News suggests major economic and political challenges ahead

The news flow this weekend was not particularly uplifting either here in the US or in Europe. Overall, the composite I get is one that dovetails with the downside risks I have outlined on both sides of the Atlantic – in the US it is political and economic. In the European Union, it is mostly political, but also economic through the policy challenges. I think we are going to struggle economically for some time to come as a result. More fleshed out thoughts below

Europe

Let me frame the spat now ongoing in Europe over coronavirus stimulus plans from a longer-term perspective.

Many countries in the European Union gave up their monetary and fiscal sovereignty to join the euro area, believing the trade-offs were politically and economically worth it. But, because the euro area is dominated by the European Central Bank, without a corresponding high-powered central fiscal agent, it means that recessions are fraught with peril, due to public debt and deficit rules.

This is particularly true now since European countries shut down their economies due to the coronavirus pandemic, with government stepping in to prevent a collapse in household and business incomes. Deficits have ballooned and the ECB has taken extraordinary measures due to the emergency nature of the experience. But now, some countries like the Netherlands, Austria, Finland, Sweden, and Denmark are looking forward to when the emergency is over. And so, they are preparing for government spending limitations to carry weight again.

That’s the longer-term perspective to the position taken by the frugal four and Finland over the weekend to limit the size of EU level fiscal spending and to make more of that spending in the form of loans. Swiss daily NZZ summed it up well, saying (paywalled link in German here):

The Prime Minister of the Netherlands, Mark Rutte, argued that the [European] Commission alone should not decide whether these plans are good enough to pay out money. Rather, he demanded that  member states also have a say. In addition, Rutte demanded that single states have veto power: If the Dutch taxpayer is already financing Italian expenditure, Rutte wants to have a say. The Hague asked for guarantees that promised reforms would be carried out. Money should not simply flow into states “that are broken in their systems”, as Austria’s Chancellor Sebastian Kurz put it somewhat awkwardly.

So, Italy, which was hit hard by the coronavirus, and which had government debt to GDP near 140% before the crisis, will have to redouble austerity and structural reform efforts to get anything, if Mark Rutte has his way. Given that Italy has had no growth for decades now – in part due to fiscal restraint adding to a lack of domestic demand – this is a recipe for economic disaster in Italy. It won’t work. And Italy will have a debt crisis.

The longer-term issue is whether the euro survives its repeated debt crises. But, in the medium-term, the big issue is growth. With coronavirus still with us and economic and budgetary rules slowly going back into effect, you can rest assured Europe’s economy is not going to take off anytime soon. There’s no domestic impulse for growth. And with the world reeling from coronavirus, the Europeans won’t be able to ‘steal’ growth from abroad either.

As an aside, let me point to an interesting piece in the New York Times which claims Germany’s economy will triumph in the post-Covid-19 world. I think it adds some context to what’s happening, though I would never frame the situation that way. And it’s interesting that Germany is not leading the charge in demanding austerity and oversight. Instead it’s the smaller, rich northern European nations.

Also see here for some insight into why Dutch PM Rutte plays the role of EU bogeyman. I think large parts of Niall Ferguson’s take on the EU makes sense. National identities in Europe are too strong for Europeans to want a United States of Europe. A move toward a central fiscal authority and debt mutualisation is not natural in any way. And the question is whether it’s worse for the likes of Denmark and Sweden, outside of the eurozone or for the Netherlands, Austria and Finland inside.

The US

As bleak as the situation in Europe seems, we need to remember that they have done a relatively good job of getting the virus under control. Their return to normalcy will be aided if they continue on that path through the fall and winter influenza season when both Covid-19 and flu will be dangerous as people move indoors.

By contrast, the US is an unmitigated disaster. I have spent enough time recounting how poorly the US is doing in combatting the coronavirus that I don’t even want to repeat it here. It’s depressing.

In the FT, Gavyn Davies has a good account of some of the numbers and the consequences though. He says the reproduction number is above 1 in all but five US states, meaning almost everywhere in the US – states with 95% of GDP – we are seeing an exponential spread of the virus. But, interestingly, spending isn’t collapsing as a result. Spending has flattened, but not collapsed, as it did when we locked down. So, things have to get worse still for a double dip recession in his view.

That is heartening from an economic perspective if chilling in terms of what it means about fatalism about infection and death amongst US consumers. The problem is that it doesn’t take into account the coming fiscal cliff. Last night, I watched the Fox News Sunday interview US President Trump did with Chris Wallace. And Trump said he is willing to defund schools that do not have in-person classes. He’s already said he could veto a spending bill that extends the $600 Pandemic Unemployment Assistance (PUA) payments. But he told Wallace he may veto certain spending bills unless they meet his criteria around Confederate flags too.

So, the US faces two hurdles here. The first is the virus, which is circulating freely in the US. The Trump administration is pushing to block new money for testing, tracing and the CDC in an upcoming coronavirus relief bill. Eventually, Covid-19 will harm consumer spending enough to cause a recession. The second hurdle is the fiscal cliff, where there is no guarantee that the Federal government will step in and prevent payments to households and small businesses from drying up.

My take

In the US, initial unemployment claims are now rising. We got 1.5 million non seasonally-adjusted claims last week, above the previous week for the first time since at least early April. If, as I believe, we are seeing more layoffs, then the unadjusted number could rise to something like 1.7 or 1.8 million claims, this coming data print.  On Friday, I pointed out that, because of statistical quirks, “for claims to not go up next week, they would need to fall from 1.5 million actual claims to 1.258 million next week.”

I didn’t mention the next week after. The week after next will see the seasonal adjustment factor sink to .841 from 1.157. That’s a seasonal adjustment change of .30 in two weeks. And then the adjustment will continue to fall through mid August. That means unadjusted initial claims have to fall from 1.5 million to 1.1 million for the reported number to stay constant. If, due to the re-opening rollback, unadjusted claims actually rise, as they did last week, we could see a huge number in two weeks. A 1.8 million unadjusted claims number divided by .841 is 2.14 million – or 800,000 more than last week. Be prepared to see something like that.

32% of US households missed their July housing payments. What will that look like if the coronavirus gets worse and/or we are pushed over the fiscal cliff? This is a disaster that doesn’t need to happen. But, it will happen in a matter of weeks if we continue on our present course.

And remember, President Trump might act as a lame duck if the polls move against him and he thinks he can’t win in November. He will have nothing to lose in not compromising with the Congressional Democrats. And that might mean US policy that’s even less than sub-optimal and more like a scorched earth policy that ends us in a Depression. Not a base case, but certainly imminently possible