Greece keeps pushing the currency union envelope. Mr. Tsipras, the socialist prime minister, is driven by his ideological convictions and therefore plays a different game than the leaders in Brussels with whom he is negotiating to keep his country afloat. The problem for the European leadership is that it seems incapable of understanding what role Tsipras’s ideology plays for his actions – Tsipras wants full independence for Greece so he can build his version of the socialist dreamland that now-defunct Venezuelan president Hugo Chavez created.
Rational arguments such as “property rights no longer exist in Venezuela” or “they have 60 percent inflation” and “crime is rampant and there is a shortage of almost every daily necessity” do not work on ideologues like Tsipras. That is the very problem with them. Therefore, you cannot reason with them as though they were swayed by the same type of “sensible” arguments that you are. But more importantly: so long as the EU leadership does not understand that politicians like Tsipras are ideologically opposed to everything that the EU stands for, they will not be able to have a rational conversation. There will be constant discords, where the EU leaders try to set goals that will help Greece stay inside the euro zone – and ultimately the EU – while Tsipras and others like him (think euro skeptics in Italy and Spain) will try to create circumstances that allow them to get what they want, namely out of the euro zone (and eventually the EU).
The biggest danger with this discord is that once the euro zone starts breaking apart, the retreat from the common currency will be disorderly. There is no doubt that the Bundesbank in Germany has a contingency plan for that disorderly dissolution, but it is far from certain that their plan will work. There are so many uncertain factors in this game that an even reasonably confident prediction is out of the question.
That said, there are some fixed points that can be put in the context of macroeconomic reasoning. That in turn should at least provide some insight into the best and worst case scenarios.
Before we get there, though, an update on the Greek situation, as reported by the EU Observer:
The stand-off between Greece and its lenders deepened over the weekend ahead of a meeting of euro finance ministers on Friday (24 April), with both sides exchanging barbs over the risk of a Greek default and its consequences for the eurozone. On Friday, Eurogroup president Jeroen Dijsselbloem said both parties should avoid “a game of chicken to see who can stick it out longer. We have a joint interest to reach an agreement quickly”.
An agreement about what? If Greece secedes from the euro it can, at least theoretically, run away from its bailout-related deals. In practice, the EU would still want to enforce loan contract, but it is much more difficult with a country that has a currency of its own – a currency that in all likelihood will be depreciating rapidly.
As for the IMF, Greece would have to deal with them separately, but it could do so much more so on its own terms once outside of the euro zone.
In fairness, though, it looks like the full extent of the Greek situation is beginning to dawn on at least some EU leaders. The EU Observer again:
EU and International Monetary Fund (IMF) leaders warned that Greece had to make quick progress to finalise a list of reforms that would enable it to receive a €7.2 billion loan. But they hinted that a Greek default could be managed by the eurozone. “More work, I say much more work is needed now. And it’s urgent,” said European Central Bank (ECB) chief Mario Draghi in Washington, where he was attending the IMF’s Spring meeting. “We are better equipped than we were in 2012, 2011, and 2010,” he added, referring to the years when fears of a eurozone break-up were at a high. “Having said that, we are certainly entering into uncharted waters if the crisis were to precipitate, and it is very premature to make any speculation about it,” Draghi also said.
So what would happen if Greece seceded from the euro? Well, the EU Observer article brushes on that subject:
Greek finance minister Yanis Varaoufakis, for his part, warned that his country’s exit would cause major problems for the rest of the region. “Some claim that the rest of Europe has been ring-fenced from Greece and that the ECB has tools at its disposal to amputate Greece, if need be, cauterize the wound and allow the rest of the eurozone to carry on,” he said on Spain’s La Sexta channel “Once the idea enters peoples’ minds that monetary union is not forever, speculation begins … who’s next? That question is the solvent of any monetary union. Sooner or later it’s going to start raising interest rates, political tensions, capital flight.”
This is a key statement. Some would interpret it as Greek leverage in negotiations with Brussels. However, the correct way to read it is as a blunt warning of what is to come: sooner or later Greece will leave the currency union, and it will do so like the men who escaped Alcatraz in 1962. Once someone has done what everyone thought was impossible, then just as Mr. Varaoufakis says, the only question on everyone’s mind will be: who’s next?
British Member of the European Parliament for the UKIP, Mr. Nigel Farage, made a great point recently when appearing on BBC (at about 2:25 into the video): the initial effect of a Greek currency secession is going to be a boost in growth as the currency depreciates. This growth spurt will inspire other struggling euro-zone states to consider a return to their national currency. Once the secession movement gets off ground, it is uncertain how many states will actually reintroduce their national currency, but it would be reasonable to expect a first round of secession to sweep from Athens to Lisbon.
The short-term financial turmoil aside, the most likely effect will be a southern European currency war. The four countries that have historically had weak currencies will find themselves returning to that position, only with an even deeper macroeconomic ditch to climb out of. The only moving part of their economies is, actually, exports, which will get a boost from a rapid currency depreciation. At the same time, that depreciation will be a major conduit for imported inflation, which in turn will eat its way into the economy a bit after the exports boom has gained momentum. The more the currency depreciates, the stronger the imported-inflation effect will be.
Inflation will have major consequences for the government budget. Depending on what type of inflation indexation is built into the welfare state’s entitlement programs, the cost of government spending will rise more or less with inflation. While inflation can also be beneficial to the revenue side of the state budget, it negatively influences the purchasing power of households and generally (but not always) depresses business profitability. As a result, domestic economic activity slows down, causing the tax base to stagnate.
And this is where the major test comes for currency secessionists: how will they handle their budget problems? With weak currencies they will have a hard time selling their treasury bonds on the international market; they can load up their banks – a likely scenario in Greece where a Syriza government could even go as far as to nationalize banks – but as the Great Recession demonstrated, leaning on banks for funding a government deficit is a particularly bad idea. When banks are overloaded with bad government debt in the midst of a macroeconomic crisis, then suddenly it is 2009 again.
Very briefly, then: once the euro zone starts falling apart the first ones to leave will face very difficult challenges. That is not to say that the remaining euro zone countries will have a better life – it is very likely that the euro zone itself won’t survive the 2017 French presidential election – but once the Southern Rim has left the euro zone the remaining countries will have a somewhat easier time following an orderly retreat plan. In fact, it would not be surprising if Germany, Austria and the BeNeLux countries remained in a “core” currency union – a Gross-Deutsch Mark, if you will. That currency could actually become a stabilizing point for a post-euro EU.
Still, even with an anchor currency in the heart of the EU, an implosion of the euro will have major negative effects for the European economy. What will those effects look like? That is a subject for another article.
The stagnant European economy does not need more bad news. Unfortunately, there is more coming. Business Insider reports:
The amazing collapse in German bond yields is continuing. Today, five-year bonds (or bunds) have a negative nominal return for the first time ever. That means that investors buying a 5-year bond on the market today will effectively be paying the German government for the privilege of owning some of its debt. This has been happening for some time now. In 2012, people were amazed when 6-month bund yields went into negative territory. In August, the two-year yield went negative too. Less than a month ago, the same thing happened with the country’s four-year bunds.
While there is a downward trend in bond yields in most euro-zone countries, there is a clear discrepancy between first-tier and second-tier euro states. Ten-year treasury bond yields, other than Germany:
- Austria, 0.71 percent, trending firmly downward; France, 0.83 percent, trending firmly downward; Netherlands, 0.68 percent, trending firmly downward; Italy, 1.87 percent, trending firmly downward.
A couple of second-tier examples:
- Ireland, 1.24 percent, trending weakly downward; Portugal, 2.69 percent, trending weakly downward.
Greece is the real outlier at 9.59 percent and an upward yield trend. But Greece is also a reason why Germany’s bond yields are turning negative. Although the Greek economy is no longer plunging into the dungeon of depression, it is not recovering. Basically, it is in a state of stagnation. Its very high unemployment and weak growth is coupled with an ongoing austerity program, imposed by the EU, the ECB and the IMF.
Add to that the political instability which, in late January, will probably lead to a new, radically leftist government. Syriza’s ideological point of gravity is the Chavista socialism that has been practiced in Venezuela over the past 10-15 years. They are also vocal opponents to the EU-imposed austerity programs, an opposition they would have to deliver on in case they want to stay relevant in Greek politics.
If Greece unilaterally ends its austerity program, it de facto means the beginning of their secession from the euro. That in turn would raise the possibility of other secessions, such as France, where a President Le Pen would begin her term in 2017 with a plan to reintroduce the franc. When that happens, the euro is history.
There is no history of anything similar happening in modern history, which makes it very difficult for anyone, economist or not, to predict what will happen. Europe’s political leaders will, of course, want to make the transition as smooth and predictable, but without experience to draw on there is a considerable risk that the process will be neither smooth nor politically controllable. Add to that the inability of econometricians to forecast the transition; based on the numerous examples of forecasting errors from the past couple of years, there is going to be little reliable support from the forecasting community for a rollback of the euro.
That is not to say the process cannot be a success. But the window of uncertainty is so large that it alone explains the investor flight to German treasury bonds.
This uncertainty is also throwing a wet blanket over almost the entire European economy, an economy that desperately needs growth and new jobs. Since 2010 the EU-28 economy has added 800,000 new jobs, an increase of 0.37 percent. For comparison, during the same time the American economy has added eleven million jobs, an increase of a healthy 8.5 percent.
There is yet more evidence that Europe, unlike the United States, is going to remain in a state of economic stagnation for a while longer. The EU Observer reports:
Italy has slipped back into recession putting pressure on Prime Minister Matteo Renzi to fulfil promises to see through major structural reform to boost growth. The Italian economy, the third largest in the eurozone, shrank 0.2 percent in the second [quarter], the country’s national statistics office said Wednesday (6 August).
The only quarterly number that Eurostat has released so far is the one adjusted for seasons and workdays, a number I would rarely use. However, it has its merits, too, as it comes as close as you can to linking GDP to the abstracted performance of economic agents. Compared to the same quarter 2013, this number shows a 0.3-percent drop in GDP over the same quarter 2013. Going back two years, the total decline is 2.5 percent. While the bulk of that decline took place in 2013, the country is still suffering from government-saving austerity programs designed to bring Italy into compliance with EU debt and deficit mandates.
But it is not over yet for Italy, not by a long shot. EU Observer again:
Finance minister Pier Carlo Padoan defended the government’s reform plans and said the country would not now need a corrective mini budget to stay on the right side of the EU’s fiscal rules. “The (GDP) figure is negative, but there are also positive elements. Industrial production is much better and consumer spending is continuing to increase, albeit slowly,” said Padoan
This statement is revealing of the purpose behind austerity. Everywhere in Europe, political leaders measure the success of austerity in terms of government fiscal balances; the metric never includes GDP growth. Greece is the prime example of this, where government-saving austerity peeled away one fifth of GDP in fixed prices. The Spanish encounter with austerity exemplifies similarly warped policy goal setting.
In addition, the finance minister’s statement about consumer spending is downright false. While there are no second-quarter Eurostat numbers yet on the spending of Italian consumers, first-quarter numbers are downright troubling. From Q1 2012 to Q1 2014, Italy’s consumer spending declined four percent. Over the last year, Q1 2013 to Q1 2014, the decline was a modest half-percent, but that is still a decline – not an increase.
Even if the GDP and consumption numbers indicate that the decline in Italian economic activity is coming to an end, there are no real signs of a sustainable uptick. It would be foolish to expect anything else, as the main fiscal-policy priority of the Italian government remains the same: save the welfare state. As we go back to the EU Observer, we get even more indications that nothing is really going to change for the better in the Italian economy:
The Italian PM has been among those calling the loudest for flexibility in the interpretation of the rules that govern debt and deficits in the eurozone. However other partners and the EU commission have indicated they wanted to see more structural reform undertaken first. The commission reiterated this on Wednesday and noted that Italy had already been told that it should stick to its budget plans. The other leader calling for flexibility and support from its EU partners is France’s Francois Hollande. In an interview with Le Monde recently, the French president urged Germany and the European Central Bank to do more to boost growth.
1. The Italian prime minister’s call for more flexibility in the interpretation of the EU’s stability and growth pact is really nothing more than a request to be allowed to increase government spending. It echoes what the socialist French president has been demanding for almost two years. However, the last thing Europe needs is more government spending.
2. When European political leaders talk about “structural reform” they do not refer to the kind of reforms actually needed, namely an orderly phase-out of the welfare state. Their take on “structural” is entirely regulatory and focused mostly on the labor market. But regulations do not build a structure – they are part of it, but they are not a structure in themselves. Furthermore, it is pointless to relax labor-market regulations without permanent tax cuts and terminations of government spending programs. Deregulation is supposed to make it easier for employers to hire and fire, but if there is no more demand for labor after the deregulation than before, there won’t be any more jobs out there.
3. It is rather amusing to see how the French president is urging others, outside of his domain, to do more for economic growth. In essence, he is telling the Germans to run their economy better, so he can continue to raise hate-the-rich taxes and drive even more entrepreneurs and hard-working high-end professionals out of France.
In conclusion, there still is no case for an economic recovery in Europe. The continent is now on its sixth year of stagnation, and in some countries an outright depression. Monetary policy has now taken the entire euro zone into the liquidity trap while fiscal policy remains stubbornly fixated on government-saving austerity policies.
Youth unemployment remains stuck above 22 percent in the EU, and above 23 percent in the euro zone. An entire generation is lost.
As painful as it is to say it, Europe is turning into an economic wasteland. It is entirely self-inflicted and if the Europeans want get out of their permanent crisis, they have the solution in their hands.
I got some really positive feedback on my first austerity video. Thank you! The topic is timely, especially with reference to the crisis in Europe. After the elections in May when statist parties on the left gained seats in the European Parliament, the debate over how to handle the perennial economic slump has intensified. Austerity critics have become more vocal, and the funniest part of that is that they do not even realize that the kind of austerity they criticize is really the kind I define as “Government-First” austerity in my video.
This is telling of what the debate over austerity in Europe is really about, and who the participants are. Proponents of the European version of austerity are not out to reduce the size of government, but to make sure government – the welfare state to be precise – survives the recession as unharmed as possible. As I point out on the video, if they had a “Limited Government” purpose behind their austerity they would use private-sector growth, or lack thereof, as their metrics for whether or not austerity was successful. But since private-sector activity has been plunging in the countries hit worst by the European version of austerity, it is clear that the purpose behind austerity as applied in the EU is of the “Government First” kind.
This puts an absurd light on far-leftist criticism of austerity. Since there are no limited-government proponents on the scene in the European debate, statists are bashing statists over not using the right tools to save the welfare state. With the noise from their fight rising, it is becoming increasingly likely that my predictions for Europe’s future will come true: the continent is bound for a new form of stagnation. So long as Europe does not dispose of the welfare state, they will end up right there, in the economic wasteland of industrial poverty.
The harder the far left works to end government-first austerity, the farther to the left they will pull economic policy in Europe. Instead of trying to balance government budgets as a means toward saving the welfare state, the far left does not even want to have to worry about the budget. Their attacks on the EU’s constitutional stability and growth pact are symptomatic of this.
Austerity criticism is not limited to the EU level. Wherever socialists have made headway in national parliamentary elections they raise their anti-austerity voices. Italy is a case in point, as illustrated by an article in the EU Observer:
The EU is at a “crossroads” between accepting a long period of austerity and high unemployment or taking steps to boost an economic recovery, Italian prime minister Matteo Renzi has warned. Speaking in national parliament on Tuesday (24 June), Renzi told deputies that “high priests and prophets of austerity” were stifling the European economy. Renzi’s government takes control of the EU’s six month rotating presidency next week and has indicated that migration and the bloc’s stability and growth pact will be its main policy priorities. The Italian prime minister has led calls for the pact’s rules on budget deficits to be interpreted in a way that encourages more public investment.
In other words, what they want to be able to do is to spend more on government-run, tax-funded education, on more roads, mass transit and so called research and development programs. They also want to pour more money into non-fossil energy, the kind of complete waste that has been Germany’s failed attempt at replacing nuclear energy with “renewable” energy sources. (Out of utter panic over rising energy prices, Germany is now building coal power plants almost as fast as the Chinese.)
None of that spending would help the economy grow. If you tax the private sector into oblivion, it does not matter if it can ship its products on four-lane highways or six-lane highways. There won’t be anyone there to buy their products in the first place. It matters even less if the energy that manufacturers would use is from sometimes-producing wind turbines or sometimes-producing solar panels. If the energy is too expensive to make manufacturing competitive, nobody is going to want to buy it in the first place.
Europe does not need more government. It does not need more government-first austerity either. It needs limited-government austerity. And soon. Otherwise, it is basically over for Europe as a first-world continent.
Never bark at the Big Dog. The Big Dog is always right.
As expected, the harsh reality of the European economy is beginning to sink in with the political leaders of the EU. For a while, the narrative has been that the European economy is rebounding and that unemployment is falling. I have maintained all along that there are no signs of any such recovery, and on Friday Eurostat released a report that begins to backtrack from the unwarranted optimism. However, as the EU Observer reports, the narrative has changed somewhat, now putting focus on differences between member states rather than the absence of any downward trend across the EU:
Figures released on Friday (2 May) by the EU’s statistical office, Eurostat, indicate large differences remain in unemployment rates across member states. The eurozone unemployment rate was 11.8% in March 2014, stable since December 2013, but down from 12.0% in March 2013 With an 11.8 percent overall jobless rate in the eurozone, the chances of people landing a job remain low in countries like Greece and Spain when compared to Austria and Germany. At 26.7 percent, austerity-hit Greece still has the worst unemployment rate in the EU, followed closely by Spain with 25.3 percent. Austria at 4.9 percent and Germany at 5.1 percent have the lowest.
There is a good reason why the new story in Europe is about differences between member states rather than the overall trend. Figure 1 reports quarterly data on total unemployment, not seasonally adjusted, for the EU as a whole and for the euro zone specifically:
Yes, there are differences between member states, but the differences become pointless of there is no overall positive trend in unemployment. Germany is a good example, with an unemployment rate at 5.5 percent in the first quarter of 2014. While this is low by European standards, it is important to note that there is no strong downward trend in these numbers. Yes, measured over the same quarter a year before (e.g., first quarter of 2014 compared to first quarter of 2013) the Germans do see a slow, weak but nevertheless visible improvement. However, the rate still fluctuates from quarter to quarter by as much as a half percentage point, showing somewhat of a weakness in the trend.
Figure 2 highlights further the lack of trend in unemployment:
Most notably, Greece and Italy have not yet reported full data for the first quarter of this year. So far their trends point steady upward, though numbers that I reported previously on the Greek GDP give us reason to believe that unemployment will be flat in early 2014. Italy is a more uncertain case, partly due to growing talks about the country leaving the euro.
It is positive, no doubt, that both Spain and Ireland saw a decline in unemployment in the first quarter of 2014 (the second quarter in a row for Ireland with a decline). However, at the same time French unemployment is steadily on the rise, a fact that, given the size of the French economy, will have hampering effects on any possible recovery in other euro-area countries.
As we return to the EU Observer story, we can hear the frustration echo through the EU head quarters:
EU social affairs commissioner Laszlo Andor called for more investment into job creation. “The ultimate factor that will determine Europe’s economic future is whether we can hold together and further strengthen our Economic and Monetary Union, or whether we let weaker members of the EU and of our societies drift away,” he said. Earlier this year, Andor warned that one in four Europeans is at risk of poverty, despite unemployment figures dropping in some member states. Young people are the worst affected by the unemployment crisis. Only around one in four people of working age under 25 have a job. To offset the trend, the EU last summer launched its Youth Guarantee scheme with a promise to help the young find jobs, continue their education, or land a traineeship within four months of becoming unemployed or leaving formal education. EU money to support the scheme is primarily sourced from the European Social Fund (ESF).
Which is built by, and maintained by, Europe’s taxpayers. Instead of doing something about the high taxes and other factors that prevent Europe’s entrepreneurs from creating jobs, the EU taxes people more so it can give money to the young men and women who cannot get jobs because of the high taxes.
Of course, as the EU Observer story continues, spending taxpayers’ money to create jobs is about as hopeless a project as trying to ride a bicycle in zero gravity:
But given the scale of the problem, the EU plan has been criticised for being underfunded and lacking in ambition. The Brussels-based European Youth Forum in a study out in April on ten member states says the scheme has yet to live up to its promises. “It is a good way of tackling youth unemployment but effectively so far there hasn’t been enough ambition in it and enough political will in some member states to implement it properly,” said a European Youth Forum spokesperson.
Wrong. The reason why it has not yet been successful is because it is a government program, spending taxpayers’ money when taxpayers should really be allowed to keep their money and spend it as they see fit. Because of the high taxes across Europe, only countries with strong exports industries are able to pull ahead (Germany and Austria are good examples). Until government rolls back its presence in the economy – on both the spending side and the taxation side – Europe will be stuck with its disastrously high unemployment levels. Temporary changes up or down will not make any difference over time.
Something is happening in Italy. There is a faint glimpse of hope that one of Europe’s largest countries may be seeing the end of its tyrannical austerity policies. From the EU Observer:
Italy is set to move off the EU ‘crisis list’ this week, as the European Commission acknowledges its efforts to reduce its budget deficit. EU sources indicated on Monday (27 May) that Italy will be among several countries to be taken out of an Excessive Deficit Procedure (EDP) when the European Commission delivers its verdict on national reform programmes (NRPs) and budget plans on Wednesday (29 May).
The reason for this has to do in part with the latest austerity measures, in part with policies to end those. This sounds contradictory, but bear with me.
Austerity measures have a positive effect on the budget deficit in their first year. In other words, an initial upswing for government finances is to be expected under austerity. It takes a year for people to fully adjust their economic behavior to the new austerity measures. However, once the private sector has adjusted to government’s increased net taking of its resources, it produces fewer jobs and a smaller tax base than what government calculated with when it put its austerity package to work.
The net effect is a downward adjustment of economic activity, a loss in revenue for government and increased demand for poverty-related entitlements. The budget deficit bounces up again.
However, if you shift policies from austerity to a strategy that is more friendly toward the private sector, growth in employment, consumer spending and investments will grow the tax base and continue the improvement of the government budget.
This may actually be what is happening in Italy. But first, back tot he EU Observer:
Economic affairs commissioner Olli Rehn will deliver “country-specific recommendations” for each of the 17 members of the eurozone. Italy’s budget deficit is predicted to fall to 2.9 percent in 2013 before falling to 2.5 percent in 2014 and the country once regarded as too big to fail in the eurozone is no longer top of the commission’s at risk list. However, it is expected to remain in recession in 2013 before recording a modest 0.7 percent growth rate in 2014.
In order for the budget deficit to fall by 0.4 percent of GDP from 2013 to 2014 the government budget has to run a surplus of that amount. The tax base, GDP, is expected to grow by 0.7 percent which means that spending cannot grow faster than 0.3 percent of GDP.
While it is very unlikely that spending will grow at such a small rate, it is possible for the tax base to grow faster. Italy’s new prime minister, Enrico Letta, wants to see a shift in policy from austerity, which increases the government’s net taking from the economy, to a more growth-friendly strategy:
The centrepiece of his tax pledge is the suspension of the hated property tax, known by its acronym IMU, that was imposed on primary residences by former leader Mario Monti and strenuously opposed by Mr. Berlusconi. He did not, however, vow to kill the tax. Some economists think it will ultimately be reduced or imposed only on residences above a certain value. He also said he hoped the planned hike in the value-added tax to 22 per cent from 21 per cent, another initiative of Mr. Monti, would not go ahead, and that taxes on employers – a “tax on jobs,” as he put it – would be cut. Mr. Letta is trying to gain European support for his anti-austerity, job-creation plans by visiting German Chancellor Angela Merkel and European Council President Herman Van Rompuy this week.
Not bad but not enough. Still, it is nice to see some European leaders ready to fight for common-sensical economic policies.
Then there is the mandatory short-sighted question:
How Italy will pay for these measures was left unsaid and Italy has virtually no flexibility, even though its sovereign funding costs are well below their crisis highs of 2011, when Mr. Berlusconi was effectively ousted and replaced by Mr. Monti. While Italy is not Greece, the country is in deep recession and is saddled with a ratio of debt to gross domestic product of 127 per cent, the second largest in Europe, after Greece.
It is precisely the wrong way forward to focus on how to pay for tax cuts. That notion presumes that the tax cuts will have no positive effects on the economy. If the pay-for-itself measure is about the government budget, there is little to fear. Tax cuts often pay for themselves, as was well proven in the U.S. economy during the ’80s.
If on the other hand the pay-for-itself question is related to jobs, GDP growth and a return to prosperity, there are reasons to not be as optimistic. The Italian recession is very deep and it will take a lot to put it back on a growth track again. Mr. Letta would have to pursue far bigger tax cuts than he is currently discussing.
That said, it is always better to cut taxes than to raise taxes. If the Italian government – and more importantly its buddies in the EU – can take their eyes off the government budget for a couple of years, then Italy might actually have a fighting chance to get back on track again. However, that chance would be much stronger if there was also a plan in place for structural spending-cut reforms. So far I don’t see any such plan on the horizon.
Bottom line: don’t count Italy out just yet, but don’t expect miracles from small spending cuts either.
And down goes another welfare state…:
Fitch Ratings has downgraded Italy’s Long-term foreign and local currency Issuer Default Ratings (IDR) to ‘BBB+’ from ‘A-‘. The Outlook on the Long-term IDRs is Negative. Fitch has simultaneously affirmed the Short-term foreign currency IDR at ‘F2′ and the common eurozone Country Ceiling for Italy at ‘AAA’.
Already before this, Italy was paying more than seven percent on its treasury bonds. This will bump up their borrowing costs yet another notch. And since the European Central Bank has promised to buy any EU member-state bonds denominated in euros, this will increase their commitment and their obligation to print even more money.
The downgrade of Italy’s sovereign ratings reflects the following key rating factors: The inconclusive results of the Italian parliamentary elections on 24-25 February make it unlikely that a stable new government can be formed in the next few weeks. The increased political uncertainty and non-conducive backdrop for further structural reform measures constitute a further adverse shock to the real economy amidst the deep recession.
It would be interesting to hear what the Fitch analysts have to say about what Italy has done thus far in terms of austerity. Effectively, they are asking for more of the same, obviously a bad idea.
There is actually a bit of irony in this. Without a “stable” government Italy will sail on as it is, and no new austerity measures will be implemented. This gives the economy a little bit of breathing space, which – at least in theory – could inspire a small recovery. That in turn would be good for future tax revenues and help toward reducing the budget deficit.
In reality, there is little to hope for here. Pressure from the EU will bring a new prime minister into office sooner rather than later, and regardless of who that person is, Italy will continue down its path of austerity. The only other option would be to leave the euro – an option that not even the Greeks could make use of. Therefore, we can expect more recession in Italy, which means weaker tax revenues, more demand for tax-paid entitlements – and thus a perpetuation of the budget problems.
That will surprise the Fitch analysts and somewhere in the future could bring about yet another downgrade. In fact, as the Business Insider reports, Fitch is already surprised by how poorly the Italian economy is performing:
Q412 data confirms that the ongoing recession in Italy is one of the deepest in Europe. The unfavourable starting position and some recent developments, like the unexpected fall in employment and persistently weak sentiment indicators, increase the risk of a more protracted and deeper recession than previously expected. Fitch expects a GDP contraction of 1.8% in 2013, due largely to the carry-over from the 2.4% contraction in 2012. Due to the deeper recession and its adverse impact on headline budget deficit, the gross general government debt (GGGD) will peak in 2013 at close to 130% of GDP compared with Fitch’s estimate of 125% in mid-2012, even assuming an unchanged underlying fiscal stance.
Nope. No peak there. Too many people have made too many predictions of peaks for the Greek government debt, and yet they were always overrun by reality. Expect the same to happen in Italy.
So long as the Italian government continues to try to defend its welfare state, it is going to run a deficit. So long as Italy runs a deficit, the EU and the ECB will demand more austerity measures. With more austerity, the current crisis will continue to get worse. How much worse is impossible to say: this type of crisis is historically new and has to do with the fact that the welfare state has matured, warped the economic incentives of a sufficiently large number of people and thus eroded its own economic foundation.
The Greek crisis is a perfect example of how open-ended this type of crisis is. It has been going on for five years now, the country has lost a quarter of its GDP and it is not over yet for them.
The European crisis is gaining more and more attention. Two days ago George Friedman, founder of the global intelligence research firm Stratfor, wrote an interesting article about the fragile state of affairs in Europe:
The global financial crisis of 2008 has slowly yielded to a global unemployment crisis. This unemployment crisis will, fairly quickly, give way to a political crisis. The crisis involves all three of the major pillars of the global system — Europe, China and the United States.
Just a quick note: the initial crisis was financial on the surface, but underneath it was the crisis of the welfare state, a system of entitlements and taxes that has been structurally unsustainable for a long time. For each recession since the oil crisis in 1979 the European welfare states have been nudged a little bit closer to the point where they become acutely fiscally unsustainable. With this recession came the point where Europe’s big entitlement systems finally overburdened their host organism, the private sector.
As the welfare state began falling apart, the EU-ECB-IMF troika set out to save it with harsh, depression-inducing austerity policies. The medicine made the patient worse, which is why there is an unforgiving unemployment crisis sweeping across Europe – with, yes, a political crisis on its tail.
Mr. Friedman does not see the welfare state’s role in this, but his analysis is nevertheless important. He points out that the exact nature of the crisis varies from country to country, but…
there is a common element, which is that unemployment is increasingly replacing finance as the central problem of the financial system. … Last week Italy held elections, and the party that won the most votes — with about a quarter of the total — was a brand-new group called the Five Star Movement that is led by a professional comedian. Two things are of interest about this movement. First, one of its central pillars is the call for defaulting on a part of Italy’s debt as the lesser of evils. The second is that Italy, with 11.2 percent unemployment, is far from the worst case of unemployment in the European Union. Nevertheless, Italy is breeding radical parties deeply opposed to the austerity policies currently in place.
This is exactly the point that I have been making for more than a year now. Glad to see others are paying attention.
The core debate in Europe has been how to solve the sovereign debt crisis and the resulting threat to Europe’s banks. The issue was who would bear the burden of stabilizing the system. The argument that won the day, particularly among Europe’s elites, was that what Europe needed was austerity, that government spending had to be dramatically restrained so that sovereign debt — however restructured it might be — would not default.
Then Mr. Friedman reveals that he has been glancing at this blog – how else would he reach the conclusion that austerity is bad for the economy…? No one else makes that point:
One of the consequences of austerity is recession. The economies of many European countries, especially those in the eurozone, are now contracting, since austerity obviously means that less money will be available to purchase goods and services. If the primary goal is to stabilize the financial system, it makes sense. But whether financial stability can remain the primary goal depends on a consensus involving broad sectors of society. When unemployment emerges, that consensus shifts and the focus shifts with it. When unemployment becomes intense, then the entire political system can shift.
It is unclear how austerity would save the financial system – the banks – even from the perspective of someone who truly thinks austerity is good for the economy. All that austerity does, according to its many supporters, is to reduce the budget deficit which raises the price of treasury bonds and reduces, perhaps even reverses, the upward pressure on interest rates.
The only link to the banking system is that they have invested heavily in treasury bonds and that austerity – if it worked according to its theory – would then improve their balance sheets. It appears to be the case that banks did indeed load up with treasury bonds prior to this recession, an aggravating circumstance that – given the destructive nature of austerity – could prolong or even accelerate the recession. Mr. Friedman does not clarify if he shares this view of where the banks fit in to the crisis picture.
He does, however, make the important observation that the Italian election is more of an accelerator than a brake pedal in the ongoing European crisis:
Only four countries in Europe are at or below 6 percent unemployment: the geographically contiguous countries of Germany, Austria, the Netherlands and Luxembourg. The immediate periphery has much higher unemployment; Denmark at 7.4 percent, the United Kingdom at 7.7 percent, France at 10.6 percent and Poland at 10.6 percent. In the far periphery, Italy is at 11.7 percent, Lithuania is at 13.3 percent, Ireland is at 14.7 percent, Portugal is at 17.6 percent, Spain is at 26.2 percent and Greece is at 27 percent. … more than half of Germany’s exports go to other European countries. Germany sees the European Union’s free trade zone as essential for its survival. Without free access to these markets, its exports would contract dramatically and unemployment would soar.
And with the escalating crisis in the EU, the German economy is in trouble. The latest forecast is that the German GDP will contract for this year, but let’s not forget that the situation gets worse with each forecast, as forecasters see that the real world is faring worse than they predicted.
In other words, Mr. Friedman is right on the euro here, and he reinforces his point by explaining how the structure of the euro zone might actually aggravate the current crisis:
The euro is a tool that Germany, with its outsized influence, uses to manage its trade relations — and this management puts other members of the eurozone at a disadvantage. Countries with relatively low wages ought to have a competitive advantage over German exports. However, many have negative balances of trade. Thus, when the financial crisis hit, their ability to manage was insufficient and led to sovereign debt crises, which in turn further undermined their position via austerity, especially as their membership in the eurozone doesn’t allow them to apply their own monetary policies.
This is indeed a very important analysis of the role that the euro plays in the crisis. Germany, says, Mr. Friedman, has by design or by intent rigged the euro zone so as to be to its own foreign-trade advantage. So long as the weaker economies were on board with the stability and growth pact this was a game Germany could not lose. But once the debt flood gates opened in Greece, and the EU rushed in with its austerity demands, it was only a matter of time before the crisis would hit Germany.
The euro zone’s artificial terms-of-trade relations work both ways, with menacing symmetry.
Mr. Friedman then moves on to a discussion about the geo-political consequences of the economic crisis:
Portugal, Spain and Greece are in a depression. Their unemployment rate is roughly that of the United States in the midst of the Great Depression. A rule I use is that for each person unemployed, three others are affected, whether spouses, children or whomever. That means that when you hit 25 percent unemployment virtually everyone is affected. At 11 percent unemployment about 44 percent are affected. … in Greece, for example, pharmaceuticals are now in short supply since cash for importing goods has dried up. Spain’s local governments are about to lay off more employees. These countries have reached a tipping point from which it is difficult to imagine recovering. In the rest of Europe’s periphery, the unemployment crisis is intensifying. The precise numbers matter far less than the visible impact of societies that are tottering.
I would disagree about the role of the numbers. But be that as it may. Mr. Friedman is expressing great concern about what the future holds for the countries in Europe that are now effectively in a depression. I am entirely on board with his statement that it will be difficult for Greece and Spain to come back from this, though I also know that the day they decide to structurally eliminate their welfare states things will get a lot better.
That is, however, little more than a dream right now. In the way of such fundamental reforms lies, e.g., the stubborn and very destructive support among Europe’s political elites for a continuation of austerity.
Mr. Friedman sees a glimmer of hope on that front, though he does not quite define it that way:
The idea that the Germany-mandated austerity regime will be able to survive politically is difficult to imagine. In Italy, with “only” 11.7 percent unemployment, the success of the Five Star Movement represents an inevitable response to the crisis. Until recently, default was the primary fear of Europeans, at least of the financial, political and journalistic elite. They have come a long way toward solving the banking problem. But they have done it by generating a massive social crisis. That social crisis generates a political backlash that will prevent the German strategy from being carried out. For Southern Europe, where the social crisis is settling in for the long term, as well as for Eastern Europe, it is not clear how paying off their debt benefits them. They may be frozen out of the capital markets, but the cost of remaining in it is shared so unequally that the political base in favor of austerity is dissolving. This is compounded by deepening hostility to Germany. Germany sees itself as virtuous for its frugality. Others see it as rapacious in its aggressive exporting, with the most important export now being unemployment. Which one is right is immaterial. The fact that we are seeing growing differentiation between the German bloc and the rest of Europe is one of the most significant developments since the crisis began.
A good analysis indeed. Turning again to Italy, Mr. Friedman concludes:
The Five Star Movement’s argument in favor of default is not coming from a marginal party. The elite may hold the movement in contempt, but it won 25 percent of the vote. And recall that the hero of the Europhiles, Mario Monti, barely won 10 percent of the vote just a year after Europe celebrated him.
In other words, there may be enough political strength building against austerity. I pointed to this after the Greek election in June last year. And already in May last year I explained that the real winners in the welfare-state crisis are the fascists. I am glad to see that Mr. Friedman’s analysis is catching up with mine:
Fascism had its roots in Europe in massive economic failures in which the financial elites failed to recognize the political consequences of unemployment. They laughed at parties led by men who had been vagabonds selling post cards on the street and promising economic miracles if only those responsible for the misery of the country were purged. Men and women, plunged from the comfortable life of the petite bourgeoisie, did not laugh, but responded eagerly to that hope. The result was governments who enclosed their economies from the world and managed their performance through directive and manipulation. … when we look at the unemployment rates today, the differentials between regions, the fact that there is no promise of improvement and that the middle class is being hurled into the ranks of the dispossessed, we can see the patterns forming. … Whether it is the Golden Dawn party in Greece or the Catalan independence movements, the growth of parties wanting to redefine the system that has tilted so far against the middle class is inevitable.
Indeed. The problem now is where Europe is heading next. If Mr. Friedman is right in that the support for austerity is coming to an end in Europe, then there are only two ways forward: the freedom-pursuing way to a structural termination of the welfare state, or the authoritarian route led by parties like Golden Dawn. (There are others to factor in, such as the party duo governing Hungary; the Front National in France; the new nationalist coalition in Britain; and the nationalist parties in Scandinavia.)
I have warned of Europe’s authoritarian future for some time now. I wish I did not feel reinforced by Mr. Friedman’s analysis in that being my default forecast for Europe. Nevertheless, as time goes by, the crisis deepens and nothing is done to stop it, the authoritarian alternative gains momentum.
There is a dark cloud hanging over Europe. Let’s hope it won’t spread its darkness beyond the Old World.
So, the Italians did basically the same thing as the Greeks did back in June: they cast a protest vote against EU-imposed austerity. The protest was actually even stronger in Italy, a fact to be taken very seriously by anyone who respects and appreciates the fact that the people delegate power to their elected officials – not the other way around.
The problem for Italy, and for Europe in general, is that not everyone appreciates the sovereignty of the people. From the EU Observer:
The European Commission has urged any future government in Italy to keep on implementing deficit-cutting measures, despite the fact that over half the electorate voted for anti-austerity parties. “Last Friday the Italians were speaking quite clearly about debt-reduction commitments as well as a series of other commitments. These Italian commitments remain in force and the commission expects compliance,” commission spokesperson Olivier Bailly said on Tuesday (26 February).
Take another look at those words: “the commission expects compliance”… Listen to them. What attitude toward the people do they convey?
There is only one word for it: totalitarianism. When government expects the people to comply with its will, democracy has lost. It may still exist pro forma, as a shiny showroom item in the hallways of politics and power. But its role as the conveyor of the will of the people is long gone. Only when the people give the right answer to the question posed by the government, is their voice allowed to echo through the legislative chambers.
The Italian election was about the question: should government continue to raise taxes and cut spending? The EU Commission expected – demanded – an affirmative answer, so when the Italian people defied the will of the Almighty Commission in Brussels, the Commission got irritated. More than likely, they are already deeply involved in the negotiations to piece together an administration that, contrary to the will of the people, will continue with the destructive austerity policies.
That would be the only administration that the EU can accept.
Back to the EU Observer:
[Mr. Bailly’s] comments come after elections in Italy – the eurozone’s third biggest economy – failed to result in a majority for the upper house of the country’s parliament. The centre-left coalition of Pier Luigi Bersani, who had pledged to continue Monti’s work, won the lower house by a whisker. The resulting stalemate has put former comedian Beppe Grillo, who ran on an anti-austerity ticket and has called for a referendum on euro membership, in kingmaker position.
In some sense, this is like Jay Leno starting a political party that manages to wedge itself in between Democrats and Republicans in Congress. Grillo does have some serious support, and he might actually use his political power to try to weaken Italy’s ties to the European Union. The power of the EU will very likely win that struggle, but if Grillo’s party and the other anti-austerity parties are given little to no influence over the fiscal policies in Italy over the next couple of years, things could easily turn for the worse.
This Italian election is yet another challenge for Brussels and its disdain for the will of the people. Its first reaction reveals that it has learned nothing from Ireland, Greece, Spain and other countries where people have voted against the EU in one way or another. On the contrary, its reaction has been to try and seize even more power over fiscal policy – the issue that defined the Italian election.
It probably won’t get that power, at least not officially, so the Eurocrats and EU-friendly politicians in member states are doing their best to close ranks after this show of defiance from the Italian people:
The commission’s Bailly … admitted that Monti’s reform path had yet to produce results. It would be “an illusion” to think that 15 months of reforms – Monti took over in November 2011 – would would lead to “joy, happiness and jobs.” Staying with austerity would eventually lower debt, which is a “brake” on growth, he added.
If that was the case, the American economy would be shrinking at the speed of sound. Yet it is growing two percentage points faster than the European economy – not a fantastic growth rate by any standards, but nevertheless a fact worth noting.
And now for the austerity choir:
Eurogroup chief Jeroen Dijsselbloem said Italy’s reforms are “crucial” for the entire eurozone, while Guido Westerwelle, the foreign minister of pro-austerity Germany, said Rome must “continue the solid policies of reform and consolidation.” Others worried about the political implications of the vote. European Parliament President Martin Schulz noted that “what happens in Italy affects all of us.” He said that unpopular reforms are being associated with the EU capital. “I take it very seriously that a lot of Italian people expressed a kind of protest against measures which are [seen] in Italy publicly as measures of the European Union. We should here in Brussels take this very, very seriously,” he explained.
And do what? Make the austerity measures look Italian?
It remains to be seen what government eventually is formed in Rome, but the very fact that the Eurocracy comes out as one voice and demands more austerity, regardless of what the people wanted, is a sign that Europe’s history of parliamentary democracy is in the balance. Austerity – a fiscal policy strategy to save the welfare state in times of recession – is worth more to the tax-paid elite in Brussels.
This is bad news for Europe. It is not far-fetched to conclude that Europe as we know it will not survive the EU. The only hope is that for each national election where the EU tries to dictate the outcome, more and more people will demand an orderly retreat from this totalitarian super-state project.
Watching Europe trying to get out of its recession is like watching a man trying to ride a bike in zero gravity. No matter how hard they try to pedal forward, they are completely and utterly stuck in one and the same spot. That GDP growth spurt that was going to jolt the European economy back to life is turning into little more than a fairy tale. In fact, reality is going in the exact opposite direction. From the EU Observer:
The eurozone economy will shrink by a further 0.3 percent in 2013, the European Commission said Friday (22 February), revising down a more optimistic previous estimate that had predicted 0.1 percent growth for this year. The data also indicates that average government debt rose by 5 percent in 2012 to 93.1 percent as a proportion of GDP. The average debt level is expected to peak at 95.2 percent in 2014, well above the 60 percent threshold set out in the bloc’s Stability and Growth Pact.
Please note that the growth rate is adjusted down by 0.4 percentage points, a relatively large adjustment for such a short period of time. The reason is probably not faulty economic models, as the EC gets its data from their own statistics bureau, Eurostat. It is more likely that the reason has to do with political meddling with the non-formal forecasting process – or, to be blunt: politicians and bureaucrats have written in their own delusional beliefs in the virtues of austerity into a forecast that otherwise would show the naked truth about said austerity.
As for the 60 percent debt level, it is entirely artificial without the slightest scientific foundation. It was imposed on the EU by a group of politicians and bureaucrats who designed the Stability and Growth Pact and wanted to look fiscally conservative. The 60-percent level was one of two arbitrary features of the Pact, the other being the requirement that EU member states cap their deficits to three percent of GDP. This latter feature is, by the way, the main culprit behind the panic-driven austerity assaults on the budgets in, e.g., Greece, Spain, Italy and Portugal. Needless to say, that has made it even harder for the member states to meet the goals of the Stability and Growth Pact.
Back to the EU Observer:
News on government budgetary positions was more positive. The average deficit in the eurozone had fallen by 1.5 percent to 3.5 percent, with the commission expecting a further 0.75 percent improvement to bring the eurozone average under the 3 percent threshold. Announcing the figures, Economic Affairs Commissioner Olli Rehn admitted that “the hard data is still very disappointing” adding that the progress made by national governments to cut budget deficits was “not yet feeding into the real economy.”
Yes they are. They are just not feeding in like Mr. Rehn thinks they should. Instead of making the economy grow, which is Mr. Rehn’s delusional belief, his spending cuts and tax increases are perpetuating and even aggravating the recession.
As for the improvement on the budget deficit front, it is an expected, temporary effect resulting from last year’s spending cuts and tax increases. Things will turn for the worse again once the latest austerity round proliferates through the economy.
To get the full story of what it is Mr. Rehn does not get, download this paper and check out Figure 3 on page 15. Given how obvious these macroeconomic mechanisms are, it is very surprising that Eurocrats like Mr. Rehn are still getting away with their austerity fantasies.
Or maybe they are not. Perhaps things have gotten so bad in so many countries now that people are prepared to throw out the balanced-budget requirements in order to allow for prosperity to start growing again. The Italian election will give us a big hint, explains another story from the EU Observer:
Italian voters are heading to the polls on Sunday and Monday (24-25 February) in a closely-watched race that could bring the country back to the brink of a bailout. Outgoing Prime Minister Mario Monti, a respected former EU commissioner and economics professor, may be the favourite among EU leaders watching from the side lines, but at home, he appears to have failed to convince voters that his reforms and sober politics are what the country needs today.
It is hardly a sign of sobriety when someone recommends higher taxes and spending cuts in the midst of a recession.
In a significant catch-up effort – thanks to his media empire and promises to pay back taxes introduced by Monti – former leader Silvio Berlusconi was just five percent behind [center-left candidate] Bersani in the 8 February survey. … For its part, Italy’s leading investment bank, Mediobanca, has predicted that if Berlusconi wins, the country would face an immediate backlash on financial markets and could be forced to ask for financial assistance from the European Central Bank.
For what reason? Berlusconi would in all likelihood abandon the austerity policies, and if he follows through on its promises to not only reverse the tax cuts but do it retroactively, he will in fact inject a stimulus into the economy of a kind that could get the Italian economy growing again. That in turn would ease the budget pressure and increase confidence among investors in, e.g., Italian treasury bonds.
If, on the other hand, Bersani wins he might form an alliance with Monti to please the Eurocrats. That in turn would increase the likelihood of more austerity hammering down on the Italian economy. Given its size, that will have clearly negative effects on the economy of the euro zone.
As will the continuing commitment to austerity in France, where the socialist government has been forced to adjust its budget deficit forecast. From the increasingly influential pan-European news site The Local:
The figure for this year, when France was due to get back within the EU’s ceiling of 3.0 percent of output, is worse than the 3.5 percent previously tipped, and leaves Socialist President Francois Hollande looking for special leeway from Brussels. European Union Economy and Euro Commissioner Olli Rehn told a press conference that France could be given more time to meet its commitments, much as Spain and others have been over the three years of the debt crisis. “If the expected negative economic headwinds bring significant, unfavourable consequences for public finances, the (EU’s) Stability and Growth Pact allows for the deadline (for France) to be pushed back to 2014,” he said.
This is not very surprising, given that the French government has been forced to acknowledge that the nation’s economy will not grow as fast as they had suggested it would. This concession is hardly surprising, given the harsh fiscal measures that President Hollande and his fellow socialists in the National Assembly have imposed on the French economy.
In fact, the situation is beginning to look a bit panicky in Paris. Another story from The Local:
France needs an extra €6 billion in revenues next year, the budget minister said on Monday, and the European Central Bank said it had to act fast to cut spending and retain credibility after slashing the 2013 growth forecast. … Budget Minister Jerome Cahuzac … did not specify how this would be achieved saying taxes “are already very high in France.”
Really…? Does that mean that even socialists acknowledge that a 75-percent hate tax on high incomes is a bad idea? Or is 76 percent the “very high” limit?
Regardless of whether the French want to have stupidly high taxes or very stupidly high taxes, the pressure is on them to keep the austerity pressure on the economy. The Local again:
French ministries have been informed how much to cut spending in order for the government to generate €2 billion in savings this year. “Economies in public spending are inevitable,” Cahuzac said. “We have started to do it, we will continue to do it,” he added. Benoît Coeure, a Frenchman who sits on the managing board of the European Central Bank, said on Monday that Paris had to take strong action to convince its European Union partners that it was serious about keeping to the EU’s deficit norms.
Surprisingly, in the midst of all this, President Hollande does not want more austerity…
arguing they would only slow growth and further aggravate the country’s finances.
But a 75-percent hate tax on the “rich” does not slow growth, right? Regardless, it seems like the French government is now forced to walk a thin rope. On the one hand, budget minister Coeure says that:
“As for credibility on the short-term, France must absolutely respect its commitment to cut the structural deficit,” … “In the medium-term, it has to take quick and concrete decisions to achieve spending cuts, so that France reassures its European partners,” he said.
On the other hand we have president Hollande’s realization that austerity might not be such a good idea after all. What to do? Well, the Eurocracy is going to maintain its pressure on Hollande and the French government, especially now that Mr. Rehn has made clear that he believes the crisis is basically over and Europe has austerity to thank for it. He is not going to let go of his story that easily, which means he will keep Hollande in check and force him to “pet the horse” as the Danes say, i.e., do as he is told.
If at the same time the Eurocrats’ favorites form the next administration in Italy, the forces of austerity will continue to prevail. Under their boot, Europe will solidly establish itself as an economic wasteland, mired in industrial poverty. The balanced budgets will shine their glory over rusting steel mills, crumbling hospitals and the masses of the unemployed.