Thursday, October 16, 2014

Europe’s Keynesian Rebuke: It’s The Supply Side, Not Lo-Flation

By David Stockman

The mainstream narrative about the current facts of economic life is just plain nuts. They were at it again this morning in a Wall Street Journal piece on Europe’s impending triple-dip. It seems that the grim reaper plaguing the continent is insufficiently exuberant consumer prices:

Fears about perilously low inflation and weak growth continued to grip markets on Wednesday, with European stocks taking a fresh tumble and safe-retreat German government bonds notching up another record high.
Now just what is so “perilous” about a temporary period of consumer price stability and paychecks which maintain their purchasing power? The answer is exactly nothing, but today’s journalists are so lazy and subservient that they simply copy and paste the nostrums dispensed by the financial market gambling houses and the policy apparatchiks who pleasure them.

In fact, anyone half-awake over the last
45 years would not be wringing their hands about too little inflation. Nearly stable prices are the vast exception. The temporary respite from the chronic depreciation of our money that is now being experienced is actually a godsend; it’s a reminder that before the modern age of central banking the alleged “peril” of stable prices was considered the norm, and a salutary one at that.

By contrast, the graph below shows what has happened to the purchasing power of  typical European’s wages or savings since 1970. Nowhere on that chart are there more than brief—hardly detectable intervals—- when prices either plateaued or fell fractionally. Altogether, consumer prices rose by 11X over the last 45 years. Stated differently, most Europeans outside of Germany have experienced a 90% decline in the purchasing power of their money during the post-Bretton Woods era of so-called enlightened monetary management.

Dialing in on more recent times after the common currency emerged in the 1990s, the story is similar. Consumer level inflation has consistently been stuck in the 1.5%to 2.5% channel except for brief intervals in the late 1990s and 2008-2009, along with the present, when the consumer price index drifted toward zero or below. Yes, in all three of these periods either world oil prices were plummeting or the Euro was gaining strength.

quick view chart
In short, there is not a snowballs chance in the hot place that Europe has an endemic “deflation” problem. Indeed, as shown below, constant dollar household consumption spending in the Euro-17 area has sharply downshifted since the financial crisis. It rose at a 3.8% CAGR during 1995-2007, but has remained essentially flat since the 2007 pre-crisis peak.

Now don’t blame that on a collapse of inflation. When the oil and currency driven oscillations are smoothed out over a reasonable period of time, the rate of consumer price gains is roughly equal. The CAGR for the 1995-2007 period is 1.9%, and the average for the past seven years is about 1.8%.

In short, there is virtually no correlation between the graph below on real consumption spending in the Euro-17, and the minor oscillation in the Euro area consumer price index shown above. Self evidently, consumers spend more on petroleum products when world oil prices are surging and less on other things; and vice versa when the global oil market goes through one of its periodic swoons. Short-lived bouts of deflating oil prices are good for airline, hotel and restaurant demand—-just as they have the opposite impact and cause household spending priorities to be re-allocated during their flare-up episodes. But the the resulting modest and fleeting impact on the CPI index has nothing to do with the fundamental ingredients of economic growth.

quick view chart
The whole deflation bugaboo is actually just Keynesian speak for the wholly confected notion of “economic slack” and insufficient “aggregate demand”. In their wisdom, Keynesian economists postulate that economies have a natural rate of growth, say 3%, and that when GDP expansion falls below this rate it means that some magic ether called “aggregate demand” is coming up short.  Naturally, it is the job of the state’s monetary and fiscal machinery to compensate for the slack or shortfall from potential GDP by means of spending stimulus through direct fiscal injections or the credit expansion channel of monetary policy.

So what the whole inflation is too low gambit is actually about is just a proxy for weak aggregate demand, and therefore more policy “stimulus”. But here’s the thing.  Aggregate demand is weak if production is weak. They only way household consumption can exceed the rate of production and income growth is if average leverage ratios are rising, thereby supplementing earned income with borrowed funds or a reduction in the pre-existing rate of savings. As should be evident by now, raising the leverage ratio is a good one time trick, but at some point balance sheets become saturated and the game ends.  Europe is at that point now, and so is the rest of the DM world.

Instead of the CPI, therefore, the better measure of economic fundamentals is supply side factors reflecting production and the burden of state intervention, and balance sheet factors reflecting the trend in leverage ratios. As shown below, these fundamentals, not the bugaboo of weak inflation, explain why Europe is heading into a triple dip.

In the first place, the Euro area has registered no net growth in industrial production since the turn of the century. After the oil price spike and financial crisis in 2008-2009, industrial output has remain stagnant at the level attained prior to the worldwide bubble of 2004-2008. The reasons for this are structural: outside of Germany, Europe’s wage rates are too high, labor protectionist laws to onerous and welfare state benefits to generous to compete with the rest of the world.  In a word, Europe is not growing because it’s supply-side is impaired. Its rates of real consumption and GDP growth have flat-lined because production and income are not expanding, not because inflation is too tepid.

quick view chart
Secondly, European governments and households alike have used up their available balance sheet headroom. Accordingly, the GDP metrics are no longer being flattered through the device of borrowing growth from the future by means of rising leverage ratios. The Keynesian spending metrics of GDP accounting are therefore once again anchored to the real economics of the production and supply side.

The graph below represent the weighted average burden of public sector debt to GDP in the Euro-17 area. Unless the entire EC wants to vault above the 100% threshold, it simply has no aggregate room for the Keynesian borrow and spend recipes now being peddled by the IMF and Brussels bureaucracies as an antidote to the phony problem of “low-flation”.

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Likewise, the household sector is also tapped out. After soaring during the early years of the euro project, leverage ratios are now rolling over, meaning household spending is once again constrained to the level of production and earned income.

Finally, it should be noted that taxes do have their price. Notwithstanding the quirky manner in which the EC statistical bureau presents its numbers, it is evident that the tax wedge on production is rising.

quick view chart
So there is a reason that Europe is being left behind compared to even the tepid growth in the rest of the DM; and that it still has not recovered it 2007 level of real output. For sure it is not because the euro-area CPI has temporarily dipped owning to the strong Euro, which is now in the rearview mirror, and the collapsing oil pries, which account for much of the inflation slowdown.
Its the supply-side and the balance sheets, stupid!

David Stockman was the Director of the Office of Management and Budget during part of the Reagan Administration, from 1981 to 1985. He is the author of The Great Deformation: The Corruption of Capitaism in America and The Triumph of Politics: Why the Reagan Revolution Failed.

 The above originally appeared at David Stockman's Contra Corner and is reprinted with permission. 

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