Deflation or Recovery?

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

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

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

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

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

Back to EU Business:

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

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

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

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

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

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

One last point from the EU Business article:

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

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

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