Europe is caught in a self-fulfilling cycle that leads to depression. Both unemployment and inflation are rising. The crisis is systemic and only system-wide solutions will prevent the worst.
|Image Source: Valuenotes|
The latest report from Eurostat brought ill news in two ways. Rising unemployment, both in the euro area and in the whole EU, and rising inflation in the eurozone. The first is the increase in unemployment which has reached an EU17 (Eurozone) average of 10%, while in the EU27 it stands at an estimated 9.5%,. These are very worrying figures, especially in terms of social coherence. The other worrying figure is annual inflation in the Euro area, which is estimated to have risen from 2.5% in August to 3% in September. I shall examine the implications of these new figures, but first I should point out that one should not look at these figures in the very short-term, since they are subject to fluctuations. Also inflation is not something that monetary policy addresses in the short-term, but it is dealt with over a much longer period of time, otherwise central banks (the ECB in the euro area) would have to change policy every few months, which would produce instability and ultimately adverse effects. Evaluations of such figures can only be made by taking into account the broader economic environment, which is what I shall try to do.
The ECB has kept primary interest rate at a relatively high level (now 1.5%) in order to contain inflation. By having its interest rate at such levels, the ECB aimed to reduce the quantity of money by reducing the incentives to hold money, by making it more expensive. There has been a big discussion on whether the ECB should follow that strategy, since the immediate effect was to worsen the position of the European periphery, by further worsening their liquidity problems (especially Spain and Italy). World renowned experts, such as Nouriel Roubini have time and again expressed their opposition to the hawkish strategy of the ECB. Indeed the policy of the ECB has only benefited central European countries. Yet I find it unproductive to contemplate on normative statements about the path the ECB governors in Frankfurt should have followed. Moreover the debate of who is responsible how and why, resembles the egg and the chicken argument, which I am not willing to discuss. What matters at present, is that despite the hawkish attempts to keep inflation low, by increasing the cost of money, inflation has still risen. Why did it rise? What should the ECB do from now on? Can the ECB alone contain inflation amid the systemic crisis of the euro? These are the questions that only make sense now and I shall attempt to provide some food for thought by answering them.
|Trade balance. Source: Streetlight|
Why did inflation rise, since primary interest rates were high? The answer lies in the overall structure of the eurozone economy. We have an export-oriented European center and an import-oriented European periphery. The center has trade surpluses, while the periphery has trade deficits. The surpluses of the center are the deficits of the periphery under the current, flawed structure of the euro which lacks stabilizing mechanisms to bridge the gap that leads to economic divergence (those who say that the periphery should reduce its trade deficits ignore that the center will also have to reduce its trade surpluses). Under the current crisis, the periphery has fallen into a deep recession which implies that their demand for the exports of the center has fallen. This in turn leads to a slowdown in the export-oriented center. The reason Germany and the rest of the surplus countries enjoyed impressive growth rates in recent times, has absolutely nothing to do with some magic policy that the policymakers have found and implemented. It was only caused by the increasing demand from emerging markets. But now emerging markets have also slowed down, because of the demand for their own exports from western countries has fallen. To cut the long story short, the two sources of aggregate demand for the European center’s exports have both been reduced, which means that the European center can no longer grow as much. How is all this related to the rise in inflation? Simply enough, the exports of the center did not allow any bubble to emerge domestically, that is why bubbles popped up in the periphery. But now that exports are declining, a bubble will eventually pop up in the European center. In my view this is the main reason inflation is rising.
What can the ECB do to contain inflation and can it do so alone? The ECB is in the unpleasant position where it has to choose between two really bad options, either to keep primary interest rate constant with all the negative effects this already has on the liquidity of the periphery and especially the worsening of the position of Italy and Spain, or to increase interest rates in an attempt to contain or even reduce inflation at the expense of depriving the real economy of much-needed liquidity. This is a tough trade-off and I am afraid to say that the ECB can do little to contain inflation since the primary source is systemic and cannot be solved through monetary policy, without hindering the economy. What is certain though is that there is absolutely no way the ECB will decrease its primary interest rate, as many wished it would. The ECB alone will not be able to solve the systemic source of the crisis, since this lies in the overall slowdown of the global economy and of the European center as explained in the above paragraph.
The lesson from the above, is that to tackle inflation the exports of the center need to be revitalized and to achieve that European countries will have to either wait for emerging countries to recover which is unlikely since they too depend on western countries who themselves have slowed down; or to find ways of allowing the European periphery to grow so as to absorb the exports of the center. European policymakers can do nothing to stimulate foreign demand. All they can do is to improve their own position, which will in turn lead to an improvement in the position of the global economy. This in practice means to devise all necessary policies to produce a growth spree that will push the European periphery and thus the whole of Europe out of the recession (to view an overview of the steps that can be followed towards that direction see Time for a Euro-wide strategy to deal with the systemic crisis).
|In red are the rates of EA17 – 10% (Eurozone) and EU27 – 9.5%(whole EU)|
Unemployment in Europe has always been at higher levels relative to other developed countries. The current crisis has made things worse and in countries like Spain (far left on the graph) it has reached a stunning 20%. There are political, sociological and economic dimensions to the matter, I shall focus on the economic, but only to mention the political impact of unemployment I say that it is the most fertile ground for populism and europhobic propaganda, with all the ramifications this might have on the way national electorates put pressure on their representatives to shape the way European leaders deal with the crisis.
The way I see it, the current recession creates unemployment which in turn puts much pressure on public finances, since the unemployed depend on state benefits to survive while their reduced income means less tax revenue for the state; while also it reduces aggregate demand, which implies that growth falls. The current strict austerity policies, what I consider a fiscal discipline delusion, since they only focus on state finances as if those exist in a vacuum, only succeed in making things worse, by increasing unemployment, reducing growth, worsening the recession. Anyone willing to board the train of thought of this process understands that without any Euro-wide growth strategy working in parallel, austerity is a self-defeating policy that creates a self-fulfilling cycle of recession and eventually state insolvencies, that will lead to catastrophic defaults. It is true that unemployment puts downward pressures on wages, which from the perspective of employers is a good thing as it reduces labor costs. However excessive unemployment in the form we now have reduces aggregate demand which is bad even for the employer. In short some unemployment is good for the economy but too much of it is very bad.
The problem which now rises is that unemployment together with inflation leads to a nightmarish scenario – stagnation in the economy and rising prices (stagflation). The two combined are by far the worst possible scenario for any society/economy as it creates a downward spiral of suffering. How to avoid this? Again the answer lies in stimulating growth, not by national authorities, since many are nearly bankrupt, but by a Euro-wide strategy that will address all three dimensions of the current systemic crisis: debt, quasi-bankrupt banks, under-investment.
My monitoring of the systemic crisis of the euro has led me to one general conclusion: there are no easy ways to deal with the crisis, both because of the systemic nature of the crisis and the fact that it unfolds in three separate realms (debt, banks, investment), but also thanks to political obstacles and structural political rigidities that do not allow space for maneuvers or at least for shaping desirable policies with ease and on time. The cruel reality is that there are no unicorns, no Santa-Klaus, no fairies that could solve the malignancies of our economies/societies/states. All measures will come with pain and suffering for the economy and the society and with political cost for all politicians.
What our leaders need to realize, before it is too late is that the crisis is systemic and will only be solved by making audacious steps within the context of a coherent system-wide strategy. For the time being our leaders have no such strategy. They only follow the approach of treating the crisis as a series of perfectly separable local (national) crises, even though this is absurd within a currency union, and they call for massive front-loaded austerity that is not accompanied by any growth plan, which renders it self-defeating.
I know that the EU/Eurozone has the capacity to solve its problems with its own means but must choose to do so. A solution can only come within the existing institutional framework – those who call for a federation as a solution to the short-to-medium term problems are simply detached from reality. A federation in Europe will require decades to take material form even though it is the desired long-term objective, so lets leave federalism for the future and keep realism for the present. The point is that our leaders must finally choose the politically costly path of solving the crisis as it really is: a systemic crisis. Their current policies muddled through kick the can down the road, pray and delay, extend and pretend together with the monolithic fiscal discipline obsession are clearly not producing the desired results. Europe has taken a path that leads to depression and the collapse of the euro. We are not there yet, but soon the point of no return will have been passed.