Europe is still dreaming of inflation. The EU Observer explains:
The eurozone edged out of a four-month period of deflation in April, according to the EU’s statistical agency. An estimate by Eurostat released on Thursday (30 April) found that consumer prices were flat in April 2015, up from -0.1% in March. Prices had fallen for four consecutive months since December.
Inflation data can be confusing. To make it simple yet still accurate, let us compare two “views” of inflation. They both report the so called Harmonized Index of Consumer Prices; the first looks at changes month to month, as reported in Figure 1:
According to this measurement, consumer prices are actually rising in the euro zone, by more than one percent in April.
However, inflation is not measured as month-to-month changes in a price index. It is measured on an annual basis. The measurement can be either calendar year or annual comparisons month by month. In the latter case the usual procedure is to remove seasonal variations from the data in order to obtain a smoother curve reflecting long-term changes in prices.
This method is dubious as it places a filter between the observer and the reality he is trying to understand. I avoid seasonally adjusted data in general as much as ever possible, and inflation data is no exception.
On the contrary, sometimes the seasonally un-adjusted data can reveal anomalies in trends that help explain current events. The following inflation data, based on the same index numbers as Figure 1, is a good example:
When reported on an annual basis, inflation in the euro zone suddenly looks quite different. The downward trend is unmistakably bound for deflation territory (and the trend line here is a third-degree polynomial function, so if there were any changes in the trend we would see them). Reasonably, prices do not plunge into deflation as fast as they do through the inflation part of the chart; once inflation hits zero the down bound trend will weaken drastically, even vanish altogether. However, not only is this a somewhat uncertain prediction – the knowledge among economists about deflation is very limited compared to their knowledge about inflation – but it is also important to keep in mind that even if prices stop plunging there is no reason to believe they will start rising again.
But what about that little uptick at the end of the curve? What about the observed positive price change for April as reported by the EU Observer above?
Here is where we have the true advantage of looking at “real” numbers, not seasonally adjusted ones. Because the data we analyze has not been smoothened out by seasonal adjustments, we have access to all the real-world kinks and crooks in the inflation curve.
Let us compare the period leading up to the little uptick in March of 2015 to the period January to June 2013:
The 2013 excerpt ends with June and an inflation rate of 1.75 percent. For July that year inflation was 1.72 percent, in other words basically the same.
After that, the rate started declining again.
For 2014/15, April is the first month beyond the excerpt. In accordance with the events of the first half of 2013, it is logical that inflation has not yet turned downward again. But it would be rather surprising if there was some sort of rebound in prices back into inflation territory at this point. There simply are no macroeconomic reasons for a rebound to happen.
And at the end of the day, that is where you find the meat and potatoes of this issue. Traditional macroeconomic analysis centers in on GDP growth, consumer spending, private-sector job creation, business investments… If there is no upward movement in those variables, it is very difficult to find any reason why there would be inflation in the economy, especially over time.
There is one exception: pure monetary inflation. The kind they have in Venezuela and Argentina.
Surely nobody in the euro zone would want that? Thought so. Which brings us back to the point just made: there will be no sustained trend of inflation in Europe until the real sector picks up and starts growing again.
On Monday, in an analysis of the ECB’s declared intentions to monetize government deficits and the apparent desire to get the wheels going again in the European economy, I wrote that:
Unless the ECB is planning to buy bonds directly from European consumers, there is no direct connection between Draghi’s bond purchases and consumer spending. If he is hoping to depress interest rates even further and thereby stimulate consumption, then he has very little to play with. In most euro-zone countries interest rates are plunging toward zero – credit is practically available for free.
My comment about consumers was a bit tongue-in-cheek; it should be apparent to everyone, I thought, that handing out cash to consumers is not the way to go if you want more growth, more jobs and more prosperity.
Apparently, I had missed out on just how desperate – or economically ignorant – well-educated people can get. Alas, from Der Spiegel:
It sounds at first like a crazy thought experiment: One morning, every resident of the euro zone comes home to find a check in their mailbox worth over €500 euros ($597) and possibly as much as €3,000. A gift, just like that, sent by the European Central Bank (ECB) in Frankfurt. The scenario is less absurd than it may sound. Indeed, many serious academics and financial experts are demanding exactly that. They want ECB chief Mario Draghi to fire up the printing presses and hand out money directly to the people.
This is being done on a daily basis. Tens of millions of working-age Europeans receive cash directly from government through all sorts of cash entitlements. In 2012 the governments of the 28 EU states handed out 2.37 trillion euros in cash benefits to its citizens. That was an increase of 288 billion euros, or 12.1 percent, over 2008.
In Spain the increase was 15.8 percent, while the economy was in complete tailspin. Greek cash entitlement handouts grew by 11.7 percent; during the same time period the Greek economy shrank by one fifth in real terms.
What some thinkers in Europe are now proposing is, for all intents and purposes, the same kind of cash entitlement program, only with a short-cut administration process: instead of governments borrowing the money from the ECB and then handing it out as entitlements, the ECB should simply send the checks directly to people.
It has not worked when done the traditional way; but shame on those who give up on a hopeless idea – maybe if we print just a little bit more money, and send it to just a little bit more people, then all of a sudden the free cash won’t have the same work-discouraging effect it currently has. If we just churn out a bit more newly printed money, we will find that sweet spot when people start spending like mad dogs.
Back to Der Spiegel:
Currently, the inflation rate is barely above zero and fears of a horror deflation scenario of the kind seen during the Great Depression in the United States are haunting the euro zone. … In this desperate situation, an increasing number of economists and finance professionals are promoting the concept of “helicopter money,” tantamount to dispersing cash across the country by way of helicopter. The idea, which even Nobel Prize-winning economist Milton Friedman once found attractive, has triggered ferocious debates between central bank officials in Europe and academics.
In addition to the fact that proponents of this ludicrous idea won’t learn from existing examples, there is also the tiny little nagging thing called the Stability and Growth Pact – Europe’s constitutional debt and deficit control mechanism. The Pact consists of three parts:
1. Government debt cannot exceed 60 percent of GDP and government deficit cannot exceed three percent of GDP;
2. Member states cannot bail out each other in times of deep deficits; and
3. The ECB is banned from monetizing debt and deficits.
For a long time, member states have almost made a habit out of breaking the first rule. In recent years that has led to intervention from the EU, the ECB and the IMF, also known as the Troika, which has imposed serious austerity programs on those countries. The effect has, at best, been temporary and minor.
Germany broke the second rule when it participated in a bailout of Greece, and the ECB has been stretching the third rule time and time again by its participation in member-state bailouts. If this cash entitlement program goes into effect, it will drive a dagger through the heart of the last, remaining piece of the Stability and Growth Pact.
Der Spiegel is not too concerned with the consequences of the Pact falling apart. Instead, their article centers in on the fight against deflation, a battle that the ECB is not winning:
Draghi and his fellow central bank leaders have exhausted all traditional means for combatting deflation. The failure of these efforts can be easily explained. Thus far, central banks have primarily provided funding to financial institutions. The ECB provided banks with loans at low interest rates or purchased risky securities from them in the hope that they would in turn issue more loans to companies and consumers. The problem is that many households and firms are so far in debt already that they are eschewing any new credit, meaning the money isn’t ultimately making its way to the real economy as hoped.
And the bright minds at the ECB headquarters in Frankfurt did not realize this before they bing lending to banks? Of course they did. They just refused to see the causality between a recession, high household debt and the inability of said households to afford more debt.
Somehow they must have thought that if only you print money fast enough, credit scores won’t matter.
Anyway. Back to the helicopter cash idea and its prominent backers in the highly sophisticated world of advanced economic thinking:
In response to this development, Sylvain Broyer, the chief European economist for French investment bank Natixis, says, “It would make much more sense to take the money the ECB wants to deploy in the fight against deflation and distribute it directly to the people.” Draghi has calculated expenditures of a trillion euros for his emergency program, funds that would be sufficient to provide each euro zone citizen with a gift of around €3,000. Daniel Stelter, founder of the Berlin-based think tank Beyond the Obvious and a former corporate consultant at Boston Consulting, has even called for giving €5,000 to €10,000 to each citizen.
If this is such a good idea, why stop there? Why not crank it up to 50,000 euros? A hundred grand? What is keeping them back?
As an addition to the magnanimous disregard for basic economic theory that is fueling the monetary helicopter:
Many academics have based their calculations on experiences in the United States, where the government has in the past provided cash gifts to taxpayers in the form of rebates in order to shore up the economy.
It is one thing to let people keep more of what they have already earned. It is an entirely different thing to give them what they have not earned. When people get a tax refund they have already been productive, they have already participated in the production of total output in the economy. When people are given a handout they have not earned, they do not participate in that same production process, partially or entirely.
Cash handouts discourage workforce participation. It does not matter if it is a one-time event or a permanent entitlement program: the effect is the same, differing only in how long it lasts. When people reduce their workforce participation they increase their demand for other entitlements as well. That effect is small for temporary cash handouts, but consider what will happen in low-income families if, as a pundit quoted above suggested, the ECB gave away 5,000 or 10,000 euros per resident. A family of four would suddenly have 20-40,000 in extra cash.
How likely is it that both parents in that family will continue to work for the next year, when they just got more cash than one of them earns in a year (after tax)?
More cash in consumer hands and less workforce participation is a recipe for rising prices. Which, one should note, is just the intention behind this program. European economists and politicians are paralyzed with fear over the imminent threat of deflation. They will do whatever it takes to get inflation up to the two percent where the ECB would like it to be.
The problem is that if they succeed in causing inflation, it is going to be a rapid spike, i.e., an upward adjustment of prices very early in the spending cycle that the ECB would stimulate with its cash entitlement program. Retailers and manufacturers, squeezed by seven years of economic stagnation, will be quick to raise prices when they see a reason to do so. The price jump will eat up a large share of the consumption stimulus that helicopter proponents expect. As a result, the effect on jobs will be modest, if even visible.
Because of the inflation bump there will not be any lasting effect of this stimulus. It will be a blip on the GDP radar. The risk, however, is that the higher prices linger, thus putting pressure on money wages across Europe. It probably would not be a serious issue, but it would most likely eradicate any remaining stimulative effects of the helicopter entitlement program.
In other words, it is hard to find reliable transmission mechanisms to take the European economy from where it is today to a recovery simply by doing a one-time cash carpet bombing of the economy.
Yes, there is more bad economic news coming out of Europe. Industrial production fell by 1.9 percent in August compared to the same month last year. Germany, the largest European economy, saw a year-to-year decline of 2.8 percent, but what is even more worrying is that German industrial production fell by 4.3 percent from July 2014 to August, the second highest month-to-month drop in the EU.
Another worrying number comes out of Greece: a decline of six percent year-to-year. While the month-to-month decline is not dramatic i itself at -1.6 percent, the Greek economy has seen industrial production fall month-to-month in five of the past six months. Not a good sign at all.
Furthermore, Sweden, a country filled with large exporting manufacturers, has seen a month-to-month decline in four of the past six months, and five of the past six months on a year-to-year basis.
As far as industrial production goes, Europe is not recovering. At best, stagnation continues. And things don’t look much better on the inflation front, according to Eurostat:
Euro area annual inflation was 0.3% in September 2014, down from 0.4% in August. This is the lowest rate recorded since October 2009. In September 2013 the rate was 1.1%. Monthly inflation was 0.4% in September 2014. European Union annual inflation was 0.4% in September 2014, down from 0.5% in August. This is the lowest rate recorded since September 2009 In September 2013 the rate was 1.3%. Monthly inflation was 0.3% in September 2014.
Despite a frenzy of liquidity expansion, the European Central Bank has not been able to reverse course. Europe as a whole is still heading for deflation. Bulgaria, Greece, Hungary, Spain, Poland, Italy, Slovenia and Slovakia are already in deflation territory. Only five EU member states, Latvia, the U.K., Austria, Finland and Romania have an inflation rate between one and two percent, the highest being 1.8 percent in Romania. The rest of the EU is stuck with zero to 0.8 percent inflation.
No wonder there is a growing conversation about the ailing currency union:
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. But the recent announcement spooked investors, unconvinced that Greece can stand alone.
The unrelenting stagnation of the European economy is bad news in itself for the sustainability of the currency union. If Greece exits, it will de facto but not de jure abandon the currency union. Moreover, things do not get better when Germans cluster together and sue the ECB for its allegedly illegal expansionary monetary policy:
[Critics] which include Bundesbank president Jens Wiedmann, say that the programme goes beyond the ECB’s mandate of maintaining price stability across the 18-country eurozone. They also say that knowing the ECB will buy their debt could make EU chancelleries less prudent. The plaintiffs had filed their case to the German Constitutional court in Karlsruhe, which in February referred the case to the European Court of Justice. In court, Gauweiler’s lawyer, Dietrich Murswiek, described the ECB scheme as an “egregious extension of [the bank’s] powers” which was designed to “avert the insolvency of member states”.
The ECB is not going to reverse course. They are stalwartly convinced that if money supply just keeps expanding, then eventually they can cause a shift from deflation to inflation. So long as they keep expanding money supply, interest rates will trend to zero. So long as interest rates dwell in that territory, more and more investors will turn to stock markets and real estate for profitable investments. This increases the volatility of those markets, without any gain in the real sector of the economy.
GDP at zero growth, double-digit unemployment, prices deflating, money supply exploding. Yep. This can’t go wrong.
But the budget deficit, folks – the budget deficit is now under control. Aren’t you happy?
When young, third-generation unemployed Europeans are getting tired walking up and down the streets looking for the jobs that aren’t there; when struggling former middle-class families have mopped up the scraps of what used to be a promising future; when the patients in austerity-ravaged hospitals are caught between untreated pain and calling the nurse in vain; when they all want to catch a break in their struggle to make ends meet in their new lives in industrial poverty; all they have to do is look up in the sky and see the shining budget balance spreading its glory over the economic wasteland.
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.
Almost everywhere you look in Europe there is unrelenting support for a continuation of policies that preserve big government. Hell-bent on saving their welfare state, the leaders of both the EU and the member states stubbornly push for either more government-saving austerity or more government-saving spending. In both cases the end result is the same: fiscal policy puts government above the private sector and leads the entire continent into industrial poverty.
Monetary policy is also designed for the same purpose, which has now placed Europe in the liquidity trap and a potentially lethal deflation spiral. The European Central Bank is fearful of a future with declining prices, thus pumping out new money supply to somehow re-ignite inflation. In doing so they are copying a tried-and-failed Japanese strategy, on which Forbes magazine commented in April after news came out that prices had turned a corner in the Land of the Rising Sun:
Japan’s government and central bank are likely to get much more inflation than they bargained for. This risks a sharp spike in interest rates and a bond market rout, with investors fleeing amid concerns about the government’s ability to repay its enormous debt load. In the ultimate irony, it may not be the deflationary bogey man which finally kills the Japanese economy. Rather, it could be the inflation so beloved by central bankers and economists that does it.
This is a good point. Monetary inflation is an entirely different phenomenon than real-sector inflation. The latter is anchored in actual economic activity, i.e., production, consumption, trade and investment. It emerges because basic, universally understood free-market mechanisms go to work: demand is bigger than supply. This classic situation keeps inflation under control because prices will only rise so long as producers and sellers can turn a profit; if they raise prices too much they attract new supply and profit margins shrink or vanish.
Monetary inflation is a different phenomenon, based not in real-sector activity but in artificially created spending power. I am not going to go into detail on how that works; for an elaborate explanation of monetary inflation, please see my articles on Venezuela. However, it is important to remember what kind of inflation European central bankers seem to be dreaming of. As they see it, monetary inflation is the last line of defense against a deflation death spiral, regardless of what is happening in Japan.
They may be right. Again, there is almost unanimous support among Europe’s political elite that whatever policies they choose, the overarching goal is to preserve the welfare state. However, there is a very remote chance that something is about to happen on that front. And it is coming from an unlikely corner of the continent – consider this story from France, reported by the EU Observer:
France has put itself on a collision course with its EU partners after rejecting calls for it to adopt further austerity measures to bring its budget deficit in line with EU rules. Outlining plans for 2015 on Wednesday (1 October), President Francois Hollande’s government said that “no further effort will be demanded of the French, because the government — while taking the fiscal responsibility needed to put the country on the right track — rejects austerity.” The budget sets out a programme of spending cuts worth €50 billion over the next three years, but will result in France not hitting the EU’s target of a budget deficit of 3 percent or less until 2017, four years later than initially forecast.
In the beginning, Holland stuck to his socialist guns, trying to grow government spending and raise taxes. However, he soon changed his mind and combined tax hikes with cuts in government spending, as per demands from the EU Commission. Now he is taking yet another step away from established fiscal policy norms by combining spending cuts, albeit limited ones, with tax cuts – yes, tax cuts:
The savings will offset tax cuts for businesses worth €40 billion in a bid to incentivise firms to hire more workers and reduce the unemployment rate. In a statement on Wednesday, finance minister Michel Sapin said the government had decided to “adapt the pace of deficit reduction to the economic situation of the country.”
The “adaptation” rhetoric is the same as the French socialists had when they took office two years ago. What has changed is the purpose: back then their fiscal strategy was entirely to grow government – because according to socialist doctrine government and only government can get anything done in this world. Now they are actually a bit concerned with the economic conditions of the private sector.
This goes to show how desperate Europe’s policy makers are becoming. In the French case it is entirely possible that Hollande is willing to become a born-again capitalist in order to keep Marine Le Pen out of the Elysee Palace. After all, the next presidential election is only three years out. But it really does not matter what Hollande’s motives are, so long as he gets his fiscal policy right.
The EU Observer again:
Last year, France was given a two-year extension by the European Commission to bring its deficit in line by 2015, but abandoned the target earlier this summer. It now forecasts that its deficit will be 4.3 percent next year. The country’s debt pile has also risen to 95 percent of GDP, well above the 60 percent limit set out in the EU’s stability and growth pact. Meanwhile, Paris has revised down its growth forecast from 1 percent to 0.4 percent over the whole of 2014, and cut its projection for 2015 to 1 percent from 1.7 percent. It does not expect to reach a 2 percent growth rate until 2019.
This is serious stuff but hardly surprising. I predict this perennial stagnation in my new book Industrial Poverty. And, as I point out in my book, a growth rate at two percent per year only keeps people’s standard of living from declining- it maintains a state of economic stagnation. There will be no new jobs created, welfare rolls won’t shrink and standard of living will not improve. For that it takes a lot more than two percent GDP growth per year.
Hollande’s new openness to – albeit minuscule – tax cuts should be viewed against the backdrop of this very serious outlook. He will probably not succeed, as the tax cuts are so small compared to the total tax burden, and the tax-cut package is not combined with labor-market deregulation. But the mere fact that he is willing to try this shows that there is at least a faint glimpse of hope for a thought revolution among Europe’s political leaders. Maybe, just maybe, they may come around and realize that their welfare statism is taking them deeper and deeper into eternal industrial poverty.
Europe’s political leaders are getting increasingly desperate, especially since the European Central Bank’s aggressively expansionary monetary policy is proving ineffective. The more money the ECB prints, the worse the euro-zone economy performs.
The desperation is now at such a level that even the president of the ECB, Mario Draghi, is calling for EU governments to start big spending programs. Writes Benjamin Fox at EU Observer:
The European Central Bank (ECB) is preparing to step up its attempts to breathe life into the eurozone’s stagnant economy. During a speech in the US on Friday (22 August), ECB chief Mario Draghi called on eurozone treasuries to take fresh steps to stimulate demand amid signs that the bloc’s tepid recovery is stalling. “It may be useful to have a discussion on the overall fiscal stance of the euro area,” Draghi told delegates at a meeting of financiers in Jackson Hole, Wyoming, adding that governments should shift towards “a more growth-friendly overall fiscal stance.” “The risks of ‘doing too little’…outweigh those of ‘doing too much’”, he added.
Some trivia first. If you want to be rich, you have a condo on Manhattan. If you actually are rich, you have an oceanfront property in West Palm Beach. If you are genuinely wealthy you have a second home in Jackson Hole. The only people who live in Jackson Hole permanently are dyed-in-the-wool Wyomingites like former Vice President Dick Cheney (a very nice man whom I have had the honor of meeting a couple of times). It is a cold place with short, mildly warm summers and long, unforgiving winters. It is also breathtakingly beautiful.
Now for the real story… There is no doubt that Draghi is beyond worried. He should be: his monetary policy is useless. Europe is in the liquidity trap, and the European Central Bank’s expansionist monetary policy is part of the reason for this. For almost a year now Draghi has pushed the ECB to arrogantly violate the principles upon which the Bank was founded. He has printed money at a pace that by comparison almost makes Ben Bernanke look like a monetarist scrooge. More importantly, the ECB has de facto bailed out euro-zone countries even though that is very much against the statutes upon which the bank was founded. They have pushed interest rates through the floor, punishing banks for overnight lending to the bank, and they have a formal Quantitative Easing program in their back pocket.
Furthermore, the ECB was an active party in the austerity programs designed to save Europe’s welfare states in the midst of the crisis. Those programs exacerbated the crisis by suppressing activity in the private sector in order to make the welfare states look fiscally sustainable. Now Draghi is asking the same governments that he helped bully into austerity to stop trying to save their welfare states and instead be concerned with GDP growth.
Superficially this sounds like an opening toward a fiscal policy that uses private-sector metrics to measure its success. However, it is highly doubtful that Draghi and, especially, the governments of the EU’s member states, would be ready to actually do what is needed to get the European economy growing again. The first part of such a strategy would be to a combination of tax cuts and reforms to reduce and eventually eliminate the massive, redistributive entitlement programs that constitute Europe’s welfare states.
The second thing needed is a monetary policy that does not provide those same welfare states with a large supply of liquidity. The more cheap money welfare states have access to, the less inclined their governments are going to be to want to reform away their entitlement programs. On the contrary, they are going to want to preserve those programs as best they can.
Therefore, the last thing the ECB wants to do right now is to launch a QE program. Which, as the EU Observer story reports, is exactly what the ECB has in mind:
The Frankfurt-based bank is preparing to belatedly follow the lead of the US Federal Reserve and the Bank of England by launching its own programme of quantitative easing (QE) – creating money to buy financial assets.
This comes on the heels of the Bank’s new policy to increase credit supply to commercial banks on the condition that they in turn increase lending to non-financial corporations. The bizarre part of this is that in an economy that is stagnant at best, contracting at worst, there is no demand for more credit among non-financial corporations. It really does not matter if banks throw money after manufacturers, trucking companies, real estate developers… they are not going to expand their businesses unless there is someone there to buy their goods and services. If there is no buyer out there, why waste time and money on producing the product – and why take on debt to do it?
I have reported in numerous articles recently on how the European economy is not going anywhere. Growth is anemic with a negative outlook. Unemployment is stuck at almost twice the U.S. level and the overall fiscal situation of EU member states has not improved one iota despite more than three years of harsh, welfare-state saving austerity.
As yet more evidence of a stagnant Europe, Eurostat’s flash inflation estimate for August says prices increased by 0.3 percent on an annual basis. This is a further weakening of inflation and reinforces my point that unless the European economy starts moving again, it will find itself in actual deflation very soon. But the macroeconomic consequences of deflation set in earlier than formal deflation, as economic agents build it into their expectations. It looks very much as if that has now happened.
Deflation is dangerous, but it is not a problem in itself. It is a very serious symptom of an economy in depression. It is important to follow the causal chain backward and understand how the macroeconomic system brings about deflation. This blog provides that analysis; very few others attempt to do so. Ambrose Evans-Pritchard over at the good British newspaper Guardian has demonstrated good insight, and a recent article by David Brady and Michael Spence of the Hoover Institution provided some very important perspectives. But so far insights about the systemic nature of the crisis are not very widely spread.
The only advice being dispensed with some consistency is, as mentioned, the one about more government spending. Dan Steinbock of the India, China and America Institute is an example of the growing choir behind that idea. He does so, however, in a somewhat convoluted fashion. In an opinion piece for the EU Observer he discusses the macroeconomic differences between Europe and America, though in a fashion that almost makes you believe he is a regular reader of this blog:
Half a decade after the financial crisis, the United States is recovering, but Europe is suffering a lost decade. Why? In the second quarter, the US economy grew at a seasonally adjusted annual rate of 4 percent, surpassing expectations. In the same time period, economic growth in the eurozone slowed to a halt (0.2%), well before the impact of the sanctions imposed on and by Russia over Ukraine. Germany’s economy contracted (-0.6%). France’s continued to stagnate (-0.1%) and Italy’s took a dive (-0.8%). How did this new status quo come about?
He is correct about the American economy widening its gap vs. Europe, he is correct about the Italian economy, about the French economy, and about the stagnant nature of the euro-zone economy. What he does not get right is his answer to the question why the European economy has once again ground to a halt:
[In] the eurozone, real GDP growth contracted last year and shrank in the ongoing second quarter, while inflation plunged to a 4.5 year low. Europe’s core economies performed dismally. In Germany, foreign trade and investment were the weak spots. The country could still achieve close to 2 percent growth in 2014-2016 until growth is likely to decelerate to 1.5 percent by late decade. In France, President Francois Hollande has already pledged €30 billion in tax breaks and hopes to cut public spending by €50 billion by 2017. Nevertheless, French growth stayed in 0.1-0.2 percent in the 1st quarter.
Then Steinbock proceeds to make a brave attempt to explain the depth of the European economic crisis:
Fiscal austerity and falling consumer confidence are preventing domestic demand from rebounding, while investment and jobs linger in the private sector. Pierre Gattaz, head of the largest employers union in France, has called the economic situation “catastrophic.” As France is at a standstill, Paris has all but scrapped the target to shrink its deficit. … The new stance is to avoid an explicit confrontation with Germany, but to redefine austerity vis-à-vis budgetary reforms.
It is unclear what Steinbock means by this. He appears to miss the point that there are two kinds of austerity: that which aims to save government and that which aims to grow the private sector. The two are mutually exclusive, both in theory and in practice. One might suspect that Steinbock refers to the government-first version, since that is the prevailing version in Europe. However, that makes it even more unclear what Steinbock has in mind when he talks about “budgetary reforms” – an educated guess would be the relaxation of the Stability and Growth Pact so that the French government, among others, can spend more frivolously.
Such a relaxation would not contribute anything for the better. All it would do is open for more government spending. Steinbock does not make entirely clear whether or not he recommends more government spending. His article, however, seems to lean in favor of that, and I strongly disagree with him on that point for reasons I have explained on many occasions. Let’s just summarize by noting that if Europe is going to replace government-first austerity with government-first spending, then it opens up an entirely new dimension of the continent’s crisis. That dimension is in itself so ominous it requires its own detailed analysis.
As I keep saying, there are no reasons for Europe’s households and entrepreneurs to be optimistic about the future. Therefore, they are not going to spend more money. They are going to drive their economy into the deep, long ditch of deflation, depression and permanent stagnation.
Eurozone private business growth slowed more than expected in August, despite widespread price cutting, as manufacturing and service industry activity both dwindled, a survey showed on Thursday (21 August).
This is an important, but hardly surprising measurement of what is really going on in the European economy. When buyers do not respond positively to price cuts, it means either of two things:
- They cannot afford to increase spending; or
- They are so pessimistic about the future that they hold on for dear life to whatever cash they have.
A less likely explanation is that they speculate, planning their purchases for a future point in time when prices are expected to be even lower. For this to be true there would have to be other signs of improving economic activity, signs indicating that, primarily, households can afford to spend money in the first place. But the European economy does not exhibit any such signs.
First of all, the cuts in entitlement programs may have wound down with some austerity measures coming to an end. But there is only a partial austerity cease-fire, with Greece, Spain, Italy, France and Sweden continuing contractionary budget measures. Austerity measures designed to save the welfare state in the midst of an economic crisis inject a great deal of uncertainty among consumers, as they can no longer trust the welfare state with keeping its entitlement promises. More of household earnings is used to build barriers against an uncertain future, causing consumer spending – the largest item in the economy – to stall or fall.
So long as austerity remains a threat to the European economy, consumers are going to hesitate.
Secondly, employment is not growing. People’s outlook on the ability to support themselves in the future is not improving. Youth unemployment is stuck at one quarter of all young being unemployed, total unemployment is almost at eleven percent and neither is budging. So long as there is no improved prospects for jobs, those who have jobs will not feel increasingly secure in their jobs, and the large segments of the population who are out of work have no more money to spend than what government provides through unemployment benefits (often hit by austerity).
Third, the European Central Bank may be flooding the euro zone with cheap money, but that is not going to help increase economic activity. Its negative interest rates on bank deposits only leaves liquidity slushing around in the banking system, making banks increasingly desperate to put the money to work. But because of the two aforementioned problems there has been no net addition of demand for credit in the European economy. While the liquidity makes no good difference in the real sector, it may find its way into financial speculation. That is a different and troubling story; the point here is that monetary policy is completely exhausted and can no longer help move the economy forward. Since the fiscal policy instruments of the European economy are entirely devoted to government-saving austerity, there is no clout left in the economic policy arsenal. The Europeans are left to fend for themselves, mired in uncertainty and stuck having to fund the world’s largest government.
In other words, there is no reason to be surprised by the lack of demand response to declining prices. There are, however, a lot of reasons to be worried about Europe’s future. Euractiv again:
Economic growth ground to a halt in the second quarter, dragged down by a shrinking economy in Germany and a stagnant France … Markit’s Composite Purchasing Managers’ Index (PMI) will provide gloomy reading for the European Central Bank (ECB), suggesting its two biggest economies are struggling like smaller members. Based on surveys of thousands of companies across the region and a good indicator of overall growth, the Composite Flash PMI fell to 52.8 from July’s 53.8, far short of expectations in a Reuters poll for a modest dip to 53.4.
Technically, any index number above 50 means purchasing managers are still expanding purchases. However, since the second-order trend is negative – the increase is flattening out – it is only a matter of a little bit of time before the PMI index itself goes negative. Shall we say three months? The Euractiv story gives good reasons for that:
Markit said the data point to third-quarter economic growth of 0.3%, matching predictions from a Reuters poll last week. “We are not seeing a recovery taking real hold as yet. We are not seeing anything where we look at it and think ‘yes, this is the point where the eurozone has come out of all its difficulties’,” said Rob Dobson, senior economist at Markit.
Again, an economist whose thinking is upside down. The right question to ask is not when the European economy is going to recover. The right question to ask is: what reasons does the European economy have to recover in the first place? In the emerging deflation climate, and with the economy stuck in the liquidity trap where monetary policy is completely impotent, Europe’s households and entrepreneurs have no reasons to change their current, basically depressed economic behavior.
Deflation is the most worrying part of their crisis. Says Euractiv:
Consumer prices in the eurozone rose just 0.4% on the year in July, the weakest annual rise since October 2009 at the height of the financial crisis, and well within the ECB’s “danger zone” of below 1%. Worryingly, according to the composite output price index firms cut prices for the 29th month – and at a faster rate than in July. … Also of concern, suggesting factories do not expect things to improve anytime soon, manufacturing headcount fell at the fastest rate in nine months.
This is not a protracted recession. This is a new normal, a state of permanent stagnation.
A state of 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.
Yes, folks, it’s time for one more article on Europe’s deflation threat. This one adds a bit more to the picture of just how dangerously close Europe is to deflation.
The European central bank will almost certainly act this week to breathe life into the eurozone’s struggling economy after a shock fall in inflation, economists said. An unexpected fall in annual inflation to 0.5% in May from 0.7% in April appeared to seal the case for additional stimulus when the ECB announces its June policy decision on Thursday. It remains well below the ECB’s target of just under 2%, and surprised economists polled by Reuters who had forecast no change.
The “Thursday” that the Guardian refers to is, of course, last Thursday’s ECB meeting where they decided to introduce negative interest rates on banks’ overnight deposits. Banks now pay a penalty for depositing money with the central bank, a move that the ECB hopes will encourage banks to lend even more aggressively to the private sector.
The problem is that the private sector in Europe in general does not have enough confidence in the future to take on more debt. Those that would gladly borrow more money are probably not credit worthy, due to half a decade of recession, unemployment and struggling businesses. Banks therefore end up with piles of liquidity they cannot make money on – unless they lower their credit standards.
Hopefully that will not happen. Back to The Guardian:
Christine Lagarde, the head of the International Monetary Fund, has been among those to raise concerns that “lowflation” will persist against the backdrop of a sluggish recovery in the 18-nation eurozone, urging the ECB to act. The fear is that weak price pressures could ultimately trigger a dangerous deflationary spiral, where consumers and businesses put off spending amid expectations that prices will fall further still. May’s fall in inflation dragged the annual rate back down to March’s four-and-a-half year low. Eurostat, the region’s statistics office, said food, alcohol and tobacco prices rose by just 0.1% in May compared with a year earlier, while energy prices were flat, as were non-energy industrial goods prices.
And this after years with a money supply that has increased several times faster than money demand, leaving plenty of new liquidity out in the economy.
All this with no effect on GDP growth. Back to The Guardian:
A sustained recovery has yet to take hold in the eurozone, with growth slowing to 0.2% in the first quarter, down from 0.4% in the previous quarter. There was some slightly better news from the labour market on Tuesday, as the unemployment rate fell unexpectedly to 11.7% in April, from 11.8% in March. The number of people out of work fell by 76,000 to 18.75 million. But the headline figure hid big disparities between the 18 member states. The lowest jobless rates were recorded in Austria at 4.9% and Germany at 5.2%. Greece had the highest rate, at 26.5% in February, followed by Spain at 25.1%. Youth unemployment also fell in the eurozone, by 202,000 to 3.38 million people. The rate fell to 23.5% from 23.9% in March. But more than half of young people in Greece and Spain do not have a job.
Small changes back and forth in unemployment make no difference over time. It would take a closer look at employment rates and similar data to find out if this is indeed the beginning of a recovery, or simply an exit from the workforce entirely. The abysmal GDP numbers would indicate the latter.
With no recovery in sight, deflation is still a real possibility in Europe. It is definitely more likely than a sustained recovery.
I have explained on numerous occasions that the European economy is not at all in recovery mode. Jobless numbers are frighteningly bad, the long-term trend is still pessimistic, GDP growth is so slow that there is a credible deflation threat hanging over Europe, the OECD recently wrote down its growth forecast for the global economy, including the EU. All in all, Europe is a slow-motion economic disaster.
Now British newspaper The Guardian reports of yet another dark cloud over the European economy:
The eurozone’s fragile economic recovery suffered a setback in the first quarter after slower-than-expected growth. The combined currency bloc scraped together growth of 0.2% between January and March, in line with growth in the previous quarter but disappointing expectations of 0.4% growth.
This amounts to 0.8 percent for the entire year, which is deeply insufficient to turn around the European economy. The best you can say about this growth figure it is yet another indicator that my forecast of Europe being stuck in long-term stagnation is correct. This long-term stagnation is not a recession – it is a new era for the European economy.
There was a huge divergence in fortunes, with Germany growing at the fastest rate of all 18 countries, with gross domestic product increasing by 0.8%. It followed 0.4% growth in Europe’s largest economy in the previous quarter. The pace of recovery also accelerated in Spain, with growth of 0.4% outpacing a 0.2% increase in GDP in the previous three months.
I have explained before that the German economy is growing because of its strong exports. The gains from the exports industry do not spread to the rest of the economy, as is evident from paltry domestic spending figures for the German economy. The same is, in all likelihood, true for the Spanish economy, whose national accounts I will take a look at as soon as time permits.
When exports drive a country’s GDP growth, the country is not in a sustained recovery. The only way a sustained recovery can happen is if private consumption and corporate investments increase together. That is not yet happening in Germany, and it is certainly not happening in Spain.
At the bottom of the pile was the Netherlands, which suffered a shock 1.4% contraction in GDP, reversing 1% growth in the previous quarter. Portugal’s economy shrank by 0.7%, following growth of 0.5% in the final three months of last year. The French and Italian economies were also dealt a blow, with zero growth in France and a 0.1% contraction in Italy in the first quarter. It followed 0.2% growth and 0.1% growth in the fourth quarter of 2013.
Stagnation, for short. And the only remedy that Europe’s political leaders seem to be able to think of is to print even more money, to saturate the economy with liquidity and to thus depreciate the euro vs. other major currencies. But with the Federal Reserve continuing its Quantitative Easing policy and the Chinese facing major problems in their financial sector it is entirely possible that the attempts at eroding the value of the euro will be neutralized by similar attempts from two of the world’s other major central banks. That in turn will put a damper on exports and rob the Europeans of even the illusion that their GDP will at some point start growing again.
At the end of the day, the fact that this negative news disappoints so many people in Europe is yet another indicator that my new book, Industrial Poverty, out in late August, is badly needed.