Tagged: Macroeconomics

Debt and Growth: A Quick Look

There is an ongoing debate here in the United States about our federal debt. Obviously, we cannot keep raising the debt-to-GDP ratio, and although the federal deficit has shrunk dramatically in the past couple of years, there is a strong likelihood that we will return to growing deficits some time beyond 2018. This obviously means that the debt will accelerate again; what will happen to the debt ratio is a question for future inquiry.

As things look now, the U.S. economy is slowly rising out of the recession at growth rates 2-3 times what the Europeans are seeing. That is somewhat good news when it comes to our debt ratio, a variable that has more than symbolic meaning. Countries with high debt-to-GDP ratios pay more on their debts than countries with low ratios. The reason is simple: a country with a low debt ratio is more likely to have enough of a tax base to both fund its current spending and meet its debt obligations. GDP, obviously, is the broadest possible tax base, so the larger it is relative government debt, the safer it is to buy a country’s Treasury bonds.

The next step in this reasoning would be to ask if the debt ratio itself has any relation to GDP growth itself. In other words, does the burden of government debt on an economy slow down its growth? If the answer is yes, then rising debt creates a vicious circle including higher interest rates, the need for higher taxes and stagnant growth.

Many would say that this vicious circle obviously exists and that no further investigation into the matter is needed. However, those who say so disregard the fact that the United States, with a debt ratio above 100 percent of GDP (we cannot count just the debt “held by the public” because all debt costs money one way or the other) has a faster-growing GDP than the EU does, where the aggregate debt-to-GDP ratio for all 28 member states is 87 percent.

Therefore, as always it is good to take a look at some data. The following figure reports Eurostat data for 27 EU member states (excluding Croatia which became a member just this year) over the period 2000-2013. The data is broken down to quarterly levels and not adjusted seasonally (this vouches for “genuine” observations). The left vertical axis reports debt-to-GDP ratios while the right axis reports inflation-adjusted GDP growth numbers, quarterly over the same quarter the previous year. Since this gives us a very large number of pairs of observations, the data is organized into deciles. Each contains 148 pairs of observations – debt ratio and GDP growth for the same quarter – except for the last decile which contains 149 observations. Each decile reports average numbers for each variable for that decile:

Debt GDP Q 00-13

*) The astute observer will notice that I am only reporting 1,481 observation pairs when 27 countries observed over 14 years, four times per year, should actually produce 1,512 observation pairs. The lower number reported here is due to two factors: only one data series is available for the fourth quarter of 2013, and both series for Malta are missing for the first few quarters.

While this is not an actual econometric study (that would take a lot more time than I have on my hand for this blog) the analysis nevertheless reports an interesting correlation. First, when the debt ratio rises above 60 percent, growth slows notably. The 60-percent debt level is often referred to in the public debate over government debt as a threshold governments should not cross. I have sometimes dismissed this level as arbitrarily chosen, and I maintain that any simple focus on this ratio for legislative purposes is indeed arbitrary. In fact, if we look at the other end of the spectrum a debt level below 40 percent appears to have very strong positive effects on growth. If we are going to have legislation about a debt ratio cap, then why not use 40 percent?

That said, the observed correlation calls for deeper investigation. Unlike some simplistic pundits (you know who you are…) I am not going to draw the immediate conclusion that high debt ratios cause low growth. Let us remember that GDP is the denominator of the debt ratio; if the denominator grows slowly for any reason, and government keeps deficit-spending as usual, then the debt ratio is going to rise for purely arithmetical reasons. However, as mentioned earlier, large deficits themselves can very well drag down GDP growth, raising the debt ratio for causal reasons.

More on that later.For now, let’s conclude this little exercise with two questions that I hope to answer soon:

1. Is there a correlation between large debt and big government spending? If so, the low growth in high-debt-ratio countries could have its explanation.

2. What happens if we delay one of the two variables one quarter? This classic, basic statistical method could tell us a lot about the causes and effects between debt and growth. I am going to take a stab at it as soon as time allows.

Needless to say, any future inquiry would have to include the United States. This one does not, simply because the raw data used here did not include U.S. numbers. Now that I have this data in a configured file of my own it is easy to add U.S. data.


Tax Hikes in Sweden a Bad Idea

The Swedish Treasury secretary, Anders Borg, has been in office now for seven years. He is one of the longest lasting masters of government funds in the free world. I’ve had a lot of criticism for him over the years, but I also want to acknowledge that he has done some things right, at least given the circumstances.

Mr. Borg came into office after the 2006 parliamentary election, and was very soon hurled into the Great Recession. I really don’t envy his job: Swedish law mandates that the government prioritizes a balanced budget, annually, above all other economic policy goals. This is an easy priority to comply with in good times, but once a recession strikes government revenue takes a nose dive. In the elaborate European welfare states, government spending increases precisely when revenue declines. In other words, government budgets are built to open major deficits in recessions.

Like all other Treasury secretaries in a similar situation, Mr. Borg chose to fight the deficit. Early on, his fiscal policy was clumsy and came with ill-conceived spending cuts. His budgets were poorly written, sometimes with outright embarrassing analytical flaws. Over time, though, things got better on the analytical side and Mr. Borg persisted in pushing for a Swedish version of the Earned Income Tax Credit. As I explain at length in a chapter in my book Ending the Welfare State, the EITC is an inefficient way of cutting people’s tax burdens, primarily because it creates very steep marginal tax effects for low-income families. That said, in a country that has a history of having the world’s highest taxes it is better to introduce an EITC of sorts than to do nothing.

In the last year or two Mr. Borg has taken yet another step toward a more comprehensive fiscal policy. He has cited Keynesian theory as the source of inspiration for his fiscal policy. Last year he emphasized, several times, the need for fiscal stimulus to get the Swedish economy going. He pointed to a further expansion of the Swedish EITC as an example.

Today Mr. Borg still abides by a crude, textbook version of the Keynesian-Neoclassical synthesis. He still wants to counter swings in the business cycle with active, stabilizing fiscal policy. There is nothing wrong in this, except for two things: Mr. Borg is still determined to defend the indefensible welfare state – and you would have to accept the fact that Sweden is now out of its recession and heading for some kind of macroeconomic over-heating.

Leaving the indefensibility of the welfare state aside for now, the notion that Sweden is in a growth period is of bigger interest than it might seem at first. In claiming that he sees a recovery in the economy, Mr. Borg echoes similar sentiments from Eurocrats in Brussels. But just as it is wrong to say that Greece is on a macroeconomic rebound, it is simply bizarre to say that Sweden is out of the recession.

Let us look at some data from Eurostat to see where Sweden really is today:

  • The Swedish unemployment rate is currently reported by Swedish statistical agencies as 7.7 percent. According to Eurostat it has been at eight percent since 2010 with no real trend in either direction.
  • Youth unemployment is also trendless. After topping out at 26.7 percent during the crisis it is now steady around 24 percent.
  • GDP growth is equally unimpressive. In the third quarter of 2013 the Swedish economy grew by 0.7 percent over the same quarter in 2012. The average annual growth rate for the last four quarters is 0.8 percent.

These are not numbers that indicate any kind of over-heating in an economy. There is not even a hint of recovery here. Okun’s law says that an economy needs to grow at more than two percent per year to bring down unemployment; so far, the Swedish economy cannot even get to half that rate.

The only variable with any kind of positive trend is private consumption. In the third quarter of 2013 Swedish households increased their spending by 2.1 percent, adjusted for inflation, over the same quarter in 2012. This was the fifth quarter in a row with accelerating consumption growth, which could be taken as a sign of economic recovery. However, if we remove spending on housing from these numbers the average growth rate declines to approximately European average. The reason why we need to make this adjustment is that Swedish households are spending exceptional amounts on housing: there is practically no production of new homes, and population growth is among the highest in the industrialized world (due to large immigration from non-Western countries). As a result, Swedish households have been forced to basically mortgage the rest of their lives, with debt-to-disposable-income ratios in excess of 180 percent. By comparison, when the American housing bubble burst in 2008, the average U.S. household had a debt of 130 percent of their disposable income.

In short: what seems like a trend of recovery in Sweden’s private consumption is in reality a debt-driven housing spending spree. It cannot and will not bring the economy back to growth.

The saddest part of this is that Mr. Borg wants to quell an overheated economy that does not exist, by raising taxes. All that this will do is perpetuate the current situation with high unemployment, almost no growth – and dangerously indebted households. In fact, by raising taxes Mr. Borg could provoke an acute debt crisis: by taking more from the private sector he raises the likelihood that private disposable income will cease to grow in the next year or two. As this happens, the ratio of household debt to disposable income will rise again, but since it is now the denominator that is stagnating, the risk of bank panic is higher than if the numerator was accelerating.

In short: Mr. Borg could provoke a meltdown on the Swedish real estate market.

Again, I applaud Mr. Borg for wanting to build his fiscal policy on an analytical foundation. His problem is that he does not give himself enough time to do the analysis (and he certainly does not have access to adequate brainpower at the Treasury Department in Stockholm…). A growth period in need of any kind of fiscal-policy moderation would look more like the Swedish economy in the 1980s when unemployment was at two percent.

Yes, two percent.

In a way, the fact that Mr. Borg does not want to wait for full employment before he takes to growth-quelling policy measures is an indication of how the past couple of decades have changed people’s perception of the macroeconomic normal. This is not just the case in Sweden, but in Europe in general.

We have to watch out here in the United States so we don’t fall for the same illusion.

EU Stagnation: More Evidence

The search for a European economic recovery continues. On February 4 British newspaper The Guardian reported that while there were somewhat disappointing news out of the United States, the European should be seeing some lights in the tunnel:

The Dow has fallen close to 5% since its all time high at the end of the year, dropping in part on fears that China’s growth is slowing and amid signs of more economic woes in emerging markets. There was stringer manufacturing data in Europe, where Greece’s factory sector was shown to have finally returned to growth for the first time in more than four years, fuelling hopes that the country’s long slump could be easing. The news of rising orders and activity for Greece’s manufacturers came amid evidence of a manufacturing recovery continuing in much of the eurozone.

We have heard these news about a European recovery several times recently, and previously it has turned out to be a macroeconomic henhouse made out of a feather. To check whether or not this is true this time, let us review some Eurostat national accounts data.

Since we do not yet have annual numbers for the European economies for 2013, quarterly data will have to do. That is not a bad idea, though, because if calibrated correctly they can give us a fine-tuned picture of what is happening on the ground. Thus, using quarterly national accounts data, adjusted for inflation, we find the following:

1. GDP growth in the 28 member states of the EU together was 0.4 percent in the third quarter of 2013 over the third quarter of 2012. This is the first positive growth number since the first quarter of 2012 (0.7 percent) which is worth noticing. At the same time, the euro zone exhibited zero growth in the third quarter of last year, admittedly an improvement over five straight quarters with shrinking GDP but hardly anything to write home about. The difference between the two growth rates suggests that it is better to stay out of the euro zone than to be part of it. Sure enough, if we isolate growth rates for the third quarter of 2013 (again over third quarter 2012) we find that out of the eleven EU member states that have a growth rate in excess of one percent, only three – Germany, Ireland and Luxembourg – are part of the euro zone. For example, the British economy outgrew the German, if only by a tenth of a percent. The explanation of this is most likely that the EU-ECB-IMF troika has targeted euro-zone countries for harsh austerity measures, allowing the non-euro EU states to more or less escape the tough fiscal repression. Greece is a good example, with a GDP growth rate of -3.0 percent. A positive side to this number is that it is the smallest quarterly GDP contraction in at least two years, but it also means that all talk about the Greek economy being in a recovery phase is nonsense.

2. Eurostat does not compile data on household consumption in the form of year-to-year quarterly consumption growth. However, they do report it for 23 member states. Of those, seven report a growth rate of one percent or more, while nine report shrinking private consumption. The unweighted average growth rate is 0.5 percent, which goes well with the GDP growth rate in the EU-28 (in normally functioning economies private consumption is the single largest contributor to GDP). Again looking at Greece, it ranks lowest of the 23 with consumption contracting 3.9 percent in the third quarter of 2013 over the same quarter 2012. Again, this is better than previous quarters: we have to go back to the third quarter of 2011 to find a less depressing figure (-2.5 percent). This is of course a good sign in itself, and we could add that the contraction rate fell throughout 2013 (with fourth-quarter numbers still not reported). That said, we could be looking at the same type of temporary relief as the third quarter of 2011 delivered: the first and second quarters of that year saw major contraction rates in private consumption (-12.3 and -6.5 percent, respectively). I don’t think that is the case, because overall it seems like the European economy in general, and the Greek economy in particular, are leaving the depression phase they have been in over the past few years. That, however, does not mean that they are heading for a recovery – far more likely is that we are witnessing the emergence of long-term economic stagnation.

3. Now for the manufacturing numbers. EU-28 saw a 0.4 percent growth rate in the third quarter of 2013, with the euro zone at 0.1 percent. With Eurostat figures from 24 of the 28 EU states we can conclude that there are vast differences between individual member states. Six states saw manufacturing grow at more than two percent; another eight experienced a growth rate of zero to one percent. In ten states manufacturing declined, led by Cyprus (-5.4 percent), Croatia (-5.4) and – yes – Greece (-5.2). Admittedly, one quarter figure does not a full story make, but the Greek situation does not improve much if we look back through the past few quarters. Before the significant decline in the third quarter, Greece saw four straight quarters of growing manufacturing. The average for those quarters was 2.3 percent, which does not compare well to the nine percent quarterly average loss in the four quarters prior to that growth period. In other words, while there has been some comeback for Greek manufacturing since early 2012, the nosedive in the third quarter shows that it is far too early to draw any definitive conclusions.

More than being a sign of a recovery, these Eurostat numbers reinforce the point I have made earlier that the Greek economy is transitioning from depression to stagnation. The same is true for the rest of Europe.

Beyond that, it is interesting to note the emerging difference between the euro-zone countries and members of the EU that still maintain their own currencies. Again, the better performance in non-euro EU states is probably not related to exchange-rate fluctuations benefitting foreign trade, the difference. Instead, it is a matter of austerity enforcement: the ECB obviously has no direct influence over non-euro states, which leaves the fiscal policy in somewhat better shape there.

OECD Wrong on European Crisis

The Great Recession continues to baffle economists around the world. Some have actually admitted that their academic research has been wrong – kudos to the economists at IMF for leading the pack – while others continue to stumble around in the dark. A story in The Guardian gives an example of economists in the latter category:

A failure to spot the severity of the eurozone crisis and the impact of the meltdown of the global banking system led to consistent forecasting errors in recent years, the Organisation for Economic Co-operation and Development admitted on Tuesday. The Paris-based organisation said it repeatedly overestimated growth prospects for countries around the world between 2007 and 2012. The OECD revised down forecasts at the onset of the financial crisis, but by an insufficient degree, it said. “Forecasts were revised down consistently and very rapidly when the financial crisis erupted, but growth out-turns nonetheless still proved substantially weaker than had been projected,” it said in a paper exploring its forecasting record in recent years.

Technically they under-estimated the effects of the credit losses that financial institutions suffered, but not for the reasons the OECD believes. Their forecasting mistake is instead founded in a two-pronged misunderstanding of the true nature of the crisis. First, they fail to realize that this was a welfare-state crisis, created by a slow but relentless growth in the burden of government on Europe’s economies. The weight of the government’s fiscal obesity eventually became so heavy on taxpayers, and the disincentives toward work and investment so strong, that it did not take much to nudge the economy into a deep, severe crisis.

The welfare state’s role in the crisis was enhanced by the fact that in the years leading up to the crisis Europe’s banks bought a trillion euros worth of Treasury bonds, a good chunk of which was from countries that soon turned out to be junk-status borrowers. This seriously aggravated the balance sheets of banks that were already struggling with credit losses.

If they had not been forced to deal with the junkification of Greek, Spanish, Portuguese and Irish government bonds, the banks would have been able to manage and endure the private-sector credit losses. But the unlimited irresponsibility of spendoholic legislators escalated a recession into a crisis.

The second prong of the OECD’s forecasting mistake has to do with austerity. Humbly put, nobody outside of my office grasped the truly negative impact of austerity as early as I did; the only ones who have caught up are IMF economists. On the other hand, their analysis of the role of the multiplier has, frankly, been intriguing. Nevertheless, by not understanding that austerity is always negative for macroeconomic activity, the OECD has missed the forecasting mark even more than by just misunderstanding the relation between the welfare state and the financial sector.

All in all, there is still a lot to be said on what has happened in Europe these past few years, and what implications that has for the future of Europe as well as for America. I am impatiently looking forward to the July release date of my book Industrial Poverty which provides a thorough analysis of the crisis.

Interestingly, as we return to The Guardian, the OECD denies my point about austerity:

The OECD said a failure to understand the impact of austerity policies in various countries did not appear to be a major driver of forecasting inaccuracies. It said the OECD became better at factoring in the impact of austerity amid little space for further monetary loosening as the crisis continued. Overall, “fiscal consolidation is not significantly negatively related to the forecast errors”.

This is a blatant refutation of what the leading economists at the IMF concluded over a year ago. The IMF paper is compelling and based directly on observed forecasting errors. Their main point is that the multiplier effect of one dollar’s worth of government spending cuts is stronger than the multiplier of one dollar’s worth of government spending increases. They show good evidence for this conclusion, evidence that the OECD ignores entirely.

Furthermore, as I report in my forthcoming book there is a wide range of literature on austerity and its effects, and that literature has one thing in common: politicians always under-estimate either of two things: the negative effects of austerity, or the persistent problems with pulling out of a recession by means of austerity.

But there is yet another point where the OECD is wrong. If the financial-sector problems were to blame for the depth and the length of this recession, then why is it that the credit losses happened several years ago, that the bank bailouts have been essentially wrapped up and that, thanks in part to the European Central Bank’s easy monetary policy, there are no longer any credit worries in the European banking system – and Europe is still sinking into higher unemployment and more budget problems??

The underlying presumption in the OECD’s focus on the financial system is again that this was a financial crisis, nothing else. But if that was the case, we would have entered the crisis with sky high interest rates; the banking system would have signaled systemic credit defaults by drying up credit and raising interest rates to the sky before the macroeconomic downturn began. But none of that happened. Interest rates in Spain, Greece and other troubled EU member states started rising only after the recession had escalated into a crisis!

What does this tell us? To answer that question, let us take one more step into the technicalities of macroeconomics. The reason why interest rates went up was not that the financial sector raised the price of credit. The reason was that Treasury bonds in Europe’s big-government states were sent to the financial junk yard. The reason why the Greek government has had to pay ten times higher interest rates than, e.g., the Swiss government is that the Swiss government has never defaulted on its loans while the Greek government forced its creditors to write off part of their loans.

In short: when interest rates started rising in Europe, it was because of unimaginable budget deficits, i.e., a crisis in the welfare state, not the financial system.

One last weirdo from the OECD:

“The macroeconomic models available at the time of the crisis typically ignored the banking system and failed to allow for the possibility that bank capital shortages and credit rationing might impact on macroeconomic developments,” it said.

Credit rationing? At a time when the central bank has flooded every corner of the economy with liquidity?? Europe’s banks hold trillions of dollars in government bonds, and in theory they could go to the ECB and, under the ECB’s bond buyback guarantee, demand cash right now for them. That would be free money for the banks who could then lend it out to whoever they wanted to lend to, and almost be guaranteed to make good money.

In reality, the rationing is not on the supply side of the credit market. It is on the demand side where there are not enough credit-worthy households and businesses to gobble up Europe’s rapidly growing money supply. The fact that the OECD fails to see this adds to my conclusion that they have not done their homework on the Great Recession.

Again: this is a welfare-state crisis, not a financial crisis.

France, Germany on the Downslope

Recently I have reported how Europe’s troubles continue, now in the form of deflation and rising poverty. But unemployment is still a major issue; recent signs of plateauing or even a minor decline in joblessness are indicators of stagnation rather than a recovery under way.

Today I can report yet more evidence that Europe’s crisis is continuing. From Euractiv:

One of French President François Hollande’s ambitions is to put in place social and fiscal convergence between his country and Germany, but for now the two economies are taking opposite turns. The number of unemployed people looking for a job has increased by 0.3% in France, which marks the president’s failure to decrease unemployment by the end of 2013. According to official figures published by the Labour Ministry this week, people without any activity (known as category A) have reached a record high number of over 3 million. Categories B and C (persons who have a slower activity) has increased by 0.5 to reach 4,898,100 in continental France and over 5 million including the overseas territories.

It is difficult to give “slower activity” a statistically meaningful definition. However, there are some ways to measure it, and as Eurostat has shown there is a widespread problem in Europe with people not getting full-time jobs. Part of the reason, especially in the French case, is the incredible rigidity of their hire-and-fire laws. But on top of that there is also the problem with unending austerity – aimed at saving the welfare state when tax revenues decline – which depresses overall economic activity. So long as European austerity continues there can be no recovery in private-sector activity. As a result, the French government will fail miserably in its attempts to put the economy back on a growth track again. This failure includes the so called “responsibility pact” that the socialist government came up with last year. Euractiv again:

These figures were published on the day when Prime Minister Jean Marc Ayrault was meeting with employers’ and trade unions’ organisations to launch the “responsibility pact” announced by the president and which looks to reduce employers’ contributions in exchange for commitments for more job creation.

Long story short, the French government is doing practically everything wrong. That includes trying to take advice from its German neighbor. Back to Euractiv (and a poorly written part of the article):

The situation is Germany is radically different. At the beginning of January, Germany unveiled that after four months of rising unemployment, figures fell by 15,000 to 2965 million [sic!] in December in seasonally adjusted (SA) data, according to the Federal Labour Office. The unemployment rate remained stable at 0.9%, [sic!] close to its lowest level since 1990, after a peak in 2011. In absolute numbers the job seekers, however, increased by 2.87 million against 2.80 million in November and the unemployment rate reached 6.7% against 6.5%.

Obviously, Germany does not have 2,965 million unemployed – the article meant to say 2.965 million. Also, the German unemployment rate is not 0.9 percent… The latest monthly Eurostat figure, from November 2013, is a seasonally adjusted 5.2 percent. This is still low, and less than half of the EU average. But the trend is no longer downward, and there is a good reason for that. Consider the following national accounts numbers for the German economy, reported in fixed prices:

2007 2008 2009 2010 2011 2012 2013
Gross exports 8.0% 2.8% -13.0% 15.2% 8.0% 3.2% 0.6%
Private consumption -0.2% 0.8% 0.2% 1.0% 2.3% 0.8% 0.9%
GDP 3.3% 1.1% -5.1% 4.0% 3.3% 0.7% 0.4%

The Gross exports numbers explain why the German economy has been so good at producing jobs recently. But as the number for 2013 shows, that boom is tapering off. In order to keep growing, the German economy would need the domestic, private sector to take over. The only way this could happen is if private consumption went into high gear, obviously has not happened. Over the seven years reported here, German private consumption has exceeded two percent growth in one year only, namely the second year of the fabulous export boom of 2010-11. With consumption growing at less than one percent, and the export boom coming to an end, it is safe to say that the German economy will not continue to push down its unemployment rate. Not surprisingly, GDP growth is now below one percent for the second year in a row, with a declining trend.

These numbers from Germany verify that the European economy completely lacks ability to grow on its own. The reason, again, is the depressing campaign to save fiscally doomed welfare states in the midst of a recession. If Europe’s political leaders had the courage – as well as moral conviction and economic insight – to let go of the delusion of a big, redistributive government, then Europe would quickly rise to once again become an engine in the global economy.

Until that happens, Europe’s fate is the same as that of other formerly great industrial nations, such as Argentina. However, because of the extreme rigidity of European politics I fear that the economic wasteland opening up in Europe will have consequences that reach even farther than the decline and fall of one of Latin America’s economic powers.

Greece: From Depression to Stagnation

We have heard it before: the tide is turning in Greece. Just one more austerity package, and things are finally going to get better. As I have explained repeatedly, and correctly, these predictions of better times have been nothing but hot air.

Over the weekend the EU Observer published another story predicting macroeconomic sunshine in Greece. This time, though, there is a grain of truth in the rhetorical optimism. But just a grain.

Here is what the EU Observer reported:

After six consecutive years of recession, the Greek economy might finally be allowed to leave its life support machine this year. The country’s debt burden should start to fall in 2014. So should unemployment. It may even post economic growth by the end of the year. Both Greek and EU officials insist that the tide is finally turning.

First of all, this is not a recession. When a country loses one quarter of its GDP in five years, and when more than half of its young are unemployed, it is in a depression.

That said, a look at some economic data from Eurostat indicates that for the first time since the crisis started, Greece may actually be seeing the end of its multi-year decline. More on those numbers in a moment. First, back to the EU Observer:

But if the Greek economy is no longer on the precipice of one or two years ago, it is hardly in good health. At 27 percent, Greece has the highest jobless rate in the EU. Its debt pile is also Europe’s highest at around 180 percent of GDP. More than a quarter of its economic output has been wiped out since 2007. The Greek government has forced through a programme of spending cuts, tax rises and labour reforms of unprecedented severity. … [Greek finance minister Stournaras] points out that in three years Greece’s primary budget balance has been transformed from being in deficit to the tune of 14 percent to a surplus of 6 percent.

The transformation of a deficit into a surplus has taken place while the fundamental tax base – GDP – has shrunken by one quarter, while poverty has skyrocketed and unemployment has turned into an epidemic. This means that the budget deficit has been wiped out not by means of sound, growing private-sector economic activity, but by a total recalibration of the Greek welfare state. In other words,

  • The eligibility criteria for entitlements have been totally revamped, primarily by severely cutting what people are eligible for (such as health care, unemployment benefits and subsidies for medical drugs);
  • The taxes that pay for the significantly smaller government spending programs have gone up in order to compensate for the revenue loss that follows when the tax base shrinks.

Austerity as applied to Greece and other EU member states is really nothing more than a massive recalibration effort. To see why, consider the following example. Government spends 100 euros and pays for it with 100 euros worth of taxes. GDP is 1,000 euros.

A recession hits, shrinking GDP to 950 euros. At constant tax rates – and with a very simple tax system – tax revenues fall to 95 euros.

Government now wants to close its budget gap, but not by encouraging GDP growth. Its method is instead that of traditional European austerity, combining tax hikes with spending cuts. It decides to cut spending by 2.50 euros and increase revenue by 2.50 euros. In order to accomplish the latter, government raises tax rates by 0.26 percent.

As the higher taxes and the lower spending impact the economy, GDP will continue to contract. The process can go on for years, as demonstrated in, e.g., Greece.

The recalibration is aimed at making government spending – the welfare state – fit into a tighter tax base. This is in fact the overarching purpose with austerity, a fact we should never forget when we analyze the European crisis. It explains why the EU and the Greek government have decided that one quarter of the Greek GDP is a perfectly acceptable sacrifice: their welfare state is more important than the jobs and the future prospects of more than 25 percent of the Greek workforce, and more important than the jobs and future prospects of six out of ten young Greeks.

Consider this for a moment while we hear a bit more from the EU Observer:

Labour costs have also seen a 25 percent reduction. Stournaras also says that average incomes have fallen by 35 percent in the past four years, signifying a huge drop in Greek living standards. … [Finance minister Stournaras] commented: “In economics there is no black and white but I am confident that there is going to be growth this year.” However, the pain is by no means over. Exports increased by 5.4 percent in the first eight months of 2013 to €18.28 billion but, if you exclude petroleum products, the figures are much less impressive – an overall drop of 2.6 percent worth €293.8 million. … Although an export surplus has long been a key target for the European Commission and Greece, it does not necessarily translate into a boon for the economy. Anaemic exports alongside declining consumption is a recipe for a spiral of deflation rather than growth.

Which brings us to some Eurostat numbers for Greece:

Changes over same period previous year; adjusted for inflation
2011Q2 2011Q3 2011Q4 2012Q1 2012Q2 2012Q3 2012Q4 2013Q1 2013Q2 2013Q3
GDP -7.9 -4.0 -7.9 -6.7 -6.4 -6.7 -5.7 -5.5 -3.7 -3.0
Private consumption -6.5 -2.5 -7.1 -9.6 -8.8 -7.5 -9.9 -8.5 -4.5 -3.9
Government debt, pct of GDP 159.0 163.7 170.3 136.5 149.2 151.9 156.9 160.5 169.1
Unemployment, 15-64 16.6 17.9 20.9 22.8 23.8 25.0 26.3 27.6 27.3 27.2
Unemployment, 15-24 43.1 45.0 49.9 52.7 53.9 56.6 57.8 60.0 59.0 57.2

There is a slowdown in the decline of GDP, but it is still declining. The same is true for the contraction of private consumption. Both unemployment measures show jobless rates plateauing, with a possible beginning of a decline on the youth side. Government debt, though, has continued to rise just as before, a fact I discussed at length back in September.

Undoubtedly, there is a convergence of indicators – GDP, private consumption and unemployment – which could be interpreted as the beginning of the end of Greece’s long, depressive decline. Under one important condition, I am willing to predict that these indicators are right, namely that the slight downturn in youth unemployment is the result of an actual, microscopic but still real increase in employment among the young.

This is a hugely important condition. If the decline is instead the result of young Greeks emigrating, then we have to exclude that variable, and open for the possibility that the plateauing of general unemployment is also due to emigration.

The slowdown in private-consumption decline could indicate that the end of unemployment rise is in fact not caused by emigration. However, the downward trend in consumption is still pretty solid, continuing at levels that we normally see in economies in serious recessions. This means that the economy as a whole is still on the depression track. Furthermore, the decline in private consumption during the depression has been so massive that what remains at this point of people’s regular spending is the bare-bones deemed quintessential for life in a poor, but still industrialized country. In other words, there is not much left for people to cut down on.

One explanation does not exclude the other. The fact that consumption is down to its bare bones could mean that households will be flattening out their spending. This stabilizes the economy at its “survival core”, where all the extras outside of mere, industrial-life survival, are cut away. As this happens, the job loss trend also flattens out, as there fewer and fewer businesses remain in the non-survival sector of the economy. As a result, there are fewer and fewer jobs to cut away.

This is the most probable explanation. It goes well with what the OECD said in November, namely that Greece will not at all recover in 2014. It also fits well with my analysis of the European crisis as a structural transition from prosperity into industrial poverty (more on that in my new book Industrial Poverty, tentative publication date July). Under this explanation, what Greece has to look forward to is not a recovery, but a stagnation that in theory can last forever. Consider life under communism in Eastern Europe a good indicator.

I wish I could be more optimistic, but so long as the ideological preference behind the fiscal policy of both the EU and the Greek government is to preserve the welfare state at all cost, that is where Greece – and eventually the rest of Europe – is heading.


Still No Recovery in Europe

Never bark at the Big Dog. The Big Dog is always right.

Europe’s tarnished political leadership, primarily in the form of the European Commission, is desperately trying to talk the European economy out of its glacial freeze. While some people with limited insight into what is actually going on in Europe are adopting the false narrative as facts, the truth always prevails. Alas, this report from Euractiv.com:

The eurozone economy all but stagnated in the third quarter with France’s recovery fizzling out and slower expansion in Germany, the latest growth data released today (14 November) showed. Although the €9.5 trillion economy pulled out of its longest recession in the previous quarter, record high unemployment, lack of consumer and market confidence continue to choke a more solid rebound.

This should not surprise anyone. The macroeconomic foundation of the European economy has not changed, nor has any policy been enacted that can be expected to change it for the better. Europe’s debt problems are worse than America’s, unemployment is going up, not down, and as a result GDP growth numbers are what you can expect when you have pounded away at the private sector with reckless austerity policies for years.

Here is what the report from Eurostat says:

GDP rose by 0.1% in the euro area (EA17) and by 0.2% in the EU28 during the third quarter of 2013, compared with the pervious quarter, according to flash estimates … In the second quarter of 2013, GDP grew by 0.3% in both zones. Compared with the same quarter of the previous year, seasonally adjusted GDP fell by 0.4% in the euro area and rose by 0.1% in the EU28 in the third quarter of 2013, after -0.6% and -0.2 percent respectively in the previous quarter.

Quarter-to-quarter data can be fun to look at, but when it comes to establishing trends you have to look at year-to-year numbers. Anyone wishing for a European recovery should therefore take very seriously the fact that its GDP declined by an annualized 0.4 percent in the third quarter. The fact that the eleven non-euro EU states managed to perform slightly better is hardly a source for joy either, given that the end result is a virtual GDP standstill.

This is obviously bad news for welfare states struggling to feed their entitlement programs, as their tax bases will continue to lag behind demand for money from those same entitlements. But even worse is the fact that Europe still is nowhere close to growth rates needed to bring down unemployment: according to the well-established Okun’s law it takes at least two percent GDP growth to shrink unemployment.

Adding insult to the GDP growth injury, Eurostat also recently reported that in the third quarter of 2013:

This is not the picture of an economy in recovery. It is the picture of an economy in long-term stagnation.

The Euractiv story has more details:

The French economy contracted by 0.1%, snuffing out signs of revival from robust growth in the previous three months. It had been expected to post quarterly growth of 0.1% and has now shrunk in three of the last four quarters. German growth slowed to 0.3%, from a robust 0.7% in the second quarter, but Europe’s largest economy clearly remains in much better shape.

That is putting it generously… The French growth slowdown is probably the result of a spike in government spending. The socialist government started its tenure in power with a new entitlement spending spree, something that gives a temporary boost to GDP but has no lasting effects. Furthermore, the socialists also saw to it to raise taxes, which needless to say takes a toll on economic activity.

Alas, no reason to be surprised that the French economy is back to stagnation.

Euractiv notes this:

France is becoming a focus for concern within the currency bloc. The Bank of France predicts the economy will expand by 0.4% in the last quarter of the year but the government’s labour and pension reforms are widely viewed as too timid. “It was particularly disappointing to see France suffer a renewed dip of 0.1% quarter-on-quarter in GDP which highlights concern about its underlying competitiveness,” Howard Archer, an economist with IHS Global Insight, said. A report on French competitiveness by the Paris-based Organisation for Economic Cooperation and Development warned that it is falling behind southern European countries that have cut labour costs and become leaner and meaner.

That has not helped those economies yet, and no one should expect any improvement until austerity is over. However, the connection between austerity and GDP growth is for some reason overlooked by virtually all the players on the European forecasting scene. That is especially true for the European Commission, whose forecast that…

the currency area will shrink by 0.4% over 2013 as a whole before growing by a modest 1.1% in 2014

is almost by definition going to be too optimistic.

Unless, of course, one changes the perception of what growth means. Euractiv again:

Spain reported last month that it had pulled clear of recession in the third quarter, albeit with quarterly growth of just 0.1%, putting an end to a recession stretching back to early 2011. Portugal is still struggling with austerity as part of its bailout plan yet managed to grow by 0.2% in the third quarter following stunning 1.1% expansion in Q2.

A growth rate of 0.7 percent is “robust” and 1.1 percent becomes “stunning”…

If that is the new normal, then I will be right on one more point: Europe has entered an era of industrial poverty.

Inflation and the Welfare State

On September 20 I explained the welfare-state debt game, noting that Europe’s welfare states have put themselves in a very dangerous situation. Their debt levels are rising steadily, despite years of attempts by the EU to get budget deficits under control, and the European Central Bank has decided to pump out whatever amount of money they think is needed in order to avoid debt default among euro-zone states. The money pump is hooked up to a bond buyback program where the ECB promises to buy every single Treasury bond issued by a troubled welfare state, any time, anywhere.

In the short term, this program is theoretically going to prevent a “run on the bond” where investors lose confidence in the Treasury bonds from one country and dump them onto the market. In practice, this program has cemented high interest rates for troubled welfare states and could even push international rates up over time: after all, why should you buy a Swiss Treasury bond at little over one percent interest when the ECB gives you an ironclad guarantee for a Greek bond at ten percent interest.

Over time, though, another threat looms, namely inflation. The ECB is already pumping out new M-1 money at a rate close to eight percent per year; since the euro-zone economy is not growing there is no growth in transactions demand for money. In short: people’s spending is at a standstill, so they can do with the same amount of money every month. Instead of feeding a need among the general public for liquidity, the M-1 money pump is going toward purchases of Treasury bonds from struggling welfare states. The ECB is using its monetary printing presses to cover budget deficits across the euro zone.

Europe’s welfare states are refusing to structurally reform away their entitlement programs. Instead they have entered a dangerous alliance with the ECB to keep funding spending programs their taxpayers are chronically unable to pay for.

In the end, funding the welfare state with printed money is a recipe for high, lasting inflation rates. Venezuela is an example of sorts, but a better one is Argentina, where entitlement spending, paid for with runaway money supply, has driven inflation up to a socially and economically explosive 30 percent. Needless to say, this inflation rate is crushing the Argentine currency, just as runaway inflation always does.

The combination of a welfare state with persistent budget deficits and a central bank willing to fund those deficits until the next Big Bang is basically a ticket for the high-speed train into a macroeconomic disaster zone. So far the “new” Europe has withstood inflation – their latest fight with it was in the late ’70s – but that could also be the reason why the leaders of the EU do not see where they are heading.

To make matters worse, the same could be said about the United States. We have a smaller government, higher growth, lower unemployment and a more resilient political system than the Europeans. If any economy in the world can avoid a new encounter with inflation, it is ours. But that holds true only for as long as we make responsible decisions, on Capitol Hill as well as in the board room of the Federal Reserve.

While I do believe that our political system will actually be able to handle the budget deficit problem, I would not bet on the right solution unless I knew for sure that the Federal Reserve would see the dangers in pumping more newly-printed dollars into the federal budget. So far Ben Bernanke has been a disappointment on this matter, and I have serious questions about his designated successor, Janet Yellen. She has been quoted as an “inflation dove”, i.e., as someone who is willing to keep feeding the Treasury even at the expense of higher inflation.

Normally a person in her position would meet fierce resistance from established economists and people in Congress. After all, Americans in general harbor a clear hostility toward inflation, and even Democrats detest it – almost as much as they hate Sarah Palin.

But there seems to be a change in tone in the public debate when it comes to inflation. A good example is a story from Moneynews.com back in August:

The economist whose research foreshadowed the unusually long slog back from the 2008 financial crash is calling for the unlikeliest kind of central banker to lead the Federal Reserve: one who welcomes some inflation. Harvard University Professor Kenneth Rogoff, whose influential 1985 paper endorsed central bankers focused more on securing low inflation than on spurring employment, is highlighting the benefits of a Fed led by either Janet Yellen or Lawrence Summers precisely because they fail his old litmus test. … What qualifies them in Rogoff’s view is their dovishness, a refusal to place too much weight on stable inflation at a time when unemployment is far above its longer-run level. Rogoff is espousing aggressive monetary stimulus, even at the cost of moderate price increases. At a time of weak global inflation, higher prices may even help the U.S. economy by lowering real interest rates and reducing debt burdens, he said.

Professor Rogoff is playing with fire. The old notion that inflation is a monetary phenomenon, caused by too much money supply, has been thoroughly proven wrong. You can flood an economy with all the liquidity you want – if there is no real-sector activity to put all that liquidity to work, there won’t be any activity that can drive up prices. In other words, the transmission mechanisms from the monetary sector to the real sector are weak and slow.

Under the old monetary notion of inflation it would be “easy” for the central bank to keep inflation at a desired level by matching that level with appropriate money supply. But in order for prices to rise as a result of a money supply increase, someone has to spend that new money on a product whose price then rises. That is where the transmission mechanisms come in; had those mechanisms been working as implicitly assumed in monetarist inflation theory, the expansion of the U.S. money supply over the past few years (ten percent in the last year alone) would have caused an explosion in consumer prices. That has not happened, precisely because the private sector is not spending the money. Consumers, bankers and businesses are too uncertain about the future to absorb the enormous amounts of liquidity that the Fed has created.

The one sector that does spend money regardless of the future outlook is – you guessed it – government. Since most of what the federal government spends money on happens to be entitlements, the welfare state is a perfect venue for work-free money to make its way into consumer markets – i.e., circumvent the normal transmission mechanisms from the monetary sector to the real sector. As a result, entitlement spending could drive inflation in the U.S. economy almost as easily as it has done so in, e.g., Argentina.

Therefore, when Professor Rogoff advocates a higher tolerance toward inflation he is in effect giving Congress a blanket endorsement to continue to deficit-spend, and to the incoming Fed chairman to continue funding that spending with newly printed money.

In an article in April, the Huffington Post quoted Yellen as sharing this dovish view of inflation:

The Federal Reserve should focus its energies on bringing down an elevated U.S. unemployment rate even if inflation “slightly” exceeds the central bank’s target, Fed Vice Chair Janet Yellen said on Thursday. Yellen, who is seen as a potential successor to Chairman Ben Bernanke, says she looks forward to the day when policymakers can abandon unconventional tools like asset purchases and return to the conventional business of lowering and raising interest rates, currently set at effectively zero. But she made that clear that time is not near, saying eventual “normalization” of policy by the Federal Open Market Committee is still far in the future. “Progress on reducing unemployment should take center stage for the FOMC, even if maintaining that progress might result in inflation slightly and temporarily exceeding 2 percent,” Yellen told a meeting sponsored by the Society of American Business Writers and Editors.

There is another factor at work here, in addition to the continued monetization of the federal budget deficit. International investors have become cautious about buying U.S. Treasury bonds, up to a point where a ten-year T-bond issued by the U.S. government pays a higher interest rate than the same bond issued by the French Treasury. If at this point the Federal Reserve continues to massively expand the U.S. money supply, the effect could easily be a combination of currency depreciation and considerably higher interest rates.

Currency depreciation quickly creates inflation.

This scenario has already been picked up by international investors. In September, a Bloomberg news report explained:

Inflation expectations in the U.S. are rising in financial markets, and hedge-fund manager Mark Spindel sees Janet Yellen’s candidacy to be the next Federal Reserve chairman as a catalyst. “If it is Janet, I think you have to price in some tolerance for higher inflation,” said Spindel, head of Potomac River Capital LLC, which manages $570 million, and former manager of $15 billion at the World Bank’s private-sector lending unit, the International Finance Corp.

The report did caution that Janet Yellen’s inflation dovishness may not be as unequivocal as some might suggest:

She might prove him and other investors wrong. Her economic framework and communications strategy show little tolerance for higher prices. She led a subcommittee of the Federal Open Market Committee that produced an explicit inflation target of 2 percent, a topic the panel debated for more than a decade. Her policy approach uses models and rules that view stable prices as a necessary condition to try to move the economy toward full employment while holding interest rates near zero. “The market does have it wrong if they think she is going to be soft on inflation,” said Stephen Oliner, a resident scholar at the American Enterprise Institute in Washington and former senior adviser at the Federal Reserve Board. “She has very little tolerance for inflation above the 2 percent target.” As the FOMC subcommittee put together a strategy document published in January 2012, Yellen stood behind a phrase that said anchoring the public’s views on inflation “enhances the committee’s ability to promote maximum employment in the face of significant economic disturbances.”

That may very well be so, but this all happened under Bernanke’s chairmanship, which technically means that he had the last say on inflation policy. But more importantly, while the Fed may have been able to pump galactic amounts of money into the federal budget – and the global economy – during the QE years, without paying any price in the form of inflation, that should not be taken as a guarantee that inflation is not on the horizon now. As the Argentine example shows, there comes a point when a central bank’s faithful funding of a welfare state’s budget deficit turns from a benevolently misguided attempt at stimulating the economy into being an inflation monster.

Once deficit-caused inflation takes charge, it won’t go away until the deficit goes away. To make the deficit go away, Congress will resort to panic-driven spending cuts combined with equally panic-driven tax hikes.

Greek austerity, for short.

I don’t see that point waiting around the corner. But we are moving in its direction. The best contribution at this point would be a clear and unwavering statement from Janet Yellen that she will:

a) end QE,

b) stand firm on the 2-percent inflation target, and

c) will not give in to pleas from either the president or Congress to keep funding their deficit.

What are the chances of this happening? Not huge, but not remote either. If, that is, common sense prevails.

Recovery Eludes EU Economy

Is there a recovery under way in Europe? The EU Observer seems to think so:

The eurozone appears to be edging towards economic recovery, according to data published on Wednesday (24 July). Statistics firm Markit revealed that its purchasing managers’ index (PMI), which measures economic conditions based on data from thousands of companies, hit its highest level in 18 months in July. It rose to 50.4, up from 48.7 in June, driven by increased output from private sector companies in France and Germany.

That’s their indicator?? Don’t bet your house on that recovery. A one-time 3.5-percent rise in an index is not exactly a trend. It is small and unique enough to be a one-time blip, and its cause could be anything from an unusual variation in survey answers (who was on vacation in June?) to a temporary spurt in actual economic activity.

It is important to keep this in mind, because Europeans are craving for a recovery, and understandably so after five years of a destructive recession.

Back to the EU Observer:

It is the first time that the index has cleared 50, which marks the tipping point between recession and growth, since January 2012. Manufacturing data was particularly encouraging. Data from Germany, the bloc’s largest economy, indicated that the country’s traditionally strong manufacturing sector rose to 52.8 from June’s 50.4, the strongest reading since February this year. Meanwhile, France’s manufacturing sector also came close to posting growth, with a PMI of 49.8 (up from 48.4 in June), itself a 17-month high.

Another aspect of this is to look at what industries did well and what industries did not do so well. A clogged-up order book at Airbus could result in a growth in manufacturing at its plants and with subcontractors, large enough to register in aggregate data. This is especially likely if the rest of the manufacturing industriy stays flat or declines.

The news has prompted the Bank of France to project that the country’s economy grew by 0.2 percent in the second quarter of 2013, potentially bringing an end to its recession.

A zero-point-two percent growth in GDP is not a reason to bring out the champagne. According to Okun’s Law, an economy that grows at less than two percent per year is not making forward progress in terms of reducing unemployment and increasing the standard of living among its citizenry. Sad to say, inflation-adjusted French GDP growth from 2005 through forecasted 2014 averages a meager 1.2 percent. The 2014 forecast of 0.8 percent is actually lower than the forecast for 2013, according to Eurostat. This points to an extended, or renewed recession, not a recovery.

In addition, the French consumer is hardly a spendoholic these days. Private consumption is the most important driver behind economic activity, and with consumption growth forecast to 0.3 percent for 2013 and an overly optimistic one percent for 2014, there is no hope for a consumption-driven recovery.

If the PMI index continues to improve I will revise my forecast. As of now, though, I am sticking to my prediction that France is going to remain in a deep, rather depressing state of recession. And the French won’t be alone in their despair: the latest GDP growth analysis from Eurostat had Germany’s economy growing at one percent in 2012 while forecasting 0.3 percent for 2013 and one percent for 2014.

Again, as of today there are no signs of a recovery in Europe. Only faint hope glimmering like fireflies in the darkness of an economic wasteland.

Systemic Errors in Europe’s Economy

A quick note today on the systemic design errors in Europe’s fiscal and monetary policies.

The new narrative in Brussels is that the common currency of the euro zone needs more support from GDP growth in order to remain a strong, credible player in the global economy. The implication is that the recent drop in support for the euro is due to the deep recession. If this is indeed what the Eurocrats really believe, then they have woken up very late to smell the coffee: they themselves are responsible for turning a regular economic recession into a depression-style crisis. Without the austerity madness that Brussels has added to the mix the economic downturn that began in 2008 would have been over by 2011.

But we will never see a full mea culpa from the Eurocracy. All they can muster is to turn down the austerity volume a little bit. British Daily Express reports:

Some EU member states were urged to ease the pace of their spending cuts in a fresh attempt at boosting the struggling single currency. Spain, Portugal, Poland, Slovenia and the Netherlands were all given more time to complete their austerity drives by the European Commission. Strong fears about the continuing recession in France were also raised. The French government was given an extra two years to bring down its budget deficit.

GDP growth is a necessary condition for the elimination of a budget deficit. Austerity stifles growth, because it increases the net cost of government to the private sector. Businesses and families have less money to spend which means they will do whatever they can to reduce their economic activity. The goal is to survive until times get better and they can start improving their lives again.

The problem is that with austerity, times never get better. That long run over which things are supposed to get better never comes to an end. There are numerous examples in Europe of countries that have seen GDP growth disappear because of austerity, but there is no example of a country where austerity has done its intended work and growth has returned.

Therefore, if this is what the leaders of the European Union and the European Central Bank are looking for in order to strengthen the euro, they won’t find it and they won’t strengthen the euro. On the contrary, there is an inherent inconsistency between the euro and the EU constitution that is supposed to support it. One feature of the constitution is the so called Stability and Growth Pact, a series of fiscal-policy rules that impose tight restrictions on the budgets of all EU member states. The Pact is the legislative vehicle that the EU Commission rides on when it imposes austerity policies on member states, policies that are supposed to support and strengthen the euro. But the euro is not strengthened by austerity – it is weakened.

Europe’s economy won’t get better so long as they keep the euro, but a recovery is also prevented by the Stability and Growth Pact. The Pact, in turn, enforces anti-growth fiscal policies that have already cost the European economy tens of millions of jobs.

If this looks like a gigantic systemic error, that is because it is a gigantic systemic error. I am working on an article to elaborate on it, which I hope to have finished in a couple of weeks. Stay tuned.