Tagged: Macroeconomics

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.

Exports Drive Weak EU Recovery

In an article commenting on the latest Eurostat GDP numbers, Euractiv,com proclaims:

Eurozone employment rose for the second consecutive quarter in the first three months of the year in a sign the recovery was finally helping the labour market. A widening trade surplus signalled a further positive contribution to growth in April.

The article goes on to report an upward trend in economic activity for the European Union. As readers of this blog know, however, such optimism should always be consumed in moderate portions. Far too many commentators, political analysts and policy leaders have far too often declared the European crisis over, and far too many of them – all, in fact – have been wrong. Therefore, let us dive into the most recent national accounts numbers from Eurostat and see what they can tell us.

In the first quarter of 2014, the total EU economy grew at an inflation-adjusted 1.4 percent over the same quarter 2013. This is the strongest growth number since the third quarter of 2011. For the 18-state euro zone, growth was not as good: a meager 0.9 percent, which again is the best number since the third quarter of 2011.

These are not growth numbers to write home about, but the fact that they are the best in 2.5 years is at least worth a note. But what is perhaps the most remarkable news in this is that the EU and the euro zone have gone two and a half years with growth below, respectively, 1.4 and 0.9 percent. In fact, the average annual growth rate for 2012 and 2013 was -0.16 percent for the EU and -0.54 percent for the euro zone.

So does this mean that Europe is now finally seeing the light in the tunnel? Not so fast. First of all, the big problem for the European economy, the welfare state, remains in place, not unscathed by the economic crisis but vigorous enough to continue to weigh down the private sector, and in fact make life even worse for taxpayers in the future. Austerity has changed the presence of government in the economy by raising taxes and cutting spending, to a point where it will start net-taxing the economy through budget surpluses far earlier in the economic recovery phase than previously. This will stifle growth and contribute to long-term economic stagnation.

There is another, even more important reason to believe that this is not the beginning of a sustained recovery. The largest component of the European economy, namely private consumption, grew more slowly than GDP did: 0.7 percent in the EU and 0.3 percent in the euro zone. This means that households remain either heavily economically depressed by the lingering effects of austerity, or that austerity has scarred their outlooks on the future (or both). They are therefore holding back consumption as best they can. Until households recover and restore their faith in the future, there will not be any sustained economic recovery.

Business investments grow faster than private consumption: up 3.5 percent in the EU and 2.3 percent in the euro zone. With private consumption growing as weakly as it does, this investment boom must have an external reason.

And it does: exports are up 4.1 and 4.0 percent, respectively in the EU and the euro zone. This may look like a jackpot for the European economy, as sharp increases in exports should lead to significant multiplier effects out to the rest of the economy. So far, it looks like that is true to some degree, as gross fixed capital formation (investments) is rising as fast as it is. However, even if these are the largest investment growth numbers since the start of the Great Recession, it is crucial to keep in mind that investments have declined, in inflation-adjusted terms, in four out of the last five years. At some point businesses simply have to replace aging equipment.

With the European Central Bank trapping the euro zone in an abundance of liquidity, this is indeed a good time to do it. But even when you pay almost no interest on your loans, you still have to make loan payments. If it was not for the rise in exports, Europe’s businesses would have relatively weak reasons to invest. But combined with the weak numbers for private consumption this means that the exports-investment “boom” may very well be isolated from the rest of the economy.

A further indication of this is that imports have grown basically on par with exports: in the EU with its 28 member states imports and exports grew at exactly the same rate, namely 4.1 percent. In the euro zone imports grew at 3.9 percent, a tenth of a percent behind exports. Since private consumption is growing slowly – much more slowly than imports – it is very likely that the increase in imports is directly related to the growth in exports. Manufacturers in Europe buy raw materials and intermediate products from low-cost suppliers outside the EU (with north and east Africa becoming increasingly important here), bring them in, assemble more advanced products and ship them off to a slowly recovering U.S. market, but also to still-growing Pacific Asia.

Due to the direct dependency on foreign trade, this is a dicey way for an economy to recover. The Chinese economy is increasingly troubled, especially by a looming real-estate crisis. Japan is on the rebound - their annual GDP growth rate has been accelerating for five quarters in a row now – and their appetite for imports is growing even faster. However, that is not enough to sustain an exports boom in Europe, especially not since Europe is increasingly burdened by high energy prices compared to competitors in North America.

Add to that the high taxes that keep household consumption down, and the case for a sustained recovery remains as weak as I have explained before.

One last point that adds to my forecast of continued stagnation in Europe: consolidated government consumption grew by 1.3 percent in the EU and 1.0 percent in the euro zone. Compare these numbers to the 0.7 and 0.3 percent, respectively, by which private consumption increased, and we have a case of continued government dominance over the domestic economy.

With government spending growing 1.8 to 3.3 times faster than private consumption (EU and euro zone respectively) Europe is simply cementing its place in history as the birthplace of the welfare state, and the economic wasteland created by it.

IMF Wants to Kill Deficit Rule

Big news. The IMF wants Europe to focus less on saving government from a crisis that government created, and to focus more on getting the economy growing again. From a practical viewpoint this is a small step, but it is nevertheless a step in the right direction.

Politically, though, it is a big leap forward. Two years after the Year of the Fiscal Plague in Europe, the public debate on how to get the continent growing again is beginning to turn in the right direction.

The EU Observer reports:

The EU’s rules on cutting national budget deficits discourage public investment and “imply procyclicality,” prolonging the effects of a recession, a senior IMF official has said. Speaking on Tuesday (10 June) at the Brussels Economic Forum, Reza Moghadam said that reducing national debt piles should be the focus of the EU’s governance regime, adding that the rules featured “too many operational targets” and a “labyrinth of rules that is difficult to communicate.” “Debt dynamics i.e., the evolution of the debt-GDP ratio, should be the single fiscal anchor, and a measure of the structural balance the single operational target,” said Moghadam, who heads the Fund’s European department.

Let’s slow down a second and see what he is actually saying. When the Great Recession broke out full force in 2009 the IMF teamed up with the EU and the European Central Bank to form an austerity troika. Their fiscal crosshairs were fixed on Greece and other countries with large and uncontrollable budget deficits. The troika put Greece through two very tough austerity programs, with a total fiscal value of eleven percent of GDP.

Imagine government spending cuts of $800 billion and tax increases of $1 trillion in the United States, executed in less than three years. This is approximately the composition of the austerity packages imposed on the Greek economy in 2010-2012. No doubt it had negative effects on macroeconomic activity – especially the tax increases. But the econometricians at the IMF were convinced that they knew what they were doing.

Until the fall of 2012. I have not been able to establish exactly what made the IMF rethink its Greek austerity strategy, but that does not really matter. What is important is that their chief economist, Olivier Blanchard, stepped in and published an impressive mea-culpa paper in January 2013. The gist of the paper was an elaborate explanation of how the IMF’s econometricians had under-estimated the negative effects on the economy from contractionary fiscal measures – in plain English spending cuts and tax increases.

The under-estimation may seem small for anyone reading the paper, but when translated into jobs lost and reduction in GDP the effects of the IMF’s mistake look completely different. It is entirely possible that the erroneous estimation of the fiscal multiplier is responsible for as much as eight of the 20 percent of the Greek GDP that has vanished since 2008 thanks to austerity.

This means that by doing sloppy macroeconomics, some econometricians at the IMF have inflicted painful harm on millions of Greeks and destroyed economic opportunities for large groups of young in Greece. I am not even going to try to estimate how large the responsibility of the IMF is for Greece’s 60-percent youth unemployment, but there is no doubt that the Fund is the main fiscal-policy culprit in this real-time Greek tragedy.

Despite the hard facts and inescapable truth of the huge econometric mistake, the IMF in general, and chief economist Olivier Blanchard in particular, deserve kudos for accepting responsibility and doing their best to avoid this happening again. Their new proposal for simplified fiscal-policy rules in the EU is a step in this direction, and it is the right step to take.

Back to the EU Observer story:

“The rules are still overlapping, over specified and detract focus from the overall aim of debt sustainability,” he said. The bloc’s stability pact drafted in the early 1990s, and reinforced by the EU’s new governance regime, requires governments to keep to a maximum deficit of 3 percent and a debt to GDP ratio of 60 percent. However, six years after the start of the financial crisis, the average debt burden has swelled to just under 90 percent of economic output, although years of prolonged budget austerity has succeeded in reducing the average deficit exactly to the 3 percent limit.

Yes, because that was the only goal of austerity. The troika – especially the EU and the ECB – did not care what happened to the rest of the economy. All they wanted was a balanced budget. The consequences not only for Greece, but for Italy, Spain, Portugal, Ireland, France, the Netherlands, Belgium and even the Czech Republic have been enormous in terms of lost jobs, higher taxes, stifled entrepreneurship, forfeited growth…

I believe this is what the IMF is beginning to realize. The European Parliament election results in May put the entire political establishment in Europe on notice, and the IMF watched and learned. They have connected the dots: austerity has made life worse in Europe; when voters see their future be depressed by zero growth, high unemployment and a rat race of costlier government and lost private-sector opportunities, they turn to desperate political solutions.

When people are looking ahead and all they see is an economic wasteland, they will follow the first banner that claims to lead them around that wasteland. Fascists and communists have learned to prey on the desperation that has taken a firm grip on Europe’s families. But the prospect of a President Le Pen in 2017 – a President Le Pen that pulls France out of the euro – has dialed up the panic meter yet another notch.

In short: the IMF now wants Europe’s governments to replace the balanced-budget goal with fiscal policy goals that, in their view, could make life better for the average European family. The hope is that they will then regain confidence in the EU project and reject extremist alternatives. I do not believe they can pull it off, especially since they appear to want to preserve, even open for a restoration of, the European welfare state.

EU Observer again:

[Critics] … argue that the [current fiscal] regime is inflexible and forces governments to slash public spending when it is most needed at the height of a recession. “Fiscal frameworks actively discourage investment….and imply pro-cyclicality and tightening at the most difficult times,” commented Morghadam, who noted that “they had to be de facto suspended during the crisis.” Procyclical policies are seen as those which accentuate economic or financial conditions, as opposed to counter-cyclical measures which can stimulate economic output through infrastructure spending during a recession.

All of this, taken piece by piece, is correct. The problem is the implied conclusion, namely that you can do counter-cyclical fiscal policy with the big government Europe has. You cannot do that. The confectionary measures at the top of a business cycle simply become too large, too fast. The reason is that taxes and entitlements are constructed in such a way that they redistribute income and resources between citizens on a structural basis. If you use this structure as a measure to stabilize a business cycle you will inevitably reinforce the work-discouraging features of high marginal income taxes at the top of the cycle, but you won’t weaken work-discouraging entitlements at the same point in time. The combination of work-discouraging incentives then accelerate the downturn.

Long story short, if you attempt to use a modern welfare state is not suited for countercyclical fiscal policy, you will end up with weaker growth periods and stronger recessions. Exactly the pattern we have seen over the past quarter-century or so in Europe, and to a lesser degree over the past 15 years in the United States.

The only viable route forward for Europe – and long-term for the United States as well – is to do away with the welfare state. Until we get there, though, this rule change, proposed by the IMF, would be a small step in the right direction. It would ease the austerity pressure, take focus away from attempts at saving government and putting the political spotlight on the need to restore the private sector of the European economy.

Europe in Permanent Stagnation

I have explained on numerous occasions that the European economy is not at all in recovery mode. Jobless numbers are frighteningly bad, the long-term trend is still pessimistic, GDP growth is so slow that there is a credible deflation threat hanging over Europe, the OECD recently wrote down its growth forecast for the global economy, including the EU. All in all, Europe is a slow-motion economic disaster.

Now British newspaper The Guardian reports of yet another dark cloud over the European economy:

The eurozone’s fragile economic recovery suffered a setback in the first quarter after slower-than-expected growth. The combined currency bloc scraped together growth of 0.2% between January and March, in line with growth in the previous quarter but disappointing expectations of 0.4% growth.

This amounts to 0.8 percent for the entire year, which is deeply insufficient to turn around the European economy. The best you can say about this growth figure it is yet another indicator that my forecast of Europe being stuck in long-term stagnation is correct. This long-term stagnation is not a recession – it is a new era for the European economy.

There was a huge divergence in fortunes, with Germany growing at the fastest rate of all 18 countries, with gross domestic product increasing by 0.8%. It followed 0.4% growth in Europe’s largest economy in the previous quarter. The pace of recovery also accelerated in Spain, with growth of 0.4% outpacing a 0.2% increase in GDP in the previous three months.

I have explained before that the German economy is growing because of its strong exports. The gains from the exports industry do not spread to the rest of the economy, as is evident from paltry domestic spending figures for the German economy. The same is, in all likelihood, true for the Spanish economy, whose national accounts I will take a look at as soon as time permits.

When exports drive a country’s GDP growth, the country is not in a sustained recovery. The only way a sustained recovery can happen is if private consumption and corporate investments increase together. That is not yet happening in Germany, and it is certainly not happening in Spain.

At the bottom of the pile was the Netherlands, which suffered a shock 1.4% contraction in GDP, reversing 1% growth in the previous quarter. Portugal’s economy shrank by 0.7%, following growth of 0.5% in the final three months of last year. The French and Italian economies were also dealt a blow, with zero growth in France and a 0.1% contraction in Italy in the first quarter. It followed 0.2% growth and 0.1% growth in the fourth quarter of 2013.

Stagnation, for short. And the only remedy that Europe’s political leaders seem to be able to think of is to print even more money, to saturate the economy with liquidity and to thus depreciate the euro vs. other major currencies. But with the Federal Reserve continuing its Quantitative Easing policy and the Chinese facing major problems in their financial sector it is entirely possible that the attempts at eroding the value of the euro will be neutralized by similar attempts from two of the world’s other major central banks. That in turn will put a damper on exports and rob the Europeans of even the illusion that their GDP will at some point start growing again.

At the end of the day, the fact that this negative news disappoints so many people in Europe is yet another indicator that my new book, Industrial Poverty, out in late August, is badly needed.

German Politician Defends Austerity

The EU parliamentary elections have barely begun – they take place over a four-day stretch from Thursday to Sunday – before representatives of the European political establishment are out in media trying to explain away the surge in support for totalitarian parties. One of the most egregious examples is Wolfgang Schäuble, treasury secretary of the German government. The EU Business reports:

German Finance Minister Wolfgang Schaeuble denied in an interview Friday that the rise of eurosceptics expected in weekend elections was due to austerity policies championed by Berlin. He was asked by The Wall Street Journal whether anticipated gains by populist and anti-EU parties in the European Parliament vote until Sunday would be the price to pay for years of belt-tightening. “Some will interpret it that way,” Schaeuble replied. “I think that’s wrong. You can see that our policy to stabilise the eurozone was successful.”

The reason why he can say this with a straight face is that his definition of “successful” is strictly limited to the fact that the EU, the ECB and the IMF - the Troika - forcefully backed by the German government, prevented a break-up of the euro zone. The Troika’s purpose with the 2012 wave of austerity policies that swept through primarily – but not exclusively – the southern rim of the European continent, was not to restore, or even open a path back to growth and full employment. The purpose was instead to end the surge in expectations that Greece and Italy were going to leave the euro zone. Policy makers and analysts in the inner circles of the Troika assumed that if they could put a leash on runaway government deficits the speculators waiting for the return of the Drakhma and the Lira would be convinced that nobody was about to exit the currency union.

In the short run, they were correct. In Greece, interest rates dropped almost as dramatically as they increased:

Greek R

However, this decline could just as well be the result of the ECB’s highly irresponsible pledge to buy any amount of treasury bonds from any country within its jurisdiction. But more importantly, even if the austerity measures calmed down speculations about a currency secession, those measures did not solve the underlying macroeconomic crisis. Greece still suffers from 55-percent youth unemployment; the economy still is not growing but actually shrinking; improvements in the Greek government budget over the past year are entirely due to one-time measures related to austerity. Once these one-time effects have worked their way through the budget, there will be no lasting improvement left.

This also means that the long-term threat to the unity of the euro zone still remains. It has just fallen under the media radar for now.

Greece’s only long-term chance is that the Troika will declare austerity cease-fire. If that happens, the Greek economy will be granted some time to catch its breath and re-structure itself to function under the combination of eroded entitlements and higher taxes. Only then can the private sector begin to create jobs again – and only then will the long-term threat of a Greek secession from the euro go away permanently.

This is all common sense, founded in a sound, solid understanding of macroeconomics. Such understanding is, however, a scarce resource among political leaders, especially in Europe. As the EU Business article continues, Mr. Shäuble continues his ignorant rant:

[Schaeuble] also rejected that the tough fiscal medicine and economic restructuring [that] Germany promoted were the causes of high unemployment and recession in much of the single currency area, declaring “that is false”. “The long recession is the consequence of a financial crisis whose origin wasn’t in the eurozone,” he said, adding in a stab at the United States: “Remind me where Lehman Brothers was based.” The 2008 collapse of the US investment bank was the biggest bankruptcy in US history and sparked the global financial crisis from which the world economy is still recovering.

Yes, the myth that this was a financial crisis… If a financial crisis is going to cause a general economic recession, it needs to transmit the negative consequences of credit losses into the real sector of the economy. Consumers and businesses must be directly impacted by the credit losses in the financial system.

The problem is that there is really no evidence of such a transmission mechanism at work in 2008-2009. Put bluntly: if that transmission mechanism existed, one of its main effects would be a rise in interest rates on loans from banks to non-financial businesses. But no such increase took place. Quite the contrary, in fact, as I have explained at length: just as the financial crisis was supposed to cause a surge in interest rates, a wipe-out of credit available even to highly qualified borrowers, interest rates on business credit actually began declining.

Available evidence (which I plan to collect and thoroughly explain in a future publication; first, let’s get my book Industrial Poverty out on the market) clearly shows that there was a recession looming independently of the financial credit crunch. That crisis was already under way when the Lehman Brothers crash happened – and without that real-sector, independent downturn we would not be able to explain why the central bank policies to save the financial sector had no visible impact on the economic crisis.

In short: businesses and consumers stopped demanding credit because of a general sense of pessimism that emerges in all recessions. The problem with the Great Recession was that once growth slowed or turned negative, once unemployment rose, an entire cadre of policy makers, from the EU to the ECB to the German government, decided to make a bad macroeconomic situation even worse by raising taxes and cutting government spending.

In Greece, austerity made a bad situation worse. It does not matter how much Wolfgang Schäuble denies it – his opinion cannot change facts and solid macroeconomic analysis. In fact, even the IMF has come around on this issue.

Of course, Schäuble tries on last trick to save the unsalvageable:

Schaeuble added that “the unemployment that we have in all advanced countries, not just in the eurozone, has to do with the dramatic transformation of labour markets through technology”. “You no longer need the same number of employees to produce goods. You have different needs for skills and qualifications of young people.”

Of course. At no point in time since the first, primitive forms of manufacturing were invented back in the late Middle Ages, has there ever been any improvement in productivity. Only in the past five years has there been a spurt in productivity in European manufacturing…

Sure. Billions.

Wolfgang Schäuble is either completely incompetent – which I doubt – or politically reckless. By defending austerity as a means to somehow improve people’s lives, he aligns his political views with those who believe that “higher goals” are more important in politics than the opportunity of private citizens to build their lives and carve out a path to prosperity for themselves and their families.

There is a name for such priorities. It is arrogance. When politicians ignore the fact that millions upon millions of people suffer as a result of their policies, those politicians have forfeited their credibility as participants in a democratic government.

It is understandable that Schäuble, somewhere, somehow, is trying to fend off the challenge that he and other pro-EU politicians face from the surging totalitarian movements across Europe. But you don’t defeat aggressive government expansionists by becoming one yourself. That is exactly what Schäuble can become if he sticks to his arrogant denial of facts and continues to believe that anti-democratic austerity policies can both save democracy and people’s jobs.

Deflation or Recovery?

Recently there have been GDP numbers circulating allegedly showing that the EU economy gained a bit more momentum in the first quarter of 2014. However, these numbers have not yet been formally published by Eurostat, which means that they have not been methodologically validated. Once Eurostat puts out the final numbers we can talk in more detail about what actually going on in the European economy. Until then, I maintain that any talk about a recovery in the European economy is more wishful thinking than anything else.

That does not stop others, of course, from insisting that there is a recovery under way. Today’s contribution comes from EUBusiness.com, a respectable blog that usually does its homework:

Eurozone business activity hit a near three-year high in April as a modest economic recovery gained momentum and began creating much-needed jobs, a closely watched survey showed on Wednesday. Markit Economics said its Eurozone Composite Purchasing Managers Index (PMI) for April, a leading indicator of overall economic activity, jumped to 54 points from 53.1 in March, the highest reading since May 2011. The report also marks the 10th month running for which it has come in above the 50-points boom-or-bust line, reinforcing the view the recovery is finally taking hold.

While I have not been tracking this index in particular, I have pointed out on several occasions that the quarters from Q3/2010 to Q2/2011 was a “rebound” period for the European economy. GDP growth exceeded 2.5 percent, adjusted for inflation, on an annual basis. Then the economy dipped again with growth declining for two years straight, down into the negative. The cause of that downturn is predominantly the massive application of ill-designed austerity, a fact that could give us reason to believe that another rebound will not be broken by bad fiscal policy.

However, this would presuppose that there has been no “recalibration” of the welfare state during the crisis. Which there has been. I will have to devote a separate article to that concept, but briefly it means that government will start running surpluses much earlier in the business cycle than before. This in turn creates an excess taxation situation where government thwarts a recovery merely by maintaining its welfare state. There is a considerable risk that this is going to happen, if Europe gets underway with a sustained recovery.

Back to EU Business:

The outcome suggested the Eurozone economy will grow by 0.5 percent in the second quarter, up from 0.4 percent in the first three months of the year, he added. The upturn in overall business activity was driven by goods producers, although the survey suggested a strong performance of the eurozone’s services economy also played a part. The PMI relating specifically to services showed an increase in activity for a ninth consecutive month, with a rise to 53.1 points from 52.2 in March. Markit attributed the sector’s strong performance to the “largest rise in new business inflows” seen over the past nine months. Manufacturing hit a three-month high of 53.3 points in April, up from 53.0 in March, with a sharp increase in new orders suggesting further gains in May.

It would be much welcome news if this was indeed to translate into more GDP growth. However, these numbers must clear a few hurdles before they constitute a real recovery. First, the driving force must be domestic spending, primarily private consumption. If it is, it means that households and families are experiencing better times and have stronger confidence in the future. If on the other hand this increased business activity is exports-related, then there is a good chance the improvement will be restricted to the exports-oriented sector of the economy.

 One reason to believe that exports are behind this recovery is that the U.S. economy is moving along at reasonable pace. So are some of Asia’s important economies as well. China is in a stagnation phase, but their imports of manufacturing products is more limited than in comparable economies, due to the joint-venture principle they have been applying for decades. Therefore, if the increased business activity in Europe is indeed driven by exports it means that the positive effects from a U.S. recovery will outweigh negative effects of a Chinese slump.

As EU Business points out, there is also another side to the European economy:

Peter Vanden Houte, from ING Bank, said the PMI report adds weight to the theory that the eurozone recovery “has legs” but warned that the risk of deflation remained, given recent very notable price weakness. Capital Economics analyst Jessica Hinds said the ongoing risk of deflation put pressure on the European Central Bank to take “more action” to stimulate the economy, a point made by most analysts.

The fact that there are expectations of deflation among economic agents in Europe reinforces my prediction that this is an exports-driven activity increase. Even if deflation has not yet set in, there is a credible risk that it will. The GDP Deflator index – the best measurement for inflation – for the EU with 28 member states (Croatia joined in January) was 121.9 in the fourth quarter of 2012 and 122.3 in the fourth quarter of 2013. This is very close to deflation, though it is important to keep in mind that occasional quarterly dips in prices does not constitute deflation. We will have to wait until prices fall for four quarters in a row before there is reason to panic. Then again, economic expectations have a nasty tendency of coming true.

One last point from the EU Business article:

Howard Archer at IHS Global Insight noted in particular the improvement in manufacturing as a positive sign and said the report was consistent with first quarter growth of 0.4 percent. At the same time, Archer highlighted the continued divergence between strongly-growing Germany and laggard France. “German expansion was robust with both manufacturing and, especially, services activity accelerating,” he said. “In contrast, the fragility of French growth was evident as manufacturing and services expansion disappointingly lost momentum in April.” The lacklustre French performance was a “vote of no confidence in the government by business,” said Christian Schulz at Berenberg Bank. It adds to pressure on Paris to deliver tax cuts and “shake up” the labour market,” Schulz said.

Not gonna happen. But more importantly, the emphasis on Germany reinforces the impression that this is an exports-driven recovery. Germany has for a long period of time been the world’s largest exporter. Even if they may have lost that position to China, they are still heavily dependent on what is happening in the global economy.

In a couple of weeks, when Eurostat releases its final quarterly GDP data for the European economy, we will know exactly what is behind the increased business activity. My bet is on exports.