Comments on Europe and thoughts on the cyclical recovery in the US

Daily commentary: 2013-03-01

Europe is in recession right now, but the US is in a weak but fairly long-lived economic recovery. The difference in economic fortunes owes entirely to differing policy responses in both regions. In Europe, the economic paradigm has favoured austerity as a policy tool. And the result has been fiscal retrenchment met with varying levels of additional private retrenchment – no confidence fairies here. That is the reason for the recessions across Europe. In the US, the policy response has been varying degrees of fiscal and monetary stimulus. And the result has been a muted recovery in both output and employment. The question is whether either of these policy paths is sustainable. I say no on both counts and want to address here why.

Now, I have already said a lot about the US, so I want to turn to Europe here first. Europe’s manufacturing PMIs and employment data came out this morning. There was good news and bad news. A number of countries saw improvements in the numbers like Spain and Greece, even though their numbers still registered a contraction i.e. PMIs below 50. But Italy registered a worsened PMI, making the electoral outcome that much more understandable. In contrast, Germany continues to roll along. Let me run through a few countries one by one.

The overall tenor of the numbers, recent elections in Italy and the UK, and the government ouster in Slovenia suggest disenchantment with the economy and economic policies.

Britain: There a number of interesting threads in Britain to write about. First was the election in Eastleigh, won by the Liberal Democrats’ Mike Thornton, who replaces Chris Huhne, who was also a Lib Dem but was forced from office due to a corruption scandal. The Tories wanted this seat but could not get it. In fact, they polled third in Eastleigh behind UKIP, the UK Independence Party fronted by Nigel Farage, a noted eurosceptic. This should tell you that euroscepticism in the UK is running high and that the Prime Minister will most likely have to play to this within his party if the tories are to have success in the general elections in 2015. UKIP is stealing their thunder. The results by the nationalized British banks Lloyds and RBS were suitably awful, with Lloyds losing £1.4 billion and RBS losing £5.2 billion. As for economic data, the Nationwide reported house prices increasing 0.2% in January and Markit’s manufacturing PMI came in well below expectations, falling to 47.9 from 50.5 in January. That’s well below the 50 mark.

The Netherlands: As I have reported repeatedly here, the housing problems in the Netherlands is going to take a toll on the fiscal situation there. I believe this turn of events will cause the Dutch to take a dovish stance on fiscal matters. Two weeks ago, when writing about the Germans’ marginalization in the ECB, I ended the post reiterating that, “I have been saying that targets are going to be relaxed because France, Spain and the Netherlands all are going to have these problems. But, the support for austerity is strong in Europe. And unlike the support for the ECB’s no-monetisation clause, this support for austerity is likely to endure.” So, the question is not whether the commitment to austerity endures but rather to what degree i.e. how relaxed the targets can get given the problems in the Netherlands, France and Spain (and Italy and Portugal). I should note here that the Dutch were one of the last countries to leave the gold standard and end austerity. The Dutch were committed to the view that government must stay focused on fiscal rectitude. This made fiscal and monetary policies much more endogenous variables and they suffered much later into the Great Depression as a result. You can read the outcome online at Wikipedia.

Italy: The Economist’s take on the Italian election is wrong-headed in my view. They say that voting for Grillo and Berlusconi is going to make matters worse. The reference to the Italians’ voting for clowns by the Economist and in Germany can only be taken with great enmity by Italians because it implies the voters are fools. However, there is good reason that voters everywhere are voting against the parties in power in Europe. Even in the UK, Eastleigh should be seen as a referendum on the economy in part and the Tories lost votes because the economy is poor. In Italy, Ida Pagnotella had a more nuanced view which we posted that suggests that disgust with the parties in power and their corruption is rising because of the economic depression. Economic depression leads to ideological extremism and the Economist simply is unrealistic in not recognizing this. The focus here has to be on sustainable political and macro policy. Italy doesn’t have that. As for outcomes, Bersani has ruled out a grand coalition. So, the situation does not look good in terms of political stability at this juncture. In Slovenia as well, the government has fallen due to anger at austerity. So these issues are all around us.

If I could sum up all of these scenarios and the ones we have not mentioned in Portugal, Greece, Ireland, Spain and France, the watch word is unsustainable. Austerity is politically unsustainable across a wide swathe of countries. You cannot have the private and public sector deleveraging at the same time without it causing a depression and serious political unrest. This is what is happening. in Europe right now.

By contrast, the situation in the US looks better, despite what should be considered austerity in the sequester coming online today. I believe we are likely to see a gradual reaction to the loss of income from the gas prices and fiscal retrenchment because people do not make one-off adjustments to economic stimuli. The adjustment process is over a period of time as people come to grips with the new reality. So, despite the US being in better shape cyclically, austerity is coming and that will have a negative impact on growth.

Let me return to discuss the asset-based economic model which I discussed in the last post though. The key here is the cyclical adjustment process. While I expect mean reversion in terms of household debt aggregates and a convergence of income and wage growth paths, it is not clear how these adjustments will occur or over what time frame. When I last wrote about the asset-based economy in October I wrote the following as a result:

“We are living through a crisis of historic proportions and the policies and programs being enacted are largely untested and unproven. The potential for error is extremely large.

“For me, this means sticking to what I know and living with an uncomfortable ambiguity on all the rest. What I do know is that:

1. modern central banks are price/rate targeting monopolists of the supply for base money reserves.
2. as such, affecting rates/price via lowering or raising interest rates is the standard first-call policy tool of central banking today.
3. the Fed and its European counterparts cannot lower interest rates any more without breaching the zero bound.
4. therefore, central banks are trying to impact economies and financial systems via the quantity dimension.
5. the Fed’s stated aims are to lower interest rates, reduce risk premia and alter portfolio preferences in order to bid up asset prices.
6. Fed policy will have an unintended consequence in the loss of interest income and concomitant changes in investor behavior.

“My assumption, therefore, is that quantity targeting, quantitative easing-type actions will have a more muted impact on the real economy than the actions of a price/rate targeting central bank, and that, as such, the central banks will fail to sustainably boost the real economy in the absence of fiscal policy expansion. Further, I believe that, to the degree central banks are effective, it will be in pumping up asset prices via lowered risk premia and the distortion of private portfolio preferences toward riskier and higher yielding assets and asset classes. In my view, this policy response is pure asset-targeting fetishism, a hallmark of our age that leads to excess private credit growth, resource misallocation and recurrent crises due to an increasingly fragile banking system and over levered private sector balance sheets. It will fail and this will be especially destructive to investors geared excessively to risk-on types of portfolios.

“But, these are my conclusions based on my analysis of how the financial system operates and how monetary policy is transmitted, which differs from the mainstream . I am open to other interpretations and I expect the next US recession to be especially helpful in demonstrating whether my interpretation holds up. In the meantime, I will keep an open mind.

“Where could I be wrong?

1. in assuming that the real economy impact of QE is more muted than the impact of traditional policy. (So far, I have been right, however.)
2. in assuming that tighter short-term fiscal policy will negate any short-term real economy effects of loose monetary policy
3. in assuming that private sector balance sheets cannot be further levered
4. in assuming that negative real yields are prima facie evidence of easy money when others like Scott Sumner believe monetary policy has been too tight

“Just like we saw in 2000 and 2001 after the tech bubble, low to negative real rates can reflate effectively. But I still ask to what effect? Sure I could be wrong about how effective QE will be from a cyclical perspective. But what happens when this business cycle ends and rates are still zero?”

That is the question I asked in the last post and I still ask now.

But look at the preceding four places I can be wrong in how the cyclical economy develops. In each case, my being wrong would support continued cyclical growth and I must be willing to understand that any or all four of these outcomes could maintain the cyclical recovery for longer than I anticipated. So when thinking about the US economic path, I see it as also unsustainable – but because it goes too far in the other direction. In both cases, in Europe and in the US, likely we will just have to sit tight and wait for the next crisis because policy will not change unless forced by events.