Fiscal deficits in Europe help to support growth

I read this article yesterday (published August 12, 2013) – The euro area needs a German miracle – among a group of articles that are concluding that things are on the improve in Europe. I expect a wave of articles which will be arguing that the harsh fiscal austerity has worked. I beg to differ. This article agrees that it is too early to “declare victory” because the austerity has to go further yet. My interpretation of that claim is that the author doesn’t think the ideological agenda to shift the balance of power away from workers has been completed yet. But the substantive point is that the fiscal austerity failed to promote growth and growth has only really shown its face again as the fiscal drag has been relaxed. This relaxation is much less than is required to underpin a sustained recovery at this stage but it is a step in the right direction. Governments, with ECB support, should now expand their deficits further and start eating into their massive pools of unemployment. In her 1942 book – An Essay on Marxian Economics – Joan Robinson wrote the following (my edition is 1974 and quote is from Page 22):

Voltaire remarked that it is possible to kill a flock of sheep by witchcraft if you give them plenty of arsenic at the same time. The sheep, in this figure, may well stand for the complacent apologists of capitalism; Marx’s penetrating insight and bitter hatred of oppression supply the arsenic, while the labour theory of value provides the incantations.

Let me be clear that I do not share John Robinson’s assessment of the role of the labour theory of value developed by Marx in his overall theoretical exposition.

But I was reminded of this quote when I read the following from the article cited in the introduction:

More structural reform in the euro area periphery will be needed to achieve the adjustment and increase exports. This includes labour markets but perhaps more importantly the numerous regulations at the firm level which hold back competition and increase rents while preventing prices from adjusting. But it would also help if German growth were more substantial.

The German growth is the “arsenic” while the “structural reforms” are the incantations.

I agree with the article that “German public investment is currently one of the lowest in the EU and in many areas the lack of public investment is becoming a bottle neck for growth”.

I also agree that a redirection of the speculative German investment that was largely unproductive in the pre–crisis period towards the domestic German economy would be beneficial for real GDP growth in that nation as well as for other nations which trade with it.

Further, the idea that Germany might invest in human capital development infrastructure (training, education etc) to “facilitate labour migration from countries with high unemployment rates” is exemplary.

The point is that more public spending is required immediately to generate growth in Europe.

There was another article in the British paper, The Independent last week (August 15, 2013) – Eurozone crisis over? The single currency bloc’s long recession has finally ended… – which also weighed into the crisis is over discussion following the release of the latest Eurostat real GDP estimates.

After noting the facts (taken off Eurostat’s data release), the article said that:

The genesis of the eurozone’s crisis was in the vast current account deficits that peripheral nations ran in the first decade of the single currency’s existence.

Which was news to me. The Genesis – that is the beginning – of the crisis was a major collapse in private spending, exacerbated by an ideological obsession with anti-growth fiscal rules (the Stability and Growth Pact) that had suppressed demand for some years and held unemployment well above the full employment levels.

The current account deficits have nothing substantive to do with the collapse in private spending. They may have had distributional consequences once real GDP growth nosedived in the face of the sharp reductions in aggregate demand. But that is another story.

The article does however note that the positive GDP results mask what is really happening in the European economy.

It tells us that:

Current account deficits have indeed fallen, but the data breakdown suggests this has mainly been achieved by crushing imports and high unemployment rather than a surge in exports and gains in competitiveness. The danger is that these deficits will simply rebound if domestic demand returns.

The decline in imports is greater than the growth in exports in many nations, which is unsurprising given the drop in national income.

The article also makes this extraordinary statement:

Despite multiple rounds of austerity, weak growth has led to stubborn budget deficits in several states

We merely need to note the word “Despite” and substitute “Because of” in its stead. I make that suggestion quite independent of the debate about syntax rules where a subordinating conjunction (because) should always introduce a subordinating clause. We stay clear of the rules of English language in this blog (probably because I have forgotten them all!).

So how are those structural reforms doing in terms of enhancing international competitiveness? Brief answer: not very well it would seem. Here is an update on the movements in the Bank of International Settlements monthly Effective exchange rate indices – which they publish for 61 countries from January 1994.

You can learn about this data from their publication – The new BIS effective exchange rate indices – which appeared in the BIS Quarterly Review, March 2006.

There was an earlier publication – Measuring international price and cost competitiveness – which appeared in the BIS Economic Papers, No 39, November 1993.

Real effective exchange rates provide a measure on international competitiveness and are based on information pertaining movements in relative prices and costs, expressed in a common currency. Economists started computing effective exchange rates after the Bretton Woods system collapsed in the early 1970s because that ended the “simple bilateral dollar rate” (Source).

The BIS say that:

An effective exchange rate (EER) provides a better indicator of the macroeconomic effects of exchange rates than any single bilateral rate. A nominal effective exchange rate (NEER) is an index of some weighted average of bilateral exchange rates. A real effective exchange rate (REER) is the NEER adjusted by some measure of relative prices or costs; changes in the REER thus take into account both nominal exchange rate developments and the inflation differential vis-à-vis trading partners. In both policy and market analysis, EERs serve various purposes: as a measure of international competitiveness, as components of monetary/financial conditions indices, as a gauge of the transmission of external shocks, as an intermediate target for monetary policy or as an operational target.2 Therefore, accurate measures of EERs are essential for both policymakers and market participants.

If the REER rises, then we conclude that the nation is less internationally competitive and vice-versa.

The following graph shows movements in real effective exchange rates since January 2008 until July 2013 for selected Eurozone nations and the Euro area overall.

Following the crisis, the general tendency was for real effective exchange rates to decline until mid-2012 However, the real effective exchange rate for Greece in July 2013 (Index value = 99.597) was virtually unchanged compared to the value in January 2008 (Index value = 100).

As the Troika was hacking into public spending and destroying jobs and pushing up poverty rates, Greece became less competitive.

However, we are now seeing a reversal of the rise in competitiveness and the indices are pushing back towards their January 2008 values albeit at different rates.

The Euro nations have not succeeded in significantly increasing their competitiveness despite massive cuts. Internal devaluation is not an effective way to increase international competitiveness. The costs of such a strategy are too high and society breaks down before you get close to the goal.

While the dogma is that a nation that cuts its wages will improve competitiveness is rife, the reality is clearly different.

The problem is that if a nation attempts to improve its international competitiveness by cutting nominal wages in order to reduce real wages and, in turn, unit labour costs it not only undermines aggregate demand but also may damage its productivity performance.

If, for example, workforce morale falls as a result of cuts to nominal wages, it is likely that industrial sabotage and absenteeism will rise, undermining labour productivity.

Further, overall business investment is likely to fall in response in reaction to the extended period of recession and wage cuts, which erodes future productivity growth. Thus there is no guarantee that this sort of strategy will lead to a significant fall in unit labour costs.

There is robust research evidence to support the notion that by paying high wages and offering workers secure employment, firms reap the benefits of higher productivity and the nation sees improvements in its international competitive as a result.

But then why is there growth in the face of the harsh austerity?

The following graphs shows the change in budget deficits (data from Eurostat) for most European nations over the last 8 quarters (2 years), then the last 6 months compared to the previous 6 months, and finally just the last six months for highlight.

The impact of the fiscal consolidation over the last two years is evident – a positive outcome means that the deficit has shrunk. You can see that for the majority of nations shown (albeit a slim one) the deficits were lower than they were two years ago.

42.8 per cent of the nations had higher deficits in the first-quarter 2013 than they had two years ago.

If we consider the more recent period and split the last 12 months into two semesters then the picture changes considerably. In the first semester of the last 12 month period, only 32 per cent of the nations shown expanded their deficits. In other words, fiscal consolidation (using the conventional terminology) was rampant – and so was the continuing recession.

However, in the second semester of the last 12 months up to the first-quarter 2013, 78.5 per cent of the nation’s expanded their deficits. In other words, there was a fiscal expansion in the vast majority of the nations shown – and there were kernels of growth.

This is the picture over the last 6 months. The fiscal positions may not be appropriate given the massive pools of unemployment but they have moved (mostly) in the right direction – to support increased growth.

Of-course, we don’t have sufficiently detailed data at present to decompose the overall change in the budget deficit outcomes for each nation into structural and cyclical components.

But for the purposes of today’s blog that is not very important. The fact is that when a deficit is rising the public sector is increasing its net spending and increasing its contribution to real GDP growth (which in some circumstances might be expressed as a small negative contribution to real GDP growth).

Conclusion

The fact is that the European growth is showing that when the fiscal austerity is eased, spending rises and so does output growth.

The related data also shows that despite all the structural change agendas, the main target of that change – improved international competitiveness is moving in the opposite direction.

The improved external deficits are thus mainly the legacy of austerity-damaged economies draining import demand than a mass outbreak of exports.

A little musical end for today

And the direction of the real effective exchange rate graphs reminded me of this great song from 1975 from the equally great Australian soul singer Renee Geyer – Heading in the Right Direction.

When you smash economies with harsh cuts to pay, pensions, public investment, health expenditure and force increasing (and historically huge) proportions of the workforce into unemployment, there is little chance that international competitiveness will rise.

The graphs showing continuing deteriorating international competitiveness are thus “heading in the right direction”.

And I also thought you might like to remininisce a little on the fashions of the mid-1970s – those flares were really something else. Did I have a pair? No personal information divulged in that regard but the answer is nyet!

That is enough for today!

(c) Copyright 2013 Bill Mitchell. All Rights Reserved.