Eurozone rescue packages will continue to fail until they deal with the central issue in Europe's recession

The international financial system is passing through the agony of a new round of the Eurozone debt crisis for the simple reason that European governments, like that in the US, refuse to deal with the core of the economic recession in Europe for reasons of economic dogma.

Anyone who looks at the economic data for the Eurozone without wearing ideological blinkers can see the situation at once – it is charted in Figure 1. The Eurozone recession is due to a collapse in fixed investment. Taking OECD data, at inflation adjusted prices and fixed parity purchasing powers (PPPs), then between the last quarter before the recession, the 1st quarter of 2008, and the 2nd quarter of 2011 Eurozone GDP fell by $204bn. But private consumption declined by only $29bn while the net trade balance increased by $32bn and government consumption rose by $91bn. However fixed investment fell by $290bn – i.e. the recession in the Eurozone was wholly due to the fixed investment decline

Figure 1

 

Equally evidently, due to its scale, until this fall in investment is reversed it will take a prolonged period for the recession to be overcome. Therefore to restore growth, which by now is generally realised is the core to turning round the budget deficit problem, the fixed investment decline must be overcome.

Nor is there anything mysterious about how to do this – the state has entirely adequate means. To take the most decisive international case China made the core of its stimulus package direct state investment particularly aimed at infrastructure and housing – the result being that China’s economy has grown by over thirty per cent in three years.

Europe and the US clearly do not have the scale of state sector, nor the political willingness, to act on the scale China did. But US history shows that even without proceeding to a socialist scale of measures direct state intervention on investment is entirely possible.

Roosevelt expanded US state investment from 3.4% of GDP to 5.0% between 1933 and 1936 (data from US Bureau of Economic Analysis Table 1.5.5). Jason Scott Smith, in his study of New Deal public spending, summarises such investment as including 480 airports, 78,000 bridges, 572,000 miles of highway - which, in addition to its immediate effect in stimulating demand, reinforced the productive position of the US economy. Roosevelt, it is superfluous to point out, was neither a socialist nor a communist (despite claims to the contrary by the US right!).

Quarterly, up to date, data is regrettably not available on what is occurring across the Eurozone for state investment, but it is available for the US and there is no reason to suppose, with  current policies, that the situation in Europe is any better. Between the peak of the previous US business cycle, in the 4th quarter of 2007, and the 2nd quarter of 2011 US private fixed investment fell from 15.8% of GDP to 12.2% - i.e. a decline of 3.6% of GDP. Yet in the same period US state investment did not compensate but also fell marginally – from 3.3% of GDP to 3.2% of GDP. Therefore while Roosevelt expanded the weight of US state investment current US administrations have been letting it fall.

Instead of directly addressing the core issue of the investment fall European administrations are either attempting to stimulate it indirectly – which, as it is ineffective, has led to fiscal/sovereign debt crises, or are acting via expansion of the money supply – which, in a situation whereby companies and households are paying down debt, is merely the famous ‘pushing on a piece of string’. 

The most favourable outcome of such a situation is that eventually the debt will be paid down, but only after several years of stagnation. The less favourable variant, of course, is that the banking system breaks under the strain and renewed recession is further propelled by fiscal cutbacks. All these problems simply arise from the fact that, under the rubric of the dogma ‘private equals good, state equals bad’, European governments refuse to use the state tools available to deal with the investment fall which is at the core of the Eurozone recession.

Some European politicians are now beginning to call for state measures to increase investment, UK Business Secretary Vince Cable being one. But the action they envisage so far is inadequate to deal with the scale of the investment fall.

China's economy, which does not have such ideological inhibitions, will continue to expand while the Eurozone remains relatively stagnant for a significant period - and as long as economic stagnation continues there will be no resolving of the Eurozone debt crisis.

 

Acknowledgement

Some of the data in this article regarding the US was worked up in an exchange with Gavyn Davies on his blog. Readers may therefore want to look at it there, where further points are developed, and some of the issues also become clearer in the context of an exchange with Gavyn Davies own analysis.

Comments

[John Ross]

PB,

Thank you for your kind remarks. The test of any theory is not the fame of who put it forward (that idea went out when there was the scientific revolution) but whether it fits the facts. That is why this blog is very fact oriented and generally uses statistical sources not newspapers.

It is a continual frustration to me that I do not have time to study and write enough on India. India's development, together with that of China, is the most important question in the world economy today. Obviously I am able to write more on China as I am a Professor at a Chinese university. I follow India as closely as I can statistically and from its media but I don't believe in writing on a subject unless you have well substantiated facts and something which adds to knowledge. However I am currently looking at two issues in detail - India's place in the world economy, and comparisons of India and China's development. I hope to be writing on these in the near future.

[John Ross]

Nichol dealing with your definitional point,

Technically investment is divided into two parts: (i)inventories (stocks), (ii) fixed investment (machinery, buildings, software purchases etc.

Inventories are a relatively small part of GDP (1-2%)and do not significantly affect productivity, although fluctuations in their levels can play an important role in business cycles. By far the largest part of investment (15%-40%+ of GDP depending on the national economy) is fixed investment.

Infrastructure (roads, railways, bridges etc) is a specific sub-category of fixed investment.

[PB]

John,

You have been correct in your predictions throughout the last few years in your debate against some famous people. I feel lucky that I found your blog early and I have been following ever since.

I am just a bit worried about the quality of the fixed investment that is going on in China. Will this be an issue in the future?

Also, could you please, if you have the time, provide us some analysis of the situation in India.

Thanks for a great blog.

[Nichol]

what is your definition of 'fixed investment', as opposed to general investment, possibly in infrastructure? Maybe it is standard economic jargon .. but it might help to explain what the whole article is about.

My view on this is that (capitalist) economy depends on creation of money and capital, which is usually done largely by banks giving out loans, most of the money for which is then 'created' by central banks. If the private sector loses confidence, and stops taking out loans, while banks are afraid of giving them out .. the result is that the whole system grinds to a halt. Unless government can take that role of lender-of-last-resort, and spend it on general the kinds of infrastructure & education that is guaranteed to pay back in the long run.

In the background of this, our populations cannot continue to grow, while fossil energy is running out, getting expensive. Those to factors are the long-term drivers of change. This crisis is just one of the large blips on that path of change.

[Glen]

Its a good point that you make, but if Governments increased investment spending as you suggest, the trade balance might just go negative i.e. net imports (particularly in the USA) would jump. So the impact on GDP could be very muted. So perhaps the answer is More investment spending in the US/EU with tarrif barriers to prevent imports?