16th April 2014
Capital has been flowing back to Europe this year, especially to the periphery, bringing long-term interest rates down sharply, helping banks to raise capital, and boosting local equity markets. Optimists say this reflow indicates fundamental improvements in the economic and financial condition and performance of the Euro Area. Skeptics say it’s more about extraneous issues such as liquidity and asset switching out of emerging markets, and one-off Europe-specific factors such as the end of economic contraction, finally, and rising confidence that the ECB is poised to launch new monetary policy stimulus measures. Financial markets have been making hay, regardless.
But does the European economy really merit the plaudits accorded by financial markets? Granted, there doesn’t necessarily have to be a close connection, provided you think you can clip coupons or exploit a recovery situation and get your money out or back at will. And the ECB has pretty much written that script since the middle of last year. Plus it would be churlish not to acknowledge at least some real improvements in fiscal deficits and labour and export competitiveness in the periphery of the Euro Area.
And yet, Europe’s dark side still looms large. With inflation running at about 0.5% and real GDP growth at little more than 1%, the nominal environment for workers and companies in Europe remains very weak. If more countries and more items in the CPI baskets succumb to falling prices, deflation and debt sustainability risks would quickly rise and undermine investor confidence again. The implications go beyond pure macroeconomics, threatening already troublesome problems in European labour markets and in Europe’s faltering social model. High unemployment and under-employment are exacerbating a high incidence of poverty and income inequality, raising self-evident social issues, but also weakening the Euro Area’s capacity for better economic performance, and possibly for political stability.
There is good news, but put in perspective
The macro picture is certainly changing in some important respects.The IMF’s latest World Economic Outlook says that real GDP in the Euro Area will rise by 1.2% in 2014 and 1.5% in 2015, that protracted low inflation is more likely than deflation, and that it will record an aggregate current account surplus of 2.25-2.5% of GDP in 2014-15. Germany’s external surplus is predicted to remain at or above 7% of GDP. Everyone else, bar France, Belgium, Finland, Latvia and Estonia, will be running surpluses.
If you look at Spain, Portugal, Italy and Greece, for example, the combined current account balance improved by an annualised €139 billion between mid-2011 and the same last year, mostly thanks to goods and services balance, a split roughly 50:50 between lower imports and higher exports (Raphael Auer, The increasing competitiveness of the Southern Eurozone, http://www.voxeu.org/article/increasing-competitiveness-southern-eurozone).
The IMF Fiscal Monitor shows that the Euro Area’s structural fiscal position (cyclically adjusted primary balance) has swung from a deficit of 2.6% of GDP in 2010 to a surplus of 1.1% GDP this year, rising to 2.5% GDP by 2019. The swing in the cyclically adjusted balance including interest payments between 2010-2014 has been almost twice as big, from -5.1% to -1.4% GDP.
On the face of it, this seems like a pretty robust confirmation of progress. But that only goes to show that a superficial sweep of macroeconomic numbers is little more than a starting point. Look how cagey the IMF’s qualifications are, quoted here:
“Domestic demand in the euro area has finally stabilized and turned toward positive territory, with net exports also contributing to ending the recession. But high unemployment and debt, low investment, persistent output gaps, tight credit, and financial fragmentation in the euro area will weigh on the recovery. Downside risks stem from incomplete reforms, external factors, and even lower inflation. Accommodative monetary policy, completion of financial sector reforms, and structural reforms are critical.”
This amounts to a fairly limp endorsement. Here’s another way of assessing the Euro Area’s condition.
Put another way….
The recession has ended, as all recessions do. The pick-up in economic growth is anaemic, and while it should continue through 2015, Euro Area real GDP growth equal to no more than its potential growth rate is going to leave ‘persistent output gaps’, including large scale labour market slack and weak income formation. Since deflation is first and foremost a function of chronic aggregate demand deficiency, it seems very likely that the build-up in deflationary pressures will continue, especially in the absence of more assertive monetary policies, such as unconditional QE. With nominal income and GDP growth so low, the fiscal and debt improvements that have permeated the Euro Area are at risk, placing debt sustainability back at the top of the agenda.
If Euro Area inflation were, for example, to average 1% over the next 3-5 years, rather than 2%, and the dispersion of inflation didn’t change, that is German inflation remained at around 1% (implying still strong downward pressures in the periphery), Greece, Italy, and maybe other countries might well find themselves drifting inexorably towards debt restructuring, if not default.
Two further weaknesses underlie this rather sober assessment. First, because the infamous link between weak sovereign and weak bank balance sheets has not been broken by the agreed form of banking union, European banks should remain under close scrutiny. Look at at Philip Legrain’s ‘Europe’s Bogus Banking Union’, for example.(http://www.project-syndicate.org/commentary/philippe-legrain-shows-how-far-the-new-framework-for-supervision-and-resolution-falls-short). He draws attention to important structural weaknesses that senior bankers and policymakers gloss over or dress up to deceive. These include the failure to address legacy losses, the absence of a Euro-wide bank resolution system to deal properly with weak banks in the periphery, a lack of focus on larger banks in the core, the ECB’s limited supervisory universe, the fact that national governments will retain a veto over bank closures, and the meagre (€55 billion) resolution fund that will be built over the next few years. We might also add the more than one hundred decision makers that will have to be involved in bank closures or rescues, and who might have to make snap but firm decisions over a weekend.
Second, no attempt has been made to rectify the adjustment asymmetry in the Euro Area, that is, the placing of economic and financial adjustment responsibility entirely on debtor countries, with credit countries remaining aloof. German friends and colleagues resent this rather black-white description, pointing to the country’s persistent willingness to bend in favour, for example, of creating and providing most of the funding for the European Stability Mechanism, and agreeing to the ECB’s OMT programme, Troika bail-outs, Greek debt restructuring, and most recently, the incremental mutualisation of funding for the Single Resolution Mechanism. In all these respects, it is true that Germany’s position has been constructive and important. But from a broader perspective, Germany has been and remains unwilling to agree to the kind of joint liability institutions in banking union and debt issuance that would give real teeth to such initiatives, and it is unwilling to contemplate formal debt restructuring arrangements that would go beyond Greek official debt.
Basically, Germany doesn’t recognise its own mercantilist leanings as part of the Euro system’s problems. These reside in Germany’s entrenched current account surplus, which is more than three times as large as China’s as a share of GDP, and which is rooted in a structural excess of savings over investment. (Download a good BIS comparative paper on this from http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2390167). It is hardly surprising that Germany’s household consumption as a share of GDP has been fairly static for many years at roughly 53-54%, significantly lower than other major OECD countries. Now, it goes without saying, but we’ll say it anyway, that it is inherently deflationary if Germany’s external surplus is rigid, if other countries such as the Netherlands and Austria also continue to register large surpluses, and if most of the rest of the Euro Area is striving to record and sustain its own surpluses.
Deflating, if not yet deflation
With consumer price inflation falling to 0.5%, comparable to where it was at the end of 2009, concerns are rife that the area is one shock away from outright deflation. Greece and Cyprus entered deflation in March and October 2013, respectively, while Portugal and Spain are on the cusp. According to the research think-tank, Bruegel, there has been a steadily rising proportion of countries drifting into or towards deflation, especially when you remove the effects of austerity-induced indirect tax hikes. (http://www.bruegel.org/nc/blog/detail/article/1293-is-there-a-risk-of-deflation-in-the-euro-area/). The report’s authors do acknowledge that even though the proportion of items in the consumer price index in deflation has doubled to about 20% since 2011-12, it is not higher than it was in 2004-05 or in 2009, and much lower when compared, say, to about 50-60% in Japan in 2000-04 and 2009-12. That said, 20% of items in deflation when Euro inflation was 2% may not be quite as alarming as 20% in deflation when the headline is 0.5%.
Markets are buzzing with speculation about the statistical quirks of inflation releases over the next couple of months but the real issue is whether the state of the European economy, aggregate demand especially, is tipping Europe closer to or away from deflation.
It is hardly surprising that there have been both growing calls for the ECB to take up arms against the risk of spreading deflation by adopting QE, and the expression of strong opposition. Former ECB board member, Jurgen Stark, wrote recently in the Financial Times that there were no signs of deflation at the Euro Area level, and that most of the ‘problem’ could be attributed to one-offs, for example, energy and commodity prices, the strong Euro, austerity tax hikes, and measures to boost competitiveness (http://www.ft.com/cms/s/0/35e0fe3e-c318-11e3-b6b5-00144feabdc0.html?siteedition=uk#axzz2z2YftlQD). He also took comfort that an extended period of stable prices would be a force that would bolster real disposable income, and saw no evidence that households and companies were holding back from consumption.
Needless to say perhaps, this strikes a lot of people as odd, and reflects a fairly standard representation of the German financial establishment’s thinking. Not for them any funny-money policies designed to create bank reserves, or higher inflation expectations. But you have to ask whether Herr Stark’s observations are properly framed, and what the alternative might be if he’s wrong?
The framing of his observations is unequivocally incorrect. Commodity prices, exchange rates and relative prices certainly colour and correlate with the trends of inflation and deflation, but can’t be said to be causes. For that, you have to stay focused on aggregate demand. Protracted low inflation can surely raise or strengthen real disposable income if nominal incomes are higher and rising, but if they aren’t one or the other, low inflation is a symptom of a much deeper and broader malaise. And that is about the weakness of income formation, the polarisation of the wage and profit shares of income distribution, and the dysfunctional nature of contemporary labour markets.
And when Herr Stark says the ECB doesn’t and shouldn’t react to current data, relative prices and short-term inflation numbers, we can probably agree: the ECB should be taking a big view about what’s happening to the Euro economy, to demand, income formation and credit intermediation and conclude that all is not well. Fair enough – we know by now that QE has only a limited mandate as far as many of these structural economic issues are concerned, but that isn’t an excuse for inaction. Hopefully Draghi and the ECB will find the right and measured response, and remind their political masters of their responsibilities too.
Greece: captures dark side conundrum well
Greece, poster child for disarray and dysfunction in the Euro Area, has come to market with a successful 5 year bond offering that was several times oversubscribed, and two of its largest banks raised over €3 billion in new equity capital. The country has turned a structural fiscal deficit (cyclically adjusted primary balance) of 11% of GDP into a surplus of over 2%, according to the Commission. And it’s running a current account surplus for the first time since the end of the Second World War.
Mission accomplished? Hardly. Here’s a country that will have received over €240 billion in financial assistance by 2016, or roughly 135% of GDP. Total sovereign debt is expected to be around 175% of GDP in 2014, and, if all goes well, it should decline to 171% in 2015, 153% by 2017 and 137% by 2019, according to the IMF. But the IMF’s numbers show that Greece will need additional relief of 4% of GDP in the next 12 months and that the nominal value of debt will barely change over this period, and that the decline in the debt share of GDP is due entirely to a) assumed nominal GDP growth of close to 5% per annum from 2016-2019, and b) an assumed cyclically adjusted primary balance that is sustained at 5.5-6% of GDP until 2017, and then around 4.5% of GDP thereafter.
If Greece were able to satisfy both of those conditions, it would be remarkable. Bear in mind the latest CPI data for March showed an annual fall of 1.5%, the 13th sequential decline. Real GDP is expected to rise 0.6% in 2014, but the assumption that it will grow at 3% per annum for the next 5 years and beyond seems rather optimistic. And it is, frankly, most unlikely that Greece will be able to sustain such high structural fiscal surpluses in the face of an unemployment rate that is now 26.7% – and 60% for young people. This speaks to a highly stressed and fragile social and political picture in which reform fatigue is already quite transparent, and the temptation to default on even its restructured obligations is probably waxing.
Latest employment data paint sombre picture
The latest Eurostat Labour Force Survey underscores the dysfunctional nature of European labour markets, revealing not just 26 million unemployed in the EU28, of which about 19 million are in the Euro Area, but also ubiquitous part-time unemployment and under-employment (http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/3-10042014-BP/EN/3-10042014-BP-EN.PDF)
In 2013, among the 15-74 age cohort, there were over 216 million people in employment, 26 million unemployed, and 137 million economically inactive. Among the 216 million, almost 44 million were part-time workers, of whom almost 10 million were under-employed. Among the 137 million inactives, there were 11.5 million who were either available for work but not actively looking, and or looking for work, but not available.
In other words, nearly a quarter of the labour force were classified as part-time, under-employed, or potential working age cohorts, with the latter two categories accounting for about 10% of the labour force. But it’s when you look at the geographic dispersion that it looks really bad. In Greece, the proportion of under-employed part-time workers was about 72% of all part-time workers, while it was between 45-60% in Cyprus, Spain and Portugal. In Italy, roughly 12.5% of the labour force could be at work, but isn’t.
The combination of high unemployment and pervasive indicators of under-employment or other labour market dysfunction constitute a worrying background for the rising incidence of poverty and income inequality in the Euro Area specifically, but elsewhere among the EU 28 as well. Worrying, not just from a social standpoint, but also because the connection between these phenomena and longer-term economic performance and political stability is increasingly being emphasised.
It is overly simplistic to say this is all due to the financial crisis and the austerity regimes adopted since 2011. Europe has struggled for some time to lift employment rates productivity, especially in service industries, and to shine in innovation, R&D, and investment in human and non-physical capital. For a fuller explanation, see The Future of Europe’s Economy: Disaster or Deliverance by the Centre for European Reform, including your scribe’s contribution. (http://www.cer.org.uk/publications/archive/report/2013/future-europes-economy-disaster-or-deliverance)
But the effect of cumulative weaknesses in these areas and the impact of developments of the last 5 years has caused Europe’s social model to crack. No one argues that fiscal retrenchments were not needed but we can and should argue
- that there should have been and there is still a strong need for symmetry in terms of adjustments by both debtors and creditors
- that public investment was unnecessarily crushed, and
- that the manner in which austerity was implemented was particularly destructive with cuts falling heavily on public services and economic affairs, the distribution of spending cuts discriminating against the young compared with older citizens, and much bigger reductions in real spending focused on families, children, the unemployed and education and health, compared with housing and age-related benefits. (see for example the Bruegel report on Europe’s social problems and growth implications (http://www.bruegel.org/publications/publication-detail/publication/823-europes-social-problem-and-its-implications-for-economic-growth/)
Kind of puts the depths to which Greek, Spanish et al bond yields have fallen into a different perspective.