European Economy Beleaguered by Recession

The European economy is in trouble. After a few years of slow growth it is now making a turn for the worse. EurActiv reports:

The eurozone economy shows little sign of recovering before the year-end despite an easing of financial market conditions, European Central Bank Mario Draghi said on Thursday (8 November) after interest rates were left at a record low. The ECB held its main rate at 0.75%, … “Economic activity in the euro area is expected to remain weak although it continues to be supported by our monetary policy stance and financial market confidence has visibly improved on the back of our decisions,” Draghi told a news conference.

That monetary policy is basically the open-ended commitment that the ECB has made to print unlimited amounts of money to buy treasury bonds from troubled euro-zone welfare states, from Greece to Portugal. By promising to flood the euro zone with fresh cash, the ECB intends to keep interest rates down, in the hope that their policy will combine two things:

  • Low investment financing costs for private businesses, intended to stimulate business growth; and
  • Low financing costs for government deficits aiming to keep debt service costs – i.e., current government expenditures – down.

The low interest rates will not help on either front. Businesses do not make major investment decisions based prmarily on their funding opportunities, but instead on the so called marginal efficiency of capital. Simply put, that is their expectations of what they can earn on their investments. The higher their expected earnings, the more inclined they are to invest. Since earnings are defined primarily by sales, a low interest rate won’t help if the economy as a whole is in the tank.

Simple Keynesian macroeconomics.

As for government deficits, a low interest rate will only encourage them to borrow more. By making its open-ended bond purchasing promise, the ECB has effectively destroyed the market mechanism for risk management. Governments that will never be able to pay down their debt (hello Greece?) can continue to rake up debt more or less with impunity.

Sadly, it seems like more expansive monetary policy – pushing for lower interest rates – is the only economic-policy instrument that the Europeans are willing to use to revive their economy. EurActiv again:

Gloomy data this week indicated the eurozone economy will shrink in the fourth quarter, which the ECB could eventually respond to by cutting rates. Recent survey evidence gave no sign of improvement towards the end of the year and the risks surrounding the euro area remain on the downside, Draghi said. He signalled the ECB would downgrade its GDP forecasts next month, describing “a picture of weaker economies”, and said inflation would remain above the ECB’s target for the rest of the year, before falling below two percent during in 2013. Before making any decision to cut rates further, the ECB will focus on making sure that its looser policy reaches companies and households across the eurozone, a mechanism that has been broken by the bloc’s debt crisis.

It is not entirely clear what he is saying here, but he is probably referring to where the new money supply is going. It is not replenishing the balance sheets of banks willing to lend to the public, but instead padding the pockets of governments. The mechanics of monetary policy are more complicated than this, but if this is how the ECB thinks, they are essentially correct: government spending, and the credit funding it, is absorbing resources that would otherwise have benefited the private sector. (For those who are familiar with the “crowing out” effect of the IS-LM model, this is somewhat different. But that’s a story for another day.)

Another aspect to the debt crisis is that a long, gloomy recession has weakened the finances of private citizens. In many instances this is leading to a new private-sector debt crisis. Sweden is steaming toward a housing bubble, and in Germany an increasing number of families can no longer afford their mortgages, car loans, credit cards, etc. German reports (including an informative chart) that “overindebtedness” – defined as more debt than someone can handle – has grown notably since 2009:

Die Zahl der überschuldeten Bürger hat sich in Deutschland wieder erhöht.  Gegenüber dem Vorjahr erreicht die Schuldnerquote 9,65 Prozent (2011: 9,38 Prozent). Damit sind 6,59 Millionen erwachsene Bundesbürger überschuldet – im Vorjahr waren es 6,41 Millionen.

This is a small but important sign that the German economy is not going anywhere but down over the next six to nine months. That in turn means less money from German taxpayers to bail out the crumbling welfare states down south of the Alps. And that, in turn, spells even more trouble for politicians in Athens, Rome, Madrid and Lisbon who are trying desperately to keep their sinking welfare states afloat.

So where does this new European recession come from? It’s quite simple: austerity. When governments take more and give less, they drain the private sector of resources while discouraging productive business activity through higher taxes. Businesses and households have less money to spend, which leads to less productive economic activity – and a shrinking tax base. As the tax base shrinks, governments fail in their attempts to balance their budgets. That means more deficits.

And more austerity.

And more recession.

Take note, America. It’s time to change course before it is too late.