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.
For more than a year the European economy has been in deflation territory. To reverse that trend the European Central Bank launched its Quantitative Easing program, aimed at flooding the euro zone with liquidity. According to crude monetary theory this will drive up prices in line with the so called quantity theory of money; few if any central bankers would admit that their take on money supply and inflation is this simple, but the only other explanation is so far-fetched that even the quantity theory of money makes sense.
The alternative theory says that the reason why businesses are not investing in Europe is that there is not enough cheap risk capital available in the economy. For this theory to work, though, the cost of borrowing that businesses face would have to have been exceptionally high during the recession. In fact, the exact opposite is true: since the Great Recession started the composite cost of borrowing for non-financial corporations in the euro zone has been in the 2-4 percent bracket. Right before the recession it topped out above ten percent.
In other words, the has been an abundance of liquidity available for anyone and everyone willing – and qualified – to borrow.
But if your business outlook says flat sales, at best, you are not going to take on new loans. And flat sales or worse has been the forecast story for European businesses for six years now.
What does this have to do with inflation? Well, low economic activity means low demand and low utilization of productive capacity. As a result, there is no upward pressure on prices and therefore no real-sector inflation in the economy. Whatever inflation may be looming in the near European future has a monetary origin.
Does this mean that the primitive quantity theory of money is correct? No, it does not. The quantity theory rests on a rigid structure of assumptions regarding the operation of a free market, both in terms of the flexibility of real-sector resources and of free-market prices. The most confounding part of the quantity theory of money is that the economy axiomatically always reverts back to full employment; then, and only then, can monetary inflation occur.
Europe is about to line up with several other countries proving that monetary inflation is just as possible – if not more possible – in a stagnant economy. In fact, when stagnation and low capacity utilization is combined with monetary inflation, there is a macroeconomic venom brewing. The worst response to this situation is one where key decision makers assume that the monetary inflation they see is actually real-sector inflation.
Somewhat surprisingly, that mistake is made by Ambrose Evans-Pritchard, who is without a doubt Europe’s best political commentator. But in his latest column in The Telegraph, Mr. Evans-Pritchard allows his otherwise astute analytical abilities to lead him astray:
Be thankful for small mercies. The world economy is no longer in a liquidity trap. The slide into deflation has, for now, run its course. The broad M3 money supply in the US has been soaring at an annual rate of 8.2pc over the past six months, harbinger of a reflationary boomlet by year’s end. Europe is catching up fast. A dynamic measure of eurozone M3 known as Divisia – tracked by the Bruegel Institute in Brussels – is back to growth levels last seen in 2007.
But GDP growth, business investments, employment and capacity utilization are far from 2007 levels. While inflation back then was a real-sector phenomenon, it is not founded in real-sector activity today.
And that should have us all worried. Evans-Pritchard included:
History may judge that the European Central Bank launched quantitative easing when the cycle was already turning, but Italy’s debt trajectory needs all the help it can get. The full force of monetary expansion – not to be confused with liquidity, which can move in the opposite direction – will kick in just as the one-off effects of cheap oil are washed out of the price data.
I know Mr. Evans-Pritchard is British, but that does not mean he has to entertain an erstwhile concept of liquidity. Just a small comment. Back to his column, where his discussion of inflation is taking a somewhat odd turn:
Inflation will soon be flirting with 2pc across the Atlantic world. Within a year, the global economic landscape will look entirely different, with an emphasis on the word “look”. In my view this will prove to be mini-cyclical in a world of “secular stagnation” and deficient demand, but mini-cycles can be powerful. Mr Stein said total loans in the US are now growing at a faster rate (six-month annualised) than during the five-year build-up to the Lehman crisis.
Again, all macroeconomic indicators point to a continuation of a ho-hum recovery here in the United States, the March GDP numbers notwithstanding. At the same time, practically nothing says that Europe will enjoy anything near a U.S. growth period any time soon. Therefore, it is wrong to compare the inflation rates in Europe and the United States as if they are apples and apples. They are not. Our inflation here in the United States is the result of a steady rise in economic activity, a tightening of available capacity in infrastructure and other capital stock and even a glimpse of labor shortage in some sectors.
In other words, traditional causes of inflation. Europe, on the other hand, still suffers from almost twice the unemployment rate, with GDP growth at half or less the rate of ours. To really drive home the point about Europe’s abundant, idling economic resources, let us once again repeat the point that the cost of borrowing for non-financial corporations is down to 2-4 percent (after topping 10 percent before the Great Recession).
There is in other words no demand-driven push on prices to rise in Europe. This means monetary inflation, and there is an abundance of evidence from the past century on just how destructive and unstable such inflation can be.
Mr. Evans-Pritchard does not see this. Instead, he is worried about monetary tightening in the United States and its possible global effects:
“The risk is that the Fed will have to raise rates much more quickly than the markets expect. This is what happened in 1994,” he said. That episode set off a bond rout. Yields on 10-year US Treasuries rose 260 basis points over 15 months, resetting the global price of money. It detonated Mexico’s Tequila crisis. Bonds are even more vulnerable to a reflation shock today. You need a very strong nerve to buy German 10-year Bunds at the current yield of 0.16pc, or French bonds at 0.43pc, at time when EMU money data no longer look remotely “Japanese”.
Just one second here… No longer remotely “Japanese”? GDP growth for 2014 in the euro zone (19 countries) was 0.89 percent, and 1.3 percent in the EU as a whole. How is that not “Japanese” data??
Yet on some points Mr. Evans-Pritchard does see the underlying real-sector dimension of the inflation issue:
[The U.S. labor market] is turning. The quit rate – a gauge of willingness to look for a better job – is nearing 2pc, the level when employers must build pay-moats to keep workers. It is true that the US economy gave a good imitation of hitting a brick wall in the first quarter. Retail sales have fallen for three months, the worst drop since 2009. The Atlanta Fed’s snap indicator – GDPNow – suggests that growth dropped to stall speed in March. The rise in non-farm payrolls slumped 126,000 in March, half expectations. Yet economies do not fall out of sky. The US has already survived the biggest fiscal squeeze since demobilisation after the Korean War without falling into recession.
And again, some sectors and states are already in tight labor supply. Try hire a Hooters waitress for less than $15/hr in North Dakota. Some trucking companies are pushing annual driver compensation north of $70,000.
But perhaps the problem, at the end of the day, is that analysts and commentators focus on too many variables at the same time. You can certainly look at the economy from an almost infinite number of angles and get different stories out of each one of them, but in reality some angles only show symptoms while others capture the causes. Mr. Evans-Pritchard stretches his analysis a bit thin, going into asset prices and a roster of secondary data, elevating those numbers to the same prominence as – actually higher prominence than – real-sector growth data.
In reality, asset prices depend on real-sector growth data; tainted by speculative expectations, they only give an imperfect image of where the economy is really heading.
When we look at the European and American economies from the angle of real-sector activity, we do again see the gaping difference between a growth, moderately healthy United States and a stagnant, industrially poor Europe. The former has a sound form of inflation on its way; the latter is experiencing the beginning of a dangerous episode of monetary inflation.
That said, I still recommend you all to keep reading Ambrose Evans-Pritchard. He is intelligent and thorough and he has no problem presenting unpopular views if he believes they are merited.
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.
The one good thing about the rising levels of frustration in Europe over the crisis, is that the public debate is being enriched with voices whose message might actually make a difference for the better. Today, a group of leading German economists has decided to speak up against the lax monetary policies of the ECB. This is a welcome contribution, but their contribution would be stronger and more to the point if they also learned a thing or two about what has actually brought Europe into the macroeconomic ditch.
Reports Benjamin Fox for the EU Observer:
The European Central Bank’s (ECB) plans to pump more cheap credit into banks risk undermining the long-term health of the eurozone, according to Germany’s leading economic expert group. The ECB’s “extensive quantitative easing measures” posed “risks for long-term economic growth in the euro area, not least by dampening the member states’ willingness to implement reforms and consolidate their public finances”, the German Council of Economic Experts (GCEE) said in its annual report, published on Wednesday (12 November).
That monetary expansion is indeed a problem. In September 2014 the M1 money supply in the euro zone had grown by 6.5 percent over September 2013. Over the past 12 months the annual growth rate has averaged 5.86 percent, showing that monetary expansion in the euro zone is actually increasing. In fact, adjusted for the large expansions in M1 euro supply that resulted from an expansion of the monetary union, the current expansion rate appears to be the highest in the history of the euro (though that is just a preliminary observation – I am not completely done with the simulation).
If current-price GDP was growing at the same rate, then all the new money supply would be absorbed by transactions demand for money. But the euro-zone GDP is practically standing still, which means that all the new money supply is directed into the financial sector (theoretically known as “speculative demand for money”). That is where the real danger is in this situation.
Unfortunately, the German economists are not primarily worried that the ECB is destabilizing the European financial system. Their concern is instead that lax monetary policy discourages fiscal discipline among euro-zone governments. They appear to be stuck in the state of misinformation where budget deficits are keeping the euro-zone economy from recovering.
Benjamin Fox again:
The Bundesbank is also uncomfortable about the ECB’s increasingly activist role in the bond and securities markets. … But the German call for the Frankfurt-based bank to limit its intervention remains a minority position. Most governments in and outside the eurozone, together with the International Monetary Fund, want the ECB to provide increased monetary stimulus. Last week the Organisation for Economic Co-operation and Development (OECD) also urged the bank to “employ all monetary, fiscal and structural reform policies at their disposal” to stimulate growth in the currency bloc, including a “commitment to sizeable asset purchases (“quantitative easing”) until inflation is back on track”.
Can any economist at the ECB, the IMF or the OECD please explain how the ECB’s money pumping is going to create inflation in any other way than the traditional monetary kind? Nothing in either my academic training as an economist or my 14 years of practicing economics as a Ph.D. gives me the slightest clue how this is supposed to work.
In fact, the only inflation I can see coming out of this would be strictly monetary – and that is not what anyone in Europe wants. Monetary inflation, unlike inflation caused by rising economic activity, can run amok deep into the double digits, as it has in Argentina and Venezuela.
It is good that leading German economists are worried about the ECB’s activities. Time now for them to take the next step and study the true structure of the economic crisis.
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.
The prevailing wisdom in some economics circles, primarily those adherent to orthodox Austrian and monetarist theory, is that an expansion of the money supply automatically causes inflation. The last few years have proven the hardline monetarist view wrong, with massive money supply expansion in the United States and accelerating money printing in the euro zone. That does, however, not mean that there is no connection whatsoever between money supply and inflation. There is, but the money needs a transmission mechanism from the banks – literally – to the real sector where prices are set.
In South America government entitlements serve that role as a transmission mechanism. In Argentina, e.g., there is a job guarantee effectively making government everyone’s employer of last resort. Together with other entitlements this has caused government spending to rise to unsustainable levels while eroding (my means of sloth and indolence) the tax base supposed to pay for those entitlements. Instead of reforming away its entitlement state, the government led by socialist president Cristina Kirchner pumps newly printed money into the government budget.
With consumer demand kept up by entitlements and productive activity kept down by the same entitlements (among other business-stifling measures) imports have increased. The massive money printing weakens the currency, causing imported inflation to compound a problem caused by domestic excess demand. Tradingeconomics.com reports the Argentinian CPI-based inflation rate at just above ten percent, though at least one other source put it above 13 percent. It is worth, though, to take any number coming out of Argentina with a grain of salt, as president Kirchner has been accused of trying to tamper with the country’s national accounts data.
Regardless of the fine print of Argentina’s inflation numbers, their economy exemplifies how excessive money printing can indeed cause inflation. One person who should definitely keep the Argentinian lesson in mind is Mario Draghi, president of the European Central Bank. Despite the restrictions put in place on the ECB when the bank was created, Draghi is pushing hard for a very expansive monetary policy. His money printing ambitions take many different forms, big and small. On Thursday August 7, e.g., in an official ECB statement, Draghi explained the ECB Governing Council’s latest policy decision:
Based on our regular economic and monetary analyses, we decided to keep the key ECB interest rates unchanged. The available information remains consistent with our assessment of a continued moderate and uneven recovery of the euro area economy, with low rates of inflation and subdued monetary and credit dynamics.
In a brief press release the same day, the ECB announced that:
the interest rate on the main refinancing operations and the interest rates on the marginal lending facility and the deposit facility will remain unchanged at 0.15%, 0.40% and -0.10% respectively.
The latest M1 money supply data from the ECB shows an annual growth rate of 5.4 percent. This is actually a reduction from a bit over a year ago when they were pumping massive amounts of euros into saving Spain and Greece from collapse. However, back then the M1 growth rate relative real GDP growth was approximately four to one, meaning money supply expanded four times faster than transactions money demand. The U.S. economy has seen similar excess growth rates for a while, though with GDP growth picking up and the Federal Reserve tapering off its Quantitative Easing policy, the U.S. rate is declining.
The exact opposite is happening in Europe. With GDP growth at best reaching one percent per year, the euro-zone excess growth rate in M1 is now at 5:1. Of every five new euros printed, one is absorbed by the economy to serve as liquidity for spending, investment, labor compensation and tax-payment purposes. The remaining four dollars go into the financial system as excess liquidity. With the ECB’s overnight lending rate for banks at -0.1 percent, that means a dangerous rise in excess liquidity in the banking system.
It could also lead to an Argentine-style monetary inflation rally. For now, though, the ECB hopes that consumers and businesses will absorb all the money slushing around in the financial system. Back to Draghi:
The targeted longer-term refinancing operations (TLTROs) that are to take place over the coming months will enhance our accommodative monetary policy stance. These operations will provide long-term funding at attractive terms and conditions over a period of up to four years for all banks that meet certain benchmarks applicable to their lending to the real economy. … Looking ahead, we will maintain a high degree of monetary accommodation. Concerning our forward guidance, the key ECB interest rates will remain at present levels for an extended period of time in view of the current outlook for inflation.
Where would the demand for these loans come from? Other than random blips on the national accounts radar, there is no real movement in either business investments or consumer spending in Europe. The only way Draghi and the European banks can push new loans on entrepreneurs and households is to lower credit qualification requirements. That, in turn, exposes banks to significantly higher default risks, without stimulating private-sector activity more than on the margin.
Thus, in order to put their relentlessly expanding liquidity supply to work, the ECB has to go for other measures. And this is where Argentina comes back into the picture. Draghi again:
[The ECB] Governing Council is unanimous in its commitment to also using unconventional instruments within its mandate, should it become necessary to further address risks of too prolonged a period of low inflation. We are strongly determined to safeguard the firm anchoring of inflation expectations over the medium to long term. … the annual rate of change of MFI loans to the private sector remained negative in June and the necessary balance sheet adjustments in the public and private sectors are likely to continue to dampen the pace of the economic recovery.
Let us translate this into plain English. The point about “unconventional instruments” means that the ECB will do whatever it takes to drive up inflation to two percent. This includes using U.S.-style QE measures to prop up deficit-struggling member states. Which opens the door to Argentina. Unlike the United States, the European economy does not have the resiliency to get out from underneath bad fiscal policy and onerous governments. Furthermore, despite our overly generous welfare systems we do not have Europe’s massive income security structure which flood households with work-free cash.
Compared to the U.S. situation, Europe is at significantly higher the risk of monetary inflation. I would not want to keep my investments in Europe when the ECB starts pumping money directly into government budgets.
The last part of Draghi’s speech reinforces my concerns:
To restore sound public finances, euro area countries should proceed in line with the Stability and Growth Pact and should not unravel the progress made with fiscal consolidation. Fiscal consolidation should be designed in a growth-friendly way. A full and consistent implementation of the euro area’s existing fiscal and macroeconomic surveillance framework is key to bringing down high public debt ratios, to raising potential growth and to increasing the euro area’s resilience to shocks.
It is precisely the pursuit of welfare-state saving austerity that has brought the European economy to its knees. So long as the short-term budget balance is more important than GDP growth, consumer spending or reduced unemployment, policy makers at the ECB as well as in the EU leadership and member-state governments will continue to keep the European economy in its increasingly perennial state of stagnation. If they push hard enough on fiscal consolidation, in other words if they add QE to their current policy mix, stagnation will become stagflation.
There is good news today from the Bureau of Economic Analysis, which reports that U.S. GDP…
increased at an annual rate of 4.0 percent in the second quarter of 2014, according to the “advance” estimate released by the Bureau of Economic Analysis. In the first quarter, real GDP decreased 2.1 percent (revised). The Bureau emphasized that the second-quarter advance estimate released today is based on source data that are incomplete or subject to further revision by the source agency
This is good news, indeed, even with the caveat that there will be revisions to the number by the end of August when more complete data has been processed. As a reminder of how big those revisions can be, consider that the estimates for the first quarter of this year ranged from -2.1 to -2.9 percent. That was an unusually large margin of error. Early estimates, like this four-percent growth figure for the second quarter, are based on limited data and matched with forecasting models that “fill in the blanks”. Those models, in turn, are based on historic trends in industrial activity throughout the U.S. economy. When real economic activity deviates from long-term, historic trends – either because of a protracted recession or because of an ongoing structural change to the economy – the part of preliminary GDP estimates that comes from forecasting models is suddenly more uncertain.
In a nutshell, while there is an underlying trend of recovery, that trend is not strong and confident enough to yield highly accurate preliminary GDP estimates. But even if there is an unusually large downward adjustment of this figure, we are still going to have satisfactory growth going in this economy.
So what is behind this good GDP news? Back to the BEA news release:
This upturn in the percent change in real GDP primarily reflected upturns in private inventory investment and in exports, an acceleration in PCE [private consumption], an upturn in state and local government spending, an acceleration in nonresidential fixed investment, and an upturn in residential fixed investment that were partly offset by an acceleration in imports.
In other words, the BEA sees an across-the-board increase in economic activity. This is very good, even though we could have done without the rise in state and local government spending. However, once the more complete numbers are out in about a month, there will be opportunity for a detailed examination of the actual growth drivers. However, the BEA gives some hints:
Real personal consumption expenditures increased 2.5 percent in the second quarter, compared with an increase of 1.2 percent in the first. Durable goods increased 14.0 percent, compared with an increase of 3.2 percent. Nondurable goods increased 2.5 percent; it was unchanged in the first quarter.
The rise in durable-goods consumption is particularly notable, as it is often associated with long-term spending or financing commitments by consumers. This could actually indicate a deeper, more lasting trend of growth, driven by strengthening consumer confidence. If so, we will see much more of GDP in the 3-percent growth bracket. That would be highly welcome, especially since the average GDP growth for the U.S. economy in the 2000s barely exceeded an inflation-adjusted 1.5 percent per year.
But before we all jump up and down with joy, keep in mind again that growth in the first quarter was a solid negative 2.1 percent. I attribute that, at least in part, to the uncertainty around Obamacare. Businesses have now adjusted to it, consumers are absorbing the cost and accommodating to it. That does not mean Obamacare has not had negative effects on the economy; wait and see what happens to health care costs, employment in the health sector and spending on medical technology.
Another indicator that the economy may be on a reinforcing rebound is the 5.3-percent increase in non-residential construction, an indication that businesses expect activity to grow on a long-term basis. Business equipment investment corroborates this, with a solid seven-percent growth (it decreased in the first quarter). Residential construction growth was even stronger, at 7.5 percent.
All in all, what has been a tepid recovery looks better today. A couple of key variables indicate reinforced confidence among consumers as well as businesses. If the Obama administration sits still and does nothing, they will make the best contribution possible to this. No more big spending programs, please. (Let’s not forget that Obama has been more fiscally conservative than any recent Republican president, Reagan included.) If Republicans take the Senate in November, there will be even more reasons to believe in a sustained recovery.
In addition to continued growth in jobs and earnings, a solid trend of growing GDP will also reduce the risk of monetarily driven inflation in the United States. From this perspective it is particularly reassuring that consumer spending on durable goods is growing, as is spending on both residential and commercial construction. All these activities rely heavily on credit, and that includes, of course, the mortgages needed to buy new homes. Excess liquidity that has been slushing around in the U.S. banking system will now go to work where it is needed.
This particular aspect of the recovery is usually under-estimated by economists. Let’s briefly compare our situation to what is happening in Europe. There, too, business credit is growing, but not for the same reason as here. EUBusiness.com reports:
Banks in the eurozone eased credit standards for loans to businesses in the second quarter for the first time since 2007, the European Central Bank said Wednesday. Announcing the upbeat results of its quarterly euro area bank lending survey, the ECB said it had also become easier for private households to get loans as confidence returned to the sector.
This is nonsense. The EU economy may be breaking into positive growth numbers, but it is closer to one than two percent annually. The best evidence of this is a very slow growth rate in private consumption. This is not enough to shore up confidence and make people crowd to the banks, desperate for loans. The same is true for businesses, whose investment growth is nowhere near American levels.
Instead of a desperately needed real-sector recovery, the increase in lending in the euro zone is a direct effect of the negative interest rates that the European Central Bank has introduced on bank over-night deposits. This measure, which de facto marked Europe’s entry into the liquidity trap, penalizes banks if they deposit excess liquidity to accounts with the ECB. Faced with a penalty from the ECB, banks have apparently decided to aggressively market loans to businesses and households.
The fact that they decide to lower credit standards right away, right as they start their loan marketing campaign, is a good indicator of cause and effect in this: if households and businesses were recovering solidly from the Great Recession, they would qualify for loans at existing standards; the fact that banks have to lower credit standards in order to sell loans to customers means that the aggregate credit profile of the European bank customer has not changed recently. That in turn means that people and businesses make roughly the same amount of money, have approximately the same employment and sales outlook on the future, and that job prospects and markets are not growing.
In other words, without the ECB’s negative interest rate and without banks lowering credit standards, there would be no increase in bank lending in Europe.
Because there is no recovery, an increase in lending to the private sector could result in monetarily driven inflation. More on that some other time, though. For now, let’s celebrate yet another U.S. macroeconomic victory over Europe.
While Europe is struggling with the outcome of the European Parliamentary elections and the United States in a macroeconomic limbo after the first-quarter GDP growth shock, countries in other parts of the world face similar economic challenges. This shows that the systemic economic problems in, primarily, Europe and, secondarily, the United States are not confined to those old, mature welfare-state economies. Other countries could learn a great deal from their experiences, but we can also learn one important lesson from them, namely that the problems plaguing Europe and America are indeed systemic and not somehow unique experiences.
South Africa is a case in point: a country run by radical socialists whose policies are slowly destroying the economy. Last year I pointed to South Africa’s growing stagflation problem, which fundamentally is caused by the ANC government’s stubborn commitment to the welfare state. Since then the inflation-unemployment problem has grown worse. Premier South African publication Business Day reports:
Last week, President Jacob Zuma was inaugurated and his new cabinet announced. Their task is to implement the National Development Plan, which targets annual growth of 5.4%, and “radical socioeconomic transformation policies and programmes”. Their task is urgent. Figures this week revealed that the economy had contracted for the first time since the 2008/09 recession.
Last year I explained that the National Development Plan, with its slew of new entitlements handed out left and right,
is yet more evidence that the ANC is determined to drive South Africa into the ditch, and then have the elephant of big government stomp her to into a pile of trash. … More tax-paid educational programs that won’t lead to any new jobs, because in order to pay for them the government has to put yet more hate taxes on the “rich”. This crushes small businesses, which are almost without exception the best job creators in any economy. And since nothing is being done about the corruption in the country, except talking about it, larger corporations are unlikely to want to expand their operations in South Africa. As a result, the young who are lured into these new ANC-proposed programs – if they ever become reality – will get an education they can’t use. Their frustration with their government may be postponed, but it will be exacerbated by the years that the young feel they wasted on a useless education. … The National Development Plan shows clearly that with the ANC in power, things are only going to deteriorate. But hopefully it will also be the motivator for the political opposition to begin formulating a common-sense alternative. South Africa deserves better than socialism.
The Plan also talks at great length about promoting “ownership among historically disadvantaged groups”, in other words about keeping racism alive two decades after the death of Apartheid. Furthermore, there are large sections about reducing income differences – called “income inequalities” in the Plan – which is nothing more than the same old ideological leftovers that Europe’s welfare states have been regurgitating for the better part of a century now. Income redistribution is a safe way to discourage people from working: the free entitlement reduces efforts by those considered to be entitled by government; the taxes that pay for those entitlements discourage higher-income earners from working. In both ends the tax base shrinks and more people end up eligible for increasingly unaffordable entitlements.
In short: the National Development Plan is a recipe for a Scandinavian welfare state in South Africa. Bad, bad idea.
In fact, the idea is even worse now than it was a year ago, given South Africa’s macroeconomic ailments. The Business Day again:
When searching for explanations for the first-quarter drop in GDP of 0.6%, it is clear that local domestic factors dominate. Newspaper headlines focus on the collapse in mining output, dragged down by a platinum strike and a drop in manufacturing output amid weak demand, and rising costs. But growth in the services sector, which expanded at an annualised rate of 1.8% in the first quarter this year, is also subdued. This highlights underlying weakness in domestic demand. Consumer spending is slowing amid sluggish job creation, waning credit growth, rising inflation and low confidence levels.
That was a good summary of South Africa’s macroeconomic problems. Adding a full-fledged Scandinavian welfare state to this mix is like pouring high-octane gasoline on a fire.
I fear that the ANC is not going to listen to such warnings, but instead charge ahead with their entitlement expansion. The only way they can pull that off, even in the short term, is by printing money faster – another thoroughly bad idea in an economy with up to 40 percent unemployment.
Business Day again:
The country’s tight electricity supply will hang over growth prospects until constraints are eased. At the same time, inflationary pressure is on the rise. CPI accelerated to 6.1% in April, breaching the Reserve Bank’s inflation target 3%-6% range. Producer prices also accelerated to an annual 8.8%, which implied further upside price pressures in the months ahead. HSBC expects CPI to rise above 6.5% later this quarter, which will put more pressure on Reserve Bank governor Gill Marcus to deal with the challenges associated with this enveloping stagflationary malaise.
Which, again, I warned about more than a year ago.
There are other knock-on effects of this weak growth. For one thing, it is likely to undermine tax revenues, while the stoppages in the platinum sector will suppress exports. The country’s twin deficits — the fiscal deficit and current account deficit — are likely to deteriorate in this environment, and the near-term outlook could be clouded by more poor data, whether from mining and manufacturing production, retail sales, international trade, or GDP growth in the second quarter.
How is the ANC government going to fund its deficit? With stagflation de facto already in place it is unlikely that foreign investors will have the confidence needed to invest in South African Treasury bonds. This effectively forces government to ask the Reserve Bank to print money to fund the deficit.
This does not necessarily mean accelerating inflation over night. But with zero growth and inflation already in place, it could have that effect sooner than in other economies (such as the euro zone where they are currently trying to fend off deflation).
That said, there are some mitigating circumstances. For example, some of the depressing growth numbers in the South African economy are due to single-sector events. Explains Mail & Guardian business reporter Thalia Holmes:
South Africa’s gross domestic product (GDP) has shrunk for the first time since the 2009 recession, decreasing by 0.6% in the first quarter of the year, and causing analysts to scale back their predictions of upcoming interest rate hikes. The nominal GDP at market price during the first quarter of 2014 decreased by R2-billion from the last quarter to R874-billion. This marked a sharp change in direction from last quarter’s GDP growth of 3.8%. South Africa’s fall in productivity was largely due to a huge loss of output in the mining and quarrying industry, which decreased by almost 25%. “Economic activity in the mining and quarrying industry reflected negative growth of 24.7%, due to lower production in the mining of gold, the mining of other metal ores [including platinum] and ‘other’ mining and quarrying [including diamonds],” said the report from Statistics South Africa (Stats SA).
Nevertheless, an economy has the structure it has. If it depends heavily on one industry, such as mining, then all its residents, businesses and households alike, as well as government will have to pay the price for that dependency. If anything, this is a wake-up call to the ANC government to get serious about promoting private-sector growth on a broad scale, to pursue industrial diversification through deregulations, tax cuts and ironclad protection of property rights.
Unfortunately, I don’t see this happening so long as their focus is on the National Development Plan.
And just to make matters a bit worse, Thalia Holmes continues:
However, Nedbank observed in an emailed note that “the economy’s fragility was on display in most other sectors too. Manufacturing output dropped sharply.” Output in the sector declined by 4.4% from last quarter. Investec group economist Annabel Bishop attributed the slowdown to “work stoppages caused by strike action and electricity constraints”. Nedbank added that “the pace of activity in most of the services industries also slowed to the low single digits. The only rays of light came from construction and agriculture, where output rose by annual rates of 4.9% and 2.5% respectively over the quarter.” At the same time, the South African Reserve Bank has released a report indicating that the country’s Leading Business Cycle Indicator has continued to decline. The leading indicator, which predicts trends in the economy, was down by -2.36% in March from the same time last year, following a similar -2.7% decline in February.
As the Business Day story pointed out, consumer spending plays a big role in this. The combination of high unemployment and high inflation is venomous to consumer spending. Add to this that many analysts in South Africa seem to expect the Reserve Bank to raise interest rates soon, and the outlook for the country’s economy is even more pessimistic. Higher interest rates discourage consumer-directed installment credit, which will hold back consumers on both the housing market and the market for cars and similar big-ticket durables. This spills over into small businesses, which are often run on basically the same terms as family finances.
South Africa’s problems are structural. The country has earned a reputation for being unreliable, and the reputation has reached such momentum that Japanese car manufacturer Nissan recently decided to choose Nigeria instead of South Africa for its African production expansion.
When you lose out to Nigeria, you know you are in trouble…
I wish I could express great hopes for South Africa, but so long as the ANC keeps pursuing their welfare-state dream and keep trying to push it onto an already struggling private sector, things can only go downhill.
If, on the other hand, the ANC abandoned its socialist delusions and actually started governing for the future, South Africa would have enormous potential.