Yes, there is more bad economic news coming out of Europe. Industrial production fell by 1.9 percent in August compared to the same month last year. Germany, the largest European economy, saw a year-to-year decline of 2.8 percent, but what is even more worrying is that German industrial production fell by 4.3 percent from July 2014 to August, the second highest month-to-month drop in the EU.
Another worrying number comes out of Greece: a decline of six percent year-to-year. While the month-to-month decline is not dramatic i itself at -1.6 percent, the Greek economy has seen industrial production fall month-to-month in five of the past six months. Not a good sign at all.
Furthermore, Sweden, a country filled with large exporting manufacturers, has seen a month-to-month decline in four of the past six months, and five of the past six months on a year-to-year basis.
As far as industrial production goes, Europe is not recovering. At best, stagnation continues. And things don’t look much better on the inflation front, according to Eurostat:
Euro area annual inflation was 0.3% in September 2014, down from 0.4% in August. This is the lowest rate recorded since October 2009. In September 2013 the rate was 1.1%. Monthly inflation was 0.4% in September 2014. European Union annual inflation was 0.4% in September 2014, down from 0.5% in August. This is the lowest rate recorded since September 2009 In September 2013 the rate was 1.3%. Monthly inflation was 0.3% in September 2014.
Despite a frenzy of liquidity expansion, the European Central Bank has not been able to reverse course. Europe as a whole is still heading for deflation. Bulgaria, Greece, Hungary, Spain, Poland, Italy, Slovenia and Slovakia are already in deflation territory. Only five EU member states, Latvia, the U.K., Austria, Finland and Romania have an inflation rate between one and two percent, the highest being 1.8 percent in Romania. The rest of the EU is stuck with zero to 0.8 percent inflation.
No wonder there is a growing conversation about the ailing currency union:
The eurozone appears to have come back onto the markets’ radar amid low inflation, poor economic news from Germany, and Greece’s bailout exit plans. Greece’s long-term borrowing costs went above 8 percent on Thursday (16 October) – their highest for almost a year – as investors took fright at the fragile political situation in the country. The government in Athens has tried to shore up popular support by suggesting it will exit its bailout programme with the International Monetary fund more than a year early. But the recent announcement spooked investors, unconvinced that Greece can stand alone.
The unrelenting stagnation of the European economy is bad news in itself for the sustainability of the currency union. If Greece exits, it will de facto but not de jure abandon the currency union. Moreover, things do not get better when Germans cluster together and sue the ECB for its allegedly illegal expansionary monetary policy:
[Critics] which include Bundesbank president Jens Wiedmann, say that the programme goes beyond the ECB’s mandate of maintaining price stability across the 18-country eurozone. They also say that knowing the ECB will buy their debt could make EU chancelleries less prudent. The plaintiffs had filed their case to the German Constitutional court in Karlsruhe, which in February referred the case to the European Court of Justice. In court, Gauweiler’s lawyer, Dietrich Murswiek, described the ECB scheme as an “egregious extension of [the bank’s] powers” which was designed to “avert the insolvency of member states”.
The ECB is not going to reverse course. They are stalwartly convinced that if money supply just keeps expanding, then eventually they can cause a shift from deflation to inflation. So long as they keep expanding money supply, interest rates will trend to zero. So long as interest rates dwell in that territory, more and more investors will turn to stock markets and real estate for profitable investments. This increases the volatility of those markets, without any gain in the real sector of the economy.
GDP at zero growth, double-digit unemployment, prices deflating, money supply exploding. Yep. This can’t go wrong.
But the budget deficit, folks – the budget deficit is now under control. Aren’t you happy?
When young, third-generation unemployed Europeans are getting tired walking up and down the streets looking for the jobs that aren’t there; when struggling former middle-class families have mopped up the scraps of what used to be a promising future; when the patients in austerity-ravaged hospitals are caught between untreated pain and calling the nurse in vain; when they all want to catch a break in their struggle to make ends meet in their new lives in industrial poverty; all they have to do is look up in the sky and see the shining budget balance spreading its glory over the economic wasteland.
Yankees baseball legend Yogi Berra coined the proverbial phrase “It ain’t over ’til it’s over”. That is certainly true about the European economic crisis. This past week saw a crop of bad news from the Old World. Nothing very dramatic – and certainly nothing that should surprise regular readers of this blog – but nevertheless bad news. In this first of two parts, let’s look at a report from the EU Observer:
The eurozone appears to have come back onto the markets’ radar amid low inflation, poor economic news from Germany, and Greece’s bailout exit plans. Greece’s long-term borrowing costs went above 8 percent on Thursday (16 October) – their highest for almost a year – as investors took fright at the fragile political situation in the country. The government in Athens has tried to shore up popular support by suggesting it will exit its bailout programme with the International Monetary fund more than a year early.
There is an important background here. The bailout program had three components:
1. The Greek government will do everything in its power to combine a balanced budget with protecting as much as possible of its welfare state against the economic depression;
2. In return for the Greek government’s tax increases and spending cuts, the International Monetary Fund, the European Union and the European Central Bank provided loans that kept the Greek government afloat cash-wise;
3. The only metric used to measure the success of bailout policies is the stability of a balanced government budget.
If GDP did not grow, if unemployment was at 30 percent, if more than half the young in Greece had no job to go to… none of that mattered. As a result, there has been no structural improvement of the Greek economy; government has not reduced its burden on the private sector – quite the contrary, in fact. Welfare systems have been reduced, but higher taxes have prevented welfare recipients from transitioning into self sufficiency.
As a result, the social situation in Greece is almost unbearable. The political reaction has come in the form of a surge for parties on the extreme flanks of the political spectrum. In my book Industrial Poverty I explain in detail what happened in Greece, what brought the country down from the heights of European prosperity to permanent stagnation. Today, sadly, the country is little more than a macroeconomic wasteland.
It is with this in mind that one should approach the news that Greece is considering leaving the bailout program. The coalition government is under enormous pressure to save the nation itself, to keep parliamentary democracy in place and to inject some sort of life into the economy. If they fail either of two extreme political movements will take over – the Chavista communists in Syriza or the Nazis in Golden Dawn.
International investors know this and are understandably scared. In their mind the bailout is the least of available evils; in reality, as I explain in my book, the attempts at balancing the budget and saving the welfare state in the midst of the crisis are the very policies that keep Greece from recovering; weak signs of a minor recovery earlier this year have yet to materialize into anything other than the “beaten dog” syndrome often following protracted periods of austertiy.
This is the very reason why Greece is now considering leaving the bailout program. They cannot continue forever to try to muddle through with an economy deadlocked in depression and a democracy so fragile that it has brought the first Nazis into a parliament in Europe for the first time since World War II.
However, as the EU Observer explains, the Greek government is caught between a rock and a hard place – as are other hard-hit euro zone economies:
But the recent announcement spooked investors, unconvinced that Greece can stand alone. Long-term borrowing costs also jumped in the weak periphery states, Spain, Italy, and Portugal. The market jitters – while not comparable to the height of the eurozone crisis in 2011 and 2012 – come as the eurozone’s main economies are once again at odds over policy responses.
France also belongs on that list, primarily for its typically European attempt at leaving the bailout program. Its government tried to leave the bailout path for a left turn into the quagmire of government expansionism. Thinking that more government spending, on top of the largest government spending in the world, could in fact bring about a recovery, the French socialists who won the 2012 elections scoffed at the EU balanced-budget rules and went full speed ahead with their government-expansionist agenda.
Two years later that agenda has hit a brick wall. Massive tax increases, supposed to pay for some of the new government spending, have only resulted in an exodus of brain power and entrepreneurship. The French GDP is standing more still than the Eiffel Tower.
In fact, the EU Observer notes,
France and Italy are fighting a rearguard action for more flexibility saying budget slashing will condemn them to further low growth. Paris is on collision course with both Berlin and the European Commission after having indicated that it wants an extra two years to bring its budget deficit to below 3 percent of GDP. Italy, meanwhile, has submitted a national budget for 2015 which brings the country to the edge of breaking the rules.
The French challenge to the budget-balance rules compounds the uncertainty emanating from the talks in Athens about a Greek bailout exit. It is more than a theoretical possibility that at least one of these countries leaves the euro zone in the next two years, and does so for a combination of political and economic reasons. That would be an institutional change to the European economy – and really the global economy – of such proportions that no traditional quantitative analysis can render justice to a forecast of its effects. It is therefore entirely logical that global investors are growing more uncertain and as a result demand higher risk premiums.
As the icing on the uncertainty cake, informed investors know that Marine Le Pen may very well become France’s next president. If she wins in 2017 her first order of business is in all likelihood going to be to exit the euro zone and reintroduce the franc. On the one hand that could be an “orderly” exit; on the other hand it would have ripple effects throughout the southern rim of the euro zone to the point where the very future of the common currency is in grave danger.
In summary: mounting uncertainty about the future of the euro is being mixed with growing uncertainty about the macroeconomic performance of the member states of the currency union.
Stay tuned for the second part about the bad news out of Europe.
At the beginning of this year there were lots of forecasts that the European economy was going to recover. I never believed them, primarily because government was a bigger burden on the economy than ever. So far I have been proven right, which is not something I would want to celebrate. But I also want to make clear that once government pulls back from its efforts at balancing its budget with higher taxes and spending cuts, the private sector will eventually start to recover.
There is a lot of research to show this. I review the public policy part of that research in chapter 5 in my new book Industrial Poverty. My conclusion is that this kind of austerity can work – the private sector emerges growing from even the most protracted periods of austerity. However, this is not a reason to use austerity as it has been applied through most of recent history, namely as a means to save government. Instead, austerity must be redesigned to reform away government. Otherwise the private-sector recovery that follows will suffer from two ailments:
1. It will look fast in the beginning, as consumers catch up with the standard of living they lost during the austerity period; and
2. Because of the recalibration of the welfare state – permanently higher taxes and permanently lower spending – the economy will hit its full employment level at a higher rate of unemployment than before the austerity episode.
It is also important to keep a watchful eye on whether or not a recovery is external or internal. In too many European countries over the past quarter century, a recovery has come from a rise in exports, i.e., been external. The consequence of this is that the domestic economy lags behind.
To make matters worse, much of modern manufacturing in Europe consists of bringing in parts produced in low-cost countries, assembling them at a highly efficient plant in a European country and then shipping them on to their final destination. This new kind of industrial production is increasingly isolated from the rest of the economy, which means that its multiplier effects on private consumption and business investments is relatively weak. It is, in other words, no longer possible for a small, exports-oriented European country to enter a lasting growth period merely on a rise in exports.
Earlier this year I pointed to Germany as an example of the feeble macroeconomic role of exports. You can get a temporary boost in GDP growth from a rise in exports, but once that boom goes away, it will have left very few lasting “growth footprints” in the economy. It looks like the same thing is now happening in Spain, which is in a recovery, according to the ECB:
The economic recovery has gathered momentum during 2014, with GDP growing at a faster pace than the euro area average.
Going by the latest national accounts numbers from Eurostat, which for obvious reasons covers only the first two quarters of 2014, it was not until Q2 this year that Spanish GDP outpaced the euro zone: 1.1 percent real growth over the same quarter previous year, compared to 0.5 percent for the euro zone.
Before that, Spain was doing worse than the euro zone by a handsome margin.
The ECB again:
Growth has been supported by a rise in domestic demand, while the external balance has weakened substantially as a result of a slowdown in export market growth and higher imports. Domestic consumption and investment in equipment are benefitting from growing confidence, employment creation, easier financing conditions and low inflation.
Over the past year there has been a slow but steady decline in Spanish unemployment, from 26.1 percent in August 2013 to 24.4 percent in August 2014. That is very good for a people hit very hard by disastrously ill designed fiscal policies over the past three years.
At the same time, there are clear signs that this is an “export bubble”. Consider these growth numbers for the country’s GDP (quarterly over same quarter previous year):
There is no doubt that GDP growth is improving. While 1.1 percent is absolutely nothing to write home about, as mentioned earlier it exceeds the euro-zone average. The big question is whether or not this improvement will last. The biggest concern is the exports numbers: good growth for two quarters, then a major leap up to 6.4 percent, only to fall back to 1.5 percent. (While these are not seasonally adjusted numbers, they are quarterly growth on an annual basis which neutralizes seasonal effects.) If exports fall back to tepid growth numbers below two percent, GDP growth will most likely slide back into zero territory.
However, there are a couple of other mildly encouraging factoids in these numbers. To begin with, government spending, while on the growth side, is expanding slowly at no more than one percent per year. This number does not account for financial payments, such as unemployment benefits and other income security entitlements, but they do account for government activities that involve government employees. Alas, restraint in government spending means very little effort from government to expand its payrolls to do away with unemployment.
The apparently stable growth in private consumption is in all likelihood attributable to the post-austerity effect I pointed to above. This means that we will not see 2+ percent growth for much longer; for that to happen there has to be a sustained and substantial addition of consumers to the economy who are capable of spending more than what is required for pure subsistence. This, in turn, will not happen until unemployment comes down more than marginally.
Another mildly encouraging sign is that business investments have stopped declining. The turnaround over the past four quarters is in all likelihood an attempt by exporters to expand their capacity. If the exports boom is coming to an end, so will probably investments.
To turn this fledgling recovery into a lasting trend, the Spanish government needs to address the underlying problem in its economy: the welfare state. Otherwise it will just experience spurts of growth here and there as anomalies to a permanent state of stagnation – and industrial poverty.
Almost everywhere you look in Europe there is unrelenting support for a continuation of policies that preserve big government. Hell-bent on saving their welfare state, the leaders of both the EU and the member states stubbornly push for either more government-saving austerity or more government-saving spending. In both cases the end result is the same: fiscal policy puts government above the private sector and leads the entire continent into industrial poverty.
Monetary policy is also designed for the same purpose, which has now placed Europe in the liquidity trap and a potentially lethal deflation spiral. The European Central Bank is fearful of a future with declining prices, thus pumping out new money supply to somehow re-ignite inflation. In doing so they are copying a tried-and-failed Japanese strategy, on which Forbes magazine commented in April after news came out that prices had turned a corner in the Land of the Rising Sun:
Japan’s government and central bank are likely to get much more inflation than they bargained for. This risks a sharp spike in interest rates and a bond market rout, with investors fleeing amid concerns about the government’s ability to repay its enormous debt load. In the ultimate irony, it may not be the deflationary bogey man which finally kills the Japanese economy. Rather, it could be the inflation so beloved by central bankers and economists that does it.
This is a good point. Monetary inflation is an entirely different phenomenon than real-sector inflation. The latter is anchored in actual economic activity, i.e., production, consumption, trade and investment. It emerges because basic, universally understood free-market mechanisms go to work: demand is bigger than supply. This classic situation keeps inflation under control because prices will only rise so long as producers and sellers can turn a profit; if they raise prices too much they attract new supply and profit margins shrink or vanish.
Monetary inflation is a different phenomenon, based not in real-sector activity but in artificially created spending power. I am not going to go into detail on how that works; for an elaborate explanation of monetary inflation, please see my articles on Venezuela. However, it is important to remember what kind of inflation European central bankers seem to be dreaming of. As they see it, monetary inflation is the last line of defense against a deflation death spiral, regardless of what is happening in Japan.
They may be right. Again, there is almost unanimous support among Europe’s political elite that whatever policies they choose, the overarching goal is to preserve the welfare state. However, there is a very remote chance that something is about to happen on that front. And it is coming from an unlikely corner of the continent – consider this story from France, reported by the EU Observer:
France has put itself on a collision course with its EU partners after rejecting calls for it to adopt further austerity measures to bring its budget deficit in line with EU rules. Outlining plans for 2015 on Wednesday (1 October), President Francois Hollande’s government said that “no further effort will be demanded of the French, because the government — while taking the fiscal responsibility needed to put the country on the right track — rejects austerity.” The budget sets out a programme of spending cuts worth €50 billion over the next three years, but will result in France not hitting the EU’s target of a budget deficit of 3 percent or less until 2017, four years later than initially forecast.
In the beginning, Holland stuck to his socialist guns, trying to grow government spending and raise taxes. However, he soon changed his mind and combined tax hikes with cuts in government spending, as per demands from the EU Commission. Now he is taking yet another step away from established fiscal policy norms by combining spending cuts, albeit limited ones, with tax cuts – yes, tax cuts:
The savings will offset tax cuts for businesses worth €40 billion in a bid to incentivise firms to hire more workers and reduce the unemployment rate. In a statement on Wednesday, finance minister Michel Sapin said the government had decided to “adapt the pace of deficit reduction to the economic situation of the country.”
The “adaptation” rhetoric is the same as the French socialists had when they took office two years ago. What has changed is the purpose: back then their fiscal strategy was entirely to grow government – because according to socialist doctrine government and only government can get anything done in this world. Now they are actually a bit concerned with the economic conditions of the private sector.
This goes to show how desperate Europe’s policy makers are becoming. In the French case it is entirely possible that Hollande is willing to become a born-again capitalist in order to keep Marine Le Pen out of the Elysee Palace. After all, the next presidential election is only three years out. But it really does not matter what Hollande’s motives are, so long as he gets his fiscal policy right.
The EU Observer again:
Last year, France was given a two-year extension by the European Commission to bring its deficit in line by 2015, but abandoned the target earlier this summer. It now forecasts that its deficit will be 4.3 percent next year. The country’s debt pile has also risen to 95 percent of GDP, well above the 60 percent limit set out in the EU’s stability and growth pact. Meanwhile, Paris has revised down its growth forecast from 1 percent to 0.4 percent over the whole of 2014, and cut its projection for 2015 to 1 percent from 1.7 percent. It does not expect to reach a 2 percent growth rate until 2019.
This is serious stuff but hardly surprising. I predict this perennial stagnation in my new book Industrial Poverty. And, as I point out in my book, a growth rate at two percent per year only keeps people’s standard of living from declining- it maintains a state of economic stagnation. There will be no new jobs created, welfare rolls won’t shrink and standard of living will not improve. For that it takes a lot more than two percent GDP growth per year.
Hollande’s new openness to – albeit minuscule – tax cuts should be viewed against the backdrop of this very serious outlook. He will probably not succeed, as the tax cuts are so small compared to the total tax burden, and the tax-cut package is not combined with labor-market deregulation. But the mere fact that he is willing to try this shows that there is at least a faint glimpse of hope for a thought revolution among Europe’s political leaders. Maybe, just maybe, they may come around and realize that their welfare statism is taking them deeper and deeper into eternal industrial poverty.
In the last quarter of the 20th century large parts of the world lifted themselves out of poverty. China and India are the best known but far from the only examples. Countries like Malaysia, Indonesia, Vietnam and Korea elevated themselves to a standard of living that for most of the population meant life in the global middle class. The Soviet sphere collapsed and allowed hundreds of millions of people from Saxony to Sakhalin to pursue happiness unhindered by government.
Now the prosperity train is slowly making its way through the African continent. Its effect is still marginal, but global corporations have discovered pockets of economic environments in Africa where they can actually set up operations with reasonable prospects of stability and profit.
While this is happening, the old industrialized parts of the world have mismanaged their prosperity. Latin America offers a split image with Argentina and Venezuela sinking into the holes of socialism while Chile and Brazil are examples of economic progress. The United States is still an economic superpower but has over the past 25 years allowed its government to grow irresponsibly large. It is still manageable and we are moving forward economically, but not at the pace we could.
Europe is the black sheep of the industrialized family, having squandered its prosperity for the sake of income redistribution. While Europe has not yet sunk into abject poverty, and probably never will, the continent has entered a stage of economic stagnation that it will take a very long time to get out of. In fact, the European economy is beginning to resemble some of the less oppressive countries in the Soviet sphere – not in terms of political oppression, but in terms of the destructive presence of government in the economy. Europe has, partially and unintentionally but nevertheless destructively, adopted the static statism that characterized countries like Poland, Czechoslovakia and Hungary before the Iron Curtain came down.
The stagnant nature of the European economy and the slower-than-capacity growth rates in the United States and Canada are all self inflicted. The fatally erroneous belief that government has a productive role to play in the economy inhibits the creation of prosperity in parts of the world where, fundamentally, the conditions for creating prosperity are better than anywhere else. This structural mismanagement of some of the world’s wealthiest economies have ramifications far beyond their own jurisdictions. By keeping their economies from growing, Europe’s political leaders hold back demand for products from countries on the verge of climbing out of poverty. By holding back the forces of prosperity, America’s political leaders prevent the creation of a surplus that otherwise could provide funds for development and investment projects in developing countries.
Instead of unleashing the prosperity machine we know as capitalism and economic freedom, governments in Europe and North America spend far too much time trying to preserve their welfare states. When their government-run entitlement programs promise more than taxpayers can pay for, they resort to growth-hampering austerity measures, aimed not at reducing the presence of government in the economy but at saving the very structure and philosophy of the welfare state. The result, again, is stagnation and industrial poverty.
The First World’s obsession with the welfare state thus prevents the proliferation of prosperity to parts of the world still struggling in poverty. By means of economic freedom, nationally and globally, the relatively wealthy can help the poor toward a better life. This cannot be stressed strongly enough; if accounts of the demerits of the welfare state are not enough to turn our political leaders in favor of economic freedom, then perhaps a new report on global poverty can help. Published by an organization called ATD Fourth World, Challenge 2015: Towards Sustainable Development that Leaves No One Behind provides a painfully direct account of abject poverty around the globe. The authors do not exhibit any deeper understanding of what causes poverty, but the parts of the report that tell the story of poverty from the “ground level” are definitely worth reading.
More than that, they provide a stark contrast to the destructive policies used in Europe and North America to preserve the welfare state. Instead of raising taxes and putting more of our own people on welfare, we owe it to the rest of the world to maximize our creation of prosperity. We can only do that by relieving our own population of the shackles of artificial redistribution. With more wealth, higher incomes and a growing standard of living we will have more money to trade with developing countries, as well as more surplus to donate to and invest in productive development projects in the poorest parts of the world.
Economic freedom has elevated billions of people from abject poverty to a respectable standard of living. It has elevated millions into true prosperity, and thousands upon thousands to almost unlimited wealth. It can do the same for those still in poverty. All it takes is that we in the most prosperous nations of the world sort out our priorities and responsibilities.
Today my book Industrial Poverty: Yesterday Sweden, Today Europe, Tomorrow America is officially available. You can order it directly from the publisher or through Amazon. An ebook version is on its way out, too, but why wait when you can get the real thing now?
In his foreword, Cato Institute senior fellow Michael Tanner writes:
Larson provides convincing evidence that the welfare state, and misguided policy choices by Europe’s governments, turned a regular recession into a systemic economic crisis. During the seemingly prosperous first years of the European Union, few people could foresee the problems ahead, and even fewer viewed these developed countries as struggling with a form of poverty. However, during this stubborn economic recession, GDP growth in many European countries slowed (or even stopped), private consumption stalled, government spending surged, and unemployment rates among the young increased. This book helps us to better understand the current situation facing Europe today, one far more complicated than the austerity versus stimulus dichotomy that is so often imposed.
And that is the most important point I hope readers will take away from this book. Europe’s crisis is not just a recession – it is the result of decades of bad policy compounded slowly into an ultimately unbearable burden for the private sector. There is plenty of evidence for this. Europe’s decline during the Great Recession is not new, but the logical continuation of four decades of slow but inevitable stagnation. The U.S. economy is on a similar, but more recent trajectory and still has the dynamics to recovery (albeit modestly) from the recession.
With slower growth it becomes more difficult for Europeans (and Americans) to increase, and eventually maintain their high standard of living. Stagnant economies also produce less surplus that can be used for aid to poor nations, either through government or through charitable donations. Trade also suffers negatively, hitting primarily low-income nations first.
Another side of economic stagnation with global repercussions is high, persistent unemployment. More than one in five young men or women in the European Union is unemployed. Overall unemployment remains stubbornly above ten percent. While the United States is experiencing declining unemployment rates, job growth is still far from as strong as it normally would in a recovery. With unemployment remaining high, it becomes increasingly difficult for Europe to provide opportunities for immigrants from poorer parts of the world.
With the two largest economies in the world tentatively on a path to long-term stagnation, the consequences for the rest of the world could be serious, especially in terms of the ability to provide disaster relief, aid and development funds. This paper suggests that the long-term stagnation is the fault of the industrialized countries. Given that the people of the prosperous nations of the world have a moral obligation to help those in abject poverty, it is immoral to fail to address the cause of long-term stagnation.
In other words, what is happening in Europe is not just a matter for the poor 500 million souls who live there, but for the rest of the world. It is of vital importance to all of us that Europe today, and the United States very soon, get their macroeconomic act together and remove the hurdles to growth and prosperity that the welfare state has created.
Yes, the welfare state. It is the root cause of Europe’s many problems. Their crisis is, to put it plainly, self inflicted. Over its more than half-century long life, the welfare state has fundamentally transformed large parts of the economic landscape. It has changed work incentives by means of both taxes and entitlements. Income-security programs, much larger in Europe than in the United States, have weakened people’s motives for participating in the workforce. The redistributive nature of the income-tax system discourages entrepreneurship and the pursuit of high-end professional careers.
Self determination and innovation are replaced by sloth and indolence.
This is a new perspective on the European crisis, a perspective that I spend my entire book explaining. The usual question “why isn’t anyone else saying this?” is easily answered: it is only recently that we have access to enough information, enough economic data, to piece together a hypothesis about the welfare state’s long-term effects on its host economy. Especially in view of the Great Recession it is now possible to study broader economic trends and the long-term macroeconomic effects of the institutions that constitute the welfare state. In this new wealth of information, a pattern is emerging, suggesting that while the welfare state can have short-term positive effects on economic growth, its long-term effects are undeniably negative.
In particular, it now appears to be possible to identify a “point of no return” beyond which the welfare state pushes an economy over the line, from the realm of GDP growth into perennial stagnation.
For more on that, and for more on what life looks like under Industrial Poverty, buy my book today!
As I keep saying, there are no reasons for Europe’s households and entrepreneurs to be optimistic about the future. Therefore, they are not going to spend more money. They are going to drive their economy into the deep, long ditch of deflation, depression and permanent stagnation.
Eurozone private business growth slowed more than expected in August, despite widespread price cutting, as manufacturing and service industry activity both dwindled, a survey showed on Thursday (21 August).
This is an important, but hardly surprising measurement of what is really going on in the European economy. When buyers do not respond positively to price cuts, it means either of two things:
- They cannot afford to increase spending; or
- They are so pessimistic about the future that they hold on for dear life to whatever cash they have.
A less likely explanation is that they speculate, planning their purchases for a future point in time when prices are expected to be even lower. For this to be true there would have to be other signs of improving economic activity, signs indicating that, primarily, households can afford to spend money in the first place. But the European economy does not exhibit any such signs.
First of all, the cuts in entitlement programs may have wound down with some austerity measures coming to an end. But there is only a partial austerity cease-fire, with Greece, Spain, Italy, France and Sweden continuing contractionary budget measures. Austerity measures designed to save the welfare state in the midst of an economic crisis inject a great deal of uncertainty among consumers, as they can no longer trust the welfare state with keeping its entitlement promises. More of household earnings is used to build barriers against an uncertain future, causing consumer spending – the largest item in the economy – to stall or fall.
So long as austerity remains a threat to the European economy, consumers are going to hesitate.
Secondly, employment is not growing. People’s outlook on the ability to support themselves in the future is not improving. Youth unemployment is stuck at one quarter of all young being unemployed, total unemployment is almost at eleven percent and neither is budging. So long as there is no improved prospects for jobs, those who have jobs will not feel increasingly secure in their jobs, and the large segments of the population who are out of work have no more money to spend than what government provides through unemployment benefits (often hit by austerity).
Third, the European Central Bank may be flooding the euro zone with cheap money, but that is not going to help increase economic activity. Its negative interest rates on bank deposits only leaves liquidity slushing around in the banking system, making banks increasingly desperate to put the money to work. But because of the two aforementioned problems there has been no net addition of demand for credit in the European economy. While the liquidity makes no good difference in the real sector, it may find its way into financial speculation. That is a different and troubling story; the point here is that monetary policy is completely exhausted and can no longer help move the economy forward. Since the fiscal policy instruments of the European economy are entirely devoted to government-saving austerity, there is no clout left in the economic policy arsenal. The Europeans are left to fend for themselves, mired in uncertainty and stuck having to fund the world’s largest government.
In other words, there is no reason to be surprised by the lack of demand response to declining prices. There are, however, a lot of reasons to be worried about Europe’s future. Euractiv again:
Economic growth ground to a halt in the second quarter, dragged down by a shrinking economy in Germany and a stagnant France … Markit’s Composite Purchasing Managers’ Index (PMI) will provide gloomy reading for the European Central Bank (ECB), suggesting its two biggest economies are struggling like smaller members. Based on surveys of thousands of companies across the region and a good indicator of overall growth, the Composite Flash PMI fell to 52.8 from July’s 53.8, far short of expectations in a Reuters poll for a modest dip to 53.4.
Technically, any index number above 50 means purchasing managers are still expanding purchases. However, since the second-order trend is negative – the increase is flattening out – it is only a matter of a little bit of time before the PMI index itself goes negative. Shall we say three months? The Euractiv story gives good reasons for that:
Markit said the data point to third-quarter economic growth of 0.3%, matching predictions from a Reuters poll last week. “We are not seeing a recovery taking real hold as yet. We are not seeing anything where we look at it and think ‘yes, this is the point where the eurozone has come out of all its difficulties’,” said Rob Dobson, senior economist at Markit.
Again, an economist whose thinking is upside down. The right question to ask is not when the European economy is going to recover. The right question to ask is: what reasons does the European economy have to recover in the first place? In the emerging deflation climate, and with the economy stuck in the liquidity trap where monetary policy is completely impotent, Europe’s households and entrepreneurs have no reasons to change their current, basically depressed economic behavior.
Deflation is the most worrying part of their crisis. Says Euractiv:
Consumer prices in the eurozone rose just 0.4% on the year in July, the weakest annual rise since October 2009 at the height of the financial crisis, and well within the ECB’s “danger zone” of below 1%. Worryingly, according to the composite output price index firms cut prices for the 29th month – and at a faster rate than in July. … Also of concern, suggesting factories do not expect things to improve anytime soon, manufacturing headcount fell at the fastest rate in nine months.
This is not a protracted recession. This is a new normal, a state of permanent stagnation.
A state of industrial poverty.
My book Industrial Poverty: Yesterday Sweden, Today Europe, Tomorrow America will be officially available as hardcopy and e-book on September 10. This book basically asks a two-step question: Has the industrialized world entered a state of permanent economic stagnation? If so, is the state of stagnation self-inflicted?
I suggest that the answer is affirmative on both accounts. The consequence is dire for the two largest economies in the world:
- Europe is stuck in a depression that is leaving one in five young man and woman with no other option than to live off welfare;
- While the U.S. economy is improving, it is a recovery that leaves a lot to be wished for, primarily in terms of job creation and economically sustainable consumer spending.
The United States will continue to move, slowly, in the right direction, but without structural reforms to end large entitlement systems it will be very difficult to achieve more than 2-2.5 percent growth per year. That is just about enough to maintain a constant standard of living on an inter-generational basis.
A growing number of economists are expressing concerns about what will come after the Great Recession. One of them is Stanley Fischer, the number two guy at the Federal Reserve. From the New York Times:
Sounding a somber note even as the economic outlook in the United States brightens, the Federal Reserve’s No. 2 official acknowledged on Monday that global growth had been “disappointing” and warned of fundamental headwinds that might temper future gains. … Stanley Fischer … noted that although the weak recovery might simply be fallout from the financial crisis and the recession, “it is also possible that the underperformance reflects a more structural, longer-term shift in the global economy.” In a speech delivered on Monday in Stockholm at a conference organized by the Swedish Ministry of Finance, Mr. Fischer also conceded that economists and policy makers had been repeatedly disappointed as the expected level of growth failed to materialize.
My book is timely, in other words… To be perfectly honest, the reason why “economists and policy makers had been repeatedly disappointed” during the Great Recession is precisely that they do not primarily think in structural – or institutional – terms. One reason is the over-reliance on traditional econometric methods, which work well so long as there is no major upset to the overall structure of the economy. Another reason is the downgrading of genuine economic theory: today’s average graduate student in economics probably will never read an original text by theory-based scholars like Keynes, von Mises, Hayek, Lerner, Harrod or even Milton Friedman. Today’s academic economics puts the cart before the horse, deciding what tools to use first and then finding a list of problems those tool may apply to. What does not make the list is not of interest.
This is, obviously, an exaggerated stylization, but it is not more than that. Instead of using methodology that asks how soon the European economy will return to business as usual, economists need to begin to ask what reason, if any, the European economy has to return to full employment and growth. I have made my contribution. Stanley Fischer is opening for the same type of non-traditional analysis. Here is what he said, directly from the Federal Reserve website:
[The] Great Recession is a near-worldwide phenomenon, with the consequences of which many advanced economies–among them Sweden–continue to struggle. Its depth and breadth appear to have changed the economic environment in many ways and to have left the road ahead unclear. … There has been a steady, if unspectacular, climb in global growth since the financial crisis. For example, based on recent IMF data from the World Economic Outlook, which uses purchasing power parity weights, world growth averaged 3percent during the first fouryears of the recovery and as of July was expected to be 3.4 percent this year. The IMF expects global growth to reach 4 percent next year–a rate about equal to its estimate for long-run growth. This global average reflects a forecast of steady improvement in the performance of output in the advanced economies where growth averaged less than 1 percent during the initial phase of the recovery to an expected 2-1/2 percent by 2015.
Again, the best we can hope for is growth that – as I explain in my book – keeps our standard of living from a continuous decline. But let us also keep in mind that if we are going to expect Europe to grow by 2-2.5 percent next year, a minor miracle has to happen. A true end to welfare-state saving austerity would be a big step in that direction, but so far we have not seen more than verbal commitments to that. But even as this European version of austerity ends, it will take quite a while before the economy will recover. Confidence, like Rome, is not built in a day, and therefore I predict that Fischer will be too optimistic about Europe.
As we return to Stanley Fischer, he stresses the tepid nature of the global recovery:
With few exceptions, growth in the advanced economies has underperformed expectations of growth as economies exited from recession. Year after year we have had to explain from mid-year on why the global growth rate has been lower than predicted as little as two quarters back. Indeed, research done by my colleagues at the Federal Reserve comparing previous cases of severe recessions suggests that, even conditional on the depth and duration of the Great Recession and its association with a banking and financial crisis, the recoveries in the advanced economies have been well below average.
Which is yet more evidence that my argument that this is a structural crisis is valid. But not only that: the structural crisis is of a kind that traditional economics has not yet grasped. The culprit is the welfare state, the depressing effect of which slowly emerged up to four decades ago. However, unlike other long-term trend suggestions, such as the Kondratiev cycle, my hypothesis about the welfare state has a realistic microeconomic underpinning. More on that at some other point; for now, back to Stanley Fischer:
In the emerging market economies, the initial recovery was more in line with historical experience, but recently the pace of growth has been disappointing in those economies as well. This slowing is broad based–with performance in Emerging Asia, importantly China, stepping down sharply from the post-crisis surge, to rates significantly below the average pace in the decade before the crisis. A similar stepdown has been seen recently for other regions including Latin America. These disappointments in output performance have not only led to repeated downward revisions of forecasts for short-term growth, but also to a general reassessment of longer-run growth.
Does the welfare-state explanation apply to the emerging economies as well? In some cases the answer is yes, with South Africa and Argentina as leading examples. I am not familiar enough with the Chinese economy to be able to tell what role the welfare state plays there, but I would be surprised if their talk from time to time about fighting social stratification has not led to an expansion of a government-based redistribution system.
But it really does not matter if the Chinese are expanding their welfare state, or are wrestling with a financial bubble. Neither is going to change the European economy, which – as we go back to the New York Times story – is showing yet more signs of perennial stagnation:
A report on Monday by the Organization for Economic Cooperation and Development warned that German economic growth might be slowing. Germany has been one of Europe’s rare bright spots, continuing to prosper even as countries on the periphery like Greece, Portugal and Spain struggle after the debt crisis of 2010-12.
Let’s take a closer look at that report on Friday. For now, let’s just note that it is good to see that more and more economists are taking a broader, less conventional look at the economy. Just as I do…
As I explained last week, the American economy is pulling ahead of Europe. One major reason why this is happening is that our welfare state, big and onerous as it is, has not quite yet grown to the point where it brings the private sector to a grinding halt. Our consumers and entrepreneurs still have enough breathing room to pursue happiness and prosperity.
It is a safe bet that Europe will continue to slide behind. More evidence of this is in this Euractiv.com report:
Germany, France and Italy have agreed on closer cooperation in the areas of energy, transport and digital infrastructure. At a meeting in Berlin on Wednesday (July 30), German Minister of State for Europe Michael Roth, French State Secretary of Europe Harlem Désir and Italian State Secretary of European Affairs, Sandro Gozi agreed on the shared goals. In an explanatory paper, the three Europe ministers emphasised the importance of bridging investment gaps. “It is necessary that we fully exploit existing instruments like the EU structural funds, loans from the European Investment Bank and project bonds,” said Roth. But it is also important to be ready to test new, suitable instruments – regardless whether public or private, he added.
The prevailing political doctrine, in other words, is that more government spending is needed in Europe. The only problem the statists have is that they do not know how to fund that new spending, and that is perhaps the only silver lining in this. After the tax hikes that came with the past few years of austerity, Europe can catch its breath for a while.
This emphasis on government spending is part of a trend that gained momentum with the socialist gains in the EU elections in May. Consequently, it is not surprising that, according to Euractiv, these European politicians…
also emphasised the desire to more strongly address high youth unemployment in many EU member states. Europe should not be reduced to a functioning internal market and a common currency, Roth explained. “Europe is also, and above all, a community of values and solidarity.” Germany, France and Italy have set common goals of fulfilling targets for sustainable growth and improving employment opportunities, said Roth. Above all, this applied to the younger generation, he added.
By using terms like “values” and “solidarity” instead of “freedom” and “opportunity”, Europe’s political leaders declare again that government is the key player in bringing the continent’s economy out of its perennial slump. When government designs policies based on “values” it means imposing ideas of income redistribution on taxpayers, who are then asked to give up some of their money for someone who has not earned it. When government pursues “solidarity” it wants to eradicate differences between individuals in terms of economic outcomes. Jack’s hard work should not give Jack more than what Joe can achieve through sloth and indolence.
There is another interesting angle to this. Euractiv again:
To free up new sources of cash, the European Commission would like to expand project bonds for large infrastructure projects. According to the Commission, these funds will be granted to private investors such as banks and pension funds to support cross-border infrastructure like power grids, roads and railways. The credit quality of loans will be improved through the acquisition of guarantees.
As I have explained numerous times on this blog, a major component of the so called financial crisis was the early and rapid credit decline of Europe’s welfare states. In the years leading up to the crisis, financial institutions in Europe had rapidly expanded their investments in European government debt. As the credit worthiness of those welfare states fell, so did the solidity of bank portfolios. Spanish, Irish, Portuguese, French, Italian and – not to forget – Greek treasury bonds were reduced from practically no credit risk to more or less junk status. As a result, bank balance sheets tumbled, and a real financial crisis emerged – not as a cause of the economic crisis, but as a result of it.
Now governments in Europe want private investors to once again trust them with their money.
Apparently, Europe has learned nothing from the crisis. Instead both voters and political leaders demand more of the very same economic ingredients that caused the crisis in the first place: entitlements, high taxes and unsustainable welfare states.
Europe has turned into an economic wasteland. So long as its politicians keep protecting the welfare state at any cost, the European continent will sink deeper and deeper into perennial industrial poverty.
As an institutional economist I focus my research on the role that institutions and policy structures play in our economy. It is a fascinating niche in economics, and when combined with macroeconomics it becomes one of the most powerful analytical tools out there. So far, over the past 2.5 years, everything I have predicted about the European crisis has turned out to be correct; my upcoming book Industrial Poverty makes ample use of institutional economics and macroeconomics to show why Europe’s crisis is far more than just a protracted recession.
In economics, the institutional methodology is often pinned against econometrics, the mainstream methodological favorite. I don’t see it that way – econometrics has its place in economics – but the mainstream of the academic side of economics has given econometrics a far bigger role than it can handle. This has led to over-confidence among econometricians which, in turn, has led to a downplay or, in many cases, complete disregard for the benefits that other methodologies bring. The worst consequence of this over-reliance on econometrics was the multiplier debacle at the IMF, with serious consequences for the Greek economy. (How many young Greeks are unemployed today because their government implemented austerity policies based on IMF miscalculations?) A wider, better understanding for economic institutions and their interaction with the macroeconomy could help mainstream economists a long way toward a deeper, more complete understanding of the economy and, ultimately, toward giving better policy advice.
As an example of how institutional analysis can inform more traditional analysis, consider this interesting article on the European crisis by Economics Nobel Laureate Michael Spence and David Brady, Deputy Director of the Hoover Institution:
Governments’ inability to act decisively to address their economies’ growth, employment, and distributional challenges has emerged as a major source of concern almost everywhere. In the United States, in particular, political polarization, congressional gridlock, and irresponsible grandstanding have garnered much attention, with many worried about the economic consequences. But, as a recent analysis has shown, there is little correlation between a country’s relative economic performance in several dimensions and how “functional” its government is. In fact, in the six years since the global financial crisis erupted, the US has outperformed advanced countries in terms of growth, unemployment, productivity, and unit labor costs, despite a record-high level of political polarization at the national level.
This is true, and as I demonstrate in Industrial Poverty, a major reason for this is that the American economy is not ensnared in a welfare state like the European. We still lack a couple of major institutional components that they have: general income security and a government-run, single-payer health care system. That said, the U.S. economy is not exactly performing outstandingly either:
Yes, we are currently in better shape than Europe, but we are also doing worse than ourselves 20, 30 or 40 years ago.
Let’s keep this in mind as we continue to listen to Spence and Brady – their discussion about political dysfunction is actually tied to the role of the welfare state in the economy:
[In] terms of overall relative economic performance, the US clearly is not paying a high price for political dysfunction. Without dismissing the potential value of more decisive policymaking, it seems clear that other factors must be at work. Examining them holds important lessons for a wide range of countries. Our premise is that the global integration and economic growth of a wide range of developing countries has triggered a multi-decade process of profound change. These countries’ presence in the tradable sector of the global economy is affecting relative prices of goods and factors of production, including both labor and capital.
And the government structures that aim to redistribute income and wealth within a country. High-tax economies lose out to low-tax economies. The Asian tigers have generally held tax advantages over their European competitors, but they have also held advantages on the other side of the welfare-state equation as well. By not putting in place indolence-inducing entitlement systems they have kept their work force more shaped toward high-productivity labor than is the case in the old, mature welfare states of Europe.
Why does the welfare state not change, then, in response to increased global competition? After all, Japan, China, South Korea and other Asian countries have been on the global market for decades. Enter the political dysfunction that Spence and Brady talk about. Unlike the United States, there is almost universal agreement among Europe’s legislators that the welfare state should be not only preserved but also vigorously defended in times of economic crisis. This has been the motive behind the European version of austerity, with the result that taxes have gone up, spending has gone down and the price of the welfare state for the private sector has increased, not been reduced as would be the logical response to increased global competition.
It is not entirely clear what kind of American political dysfunction Spence and Brady refer to, but if it has to do with fighting the deficit, they are absolutely on target.
In fact, probably without realizing it, Spence and Brady make an important observation about the long-term role of the welfare state:
Relatively myopic policy frameworks may have worked reasonably well in the early postwar period, when the US was dominant, and when a group of structurally similar advanced countries accounted for the vast majority of global output. But they cease working well when sustaining growth requires behavioral and structural adaptation to rapid changes in comparative advantage and the value of various types of human capital.
If understood as a general comment on the institutional structure of an economy, this argument makes a lot of sense. So long as the traditional industrialized world only had to compete with itself, it could expand its welfare states without paying a macroeconomic price for it. Gunnar Myrdal, Swedish economist and a main architect of the Scandinavian welfare-state model, confidently declared back in 1960 that the welfare state had no macroeconomic price tag attached to it. Back then, it was easy to let government sprawl in every direction imaginable without any losses in terms of growth, income and employment. That is no longer possible.
Spence and Brady then make this excellent observation of the American economy:
What, then, accounts for the US economy’s relatively good performance in the post-crisis period? The main factor is the American economy’s underlying structural flexibility. Deleveraging has occurred faster than in other countries and, more important, resources and output have quickly shifted to the tradable sector to fill the gap created by persistently weak domestic demand. This suggests that, whatever the merit of government action, what governments do not do is also important. Many countries have policies that protect sectors or jobs, thereby introducing structural rigidities. The cost of such policies rises with the need for structural change to sustain growth and employment (and to recover from unbalanced growth patterns and shocks).
The move of resources from the domestic to the foreign-trade sector is visible in national accounts data as a rise of gross exports as share of current-price GDP from 9.1 percent in 2003 to 13.5 percent in 2013. Furthermore, actual growth numbers for exports relative private consumption reinforce the point made by Spence and Brady: from 20087 to 2013 private consumption has increased by 15 percent in current prices, while gross exports have increased by more than 22 percent. For every new dollar Americans doled out on cars, food, haircuts and motel nights, foreign buyers added $1.50 to what they spend on our products.
However, let us once again remember that the adaptation of the American economy should be viewed against the backdrop of a smaller welfare state. As I have discussed on several occasions, European countries are also making big efforts at increasing exports. They are not as lucky in using foreign sales as a demand-pull mechanism for restarting their economies. One reason, again, is the rigor oeconomicus that the welfare state injects into the economy.
Spence and Brady also compare the United States to a number of other countries, noting that:
Removing structural rigidities is easier said than done. Some stem from social-protection mechanisms, focused on jobs and sectors rather than individuals and families. Others reflect policies that simply protect sectors from competition and generate rents and vested interests. In short, resistance to reform can be substantial precisely because the results have distributional effects. Such reform is not market fundamentalism. The goal is not to privatize everything or to uphold the mistaken belief that unregulated markets are self-regulating. On the contrary, government has a significant role in structural transitions. But it must also get out of the way.
In short – and my words, not theirs: reform away the welfare state. Its detrimental influence actually stretches deeper than perhaps Spence and Brady recognize: it does indeed protect large sectors from competition by simply monopolizing them. Health care is a good example, with a government monopoly spilling over on medical-technology products. Another good example is income security, where many European countries have de facto monopolized every aspect from parental-leave benefits to retirement security. Education is a third example, where the United States, despite its heavily socialized K-12 system has a very strong private sector for academic education. This sector is almost entirely absent in many European countries.
Again, it is good to see a different approach to economic analysis than the traditional one based on econometrics and often irresponsibly simplified quantitative analysis. In a situation like the European crisis, it is very important for economists and other social-science scholars (Brady is a political scientist) to broaden the analysis and focus on such variables that rarely change. Among those are economic institutions such as the welfare state, and the political and economic incentives at work in Europe to preserve it, even in the face of mounting global competition.