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
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.
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.
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.
Yankees baseball legend Yogi Berra coined the proverbial phrase “It ain’t over ’til it’s over”. That is certainly true about the European economic crisis. This past week saw a crop of bad news from the Old World. Nothing very dramatic – and certainly nothing that should surprise regular readers of this blog – but nevertheless bad news. In this first of two parts, let’s look at a report from the EU Observer:
The eurozone appears to have come back onto the markets’ radar amid low inflation, poor economic news from Germany, and Greece’s bailout exit plans. Greece’s long-term borrowing costs went above 8 percent on Thursday (16 October) – their highest for almost a year – as investors took fright at the fragile political situation in the country. The government in Athens has tried to shore up popular support by suggesting it will exit its bailout programme with the International Monetary fund more than a year early.
There is an important background here. The bailout program had three components:
1. The Greek government will do everything in its power to combine a balanced budget with protecting as much as possible of its welfare state against the economic depression;
2. In return for the Greek government’s tax increases and spending cuts, the International Monetary Fund, the European Union and the European Central Bank provided loans that kept the Greek government afloat cash-wise;
3. The only metric used to measure the success of bailout policies is the stability of a balanced government budget.
If GDP did not grow, if unemployment was at 30 percent, if more than half the young in Greece had no job to go to… none of that mattered. As a result, there has been no structural improvement of the Greek economy; government has not reduced its burden on the private sector – quite the contrary, in fact. Welfare systems have been reduced, but higher taxes have prevented welfare recipients from transitioning into self sufficiency.
As a result, the social situation in Greece is almost unbearable. The political reaction has come in the form of a surge for parties on the extreme flanks of the political spectrum. In my book Industrial Poverty I explain in detail what happened in Greece, what brought the country down from the heights of European prosperity to permanent stagnation. Today, sadly, the country is little more than a macroeconomic wasteland.
It is with this in mind that one should approach the news that Greece is considering leaving the bailout program. The coalition government is under enormous pressure to save the nation itself, to keep parliamentary democracy in place and to inject some sort of life into the economy. If they fail either of two extreme political movements will take over – the Chavista communists in Syriza or the Nazis in Golden Dawn.
International investors know this and are understandably scared. In their mind the bailout is the least of available evils; in reality, as I explain in my book, the attempts at balancing the budget and saving the welfare state in the midst of the crisis are the very policies that keep Greece from recovering; weak signs of a minor recovery earlier this year have yet to materialize into anything other than the “beaten dog” syndrome often following protracted periods of austertiy.
This is the very reason why Greece is now considering leaving the bailout program. They cannot continue forever to try to muddle through with an economy deadlocked in depression and a democracy so fragile that it has brought the first Nazis into a parliament in Europe for the first time since World War II.
However, as the EU Observer explains, the Greek government is caught between a rock and a hard place – as are other hard-hit euro zone economies:
But the recent announcement spooked investors, unconvinced that Greece can stand alone. Long-term borrowing costs also jumped in the weak periphery states, Spain, Italy, and Portugal. The market jitters – while not comparable to the height of the eurozone crisis in 2011 and 2012 – come as the eurozone’s main economies are once again at odds over policy responses.
France also belongs on that list, primarily for its typically European attempt at leaving the bailout program. Its government tried to leave the bailout path for a left turn into the quagmire of government expansionism. Thinking that more government spending, on top of the largest government spending in the world, could in fact bring about a recovery, the French socialists who won the 2012 elections scoffed at the EU balanced-budget rules and went full speed ahead with their government-expansionist agenda.
Two years later that agenda has hit a brick wall. Massive tax increases, supposed to pay for some of the new government spending, have only resulted in an exodus of brain power and entrepreneurship. The French GDP is standing more still than the Eiffel Tower.
In fact, the EU Observer notes,
France and Italy are fighting a rearguard action for more flexibility saying budget slashing will condemn them to further low growth. Paris is on collision course with both Berlin and the European Commission after having indicated that it wants an extra two years to bring its budget deficit to below 3 percent of GDP. Italy, meanwhile, has submitted a national budget for 2015 which brings the country to the edge of breaking the rules.
The French challenge to the budget-balance rules compounds the uncertainty emanating from the talks in Athens about a Greek bailout exit. It is more than a theoretical possibility that at least one of these countries leaves the euro zone in the next two years, and does so for a combination of political and economic reasons. That would be an institutional change to the European economy – and really the global economy – of such proportions that no traditional quantitative analysis can render justice to a forecast of its effects. It is therefore entirely logical that global investors are growing more uncertain and as a result demand higher risk premiums.
As the icing on the uncertainty cake, informed investors know that Marine Le Pen may very well become France’s next president. If she wins in 2017 her first order of business is in all likelihood going to be to exit the euro zone and reintroduce the franc. On the one hand that could be an “orderly” exit; on the other hand it would have ripple effects throughout the southern rim of the euro zone to the point where the very future of the common currency is in grave danger.
In summary: mounting uncertainty about the future of the euro is being mixed with growing uncertainty about the macroeconomic performance of the member states of the currency union.
Stay tuned for the second part about the bad news out of Europe.
At the beginning of this year there were lots of forecasts that the European economy was going to recover. I never believed them, primarily because government was a bigger burden on the economy than ever. So far I have been proven right, which is not something I would want to celebrate. But I also want to make clear that once government pulls back from its efforts at balancing its budget with higher taxes and spending cuts, the private sector will eventually start to recover.
There is a lot of research to show this. I review the public policy part of that research in chapter 5 in my new book Industrial Poverty. My conclusion is that this kind of austerity can work – the private sector emerges growing from even the most protracted periods of austerity. However, this is not a reason to use austerity as it has been applied through most of recent history, namely as a means to save government. Instead, austerity must be redesigned to reform away government. Otherwise the private-sector recovery that follows will suffer from two ailments:
1. It will look fast in the beginning, as consumers catch up with the standard of living they lost during the austerity period; and
2. Because of the recalibration of the welfare state – permanently higher taxes and permanently lower spending – the economy will hit its full employment level at a higher rate of unemployment than before the austerity episode.
It is also important to keep a watchful eye on whether or not a recovery is external or internal. In too many European countries over the past quarter century, a recovery has come from a rise in exports, i.e., been external. The consequence of this is that the domestic economy lags behind.
To make matters worse, much of modern manufacturing in Europe consists of bringing in parts produced in low-cost countries, assembling them at a highly efficient plant in a European country and then shipping them on to their final destination. This new kind of industrial production is increasingly isolated from the rest of the economy, which means that its multiplier effects on private consumption and business investments is relatively weak. It is, in other words, no longer possible for a small, exports-oriented European country to enter a lasting growth period merely on a rise in exports.
Earlier this year I pointed to Germany as an example of the feeble macroeconomic role of exports. You can get a temporary boost in GDP growth from a rise in exports, but once that boom goes away, it will have left very few lasting “growth footprints” in the economy. It looks like the same thing is now happening in Spain, which is in a recovery, according to the ECB:
The economic recovery has gathered momentum during 2014, with GDP growing at a faster pace than the euro area average.
Going by the latest national accounts numbers from Eurostat, which for obvious reasons covers only the first two quarters of 2014, it was not until Q2 this year that Spanish GDP outpaced the euro zone: 1.1 percent real growth over the same quarter previous year, compared to 0.5 percent for the euro zone.
Before that, Spain was doing worse than the euro zone by a handsome margin.
The ECB again:
Growth has been supported by a rise in domestic demand, while the external balance has weakened substantially as a result of a slowdown in export market growth and higher imports. Domestic consumption and investment in equipment are benefitting from growing confidence, employment creation, easier financing conditions and low inflation.
Over the past year there has been a slow but steady decline in Spanish unemployment, from 26.1 percent in August 2013 to 24.4 percent in August 2014. That is very good for a people hit very hard by disastrously ill designed fiscal policies over the past three years.
At the same time, there are clear signs that this is an “export bubble”. Consider these growth numbers for the country’s GDP (quarterly over same quarter previous year):
There is no doubt that GDP growth is improving. While 1.1 percent is absolutely nothing to write home about, as mentioned earlier it exceeds the euro-zone average. The big question is whether or not this improvement will last. The biggest concern is the exports numbers: good growth for two quarters, then a major leap up to 6.4 percent, only to fall back to 1.5 percent. (While these are not seasonally adjusted numbers, they are quarterly growth on an annual basis which neutralizes seasonal effects.) If exports fall back to tepid growth numbers below two percent, GDP growth will most likely slide back into zero territory.
However, there are a couple of other mildly encouraging factoids in these numbers. To begin with, government spending, while on the growth side, is expanding slowly at no more than one percent per year. This number does not account for financial payments, such as unemployment benefits and other income security entitlements, but they do account for government activities that involve government employees. Alas, restraint in government spending means very little effort from government to expand its payrolls to do away with unemployment.
The apparently stable growth in private consumption is in all likelihood attributable to the post-austerity effect I pointed to above. This means that we will not see 2+ percent growth for much longer; for that to happen there has to be a sustained and substantial addition of consumers to the economy who are capable of spending more than what is required for pure subsistence. This, in turn, will not happen until unemployment comes down more than marginally.
Another mildly encouraging sign is that business investments have stopped declining. The turnaround over the past four quarters is in all likelihood an attempt by exporters to expand their capacity. If the exports boom is coming to an end, so will probably investments.
To turn this fledgling recovery into a lasting trend, the Spanish government needs to address the underlying problem in its economy: the welfare state. Otherwise it will just experience spurts of growth here and there as anomalies to a permanent state of stagnation – and industrial poverty.
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.
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):
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:
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:
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.
On Friday I reported that the European Central Bank has downgraded its growth forecast for the euro zone. This wraps up a summer of bad economic news from Europe, all together showing that there is no recovery under way. At the same time, as I have explained in a series of blogs elsewhere (Ode to the American Economy, parts one, two and three), the United States continues its sleepwalk out of the Great Recession.
The differences between the U.S. and EU economies are striking. A review of the most recent Eurostat quarterly national accounts data shows that the American economy is not only outgrowing its European counterpart, but it is also in the healthier position of being dominated by consumer spending.
Let us begin with GDP growth (using the single-currency euro zone as the proxy for Europe):
Over the past 20 years for which Eurostat provides quarterly, inflation-adjusted data, there are three episodes where the United States outgrows Europe. The first episode was the heydays of the ’90s, when our unemployment was trending below four percent. Europe was struggling with twice as high unemployment rates and, in fairness, the remaining issues with Europe’s reunification. That said, with the right fiscal policies the 18 current euro-zone countries could easily have enjoyed the same forceful growth as the U.S. economy was producing.
The second episode of faster U.S. growth comes between the Millennium and Great Recessions. Many would attribute this to the housing bubble, and I am inclined to agree to some extent. However, it is important not to forget the Bush tax cuts, which in two phases – 2001 and 2003 – created a one-two punch of multiplier and accelerator effects on economic activity.
Unfortunately, this was also a period of excessive federal spending. The U.S. government grew its budget by 6.7 percent per year, on average, from 2001 to 2009, with the heaviest spending growth allocated to the latter half of that period. Indirectly, this drew resources away from private-sector growth, which partly explains the weakening of GDP growth from the top in early 2004.
As for Europe, the bump in growth right before the Great Recession is not easily explained. As shown in the two charts below, neither consumption nor exports were strong enough to produce that bump.
The third episode of American dominance is the one we are in right now. Amazingly, at a GDP growth rate mostly below 2.5 percent per year, we are leaving Europe in the dust. The difference is easily explained: after the serious dip early in the recession, U.S. fiscal policy has basically been neutral, with only marginal movements in taxes and spending. In fact, after the American Recovery and Reinvestment Act, President Obama has been the fiscally most frugal president since before Reagan. The states have also held back their spending, and even though most states still struggle with budget problems the overall trend in taxation is weakly in favor of lower taxes.
From this viewpoint the American economy has actually for the most part benefited from the Congressional deadlock and President Obama’s passion for playing golf. Our federal government is doing the American economy a favor by doing nothing. It would of course, be better if they cut taxes, reformed away entitlement programs and deregulated, but in lieu of that it is better that they continue to do nothing while we go about our business and slowly bring this economy back to something that resembles full employment.
Europe, on the other hand, is continuing to suffer from years of government-saving austerity. Their tax hikes and spending cuts have been motivated by a desire to keep as much as possible of the welfare state through the Great Recession, with little or no regard for what happens to the private sector. The European people and their businesses are now paying the price in the form of almost zero growth, eleven percent unemployment and a grim outlook on the future.
Adding insult to this national-accounts injury, the next chart shows the role of private consumption in each of the two economies:
There is a simple way to show the importance of private consumption in an economy. Subtract GDP growth from the growth rate of private consumption per period observed, in this case quarters. Sum up the difference per period and divide by the number of periods. If the resulting number is negative, it means that GDP grows faster on average than private consumption; if it is positive the opposite is true. An economy where consumption grows at least as fast as GDP is an economy where the consumer is the key economic agent, where he enjoys a high degree of economic freedom and where, therefore, the free market is a major player in the rest of the economy. In a consumption-drivene economy, the dominating end purpose of productive economic activity is to win over consumer spending on a free market, hence private businesses have to operate as free-market entities as well.
The U.S. consumption growth ratio is 1.3, meaning that for the period observed here, private consumption growth exceeds GDP growth by 1.3 percent per quarter, on average. By contrast, the euro-zone economy has a ratio of -0.7, showing that growth is driven by other variables than private consumption.
Is that “other variable” exports? Let’s take a look:
Interestingly, since the Millennium Recession there has been no major difference in the growth rate of U.S. exports and exports from euro-zone countries. The growth rates are high, especially compared to GDP growth, which means that for the slow-growing euro-zone economy the exports sector has helped keep growth up. This explains why GDP in the euro-zone countries outgrow their own private consumption, but since strong exports growth does not translate into household spending (if it did, private consumption would grow on par with exports) this means that the euro-zone economies are increasingly dependent on foreign markets to grow at all.
With its strong private-consumption growth, the U.S. economy has a big leg up on the European economy. We are, simply, a domestically dominated economy and are much less vulnerable to ups and downs of the international business cycle. Europe’s GDP, on the other hand, basically stands and falls with spending on other continents.
Furthermore, with as big a government sector as the Europeans have, their austerity policies which raise taxes – thus diminish the private sector – and cut government spending actually depress GDP in two ends.
The compounded effect on GDP is, as shown here, rather depressing. Pun intended.
Analysts are grasping for explanations of why the European economy has once again stalled. The European Central Bank, which has lowered its forecast for GDP growth in the euro zone, suggests that this weakening is not part of a trend, but an aberration from a trend:
First, activity in the first quarter was subject to an unusual upward effect from the low number of holidays (as the entire Easter school holiday period fell in the second quarter) and from the warm winter weather that had boosted construction. Neither of these upward effects in the first quarter was sufficiently captured by seasonal or working day adjustment. As they unwound in the second quarter, this dampened growth. Second, negative calendar effects related to the more than usual number of “bridge days” around public holidays in many euro area countries may have reduced the number of effective working days in May, a factor that was not captured by the working day adjustment.
I have a lot of respect for the macroeconomists at the ECB, but frankly, this is below what we should expect of them. Calendar days and weather always vary – some claim that the bad performance of the U.S. economy in the first quarter of this year was due to the unusually cold winter. In reality, that growth dip was more than likely the result of businesses trying to adjust to the impact of Obamacare. By contrast, the slow growth numbers in the European economy are part of a trend of economic stagnation. A 30,000-foot review of what the European economy looks like is a good way to become aware of that trend.
The profession of economic has to some degree drifted away from the bigger-picture thinking that characterized its earlier days in the 20th century. While econometrics is important, there is too much emphasis on it today, drawing attention away from longer, bigger trends and the kind of institutional changes that characterize Europe today. Based on this broader analysis, my conclusion stands: Europe is not going to recover until they do something fundamental about their welfare state. Or, more bluntly: so long as taxes remain as high as they are and government provides entitlements the way it does, there is no reason for the productive people in the European economy to bring about a recovery.
The problem with short-sighted, strictly quantitative analysis is that it compels the economist to keep looking for a reason why the economy should recovery, as if it was a law of nature that there should be a recovery.
This problem is reflected in the ECB forecast paper:
Regarding the second half of 2014, while confidence indicators still stand close to their long-term average levels, their recent weakening indicates a rather modest increase in activity in the near term. The weakening of survey data takes place against the background of the recent further intensification of geopolitical tensions (see Box 4) together with uncertainty about the economic reform process in some euro area countries. All in all, the projection entails a rather moderate pick-up in activity in the second half of 2014, weaker than previously expected.
It would be interesting to see the results of a survey like this where the questions centered in on the more long-term oriented variables that focused on people’s ability and desire to plan their personal finances. I did a study like that as part of my own graduate work, and the results (reported in my doctoral thesis) were interesting yet hardly surprising. When people are faced with growing uncertainty they try to reduce their long-term economic commitments as much as possible. This results in less economic activity today without any tangible commitment to future spending.
Since I do not have the resources to study consumer and entrepreneurial confidence in Europe at the level the ECB can, I cannot firmly say that people in Europe today feel so uncertain about the future that they have permanently lowered their economic activity. However, my survey results corroborate predictions by economic theory, and the reality on the ground in Europe today points in the very same direction. In other words, so long as institutional uncertainty remains, there will be no recovery in Europe.
The ECB does not consider this aspect. Instead they once again forecast a recovery, just as assorted economists have done for about a year now:
Looking beyond the near term, and assuming no further escalation of global tensions, a gradual acceleration of real GDP growth over the projection horizon is envisaged. Real GDP growth is expected to pick up in 2015 and 2016, with the growth differentials across countries projected to decline, thanks to the progress in overcoming the fragmentation of financial markets, smaller differences in their fiscal policy paths, and the positive impact on activity from past structural reforms in several countries. The projected pick-up in activity will be mainly supported by a strengthening of domestic demand, owing to the accommodative monetary policy stance – further strengthened by the recent standard and non- standard measures – a broadly neutral fiscal stance following years of substantial fiscal tightening, and a return to neutral credit supply conditions. In addition, private consumption should benefit from a pick-up in real disposable income stemming from the favourable impact of low commodity price inflation and rising wage growth.
A key ingredient here is “smaller differences in … fiscal policy paths” and “a broadly neutral fiscal stance”. This means that the ECB is expecting an end to austerity policies across the euro zone, an expectation that has been lurking in their forecasts for some time now. But austerity has not ended, nor have the budget deficit problems that brought about austerity. The austerity artillery is not as active now as it was two years ago, but it has not gone quiet. France, e.g., is currently in a political leadership crisis because of the alleged need to continue budget-balancing measures.
France also indicates where the fiscal trend in Europe is heading. If the radical side of the French socialists could have it their way they would chart a course back to big-spending territory. But they would also couple more spending with even higher taxes, in order to avoid conflicts with the debt and deficit rules of the EU Stability and Growth Pact. While technically a “neutral” policy, the macroeconomic fallout would be a further weakening of the private sector – in other words a further weakening of GDP growth.
Another aspect that the ECB overlooks is the effects of the recalibration of the welfare state that has taken place during the austerity years. I am not going to elaborate at length on this point here, but refer instead to my new book where I discuss this phenomenon in more detail. Its macroeconomic meaning, though, is important here: the recalibration results in the welfare state taking more from the private sector, partly in the form of taxes, and giving less back in the form of lower spending. As a result, the private sector is drained, structurally, of more resources, with the inevitable result that long-term GDP growth is even weaker.
None of this is discussed in the ECB forecast paper, which means that we will very likely see more downward adjustments of their growth forecasts in the future.
There would be no problem with the ECB’s erroneous forecasts if it was not for the fact that those forecasts are used by policy makers in their decisions on taxes, government spending and monetary supply. The more of these “surprising” downward corrections by forecasters, the more of almost panic-driven decisions we will see. Alas, from EUBusiness.com:
The European Central Bank cut its forecasts for growth in the 18-country euro area this year and next, and also lowered its outlook for area-wide inflation, at a policy meeting on Thursday. The ECB is pencilling in gross domestic product (GDP) growth of 0.9 percent in 2014 and 1.6 percent in 2015, the central bank’s president Mario Draghi told a news conference. “Compared with our projections in June, the projections for real GDP growth for 2014 and 2015 have been revised downwards,” he said. The bank said inflation was expected to be 0.6 percent this year — a lower rate than the 0.7 originally forecast, Draghi said.
And therefore, the ECB decided to cut its already microscopic interest rates. Among their cuts is a push of the overnight bank lending rate further into negative territory, so that it now stands at -0.3 percent. But all these measures, aimed at injecting more cheap credit into the European economy, will fall as flat on their bellies as earlier interest-rate cuts. The problem is not that there is not enough liquidity in the economy – the problem is, as mentioned earlier, that the European economy suffers from institutional and structural ailments. Those are not fixed with monetary policy. Yet with the wrong analysis of the cause of the crisis, Europe’s policy makers will continue to prescribe the wrong medicine and the patient will continue to sink into a vegetative state of stagnation and industrial poverty.
In economics, a lot of academic research is focused on high-end sophisticated quantitative methods. Many economists who work in public policy consider such research more or less useless. I agree only to some extent. There is a lot of technically advanced research that informs us in the interface between politics and academia. Right now, e.g., I am reading highly technical and theoretical research in price theory for a paper that develops new policy applications.
That said, the technical experts in economics have run away with the discipline. Far more resources are spent on advanced mathematical research and sophisticated statistical methods than can ever be merited by real-world applicability. This technical overkill has led to two problems in the practice of economics: econometricians make errors in forecasting and economists ignore problems that do not easily lend themselves to high-end technical analysis.
The more I read of economics literature, and the more time I spend in the public policy interface of politics and economics, the more convinced I am that economics needs a thought revolution. I find myself relying on erstwhile thinkers and basic macroeconomic theory developed early in the 20th century, because I have had much more use of it than more modern, less theoretical research.
One example of where I find the basics very useful is in the understanding of why there is such a difference in inflation patterns in Europe and the United States. While U.S. inflation is slowly trending up toward two percent, Europe is moving steadily into deflation territory. From The Guardian:
Eurozone inflation fell to its lowest level in almost five years in July, bringing the threat of a dangerous deflationary spiral closer. The annual rate of inflation fell unexpectedly to 0.4% from 0.5% in June, dragged lower by accelerating falls in food, alcohol and tobacco prices. Energy prices also fell sharply, by 1%, compared with a 0.1% rise in June. It was the lowest level of annual inflation since October 2009, when prices were in negative territory.
I have warned about deflation several times. It is not hard to predict deflation in Europe:
1. Government consumes 40-50 percent of the economy;
2. Austrian theory explains how government misallocates resources, thus lowers overall economic activity;
3. When the recession hit in 2008-09, growth was already so weak that the European economy lacked the resiliency needed to recover;
4. Austerity, designed to save the welfare state, has further depressed private-sector activity, just as Keynesian theory predicts;
5. More recently the ECB has flooded the euro zone with money in a desperate attempt to revive business investments;
6. Since austerity has left the private sector more heavily taxed, with even weaker support from government, businesses and consumers are even less inclined to spend money and take on new loans than before austerity;
7. When real-sector activity is depressed, the monetary sector cannot revive economic activity even when it pushes private-sector loan interest rates into negative territory, as the ECB has done.
No matter how hard the ECB tries, it is not going to restart the European economy. Instead, it has firmly planted the euro zone in the liquidity trap where monetary policy is useless.
As for inflation, the only kind that Europe could see in this situation is the monetary kind. That is important to keep in mind, especially since there is probably a widespread desire for inflation among Europe’s political leadership. There, inflation is considered a blessing because it drives up tax revenues. But monetary inflation would have such detrimental consequences for the economy that nobody should sit around and wish for it to happen.
I honestly believe that Europe’s politicians and central bankers share that thought – they want real-sector driven inflation but unlike their peers in the United States they don’t know how to get the real sector going.
The Guardian again:
Peter Vanden Houte, chief eurozone economist at ING, said the threat of eurozone deflation was likely to persist. “[July's] figures don’t give any assurance that the eurozone is already out of the deflation danger zone,” he said. … The fear is that weak price pressures could ultimately trigger a dangerous deflationary spiral, where consumers and businesses damage their domestic economies by putting off spending amid expectations that prices will fall further still.
Exactly right. Both Keynes and the Austrians point to this, in different forms. But more importantly, the first thing you need to do when you are in a liquidity trap, on he verge of deflation, is to quit printing money. Deflation and growing money supply reinforce the depression effect of deflation itself. When liquidity is abundantly available, and prices of what you would buy with that liquidity are falling, you may borrow the money, but you put it in the bank. As prices continue to fall, your liquidity gains in net value; if the net gain exceeds the interest rate (not hard when interest rates are practically zero), you make money off borrowing and not spending.
I borrow $100 today to buy a bicycle. The interest rate is one percent and deflation is two percent. Tomorrow I pay one dollar to the bank but only $98 for the bike. I can use an extra dollar in “profit” toward paying back the loan. The longer I wait with buying the bike, the larger my “profit” will be. In other words, I have a speculative incentive to depress economic activity further.
If the interest rate is higher than deflation, I will borrow the money but buy the bike it immediately. The only way, though, that the interest rate can go up is if the ECB tightens liquidity supply in the euro zone. That, however, won’t happen any time soon. The Guardian reminds us of how the ECB took the euro zone into negative interest rate territory:
Policymakers at the European Central Bank (ECB) took action in June to stave off the threat of deflation and breathe some life into the currency bloc’s flagging economy. The main interest rate was cut to a record low of 0.15% and a €400bn (£317bn) package of cheap funding for banks was announced, with the condition that the money be used to lend to companies outside the financial sector, and not for mortgages. The ECB also announced it would in effect charge banks to deposit money, by imposing a negative rate of interest of -0.1% on deposits. The hope is that it will encourage banks to lend more to consumers and businesses, boosting the wider economy.
Fortunately, the ECB has announced that it will hold off on further monetary “stimulus” for now. Perhaps the weaker euro, which the Guardian also mentions, will inject a little bit of import-price inflation into the European economy. That would weaken the deflation trend, but it is unlikely that it will do enough to lift the euro zone our of the liquidity trap.
Overall, economic theory and the current course of the European economy together suggest that the continent’s economy is going to continue its journey into the shadow realm of deflation and permanent stagnation.
In the meantime, the U.S. economy will continue to grow, with a healthy dose of low, real-sector driven inflation. The differences between the eastern and western shores of the Atlantic Ocean will also continue to grow. The sharp contrast emerging will be one between thriving free-market based capitalism and stagnant welfare-state based socialism.
Take your pick.