The Structural Crisis: More Evidence

The European crisis still seems to confuse the continent’s policy makers. After having believed for several years that austerity would both save the welfare state and increase growth, they have now slowly began walking away from the EU’s constitutionally required government deficit and debt rules. Instead, there is now growing belief in government spending as the remedy for the persistent crisis.

For the most part, the debate now seems to gravitating toward the question of how much government stimulus is needed. If the continent is indeed in a recovery mode, as some suggest it is, then there is not this big need for more government spending.

It is understandable that some believe there is a recovery under way. According to Eurostat, GDP for the EU as a whole grew by an inflation-adjusted 1.5 percent in the first quarter of 2014, over the same quarter of 2013. This is an increase from the last quarter of 2013 (1.0 percent) and in fact the fourth quarter in a row with improving growth numbers.

Technically, this represents a recovery. However, in no way does this mean that Europe is out of the crisis. To see why, let us compare GDP growth rates for EU-28 during the 2009-10 spurt to the one that started in 2013:

Q2 2009 Q3 2009 Q4 2009 Q1 2010 Q2 2010
Q1 2013 Q2 2013 Q3 2013 Q4 2013 Q1 2014
2009-10 -5.9 -4.4 -2.1 1.1 2.5
2013-14 -1.3 0.1 0.5 1.0 1.5

Early on in the Great Recession, the European economy made a rapid recovery and kept growing at more than two percent per year for four quarters straight. The rate slowly fell, though, and by the second quarter of 2011 growth was once again below two percent. By the end of that year it was below one percent, and down into negative territory in Q2 of 2012.

But should not a growth spurt count as a definitive recovery? Are not four quarters of improvement enough, especially if followed by a year of growth above two percent?

There is some merit to that argument. The problem is that the growth rates discussed here are not the kind of rates that normally would constitute a recovery, let alone a growth phase of a business cycle. Europe is in a structural crisis, which means that its growth rate is permanently lower than it was before. This is now becoming painfully evident in Eurostat’s national accounts data.

It has now been six years since the Great Recession began. For the entirety of the crisis that we have seen so far, namely 2008-2013, the average inflation-adjusted annual GDP growth rate for the European Union is a depressing -0.1 percent.

This is despite the aforementioned growth spurt.

Compare that to the six preceding years, 2002-2007: 2.4 percent. And that covers the back end of the Millennium Recession. Going back yet another six-year period to 1996-2001, we include the opening and trough of that recession, and still come out with 2.8 percent per year!

To further emphasize the structural nature of the European crisis, let us look at a long-term trend in growth. The following figure illustrates GDP growth in the EU as a six-year moving average. Starting in the fourth quarter of 2001 the average begins by covering the 1996-2001 period. The average is quarter-based to give as detailed an image as possible:

LB GDP EU28 6YR MAVG

The red trend line conveys a chilling message of structurally driven decline. In order to get Europe out of this decline and persistent crisis, economists must re-write their own books on macroeconomics. Surely, the conventional relative-price based advice from accomplished economists such as Michael Spence is still valid: a reduction in the cost of production in Spain vs. other exporting countries will eventually bring about a boost in exports. But as I have pointed out on several occasions, when that boost happens, such as in Germany or Sweden, it has very little influence on GDP growth as a whole. Modern foreign trade in industrialized economies is an isolated activity as many inputs are imported from elsewhere.

But more importantly, the presence of the welfare state throws a heavy, wet blanket over the economy. Austerity, as practiced in Europe in recent years, has added insult to injury by means of even higher taxes and even more perverted economic incentives.

As Michael Spence points out in the aforementioned article, it does not help Europe’s most troubled economies to share currency with Germany. This prevents the exchange rate adjustment needed to reflect global relative production costs. But the conventional macroeconomic wisdom also tends to downplay the growth-hampering effect that welfare states, and welfare-state saving austerity policies, have on GDP.

Spence actually opens for a recognition of this problem in another article together with political scientist David Brady. They acknowledge that modern Western governments have difficulties unifying all their policy goals, including income redistribution. However, Spencer and Brady do not go into more depth on the role that income-redistributing policies may play in causing the downward growth trend illustrated above. Their choice not to do so is understandable – their focus is elsewhere – but it also reflects somewhat of a conventional wisdom among economists: income redistribution and its institutional form, the welfare state, is just another sector of the economy.

It is not. It is the overweight on the private sector that is slowly but inevitably destroying the prosperity of the West. For more on that, stay tuned for my book Industrial Poverty. Out soon!