Eurozone rescue packages will continue to fail until they deal with the central issue in Europe's recession

By John Ross

The international financial system is passing through the agony of a new round of the Eurozone debt crisis for the simple reason that European governments, like that in the US, refuse to deal with the core of the economic recession in Europe for reasons of economic dogma.

Anyone who looks at the economic data for the Eurozone without wearing ideological blinkers can see the situation at once – it is charted in Figure 1. The Eurozone recession is due to a collapse in fixed investment. Taking OECD data, at inflation adjusted prices and fixed parity purchasing powers (PPPs), then between the last quarter before the recession, the 1st quarter of 2008, and the 2nd quarter of 2011 Eurozone GDP fell by $204bn. But private consumption declined by only $29bn while the net trade balance increased by $32bn and government consumption rose by $91bn.

However fixed investment fell by $290bn – i.e. the recession in the Eurozone was wholly due to the fixed investment decline

Figure 1

Equally evidently, due to its scale, until this fall in investment is reversed it will take a prolonged period for the recession to be overcome. Therefore to restore growth, which by now is generally realised is the core to turning round the budget deficit problem, the fixed investment decline must be overcome.

Nor is there anything mysterious about how to do this – the state has entirely adequate means. To take the most decisive international case China made the core of its stimulus package direct state investment particularly aimed at infrastructure and housing – the result being that China’s economy has grown by over thirty per cent in three years.

Europe and the US clearly do not have the scale of state sector, nor the political willingness, to act on the scale China did. But US history shows that even without proceeding to a socialist scale of measures direct state intervention on investment is entirely possible.

Roosevelt expanded US state investment from 3.4% of GDP to 5.0% between 1933 and 1936 (data from US Bureau of Economic Analysis Table 1.5.5). Jason Scott Smith, in his study of New Deal public spending, summarises such investment as including 480 airports, 78,000 bridges, 572,000 miles of highway - which, in addition to its immediate effect in stimulating demand, reinforced the productive position of the US economy. Roosevelt, it is superfluous to point out, was neither a socialist nor a communist (despite claims to the contrary by the US right!).

Quarterly, up to date, data is regrettably not available on what is occurring across the Eurozone for state investment, but it is available for the US and there is no reason to suppose, with  current policies, that the situation in Europe is any better. Between the peak of the previous US business cycle, in the 4th quarter of 2007, and the 2nd quarter of 2011 US private fixed investment fell from 15.8% of GDP to 12.2% - i.e. a decline of 3.6% of GDP. Yet in the same period US state investment did not compensate but also fell marginally – from 3.3% of GDP to 3.2% of GDP. Therefore while Roosevelt expanded the weight of US state investment current US administrations have been letting it fall.

Instead of directly addressing the core issue of the investment fall European administrations are either attempting to stimulate it indirectly – which, as it is ineffective, has led to fiscal/sovereign debt crises, or are acting via expansion of the money supply – which, in a situation whereby companies and households are paying down debt, is merely the famous ‘pushing on a piece of string’.
The most favourable outcome of such a situation is that eventually the debt will be paid down, but only after several years of stagnation. The less favourable variant, of course, is that the banking system breaks under the strain and renewed recession is further propelled by fiscal cutbacks. All these problems simply arise from the fact that, under the rubric of the dogma ‘private equals good, state equals bad’, European governments refuse to use the state tools available to deal with the investment fall which is at the core of the Eurozone recession.

Some European politicians are now beginning to call for state measures to increase investment, UK Business Secretary Vince Cable being one. But the action they envisage so far is inadequate to deal with the scale of the investment fall.

China's economy, which does not have such ideological inhibitions, will continue to expand while the Eurozone remains relatively stagnant for a significant period - and as long as economic stagnation continues there will be no resolving of the Eurozone debt crisis.

A Brighter Economic Future For Britain

By Michael Burke

‘A Brighter Economic Future for Britain’ is the title of a new pamphlet co-written by the present author and Professors George Irvin and John Weeks. In the Guardian we set out the rationale for the publication:

‘The UK depression has already lasted three years, and NIESR argues that is likely to last five years or more – longer than that of 1930s.

Yet economic debate is dominated by counterproductive attempts to reduce the deficit through cuts in public spending, which are now the single most important cause of the depression.’

The full article can be read here.

In an argument that will be familiar to regular readers of SEB, the pamphlet argues that public spending cuts are counter-productive both in terms of reviving growth and in reducing the public sector deficit. This is because the deficit itself is primarily a product of the depression.

Further the underlying cause of the depression is a private sector investment decline, which by the end of the 1^st quarter of 2011 accounted for 80% of the total lost output since the economy began to contract 3 years earlier – that, is £44.9bn of a total of £56.3bn.

Therefore breaking that investment strike is a pre-requisite to any sustained recovery. By investing in areas such as housing, transport, infrastructure and education, the government can lead an economic recovery that meets acute economic needs and reverses the rise in joblessness.

The pamphlet puts forward two related solutions to the crisis- the creation of a state-owned Investment Bank and using the excess capital at the state-owned banks to fund the needed investment.

Importantly, this analysis is beginning to win political support. In welcoming the attempt to turn the debate towards an investment-led recovery Jon Trickett MP argues in a foreword to the pamphlet,

‘Collapsing investment hits current growth and long-term productivity.....Working on the premise that we must tackle investment and long-term competitiveness the authors argue that one way forward which would increase demand in the economy, and raise both employment and productivity, would be to take action now to address this issue.....The pamphlet sets out one idea from the authors to tackle this collapse investment; a National Investment Bank, using the government’s majority stake in Lloyds-TSB and RBS.....There are those who would argue that this would indeed be poetic justice.’

The continued economic stagnation in Britain and some other leading economies will force a reconsideration of policy even among the architects of the current crisis and their supporters. In Britain , though, a Tory economic ‘Plan B’ is likely to include privatisation, deregulation as well as attacks on social protections such as maternity/paternity leave, pensions and an abuse of youth ‘training’ programmes to provide unpaid labour. But none of this will alter the basic problem that private firms are sitting on hoards of cash that they refuse to invest, while also leading to further impoverishment for the overwhelming majority of the population.

Likewise, since at least the ‘worse than Thatcher’ New Labour Budget of 2010 there are many now on the opposition benches who fundamentally agree with the ‘austerity’ policy. They merely advocate slower, shallower, more anguished cuts. But as the economy has already stalled under the impact of less severe cuts than they would now be implementing, the Labour supporters of cuts are also obliged to look for a ‘Plan B’. Whether they move towards Osborne, or in the direction of state investment to generate recovery remains to be seen.

In any event, as the pamphlet argues there can be no suggestion of a sustained recovery without replacing the policy of cuts with a government-led investment recovery.

Social Unrest and Government Policy

By Michael Burke

There’s a very good piece on LabourList titled ‘Who Didn’t Predict a Riot?’ It lists many of the bodies or leading individuals who warned that deep cuts to public spending would lead to social unrest and violence. The short piece is worth reading in full, but here is a (far from exhaustive) list of those who did predict riots and civil disturbances because of the policies of the Tory-led government:

• Derek Barnett, president of the Police Superintendents' Association
• The Commissioner of the Metropolitan Police
• Karen Ward, senior economist at HSBC
• The Governor of the Bank of England
• The Archbishop of Canterbury
• Nick Clegg, and not least,
• Youth workers in some of the affected areas

The latter prediction was made in response to the closure of most of the youth clubs in Haringey, but all the warnings were made in an assessment of the impact of the cuts.

The disturbances were therefore not only a predictable cause of the government’s policies, they were predicted by a broad array of specialists and commentators, many of whom are not particularly hostile to the government (and one is a leading member of it). Based on historical experience, not least the effects of Thatcher’s cuts in the early 1980s, it was inevitable that riots and other disturbances would follow as a consequence of government policy. The list is a bit long and comprehensive for the Tories to dismiss them all as excusing rioting – although doubtless that won’t stop them.

Analysis from the Guardian has shown that, while rioting and looting include many layers of society and has many motivations, the striking fact is that of those currently charged with offences, 41% live in the most deprived 10% of areas in England. This too is predictable. As bodies such as the Institute for Fiscal Studies have pointed out, the poorest have been hardest hit by the cuts. Therefore, just as it is inevitable that deep cuts to public spending will lead to social unrest, those most harmed by the cuts, or at least some living in those communities will be at the forefront of that unrest. Latest analysis from the TUC shows that in some of the riot-affected areas there are 20 jobskeekers for every job vacancy.

Of course, even in the most deprived areas, the majority of people do not riot, still fewer engage in looting or approve of it. But opinion polls also show that while most think the police responded well to the riots (despite widespread media criticism of them) most also believe that David Cameron, Theresa May and Boris Johnson did not respond well to the riots.

Strikingly, while a majority of between 8% and 10% believe that government policies on welfare, education and law and order will make matters worse, double that level, 20% believe that government economic policies will have the same effect. A net 23% also oppose the cuts to police budgets.

Although opinion polls only ever represent a snapshot, and views expressed are often contradictory, this set of opinions reflects a fundamental truth. Government policies are not only impoverishing the majority, they have predictably led to violent social unrest. The continuation of these policies will only exacerbate those trends.

Tory policies are making the overwhelming majority worse off while also making their neighbourhoods and town centres less safe.

Economic Crisis Is Cause of Deficits, Not Vice Versa

By Michael Burke

SEB has repeatedly argued that it is the economic crisis which has caused the rise in government budget deficits, not vice versa. This view is reinforced by the recent gyrations in global financial markets. .

This issue is crucial for the debate on economic policy, as understanding the real factual situation clearly leads to promoting growth as the means to tackle the deficits. By contrast, an analysis which suggests that it is the increase in government spending which has caused the economic slowdown can simply be addressed by cutting that spending.

The latter is the policy pursued by the Tory-led Coalition. It has strong ideological support across the media, including the BBC. It is not at all based on the facts. Before the Great Recession began in 2008 the public sector deficit in the UK economy was 2.7% of GDP. It rose to nearly 4 times that level in 2010 at 10.4% of GDP. The same is true across the Euro Area as a whole, where the deficit was a negligible 0.7% of GDP in 2007, and rose to 6% last year.¹ The same pattern is evident in the US where the deficit rose from 2.8% to 10% of GDP, and in Japan from 2.4% to 9.7%. The public sector deficits in all cases rose under the impact of the recession and the varied efforts of governments to offset its effects. There is a very useful dissection of the sources of the US deficit here from Professor John Weeks . In the US as elsewhere, the deficit is driven by the fall in both income and corporate tax revenues, and a rise in unemployment benefit payments as the jobless total rose.

The recent turmoil in financial markets arises because of the accumulating evidence of a renewed slowdown in economic activity, including both in the US and Europe. But this has not prevented the widespread assertion that the turmoil was caused by the European debt crisis. This is to compound the initial error, which also views the world through the wrong end of the telescope and holds that deficits are causing the slowdown.

A characteristic example of this incorrect assertion comes from the BBC’s business editor Robert Peston. On August 7 Peston wrote: ‘Although bankers say the downgrading of America’s credit rating was unwelcome, their more pressing worry is the rising price Italy has to pay to borrow - the rising price of Italian government debt’. Italy is extremely important, as it is both the third largest economy in the Euro Area and has the largest level of outstanding government debt. But the yields on Italian government debt had peaked on August 4, and as the chart below shows fell continuously through the following week.

Figure 1 Italian government debt yields

Bond prices rose for all EU governments and their yields fell as the ECB bought €22bn in EU government debt. This is a welcome departure from the ECB, and represents a further small step in the direction of EU-wide solution to the crisis rather than further attacks on ‘peripheral’ economies. It is also likely to be insufficient given the scale of the deficits and existing debts in the Euro Area. But it is clear from the chart that the continued turmoil in stock markets is not driven by EU bond markets - they had stabilised.

At the time of writing, most major stock markets are falling once more in reaction to the weak German GDP for the 2^nd quarter, up just 0.1% in the quarter. By contrast government bond prices are rising and yields falling - in the case of Germany and the US to new record lows . And bond yields for the crisis-hit European countries are now back at levels last seen a month ago, before the EU summit on Greece.

The same cannot be said for stock markets. The chart below shows the performance of leading stock markets. All the major stock indices of the US, Germany, France and Britain are nursing losses in the range of 5-10% - the exception is the Shanghai Composite Index which has recovered all the recent lost ground.

Figure 2 Major Stock Market Indices

There is a clear message from the divergent paths of major financial markets in recent days. Stocks have fallen and bonds have risen because growth is weakening once more. The markets have taken fright not from public sector deficits, which remain large - yet bond yields are falling. They have taken fright from slowing economic activity. Financial markets are not clamouring for spending cuts, VAT hikes and job losses. The remedy they seek is the one that is necessary for the economy- a return to growth.

Notes

1. Eurostat, Euro Area Spring Forecasts 2011,

More than three years without full economic recovery in the developed economies - the latest GDP figures in context

By John Ross

The publication of the European Union (EU) and German 2nd quarter GDP figures, following those for the US and Japan, completes the data regarding the state of the business recovery in the main developed economies. The picture is completely clear – Figure 1:

• By the 2nd quarter of 2011 none of the major regions among the developed economies has recovered their peak level of GDP more than three years after the high point of the previous business cycle.

• US GDP is 0.4% below its peak level in the the 4th quarter of 2007.


• EU GDP is 1.8% below its peak level in the 1st quarter of 2008.


• Japan’s GDP is 6.0% below its peak level in the 1st quarter of 2008 – Japan’s data is of course affected by the earthquake and tsunami.

Overall, taking the period as a whole, this represents over three years of net negative growth in the developed economies. The key economic issue is not the possibility of a double dip recession, which the media is speculating on, but this extremely low growth rate even without one.

For comparison it may be noted that China’s economy has grown by over 30% in this same three year period.

Figure 1

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This article originally appeared on the blog Key Trends in Globalisation.