When a downturn is the result of structural rather than cyclical problems, it requires different solutions – and Euroland doesn’t have them.
We have written about economic depression before. It is not our favourite subject. However, the recent GDP reports from Euroland raise the issue again: What exactly is happening in Euroland, and what, if anything, has to be done to fix it?
If, for instance, Euroland were in a recession, no policy response would be required to fix it. "Recession" is easy-speak for what the National Bureau of Economic Research calls a business cycle downturn. The word "cycle" is significant: A recession is part of the regular rhythm of an economy. Normal economic expansion leads to excesses: Inventories may get too high. Financial risk-taking may become too prevalent. Markets may rally too long without a consolidation. There are many kinds of excesses, any one of which can reach a breaking point and require a contraction of economic activity to mend the problem.
The classic economic event triggering the downside is a purge of excess inventories. Excessive stockpiles – perhaps caused by excessively fast production growth in good times, or by a retrenchment of demand caused by policy or a shock – lead to a slump in production, as orders are filled from stockpiles rather than new production. Production only picks up when excess inventories have been worked down. Or borrowers may become overextended – or central bank tightening may raise financing costs – prompting a reduction of credit and credit-related activity. Or governments may enter a phase of austerity to reduce fiscal deficits. Or politicians goosing up spending in pursuit of re-election may start reversing their pork-barrel largesse once they are elected.
The point of that little rant is that recessions are cyclical events that are self-correcting. Once the excess has been purged, the economy can grow again. A recession typically produces an economic contraction of three or four quarters. Technically, no policy response is needed to end a recession. Practically, most governments and central bankers tend to "lean against the wind" when an economy slows, hoping to shorten, or shallow out, the downturn.
We think Euroland's problem is best described as an economic depression – a downturn of the economy that is the result of a systemic breakdown. This is not a cyclical event. Regardless of what causes an economic depression – a crop failure, bank failures, stock market failures, real-estate market crashes – wealth is destroyed on a large scale, and no automatic mechanism exists to correct it. Without a policy response to the failure within the economy, a depression will never end.
For instance, economist John Maynard Keynes noted that with the banking system, the agricultural economy and industry all hobbled at once in the Great Depression of the 1930s, the only way to rekindle economic growth was a shot of fiscal stimulus. Keynesian economists suggest that in the United States, without the fiscal stimulus of the Franklin D. Roosevelt administration, the Great Depression would have lingered for decades. Depressions tend to be long and deep, in part because policymakers are typically slow to recognize that their economies are depressed and that fiscal horsepower is needed to pull them along.
We believe the Euroland economy is in a depression. Governments are not taking steps to fix what is broken. Therefore, the economic decline will only deepen, and run for a very long time.
Here is the Euroland situation: GDP contracted 0.2 per cent in the first quarter and was 1 per cent lower than a year earlier, according to flash figures published by EuroStat. In the previous quarter, GDP declined 0.6 per cent and was 0.9 per cent lower than a year earlier. GDP in the Euro Zone contracted in each of the past six quarters, and it has slowed on a year-over-year basis in each of the past eight quarterly reports.
GDP was 3.2 per cent lower in the first quarter of this year than it was in the first quarter of 2008, when the economic crash began, and it was no higher in the first quarter than it was seven years ago, in 2006. The economy has never once regained its pre-crash level of activity, reached in the first quarter of 2008 – five years ago – and it is contracting again.
Unemployment in the euro zone is at a record high. Industrial output has been reduced to levels not seen in 15 years, and it is contracting again. Money and credit are contracting. Consumer price index increases are below target and falling. Equity prices remain 25 per cent below their mid-2007 peak.
Why would you not call a five-and-a-half-year downturn like this a depression?
Why doesn't Euroland recover on its own? Well, its banks are broken: They cannot create credit because they are under-capitalized, and there is no public policy to fix them. Fiscal policies have been put in place to bring about structural reform, but they depress demand rather than promote it. Institutional arrangements constrain monetary policy from offsetting the impact of the contraction of credit. Inappropriate policy is making the economic downturn worse, at a time when recovery is impossible without appropriate policy.
What this means, we think, is that we have to expect more of the same in the months and years ahead until policies are implemented to address the challenges. Until governments recapitalize the banks and stimulate demand with fiscal policy, and until the European Central Bank can be authorized to do what is needed with monetary policy, we have to expect an extended economic contraction, record high unemployment, diminishing industrial output, falling prices and lacklustre stocks.
Some talk of fiscal reflation is in the air, and that will help. However, the core problem remains the banking system. For at least three years now, our mantra for Euroland has been, "Save the banks, save the world!" It still is.
Carl Weinberg is the founder and chief economist of High Frequency Economics, an independent economic research firm based in Valhalla, N.Y. www.hifreqecon.com