Tagged: Macroeconomics

Deflation and Economic Theory

In economics, a lot of academic research is focused on high-end sophisticated quantitative methods. Many economists who work in public policy consider such research more or less useless. I agree only to some extent. There is a lot of technically advanced research that informs us in the interface between politics and academia. Right now, e.g., I am reading highly technical and theoretical research in price theory for a paper that develops new policy applications.

That said, the technical experts in economics have run away with the discipline. Far more resources are spent on advanced mathematical research and sophisticated statistical methods than can ever be merited by real-world applicability. This technical overkill has led to two problems in the practice of economics: econometricians make errors in forecasting and economists ignore problems that do not easily lend themselves to high-end technical analysis.

The more I read of economics literature, and the more time I spend in the public policy interface of politics and economics, the more convinced I am that economics needs a thought revolution. I find myself relying on erstwhile thinkers and basic macroeconomic theory developed early in the 20th century, because I have had much more use of it than more modern, less theoretical research.

One example of where I find the basics very useful is in the understanding of why there is such a difference in inflation patterns in Europe and the United States. While U.S. inflation is slowly trending up toward two percent, Europe is moving steadily into deflation territory. From The Guardian:

Eurozone inflation fell to its lowest level in almost five years in July, bringing the threat of a dangerous deflationary spiral closer. The annual rate of inflation fell unexpectedly to 0.4% from 0.5% in June, dragged lower by accelerating falls in food, alcohol and tobacco prices. Energy prices also fell sharply, by 1%, compared with a 0.1% rise in June. It was the lowest level of annual inflation since October 2009, when prices were in negative territory.

I have warned about deflation several times. It is not hard to predict deflation in Europe:

1. Government consumes 40-50 percent of the economy;

2. Austrian theory explains how government misallocates resources, thus lowers overall economic activity;

3. When the recession hit in 2008-09, growth was already so weak that the European economy lacked the resiliency needed to recover;

4. Austerity, designed to save the welfare state, has further depressed private-sector activity, just as Keynesian theory predicts;

5. More recently the ECB has flooded the euro zone with money in a desperate attempt to revive business investments;

6. Since austerity has left the private sector more heavily taxed, with even weaker support from government, businesses and consumers are even less inclined to spend money and take on new loans than before austerity;

7. When real-sector activity is depressed, the monetary sector cannot revive economic activity even when it pushes private-sector loan interest rates into negative territory, as the ECB has done.

No matter how hard the ECB tries, it is not going to restart the European economy. Instead, it has firmly planted the euro zone in the liquidity trap where monetary policy is useless.

As for inflation, the only kind that Europe could see in this situation is the monetary kind. That is important to keep in mind, especially since there is probably a widespread desire for inflation among Europe’s political leadership. There, inflation is considered a blessing because it drives up tax revenues. But monetary inflation would have such detrimental consequences for the economy that nobody should sit around and wish for it to happen.

I honestly believe that Europe’s politicians and central bankers share that thought – they want real-sector driven inflation but unlike their peers in the United States they don’t know how to get the real sector going.

The Guardian again:

Peter Vanden Houte, chief eurozone economist at ING, said the threat of eurozone deflation was likely to persist. “[July's] figures don’t give any assurance that the eurozone is already out of the deflation danger zone,” he said. … The fear is that weak price pressures could ultimately trigger a dangerous deflationary spiral, where consumers and businesses damage their domestic economies by putting off spending amid expectations that prices will fall further still.

Exactly right. Both Keynes and the Austrians point to this, in different forms. But more importantly, the first thing you need to do when you are in a liquidity trap, on he verge of deflation, is to quit printing money. Deflation and growing money supply reinforce the depression effect of deflation itself. When liquidity is abundantly available, and prices of what you would buy with that liquidity are falling, you may borrow the money, but you put it in the bank. As prices continue to fall, your liquidity gains in net value; if the net gain exceeds the interest rate (not hard when interest rates are practically zero), you make money off borrowing and not spending.

I borrow $100 today to buy a bicycle. The interest rate is one percent and deflation is two percent. Tomorrow I pay one dollar to the bank but only $98 for the bike. I can use an extra dollar in “profit” toward paying back the loan. The longer I wait with buying the bike, the larger my “profit” will be. In other words, I have a speculative incentive to depress economic activity further.

If the interest rate is higher than deflation, I will borrow the money but buy the bike it immediately. The only way, though, that the interest rate can go up is if the ECB tightens liquidity supply in the euro zone. That, however, won’t happen any time soon. The Guardian reminds us of how the ECB took the euro zone into negative interest rate territory:

Policymakers at the European Central Bank (ECB) took action in June to stave off the threat of deflation and breathe some life into the currency bloc’s flagging economy. The main interest rate was cut to a record low of 0.15% and a €400bn (£317bn) package of cheap funding for banks was announced, with the condition that the money be used to lend to companies outside the financial sector, and not for mortgages. The ECB also announced it would in effect charge banks to deposit money, by imposing a negative rate of interest of -0.1% on deposits. The hope is that it will encourage banks to lend more to consumers and businesses, boosting the wider economy.

Fortunately, the ECB has announced that it will hold off on further monetary “stimulus” for now. Perhaps the weaker euro, which the Guardian also mentions, will inject a little bit of import-price inflation into the European economy. That would weaken the deflation trend, but it is unlikely that it will do enough to lift the euro zone our of the liquidity trap.

Overall, economic theory and the current course of the European economy together suggest that the continent’s economy is going to continue its journey into the shadow realm of deflation and permanent stagnation.

In the meantime, the U.S. economy will continue to grow, with a healthy dose of low, real-sector driven inflation. The differences between the eastern and western shores of the Atlantic Ocean will also continue to grow. The sharp contrast emerging will be one between thriving free-market based capitalism and stagnant welfare-state based socialism.

Take your pick.

Comparing U.S. and EU Economies

When the good news came about the second-quarter GDP growth in the American economy, some commentators used the relatively low jobs number of 209,000 to make a case that the economy is not at all very strong.

If the spending growth that drove the GDP number were of a more transitional nature, then I would agree with them. But as I explained on Wednesday, the numbers indicate strengthening confidence among consumers and entrepreneurs. It is very likely, therefore, that this is a sustainable recovery.

Not a perfect recovery, but a sustainable one. We should be happy for it. After all, things could be much worse.

We could be Europe.

Just like us, the Europeans took a beating in 2009 when the Great Recession began. Both the U.S. and the EU economies saw unemployment rise rapidly. Deficits swept through government budgets.

On both sides of the Atlantic Ocean, politicians made the wrong choices. The Obama administration and Congress thought massive government spending could save the day. As a result, we got the American Recovery and Reinvestment Act in 2009 but had to wait until 2012 for the recovery to begin.

In Europe, political leaders took to a statist version of austerity in order to save the welfare state from disastrous budget deficits. The outcome was thoroughly bad: while the ARRA “only” delayed our recovery, the European economy actually went into an even deeper recession.

The contrast is clearly visible in Figure 1, which reports the difference in inflation-adjusted growth between the U.S. economy and the EU. Blue columns show how much higher (or lower) the U.S. GDP growth rate was compared to the EU. Grey columns show the growth difference for private consumption:

RFC LB joint blog

Some facts:

  • In nine of the 13 years covered the U.S. economy outgrew Europe;
  • American consumers increased their spending faster than European consumers in 12 out of 13 years;
  • On average consumption growth was twice as fast in America as in Europe, 2.12 percent per year compared to 1.07 percent per year.

There are other differences. Our unemployment rate is 6.2 percent; theirs is 10.3 percent. Our youth unemployment rate is trending down; theirs is basically stuck. Our federal deficit is declining while GDP is growing; the EU economy is barely growing and deficits are frustratingly persistent.

Those who complain that is not a perfect recovery should keep in mind what a perfect recovery would require: a perfect tax policy, perfect downsizing reforms of government spending and perfect deregulation.

We have none of that, so let’s celebrate the recovery we have. It is not that bad.

And as Europe reminds us, we could be stuck in an economic wasteland where the only future to hope for is one in the stagnant life of industrial poverty.

Methodological note: The GDP numbers reported in the attached chart are from the Bureau of Economic Analysis (the U.S. economy) and Eurostat (the EU). In both cases, GDP growth is reported in chain-linked, inflation-adjusted prices. The base year for the U.S. data is 2009 but 2005 for the EU numbers. This difference would normally preclude a comparison. For example, the apparent strength of European growth from 2005 to 2009 could be a statistical anomaly caused by the base year difference. However, due to limited availability of national accounts products from Eurostat, these two time series were the best comparison objects. The short time span covered is also dictated by limitations of the Eurostat database.

American Economy Growing Stronger

There is good news today from the Bureau of Economic Analysis, which reports that U.S. GDP…

increased at an annual rate of 4.0 percent in the second quarter of 2014, according to the “advance” estimate released by the Bureau of Economic Analysis. In the first quarter, real GDP decreased 2.1 percent (revised). The Bureau emphasized that the second-quarter advance estimate released today is based on source data that are incomplete or subject to further revision by the source agency

This is good news, indeed, even with the caveat that there will be revisions to the number by the end of August when more complete data has been processed. As a reminder of how big those revisions can be, consider that the estimates for the first quarter of this year ranged from -2.1 to -2.9 percent. That was an unusually large margin of error. Early estimates, like this four-percent growth figure for the second quarter, are based on limited data and matched with forecasting models that “fill in the blanks”. Those models, in turn, are based on historic trends in industrial activity throughout the U.S. economy. When real economic activity deviates from long-term, historic trends – either because of a protracted recession or because of an ongoing structural change to the economy – the part of preliminary GDP estimates that comes from forecasting models is suddenly more uncertain.

In a nutshell, while there is an underlying trend of recovery, that trend is not strong and confident enough to yield highly accurate preliminary GDP estimates. But even if there is an unusually large downward adjustment of this figure, we are still going to have satisfactory growth going in this economy.

So what is behind this good GDP news? Back to the BEA news release:

This upturn in the percent change in real GDP primarily reflected upturns in private inventory investment and in exports, an acceleration in PCE [private consumption], an upturn in state and local government spending, an acceleration in nonresidential fixed investment, and an upturn in residential fixed investment that were partly offset by an acceleration in imports.

In other words, the BEA sees an across-the-board increase in economic activity. This is very good, even though we could have done without the rise in state and local government spending. However, once the more complete numbers are out in about a month, there will be opportunity for a detailed examination of the actual growth drivers. However, the BEA gives some hints:

Real personal consumption expenditures increased 2.5 percent in the second quarter, compared with an increase of 1.2 percent in the first. Durable goods increased 14.0 percent, compared with an increase of 3.2 percent. Nondurable goods increased 2.5 percent; it was unchanged in the first quarter.

The rise in durable-goods consumption is particularly notable, as it is often associated with long-term spending or financing commitments by consumers. This could actually indicate a deeper, more lasting trend of growth, driven by strengthening consumer confidence. If so, we will see much more of GDP in the 3-percent growth bracket. That would be highly welcome, especially since the average GDP growth for the U.S. economy in the 2000s barely exceeded an inflation-adjusted 1.5 percent per year.

But before we all jump up and down with joy, keep in mind again that growth in the first quarter was a solid negative 2.1 percent. I attribute that, at least in part, to the uncertainty around Obamacare. Businesses have now adjusted to it, consumers are absorbing the cost and accommodating to it. That does not mean Obamacare has not had negative effects on the economy; wait and see what happens to health care costs, employment in the health sector and spending on medical technology.

Another indicator that the economy may be on a reinforcing rebound is the 5.3-percent increase in non-residential construction, an indication that businesses expect activity to grow on a long-term basis. Business equipment investment corroborates this, with a solid seven-percent growth (it decreased in the first quarter). Residential construction growth was even stronger, at 7.5 percent.

All in all, what has been a tepid recovery looks better today. A couple of key variables indicate reinforced confidence among consumers as well as businesses. If the Obama administration sits still and does nothing, they will make the best contribution possible to this. No more big spending programs, please. (Let’s not forget that Obama has been more fiscally conservative than any recent Republican president, Reagan included.) If Republicans take the Senate in November, there will be even more reasons to believe in a sustained recovery.

In addition to continued growth in jobs and earnings, a solid trend of growing GDP will also reduce the risk of monetarily driven inflation in the United States. From this perspective it is particularly reassuring that consumer spending on durable goods is growing, as is spending on both residential and commercial construction. All these activities rely heavily on credit, and that includes, of course, the mortgages needed to buy new homes. Excess liquidity that has been slushing around in the U.S. banking system will now go to work where it is needed.

This particular aspect of the recovery is usually under-estimated by economists. Let’s briefly compare our situation to what is happening in Europe. There, too, business credit is growing, but not for the same reason as here. EUBusiness.com reports:

Banks in the eurozone eased credit standards for loans to businesses in the second quarter for the first time since 2007, the European Central Bank said Wednesday. Announcing the upbeat results of its quarterly euro area bank lending survey, the ECB said it had also become easier for private households to get loans as confidence returned to the sector.

This is nonsense. The EU economy may be breaking into positive growth numbers, but it is closer to one than two percent annually. The best evidence of this is a very slow growth rate in private consumption. This is not enough to shore up confidence and make people crowd to the banks, desperate for loans. The same is true for businesses, whose investment growth is nowhere near American levels.

Instead of a desperately needed real-sector recovery, the increase in lending in the euro zone is a direct effect of the negative interest rates that the European Central Bank has introduced on bank over-night deposits. This measure, which de facto marked Europe’s entry into the liquidity trap, penalizes banks if they deposit excess liquidity to accounts with the ECB. Faced with a penalty from the ECB, banks have apparently decided to aggressively market loans to businesses and households.

The fact that they decide to lower credit standards right away, right as they start their loan marketing campaign, is a good indicator of cause and effect in this: if households and businesses were recovering solidly from the Great Recession, they would qualify for loans at existing standards; the fact that banks have to lower credit standards in order to sell loans to customers means that the aggregate credit profile of the European bank customer has not changed recently. That in turn means that people and businesses make roughly the same amount of money, have approximately the same employment and sales outlook on the future, and that job prospects and markets are not growing.

In other words, without the ECB’s negative interest rate and without banks lowering credit standards, there would be no increase in bank lending in Europe.

Because there is no recovery, an increase in lending to the private sector could result in monetarily driven inflation. More on that some other time, though. For now, let’s celebrate yet another U.S. macroeconomic victory over Europe.

An Institutional Analysis of the Crisis

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:

LB 7 28 14 2

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.

The Structural Crisis: More Evidence

The European crisis still seems to confuse the continent’s policy makers. After having believed for several years that austerity would both save the welfare state and increase growth, they have now slowly began walking away from the EU’s constitutionally required government deficit and debt rules. Instead, there is now growing belief in government spending as the remedy for the persistent crisis.

For the most part, the debate now seems to gravitating toward the question of how much government stimulus is needed. If the continent is indeed in a recovery mode, as some suggest it is, then there is not this big need for more government spending.

It is understandable that some believe there is a recovery under way. According to Eurostat, GDP for the EU as a whole grew by an inflation-adjusted 1.5 percent in the first quarter of 2014, over the same quarter of 2013. This is an increase from the last quarter of 2013 (1.0 percent) and in fact the fourth quarter in a row with improving growth numbers.

Technically, this represents a recovery. However, in no way does this mean that Europe is out of the crisis. To see why, let us compare GDP growth rates for EU-28 during the 2009-10 spurt to the one that started in 2013:

Q2 2009 Q3 2009 Q4 2009 Q1 2010 Q2 2010
Q1 2013 Q2 2013 Q3 2013 Q4 2013 Q1 2014
2009-10 -5.9 -4.4 -2.1 1.1 2.5
2013-14 -1.3 0.1 0.5 1.0 1.5

Early on in the Great Recession, the European economy made a rapid recovery and kept growing at more than two percent per year for four quarters straight. The rate slowly fell, though, and by the second quarter of 2011 growth was once again below two percent. By the end of that year it was below one percent, and down into negative territory in Q2 of 2012.

But should not a growth spurt count as a definitive recovery? Are not four quarters of improvement enough, especially if followed by a year of growth above two percent?

There is some merit to that argument. The problem is that the growth rates discussed here are not the kind of rates that normally would constitute a recovery, let alone a growth phase of a business cycle. Europe is in a structural crisis, which means that its growth rate is permanently lower than it was before. This is now becoming painfully evident in Eurostat’s national accounts data.

It has now been six years since the Great Recession began. For the entirety of the crisis that we have seen so far, namely 2008-2013, the average inflation-adjusted annual GDP growth rate for the European Union is a depressing -0.1 percent.

This is despite the aforementioned growth spurt.

Compare that to the six preceding years, 2002-2007: 2.4 percent. And that covers the back end of the Millennium Recession. Going back yet another six-year period to 1996-2001, we include the opening and trough of that recession, and still come out with 2.8 percent per year!

To further emphasize the structural nature of the European crisis, let us look at a long-term trend in growth. The following figure illustrates GDP growth in the EU as a six-year moving average. Starting in the fourth quarter of 2001 the average begins by covering the 1996-2001 period. The average is quarter-based to give as detailed an image as possible:

LB GDP EU28 6YR MAVG

The red trend line conveys a chilling message of structurally driven decline. In order to get Europe out of this decline and persistent crisis, economists must re-write their own books on macroeconomics. Surely, the conventional relative-price based advice from accomplished economists such as Michael Spence is still valid: a reduction in the cost of production in Spain vs. other exporting countries will eventually bring about a boost in exports. But as I have pointed out on several occasions, when that boost happens, such as in Germany or Sweden, it has very little influence on GDP growth as a whole. Modern foreign trade in industrialized economies is an isolated activity as many inputs are imported from elsewhere.

But more importantly, the presence of the welfare state throws a heavy, wet blanket over the economy. Austerity, as practiced in Europe in recent years, has added insult to injury by means of even higher taxes and even more perverted economic incentives.

As Michael Spence points out in the aforementioned article, it does not help Europe’s most troubled economies to share currency with Germany. This prevents the exchange rate adjustment needed to reflect global relative production costs. But the conventional macroeconomic wisdom also tends to downplay the growth-hampering effect that welfare states, and welfare-state saving austerity policies, have on GDP.

Spence actually opens for a recognition of this problem in another article together with political scientist David Brady. They acknowledge that modern Western governments have difficulties unifying all their policy goals, including income redistribution. However, Spencer and Brady do not go into more depth on the role that income-redistributing policies may play in causing the downward growth trend illustrated above. Their choice not to do so is understandable – their focus is elsewhere – but it also reflects somewhat of a conventional wisdom among economists: income redistribution and its institutional form, the welfare state, is just another sector of the economy.

It is not. It is the overweight on the private sector that is slowly but inevitably destroying the prosperity of the West. For more on that, stay tuned for my book Industrial Poverty. Out soon!

The Future of the Euro

The economic problems in Europe make themselves known in many different ways. Among them, a weakening of the euro. TorFX reports, via EUBusiness.com:

While the Euro recovered losses sustained in the wake of Portugal’s mini-banking crisis earlier in the month, the common currency put on a fairly lacklustre performance last week. The Euro dropped to a fresh 22-month low against the Pound and struggled against the US Dollar as investors speculated on the prospect of the European Central Bank bringing in additional stimulus measures.

It is important to keep in mind that exchange rates swing very frequently and sometimes violently, only to return to long-term stability. However, there is more than a short-term message in a 22-month low for the euro. Four variables are aligning to make the euro’s future difficult:

1. The negative interest rate. The ECB is penalizing banks for depositing excess liquidity with the bank’s overnight accounts. Even the moderately skilled speculator knows that a negative interest rate means he will have less money on Friday than he had on Monday, which of course drives investors to other currencies. The British pound comes to mind, as does the U.S. dollar. The problem for Europe is that once it has dug itself into a hole with the negative interest rate, it is mighty hard for the ECB to get out of there without any macroeconomic gains to show for it. The argument for the negative interest rate is that it will “encourage” more lending to non-financial corporations – business investments, for short. But businesses do not want to invest unless they have credible reasons to believe they will be able to pay back the loans. That really does not change because interest rates drop from almost zero to zero.

Bottom line: the ECB has entered the liquidity trap and will be stuck there for a long time to come, negative interest rate and all. This weakens the currency, especially over the short term.

2.  Deflation. Part of the reason for the ECB’s move into negative interest territory is the spreading fear of deflation. The past few years have shown that a rapid expansion of the money supply has no effect on inflation, either in Europe or in the United States. Therefore, the ECB cannot reasonably be hoping to cause monetary inflation with a desperate move like negative interest rates. Its hope is instead hitched to a rise in business investments which would cause inflation through traditional, Phillips-curve style excess-demand effects.

Bottom line: not gonna happen. As mentioned earlier, businesses are not borrowing at almost-zero interest rates – why would they borrow at zero rates? There is no profit-promising activity in other parts of the economy, and there won’t be, as our next point explains.

3. Austerity and government debt. Ever since the Great Recession began, Europe has used austerity not to reduce the size of government, but to preserve the welfare state. This has led to perennially slow or non-existent GDP growth and high, perennial unemployment. This has two consequences that spell trouble for the euro over the longer term. The first is that persistent lack of economic activity discourages business investments per se. Austerity, European style, includes tax hikes which constitute further government incursions into the private sector. The perpetuation of European austerity therefore means the perpetuation of low levels of business activity. The second consequence is that even if economic activity picks up, because, e.g., a long-term rise in exports (unlikely to happen) there is so much excess capacity in the economy that there will be no excess-demand driven inflation for a year, maybe even two. The excess supply, of course, consists of massive amounts of un-demanded liquidity slushing around in the European economy, and perennially high unemployment, including 20+ percent youth unemployment in a majority of EU member states.

Bottom line: political preferences to preserve the welfare state will keep macroeconomic activity low. Long-term outlook is continued stagnation. No support for a return to interest rates above liquidity-trap levels.

4. Continued recovery in the United States. Despite dismal growth numbers for the first quarter, the long-term outlook for the U.S. economy is moderately positive. We have not applied the destructive European version of austerity, even though its tax-hiking component makes it a wet dream for many statists. Furthermore, Obama has been surprisingly restrained on the spending side of the federal budget, being far more fiscally conservative than, e.g., Ronald Reagan. This has created reasonably good space for U.S. businesses to grow. There are caveats, though, such as the implementation of Obamacare, which in all likelihood contributed to  the negative GDP number in the first quarter of this year. There has also been a regulatory barrage from the Obama administration that has stifled a lot of business activity, although it has subsided somewhat in the last year and a half. But even a moderately positive business climate makes the U.S. economy notably stronger than its European competitor.

Bottom line: a slowly strengthening dollar will attract investments that otherwise would have gone to the euro zone, putting further downward pressure on the euro.

There is actually a fifth variable, which is entirely political. If Marine Le Pen gets elected president in France in 2017 she will pull her country out of the euro. That means goodnight and farewell for the common currency. Long-term minded investors would be wise to keep this in mind.

All in all, the case for the euro is not good. Stagnation at best, weakening more likely, with the probability of its demise slowly gaining strength.

Economics and the Great Recession

So what is really happening to the U.S. economy? Is it in recovery mode, or did the very negative growth numbers for the first quarter signal a new recession? Is the European economy in a recover phase, or not?

While I have firmly said “no” on the European recovery question, there is no doubt that economists in general will wrestle with these questions for at least the remainder of 2014. The past few years have been particularly challenging for economists, especially those whose days are spent on mainstream, econometrics-based forecasting. In an excellent article for the Wall Street Journal, republished by the Hoover Institution, financial economist John Cochrane shows just how challenging those years have been.

Put bluntly, over the course of the Great Recession, leading macroeconomists have missed the target in their predictions of GDP growth by so much that if they tried to send a space chip to Mars it would go to Jupiter instead.

Fortunately, economists do not build space ships. But major errors in macroeconomic forecasting are a serious matter. Politicians decide fiscal policy based on those forecasts. In Greece, for example, the government followed advice on tax increases and spending cuts from leading economists at the International Monetary Fund (IMF). The IMF economists had grossly under-estimated the negative reactions in the private sector to government spending cuts.

The error, concentrated to a so called fiscal multiplier, was of such dimensions that one fifth of all young in Greece are now unemployed indirectly as a result of that forecasting error.

As I have reported before, IMF chief economist Olivier Blanchard, a highly respectable economist, issued a full mea-culpa paper soon after they discovered the error. The paper is a stark but honorable warning to other economists to be more cautious about forecasting the future – and about offering legislative advice.

As a macroeconomist I have great difficulty discouraging anyone from listening to advice from economists. Generally, we do well on the policy side. But the Great Recession has challenged a lot of widely held beliefs in economics, among them the belief that econometrics – currently the technical core of economic forecasting – is the supreme tool for predicting the future.

Unorthodox economists like yours truly have long criticized mainstream economists for relying too much on so called rigorous quantitative tools. As Cochrane’s article shows, this debate is gaining strength, and it is a safe bet that it will continue for a long time. In fact, I believe it will constitute the groundwork for major reforms to macroeconomics, both in theory and in methodology, over the next decade or two.

We need those reforms, and we all need to pull our load to make them happen. I do not pretend to have a big voice, but my new book, Industrial Poverty, about the European crisis, will be my first contribution to the conversation.

Politicians, businesses and other members of the general public depend on us knowing what we do. If we are not willing to reconsider our theory, our methodology and everything else all the way down to our forecasting methods, then economists will ultimately be responsible for more surprises in the future, like the one with the U.S. growth numbers, or the one that has been unfolding in Europe over the past five years.

Spain: A Macroeconomic Assessment

We keep hearing from the soothsayers who suggest Europe is in the recovery phase of a protracted recession. The latest to join the chorus is the British newspaper The Guardian:

Spain’s economic recovery was underlined as its manufacturing sector recorded its greatest activity in seven years, but the financial crisis has left its mark with separate figures showing a sharp rise in people leaving the country. A snapshot of the state of Spanish factories combining output, orders and employment showed activity rose to a seven-year high in June. The Markit PMI increased to 54.6 from 52.9 in July – with a reading above 50 indicating expansion. That puts growth in Spain’s manufacturing sector ahead of Germany, France and Italy and is further evidence that its economy is outperforming the eurozone as whole.

To begin with, it is not very hard to outperform the euro zone, where GDP growth is as close to zero as anything can be. Private consumption is exceptionally weak, and even the OECD has been forced to downgrade its previously optimistic growth forecast for the EU.

But more importantly, a rise in an index is not a rise in actual economic activity. For that to happen, there must be a change for the better in national accounts data. More on that in a moment – first we return to the Guardian story:

The struggling Spanish car industry in particular is showing signs of recovery thanks in part to a government incentive scheme, now in its sixth year, for people to upgrade their vehicles. Christian Schulz, senior economist at Berenberg bank, said Spain was benefiting from the reforms that it put in place in response to the financial crisis. “If we add similarly impressive readings for the Spanish services sector, we can safely conclude that Spain is reaping the rewards of its tough labour market reforms of 2012 and is becoming a mainstay of eurozone growth,” he said.

The program referred to is one where government offers 1,000 euros toward the down payment on a new car that costs no more than 25,000 euros, provided the buyer trades in a 7-10-year-old, less fuel efficient car. According to at least one report this has contributed to the sales of 300,000 cars in Spain in the last couple of years.

There are a couple of problems with programs like these. First of all, they create a sense of entitlement among consumers, who learn to expect their government to chip in. Today it is toward cars, tomorrow – who knows? Homes? Furniture? Haircuts?

Secondly, it skews the car market. People buy smaller cars than they otherwise would, sending signals of demand to car manufacturers that are not based on free-market conditions but government subsidies. When those subsidies end because they are too costly for government, manufacturers will be left there with production capacity designed not based on the free market, but on defaulted government promises.

Third, the rebate increases the purchasing power of consumers who would otherwise not be able to afford a car. As a direct result, consumers can get approved for car loans with weaker ability to repay them than if there had been no tax-paid incentives program. What happens when those consumers default on their loans?

It remains to be seen how important this program is for the weak but nevertheless increase in private consumption that we can see in Spain’s GDP numbers.

LB7714Spain2

Adjusted for inflation, Spanish private consumption fell for 13 quarters in a row, from third quarter 2010 to third quarter 2013. In the fourth quarter of last year and the first this year, households increased their spending by, respectively, one and two percent.

Does this signal a recovery? It is too early to tell, especially since there was a similar spike in early 2010. But it is entirely likely that the car-buyer incentives program has artificially boosted the shift in consumer spending from decline to increase. This means that the reversal from worse to better – at least in consumer spending – is the result of government spending. Since Spanish government finances are in bad shape due to the economic depression, this only means that the macroeconomic problems that the Spanish government is trying to solve are just being shuffled around.

There is more evidence of this. In the figure above, the strongest growth is not in private consumption but in exports. In the past 17 quarters, since the beginning of 2010, Spanish gross exports have increased by an annual rate of 6.7 percent on average. By contrast, private consumption contracted by an annual average of 1.3 percent over the same period. This marks a shift in importance for GDP, with private consumption slightly declining as growth driver, and exports rising in its place.

Arithmetically, this makes a lot of sense. A variable that constitutes a small share of GDP grows rapidly for a long period of time. At some point it ceases to be a small variable and instead becomes important for GDP. When it does, its effect on GDP increases, accelerating GDP growth while exports still grow at the same pace as before.

However, this is a problem from a macroeconomic viewpoint. The Spaniards are not getting wealthier from the exports boom. Private consumption is not moving anywhere, and when it seems to be increasing it is ostensibly because of a government subsidy in one particular area. (There is also a home buyer’s program, but let’s not even get into that today…)

But it is not just private consumption that shows that there is no real domestic recovery in Spain:

LB7714Spain

While, as the green line shows, the exports share of GDP has been growing steadily during the Great Recession, the orange line shows that business investments have been on a steady decline (again as share of GDP). And this decline is all the more dramatic: Spanish businesses have decreased their investments, in fixed prices, for five straight years now.

Yes – five straight years. Since the first quarter of 2009 there is not a single quarter with growth in business investments. Measured in fixed prices, the amount that Spanish businesses spent on investments in the first quarter of 2014 was only two thirds of what they spent in the first quarter of 2009. This has happened while, again, exports have been growing solidly.

So long as businesses do not reverse the downward trend in investments on a sustained basis, there can be no recovery in the Spanish economy. Growing exports will not generate a recovery, especially not when the growth is concentrated to manufacturing. Modern manufacturers in Europe often import parts and assemble them on European soil. This means that growing exports are followed by growing imports of manufacturing inputs – in essence a passing-through of products that does not have any positive repercussions for the rest of the economy.

In January I explained that Germany has precisely this problem. If the exports were a sign of recovery in other EU countries, there would be hope for a recovery across Europe. But that is not the case: everywhere you look in Europe, private consumption and other domestic-spending variables are growing very reluctantly, if at all. The exports that the Euroepans are so happy about are, in other words, bound for other continents, without having any real positive effect on the European economy itself.

Europe will not return to growth, prosperity and full employment until its political leadership realizes what the problem is: the big, burdensome welfare state and its high taxes and anti-productive set of incentives that steer people away from self sufficiency and straight into life long career of sloth, indolence and government dependency.

EU Economy Going Nowhere

There is no better macroeconomic “health indicator” for an economy than private consumption. Not only is it the largest part of GDP, but private consumption also reflects well the overall sentiment of households. Since households are important spenders, taxpayers and workers all baked into one type of economic unit, the growth rate of private consumption is the best quick-check “wellness test” of an economy. (A more detailed understanding of the shape of an economy obviously requires a more detailed macroeconomic and microeconomic analysis.)

Since I have recently reported on how the European economic recovery has not materialized, I figured it would only be fair to perform a quick-check macroeconomic “wellness test”. Alas, I pulled private consumption data from Eurostat, and I made sure to get inflation-adjusted figures based on a price that is relatively distant in time. (If the index year is close in time there can be growth distortions based on the mere proximity to “year zero”.) I also selected quarterly data, which is not commonly used for this purpose. My motivation, though, is that if the quarterly data is not seasonally adjusted it allows for a more frequent communication of household sentiments.

You would expect this type of data to be available from every EU member state for every quarter you might want it. I often encounter that attitude from consumers of public policy research: somehow they assume that every piece of statistical information anyone could ever want is readily available within two clicks into the internet. That is not the case, though, and the reason is simple. Quality statistical material requires careful data collection, according to detailed and very rigid collection methods; it requires methodologically rigorous processing according to standards defined not just for this piece of information, but for every comparable piece of information in the world.

There are other methodological restrictions on statistical information that contribute to the production cost. We should actually take this as a sign of quality for the data we have access to; I always get suspicious when scholars claim to have produced large sets of quantitative information in short periods of time – it often leads to bombastic conclusions that later prove to be little more than a house of cards built on clay feet.

Anyway. Back to the European economy. For reasons of high quality standards and therefore reasonably high production costs for national accounts data, not every EU member state reports the kind of consumption data analyzed here. Figure 1 below reports real private consumption growth in 24 EU member states from 2002 through 2013:

Figure 1

C pr EU 24

The growth rates, again, are inflation-adjusted rates per quarter, over the same quarter the year before. This means that the blue line reports a rolling annual growth rate, updated quarterly. As such it helps us pinpoint business cycle swings with good accuracy. The  most obvious example is that private consumption nosedives in the second quarter of 2008: after having averaged an acceptable two percent per year from 2003 through 2007, private consumption literally came to a standstill over the next five years. From 2008 through 2012 the average growth rate was zero percent.

The difference may not seem like much, but for two reasons it would be wrong to draw that conclusion. First, a one-percent reduction in private consumption equals a decline in spending worth a bit over two million jobs in the EU-28 economy. This does not mean that two million Europeans automatically lose their jobs if households cut spending by one percent – the economy is more dynamic than that. But it does mean that if private businesses lose sales over a sustained period of time they cannot afford to keep all of their employees. At the macroeconomic level this eventually translates into, roughly, two million jobs per one percent private consumption (measured in current prices).

In other words, even seemingly small fluctuations in household spending can have major effects on the economy.

Secondly, sluggish private consumption means that the economy is not evolving. If the growth rate falls below two percent, then at least in theory consumers are no longer improving their standard of living. I explain in detail how this works in my book Industrial Poverty (out August 28); a very brief explanation is that it takes a certain level of sustained spending to maintain one’s standard of living. As products get better and other factors affect the quality of our consumption, we have to grow our outlays by a certain minimum rate just to make sure we keep our standard of living intact.

For the first half of the 12 years reported in Figure 1, households in the 24 selected EU member states managed to maintain their standard of living; on the other hand, for the second half of the period they did not maintain that standard. With an average growth rate of zero (adjusted for inflation) the theoretical loss of standard of living was two percent per year.

In addition to creating unemployment, this protracted sluggishness in household spending is a long-term prosperity downgrade for Europe’s consumers. What is even worse is that there are still no signs of a return to higher growth rates. While 2013 saw an average .8 percent growth in the EU-24 we discuss here, that came on the heels of ytwo years of negative growth (-0.6 percent). There was a similar, and bigger, uptick in 2010 (1.5 percent) that proved to be an anomaly compared to the two years before and after.

Furthermore, data for the first quarter of 2014, which is available for 20 of the 24 EU member states, shows a rise in inflation-adjusted private consumption in three countries only. While it is good to see a rise in Greece and Spain, which have been the hardest hit by the crisis (Austria is the third) this is far too isolated and far too small to be the turnaround many economists have hoped for.

More importantly, this is where the use of quarterly data can spook the careless observer. Spanish private consumption, which is up by 3.1 percent in the first quarter of this year, has a pattern of growing every other quarter. Since it was down 1.3 percent in the last quarter of 2013, this only means that the economy is on track with its historic path (which, sadly, means zero growth over the 16 quarters in 2010-2013). The rise in Greek private spending is part of a similar pattern, coming on the heels of a 2010-2013 average of -1.1 percent.

Bottom line, then, is that European households are unwilling or, more likely, unable to unleash that spending spree the European economy needs so badly. This should not surprise any regular reader of this blog, but it will in all likelihood be a surprise to those who live in the illusion that big government and the welfare state are the blessings that prosperity is built from.