viewpoint, it was a clear political signal to Congress to get serious about the federal debt. If Congress starts shrinking the deficit they will reduce their reliance on the Federal Reserve as one of the main funders of the deficit; by reducing the need for more deficit funding from the Fed, Congress would greatly reduce the risk for monetarily driven inflation.
But it is not just China that appears to be aware of the prospect of American inflation. From Yahoo Finance:
Marc Faber, publisher of The Gloom, Boom & Doom Report, told CNBC on Monday that investors are asking the wrong question about when the Federal Reserve will taper its massive bond-buying program. They should be asking when the central bank will be increasing it, he argued. “The question is not tapering. The question is at what point will they increase the asset purchases to say $150 [billion] , $200 [billion], a trillion dollars a month,” Faber said in a ” Squawk Box ” interview. The Fed-which is currently buying $85 billion worth of bonds every month-will hold its October meeting next week to deliberate the future of its asset purchases known as quantitative easing. Faber has been predicting so-called “QE infinity” because “every government program that is introduced under urgency and as a temporary measure is always permanent.” He also said, “The Fed has boxed itself into a position where there is no exit strategy.”
This reinforces the point I have been making about Janet Yellen and the spending-addicted lawmakers on Capitol Hill, and the equally spending-addicted man in the White House. She is, essentially, a carte blanche to Congress and the President to heed the battle cry: “Damn inflation, full spend ahead!”
It is bad enough that the Europeans are committing macroeconomic suicide. It is bad enough that the Old World has chosen to try to preserve the welfare state with a combination of austerity and exceptionally loose monetary policy. The United States does not need to follow in their footsteps.
If Congress does not change its spend-til-no-end mind, the Federal Reserve will, as Faber explains above, continue ad infinitum to print money and give it to the Treasury to spend. Eventually, inflation catches on, and once it does, an entire generation of Americans, who have no living memory of double-digit inflation, will learn the hard way what happens when you try to keep a welfare state on artificial monetary life support.