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 truth about the European economic crisis is spreading. The latest evidence of this growing awareness is in an annual report by the European Commission. Called “Report on Public Finances”, the report expresses grave concerns about the present state as well as the economic future of the European Union. It is a long and detailed report, worthy of a detailed analysis. This article takes a very first look, with focus on the main conclusions of the report.
Those conclusions reveal how frustrated the Commission has become over Europe’s persistent economic stagnation:
The challenging economic times are not yet over. The economic recovery has not lived up to the expectations that existed earlier on the year and growth projections have been revised downwards in most EU Member States. Today, the risk of persistent low growth, close to zero inflation and high unemployment has become a primary concern. Six years on from the onset of the crisis, it is urgent to revitalise growth across the EU and to generate a new momentum for the economic recovery.
Yet only two paragraphs down, the Commission reveals that they have not left the old fiscal paradigm that caused the crisis in the first place:
The aggregate fiscal picture for the EU and the euro area is now considerably more favourable, thanks to the commendably large consolidation efforts made in the past. … this has allowed Member States to slow the pace of adjustment. The aggregate fiscal stance is now expected to be broadly neutral in 2014 and 2015, both in the EU and the euro area. This will reduce one of the drags on growth and should therefore be welcomed.
If Europe is ever to recover; if they will ever avoid decades upon decades of economic stagnation and industrial poverty; the government of the EU must understand the macroeconomic mechanics behind this persistent crisis. To see where they go wrong, let us go through their argument in two steps.
a) “The aggregate fiscal picture for the EU and the euro area is now considerably more favourable, thanks to the commendably large consolidation efforts made in the past.” There are two analytical errors in this sentence. The first is the definition of “fiscal picture” which obviously is limited to government finances. But this is precisely the same error in the thought process that led to today’s bad macroeconomic situation in Europe: government finances are not isolated from the rest of the economy, and any changes to spending and taxes will affect the rest of the economy over a considerable period of time. The belief that government finances are in some separate silo in the economy led to the devastating wave of ill-designed attempts at saving Europe’s welfare states in 2012.
Austerity, as designed and executed in Europe, was aimed not at shrinking government but making it affordable to an economy in crisis. The end result was a permanent downward adjustment of growth, employment and prosperity. In order to get their economy out of this perennial state of stagnation, Europe’s leaders need to understand thoroughly the relations between government and the private sector.
b) “The aggregate fiscal stance is now expected to be broadly neutral in 2014 and 2015, both in the EU and the euro area. This will reduce one of the drags on growth and should therefore be welcomed.” Here the Commission says that if a government runs a deficit, it causes a “drag” on macroeconomic activity. This is yet another major misunderstanding of how a modern, monetary economy works.
Erstwhile theory prescribed that a government borrowing money pushes interest rates up, thus crowding out private businesses from the credit market. But that prescription rested on the notion that money supply was entirely controlled by the central bank; in a modern monetary economy money supply is controlled by the financial industry, with the central bank as one of many players. Its role is to indicate interest rate levels, but neither to set the interest rate nor to exercise monopolistic control on the supply of liquidity.
A modern monetary economy thus provides enough liquidity to allow governments to borrow, while still having enough liquidity available for private investments. In fact, it is rather simple to prove that the antiquated crowding-out theory is wrong. All you need to do is look at the trend in interest rates before, during and after the opening of the Great Recession, and compare those time periods to government borrowing. In a nutshell: as soon as the crisis opened in 2008 interest rates plummeted, at the same time as government borrowing exploded.
This clearly indicates that the decline in macroeconomic activity was not caused by government deficits; it was the ill-advised attempt at closing budget gaps and restore the fiscal soundness of Europe’s welfare states that caused the drag. And still causes the drag.
In other words, there is nothing new under the European sun. That is unfortunate, not to say troubling, but on one front things have gotten better: the awareness of the depth of the problems in Europe is beginning to sink in among key decision makers. What matters now is to educate them on the right path out of the crisis.
There is a lot more to be said about the Commission’s public finance report. Let’s return to it on Saturday.