European economic stagnation: diagnoses and treatments

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Trade unions in Greece have announced a general strike against austerity to take place on November 27, 2014.

By Dick Nichols

November 4, 2014 -- Links International Journal of Socialist Renewal -- For 48 hours it looked as if Thursday, October 16, 2014 might join similar October Thursdays in 1907, 1929 and 1979 as another dramatic moment when share market panic triggered economic downturn.

However, it was not to be. The three trillion dollar slump in world share market values in the first two-and-half-weeks of October has so far been partially reversed by a coordinated effort of “calm engineering” by central bankers. But how long can that treatment—whose message to the gambling fund managers is that interest rates will stay low—succeed?

Europe is presently the weakest link in the global economic chain, and within Europe the weakest links are the stagnating economies of its southern “periphery”. No surprise, then, that in the first two weeks of October the Madrid stock exchange’s Ibex 35 lost 10.7%, while the yield on Spanish public debt—steadily falling from 7.6% at the height of the euro crisis in July 2012—jumped from 2.05% to 2.3%.

In Greece, the Athens stock exchange, which had lost 11.9% over the year to September 30, surrendered a further 16% in the first two weeks of October before partially recovering to be 17.5% down on October 22. Speculator nervousness was particularly marked because of Greek conservative government talk of early exit from the European Union, International Monetary Fund and European Central Bank “bailout”, and because of the rising lead of left party Syriza in local opinion polls.

The underlying cause of the sell-offs, common to all finance markets in Europe, has been the region’s very sluggish and uneven economic recovery and a recent run of “negative data”. Is Europe about to topple into its third recession since 2008? This would not only torpedo company profits but also revive the crisis of the euro that ECB action has so far seemed to contain.

For the fund managers, the thought that all their zillions of “peripheral” European government debt might again have to be “restructured” provoked a semi-stampede of flight from risk. This saw the Greek 10-year bond rate jump from 5.57% to 8.96% between September 8 and October 16, before subsiding to 7.53% (October 22), as some “players” tip-toed back into the market.

The speculators are right to be jumpy. Not only has evidence of economic slowdown been growing, so too have the entrenched differences among European economic policymakers over how to respond. For its part the IMF assigns a 40% probability to recession striking Europe within a year.

The investment slump

At the heart of the malaise lies the ongoing slump in private investment (see Chart 1).

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This shows that in the euro area the investment rate (as measured by Gross Fixed Capital Formation as a share of Gross Value Added[i]) has fallen from its 2003-2008 average of 21.8% to 20% for 2009-2013. The numbers are the same for the EU as a whole. Since 2009, business and households in the EU have been investing an annual average of roughly €220 billion less (in 2013 euros).

To date this investment slump has almost totally failed to respond to treatments applied by the European Central Bank. Since 2011, the ECB has progressively reduced its base lending rate to a record low 0.05%, effectively handing private banks trillions of euros. However, this extremely easy money has not flowed through into lending to business at low rates of interest, but rather to banks’ buying government debt and using the guaranteed taxpayer-funded proceeds to pay off their own massive debts (deleveraging). Today, for example, Spanish banks who access ECB funds at 0.5% still charge business customers around 5% for a million euro loan.

In July, the ECB launched its Targeted Longer-Term Refinancing Operations, an incentive scheme to induce bank lending to “non-finance sector” customers at low rates of interest. However, when the first offer of €400 billion under the TLTRO was launched on September 17, the banks borrowed only €82.7 billion. According to ECB surveys, total euro area bank lending to private business in the year to September had fallen by 1.2%, less than the August figure (1.5%) but still negative.

This state of affairs is confirmation that lack of credit availability, while certainly damaging small and medium business in southern Europe, is not the main factor constraining investment (and eventually employment) recovery. The root cause is the lack of profitable investment opportunities in production, even as big business drowns in its retained earnings (see Charts 2).

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Chart 2 shows the recovery in the net financial wealth of non-financial corporations has exceeded its level at the peak of the previous boom. This has been mainly due to a reduction in its liabilities and the increased value of its share holdings.

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However, Chart 3 shows the ratio between investment and all business profits (before payment of tax, interest and other charges). In 2008, at the peak of the boom, this figure was 55.7%. By 2013 it had fallen to 45.5%.

In this context, even if ECB president Mario Draghi were to override the resistance of the German Bundesbank to the ECB’s conducting “unconventional” monetary easing along the lines of the US Federal Reserve, it is very hard to imagine how any purely monetary manoeuvres could kick-start enough private investment to ward off recession.

The fact that only 13 of the 123 banks recently “stress-tested” by the European Banking Authority were judged vulnerable to a severe economic downturn doesn’t change that picture. In the words of retired Austrian banker Klaus Kastner: “Anyone who concludes that the Euro area financial system is on solid grounds is living in an illusion. The leverage of the large banks (mostly German and French) is far too high and they are far too reliant on “hot money” for their refinancing. And structural issues have not been addressed at all. Many of the countries are totally overbanked leading to the situation where no bank on its own can make enough money without entering into undue risks.”[ii]

Given the impact of possible deflation and the still-present risk of a Greek default, it was no surprise that the governor of the Bank of Spain also commented that Spain’s banks (which all passed the test, but at the cost of€32 billion in taxpayer funding) still needed to improve their capital adequacy.

Roots of stagnation

Even as the Bundesbank gets berated by many economists for not allowing the ECB to operate like the Fed, it shouldn’t be forgotten that the present US recovery is itself the weakest and slowest since World War 2 (see Chart 4).

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The underlying reason, common to all the advanced capitalist economies is the stagnation in final consumption, driven by the fall or slowdown in real wage growth (see Chart 5) and the sharp rise in income and wealth inequality (see Chart 6).

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Since the economic crisis struck in 2008 the main component of demand, final consumption, has, increased by only 0.2% a year across the EU (to 2013). In the five afflicted countries of the “periphery” (Ireland, Portugal, Greece and Italy) consumption[iii] has fallen on average by 1.9% a year over the same period (See Chart 7).

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As families struggle to maintain living standards or just survive, their savings also erode away (see Chart 8).

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As for “net exports” (the surplus of exports over imports)—the motor of German growth and the supposed economic hope for the countries that have increased competitiveness through “internal devaluation” (wage cuts)—its contribution to growth, both across the EU and the Euro area and in the “periphery” has, with, Ireland excepted, been falling ever since it peaked in mid-2011. This is shown in Chart 9.

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In August, seasonally adjusted German exports fell by 5.8% over July, their biggest fall since January, as foreign demand for German production declined, both inside the EU but also in the US and Asia. In the same month, Spanish exports fell by 5.1% over the year, as demand in China and Latin America slowed.

Also in August, industrial production for the whole EU was down 0.8% over the previous year, with the biggest falls in the sectors most closely related to investment—capital goods (2.3%) and energy (3.3%). For the Euro area, the numbers were even worse, with respective falls of 1.9%, 3.7% and 3.5%.

The end result of the decline in all the components of growth was that at the end of 2013 GDP in both the euro area and the EU was still below its 2008 peak. Real demand in the Euro area in mid-2014 was still lower than at the beginning of 2008 (see Chart 10).

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How these malign influences on growth and employment come together can be seen in Chart 11, showing the changing impact of consumption, investment and net exports on GDP change since 2003.

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Table 1 compares the average contribution to nominal GDP growth of its components parts for the pre-crisis period (2003-2008) to their contribution for the post-crisis “great recession” (2009-2014).

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With the exception of net exports, the main components of nominal GDP growth have collapsed, with no sign that the falls in consumption and investment will ever be compensated for by the rise in net exports. Indeed the rise in net exports is exclusively due to the fact that since 2009 imports have fallen more than exports, which have also fallen.

Finally, confirmation of the Europe-wide shortfall in demand also comes in the continuing decline in the EU inflation rate. This fell to a new annual low of 0.4% in September and was zero or negative in four of the crisis-hit countries of the “periphery”—Greece, Portugal, Spain and Italy (see Chart 12)

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In Chart 11, which breaks down GDP according to its expenditure components, government consumption and investment is included in the categories of consumption and gross fixed capital formation. When expenditure on GDP is broken down according to the economic sectors doing the spending, government spending (on consumption and investment) appears as in Chart 13.

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The chart reveals the complete failure in the great recession of government spending to compensate for the decline in private consumption and investment expenditure. Table 2 summarises the data behind the chart.

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More public spending and/or debt relief?

Why was this? Expansionary fiscal policy (greater public spending), the accepted antidote to recession, was supposedly impossible after 2009 because of high government indebtedness in the economies of the “periphery” and the risk of their defaulting. This state of affairs supposedly made reducing public spending a priority—precisely at the moment it needed to be maintained or increased.

However, this judgment was a political decision that put the interests of the creditor finance institutions, chiefly German and French banks, ahead of those of the mass of working and taxpaying people and of the overall interest of the economies themselves.

In the words of Kenneth Rogoff, Harvard economist and co-author of This Time Is Different: Eight Centuries of Financial Folly[iv]: “…rather than pouring fiscal stimulus into a German economy that has for some time arguably been overheated, it would have been far better to give periphery countries more help. And the best and most sustainable way to accomplish this would have been to write down debt across the periphery, including at the very least Greece, Spain, Ireland and Portugal…The point that periphery countries suffer from debt overhang should be an obvious one by now, and anyone interested in ‘progressive’policies should be supporting efforts to alleviate it.”[v]

Rogoff makes a similar point about the US sub-prime crisis: “Without question the best and most effective approach to the problem would have been to bail out the subprime homeowners directly, forcing banks to take losses but keeping them manageable. For an investment of perhaps a few hundred billion dollars, the US Treasury could have saved itself from a financial crisis whose cumulative cost, counting lost output, already runs into many, many trillions of dollars. Instead of ‘saving Wall Stree’”, a subprime bailout would have been targeted, almost by definition at lower-income households. But unfortunately, this approach too would have been politically impossible prior to the crisis.”

In the case of the European Union, the cost of financial sector bailouts to taxpayers was €5.1 trillion to the end of 2013, when the EU shifted the burden of financing its bailout fund to the banks and their shareholders and bondholders.[vi] That’s around 40% of annual GDP for the 28 countries of the EU.

Rogoff’s argument counterposes debt relief to increasing public expenditure in the EU and Eurozone core, primarily Germany. Are both these policies necessary to end the great recession, or is one or other sufficient? And if they are both needed, how should they be combined?

These questions are presently a subject of strong debate and difference among economists wrestling with the European stagnation and its possible impacts on the world economy. The evidence of the costs of stagnating private investment has now become so strong that many, including IMF chief economist Oliver Blanchard, have called on the Merkel government to take advantage of its very low borrowing costs to increase its deficit and fund public investment in infrastructure. According to this argument, that measure would increase demand across the EU and help growth in the “periphery”.

A similar message came through an October 21 article by lead Financial Times economic commentator Martin Wolf. He said: “Negligible costs of borrowing must transform views of the costs of fiscal deficits. Germany should both refinance its debt at such rates and borrow to finance additional public investment. Focus on whether the French deficit breaks the [EU fiscal compact] rules is absurd. Even French 10-year bonds are yielding 1.1%. The markets are screaming: borrow.”

However, German Bundesbank president Jens Weidmann gave Blanchard’s proposal a frosty response in an October 17 speech to a Bank of Latvia conference. Claiming that “the boost to the peripheral countries from an increase in German public investment is…likely to be negligible”, Weidmann added: “Germany is not in need of stimulus either.”

So what are Greece and Spain, with their 25% plus unemployment, and Italy, already in technical recession (two quarters of “negative growth”), supposed to do? As he lamented the emergence of a French-Italian bloc in favour of bending the rules of the EU fiscal pact, the Bundesbank president’s response was predictable— more business-friendly deregulation, more labour market reform, more fiscal discipline and tougher penalties for countries violating the rules. If such measures had enabled Germany to build export-led growth after 2004, everyone else should follow suit.

Weidmann concluded: “The biggest bottleneck for growth in the euro area is not monetary policy, nor is it the lack of fiscal stimulus: it is the structural barriers that impede competition, innovation and productivity.”

A parallel exchange took place in late October between two former members of the ECB executive board, German Otmar Issing, former ECB chief economist, and Italian Lorenzo Bini Smaghi. According to Issing, writing in the October 23 Financial Times, “from a purely national point of view Germany needs a much less expansionary policy than it is getting from the European Central Bank. This is a strong argument why fiscal policy should not be expansionary, too.”

Germany, however, is not an island, but an economy that, like China’s, has a huge excess of private domestic savings (mainly company profits) over its spending on domestic investment. Because its government budget is in balance, this excess of German private savings has to be absorbed by economies outside Germany.

Bini Smaghi pointed out: “[W]hile Germany’s desire to accumulate wealth seems infinite—the foreign asset position of Germany is approaching 100% of GDP—the ability of other countries to borrow and issue debt assets is not. In fact, the external debt of several peripheral countries has risen above 100% of GDP and has become unsustainable, forcing them to sharply cut spending…

“Europe is thus in a Catch-22. On the one hand, Germany and a few other countries want to continue to save a high portion of their income and accumulate assets through record current account surpluses. On the other hand, peripheral countries cannot, and do not want to, borrow more from abroad because they have to deleverage in order to put their own houses in order and reduce their excessive debt…

“If [German] domestic demand does not rise and compensate for the slowdown in world demand, the huge excess of German savings over investment will drag the European economy into a deflationary spiral. That is what standard economic analysis suggests, and that is what happened in the 1930s and led to the economic and political disasters of which we all know.”

Treatments, band-aid and real

The myopic Bundesbank position, therefore, not only threatens to guarantee a third European recession in seven years—it does so when rising popular anger is increasing the chances of EU-disobedient governments coming to power, most immediately in Greece, but also, given the rise of Podemos,in Spain.

This is not lost on more acute ruling-class observers, like private equity executive Charles Dallara, former head of the Institute of International Finance, who helped orchestrate Greece’s 2012 debt restructuring. Dallara not only supports Germany adopting expansionary measures, but also proposes a one-to-two-year moratorium on public debt reduction targets. On October 16, he told Bloomberg that “it goes to a recognition that we are in extremis again.”

Bini Smaghi’s suggested treatment for the malaise is tax cuts for German consumers and tax relief for German capitalists investing at home. However, there is not much appetite for such policies in the German conservative-social democratic government and, even if there were, it is not clear how much economic impact they would have.

The European economic malaise is so entrenched that a two-year debt reduction moratorium, some increased public investment and tax relief by Germany would not change much, especially in the European economy and society suffering most—Greece. That’s because, in the words of Athens economist Yanis Varoufakis, “the euro crisis never went away. What happened was that Mr Draghi’s skillful interventions in the summer of 2012 suppressed the crisis in the bond markets but, at the same time, pushed it deeper into the foundations of the real economy…

“It was inevitable that, as the crisis was wrecking these foundations (with deflationary forces, desperately low levels of private and public investment and increasing debt to GDP ratios in the periphery), it would resurface.”

As for Greece, “it is in the clasps of a triple insolvency: an insolvent state, insolvent banks and an insolvent private sector...Until and unless we have a new agreement [with the EU, imposed by a Syriza government], everything Europe and the IMF will do will remain in the realm of window-dressing.”

The Junker plan

Isn’t Varoufakis exaggerating? Is it, for example, really accurate to describe the three-year €300 billion public spending plan developed by new European Commission president Jean-Claude Juncker as “window dressing”? Especially when this plan is partly based on the recognition of the futility of asking the German government to exclusively shoulder the burden of economic stimulus?

The Juncker plan was discussed at an October 16-17 workshop in Brussels of the Rosa Luxemburg Foundation, dedicated to analysing the economic situation in Europe and laying the basis for a left industrial policy for Europe.

According to the transform! web site report on the event,Paloma Lopez, a Spanish United Left member of the European Parliament and former trade unionist said that “even if initiatives such as Juncker’s are welcome, the total amount is too small to really make a difference. Spain does not need 300,000 jobs, it needs three million of them. Moreover, investment is coupled with the further implementation of austerity and structural reforms, as well as internal devaluation and the design of an export-led growth model.

“What is given with one hand is taken away with the other. The labour force is still considered as a cost, which does not bode well for domestic demand and improvements in workers’ skills; no serious move towards the ecological transition is in sight; the financialisation of the real economy is being completely ignored, and so are issues related to economic democracy.”

Whatever benefits the Juncker plan might eventually bring (if it actually gets implemented and doesn’t just amount to a re-description of already earmarked spending, like other EU “jobs plans), Lopez’s comments point to a crucial issue: it critically matters what political forces implement increased public spending, and in what perspective they do it.

Juncker’s plan will probably seek to emulate the German Hartz IV model of casualised, low-paid “minijobs”, in an attempt to spread German “competitiveness” into other EU regions. In southern Europe this would simply boost the growing numbers of working poor, whose situation would be better than the complete destitution of unemployment, but not by much.

By contrast, the emergency economic plan of Syriza, presented to the Brussels forum by Alex Charitsis, “is based on three main pillars: confronting the humanitarian crisis, restructuring of production, and reforming the state and public administration.”

According to Charitsis: “The first phase consists in…an increase in wages, pensions and unemployment allowances to the pre-crisis level, restoration of more protective labour legislation and healthcare, an extensive program for housing and feeding those in need.

“The second phase, actually ensuring the productive and social transformation, depends on a deal regarding the sovereign debt based on cuts in its illegitimate part and a moratorium period during which the payment of the rest of the debt will be linked to a development clause.

“The role of labour will be upgraded, public goods and public property will be key factors in the program (which implies a reconfiguration of the role of the state and a redistribution of wealth), small and medium enterprises must be fostered and the potential of social and community-based economy developed---notably to respond to youth employment needs and avoid a further ‘brain drain’.”

Non-payment of illegitimate public debt, a massive program of “green” public works launching the transition to ecological sustainability, extensive special programs to lift up the social groups and regions most wounded by the crisis—these measures alone would constitute real recovery from economic stagnation.

And they can only be carried out by those political forces with their roots in the last four years of mass struggle against austerity.

[Dick Nichols is Green Left Weekly’s European correspondent, based in Barcelona. A preliminary version of this article appeared its October 27 issue.]


[i] Gross Value Added (GVA) measures the contribution to the economy of each individual producer, industry or sector. GVA plus taxes on products minus subsidies to products gives Gross Domestic Product (GDP).

[iii] We leave aside the issue of the composition of consumption by “households”, which lumps together markets where consumption is recovering—like Mediterranean real estate and luxury yachts—and those where it continues to stagnate, like the consumption spending of workers, people on welfare and the impoverished middle classes on the “periphery”.

[iv] In an August 20 review in Prospect Magazine of The Shifts and the Shocks by Financial Times chief economic commentator Martin Wolf. See