Eurozone Stagnation: Wrong diagnosis, wrong medicine, no recovery

 

By John Weeks

What the EC Doctors Said

If a doctor misdiagnoses a patient’s malady and prescribes an inappropriate medicine, we would not expect recovery to good health.  Should the doctor persist in the faulty diagnosis and prescribe further doses of the wrong medicine, the wise patient seeks a second opinion.  As evidenced by the experience of Greece last year, it is the misfortune of the residents of the eurozone that second opinions are not allowed.

In the early years of this decade the European Commission, fronting for governments powerful members, diagnosed eurozone members as suffering from lack of competitiveness in international trade.  The medicine implied by this diagnosis, controversial from the outset, included fiscal “consolidation” and “structural reforms”.

The first of these, summarized in the word “austerity”, dictated expenditure reduction and tax increases to reduce fiscal deficits.  The diagnosis implied emphasis on the former, because social expenditures allegedly harm competitiveness, as would higher taxes.  The most important “structural reforms”, vague enough to cover all policies to make policies more pro-business, involved reduction in worker and trade union rights, especially collective bargaining.

Governments of the putatively “uncompetitive” countries were lectured that obedience to the Commission’s prescriptions would eliminate efficiency-undermining maladies by “down-sizing” the public sector and directly reducing the production costs constraining wage growth.  In a more enlightened era this diagnosis and prescription would have been described as “mercantilist”, selecting government policies with the explicit goal of a trade surplus.

Ambiguous Fiscal “Consolidation”

The chart below shows that the Commission-fronted fiscal policies were associated with a decline in public sector deficits.  Fiscal deficits bottomed out in late 2009 (France, Italy and Spain) and late 2010 (Germany).  On average the Euro 15 (the foregoing four plus others adopting the euro in 2000-2001) reached its lowest point in early 2010 and subsequently rose.  Was this a success of austerity policies?

Dating the beginning of austerity policies involves considerable subjectivity.  As a programme implemented across the eurozone 2011 seems an appropriate date.  On the basis of when governments adopted European Commission approved austerity packages the BBC suggests late 2011 or early 2012.  If we accept this dating, the onset of deficit reduction preceded austerity policies by at least a year except for Spain.

Scepticism about the effectiveness of the EC prescription for deficit reduction increases by comparing the terminal years in the chart.  Though the German fiscal balance rose into surplus, after eight years France and Spain remained slightly below their 2008 values.   The Italian government achieved a very marginal deficit reduction (-2.7 to -2.5), and the contraction of the deficit for the Euro 15 disappears if we exclude Germany.

Overall Fiscal Balance Share of GDP, Euro 15, France, Germany, Italy & Spain, Quarterly 2008-2016 (4 quarter moving average)

0906weeks--fig.1

Source: Eurostat

Notes: Euro 15 is an EU category includes those eurozone members from 2001.

 

Mercantilism in Real time

Current account statistics provide more favourable results for the EC diagnosis and prescription (see chart below).  The German current account balance increased to over 8% of GDP in 2016, which according to the FT “boosted” the government’s popularity.  In Spain a deficit of almost -9% of GDP changed to a small surplus (net reversal of ten percentage points), with a less dramatic but strong shift in Italy from about -3% to +2%.  The French current account increased slightly (briefly positive), and all Euro 15 countries showed increases except Belgium and Luxemburg.

When assessing success in generating current account surpluses one must keep in mind that a decline in a country’s trade deficit implies a fall in domestic expenditure.  The most common form this takes is a decline in household consumption.  The striking case among the larger countries is Spain.

In 2008 Spanish per capita income was €24,400 and in 2016 will be slightly lower at 23,740.  Had it remained the same share of GDP, household consumption would have fallen by about 2.5% over the eight years.  Because of the large shift in the trade balance, private consumption per capita in 2016 was almost ten percent lower than in 2008.  In Ireland, one of the Euro 15, the trade surplus shifted by a massive 30 percentage points, leaving household consumption in 2016 almost 25% below its 2008 level.

These numbers demonstrate what until recently was a consensus across the economics profession – generating trade surpluses reduces the welfare of a population and in extreme cases impoverishes households.  This is especially the case when a surplus derive from depressing wages and output.

In itself a trade deficit need not bee a problem because short or long term money inflows can finance it.  Many countries, including EU members, have sustained trade deficits for extended periods, Britain being most obvious case.  A trade deficit does not necessarily indicate “lack of competitiveness” however defined.  In general it is not a problem that requires policy action even within a currency union.

Current Account Balance Share of GDP, Euro 15, France, Germany, Italy & Spain, Quarterly 2008-2016 (4 quarter moving average)

0906weeks--fig.2

Source: OECD

Note: numbers in legend average for entire period.

Was It All Worth It?

A recent article in the Financial Times cites the dubious Markit indices to tell the reader that the eurozone recovery has “weathered the shock” of the British vote to leave the European Union.  I stress “dubious” because the PMI for Germany showed an increase while the Munich-based Ifo index reported a drop in “business confidence”.

Considerably more informative than these methodologically problematical attempts to capture subjective sentiments is that the FT considered annual growth rates less than 2% to qualify as “recovery”.  This is a textbook case of redefining failure as success.  Productivity growth plus growth of the labour force represents the lower limit to the potential growth rate when a country’s economy operates near full capacity.  When below full capacity, the case for all eurozone countries with the possible exception of Germany, growth rates can rise considerably above this.

Across the eurozone countries private sector labour productivity growth slowed after the financial crisis of 2008-2010, but was well above one percent annually.  This number implies that taken together the eurozone countries must growth at least by 1.5% to prevent a rise in unemployment.  As the chart below shows, since 2012 only the Spanish economy sustained an annual rate of growth substantially above 1.5%.

Over the four quarters through June 2016 the German and French economies grew at rates just sufficient to prevent unemployment increasing, while the Italian rate fell far short.  On average across the eurozone GDP expansion was insufficient to lower the unemployment rate.  No rational person would call this “slow recovery”.  It is stagnation.

Annualized GDP Growth Rates Euro 15, France, Germany, Italy & Spain, Quarterly 2008-2016 (4 quarter moving average)

0906weeks--fig.3

Source: OECD

Note: numbers in legend average for entire period.

Fiscal deficits have fallen across the eurozone and most countries have passed from current account deficits to surpluses.  So slow has been progress on the former that the hypothesis cannot be rejected that initially larger deficits due to fiscal stimulus would have brought deficits down faster.  Similarly, the current account surpluses in most countries may reflect depressed domestic demand rather than greater competitiveness.

The German Chancellor described the British referendum result a “deep break in European history”.  At the meeting in Bratislava in mid-September she will face a range of complains and challenges, many of which have their source in the region’s economic stagnation.  One can speculate about the political health of the EU had she and her finance minister spent the last six years stimulating the European economies rather than “consolidating” and “reforming”.

James Galbraith Tells Us What Everyone Needs to Know About Inequality

By Polly Cleveland

Inequality has surged in the U.S. over the last forty years; many observers now blame the deregulation and tax cuts for the rich starting with the presidency of Ronald Reagan in 1980. In his new short book, Inequality: What Everyone Needs to Know, James Galbraith explains how this happened through the change in U.S industrial structure:

“In the early postwar period, the dominant American industrial corporation–such as General Motors, General Electric, American Telephone & Telegraph, International Business Machines–was an integrated behemoth that contained within itself not only production, but every phase of basic research, product design, and marketing that was relevant to its mission. Therefore incomes were distributed within the corporation by administrative decisions, governed by the bureaucratic imperatives and prerogatives of those in charge, and strongly responsive to the incentives of a highly progressive income tax structure. Top scientists and engineers, as well as top executives, were paid salaries, and salaries were regulated by the corporation. Tax structures also gave strong incentives for the corporation to retain profits, rather than pay them out as dividends, and to reinvest the proceeds–whether in factories or in the palatial towers that grew up in Manhattan, San Francisco, and Chicago in those years.

All of this changed with the tax “reform” movements of the 1970s and 1980s, which pushed for lower top marginal tax rates, fewer special exemptions from the tax, and for a “shareholder-value” model of corporate compensation. And a special feature of this change was that it created strong incentives to restructure the corporation itself.

“In particular, as the digital revolution came into view, the top technologists in the big corporations realized that they would be far better off if they set off on their own, incorporated themselves as independent technology firms, and then sold their output back to the companies for which they had formerly worked in salaried jobs.…

The effect of this structural transformation on the distribution of household incomes in the United States, as recorded in the tax records, is astonishing. For there were created, mainly in the 1990s, a handful of citadels of stratospheric incomes, previously unknown in the country and concentrated in the tiny handful of locations. One of these was Manhattan, the home of Wall Street and the source of finance. A second was Silicon Valley, a cluster of counties in Northern California. And the third was Seattle, Washington, and its near suburbs.”

Galbraith is describing the same phenomenon that Barry Lynn documented at length in his chilling 2010 exposé: Cornered: The New Monopoly Capitalism and the Economics of Destruction. That is, the transformation from vertically integrated firms to horizontally-integrated monopolistic trading companies, buying inputs from all over the world, squeezing both their suppliers and their customers. But Galbraith adds a new insight: not only did the postwar high-tax regime induce corporations to keep executive pay in check, it also induced them to retain profits and reinvest them in the corporation. With the 1980’s “greed is good” transformation, rates of reinvestment slowed as executives started taking more for themselves—surely helping slow the overall rate of growth.

Wait a moment! High taxes on income and profit produced more investment and growth? That’s the exact opposite of today’s Republican, and often Democratic, mantra that high taxes kill investment and growth. But the postwar taxes that tamed the corporate behemoths were in fact high marginal rates, top rates in a steeply progressive system. These were the very taxes imposed at the beginning of World War II to prevent war profiteering. These were taxes designed to capture the “unearned income” or “economic rent” of powerful corporations and wealthy individuals. It was perfectly logical for such corporations and individuals to “avoid” such taxes by investing money they would otherwise lose.

If high marginal income and profit taxes are so beneficial, is there any prospect—given the political will— of returning to such tax levels? Unfortunately, now that so many multinational corporations and wealthy individuals are registered or domiciled in tax haven countries, any simple effort to impose truly high marginal rates on profits or income will simply lead to more creative evasions, corruption (see Panama), and tax wars.

But, assuming the political will, are there other approaches? Galbraith proposes:

A much older and yet, to this day, still more promising alternative to taxing financial wealth is to tax land value, including the value of mineral and energy resources in the ground. The economic concept behind this idea is that of Ricardian rent–the argument that rents (which are inherently unproductive) flow to the owners of the fixed and non-reproducible asset, namely land. By taxing land and minerals, one reaches the least defensible forms of accumulated wealth, while at the same time doing the least to distort market decisions as between capital investment and hiring of labor. And there is another advantage: unlike financial wealth, land stays put. It exists in fixed jurisdictions with registered ownership; all the taxing authorities need to do is to send an appraiser, and then a bill. Local property taxes already work this way; however, in the United States landowner opposition to land taxes has been fierce, and many states are barred by their constitutions from levying property tax on a statewide basis. In California, notoriously, even local property taxes were capped in the late 1970s by a ballot measure strongly supported by wealthy landholding interests.

Land taxation has been for a century the program of the followers of the 19th century American economist Henry George, whose influence was vast around the world a century ago. One of his followers was the Chinese revolutionary Sun Yat-Sen, founder of the Republic of China in 1911. And Maoist China, by conducting an early war against landlords, ended up having the world economy most like the Georgist program in the modern age. But instead of taxing land value, the Chinese state actually owns it, and collects the land rent for itself. By doing this, Chinese municipalities and provinces have enjoyed ample revenue from which to make capital improvements, which is why Chinese cities have been able to grow like weeds in the reform era…

To this I would add that land taxes weren’t new in China: they financed Chinese empires as early as 2000 BC. Stiff land taxes of four shillings to the pound of assessed value financed the transformation of British finance in 1688; Adam Smith deemed them “the most equitable of all taxes.” Taxes on high profits and incomes and on land values all capture unearned income, or rents, forcing taxpayers to invest productively to pay the tax.