Tagged: Macroeconomics

EU Still Wrong on Economic Crisis

The truth about the European economic crisis is spreading. The latest evidence of this growing awareness is in an annual report by the European Commission. Called “Report on Public Finances”, the report expresses grave concerns about the present state as well as the economic future of the European Union. It is a long and detailed report, worthy of a detailed analysis. This article takes a very first look, with focus on the main conclusions of the report.

Those conclusions reveal how frustrated the Commission has become over Europe’s persistent economic stagnation:

The challenging economic times are not yet over. The economic recovery has not lived up to the expectations that existed earlier on the year and growth projections have been revised downwards in most EU Member States. Today, the risk of persistent low growth, close to zero inflation and high unemployment has become a primary concern. Six years on from the onset of the crisis, it is urgent to revitalise growth across the EU and to generate a new momentum for the economic recovery.

Yet only two paragraphs down, the Commission reveals that they have not left the old fiscal paradigm that caused the crisis in the first place:

The aggregate fiscal picture for the EU and the euro area is now considerably more favourable, thanks to the commendably large consolidation efforts made in the past. … this has allowed Member States to slow the pace of adjustment. The aggregate fiscal stance is now expected to be broadly neutral in 2014 and 2015, both in the EU and the euro area. This will reduce one of the drags on growth and should therefore be welcomed.

If Europe is ever to recover; if they will ever avoid decades upon decades of economic stagnation and industrial poverty; the government of the EU must understand the macroeconomic mechanics behind this persistent crisis. To see where they go wrong, let us go through their argument in two steps.

a) “The aggregate fiscal picture for the EU and the euro area is now considerably more favourable, thanks to the commendably large consolidation efforts made in the past.” There are two analytical errors in this sentence. The first is the definition of “fiscal picture” which obviously is limited to government finances. But this is precisely the same error in the thought process that led to today’s bad macroeconomic situation in Europe: government finances are not isolated from the rest of the economy, and any changes to spending and taxes will affect the rest of the economy over a considerable period of time. The belief that government finances are in some separate silo in the economy led to the devastating wave of ill-designed attempts at saving Europe’s welfare states in 2012.

Austerity, as designed and executed in Europe, was aimed not at shrinking government but making it affordable to an economy in crisis. The end result was a permanent downward adjustment of growth, employment and prosperity. In order to get their economy out of this perennial state of stagnation, Europe’s leaders need to understand thoroughly the relations between government and the private sector.

b) “The aggregate fiscal stance is now expected to be broadly neutral in 2014 and 2015, both in the EU and the euro area. This will reduce one of the drags on growth and should therefore be welcomed.” Here the Commission says that if a government runs a deficit, it causes a “drag” on macroeconomic activity. This is yet another major misunderstanding of how a modern, monetary economy works.

Erstwhile theory prescribed that a government borrowing money pushes interest rates up, thus crowding out private businesses from the credit market. But that prescription rested on the notion that money supply was entirely controlled by the central bank; in a modern monetary economy money supply is controlled by the financial industry, with the central bank as one of many players. Its role is to indicate interest rate levels, but neither to set the interest rate nor to exercise monopolistic control on the supply of liquidity.

A modern monetary economy thus provides enough liquidity to allow governments to borrow, while still having enough liquidity available for private investments. In fact, it is rather simple to prove that the antiquated crowding-out theory is wrong. All you need to do is look at the trend in interest rates before, during and after the opening of the Great Recession, and compare those time periods to government borrowing. In a nutshell: as soon as the crisis opened in 2008 interest rates plummeted, at the same time as government borrowing exploded.

This clearly indicates that the decline in macroeconomic activity was not caused by government deficits; it was the ill-advised attempt at closing budget gaps and restore the fiscal soundness of Europe’s welfare states that caused the drag. And still causes the drag.

In other words, there is nothing new under the European sun. That is unfortunate, not to say troubling, but on one front things have gotten better: the awareness of the depth of the problems in Europe is beginning to sink in among key decision makers. What matters now is to educate them on the right path out of the crisis.

 There is a lot more to be said about the Commission’s public finance report. Let’s return to it on Saturday.

More Signs of Spanish Recovery

It is very easy to establish that Europe’s economy is stuck in a state of deep, solid stagnation. As I have explained recently, you have to look carefully to find any exceptions to that rule. However, those exceptions exist in the form of Greece and Spain. So far neither country has reached a state of real recovery – so far their economies have elevated themselves out of the deepest part of a depression, but their economies have so far only risen to the same state of stagnation that has slowly but steadily spread to the entire continent.

That is not to say Spain and Greece can’t do better. They can. To find out more about their economies I decided to review the value-added side of their economies. For those of you who are not macroeconomic nerds, there are three ways to calculate GDP: the income approach, the expenditure approach and the value added approach. The third is the least commonly used one, mostly because it does not say very much about the two major forms of activity in an economy such as the European: private consumption and government spending. However, value added can tell us a great deal about what industries are flourishing and which ones are doing poorly.

The following four industries represent almost 40 percent of the Greek economy:

VA Greece

Correction: the industry labeled “Tourism etc” should really be “Wholesale trade, tourism etc”.

This is unfortunately not the image of an economy in steady recovery. Manufacturing, which is only responsible for nine percent of the added value in the Greek economy, is definitely in a state of stagnation; if all the talk about an exports renaissance in Europe were true, Greek manufacturing would be surging.

Instead, it is “Wholesale trade, tourism, etc” that is on a clear trajectory to recovery.  Producing 22 percent of the value added, this industry is labor intensive and close to consumers. The sustained improvement in activity is encouraging and has a potential for spreading its upturn to other sectors. First and foremost, it could mean that the young in Greece, whose chances of finding a job – any job – is the worst in the industrialized world, might regain some sort of faith in the future. That would be good for the long-term stability of both the economy and the Greek democracy.

That said, the figure of the Greek economy also shows that the other major industries are still in decline – or at least were in decline through the second quarter of this year. Greece needs a lot more to regain some of its status as an industrialized economy with a future.

Things look a bit different in Spain:

VA Spain

Together, these four industries are responsible for 46 percent of the total value produced in the Spanish economy. The three recovering industries represent 38 percent of total value added, a share big enough to positively affect the rest of the economy.

Adding to the cautious optimism about the Spanish economy is the fact that the growth rate of value added in two of the three recovering industries is actually accelerating. Manufacturing saw accelerating growth in five consecutive quarters:

2013Q1 2013Q2 2013Q3 2013Q4 2014Q1 2014Q2
Professional -1.61% -0.80% 0.23% 1.97% 1.49% 2.23%
Wholesale, Tourism etc -2.45% -0.64% 1.07% 1.35% 1.69% 2.83%
Manufacturing -3.33% -0.71% -0.08% 0.76% 1.83% 1.29%
Construction -7.89% -8.46% -7.68% -6.87% -7.71% -3.15%

It deserves to be repeated that in total, the Spanish economy is still very much in recession mode. Austerity is still a real fiscal-policy threat, and the declining euro-zone interest rates pose a threat in terms of renewed financial speculation. However, the sectorial recovery has enough momentum that if it is allowed to continue, it will give the Spanish economy a reasonable shield against moderate negative shocks.

That said, should austerity again come to define fiscal policy at the levels it saw in 2012, there is a substantial risk that the recovering industries will fall back into recession mode. They will then pull the entire economy back down into the hole of depression.

Bottom line: Greece is far from out of its depression, farther than a cursory analysis would show. Spain on the other hand is worth watching closely.

Eurostat Confirms GDP Stagnation

European third-quarter GDP growth data is beginning to make its way out in the public. What we have seen so far is just more of the same new normal – the same new stagnated way of life in industrial poverty.

Starting from the aggregate level, Eurostat’s third-quarter growth report says that the EU-28 grew at 1.3 percent per year in Q3 of 2014 over the same quarter 2013. The euro zone’s growth rate was half-a-percentage point lower at 0.8. This difference is the same as over the past few years: the last quarter where the euro zone grew faster than the entire EU was in Q1 of 2011. It shows that austerity is still taking a tougher toll on Europe’s core countries than its non-euro members on the outer rim.

Or, to make the same argument from the other side: if you are a European welfare state, it pays to keep your own currency.

The growth numbers for the EU and the euro zone are poor in and by themselves. By not even coming close to two percent per year, Europe is not even able to reproduce its own standard of living. But even worse is the fact that the U.S. economy grew by more than two percent annually for the second quarter in a row: 2.3 percent in Q3 of 2014, compared to 2.6 percent in Q2 of 2014. This growth disparity is slowly becoming a self-reinforcing phenomenon: when global investors see that the U.S. economy is growing while the Europeans are standing still, they choose to reallocate their investments to the United States. That way investments and new jobs go to where investments and new jobs are already going.

But does not that mean that the U.S. economy will run into inflation problems that, in turn, will even out the differences between the United States and Europe? No, not necessarily. In fact, that is a very unlikely scenario. We are now rising to become the global leader in producing energy, with costs far below those of European countries. Right-to-work states offer a union-free manufacturing environment, something that, e.g., Volkswagen successfully took advantage of when they opened their new plant in Tennessee. The large US-only Passat they build there is a runaway sales success, $7,000 cheaper and selling ten times more (100K units per year) than its German-built predecessor.

Long-term, it looks like manufacturing is making its way back to the United States. This does not bode well for Europe, whose exporting manufacturing industry has, basically, been the only part of the economy that has not sunken into the three shades of gray that is industrial poverty. That European manufacturing is in trouble is well proven by the Eurostat report, according to which Germany has seen a decline in growth for two quarters in a  row: now down to 1.2 percent on an annual basis.

Another supposedly big manufacturing economy, France, barely finished the third quarter with growth at all: 0.4 percent over Q3 of 2013. Austria’s growth is also dwindling, with 0.3 percent this quarter compared to 0.5 in Q2 and 0.9 in Q1.

The only real positive news is that the Greek economy showed annual growth for the second quarter in a  row – at 1.4 percent this quarter – with growth numbers improving steadily for a year now. Spain also shows positive growth, 1.6 percent, with a similar upward long-term trend.

Neither the Greek nor the Spanish number is anything to write home about, but it looks like the two countries are slowly recovering from the bad austerity beating they took in 2012 and 2013. It is an extremely hard journey back for both of them, though, especially for Greece which lost one quarter of its economy to destructive austerity policies. The welfare states of both Spain and Greece have now been recalibrated, so that government budgets paying for the welfare states will balance at a much lower employment level than before. This means, effectively, that government will begin to net-tax the economy and thereby cool off a growth trend long before full employment is restored.

This structural problem is entirely unknown to Europe’s lawmakers – and, frankly, to almost every economist on the planet. I defined the problem in my book Industrial Poverty; if unsolved, this problem will guarantee permanent economic stagnation in Europe for, well, ever.

That said, I don’t want to spoil the fun for Greek and Spanish families who are now seeing the first glimpse of daylight after a long, horrible nightmare. Let them celebrate today; tomorrow they will still be living in industrial poverty.

Europe’s Flawed Monetary Policy

Today’s blog will be a short one, just a reminder of some vital statistics relating to the liquidity trap – an important topic now that Sweden, a non-euro member state of the EU, has joined the euro-zone in the trap.

The practical meaning of the trap is a situation where GDP is stalled – in other words the economy is stuck in a recession – and there is so much liquidity available in the economy that adding another euro (or krona) will not make any difference at all. Monetary policy is useless. That is where the euro zone is now, something that ECB leader Mario Draghi is well aware of, as he recently sent out a desperate call for help from Europe’s political leaders. He knows that monetary policy has reached the end of the road and that the only remaining options are within the realm of fiscal policy.

Despite this, Draghi continues to pump out M1 money supply into the euro zone like the recovery actually depended on it. Consider Figure 1:

Fig. 1: Quarterly growth rates. Sources: ECB and Eurostat

LB Euro growth

The blue line, depicting growth in euro-zone M1 money supply, deserves an explanation. The two growth peaks, one at the end of 2005 and one in late 2009, are largely related to the expansion of the euro zone, which went from 12 to 16 member states between 2006 and 2009. (Since then Estonia and Latvia have also joined.) If we adjust for the enlargement, money supply is fairly well in tune with GDP growth – until we get to 2012. That is when the ECB started making promises to buy any and all treasury bonds from “troubled” euro-zone countries, as well as to participate in the massive austerity programs that the EU and the IMF convinced the worst-off member states to adopt.

On top of that, the ECB decided this summer to take its interest rate to zero, and to punish banks – charge a negative interest rate – for depositing cash in overnight accounts with the ECB. This has flooded the euro zone with liquidity; if the theory behind this policy were right, we would see a major upturn in business investments and notable workforce expansion. However, we don’t see that; at best, year-over-year quarterly GDP growth rates show an economy barely struggling to stay afloat.

The inevitable – and from both a Keynesian and an Austrian viewpoint rather obvious – conclusion is that the theory behind the liquidity expansion is flawed. In fact, the ECB is playing with fire: sooner or later the massive supply of liquidity will go look for profitable investment opportunities. So long as the real sector of the economy remains essentially stagnant that search for profit will rapidly climb the speculative hills in the real estate and stock markets.

Again: welcome to life in the liquidity trap.

Sweden Falls into the Liquidity Trap

Four months ago the European Central Bank officially kicked the euro zone into the liquidity trap with its zero interest rate. Non-euro members of the EU have been resisting – or pretending to resist – the temptation of going all the way out with their central banks. But now Sweden has succumbed to the temptation. The Telegraph reports:

The world’s oldest central bank has slashed interest rates to a record low of 0pc as it battles to ward off deflation. Sweden’s Riksbank decided to cut its benchmark “repo rate” by 25 basis points from 0.25pc at this month’s monetary policy meeting, following three previous rate cuts this year. The decision was not expected by polled analysts who forecast the benchmark rate to be lowered to 0.1pc. The move is designed to increase lending and push up prices and reflects worries about the real threat of deflation which have now gripped the economy.

The Swedish central bank is foolish. The ECB has already proven that you cannot fend off deflation with massive money printing. The ECB has also demonstrated that zero interest rates do not bring about the recovery that almost-zero interest rates did not bring about. In other words, the marginal policy effects of going to a zero interest rate are just that – zero.

While there are no benefits from the zero rate, there are certainly costs and risks associated with it.

To begin with, the zero rate opens the last floodgates of liquidity supply. Banks can borrow money from the central bank at practically no cost.  This pushes even more money out to the supply side of the credit markets, primarily for mortgages. With an already overheated real estate market, Sweden will now see further injections of virtually cost-free lending to home buyers and speculators.

At the same time, private consumption has been driven in good part by virtually cost-free access to credit. Swedish families are among the most indebted in Europe, with a household debt-to-income ratio far higher than it was here in the United States – even if we go back to right before the recession.

Loans are collateralized against real estate, which essentially means that most of the growth in private consumption in Sweden is directly related to the easy access to mortgages. The situation is increasingly unsustainable, and it is only a matter of time before the national legislature either puts an end to the debt fest by reintroducing amortization requirements for mortgages (yes, interest-only loans are very popular in Sweden) or the market puts an end to the endless upward price trend as banks run their balance sheets to the end.

The former is a distinct possibility – the latter is increasingly plausible as shareholders begin to worry about if mortgage-happy banks will ever get their money back…

The latter could actually happen simply by means of growing loan defaults. Yes, a lot of home owners do not even pay on their loan principals, but a notable tightening of fiscal policy could send many of them out in unemployment. The new green-socialist coalition government has just presented a budget filled to the brim with tax increases. Among them is a restoration of a higher level of payroll taxes for young employees, which will very likely wipe out tens of thousands of jobs for individuals and couples just getting started with their lives. Many of them have bought their first, tiny little apartment and now risk being hurled out in joblessness – and homelessness.

A wave of loan defaults would quickly gain the critical mass needed to send a shockwave through the entire Swedish mortgage industry. That will shut the door for one investment opportunity for the mass of liquidity floating around in the banking system. Banks will have to go find another place to turn their liquidity into revenue.

And here is where the zero-interest central bank policy gets in the way: by dropping their key interest rate to zero, the price of treasury bonds has by definition reached its expectational maximum. The only way for bond prices to go now is down. Therefore, the only place to go is to the stock market.

The problem with the Swedish stock market is that it operates in an economy that is stuck in a long, irritating recession. There are profitable corporations to invest in, but those are of limited supply – especially when the supply of liquidity on the stock market increases rapidly as the real-estate market grinds to a halt. This will push investors out from the low-risk, safe stocks toward stocks that carry increasing rates of risk. As investors go after increasingly risky stocks they will demand speculative returns to match that risk. This exacerbates risk taking, putting the market at risk for self-magnifying destabilization.

It is no longer impossible that Sweden could end up in a situation where both the real estate market and the stock market destabilize at the same time. I would consider this risk theoretical at this point – the stock market is sophisticated and operated with both derivatives and other stabilizing instruments. However, so long as the Riksbank’s monetary policy had some restraints on it, there was not even a theoretical possibility of two-market instability.

Many economists dismiss this scenario by saying that Sweden has performed spectacularly from a macroeconomic viewpoint. However, the seven-year average, inflation-adjusted GDP growth rate covering the entirety of the Great Recession (2007-2013) is a not-so-impressive 1.39 percent. If you deduct the effect from exports and from debt-driven consumption, there is nothing left. In fact, private consumption including that paid for with second and third mortgage loans has averaged 1.1 percent since 2007.

It is therefore irresponsible, not to say reckless, to suggest that Sweden can handle zero interest rates because of some underlying macroeconomic strength. That strength does not exist. The slightest aberration in real estate price trends could eradicate the domestic source of GDP growth.

Sweden has made the same mistake as the rest of Europe: they combined tight fiscal policy with very lax monetary policy. This is a recipe for liquidity-trap stagnation – just as Lord Keynes explained some 80 years ago. Students of Austrian economics have also reached this conclusion, especially through the analysis of the role that lax monetary policy plays in a modern economy.

Sadly, both Keynesian and Austrian economics are left out of the curriculum when modern graduate schools train tomorrow’s generation of economists. Advanced econometrics is passed off as the fix-it-all for our profession. Yet as Paul Ormerod and others have explained so elegantly, econometricians get it right so long as nothing is happening in the economy. Once the economy starts moving like it did in 2008-2009, prediction models based on stability rapidly become useless.

But that is a topic we will have to return to later.

Europe’s Mounting Recession Worries

As awareness rises that Europe’s economy is going nowhere but down again, anxiety among the political leadership is beginning to catch up. The latest addition to the ranks of the worried is the president of the European Central Bank, Mario Draghi. At a summit with all the euro member states on October 24 he gave a speech that echoed of the panic from 2012:

European Central Bank chief Mario Draghi on Friday (24 October) gave a stark warning to eurozone leaders about the risk of a “relapse into recession” unless they agree on a “concrete timetable” of reforms and spur investments. “The eurozone is at a critical stage, the recovery has lost its momentum, confidence is declining, unemployment is high. Commitments were made but often words were not followed by deeds,” Draghi told the 18 leaders of eurozone countries who gathered for a special meeting at the end of a regular EU summit in Brussels.

He turned his presentation into a good, old show-and-tell by providing his audience with a slide show. The slides show the following:

  • Quarter-on-quarter GDP growth for the euro zone is in an almost perfect state of stagnation since at least early 2012;
  • Unemployment has fallen slightly in the last year, but that decline is in no way different from the decline in 2012; after that decline unemployment shot up significantly;
  • Per-employee compensation growth is the lowest in ten years;
  • Inflation is trending steadily downward, and will flip into economy-wide deflation within six months;
  • While real GDP has remained stagnant since 2008 – with a growth index a hair below 100 – private investment has dropped to an index of 85 with no signs of growth;
  • Government-sector investment has dropped even further, below growth index 80, and continues to decline.

Toward the end of Draghi’s show-and-tell session he inevitably points to euro-zone government debt and deficit ratios. Then, equally inevitably, he turned to the empty toolbox for macroeconomic solutions to the zone’s macroeconomic problems:

To get the economy growing again, Draghi said leaders should not count only on actions by the ECB, but also do their share: boost investments and implement reforms. He welcomed plans made by the new EU commission chief, Jean-Claude Juncker, to raise private and public money for €300 billion worth of investments for 2015-2017. Draghi alluded to Germany by saying that countries “with fiscal space” should boost internal demand in order to help out the rest of the eurozone.

On the one hand Draghi keeps bashing the member states for not complying with the Stability and Growth Pact debt and deficit rules; on the other hand he demands some sort of help from states in activating the economy again.

Evidently, the knowledge of macroeconomics is rather limited in the higher layers of the European political and economic leadership. That is one of the big reasons why I stand by the same forecast that I have put forward all year long: Europe is in a permanent state of economic stagnation – and there is only one way out of it.

Bad Economic News, Part 1

Yankees baseball legend Yogi Berra coined the proverbial phrase “It ain’t over ’til it’s over”. That is certainly true about the European economic crisis. This past week saw a crop of bad news from the Old World. Nothing very dramatic – and certainly nothing that should surprise regular readers of this blog – but nevertheless bad news. In this first of two parts, let’s look at a report from the EU Observer:

The eurozone appears to have come back onto the markets’ radar amid low inflation, poor economic news from Germany, and Greece’s bailout exit plans. Greece’s long-term borrowing costs went above 8 percent on Thursday (16 October) – their highest for almost a year – as investors took fright at the fragile political situation in the country. The government in Athens has tried to shore up popular support by suggesting it will exit its bailout programme with the International Monetary fund more than a year early.

There is an important background here. The bailout program had three components:

1. The Greek government will do everything in its power to combine a balanced budget with protecting as much as possible of its welfare state against the economic depression;

2. In return for the Greek government’s tax increases and spending cuts, the International Monetary Fund, the European Union and the European Central Bank provided loans that kept the Greek government afloat cash-wise;

3. The only metric used to measure the success of bailout policies is the stability of a balanced government budget.

If GDP did not grow, if unemployment was at 30 percent, if more than half the young in Greece had no job to go to… none of that mattered. As a result, there has been no structural improvement of the Greek economy; government has not reduced its burden on the private sector – quite the contrary, in fact. Welfare systems have been reduced, but higher taxes have prevented welfare recipients from transitioning into self sufficiency.

As a result, the social situation in Greece is almost unbearable. The political reaction has come in the form of a surge for parties on the extreme flanks of the political spectrum. In my book Industrial Poverty I explain in detail what happened in Greece, what brought the country down from the heights of European prosperity to permanent stagnation. Today, sadly, the country is little more than a macroeconomic wasteland.

It is with this in mind that one should approach the news that Greece is considering leaving the bailout program. The coalition government is under enormous pressure to save the nation itself, to keep parliamentary democracy in place and to inject some sort of life into the economy. If they fail either of two extreme political movements will take over – the Chavista communists in Syriza or the Nazis in Golden Dawn.

International investors know this and are understandably scared. In their mind the bailout is the least of available evils; in reality, as I explain in my book, the attempts at balancing the budget and saving the welfare state in the midst of the crisis are the very policies that keep Greece from recovering; weak signs of a minor recovery earlier this year have yet to materialize into anything other than the “beaten dog” syndrome often following protracted periods of austertiy.

This is the very reason why Greece is now considering leaving the bailout program. They cannot continue forever to try to muddle through with an economy deadlocked in depression and a democracy so fragile that it has brought the first Nazis into a parliament in Europe for the first time since World War II.

However, as the EU Observer explains, the Greek government is caught between a rock and a hard place – as are other hard-hit euro zone economies:

But the recent announcement spooked investors, unconvinced that Greece can stand alone. Long-term borrowing costs also jumped in the weak periphery states, Spain, Italy, and Portugal. The market jitters – while not comparable to the height of the eurozone crisis in 2011 and 2012 – come as the eurozone’s main economies are once again at odds over policy responses.

France also belongs on that list, primarily for its typically European attempt at leaving the bailout program. Its government tried to leave the bailout path for a left turn into the quagmire of government expansionism. Thinking that more government spending, on top of the largest government spending in the world, could in fact bring about a recovery, the French socialists who won the 2012 elections scoffed at the EU balanced-budget rules and went full speed ahead with their government-expansionist agenda.

Two years later that agenda has hit a brick wall. Massive tax increases, supposed to pay for some of the new government spending, have only resulted in an exodus of brain power and entrepreneurship. The French GDP is standing more still than the Eiffel Tower.

In fact, the EU Observer notes,

France and Italy are fighting a rearguard action for more flexibility saying budget slashing will condemn them to further low growth. Paris is on collision course with both Berlin and the European Commission after having indicated that it wants an extra two years to bring its budget deficit to below 3 percent of GDP. Italy, meanwhile, has submitted a national budget for 2015 which brings the country to the edge of breaking the rules.

The French challenge to the budget-balance rules compounds the uncertainty emanating from the talks in Athens about a Greek bailout exit. It is more than a theoretical possibility that at least one of these countries leaves the euro zone in the next two years, and does so for a combination of political and economic reasons. That would be an institutional change to the European economy – and really the global economy – of such proportions that no traditional quantitative analysis can render justice to a forecast of its effects. It is therefore entirely logical that global investors are growing more uncertain and as a result demand higher risk premiums.

As the icing on the uncertainty cake, informed investors know that Marine Le Pen may very well become France’s next president. If she wins in 2017 her first order of business is in all likelihood going to be to exit the euro zone and reintroduce the franc. On the one hand that could be an “orderly” exit; on the other hand it would have ripple effects throughout the southern rim of the euro zone to the point where the very future of the common currency is in grave danger.

In summary: mounting uncertainty about the future of the euro is being mixed with growing uncertainty about the macroeconomic performance of the member states of the currency union.

Stay tuned for the second part about the bad news out of Europe.

Spanish Growth An Exports Bubble?

At the beginning of this year there were lots of forecasts that the European economy was going to recover. I never believed them, primarily because government was a bigger burden on the economy than ever. So far I have been proven right, which is not something I would want to celebrate. But I also want to make clear that once government pulls back from its efforts at balancing its budget with higher taxes and spending cuts, the private sector will eventually start to recover.

There is a lot of research to show this. I review the public policy part of that research in chapter 5 in my new book Industrial Poverty. My conclusion is that this kind of austerity can work – the private sector emerges growing from even the most protracted periods of austerity. However, this is not a reason to use austerity as it has been applied through most of recent history, namely as a means to save government. Instead, austerity must be redesigned to reform away government. Otherwise the private-sector recovery that follows will suffer from two ailments:

1. It will look fast in the beginning, as consumers catch up with the standard of living they lost during the austerity period; and

2. Because of the recalibration of the welfare state – permanently higher taxes and permanently lower spending – the economy will hit its full employment level at a higher rate of unemployment than before the austerity episode.

It is also important to keep a watchful eye on whether or not a recovery is external or internal. In too many European countries over the past quarter century, a recovery has come from a rise in exports, i.e., been external. The consequence of this is that the domestic economy lags behind.

To make matters worse, much of modern manufacturing in Europe consists of bringing in parts produced in low-cost countries, assembling them at a highly efficient plant in a European country and then shipping them on to their final destination. This new kind of industrial production is increasingly isolated from the rest of the economy, which means that its multiplier effects on private consumption and business investments is relatively weak. It is, in other words, no longer possible for a small, exports-oriented European country to enter a lasting growth period merely on a rise in exports.

Earlier this year I pointed to Germany as an example of the feeble macroeconomic role of exports. You can get a temporary boost in GDP growth from a rise in exports, but once that boom goes away, it will have left very few lasting “growth footprints” in the economy. It looks like the same thing is now happening in Spain, which is in a recovery, according to the ECB:

The economic recovery has gathered momentum during 2014, with GDP growing at a faster pace than the euro area average.

Going by the latest national accounts numbers from Eurostat, which for obvious reasons covers only the first two quarters of 2014, it was not until Q2 this year that Spanish GDP outpaced the euro zone: 1.1 percent real growth over the same quarter previous year, compared to 0.5 percent for the euro zone.

Before that, Spain was doing worse than the euro zone by a handsome margin.

The ECB again:

Growth has been supported by a rise in domestic demand, while the external balance has weakened substantially as a result of a slowdown in export market growth and higher imports. Domestic consumption and investment in equipment are benefitting from growing confidence, employment creation, easier financing conditions and low inflation.

Over the past year there has been a slow but steady decline in Spanish unemployment, from 26.1 percent in August 2013 to 24.4 percent in August 2014. That is very good for a people hit very hard by disastrously ill designed fiscal policies over the past three years.

At the same time, there are clear signs that this is an “export bubble”. Consider these growth numbers for the country’s GDP (quarterly over same quarter previous year):

SPAIN 2013Q3 2013Q4 2014Q1 2014Q2
Real GDP -0.6 -0.1 0.7 1.1
Private cons. -1.2 1.1 2.1 2.2
Exports 3.7 3.2 6.4 1.5
Investments -5.4 -2.4 -0.7 0.6
Government 0.5 -3.7 0.5 1.0

There is no doubt that GDP growth is improving. While 1.1 percent is absolutely nothing to write home about, as mentioned earlier it exceeds the euro-zone average. The big question is whether or not this improvement will last. The biggest concern is the exports numbers: good growth for two quarters, then a major leap up to 6.4 percent, only to fall back to 1.5 percent. (While these are not seasonally adjusted numbers, they are quarterly growth on an annual basis which neutralizes seasonal effects.) If exports fall back to tepid growth numbers below two percent, GDP growth will most likely slide back into zero territory.

However, there are a couple of other mildly encouraging factoids in these numbers. To begin with, government spending, while on the growth side, is expanding slowly at no more than one percent per year. This number does not account for financial payments, such as unemployment benefits and other income security entitlements, but they do account for government activities that involve government employees. Alas, restraint in government spending means very little effort from government to expand its payrolls to do away with unemployment.

The apparently stable growth in private consumption is in all likelihood attributable to the post-austerity effect I pointed to above. This means that we will not see 2+ percent growth for much longer; for that to happen there has to be a sustained and substantial addition of consumers to the economy who are capable of spending more than what is required for pure subsistence. This, in turn, will not happen until unemployment comes down more than marginally.

Another mildly encouraging sign is that business investments have stopped declining. The turnaround over the past four quarters is in all likelihood an attempt by exporters to expand their capacity. If the exports boom is coming to an end, so will probably investments.

To turn this fledgling recovery into a lasting trend, the Spanish government needs to address the underlying problem in its economy: the welfare state. Otherwise it will just experience spurts of growth here and there as anomalies to a permanent state of stagnation – and industrial poverty.

In Search of Economic Leadership

The global economy is gradually becoming more disparate. The United States and Japan are pulling ahead while Europe is in a permanent state of stagnation and China is likely going to experience its first, real industrialized recession ever.

In this structurally changing world there is a need for thought leadership, both nationally and globally. We have institutions that, at least to some degree, where created for that purpose. The International Monetary Fund is a good example. Unfortunately, the IMF is not taking a lead, echoing instead much of the same analysis and arguments heard from the national governments whose macroeconomic ineptitude created this long crisis in the first place.

A good example of the Fund’s attitude is put on display in a new report where the managing director of the IMF notes that:

the IMF’s World Economic Outlook had trimmed its growth forecasts for the global economy. “In the face of what we have called the risk of a new mediocre, where growth is low and uneven, we believe that there has to be a new momentum and that is what we will be discussing with the membership in the coming days. “This new momentum—with, hopefully more growth, more jobs, better growth, better jobs—is certainly something we would call on the membership to produce,” Lagarde declared.

So what is the IMF’s idea on how to get the world economy growing again? Well, Lagarde said…

the IMF has noted growing country specificity in its analysis, where within each group of economies some countries are progressing and others are lagging behind. She said the IMF recommends action in three particular areas. Monetary policy where, particularly in the euro zone and Japan, more accommodative monetary policy is needed going forward to support the economy.

This is actually the wrong recipe. Europe is already profusely accommodating with a stretched-to-the-limit monetary expansion totally unbecoming of what the founders of the ECB had in mind. Accommodation policies are in fact so bad that the euro zone is now over-saturated with liquidity and interest rates on bank overnight lending have gone negative.

None of this has helped. There is no sign on the European horizon that real-sector activity has picked up. Instead, it looks very much as though Europe has now entered its own version of the Japanese decade. After almost 15 years of a combination of stagnation, deflation and liquidity saturation, the economy has now finally entered a recovery phase. But there is no doubt whatsoever that the very protracted monetary expansion period put a lid on real-sector activity, precisely the opposite of what was intended.

The mechanisms that brought about the Japanese decade were those that Keynes specified when he defined the liquidity trap. The mechanics of the trap are important, but a topic for a separate article. What is important here is that IMF managing director Lagarde no doubt disagrees with the Keynesian analysis and, despite lack of evidence in her favor, suggests that yet more liquidity supply would get the European economy going again. That does not bode well for the Europeans.

But what about fiscal policy? Well, says the report,

more growth-friendly measures can be put in place as outlined in the IMF’s latest Fiscal Monitor that called attention to fiscal policies adjusted to support job market reforms.

No word about the need for lower taxes, more reforms promoting private deliveries on government promises. No word on how structurally over-bloated welfare states have put an unbearable burden on the welfare state in the vast majority of the world’s industrialized nations.

The IMF should be a thought leader on these issues. Instead, it has become a service organization for countries that have become stuck in a permanent state of anemic growth, recommending 20th century solutions to 21st century problems.

A Japanese Recovery

Last week I mentioned Japan in an article about France. Quoting an article from Forbes Magazine I made the point that Japan has been stuck in the liquidity trap for a very long time, and that the inflation the country is now experiencing is of the dangerous, monetary kind. The Japanese story illustrates why it is so dangerous for Europe to try to get out from underneath a perennial recession by aggressively expanding money supply.

The lesson for Europe stands firm: printing money when there is no demand for that money is a thoroughly bad idea, and Japan is a good example of why. From the time the Japanese deflation era started, in the late ’90s, the growth rate in the money supply accelerated. This went on for most of the next decade and a half; coincidentally, starting in the late ’90s Japan experienced almost 15 years of deflation.

It is, in other words, safe to warn the Europeans that massive expansion of the money supply will not break deflation. But it is also important to acknowledge that Japan is now showing signs of leaving deflation behind, just as the Forbes article suggested.

The problem is that the new Japanese inflation is not of the kind that Forbes suggested. I quoted the article and took its point as given – it referred to a side point in my article and therefore I accepted the conclusion of what looked like a credible source. But I also had an unrelenting feeling that I needed to look into the veracity of the point from the Forbes story. After all, if Japan had suddenly gone from deflation to inflation without an underlying upturn in real-sector activity, there would be a big case for studying the transmission mechanisms that channeled all that extra liquidity into prices.

In other words, it would have been a historic opportunity for monetarists to prove that their theory of inflation is actually true. It would be “true in the long run”, a 15-year long run, but it would nevertheless be true.

As I started digging through national accounts data it turned out that Japan is not at all entering an era of monetary inflation. The push upward on prices originates in the real sector: production, consumption and gross fixed capital formation (business investment).

Figure 1 reports inflation-adjusted growth in GDP (all data reported below is from Eurostat):

JP 1

Japanese GDP growth exhibits some volatility, but since 2011 the trend is closer to the American economy than the euro zone.

Figure 2 reports private consumption growth:

JP 2

Here the trend is actually fairly good for an economy that has been stagnant for almost two decades. It is still nothing to cheer about – Japan, like the United States, cannot break the Industrial Poverty line of two percent. But at least Japanese consumers are out there spending money, which is far more than you can say about their peers in the depressed euro zone.

Figure 3, finally, tells the story of business investments:

JP 3

This is perhaps the most compelling piece of evidence that the Japanese economy is in recovery mode after 15 years in the economic wasteland. Growth rates in corporate investments are not ecstatically high, but they are the best since the mid-’90s. Again, activity in the Japanese economy is showing the same modest but real recovery tendency as the American economy.

Normally, growth rates around two percent should not even come close to driving inflation. However, with 15 years of stagnant business investments there is very little excess capacity in the economy. Add to that a shrinking work force and the capacity ceiling is lower in Japan than in many other economies.

So there you have it. Japan is leaving the shadow realm of stagnation and deflation. The real sector is recovering, and with production capacity adjusted to stagnation, not growth, excess-demand inflation sets in earlier than in, e.g., the United States. Not to mention Europe.

The Japanese deserve kudos for their apparent return to growth. Let us hope they keep it up.