Key Trends in Globalisation

Misanalysis in China of Europe’s economic crisis

The following article originally appeared in Beijing Times.

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This week Greece’s Prime Minister Samaras met, and publicly argued, with German Chancellor Merkel over the EU’s latest attempt to solve the Greek economic crisis. Given that earlier misunderstandings in China of the dynamics of Europe’s crisis have damaged its own economy it is therefore important that a correct assessment is made of this new stage in Europe.

The reason China was previously damaged by a wrong analysis was that the seriousness of Europe’s economic crisis was considerably underestimated. By July 2012 China’s exports to the EU had declined by 16% in a year – easily the most serious blow to China’s exporters. Yet a year previously few analysts in China were predicting such negative European trends.

The reason for this widespread underestimation of the seriousness of the situation was that many analysts in China supported austerity policies being pursued in Europe and rejected the alternative proposal for European governments to launch economic stimulus programs. As most European governments were following austerity, and austerity was considered the correct policy, such Chinese analysts concluded Europe’s crisis would be overcome.

However the results clearly show that Europe’s austerity policies have worsened the situation and analysts who supported Europe’s austerity policies were dangerously mistaken.

To assess accurately Europe’s real economic dynamics, and their consequences for China, first the overall results of the different policies pursued internationally to deal with the financial crisis can be summarized and then the situation in individual European countries analyzed.

Internationally three types of policies were adopted in response to the financial crisis:

· The EU combined loose monetary policy with no stimulus to the productive economy – the ‘austerity’ approach. The outcome is that EU GDP is 2.1% below its peak of four years ago and Europe is in ‘double dip’ recession.

· The US combined loose monetary policy with a stimulus to consumer spending via a large budget deficit. The outcome is that average annual US GDP growth in the last four and a half years is only 0.4%

· China combined loose monetary policy with an investment focused stimulus to the productive economy. China’s GDP grew by more than 40% in four years.

The EU’s ‘austerity’ policy was therefore easily the least successful approach to dealing with the financial crisis. This is further confirmed by analyzing the individual EU countries committed to austerity. In the UK, where Cameron’s government voluntarily implemented the policy, GDP is 4.5% below its peak output and the UK is in a new recession. Considering countries which adopted austerity as a condition for bailouts, Ireland’s economy is 8.8% below its peak, Portugal’s GDP is 5.2% below its peak and has been declining for two years; Spain’s economy is 4.7% below its peak and is in a new recession, while in Greece the economy has contracted by 13.0%.

Given these dreadful economic results analysts in China should realize support for Europe’s austerity policies was mistaken. Instead they should hope European leaders will initiate an EU wide economic stimulus. As Greece is clearly too small to launch this, a stimulus must be started by the main European economies. International experience confirms such a stimulus will be more effective if concentrated on investment, as in China, rather than on consumption as in the US. If neither stimulus is launched then China must prepare for a long drawn out European crisis with negative consequences for China’s economy.

To get out of its economic crisis Europe needs to learn from China

Four years into the international financial crisis, it is clear that the economic policies followed in Europe to deal with it have failed to do so. For a long time, there was a refusal to examine the real facts of Europe's economic situation and take the appropriate policy measures. Once Europe does start to analyse its economic problems correctly, however, it will see that it has a lot to learn from China. Naturally this does not mean that Europe can mechanically copy China's approach, but there are important trends which Europe can study.

The fundamental trends in Europe's economy are illustrated in Figure 1. This shows the changes in different components of the European Union (EU)'s GDP since the first quarter of 2008 – the peak of the last business cycle and immediately before the onset of the financial crisis. It may be seen that the negative trend in the EU economy is entirely dominated by its fall in investment. The EU's trade balance has improved during the financial crisis, government consumption has risen, and the fall in personal consumption is relatively small. But the fall in fixed investment is huge, amounting to 150 percent of the total decline in GDP. This fall far more than offsets the performance in other economic sectors. The economic situation in Europe is therefore entirely dominated by this investment fall.

Figure 1

 

After four years of failing to look at the real situation, an identification of this actual core problem in Europe's economy is beginning to emerge. European Parliament President Martin Shulz recently wrote on Europe's crisis: "…what is to be done? First, targeted investment should be given priority." José Manuel Barroso, the European Commission president, and Olli Rehn, the European commissioner charged with dealing with the euro crisis, have now said it is likely that EU leaders will agree next month to increase the capital of the European Investment Bank by €10bn ($13 billion), which could be used as collateral to start large infrastructure "pilot projects" on a pan-European scale.

These policy changes, while a step in the right direction, are too small to turn the situation around. The EU is a US$16 trillion economy. The idea that a $13 billion program, only 0.06 per cent of the EU GDP, can offset the US$343 billion decline in EU investment since the first quarter of 2008 is clearly unrealistic.

The European Commission admits that there is €82 billion (US$106 billion) in unused structural funds in the EU's medium-term budget. This could theoretically be used to tackle the investment decline. But firstly, even the use of this entire sum is less than one third of the decline in investment which has taken place in Europe. Secondly, national governments have not yet agreed that these funds can be used for a European investment program.

Therefore four years after the beginning of the crisis, EU governments are beginning to discuss the right issues, but the practical measures they are proposing are still much too small to deal with the scale of problems that Europe faces.

The difference with China can be seen clearly in Figure 2, which shows the results of the stimulus program launched by China in 2008 to counter the international financial crisis. This stimulus program directly targeted raising investment – in particular infrastructure and now housing. The results are evident. Far from falling sharply, as in Europe and the US, China's investment rose. Consequently, compared to the situation on the eve of the financial crisis, China's economy expanded by over 40 per cent in four years compared to growth of 1 per cent in the US and a contraction of 2 per cent in Europe. China's stimulus program was $586 billion, or about 13 per cent of China's 2008 GDP – the majority part directly targeted investment.

Figure 2

 

China's stimulus, in terms of proportion of GDP, is equivalent to a program of US$2 trillion in the EU today. An investment program on that scale would be substantially too large in the EU at present – the situation is not as critical as in 2008. Nevertheless it is only necessary to compare this number to the $13 billion discussed by EU commissioners today, to see how inadequate is the scale of the proposed EU response to the present situation.

Jens Weidman, president of Germany's Bundesbank, has complained about the lack of policy tools available in Europe: "Now that fiscal stimulus has reached the bounds of feasibility in many countries, monetary policy is often seen as the 'last man standing'…However…contrary to widespread belief, monetary policy is not a panacea and central banks' firepower is not unlimited." But Weidman's conclusion exists only because Europe, somewhat arrogantly, refuses to study the country which passed most successfully through the international financial crisis – China.

Two years ago I wrote: "The dispute… between the US and Europe over'economic stimulus' versus 'deficit reduction' convincingly demonstrates the superiority of China's system of macro-economic regulation. China has faced no similar dilemma. It has simultaneously carried out the world's biggest economic stimulus package while running a budget deficit which is entirely sustainable – under 3 percent of GDP. China has therefore not had to face the choice between continuing fiscal economic stimulus measures and placing the priority on budget consolidation."

This remains the key problem. Unless Europe is prepared to grasp the nettle of a large "China style" program, one based on state-led investment, Europe is likely to face, at best, years of economic stagnation.

China's authorities have always rightly clarified that it is not arguing for its economy to be a model for others. It rightly insists every country is specific and therefore no country can or should mechanically copy another. But nevertheless China learned many things from other countries. For its own sake, Europe should start to learn from China

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This is an edited version of an article which originally appeared at China.org.cn.

Europe's largest economic failure is not in Greece - but in the UK, Italy and Spain

With the European Union (EU) heading into a double dip recession, even before the peak level of GDP of the previous business cycle has been regained (Figure 1), it is evident that the solutions adopted to deal with Europe's economic crisis have failed. But the focus of financial markets on Greece's debt crisis should not obscure the fact that the largest scale economic failures in Europe, with the most direct impact on world growth, are not in Greece, the GDP of which accounts for only 1.8 per cent of the EU’s, but in the UK, Italy and Spain. The latter economies collectively account for over one third, 34.7 per cent, of EU GDP. Furthermore these large EU economies, having failed by significant margins to regain their previous peak levels of GDP, are again turning down.

To give some idea of the relative scale of these problems it may be noted that the combined GDP of the UK, Italy and Spain is equivalent to 40.9 per cent of US GDP, whereas Greece’s GDP is equivalent to a mere 2.0 per cent of US GDP. Even the combined GDP of the three economies under EU bailout measures (Portugal, Ireland and Greece) is only 5.1 per cent of US GDP. In short, while they pose significant problems for financial markets the recessions in the peripheral Eurozone economies are simply to small to make a direct significant difference to global growth prospects.

In contrast the failures in the UK, Italy and Spain - respectively Europe’s 3rd, 4th and 5th largest economies - are on quite large enough scale to create a serious negative impact on global growth – economies approaching half the size of the US are, at best, essentially stagnant and now facing new downturns.

The aim of this article, therefore, is to place the financial difficulties in Greece against the background of these larger growth failures in Europe.

Overall trends in the EU

The overall trends in the EU’s GDP are compared to the US and Japan in Figure 1. They are shown in detail in Table 1 below.

GDP data for the EU for the 4th quarter of 2011 is not yet available – on the basis of partial statistics it is highly likely to show downturn. But on the most up to date data available, for the 3rd quarter of 2011, EU GDP was still 1.7 per cent below its peak in the previous business cycle and Eurozone GDP 1.9 per cent below, In contrast by the 4th quarter of 2011 US GDP was 0.7 per cent above its last business cycle peak. With EU GDP likely to have turned down in the 4th quarter of 2011, Europe is suffering a strictly defined ‘double dip’ recession - i.e. a fall in output before the previous peak level of GDP has been regained .

Figure 1

 

Considering the detailed data for the EU economies, plus those in Eastern Europe, in Table 1 below, the overwhelming majority of European economies have not regained the peak levels of GDP recorded in the previous business cycle. All three economies which have published official Eurostat data for the 4th quarter of 2012 (Spain, Lithuania and the UK) showed a renewed fall in output - a more detailed analysis of the groupings within the European economies is given below.

Failure of recovery in the UK, Italy and Spain

The focus of attention in the European crisis has been on small peripheral Eurozone economies – Portugal, Ireland and Greece – or on a 'Germany v the periphery' divide. But from the point of view of EU GDP by far the most serious situation is the failure of recovery in three large EU economies – the UK, Italy and Spain. These are respectively the 3rd, 4th and 5th largest EU economies. The GDP trends in the five largest EU economies are shown in Figure 2.

Figure 2

 

By themselves the peripheral Eurozone economies are far too small to pull the Eurozone economy into recession - for comparison the combined economies of Portugal, Ireland and Greece are only one eighth of the size of combined economies of the UK, Italy and Spain. The key problem in European output is that while Germany’s economy has recovered - up to the 3rd quarter of 2011 its GDP performance since the peak of the last business cycle was marginally better than the US, and France’s recovery was significant, reaching only 0.6 per cent below the pre-financial crisis peak, the EU’s other large economies had not recovered and were heading into a new downturn. On the latest available data the UK’s GDP was still 3.8 per cent below its peak in the previous business cycle, Spain’s GDP was 3.9 per cent below and Italy’s was 4.7 per cent below. Furthermore in all three economies the latest available data shows a further downturn in GDP.

Failure in the European bail-out economies

In addition to the failure of recovery in the EU as a whole, primarily due to this situation in the UK, Italy and Spain, a further striking feature is that none of the economies subject to special EU bail out programmes – Portugal, Ireland, Greece – shows any sign of recovery (Figure 3). The latest data for both Ireland and Portugal shows renewed economic downturn, while no Eurostat certified Greek GDP data has been published since the 1st quarter of 2011 – it would be highly likely to show further economic decline. This failure of recovery is despite the fact that Ireland, for example, has undergone almost four years of economic downturn and Portugal is well into the third year of downturn.

The EU bailout programmes may therefore be correctly characterised as having failed.

Figure 3

 

Widespread downturn in Eastern Europe

An equallly severe, although less reported, decline in European production than in the bail-out countries has taken place in the Baltic republics – Estonia, Latvia and Lithuania (Figure 4). The downturn in Latvia (16.6 per cent) is the worst for any European country while those in Estonia (8.6 per cent) and Lithuania (9.0 per cent) are only slightly better than Greece (9.9 per cent) and Ireland (11.6 per cent)

This crisis in the Baltic Republics, incidentally, as with the different case of the UK, shows that the European crisis spreads to far more than Eurozone – only Estonia of the Baltic republics is a Eurozone member.

Figure 4

 

In addition to the Baltic Republics economic downturn has continued in most of Eastern Europe (Figure 5) – with only Poland and Slovakia having recovered to pre-crisis levels of output (Figure 6).

Figure 5

 

Recovery economies

The trends above leave only two large European economies, Germany and France, together with a number of medium sized ones (Netherlands, Switzerland, Belgium, and Poland) having undergone serious economic recovery (Figure 6). However, although Germany and France are the 1st and 2nd largest economies in the EU their combined GDP, at 36.2 per cent of the EU total, is only slightly greater than the 34.7 per cent of the UK, Italy and Spain combined.

In short the stagnant and declining situation in the UK, Italy and Spain is enough to essentiallly entirely offset recovery in Germany and France.

Figure 6

 

Large stagnant economies

Finally the position of the UK, Italy and Spain as large economies which have failed to significantly recover, together with smaller economies in the same situation, is clear in Figure 7.

Figure 7

 

Conclusions

A number of clear conclusions follow from these factual trends in Europe.

• Financial crisis may be focussed at present in Greece, but the most serious drags in output are not the peripheral Eurozone economies but the UK, Italy and Spain.
• Remaining outside the Eurozone is unlikely by itself to be sufficient to ensure economic recovery. Economic downturn in the UK, which is outside the Eurozone and has undergone substantial devaluation during the international financial crisis, is as severe as in the other large sluggish economies of Italy and Spain within the Eurozone. The non-Eurozone Baltic Republics of Latvia and Lithuania have undergone as serious declines in GDP as Eurozone member Estonia. Poland, which is outside the Eurozone, has largely escaped recession but due to large scale public investment. 
• Given these trends, overcoming the financial crisis in Greece is unlikely to relaunch economic growth as the largest problems in Europe's economic recovery are located in the UK, Italy and Spain. Of these UK is not even a number of the Eurozone, while the lack of growth in Italy's economy has been prolonged - annual average GDP growth in Italy in the last decade has been only 0.2 per cent.

The overall conclusion is clear. The Eurozone crisis was predictable - the present author noted 15 years ago in 'Fundamental Economic Implications of a Single European Currency' that: '‘The process that would unfold with the creation of a single currency by this method [the Treaty of Maastricht] may be predicted with certainty. Substantial parts of the EU… will be pushed into severe recession if they join. There will be sharply deepening regional imbalances and inequalities. The malignant expressions of economic depression — unemployment, poverty, collapse of the welfare system, weakening of trade unions, racism, chauvinism, crime — will multiply. The end will be either an economic tragedy, or the deepest crisis in the history of the EU, or more probably both.’

This analysis has clearly been vindicated. But it would, nevertheless, as seen above, be wrong to conclude that the exclusive core of the problems in Europe's economy is the Euro - or to see the situation exclusively in terms of a 'Germany and periphery' situation.

The greatest drag on economic growth in Europe is its 'stagnant middle' of the UK, Italy and Spain. These three economies together are equivalent in size to Germany and France. If Germany and France are supposed to provide the 'growth engine' of Europe these three economies may be conceived of as currently providing its 'drag factor'.

Unless the situation within the UK, Italy and Spain can  be resolved it is most unlikely that overcoming the economic problems in Greece will relaunch substantial European growth. For this reason, whatever occurs in Greece, the European crisis is going to be prolonged and other parts of the world economy must both take this into account and understand the more powerful factors in European economic stagnation.

Table 1

The incredible shrinking UK economy

The magnitude of the blow suffered by the UK economy since the beginning of the financial crisis is very considerably minimized by not presenting it in terms of a common international yardstick. Gauged by decline in GDP, using a common international purchasing measure, dollars, no other economy in the world has shrunk even remotely as much as the UK (Figure 1 and Table 1).

As most countries produce only annualized GDP data it will be necessary to wait before a comprehensive global comparison can be made for 2011. However it is clear no substantial growth in dollar terms took place in the UK economy during that year – GDP at national current prices rose only 1.4 per cent between the 1^st and 3^rd quarters and the change in the pound’s exchange rate against the dollar during the year was a marginal 0.3 per cent. Therefore there will have been no significant recovery from the UK data set out in Table 1 below, and the gap between the UK and other European economies, which form the next worst performing major group, is too great to have been qualitatively affected by changes in the Euro’s exchange rate – the Euro declined against the pound by only 3.3 per cent in 2011.

Table 1 shows that the fall in UK GDP in 2007-2010 was $562 billion compared to the next worst performing national economy, Italy, with a decline of $65 billion – i.e. the decline in UK GDP in the common measuring yardstick of dollars was more than eight times that of the next worst performing national economy. Table 1 shows the 10 national economies suffering the greatest declines in dollar GDP.

It is also extremely striking that the UK’s decline was more than two and a half times that of the entire Eurozone. The UK accounted for a somewhat astonishing 77 per cent of the EU's decline.

Table 1

Figure 1

 

Expressed in percentage terms the situation is no better. of all economies for which World Bank data is available only Iceland, with a decline in dollar GDP of 38.4 per cent, suffered a worst percentage fall than the UK - even bail out economy Ireland, with a fall of 18.4 per cent, outperformed the UK economy.

Two trends intersected for the UK's performance to be so much worse than that of any other economy. First, contrary to the government's anti-European rhetoric, UK economic performance in constant price national currency terms has been significantly worse than the Eurozone during the financial crisis (Figure 2). Up to the latest available data, for the 3rd quarter of 2011, UK GDP was still 3.6 per cent below its pre-financial crisis peak compared to the Eurozone's 1.7 per cent below. Second, between the beginning of 2008 and the beginning of 2012, the pound's exchange rate has fallen by 21.0 per cent against the dollar compared to the Euro's 11.4 per cent drop in the same period. The multiplicative effect of the severity of the relative drop in constant price GDP and the fall in the pound's exchange rate accounts for the unequalled decline in UK GDP in dollars.

Figure 2

 

As at present the UK economy shows no substantial sign of recovery, the present UK government, which maintains a steadfastly ostrich like attitude towards Europe in particular, and most other countries in general, may argue that a measure in terms of dollars at current exchange rates is irrelevant – the UK currency is the pound and what counts is constant price shifts. Such an argument is false and an attempt to disguise the true scale of the decline of the UK economy.

The internationally unmatched decline in UK dollar GDP is a huge fall in real international purchasing ability. The far higher than targeted inflation in the UK during the last two years, which has substantially eroded the population's living standards, is itself in part a reflecton of the decline in the UK's exchange rate and consequent raising of import prices. In short, the decline in the international purchasing power of the UK's economy translates into a direct fall in real incomes. The decline in the UKs ranking among world economies in terms of GDP, being recently overtaken by Brazil, statistically reflects the same process.

It may also be seen that the government's claim that the UK is outperforming Europe and the Eurozone is entirely without foundation even in constant price national currency terms. But when measured in terms of real international comparisons, i.e. in dollars, the UK's performance is incomparably worse than Europe's.

It appears extremely unlikely that the UK's economy will escape from this circle of decline in the next period. The austerity policies pursued by the present UK government have substantially slowed the economic recovery that was taking place in 2009 and the first part of 2010 - between the 3rd quarter of 2010 and the 3rd quarter of 2011 the UK economy grew by only 0.5 per cent. The opposition Labour Party has recently also endorsed essentially the same austerity policies which have failed not only in the UK but in other European economies, such as Greece and Ireland, where they have been pursued.

Even if any partial recovery takes place, for example by some increase in the exchange rate of the pound against the Euro, the sheer magnitude of the decline in the UK economy makes it implausible that this could be on a scale sufficient to reverse the fall in its relative international position.

 

China and developing economies will determine the chances for world growth in 2012

China’s economic growth has become a key factor not only for itself but for world markets. As the scale of China's impact is still too frequently underestimated it should be noted that, measured in current dollars and at market exchange rates, i.e. in terms of actual effective demand, in the three years following the start of the international financial crisis China contributed 33.4 per cent of global market growth – more than four times as much as the US 8.1 per cent (Table 1). While final data for 2011 is not yet available, it is already clear from the first three quarters figures that China’s market last year expanded by over $1 trillion – approximately twice as much in dollars as the US, despite US growth having resumed. Table 1 makes clear no other economy has approached China in terms of market/global aggregate demand expansion.

It is therefore a key question whether China will continue essentially the same scale of market growth in 2012. The answer is ‘yes’  - but because of the issue’s importance the reasons should be clearly outlined. Interlinked with this is the decisive role played by developing economies in recovery from the financial crisis – the interlinking being that China is by far the largest developing economy, while the developing economies have become China’s largest trade partners.

In the three years covering the period from the beginning of the international financial crisis to the latest available annual data, i.e. in 2007-2010, developing economies accounted for 78.6 per cent of world market growth and developed economies for only 21.4 per cent. Considered from another angle, simply taking different classifications, either the BRIC economies (Brazil, Russia, India and China), or China plus Latin America, contributed the majority of world market/effective demand expansion – either of these groupings accounting for more than twice as much market expansion as the developed economies.

Table 1

 

Turning to more detailed trends, the first feature determining China’s continued dominant position in world market expansion, one the consequences of which are insufficiently frequently noted, is that as China’s economy becomes larger a similar percentage yearly growth necessarily turns into an increasingly large annual absolute market increase - in inflation adjusted terms, China’s economy expanded by 2.3 trillion RMB in 2008, 2.4 trillion RMB in 2009, and 3.1 trillion RMB in 2010.

But even frequently cited constant price growth figures underestimate the expansion of China’s position in the world market. Actual sales, and therefore changes in aggregate demand, use real money which is affected by exchange rate shifts and inflation – further figures in this article are therefore at current market exchange rates and prices unless otherwise stated. In 2009, when China froze the RMB’s exchange rate due to the international financial crisis, China’s economy grew by $469 billion – compared to a US contraction of $353 billion. In 2010, when China allowed the RMB exchange rate to rise, its annual economic expansion rose to $935 billion and the figure will be over $1 trillion in 2011 – roughly twice US market expansion.

Table 1 also makes clear the second reason China’s market will continue  its expansion. World growth is now dominated by developing economies and China is their most rapidly expanding trading partner.

Considering trends among developing economies, China accounting for 33.4 per cent of global market expansion. Latin America was second – constituting 17.3 per cent of world growth, with Brazil accounting for 58 per cent of this. China and Latin America together accounted for 50.7 per cent of world market growth..

Among other developing economic regions, South Asia contributed 8.0 per cent to world market growth, with India accounting for 84 per cent of this. Developing East Asian economies, excluding China, accounted for 7.0 per cent of world growth – Indonesia constituting 54 per cent of this. The Middle East and North Africa accounted for 6.1 per cent of world growth with no single dominant regional economy – the largest contributor, Egypt, constituted only 19.9 per cent of the total. Developing countries in Europe and Central Asia accounted for 4.5 per cent of world growth – of which 55 per cent was Russia. Sub-Saharan Africa grew rapidly, but due to its low starting point only contributed 2.1 per cent of world growth.

Turning to developed economies, Japan illustrates the importance of currency movements for shifts in markets measured in dollar terms. Due to the yen’s sharp exchange rate rise, Japan contributed 14.9 per cent of the dollar expansion of the world market despite Japan’s economy contracting in inflation adjusted terms. The US contributed 8.2 per cent to world market growth, despite the US not having grown in constant price terms, due to the dollar rising against other currencies,

The ‘disaster area’ for world markets was the developed European economies with a decline of $668 billion - equivalent to subtracting 9.2 cent from world growth.

It is already clear 2012 will show no fundamental change in this pattern. Developed European economies will again be the worst performing region – suffering a recession possibly magnified by a low Euro exchange rate. The US should expand, but slowly compared to previous upswings in US business cycle. Therefore if the world economy is to grow this will again have to be primarily due to developing  economies.

Fortunately, the large developing economies are slowing but still growing substantially more rapidly than developed ones. China, the dominant factor in the equation, even on pessimistic estimates is likely to grow by at least 7-8 per cent in real terms this year which, after increases in the exchange rate of the RMB and inflation is take into account, means an expansion of its market of probably 12-15 per cent in dollar terms. Minimum real growth estimates for India are at least seven per cent.

It is also clear from the pattern in Table 1 why BRIC economies will again dominate world growth – in 2007-2010 they contributed 52.5 per cent of world market expansion. Not only are the BRICs individually the largest developing economies but each is the centre of a major regional economic area. While Brazil has slowed, Russia’s economy has been accelerating, and it is in any case China and India which are the dominant dynamic BRIC economies.

This overall situation clearly interrelates with China as it already carries out the majority of its trade with developing economies – 54 per cent of total trade, 49 per cent of exports and 60 per cent of imports.

The implications for China’s markets are clear. China has not only the world’s most rapidly expanding domestic market, and declining inflation gives it extra room for domestic economic loosening/stimulus in 2012, but its biggest trading partners are the most rapidly growing regions of the world economy. It is this combination of domestic and international factors which determines that  China will continue to remain the world’s most rapidly expanding market/supplier of increased aggregate demand in 2012. Given the negative prospects in Europe, and slow growth in the US, it will then be the situation in the developing economies, which is increasingly related to the situation in China, which will necessarily determine the overall prospects for world growth in 2012.

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This is an expanded version of an article which originally appeared in Shanghai Daily.

The weakness in world trade - pre-crisis trade levels only regained in Asia and Latin America

Europe’s economy is probably entering a double-dip recession. The indications from world trade, as analysed previously, are so far that the world economy as a whole is facing slowdown but not renewed recession. However a detailed breakdown shows extreme unevenness in the trade recovery - with only Asia and Latin America surpassing pre-financial crisis levels. Regional trends for imports and exports, using a three month moving average to smooth short term fluctuations, are shown in Figures 1 and 2.

Considering trends in detail, pre-crisis world trade peaked in April 2008. In the latest month for which data is available, September 2011, world trade was 2.3 per cent above its pre-crisis maximum on individual month comparisons and 3.6 per cent above on a three monthly moving average.

Table 1 shows a detailed breakdown of trade since the financial crisis by region. This data shows that only in developing Asia and Latin America are both exports and imports clearly above pre-financial crisis levels. Taking three monthly moving averages, imports are up from pre-crisis levels by 16.7 per cent in developing Asia and 9.4 per cent in Latin America, with exports up 17.0 per cent in developing Asia and 6.9 per cent in Latin America. In the US exports are slightly above pre-crisis levels but imports are significantly below. In all other regions – the Euro area, Africa and the Middle East, Central and Eastern Europe, and Japan – both exports and imports remain below pre-crisis levels.

The recovery of world trade to above pre-crisis levels is therefore due to the situation in two developing regions. The weakness of trade in the Euro area is worse than most regions, particularly in terms of imports, but not really exceptional. Trade in most areas of the world economy remains significantly below pre-crisis levels.

Table 1

 

Trade with China

Among the largest economies the chief beneficiary of this pattern of world trade is China - although it is likely the pattern itself is in significant part a result of the dynamics of China's trade.

In the period between China's peak pre-crisis level of exports and imports, in July 2008, and September 2011 China's exports to Asian developing economies rose by 22.9 per cent and its imports from these economies rose 31.4 per cent. China's exports to Latin America rose by 53.0 per cent and its imports by 59.9 per cent. These are clearly exceptional growth rates. China is the main trade partner for most developing Asian economies as well as for a significant number of Latin American economies including Brazil.

The patterns of world trade since the financial crisis therefore indicate the consolidation of a dynamic trading interaction between China, developing Asia and Latin America. China's economy and trade is not yet sufficiently large to offset a global scale recession in the EU and/or US, but there is clear evidence that China's economy is sufficient to produce the most dynamic of post-crisis world trade interactions centred on Asia and Latin America.

Figure 1

Figure 2

During the last four years the EU's economy has grown by -0.3%, the US by 0.6%, and China by 42.2%

The full scale of the difference in economic performance of China compared to the US, Europe and Japan during the international financial crisis is shown in Figure 1. It is summarised in the following figures:

• In the four years to the latest available data, for the 3rd quarter of 2011, China’s GDP expanded by 42.2%
• In the four years to the latest available data, also for the 3rd quarter of 2011, US GDP increased by 0.6%.
• In the four years to the latest available data, for the 2nd quarter of 2011, European Union (EU) GDP shrank by 0.3%.
• In the four years to the latest available data, for the 2nd quarter of 2011, Japan’s GDP contracted by 5.2%.

Figure 1

 

 

These are evidently extraordinary statistics. During this four year period China’s economy expanded 70 times as fast as the US.

Such data also clearly refutes the current attempt to claim that in China there is an economic ‘crisis’ in some sense equivalent to that in the US or Europe. Such arguments are intellectually sloppy (at best) attempts to undermine rational thought by destroying any serious quantitative comparisons.  

To give examples of such claims, a recent article by Nouriel Roubini and Ian Bremmer in the Wall Street Journal is introduced: ‘With Europe, China and the U.S. in crisis, the real question is which of them will stumble first.’ Similarly Will Hutton in the UK’s Observer claims: ‘Nobody would start from here – an ill-designed single currency interacting with an insupportable burden of private debt created by oversized, undercapitalised banks. And it's as much a problem in the US and China as in Europe.’

The data given above shows such claims are false. GDP growth of 42.2% in China, an annualised 9.8%, is not remotely comparable to the US’s annualised 0.2%, or the EU’s annualised minus 0.1%.

Naturally it is impossible to have an annual 9.8% growth rate for almost four years and have no problems at all – in fact no economy ever has no problems! China has had consumer price inflation, primarily due to international commodity price increases, which reached 6.5% before falling and it has had excessively high house price increases – which are also now falling. But none of this constitutes a ‘crisis’ on anything quantitative scale remotely approaching that of the US and Europe.

Nor, to take Hutton’s point, does the EU financial crisis have anything like the same impact in China, or even the US, as in the EU. The effect of the decline in imports from the EU on China’s exports is noticeable but only in the sense that it reduces China’s overall export growth from a very high to a high rate of growth – 15.8% last month, in a factual situation in which none which China’s GDP growth in the last four years has come from net trade. Indeed reduction of China’s trade surplus means that net trade has been a subtraction from China’s GDP growth during that period. The exposure of China’s banks to Europe’s debt crisis is also minimal. While the financial exposure of the US to the Eurozone is certainly higher than China’s there is also no indication that the actual scale of crisis or defaults in Europe is pushing the US into recession – whereas a double dip recession in Europe itself is extremely possible.

Hutton, in short, is engaging in inflated rhetoric to attempt to create a relative equals sign between the situation in China (and the US) and that in Europe when none exists. Inflated rhetoric is merely a form of destroying the quantitative scale of comparison which is a precondition for rational thought.

The GDP data for China, US and Europe GDP data should also end attempts by Kate Mackenzie the Financial Times and Nouriel Roubini to present the US’s Michael Pettis, and similar analysts, as having had a correct analysis of China. Michael Pettis runs an objectively moderated blog on China but his analysis of China has been factually shown to be quite erroneous – claiming that: 'the US would be the first major economy out of the crisis and China one of the last.’ Evidently a situation where China has grown by 42.2% and the US has grown by 0.6% shows the reverse has been the case. Claims that it is too early to judge whether China or the US has been more successful in coming through the financial crisis are just attempts to avoid the test of facts that has taken place. Even if, against the evidence, China’s economy were now to slow significantly the scale of growth it has already achieved demonstrates that has come through the financial crisis far more successfully than the US or Europe.

The basis of any serious analysis or theory is facts. Those who refuse to refer to the data of the relative performance of China, the US or Europe during the last four years do so only because their analyses will not stand the test of examination by these facts.

China in face of the West's 'Great Stagnation'

I have a new article at China.org.cn which analyses the impact of the present 'Great Stagnation' in the developed economies on the prospects for China's economy.

It concludes:'Given extremely slow growth in the developed economies, and that examination of underlying macro-economic factors such as savings and investment indicates no reason to expect a substantial growth acceleration, this places China in a new international economic situation. For almost the entire period since China launched its economic reforms in 1978, it has been growing more rapidly than other economies but in an international context where the developed economies were growing significantly. The only serious previous recession in the advanced economies during China's reform period was right at its beginning, in 1980-81, when China was scarcely integrated in the international economy. The international slowdowns in 1990 and 2000 were brief and mild and while the 1998 South East Asian financial crisis impacted China significantly, it did not originate in the developed economies...

'In economics and business there is no virtue in either optimism or pessimism, there is only a virtue in realism. Given current trends, China has to base itself on a perspective that for several years there will be slow growth of the developed economies and therefore slow growth of their imports. Developing economies, while growing more rapidly than developed ones, will not in the very short term be able to fully compensate China's exports for stagnation in developed economies.

'The international framework for China's economy is therefore clear. It is important to understand that what is faced is a 'Great Stagnation' not a new 'Great Recession' - that is there is no reason to anticipate major international economic downturn of the 2008 type. China therefore does not need a new huge stimulus program of the type it launched in 2008 - which would lead to severe economic overheating. But the international economic situation requires adjustments in emphasis.

'First, even more than previously, China has to rely on developing domestic demand. Greater analytical clarity on this is important as at present domestic demand is frequently confused with domestic consumption - the two are not the same.

'Second, while developing economies will not immediately be able to fully make up for the negative pressure on China's exports from the 'Great Stagnation', they provide an important addition to China's domestic demand - in the last fifteen years the percentage of China's exports going to developing economies have risen from 35 percent to 50 percent. All developing economies face the Great Stagnation, therefore all face constriction on exports to developed countries, while China's imports are continuing to expand. This will produce greater integration of developing economies with China in both exports and imports.

'Within developing economies many of China's top companies, such as Huawei, Haier, and Lenovo already have high brand values and the present situation therefore creates opportunities to further enhance the positions of China's international brands.'

The full article, including a brief comparative analysis of the 3rd quarter US GDP figures with previous US post-war business cycles, may be found here.

Economic downturn even worse in UK than Eurozone - due to government deficit cutting policies

One of the more factually inaccurate pictures being spread by supporters of the policies of the present UK government - with its priority to budget deficit reduction - is that UK economic performance during the financial crisis is superior to that of the evidently crisis hit Eurozone. A typical version of this appears in an article on 3 October in the Daily Telegraph by its international business editor Ambrose Evans-Pritchard.

Evans-Pritchard states: ‘My sympathies go to the hard-working citizens of Germany, Spain, Italy, Portugal, and Ireland for being led into this impasse [the Eurozone] by foolish elites.’ Presumably Evans-Pritchard's sympathy goes to the inhabitants of the Eurozone, rather than his own country the UK, because he believes the UK has been doing better than the Eurozone.

The factual situation is the exact opposite of the impression presented by Evans-Pritchard. Judged by economic performance, the average citizen of the UK far more needs Evans-Pritchard’s sympathy than the average citizen of the Eurozone - i.e. the UK’s economic performance during the financial crisis is much worse than that of the Eurozone. This may be seen in Figure 1 – which shows UK GDP compared to that of the Eurozone since the peak of pre-financial crisis output. Comparison is straightforward as in both the Eurozone and the UK the peak of the previous business cycle was in the 1st quarter of 2008.

Bn the 2nd quarter of 2011, that is 14 quarters after the peak of the previous cycle, Eurozone GDP was 2.0 per cent below its previous peak level whereas UK GDP was 3.9 per cent below its previous peak - i.e. UK economic performance was almost twice as bad as that of the Eurozone.

Figure 1

 

Equally striking is the clear way in which present government’s policies made UK economic performance worse than in the Eurozone. It may be seen from Figure 1 that while the initial decline in UK GDP was greater than in the Eurozone - the greatest decline in UK GDP being 6.4 per cent registered in the 3rd quarter of 2009, compared to a maximum Eurozone drop of 5.5 per cent in the 2nd quarter of 2009 - recovery in the UK was also initially more rapid. This may be clearly seen in Figure 2, which shows year on year GDP changes.

The UK and the Eurozone reached their 1st quarter 2008 peaks with almost exactly the same economic momentum behind them – 1.9 per cent growth in the previous year in the UK and 2.0 per cent in the Eurozone. However by the 3rd quarter of 2010, the one immediately following the departure of the  previous government, UK GDP was rising at 2.5 per cent compared to 2.0 per cent in the Eurozone. Eurozone recovery subsequently slowed somewhat to 1.6 per cent by the 2nd quarter of 2011.

However UK GDP growth under the new government, which gave priority to budget deficit reduction, dropped astonishingly, by more than two thirds, from 2.5 per cent to 0.7%. Under the new government the year on year growth of UK GDP therefore fell from being higher than that of the Eurozone to being less than half that of the Eurozone!

Figure 2

 

The present author is not a supporter of the present constitution of the Euro. On the contrary I predicted the current events unfolding in Greece and other countries in advance due to fundamental weakness in the design of the Euro. Writing in 1996, i.e. fifteen years ago:’ [the Treaty of] Maastricht’s proposals are … disastrous. It proposes to create the most fundamental features of a common state — a single currency and a central bank. But it does not create any state budget which can deal with the huge regional and sectoral implications of this. The process that would unfold with the creation of a single currency by this method may be predicted with certainty. Substantial parts of the EU… will be pushed into severe recession if they join.There will be sharply deepening regional imbalances and inequalities.’There is evidently no reason to revise that analysis.

It is therefore all the more striking that UK economic performance is actually worse than in the Eurozone. And a substantial reason it is worse is clearly due to the policies of the present government with their priority to budget deficit reduction.

In any discussion of the relative economic performance of the Eurozone and the UK two fundamental facts must be held in mind against unsubstantiated myths:

• UK economic performance during the financial crisis is substantially worse, almost twice as bad, as that of the Eurozone.
• And the reason it is that bad is because the present government, through its priority to cutting the budget deficit, reduced the UK’s rate of economic recovery from substantially above that of the Eurozone to less than half that of the Eurozone.

This factual situation evidently has a more general economic significance than merely for the UK and the Eurozone. For reasons dealt with frequently on this blog a policy of simply running budget deficits is inadequate to deal with the consequences of the present financial crisis as it does not tackle its driving force - the decline in investment. But under conditions of private sector weakness any rapid reduction in the budget deficit will lead to rapid economic slowdown or contraction. This is sharply illustrated by the fact that the UK government, by such policies, has reduced the UK's rate of economic recovery to less than half that of the openly crisis struck Eurozone.

Other countries thinking of embarking on immediate deficit reduction policies, such as those advocated by the Republicans in the US, should look at the UK and draw the appropriate negative conclusions. Do not be totally distracted by financial fireworks: the policies of the present UK government are so bad they have produced an economic recovery which is only half that of the Eurozone!

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.

What lies behind the renewed international economic crisis - and what policies are required to deal with it?

Given the onset of a renewed round of the international financial crisis it is useful to draw together its various elements in an analysis of its overall determinants, its course, and the policies necessary to deal with it. This is the aim of this article.

* * *

For the second time in three years almost all parts of the world economy are being shaken by a renewed financial and economic crisis. The most important immediate drivers of this are not Standard and Poor's downgrading the US's credit rating, or political struggles between President Obama and Republicans in Congress, but weak US economic recovery, Europe's widening debt crises, the consequent $8 trillion loses on international share markets by 9 August with knock on effects on balance sheets and spending, the continuing decline of US house prices and a new developing crisis of the banking system.

Reasons for the open reappearance of crisis

The reason severe crisis has reappeared, and what determines its dynamic, is the failure of US and European government policies to resolve the issues which created 2008's financial collapse. The policies pursued since then, which were adapted to deal with much more minor economic events than the ones which occurred, postponed the unwinding of the crisis without removing its underlying causes. As a result the focus of the crisis changed but it was not resolved.

The immediate cause of the financial crash of 2008 was an unsustainable build-up of US private sector debt – this debt being accumulated due to the attempt to maintain the growth of the US economy and to ensure political stability by sustaining US living standards. By the 4th quarter of 2007, the peak of US economic expansion, total US household, private non-financial company, and government debt was 218 per cent of US GDP – Figure 1. That the fundamental debt build up was private, and not government, is shown by the fact that household and non-financial company debt was equivalent to 168 per cent of GDP compared to 51 per cent of GDP for government debt - i.e. private debt was more than three times as large as government debt.

Figure 1

 

Interest rate increases introduced leading to 2008, in order to deal with inflation, resulted in the inability of the US private sector to finance this debt burden. The US sub-prime mortgage crisis was simply the weakest link in the overall excessive US private debt.

In 2008 the inability of the US private sector to meet its debt obligations, with consequent falls in asset values, initially in housing and then in shares and other financial instruments, destroyed US financial institutions’ balance sheets. The US financial sector overall became insolvent. Therefore a stronger and more centralized financial instrument, the US state, had to step in to rescue the private financial system - with a similar process occurring in other countries. The new crisis has broken out because of the risk that the tools available to the US and European states themselves will be insufficient to restore stability.

Transfer of private sector debt into the public sector

The debt data clearly show the process of transfer of the original excessive US private debt into the public sector – the changes in US debt since the peak of the previous business cycle are shown in Figure 2.

Following the onset of the US economic downturn in 2008, the overall US debt burden rose, reaching 247 per cent of GDP in the 3rd quarter of 2009 – these changes reflecting the decline in US GDP as well as increasing debt. Since then up to the 1^st quarter of 2011, the latest available data, US debt fell only marginally to 243 per cent of US GDP - still 26 percentage points above pre-recession levels.

However the internal structure of US debt shifted. US private sector debt peaked at 180 per cent of GDP in the 2nd quarter of 2009. It then fell to 163 per cent of GDP – still 5 percentage points above its pre-recession level. But any recent decline in private sector debt has been almost entirely offset by increases in government debt created by budget deficits exceeding 10 per cent of GDP.

Figure 2

 

The US therefore simply ‘nationalized’ its debt problem – replacing private with public debt. The mechanisms by which this occurred were the indirect consequences of the financial crisis, with recession increasing welfare payments and reducing tax receipts, as well as transfer of funds to the private sector in bank bailouts and similar measures.

John Mauldin and Jonathan Tepper therefore put it correctly in their book Endgame: ‘Debt is moving from consumer and household balance sheets to the government. While the debt supercycle was about the unsustainable rise of debt in the private sector, endgame is the crisis we will see in the public sector debt.’ (p25)

In short, although the US crisis may currently appear in the form of a government deficit and debt issue, the origins of the problem lay in the private sector and the government debt issue is the consequence of nationalization of private sector debt.

The European debt crisis

Europe followed a similar path to the US but with some countries, e.g. Greece and Italy, building up large public sector debts alongside the private ones in Spain and other states. Europe’s situation is structurally more potentially threatening than the US as the Federal Reserve has greater resources than the European Central Bank and the US state is able to react in a more centralized way than the decentred structure created by the different states of the European Union.

The European Central Bank simply does not have sufficient resources to be able to deal with a spread of the debt crisis into the larger EU economies such as Spain and Italy. Given the exposure of European banks to national state debt the spreading of the European sovereign state crisis to major economies therefore has the potential to bring down the European banking system. For this reason there have been rising European interbank lending rates, reflecting banks decreasing willingness to lend to each other, extremely high rates for bank insurance in a number of countries, and sharply falling bank share prices in both Europe and the US.

Kenneth Rogoff, author of the notable quantitative study of debt crises This Time is Different, and former chief economist of the IMF, accurately summarized the situation in the financial sector as follows:

‘Securitization, structured finance, and other innovations have so interwoven the financial system’s various players that it is essentially impossible to restructure one financial institution at a time. System-wide solutions are needed… the financial system remains on government respirators… in the US, UK, the euro zone, and many other countries today. 

‘Most of the world’s largest banks are essentially insolvent, and depend on continuing government aid and loans to keep them afloat. Many banks have already acknowledged their open-ended losses in residential mortgages. As the recession deepens, however, bank balance sheets will be hammered further by a wave of defaults in commercial real estate, credit cards, private equity, and hedge funds. As governments try to avoid outright nationalization of banks, they will find themselves being forced to carry out second and third recapitalizations.

‘Even the extravagant bailout of financial giant Citigroup, in which the US government has poured in $45 billion of capital and backstopped losses on over $300 billion in bad loans, may ultimately prove inadequate.’ 

Political struggles are the symptom of the renewed crisis and not its cause

Given the scale of the debt situation none of the means used for tackling the debt problem in the US and Europe can avoid severe economic pain. The political fighting which has broken out is simply over how this pain should be shared. The political struggles which have occurred, for example between President Obama and Republicans in Congress, or between Germany’s government and other European states, are therefore not the cause of the renewed economic crisis but its result. Analysing the different responses however leads directly to the issue of the necessary policies to deal with the financial and economic crisis.

The necessity to run budget deficits

The most ideologically right wing forces - the US Tea Party and those in Europe sharing the views of the British Conservatives - advocate limiting the public debt build up by radically reducing government spending. This is linked to a theory that the state is ‘crowding out’ the private sector. This entire analysis is false. Because of its ideological blinkers it fails to see that the origin of the crisis lay in the private sector debt. It is also extremely dangerous in terms of economic policy.

The main transmission belt from excessive debt into recession is the fall in private investment. As may be seen in Figure 3 the entire decline in GDP in the G7 economies between the 1^st quarter of 2008, the peak of the previous business cycle, and the 1^st quarter of 2011, the latest available data, was accounted for by the decline in fixed investment. In fixed price parity purchasing powers (PPPs) the decline in G7 GDP was $381 billion and the decline in fixed investment was $591 billion – the decline in fixed investment can be greater than the decline in GDP as it is offset by increases in household and government consumption.

Figure 3

 

The theory of ‘crowding out’ argues that resources used to finance the budget deficit would be used to generate economic expansion if released to the private sector – for example US financial analyst John Mauldin argues ‘increasing government debt crowds out the necessary savings for private investment, which is the real factor in increasing productivity.’ (Endgame p59)

But reducing budget deficits by cutting public spending cannot create an economic way out in present conditions. Reducing budget deficits cuts demand. But resources released to the private sector are used to pay down debt, so private spending will not increase sufficiently to compensate for the fall in public spending. Total demand will fall, increasing recessionary pressure.

In short, it is vital in the short term to maintain budget deficit spending, including by targeting maintaining or expanding consumption – state spending on investment is analysed below. Attempts to immediately reduce budget deficits must be strongly resisted. Countries facing an economic slowdown should run, or increase, budget deficits to compensate for the shortfall of private sector demand.

Richard Koo, in his important books Balance Sheet Recession and The Holy Grail of Macroeconomics, has dealt with this correctly in analysing the experience of the decades long fight against the consequences of over-indebtedness in Japan. As Koo noted:

‘What sets Japan’s Great Recession apart from the U.S. Great Depression is that Japanese GDP stayed above bubble peak levels in both nominal and real terms despite the loss of corporate demand worth 20 per cent of GDP and national wealth worth ¥1,500 trillion… The financial deficit of the government sector mounted sharply, leaving in its wake the national debt we face today. But it was precisely because of these expenditures that Japan was able to sustain GDP at above peak-bubble losses despite the drastic shifts in corporate behavior and a loss of national wealth equivalent to three years of GDP. Government spending played a critical role in supporting the economy…

‘Japan was left with a large national debt. But if the government had not responded with this kind of stimulus, GDP would have fallen to between one-half and one-third of its peak – and that is an optimistic scenario. U.S. GNP shrank by 46 per cent after falling asset prices destroyed wealth worth a year’s worth of 1929 GNP during the Great Depression, and the situation in Japan could easily have been much worse. This outcome was avoided only because the government decided early on to administer fiscal stimulus and continue it over many years…

‘In summary, the private sector felt obliged… to pay down debt… Disastrous consequences were avoided only because the government took the opposite course of action. By administering fiscal stimulus, which was also the right thing to do, the government succeeded in preventing a catastrophic decline in the nation’s standard of living despite the economic crisis.’ (The Holy Grail of Macroeconomics p22-25)

Naturally the form the budget deficit takes is itself extremely important. Government spending on those on average and low incomes, and on investment, is not only socially more just but is far more effective as a stimulus than tax cuts for the best-off – who save, rather than spend, a higher proportion of their income. Equally spending on investment is far more effective in expanding the economy that military spending – which does not add to productive capacity. But overall it is necessary to fight moves by fiscal conservatives to reduce the budget deficit in the short term. As an immediate response to the financial crisis countries facing the threat of economic downturn should run or maintain stimulus packages funded, if necessary, by budget deficits.

Budget deficit and the medium term

While budget deficits with a large component targeted at maintaining consumption are immediately vital to prevent short term economic decline they are not sufficient, faced with deep economic problems, to relaunch substantial growth because they do not deal with the most fundamental issue driving the downturn – the investment fall. This is in addition to the fact that few countries have Japan’s financial strength, which enabled it to sustain a very large budget deficit over a long period. For most countries large budget deficits can be run in the short term but are financially unsustainable in the medium term.

A policy of running large budget deficits is often inaccurately described as a 'Keynesian' one  - inaccurately as Keynes own central concern was factors affecting investment and not budget deficits.¹ Paul Krugman in the New York Times, for example, regularly but wrongly argues that the budget deficit is both the most central issue in economic policy and the core of Keynes views. US economist Paul Davidson similarly claims in The Keynes Solution: ‘Anything that increases spending on goods and services increases the profitability of business firms and the hiring of workers.’ (p54) But this is false - for example, an increase in spending on goods and services accompanied by cost increases may lead profits to fall.

However, even if profit did increase due to increases in demand, companies may not reverse the cuts in investment that are the core of the recession. Keynes pointed out that to generate investment a price must be paid to overcome ‘liquidity preference’ - the advantages of holding assets in cash and other liquid forms. In circumstances of high uncertainty, such as at present, the cost of overcoming liquidity preference may be prohibitive and therefore it will prevent investment taking place even if such investment would yield a positive profit.

Low interest rates necessary but not sufficient

Even more fundamental than liquidity preference in the present situation is that, given excessive indebtedness, companies use resources to repay debt, that is to build up their balance sheets, and not to invest even if demand increases. Therefore stimulating demand by budget deficits may prevent worse declines in production but does not produce significant output increases.

In such conditions low interest rates are also insufficient as an economic policy to provide a way out. Low interest rates are necessary to prevent interest payments becoming unsupportable and to remove a block to borrowing for investment. But they do not lead to investment under conditions where companies are intent on paying down debt and have no intention of borrowing for investment.

International redistribution of debt

As any solution to the present situation must involve medium term debt reduction a number of states are seeking to achieve this at the expense of other countries even without formal defaults on debt payments. In particular the US, via falls in the exchange rate of the dollar, reduces the real value of its debt at the expense of countries which hold dollar assets. Such policies however clearly only aid one country at the expense of others, effectively redistributing the debt without reducing the overall debt burden.

Inflation is not a relatively harmless solution

It is important to remove an illusion currently being suggested that inflation would be a relatively painless and non-harmful way to reduce debt. The idea behind this is that while the monetary volume of debt, its nominal value, would remain the same its real size would be reduced. Kenneth Rogoff, for example, has argued this:

‘It is time for the world’s major central banks to acknowledge that a sudden burst of moderate inflation would be extremely helpful in unwinding today’s epic debt morass…. Moderate inflation in the short run – say, 6% for two years – would not clear the books. But it would significantly ameliorate the problems, making other steps less costly and more effective. ‘

Similarly the British economist Will Hutton has argued:

‘As the IMF's chief economist, Olivier Blanchard, has suggested, if the options are public and private default, continuing bank weakness, economic stagnation (perhaps depression), or inflation, then the least bad option is to accept inflation, but to manage it within bounds.

‘Since inflation will happen anyway as governments seek the least bad way out, the choice in reality is whether to accept and manage it or not. Once debt is at a sustainable level and growth has resumed, then the world's financial system can be redesigned to avoid a repeat, and price stability restored.

‘This is the truth that cannot speak its name: as a senior financial policy official told me, even to raise it at home or abroad merely as an issue for debate is to invite universal disapproval. But truth must be faced. Britain should provide a lead – both for its own economic fortunes and to set the new international standard. As a minimum it should announce a new programme of quantitative easing, in effect printing money; insist the Bank of England uses the money it prints to buy the broadest range of private debt; and immediately replace the 2% inflation target with a target for the growth of money GDP – so getting Britain off the hook of its unpayable private debts.’²

However someone will have to suffer the loss in real resources created by the inflation. Usually this is the majority of the population as the rate of increase of incomes fall behind the rate of inflation. Politically a policy of lowering debt by inflation is therefore likely to be drastically unpopular for whoever implements it.

Furthermore economically inflation, striking at the majority of the population by reducing living standards, will actually cut consumption – which strengthens recessionary tendencies. Inflation also does not deal with the issue of increasing investment – the fall in which drove the recession. In short inflation is not a solution either politically or economically to a crisis of the depth which currently exists.

Indirect means of stimulating investment

If the way out is turned to, the necessary policies cannot be separated from the analysis of the depth of the crisis.

If the current economic crisis were of small or moderate dimensions then it could indeed be tackled by increases in budget deficits which primarily raised or maintained consumption. Such deficits would increase demand while liquidity preference, lack of profitability and debt levels would be insufficient to prevent companies responding to the increase in demand by raising investment - therefore substantial economic recovery would occur. This, however, has clearly not occurred in the crisis since 2008 despite large budget deficits being run.

Given budget deficits have been insufficient, attempts are also made to raise investment by extremely low interest rates and by seeking to reduce liquidity preference – the latter being a key goal of the talk regarding the need to ‘restore confidence’. These measures have also clearly not succeeded.

Confronted with this impasse more logical economic commentators are therefore beginning to address the need to raise investment. Such discussion currently primarily centres on advocating indirect means such as tax breaks. For example Joseph Stiglitz recently argued:

‘those worried about the shortage of policy instruments are partially correct. Bad monetary policy got us into this mess but it cannot get us out. Even if the inflation hawks at the Federal Reserve can be subdued, a third bout of quantitative easing will be even less effective than QE2. Even that probably did more to contribute to bubbles in emerging markets, while not leading to much additional lending or investment at home.

‘The Fed’s announcement that it will keep the target federal funds rate near zero for the next two years does convey its sense of despair about the economy’s plight. But, even if it succeeds in stopping, at least temporarily, the slide in equity prices, it won’t provide the basis of recovery: it is not high interest rates that have been keeping the economy down. Corporations are awash with cash, but the banks have not been lending to the small and medium-sized firms… The Fed and Treasury have failed miserably in getting this lending restarted, which would do more to rekindle growth than extending low interest rates though 2015.

‘But the real answer, at least for countries such as the US that can borrow at low rates, is simple: use the money to make high-return investments. This will both promote growth and generate tax revenues, lowering debt to gross domestic product ratios in the medium term and increasing debt sustainability. Even given the same budget situation, restructuring spending and taxes towards growth – by lowering payroll taxes, increasing taxes on the rich, as well as lowering taxes for corporations that invest and raising them on those that do not – can improve debt sustainability. ‘

By identifying raising investment as the key target Stiglitz does address the central dynamic of the recession. But the issue is once again quantitative and related to the depth of the crisis. Will measures such as tax breaks be sufficient to raise investment if they are added to other policies such as running budget deficits and low interest rates? If the economic crisis is not deep they will suffice. If the economic crisis, and the necessity to pay down debt, is stronger then indirect measures to target investment, such as tax breaks, will not be sufficient.

The current indications, given the scale of the economic problems and debt burden, is that indirect means to stimulate investment by policies such as tax breaks will be insufficient to relaunch substantial economic growth.

Direct means of raising investment

The most decisive way to overcome the current situation flows from the above trends. Its practical effectiveness was shown by its use by China in its successful 2008 stimulus package, which was followed by over 30 per cent GDP growth in three years. Keynes also analysed and advised it. This is that the state must overcome the reality or threat of a fall in investment by itself undertaking and organizing investment. Keynes noted this in The General Theory of Employment, Interest and Money: ‘It seems unlikely that the influence of banking policy on the rate of interest will be sufficient by itself to determine an optimum rate of investment. I conceive, therefore, that a somewhat comprehensive socialization of investment will prove the only means of securing an approximation to full employment.’ (p378)

Such an analysis flowed from Keynes practical experience regarding the relation between the depth of economic crisis and lack of sufficient efficacy of other economic instruments: 'Only experience… can show how far management of the rate of interest is capable of continuously stimulating the appropriate volume of investment… I am now somewhat sceptical of the success of a merely monetary policy directed towards influencing the rate of interest… I expect to see the State… taking an ever greater responsibility for directly organising investment; since it seems likely that the fluctuations in the market estimation of the marginal efficiency of different types of capital… will be too great to be offset by any practicable changes in the rate of interest.' (p164) Therefore: ‘‘I conclude that the duty of ordering the current volume of investment cannot safely be left in private hands.’ (p320)

Keynes naturally did not advocate an administered economy. But he therefore explicitly argued in the General Theory that the state should have the ability to intervene sufficiently to determine overall investment levels.

Keynes also noted that this 'somewhat comprehensive socialisation of investment' and 'the duty of ordering the current volume of investment' did not mean the elimination of the private sector, but socialised investment operating together with a private sector: 'This need not exclude all manner of compromises and devices by which public authority will co-operate with private initiative… apart from the necessity of central controls to bring about an adjustment between the propensity to consume and the inducement to invest there is no more need to socialise economic life than there was before…. The central controls necessary to ensure full employment will, of course, involve a large extension of the traditional functions of government.' (p378)

The country which most approximates to this economic system is China. China, of course, describes its economy in a different way and using Marxist terminology. China defines itself as passing through ‘the primary stage of socialism’ and its overall system as ‘socialism with Chinese characteristics’. However it is not the important question whether China’s definition of its own system should be accepted, or whether its economy should instead be regarded as conforming in important features to the system described by Keynes in the General Theory of Employment, Interest and Money. What is important is understanding how such an economic system works and to note that China has been able to run the world’s largest stimulus package without an unsustainable budget deficit, and why its macroeconomic policy has come through the international financial crisis more successfully than the US and Europe – and why China’s economic system has generated, during the last thirty years, the most rapid economic growth of any major economy in the world.

China’s economy

The difference between China and the US and Europe, of course, lies in economic structure. After its 1978 economic reforms China abandoned an administered economy. But it did not abandon the ability of the state to set the overall level of investment, and it maintains a state owned banking system which is  stronger in a crisis than the ones in the US and Europe and which can be instructed to expand lending in order to sustain stimulus packages. China therefore actually implements Keynes point that ‘the duty of ordering the current volume of investment cannot safely be left in private hands.’ That is, a ‘somewhat comprehensive socialization of investment’ does exist in China, not in the sense that the private sector is eliminated, on the contrary China’s private sector is large and dynamic, but in the sense that the state has sufficient levers to determine the overall level of investment. In contrast in the US and Europe the conditions outlined by Keynes do not exist, and the state sector is insufficiently large to deliver an investment-led stimulus.

As a conseuence of these differences China has come through the financial crisis far more successfully than the US or Europe

Implication of the differences

Once again the interaction of these different factors cannot be separated from analysis of the scale of economic crisis itself. China’s economic structure clearly gives it a superiority which has allowed it to avert serious downturns, as shown both in the 1997 Asian debt crisis and in the international financial crisis since 2008, and to maintain very long term rapid economic growth. But how serious the lag in the US and Europe compared to China is depends on how serious the economic crisis is.

If the economic crisis is not deep then gradually time, and greater application of the measures which are available to the US and European economies – budget deficits, low interest rates, tax breaks for investment – will overcome the investment decline. China will still grow more rapidly, but the US and Europe will also resume growth. If the crisis is deep then only adoption of full scale Chinese methods of direct state action to implement ‘the duty of ordering the current volume of investment’ would suffice. That, however, would require a huge extension of the state sector of the economy, and therefore greater application of the indirect methods available in the US and Europe will be tried first.

One clear implication, of course, is that in all these different circumstances China continue to will grow much more rapidly than the US and Europe even if the latter escape a 'double dip' recession.

Conclusion

The realistic conclusions which follow from the present renewal of the international financial crisis, in terms of both analysis and the required policy response, are therefore clear:

• The International financial crisis has recurred because the economic policies to deal with the 2008 crash in the US and Europe did not remove its underlying cause - excessive debt build up in an attempt to sustain US economic growth and living standards. The post-2008 policies failed because they were designed to deal with much less serious economic events than the ones which unfolded.
• The effect of the policies pursued after 2008 has been to nationalize large part of the debt that originated in the private sector. Therefore, in most cases, and in particular in the US, even if the crisis reappears around state finances the actual origins of the problem lay in the private sector debt.
• The strategic failure to overcome the debt crisis creates strong pressure to a renewed crisis of the banking system.
• The debt crisis transmits itself into the real economy above all though a collapse in investment – taking the G7, the entire decline in GDP is due to the fall in fixed investment.
• In the short term it is necessary to deal with the crisis by continuing to run budget deficits, and countries that have not done so may well need to introduce budget deficit spending. China is an exception because its economic structure allows it to run large stimulus packages without budget deficits due to its ability to directly stimulate investment. Only a handful of other countries, however, have a state sector large enough to fund and run such investment programmes and therefore other economies will have to run budget deficits in the short/medium term. However while budget deficits are necessary to avoid sharp economic decline the experience of the last three years has shown that the economic crisis is too deep for budget deficits by themselves to stimulate significant growth because they do target the core of the recession, the investment decline.
• Very low interest rates must be maintained in order to lighten the burden of interest payments on the overextended debt, and to remove an obstacle to investment. However, once again the experience of the last three years has shown that the economic crisis is too deep for low interest rates themselves to relaunch investment and substantial economic growth.
• China possesses the advantage that it can directly stimulate investment. In other countries there is also a growing realisation that the core transmission of the economic problem lies in investment falls. But without a sufficiently large state sector most other countries do not have the means to directly launch investment. Therefore indirect methods such as tax incentives for investment and similar measures are being proposed. It remains to be seen in practice, if these are introduced, whether they are effective. Given the depth of the crisis the probability is that even if such measures are introduced they will not be enough to sufficiently overcome the low investment level. Consequently growth will continue to be very slow in the US and Europe even if a new recession can be avoided.
• The world economy will therefore see a further period in which China’s economy will grow rapidly while the US and Europe remain at best relatively stagnant.

 

Notes

1. See Ross, J. ‘Deng Xiaoping and John Maynard Keynes’. Soundings Winter 2010.

2. The British newspaper The Observer made the same call:

‘The only alternative to default is inflation – governments printing money to get out of the corner they, their banks and their citizens are in. The question facing policymakers in the years ahead will be which of the unpalatable options they confront – economic stagnation, public and private default together with endemic bank weakness, or uncontrolled or managed inflation – they are going to choose…

‘The British government's policies are locked in the same impotent stasis as the rest of the world's – battening down the hatches, cutting public spending and borrowing, and refusing to accept realities. The government should declare independence. It should abandon the suffocating 2% inflation target and replace it with a target for the total volume of spending in the economy. It should prepare to stimulate the economy with more quantitative easing – in effect printing money – using the proceeds to lend directly to public agencies and departments prepared to lift capital spending.’

The financial crash and macro-economic policy - why the US and Europe have budget crises and China does not

The events precipitating the renewed financial crash were the combination of debt crises and confirmation of slow US economic growth. Regarding the former countries were either trying to cut deficits (the US, Greece, Italy, the UK) or feared they will have to bail out those running unsustainable ones (Germany, France). But these large deficits were not accompanied by strong economic growth – although it can be cogently argued that they were necessary to stave off sharp economic downturn.¹

Japan is currently preoccupied with overcoming the consequences of the tsunami and earthquake, but it also will soon have to face the reality that, due to decades of budget deficits, it has the largest government debt as a percentage of GDP of any country – twice that of the US.

In contrast China in 2008 launched the world's largest state stimulus package to counter the international financial crisis. But it is not running any substantial budget deficit - this year it will only be around two per cent of GDP. But China has enjoyed rapid economic growth.

It has been claimed that China is applying ‘Keynesianism’, but if budget deficits were the key issue defining such policies then China is clearly not pursuing ‘Keynesianism’ at all.

Actually, the core of Keynes’ analysis did not lie in advocating budget deficits, and in some ways China has a policy which more corresponds to his views than that pursued in the US and Europe. This is is briefly outlined below. But before dealing with this it is illuminating to contrast the nature of the economic policies pursued by the US and Europe in the last three years on the one hand, and by China on the other, and to analyse why the latter was able to launch such a large stimulus package without a significant budget deficit.

The actual core of the Great Recession

The core of the difference between the policies pursued in the US and Europe on the one hand, and that followed in China on the other, requires understanding what actually occurred during the 'Great Recession' after 2008. A more extensive analysis has been given elsewhere but to summarise in the US and Europe the Great Recession was dominated by an investment collapse. To take the largest example, in the 2nd quarter of 2011 US GDP was still $56 billion below its 4th quarter of 2007 peak. However all major components of US GDP except fixed investment were already above their previous peak levels – inventories were $37 billion above, government consumption $51 billion above, personal consumption $66 billion above, and net exports $159 billion above. But US private fixed investment was $388 billion below its 4th quarter 2007 level. The entire decline in US GDP was therefore due to the fixed investment fall.  These changes are shown in Figure 1. A similar pattern exists in almost every major developed country.

Figure 1

 

This investment fall, by driving and maintaining the downturn, produced a decline in personal and company income and therefore a fall in tax revenue – the latter being the primary reason for budget deficits. The crucial issue, both for economic development and to close the budget deficit, is therefore how to relaunch growth.

China's situation was different and explains why it ran no significant budget deficit. China abandoned administrative running of its economy with the economic reforms beginning in 1978, but it still has a sufficiently large state sector that this could be, and was, instructed to increase investment. As the key banks are state owned they could be instructed to increase lending to companies – in the US the opposite occurred and lending to companies fell sharply. The rapid economic growth initially generated by China's state companies in turn stimulated the private sector.

The result, during the crucial period 2008-2009, is shown in Figure 2. Instead of China's investment falling it rose by $420bn. Consequently there was no recession. Under the impact of the increase in jobs and incomes created by the stimulus package, China's household expenditure also rose by $160bn. Therefore despite the combined effect of a fall in net exports and inventories of $160bn China's GDP in 2009 rose by $440bn.

As there was no recession there was no fall in tax revenue and no major budget deficit. As this process continued, by 2011 China's GDP had increased by over 30 per cent, $2.3bn in current price terms, compared to pre-crisis level. In contrast by the 2nd quarter of 2011 US GDP was still 0.4 per cent below its 2007 peak level.

Figure 2

 

In the US and Europe the budget deficits were increased by government attempts to restart growth. China could instruct its state companies to invest and its state banks to lend, but the state sector in the US and Europe is too small for this to be effective. Only indirect means, such as quantitative easing (printing money) and budget deficits were available as policy tools. Both proved ineffective in restarting rapid growth. But the latter policy worsened the deficits. China, due to the rapid growth resulting from the investment stimulus, had no significant budget deficit.

Relative scale of economic problems in the US, Europe and China

Naturally the above does not mean China escaped all economic problems - particularly food price inflation, but these are not on the same scale as the budget deficit crises gripping the US and Europe.

Nor do such developments mean China does not face economic policy choices. It is impossible to judge the size of a stimulus package perfectly in advance. The crucial thing in 2008, confronted with the worst economic crisis for eighty years, was to act rapidly and forcefully to head off downturn. This was achieved.

Indeed, so successful was the stimulus that by the 2nd quarter of 2010 China's GDP growth was 11.9 per cent – well above the average 9.9 per cent since its economic reforms began and unsustainably high. Also, despite the government's efforts, it is always impossible to prevent some part of a stimulus spilling into unintended areas  - creating a too high rate of increase in China's house prices.

In summer 2010 world food price inflation also began. China suffered from this less than other comparable BRIC countries – Brazil, India and Russia. But countering these price rises required monetary tightening and slowing the economy

Finally, a medium term problem must be tackled. It is impossible to implement a huge lending increase, under conditions of international economic downturn, without some increase in bad loans. When China's government launched the 2008 stimulus package it anticipated this by making banks increase provisions for bad loans and stating they would have to raise extra capital. The government's calculation was simply that large scale economic growth resulting from its policies would generate more than sufficient resources to deal with any bad loans problem of the type now appearing in municipal debt – i.e. far more would be gained than lost. With more than 30 per cent growth in three years China's economy has easily enough resources to deal with bad loans.

In short China's economic structure does not produce perfection – which only exists in heaven. But the problems it faces are far smaller than the budget deficit and debt crises in Europe and the US.

China's economy grew by more than 30 per cent in three years while Europe and the US remain below their peak levels of output. It is therefore easy to see which policy has been more successful.

Keynes and Chinese descriptions of China’s economic system

How is such an economic system as that operating in China to be described? China itself, of course, uses Marxist terminology – it describes itself as passing through ‘the primary stage of socialism’ and its overall system as ‘socialism with Chinese characteristics’. However there is another, more familiar in the West, way of looking at it.²

Keynes in the General Theory of Interest, Employment and Money evidently did not advocate an administered economy.³ But he did explicitly argue that the state would have to intervene sufficiently to determine the overall level of investment: ‘I conclude that the duty of ordering the current volume of investment cannot safely be left in private hands.’ (p320)

Keynes, as is well known, attached great weight to changes in the rate of interest in affecting the investment level. But he did not believe these would be sufficient by themselves: 'Only experience… can show how far management of the rate of interest is capable of continuously stimulating the appropriate volume of investment… I am now somewhat sceptical of the success of a merely monetary policy directed towards influencing the rate of interest… I expect to see the State… taking an ever greater responsibility for directly organising investment; since it seems likely that the fluctuations in the market estimation of the marginal efficiency of different types of capital… will be too great to be offset by any practicable changes in the rate of interest.' (p164)

This led Keynes to the conclusion: 'It seems unlikely that the influence of banking policy on the rate of interest will be sufficient by itself to determine an optimum rate of investment. I conceive, therefore, that a somewhat comprehensive socialisation of investment will prove the only means of securing an approximation to full employment.' (p378)

Keynes noted that 'somewhat comprehensive socialisation of investment' and 'the duty of ordering the current volume of investment' did not mean the elimination of the private sector, but socialised investment operating together with a private sector: 'This need not exclude all manner of compromises and devices by which public authority will co-operate with private initiative… apart from the necessity of central controls to bring about an adjustment between the propensity to consume and the inducement to invest there is no more need to socialise economic life than there was before…. The central controls necessary to ensure full employment will, of course, involve a large extension of the traditional functions of government.' (p378)

It does not seem the most interesting question is whether we should accept China’s definition of its own system, or whether its economy instead should be regarded as conforming in important features to the system described by Keynes in the General Theory of Employment, Interest and Money. What is important is understanding how China’s economy actually works, why it has been able to run the world’s largest stimulus package without a budget deficit, and why therefore its macroeconomic policy has come through the international financial crisis more successfully than the US and Europe.

Notes

1. For an analysis of this see Richard Koo’s The Holy Grail of Macroeconomics: Lessons from Japan’s Great Recession.

2. A more detailed discussion of these issues can be found in Ross, J. ‘Deng Xiaoping and John Maynard Keynes’. Soundings Winter 2010.

3. All page references are to the 1983 Macmillan edition of the The General Theory of Employment, Interest and Money.

Since the financial crisis began China's economy has expanded by almost 40% and the US and Europe not at all

The publication of GDP data for the first half of 2011 for the world’s two largest economies, the US and China, provides a suitable moment to assess trends in economic growth since the international financial crisis commenced. Publication of 2nd quarter GDP data for the European Union (EU) and Eurozone later this month will alter details but is highly unlikely to alter the overall picture.

Ideally quarter by quarter GDP growth data would be available for all countries but unfortunately, until the beginning of 2011, China only produced figures for quarterly GDP calculated on a year on year basis compared to the same quarter for the previous year. Fortunately for clear analysis, the differences in growth rates between the main economies are sufficiently large that utilising annual data leaves no doubt as to fundamental trends.

The peak of pre-crisis US GDP was in the 4th quarter of 2007 - the peak for the EU and Japan was only one quarter later in the 1st quarter of 2008. Therefore the appropriate starting point for comparison, using annual data, is with the final pre-crisis year of 2007.

Data for GDP growth using a base year of 2007 is therefore shown in Figure 1. As 2011 is not yet over the working assumption has been made that the growth for this entire year is the same as the year on year change in the latest available quarter – the 2nd quarter 2011 for the US and China and 1st quarter 2011 for the EU. These projections will be modified as subsequent data is published.

Both the US and China are slowing – see Figure 2. Therefore, projecting for the whole of 2011 the latest available quarterly year on year change may therefore somewhat exaggerate growth for the year as a whole. However the difference between China on the one hand, and the US and the US and Eurozone on the other, is so large that no significant change in relative positions will result if the eventual 2011 growth rate for all three is altered by any reasonable margin.

Japan’s data will, of course, be highly depressed by the aftermath of the earthquake and tsunami. Therefore, apart from noting that the fall in Japan’s GDP during the financial crisis was greater not only than for China but also for the US and Eurozone, emphasis is not given here to quantitative comparisons for Japan.

Taking the above assumptions, then taking the entire period between 2007 and 2011:

• China’s GDP will have expanded by 44.5%.
• US GDP will have expanded by 0.8%.
• Eurozone GDP will have expanded by 0.4%.

Assuming some deceleration during the second half of 2011, the essential qualitative parameters of economic performance during the four years since the beginning of international financial crisis will therefore be that China’s economy has expanded by somewhat over 40% while the US and Eurozone economies have approximately not grown at all.

Such facts evidently have major implications both at the level of the objective development of the world economy and of analysis.

• In terms of development of the world economy, a 40%+ expansion of China’s economy during a four year period, simultaneously with essentially zero growth in the US and Eurozone, is sufficient to significantly alter the balance between the world’s major economies. To take an example of implications, in assessing when China’s GDP will overtake the US to become the largest in the world, the types of assumptions typically employed have been that the US economy will expand at around 2.5% a year and China’s at around 8.0% a year. However at present China is somewhat outperforming this figure, with an annual average growth rate of 9.6% in the last four years, while the US is substantially underperforming. Evidently, projecting US growth continuing at only an annualised 0.2%, as would be the case during the last four years from the data above, would be entirely unreasonable. But any lowering of the US annual growth rate below 2.5%, which appears a clear possibility, would bring forward the data when China’s GDP will overtake the US at market exchange rates from the 8-10 year period which is generally calculated to a 5-7 year period.
• The growth of China’s GDP by around forty per cent in the last four years, while the US has not grown at all, is already sufficient to show as incorrect those analyses, publicised in the Financial Times and elsewhere, which projected that  the US would recover from the financial crisis more rapidly than China. For example Michael Pettis of Beijing University analysed that: ''the US would be the first major economy out of the crisis and China one of the last.' Attempts have been made to defend this and similar analyses by stating that the crisis is not yet over, therefore it is too early to pass judgement. In reality, with China’s economy expanding by 40% while the US has not grown at all, even if China’s growth were to slow it is already clear it has come through the financial crisis far more successfully than the US. Michael Pettis and those with similar views should therefore note that they were wrong, that those such such as this blog and others who analysed the opposite were correct, and begin to examine what errors in economic theory and analysis led to these wrong conclusions.

Growth of 40% in China over a four year period, compared to zero per cent in the US and Eurozone, is a quite sufficient test by facts to establish which analysis was right and which was wrong regarding the relative trajectories of China’s and the US economies during the international financial crisis.

Figure 1

Figure 2

International economic consequences of the Greek debt bailout

The Greek debt crisis is both a significant economic event and a foreign policy success for Germany. It has, for the present, shifted the economic balance of power in Europe, and to some extent more widely, in Germany’s favour and against those in the US and Britain who do not favour the Euro and prefer a weak European Union (EU). These aspects are interlinked and both worth analysing.

Economics of the Greek bailout

At the economic level the media has widely and correctly reported that the new Greek bailout agreement was a step in the direction of European economic integration. It was also a move towards dealing with some of the contradictions that have existed in the Euro since its creation – as analysed below. Most immediately the partial Greek debt default, writing down the value of its bonds by 21 per cent, together with reducing its interest rate on bailout loans from 5.5 per cent to 3.5 per cent, extending the existing repayment period from seven to a minimum of fifteen years, generating debt relief of $19.4 billion or about a quarter of the total, all in the context of an overall $157 billion bailout package, should allow short term stabilization of Greece’s financial situation.

Nevertheless key economic issues remain unresolved. Greece’s debt still stands at 150 per cent of GDP. The 21 per cent write down of its bonds is far less than the 40 per cent by which they were being discounted by the market – an explicit indication the write off may be insufficiently large to generate medium/long term Greek financial stability. The European Financial Stability Facility (EFSF) has not been increased in size to deal with its new obligations. The declaration that this bailout package applies only to Greece is purely words. Despite Ireland and Portugal having had interest rate on bailout funds reduced to 3.5 per cent one or either is likely to enter a new crisis – and the interest rate reduction is already a partial extension of the terms of the Greek bailout.

Most fundamentally the Euro still contains a central contradiction as long as a united European state does not accompany European monetary union. A currency union, such as the Eurozone, means the effects of inevitable changes in relative regional productivity, and therefore costs of production, which take place in a continental scale economy can no longer be dealt with, as in Europe’s past, by changes in exchange rates. Those parts of Europe’s economy with relatively low productivity, such as Greece, will inevitably become increasingly uncompetitive compared to economies with higher rates of productivity and productivity growth such as Germany, France or Holland. This will push the weaker states towards economic depression and social crisis.

In a unified state covering a continental scale economy, such as in the US or China, the resulting problems can be dealt with by budget transfers from richer regions to poorer ones. But this in turn is possible because the largest part of taxation goes to the central government which can then redistribute it between regions.

However, in Europe the central EU budget is small compared to the national budgets. Therefore insufficient resources for such redistributive policies exist. The main European governments remain opposed to any EU budget adequate for such transfers. As the Financial Times cited the current position of Angel Merkel: ‘As for a “transfer union”, if it meant paying for other people’s debts, “my conviction is that it will never happen”.’

Of course Chancellor Merkel’s position need not be taken totally at face value – probably a year ago she would have said that the present degree of partial integration arrived at by the Eurozone was also out of the question. But nevertheless a fully-fledged fiscally federated Eurozone is not politically on the cards at present.

Short term trends

This fundamental contradiction at the heart of the Euro, however, need not explode in the short term. If significant European economic growth can be resumed then the resources will be generated to make adequate transfers to save the financial systems of countries such as Greece and to prevent an uncontrollable financial meltdown in major economies such as Italy or Spain. The time thereby gained can potentially be used to shift European institutions, and possibly public opinion, in favour of greater European integration. But the problem is that at present vigorous European growth appears unlikely – a group of economies around Germany and France are growing rapidly, but Europe as a whole remains bogged down by the low growth of the UK, Italy and Spain.

German economic gains from the Euro

The core to the agreement on Greece, and coming events, is that during a difficult period in the European economy German business gains greatly from the Euro. The Eurozone countries cannot carry out competitive devaluations against Germany – and Germany’s economic strength means it can out-compete the other main European economies. Furthermore, whatever the financial transfers required to countries such as Greece, Germany actually gains in exchange rate terms from its association with weaker economies - as these drag down the Euro’s exchange rate. At the time of writing the exchange rate of the Euro against the dollar is 1.44. However without the weaker currencies, that is if Germany was alone, it would face a significantly higher exchange rate, harming German exports.

Naturally Germany suffers some disadvantages – for example transfers to Greece to help pay interest on the latter’s debts, and higher German bond yields, that is higher German interest rates, because of its links to weaker currencies. These drawbacks have led to some leaders of German institutions, as well as large sections of the public, expressing reservations about the deal. These include Jens Weidmann, president of the German Central Bank who stated: ‘By transferring sizeable additional risks to aid-granting countries and their taxpayers, the euro area made a big step toward a collectivisation of risks in cases of unsolid public finances and economic mistakes… That's weakening the foundations of a monetary union founded on fiscal self-responsibility. In future, it will be even more difficult to maintain incentives for solid fiscal policies.’ Also critical of the deal was the influential Ifo think tank.

But these drawbacks are judged by German business to be smaller than the gains – and believing one can have a policy which only has upsides and no downside is entirely unrealistic – hence the necessity to make compromises provided essential German interests are maintained.

Some opponents of the Euro hope that the electorate of Germany will overturn it under the impact of events such as the deal on Greece. Edmund Conway in the British Daily Telegraph for example analysed: ‘At some point the Germans will realise that the package is a thinly-veiled fiscal union which makes the transfers they funnelled into East Germany look like small change, and they will revolt at the ballot boxes.’

But this is naive nonsense. It is a cardinal principle for arriving at an accurate prediction of the economic course of a country to understand that this will be determined, on central matters, by the interests of big business and not the opinions of the electorate – sentimental analysis to the contrary leads to wrong predictions. German big business has an interest in the Euro and for that reason all major political parties in Germany support it. Therefore, in the end, the key measures to support the Euro will be taken. Even if the Social Democrats returned to power in Germany they would follow essentially the same policies on this issue as Angela Merkel. Only fringe German parties, with no chance of coming to power, oppose the Euro and therefore the policies necessary to sustain it. A few concessions to public opinion may therefore be made round the edges, but there will be no electoral revolt in Germany which will overturn the Euro.

Political dimension

The international political dimension of the Greek bailout is linked to these steps taken to maintain the Euro.

The Euro is today the main alternative reserve currency to the dollar. The fact that the Euro’s exchange rate has risen even more strongly against the dollar since 2000 than alternative potential reserve currencies, such as Japan’s yen or China’s RMB, has increased its attractiveness to both Central Banks and private investors – see Figure 1. While in the future China’s RMB is more solidly based as an alternative to the dollar than the Euro, because of China’s economic dynamism and because unlike the Euro it is backed by a united state, nevertheless immediately China’s economy is still too small, and the convertibility of the RMB too limited, for it to function as a real reserve currency alternative to the dollar. In the immediate situation it is therefore the Euro, not the RMB, which is the real alternative reserve currency to the dollar.

Figure 1

 

The decline of the position of the dollar as a reserve currency is slow. As a percentage of allocated foreign exchange reserves for all countries, holdings of dollars have fallen from 71.2 per cent in the first quarter of 1999 to 60.7 per cent in the latest available data from the IMF for the 1^st quarter of 2011 – see Figure 2. The percentage of allocated world reserves held in euros rose from 18.1 per cent to 26.6 per cent in the same period – no other currency has even a five per cent share.

Figure 2

 

However while the decline in the position of the dollar is slow it is clear. Given that the position of the dollar as the effective world reserve currency is one of the fundamentals of the economic position of the US, and of its current economic policies, therefore how to deal with the Euro is a key issue for US economic policy.

US-European political relations

To the economic challenge constituted by the Euro to the dollar was added in 2003 a political issue between the major European states and the US. France and Russia, supported by Germany, made it clear they would veto in the UN any resolution supporting the invasion of Iraq by the US. Subsequent events showed that the European states stance that this invasion was a major miscalculation was correct – and the new US president Obama had himself opposed the war. But US administrations are accustomed to automatic support from Europe for their foreign policy. ‘Neo-con’ circles in the US were therefore determined to secure renewed European support for whatever foreign policy the US adopted.

Important successes in this goal were subsequently gained by Sarkozy being elected President of France – Sarkozy including in his platform a pledge of a new closer relation of France with the US and he has carried out full French re-entry into NATO. In Germany the Social Democrat led government, which had opposed the Iraq war, was replaced by the Christian Democrat led coalition under Merkel. Both events were seen as important US foreign policy successes by neo-con viewpoints.

These successes also allowed the British Conservative Party which, apart from partial independence for a short episode under Edward Heath, has always reflected US foreign policy in Europe to play an aggressive role in rallying forces opposed to deeper European integration. The Conservatives withdrew from the main centre right grouping in the European parliament, on the grounds it was ‘Euro-Federalist’ – and to do this were prepared to align themselves with various unsavoury xenophobic parties in eastern Europe. US policy simultaneously stressed relations with the ‘new Europe’, centred on Poland and other East European states – which were seen as more supportive of United States foreign policy.

Impact of the international financial crisis

The impact of the 2008 financial crisis, and the successive European debt crises, has shaken up this situation. It became clear to the German government, after some initial prevarication, that either greater steps would have to be taken towards greater European economic and fiscal integration or the Euro would unravel thereby greatly harming German economic interests. Germany also had the economic weight within Europe to impose its solution provided it had the will – which is what Chancellor Merkel chose to deploy.

The final terms of the Greek bailout therefore corresponded, in its key terms, to conditions laid down by Merkel in order to safeguard German business interests. There was a private sector write down, in the form of a partial Greek default in order to lessen the burden falling on the German taxpayer, contrary to the earlier declarations of European Central Bank head Trichet. Contrary to the proposals of Sarkozy no European bank tax was introduced.

Furthermore by forcing through a deal consolidating the Euro Merkel also called the bluff of, and defeated, the British Tory Party. The Conservatives were faced with the reality that a deep crisis or collapse of the Euro, with its side effects, would create such international financial dislocation that it threatened to bring down the already weakened big British banks, with consequent worsening of Britain’s already weak economic position, and that the only way to prevent such a crisis of the Euro was to move towards greater integration in Europe. Therefore the Conservatives, previously bitter opponents of deeper European integration, suddenly became favourable to fiscal union in the Eurozone.

As the Financial Times noted: ‘The chancellor [George Osborne]… was “very ­worried” about the possibility of the eurozone crisis spiralling out of control, warning that it posed an additional threat to Britain’s already “tough” economic situation.

‘“We see the potential for a set of economic events that could be as damaging as 2008,” he said...

‘The chancellor was optimistic that the eurogroup of finance ministers would make progress with involving the private sector in reducing Greece’s debts but said this was only the first step towards a necessary fiscal union in the single currency area.

‘He recognised that his enthusiasm for greater eurozone integration turned British policy on its head… He said “the remorseless logic” of monetary union was greater fiscal union…

‘Mr Osborne… called for greater economic integration of the single currency area, adding that the idea of eurozone bonds was “worthy of serious consideration”…

‘Core eurozone countries, such as Germany, would have to stand behind southern European sovereign debt as guarantors, while the periphery would have to accept German-designed economic policy in return.’

The British government then de facto fell into line with the German imposed settlement for Greece by reducing the interest rate on Britain’s loan to Ireland to 3.5 per cent - in line with the policy of the eurozone countries. The cost to the British Exchequer of this step was up to £400 million ($650 million).

Germany looks east

The ability of Germany’s government to determine the essential conditions for a Greek bailout also comes at a time when Germany has been pursuing a more independent economic policy with important success – Germany has become the first major European economy to regain its pre-crisis level of GDP, and from 2010 onwards it began to enjoy rapid economic growth.

To pursue this policy Germany has sought closer relations with China – German exports to China are now greater than to the US, which has meant Germany not significantly supporting US demands that China increase the RMBs exchange rate. The German government has also sought good relations with Russia – although it has also tried to interfere in Russia’s internal affairs by de facto urging President Medvedev to stand for another term as president rather than Vladimir Putin.

Germany has also declined to participate in the NATO military action in Libya, although it has provided limited financial support for the opposition to Gadaffi. This reflects that Germany does not wish to impose an economic burden on itself through higher military expenditure and because Chancellor Merkel knew she had to push through unpopular policies to bail out Greece and did not want simultaneously to face opposition from a German peace movement.

On both economic and political issues, therefore, Germany has taken a position more independent from the US - and this policy has been accompanied by economic success.

Therefore while media attention has focussed on Chancellor Merkel’s short term success in forcing through a private sector 21 per cent debt write down for Greece much more important was the strategic decision taken by, and victory gained, by Germany – which reflected rather broad policy issues.

While Germany’s current policies have brought it economic success, when pursuing a course relatively independent of US administration policy, it is inevitable that there will be a new attempt by neo-con circles in the US aimed at subordinating German economic policy to US interests and policies. It will be interesting to see what occurs with this.

China and the US

As would be anticipated from the above the steps towards at least immediate stabilisation of the Euro constituted by the bailout for Greece were not welcomed by neo-con circles who fear for the dominance of the dollar. The Wall Street Journal, in particular, carried a whole series of negative assessments of the Greek bailout. This paralleled similar positions among Eurosceptics in the UK – who were critical of the new stance taken by the Conservative Party leadership.

China, on the contrary, strongly welcomed the consolidation of the Euro. Its central bank governor Zhou Xiaochuan issued a statement declaring: ‘This will help in promoting a resolution of the Eurozone sovereign debt issues, maintaining financial stability in the Eurozone and its member states, and maintaining market confidence.’ He noted: ‘We support the efforts made by the European Union and the Eurozone in combating the global financial crisis and improving their fiscal situation.’ Also he noted: ‘China has always been confident regarding the Eurozone and the euro and will continue to play an active and stable role in the international financial market.’ China is clearly far more supportive of the Euro than many circles in the US.

In short the measures taken around the Euro are far from purely a European matter. They affect the interrelation of Europe, the US and China – the three greatest economic powers in the world. Within that framework Germany has gained a notable foreign policy success. The events round Greece are therefore both a major economic and a political event.

Postscript

The key internal problems of the Euro exposed by the Greek, Irish and Portugese debt crises are not newly discovered but were analysed in advance by the theoretical views which inform this blog. Anyone interested in a more comprehensive analyses of these may therefore like to read the September 1996 article 'Fundamental economic implications of a single European currency.' 

 

 

The Eurozone crisis and China

As Europe’s debt crisis intensifies again an interesting international aspect is the policy choices this poses for China.

It is a further sign of the growing international effect of China’s economic strength that it had already become part of the discussion on how to resolve Greece's specific debt crisis – which is why Chinese premier’s Wen Jiabao's recent European visit received even more extensive than usual coverage in the continent's media. The new twist of the Eurozone’s crisis, with Italy being drawn in, once more shows the careful calculations that have to be made by China’s economic policy makers.

Overall economic relations between China and the European Union (EU) are clearly advancing. During Wen Jiabao’s visit to Germany contracts worth $15 billion were signed. Germany now exports more to China than to the US. In Hungary, which Wen Jiabao also visited, China's announcement that it would include that country in its international bond purchases was (with some hyperbole) described by Hungary’s government as ‘a decision of historic significance.’ In Britain, where only $2 billion of contracts were signed, prime minister Cameron appears to have soured relations by attempting to lecture China on human rights. The Financial Times reported: ‘a senior Chinese official told the... FT that the UK “is losing its standing in Europe as far as China is concerned and that Britain is now viewed less favorably in Beijing than Germany, France, Italy and Spain.”'

The Economist positively summed up its analysis of Wen’s visit, and of overall EU-China relations, in an editorial: ‘Investment bankers there [in Europe] are now sure to dial Chinese clients if they hear that a firm is a possible bid target. China's banks are rapidly increasing their presence in Europe... Chinese direct investment abroad has increased faster in Europe than in any other region.

‘The Europeans get more than just money. A Chinese partner is a good way for a European brand to gain access to the world's soon-to-be-biggest economy. Ask France's Club Med, which now has a big Chinese shareholder and recently opened its first holiday resort in the country. Or CIFA, an Italian construction equipment maker whose products are now marketed as a premium brand by its Chinese owner. Or Sweden's Volvo, which was bought by Geely, a Chinese carmaker, in 2010 and now calls China its second home market.’ The magazine concluded its editorial: ‘In welcoming China, Europe is swimming with the tide of history. America is struggling against it.’

However the Eurozone crisis is a specific issue within this context regarding which China’s government must be doing careful analysis. At least one of the Eurozone countries is going to have to stage a partial default. For example, Greece's debt next year is projected to reach 159 percent of GDP, its interest rates are 15 percent above German equivalents, and its balance of payments deficit is 5.5 percent of GDP. No serious economic recovery is taking place nor is it likely to under the bailout packages signed with the EU. This combination is totally unsustainable. A starting point has to be that the present bailout packages are not going to work and in the end Greece, and quite likely some other countries, will have to partially default on its debt - to the disadvantage of its creditors.

The overwhelming majority of international analysts are aware of this inevitable default. They are merely divided between those who believe default should occur now or whether it would be better to postpone it. The proclamations by European governments that even partial default is ‘unthinkable’, which has been shown to carry little credibility in markets or among serious analysts, merely means in practice they are going down the road of postponement.

The purpose of this postponement and what is taking place during it is clear - and it is this which brings in China. The core process in the postponement is giving time for European and other banks to exit from holdings of Greek debt and transfer it to governments - which in the real world means taxpayers. The latter will therefore pick up the eventual bill when the partial default comes. This is the reality behind strong public opposition to the European Union’s bailout plans not only in austerity-hit Greece but in creditor countries such as Germany, and it is why Angel Merkel has been periodically threatening to try to make the private sector pick up at least some of the bill.

The eventual division of losses purely between European banks and European taxpayers evidently does not affect China directly financially. But China is being asked to pick up some of the bill when the eventual default comes. The mechanism of this is that a default will have consequences not only for the country concerned but across Europe. China's government is being asked to buy, and indeed is buying, bonds in some European countries on terms that may worsen after a default. China is, of course, directly financially affected by this.

From an economic point of view China purchasing European bonds, even with knowledge that there will be a partial default, may be a sensible step. It may be that the overall benefits of participating in a deal to postpone default, which presumably will also make it more orderly, outweigh any direct financial losses China will incur. Certainly it would be viewed favorably as very responsible behavior by a number of European governments,

But there are several imponderables. First are China’s policy makers fully aware such a partial default will not be avoided? Second, while China has large foreign exchange reserves it also has a need to utilize these efficiently. The overall benefit must outweigh any loss. China, entirely rationally, has no time for approaches such as Cameron’s which consist of wanting China’s business while delivering lectures.

Given the US would gain benefits from the collapse of the Euro, as it would remove an international alternative to the dollar, and will therefore not significantly aid the Eurozone governments, China must weigh both pluses and minuses of any help. While the central drama is in Europe itself we can be sure developments in the Eurozone are being carefully followed in Beijing.

Greece and other failures of EU bailout packages

The great majority of serious economic commentators know that the ‘bailout’ package just agreed between the EU and Greece is going to fail. That in the end Greece will be forced into partial default worsening the terms for its creditors. This will, of course, be politely termed ‘rescheduling’, ‘reprofiling’ or some similar phrase in order to attempt to camouflage reality. The camouflage may, however, be so transparent that the ratings agencies will still declare a default. The main discussion is whether it is better for Greece to default immediately or whether the bailout package is a good idea, not because it will work in the end, but because it will postpone the default.

It is therefore useful to understand that all three bailout packages agreed between the EU and its member countries struck by debt crisis are failing in their declared purpose of promoting economic recovery – that is not only in Greece but also in Ireland and Portugal. This is clear from Figure 1, which shows the trend in GDP for these three countries since its peak in the last business cycle.

As may be seen in none of these countries is serious recovery occurring. Attempts to claim it is, for example by making optimistic publicity about the latest quarter’s GDP figures from Ireland, consists of taking data out of context – Ireland’s GDP figures were better only in comparison to the precipitate collapse which had occurred in the previous quarter.

Taking the three countries which have made agreements with the EU the latest available data, for the 1st quarter of 2011, shows:

• Greece’s GDP is 9.9% below its peak with an insignificant recovery from the low of 10.0% below.
• Portugal had been recovering, but its GDP has turned down in the last two quarters and is now 2.7% below its peak.
• Ireland’s GDP is 11.5% below its peak and is the same level as in the 3rd quarter of 2009 – i.e. no net growth has taken place for the last year and a half of austerity packages.

In short no serious recovery has been created by any EU ‘bailout’.

Figure 1

Europe's 'stagnant middle' will determine EU's economic trajectory

Summary

Media attention regarding Europe's economy has largely focussed on the debt crisis in Greece, Ireland and Portugal, together with some discussion of whether the radical cuts in public spending in the UK will undermine its economic recovery. Both are important topics. However they are insufficient to answer a more general question – how well is the European Union (EU) recovering from the Great Recession?

This relates to another misunderstanding of the trend in Europe's economies - a tendency to present the situation as a 'two track Europe'. In this conception, there is primarily a division between ‘northern' and 'southern’ Europe – with the former recovering and the latter not (in this perspective Ireland is an honorary member of southern Europe).

Examination of factual trends, however, shows a different situation. There are three groups, not two, within the EU's economy:

• Significantly recovering economies - centred on Germany and France.
• Small economies which have undergone serious economic decline, of which the most well known cases are Greece and Ireland - but even taken as a group these are too small to determine the course of Europe's economy.
• A group centred on what may be termed the ‘large relatively stagnant economies’ - the UK, Italy and Spain, which underwent substantial economic decline and in which recovery is currently slow.

Due to their size it is likely to be this third group that determines the dynamic of the EUs economy in the coming period.

This article analyses these trends

The overall situation in the EU economy

To give a context for the the EU's economic performance, the overall trends in GDP in the three major centres of developed economies – the US, the EU, and Japan – are shown in Figure 1. This shows GDP since the peak of the previous business cycle.

Regarding the EU, its GDP in the last quarter of 2010 remained 2.8% below in its peak – the latter occurring in the 1st quarter of 2008. It is highly improbable that growth in the 1st quarter of 2011 will be sufficient to take EU GDP back to its previous peak level. Therefore, over a three year period, the EU will have experienced net negative growth.

To take a comparison, three years after the beginning of recession, US GDP just regained its previous peak level in the last quarter of 2010 - technically on OECD data it was 0.1% above it. Japan’s GDP remained 4.2% below its previous peak.

Figure 2 shows that there is no essential difference between the performance of the EU as a whole and that of the Eurozone. Therefore in this article concentration will be on the Eurozone plus the one large European economy outside it – the UK. Together these determine the European economic situation.

Figure 1

 

Figure 2

 

Three groups in the EU

Considering trends within the EU in more detail, three distinct groups in terms of economic recovery can be identified.

• The first group, centred on Germany and France, is enjoying relatively synchronised and significant recovery.
• A second group, consisting of Greece, Ireland, Estonia, and Slovenia has undergone severe economic contraction and recovery in these states is either limited or so far has not occurred. The combined GDP of these countries is, however, too small to determine the overall economic situation in the EU.
• A third group includes three major European economies – the UK, Italy and Spain. These underwent more substantial economic decline than the grouping centred on Germany and France. Recovery in this third group of economies substantially slowed during 2010. Given that these economies have significant economic weight, equal to approximately three quarters of the GDP of the states centred on Germany and France, it is the performance of what may be termed ‘large relatively stagnant economies’ that is likely to determine the course of the EU’s recovery as a whole. These might be termed so far 'Europe's stagnant middle'.

The three groups will be considered in turn.

German/French group of recovering economies

The first group of EU economies centres on Germany and France. Their situation is shown in Figure 3. All have recovered significantly from recession.

Both Germany and France are specified in this group as, contrary to some media impressions, Germany's overall economic performance during the ‘Great Recession’ has not, so far, been notably superior to France’s. While in the most recent quarters German economic growth has been more rapid than French, German economic decline at the beginning of the downturn was significantly greater than in France. Overall, by the 4th quarter of 2010, Germany and France’s economic recovery differed only marginally – Germany’s GDP being 1.4% below its previous peak and GDP in France being 1.6% below its peak.

Continuation of more rapid German economic growth in 2011 would, of course, alter this picture and create a situation of significantly superior German recovery. This trend must therefore be watched. However to date France’s economy has also recovered significantly.

The smaller states in this group of substantially recovering economies are the Netherlands, Belgium, Austria, Portugal, the Slovak Republic, and Luxembourg. The GDP of none, in the 4th quarter of 2010, was more than 2.1% below its previous peak level.

As analysed elsewhere, it remains to be seen if Portugal’s agreement of an austerity package with the EU will lead to it dropping out of this category.

The combined GDP of this group of economies, measured on an annualised basis in the 4th quarter of 2010, was $8.2 trillion, or 55% of the GDP of the combined Eurozone plus UK – Table 1.

The size of this group of economies is therefore substantial, but as it represents only slightly over half the GDP of the Eurozone economies plus the UK it is not sufficient in itself to determine the course of the EU’s economy. Only if these economies can act, together with other factors, as a locomotive for a wider range of states can Europe's broader economy undergo substantial or accelerated recovery.

Figure 3

Table 1

EU economies suffering sharp economic decline

The second economic group, which has received much attention due to the European debt crisis, includes the two economies which have agreed emergency debt packages with the EU – Greece and Ireland. Two other Eurozone economies, Estonia and Slovenia, have also suffered severe economic declines without having to reach debt agreements with the EU. In the case of all these economies, current GDP is at least 6% below the peak of the previous business cycle – Figure 4.

Slovenia and Estonia are undergoing some recovery. Greece and Ireland, in the 4th quarter of 2010 were still undergoing economic decline.

The financial impact of the crises in Greece and Ireland was, of course, considerable. The economic impact of their recessions on the population of these countries is severe. But this entire group of economies is too small to determine the economic course of the EU or Eurozone. Their collective GDP, $0.5 trillion, is significantly smaller than that of the Netherlands alone, and less than 4% of the total GDP of the Eurozone plus the UK. It is only 7% of the size of the recovering economy group centred on Germany and France – Table 2.

While this group of economies has received great publicity due to the impact of the debt crisis, it is therefore too small to directly inflect the course of EU GDP.

Figure 4

Table 2

Large and relatively stagnant EU economies

The third group, which may be charcterised as ‘large and relatively stagnant economies’ –  is constituted by the UK, Italy and Spain. These underwent both more substantial recession than the group centred on Germany and France and their recovery is much weaker. In each case their GDP’s remain 4-6% below previous peak levels – Figure 5. In the 4th quarter of 2010 Spain's GDP was 4.3% below its peak, the UK's 4.6% below, and Italy's 5.2% below. In Italy and Spain, after the decline during the recession, recovery has been extremely weak, while in the UK there was significant recovery during 2009 which then stalled in the the last quarter of 2010.

Finland's much smaller economy falls in the same range of percentage decline but its recent grown has been more dynamic.

These economies are substantial, accounting for 42% of the GDP of the Eurozone plus the UK.

It is clear that without serious recovery in the three large economies in this group, France and Germany by themselves are not large enough to lead to rapid economic recovery in the EU as a whole. It is therefore in these economies constituting 'the stagnant middle' that the trajectory of Europe's economy will be decided.

Figure 5

Table 3

Conclusion

The analysis of Europe's economy as being essentially divided into a 'recovering north' and a 'crisis ridden south' is not accurate. A bloc of countries centring on Germany and France is clearly recovering. A number of states, most spectacularly Greece and Ireland, remain in deep crisis but are too small to determine the overall economic trajectory in Europe. It is therefore likely to be the so far 'stagnant middle' - the UK, Spain and Italy - which detemines whether relatively rapid recovery remains confined to economies centred on Germany and France or spreads to Europe as a whole.

Regarding this group of economies, the evident key factors will be the unwinding of the property bubble in Spain, the impact of the deep cuts in public spending in the UK, and whether Italy can break out of what is now a prolonged economic stagnation - Italy's average annual growth rate over the last 20 years is 0.9%, a performance as bad as Japan's.

The UK, Italian and Spanish cases should therefore be analysed not only individually but in terms of their impact on the trajectory of Europe's economy as a whole.

Debt deals ravage Ireland and Greece's economies - Portugal's package to have the same result?

The full scale of the economic declines in Ireland and Greece, under the impact of the debt agreements and consequent contractionary fiscal policies agreed by their governments, is shown in Figure 1 below. This illustrates the change in GDP, since the peak of the previous business cycle, in the so called ‘PIGS’ economies (Portugal, Ireland, Greece, Spain) compared to Germany and France.

GDP in Greece has fallen by 8.9% since its peak. In Ireland the decline is 14.6%. Both countries saw GDP in the 4th quarter of 2010 fall to its lowest level in the recession – i.e. no recovery had begun. In contrast GDP in Germany is 1.4% below its peak and in France 1.6% below - in both economies recovery has been taking place for seven quarters, since the 1st quarter of 2009.

Figure 1

 

Considering Portugal, the latest country to apply for an EU economic package, it is clear that to date its economy has more closely followed the performance of France and Germany than Greece or Ireland.

Portugal has also outperformed Spain. In the 4th quarter of 2010 Portugal’s GDP was 2.0% below its peak level compared to Spain’s decline of 4.3%.

Furthermore until the 4th quarter of 2010 Portugal’s GDP had been recovering.

Based on the experience of Ireland and Greece, and basic economic analysis. the imposition of a fiscally contractionary debt agreement on Portugal, after its request for an agreement with the EU, will lead to sharp economic decline.

The deep economic contraction in Greece and Ireland has already made it more difficult for them to repay their debts according to the terms agreed. The problem in both economies is not liquidity but their balance sheets. The debt to GDP ratio in Greece, for example, is 140% of GDP. In Ireland exposure to bank bail outs is several times GDP.

The rationale for the loans organised by the EU for Ireland and Greece would be that their economies would grow and therefore make possible repayment of the loans at a future date. In fact the severe economic decline resulting from the contractionary fiscal policies makes this implausible. Figure 1 therefore also indicates the likely consequences if such policy spreads to Portugal.

The depth of the recessions in Ireland and Greece therefore confirms that the EU package to be developed for Portugal is likely to contribute to worsening the consequences of the EU debt situation rather than alleviating it.

 

The pattern of the Great Recession in the US and Europe - by John Ross and Xu Xi Chi

As articles on this blog have noted previously, the core of the Great Recession is the severe fall in fixed investment in developed economies. Factually analysing this is crucial for positively establishing the driving force of developments. It also refutes alternative theories, such as that the dominant factor in the international economic situation is a fall in US consumption – which some projected would be caused by a rise in US saving and deleveraging of US consumers.

Recent publication of the second, revised, estimate of US 3^rd quarter GDP, together with aggregated data for the OECD economies in Europe, allows further verification of the actual international trends. Precise quantitative comparisons of the published data should not be made between the US and Europe, as that for the US is in constant 2005 dollars whereas the aggregated OECD data is calculated in parity purchasing powers (PPPs). But in both cases the trend is quite sufficiently clear as to leave no doubt as to the processes occurring

Europe

Taking first Europe, the changes in components of GDP between the peak of the previous business cycle, in the 1^st quarter of 2008, and the latest available data, for the 2^nd quarter of 2010, are shown in Figure 1. The entire decline in OECD Europe GDP during this period, $387bn in constant PPP terms, is more than accounted for by the decline in fixed investment of $396bn. The fall in personal consumption, $80b, is slightly more than offset by the rise in government consumption, $114bn, while the fall in imports, $374bn, is slightly greater than the decline in exports of $360bn.

Therefore essentially 100% of the decline in GDP in Europe is due to the decline in fixed investment.

Figure 1

 

US

Turning to the US, the revised second estimate for US 3^rd quarter GDP does not show a marked contrast with the first estimate. Annualised GDP growth rate was revised up from 2.0% to 2.5%, which might appear large until it is remembered that, unlike most countries, the US publishes its quarterly GDP changes on an annualised basis. So the upward revision of GDP is only 0.1% or $17bn, in 2005 constant price terms, in a $13,277bn economy.

Taking the components of US GDP, again in constant price terms, US GDP in the 3^rd quarter of 2010 remains $86bn, or 0.6%, below its all time peak in the 4^th quarter of 2007. Over that period net exports have improved by $54bn, inventories by $99bn, and government expenditure by $135bn. Personal consumption has fallen by a marginal $2 billion – confirming that a fall in US consumption is not the driving force of the recession. Indeed total US consumption, that is personal and government consumption combined, is now clearly above its previous peak level in the 4th quarter of 2007.

The driving force of the US recession is the $405bn decline in fixed investment – residential investment down $200bn and non-residential down $207bn.¹ The fall in fixed investment accounts for all the decline in US GDP – indeed the fixed investment drop is approximately five times as large as the entire decline in US GDP and is merely partially offset by expansion in other GDP components.

Figure 2

 

Long term trends

The sharp decline in fixed investment that has driven the Great Recession in both the US and Europe, however, has longer term consequences for their economic growth. Fixed investment is the prime driving force of economic growth, accounting for about 50% of GDP growth in proper growth accounting terms. A sharp decline in fixed investment in the US and Europe will therefore have not merely immediate but medium and longer-term consequences in slowing the trend rate of economic growth.

As may be seen from Figure 3, measured in current price terms, the recent fall in fixed investment in Europe is the culmination of a long decline in the percentage of fixed investment in GDP. This has now dropped, measured in PPP terms, by seven percentage points of GDP from its peak in 1973, at the end of the ‘Golden Age’ of post-World War II economic growth – declining from 25.3% of GDP to 18.2%.

Figure 3

 

In the case of the US, measuring in current dollar terms, the percentage of fixed investment in GDP also fell by seven percent of GDP, from a peak of 18.7% in the third quarter of 1979 to a post-World War II low of 11.7% of GDP at its trough in the first quarter of 2010 – see Figure 4. The recovery to the third quarter of 2010 is purely marginal – to 12.0% of GDP.

The severe fall in investment in both the US and Europe is therefore not simply the driving force of Great Recession but ensures that these economies will experience slower than previously attained levels of growth at least in the medium term.

If the driving force of the Great Recession had been a decline in consumption it could be conceived as a very violent cyclical movement that would be followed by a return to 'normal' - i.e. to previous trend growth rates. The fact that the centre of the Great Recession is a severe decline in investment has longer term consequences in depressing trend and therefore average growth rates.

Accurate diagnosis of the driving force of the recession is therefore important not only for short term but for medium and longer term analysis.

Figure 4

 

Notes

Germany's 'continental economy' - comparisons to the US, India and China

Data released by the German statistical service shows how much Germany, until this year the world's largest exporter, and still the second largest, relies on its European market - particularly in a period of severe economic downturn such as 2009.

Approximately three quarters of German exports were to European countries. 63% of all exported German goods were delivered to the member states of the European Union.

Asia, the second most important market for German export goods in 2009, trailed far behind with 14% of German exports. The US accounted for 10%.. Africa and Oceania (including Australia) accounted for only 2% and 1% of German exports.

In terms of imports Germany was almost equally Europe dominated. 71% of Germany's imports came from Europe, with 18% from Asia and 9% from the US. Goods from Africa and Oceania represented just 2% and 0.4%, of Germany's imports.

Germany's economy, in short, is not really a balanced 'international' one - in particular in an economic downturn. It is, in export terms in particular, a European continental economy with secondary add ons in Asia and the US.

What implications flow from this?

Key trends in the Financial Times Global 500

As always the publication of the Financial Times Global 500 conveys a great deal of information about the world's most important publicly quoted companies - FT rankings are by stockmarket capitalisation. http://www.ft.com/cms/s/0/e01aab98-40c9-11dd-bd48-0000779fd2ac.html

However the presentation of the material by the FT does not bring out some of the most important trends as a comparison to 1996 is carried out in terms of individual countries. Reorganisation and aggregation of the data shows key trends more clearly.
The most striking trend is the sharp decline in the weight of US and Japanese companies.
In 1996 US companies accounted for 40.6 per cent of the total number of Global 500 companies, and by 2008 this had declined to 33.8 per cent. The decline of Japanese companies was even sharper from 22.0 per cent to 7.8 per cent. A smaller decline took place for the UK.
Unsurprisingly the largest gainers were BRIC (Brazil, Russia, India, China) companies. These rose from 3.2 per cent of the total in 1996 to 14.4 per cent in 2008.
But Eurozone based companies also advanced significantly from 13.4 per cent to 19.8 per cent of the companies in the same period.

The weight of the traditional bloc of US, Japanese and UK companies declined from 71.8 per cent of the total to 48.6 per cent.

These shifts are magnified by the decline in the value of the dollar, but that in turn partially reflects overvaluation of the dollar in the previous period.

At the level of national economies the shift in the balance of the world economy is well recognised - the majority of world GDP growth last year being in China, India and Russia, and in terms of dollar devaluation the Eurozone, in current exchange rates, became the world's largest economic unit following the decline of the dollar. But this new data also shows strikingly the shifts in terms of companies.

Fundamental economic implications of a single European currency

Preface - written with Ken Livingstone

An old Soviet joke sums up Maastricht’s attempt to create a single European currency (European Monetary Union — EMU).

President Gorbachev visits Britain, and is impressed. Wishing to copy this model he returns to the USSR, where he announces to the Politburo that he has discovered the secret of UK success. ‘Britain drives on the left, whereas we drive on the right. Therefore I will issue a decree. From now on, everyone in the Soviet Union will drive on the left hand side.’

The Politburo think about it a minute, and reply. ‘This is extremely radical. The people will not understand it. We must avoid extremism’

Gorbachev ponders ‘You are right. The decree will be altered. Half the cars will drive on the left, and half on the right.’

The proposal to create a single European currency, through the methods of the Treaty of Maastricht, is neither fish nor foul, and the resulting dish will be extremely unpleasant. There are two possible, coherent, ways to regulate relations between the different European economies. One is to create a de facto or de jure European federal state, with a sufficiently large budget to pursue an effective regional policy. This requires powerful democratic institutions that can control this budget — i.e. a greatly reinforced European parliament. This model could sustain a single European currency.

For reasons analysed below, this is the only long term solution for Europe. I [Ken Livingstone] openly champion it, and have no common ground with Tory ‘little Englander’ critics of Maastricht. Far from dreading ‘Huns,’ ‘Frogs,’ and others demons of the Tory right, I would welcome the day a common European democratic sovereignty was created.

The other model is that of adjusting economic relations between European states by means of exchange rate movements. This, for example, allowed Britain and Italy to escape from deep recessions imposed on them by membership of the ERM in the early 1990s. If the creation of a large European budget, with the ability to carry out substantial regional transfers, is rejected then this is the only model that will avoid deep economic problems. It is not viable in the long term, but can bump along for a few more years without disaster,

Maastricht’s proposals are, instead, disastrous. It proposes to create the most fundamental features of a common state — a single currency and a central bank. But it does not create any state budget which can deal with the huge regional and sectoral implications of this.

The process that would unfold with the creation of a single currency by this method may be predicted with certainty. Substantial parts of the EU, including Britain, will be pushed into severe recession if they join.

There will be sharply deepening regional imbalances and inequalities. The malignant expressions of economic depression — unemployment, poverty, collapse of the welfare system, weakening of trade unions, racism, chauvinism, crime — will multiply. The end will be either an economic tragedy, or the deepest crisis in the history of the EU, or more probably both.

It is, therefore, necessary to reject the Treaty of Maastricht. Not from the viewpoint of a utopian retreat into little England, but in the name of the democratic, and socially oriented, Europe which can alone provide an international framework for developing the living standards of the people of Britain and Europe. Precisely because Maastricht can only end in an economic, social and political debacle — just as did Britain’s earlier membership of the ERM — it actually stands as an obstacle to the Europe which we need.

A number of criticisms of the Maastricht Treaty’s proposals for EMU have, of course, been discussed in many publications — its deflationary bias, its anti-welfare and anti- Keynesian positions on public spending, the problem of lack of transfer payments between regions, absence of democracy in its economic mechanisms. However, these are frequently seen as individual points, rather than their integrated character being understood. The aim of this issue of Socialist Economic Bulletin is to draw together the issues in a systematic fashion, to examine underlying processes involved in the creation of a single European currency, and to show why it is impossible to separate economic and political issues in EMU.

* * *

The attempt to create a single European currency, by the means of the Treaty of Maastricht, is reshaping and shaking not merely Britain’s but the continent’s politics. Infighting in the Tory party is merely a somewhat grotesque link in a European chain which includes last year’s mass strikes in France, the most severe austerity package in Germany since World War II, that country’s largest post-war protest demonstration, the long agony of government in Italy, the collapse of the Socialist government in Spain, and renewed strains on European currency markets

But the issues of politics and economics in the creation of the euro are too frequently treated as parallel but separate. Even Tory Euro-sceptics, constantly emphasising ‘national sovereignty,’ attempt to prise the two apart — claiming to support a ‘free trade area’ within a ‘Europe of nations.’ Unfortunately, it has escaped their 19^th (or perhaps 17^th) century frame of reasoning that free trade long ago escaped bounds within which it could be organised purely via ‘sovereign nations.’

Some on the left also pose as defenders of national sovereignty and therefore lock themselves into a doomed return to the discredited concept of the siege economy. Others on the left relegate unacceptable features of the Treaty of Maastricht to only a somewhat apologetic ‘democratic deficit’ — an apparently regrettable, but insignificant, blot on an otherwise clean table cloth of European economic integration.

Such approaches are inadequate. It is not possible to mix economic and political systems at will, without understanding the necessary relations which exist between them. An economy determines definite parameters within which political forms can exist. Unrestrained national sovereignty, and a free trade area, in a 20^th century economy, are incompatible — for reasons outlined below. Rantings by Tory Eurosceptics will not succeed in generating viable off spring from the attempt to mate the elephant of modern large scale production with the mouse of 19^th century absolute national sovereignty.

This, finally, reflects the fact that economics is not about self-sustaining theoretical relationships. The realities of economic policy, no matter what abstract form they are presented in, are valid only insofar as they reflect relationships between real structures. The real world is not obliged to match an economic theory; but an economic theory is only valid insofar as it conforms to the real world.

This reality is sharply posed in the debate on a European currency. If theory and the real world do not coincide, only two courses are available. A sensible person abandons the theory. Only a fool ignores the real world — demanding that it desert its sinful ways and correspond to their abstract theory.

The scale of issues involved

This issue is acute because the economic consequences for Europe in monetary union, including for Britain, are impossible to underestimate. Exchange rates determine the relation between all prices in respective states, and not purely those of individual sectors — money, by its nature, enters every economic transaction. In turn, decisions taken by the currency’s Central Bank, with their effects on budgetary policy, will set the economic framework for each participating country. Such changes will be permanent.

The issue of a single European currency is, therefore, far more important than even the most significant sectoral policies for manufacturing, education, or transport. Due to the timetable for introducing a common currency, a decision on membership will have to be taken almost immediately the next Labour government is elected.

1. The Historical Development of Exchange Rate Systems

The clearest way to understand the economic and political implications of the single currency is to consider the question of exchange rates from their most fundamental aspect. This will immediately show why political and economic issues in European economic integration are inseparable; why the attempt to create a single currency by the methods of the Treaty of Maastricht will do extreme damage to both, and illustrates the real means by which an integrated European economy, including a single currency could be created.

This poses issues which are more general, and long term, than those usually dealt with in Socialist Economic Bulletin, but allows the full implications of the proposal for a single currency to be grasped. Detailed and specific issues then readily fall into place.

Gold and money

Exchange rates could only come to occupy a significant place in economic policy with the rise of truly national, essentially paper, currencies. Prior to this, precious metals were acceptable as a form of international payment — either in their direct form or, in certain cases, as coin. Gold was, and is, the pre dominant metal used in this fashion.¹ In a system in which gold is the universal means of payment, the issue of exchange rates does not exist in any fundamental form, as gold has an essentially uniform international price.² Direct use of precious metals in international payments may be termed a ‘pure gold’ system. In such a system a single European currency automatically existed — gold itself.

The gold standard

The first recognisably modern exchange rate system, based on pa per currency, was the gold standard from the 1870s until the early 1930s. This transposed the historic primacy of gold into the sphere of exchanges between paper currencies. Each participating currency, including all major ones, was ex changeable for gold at a fixed exchange rate.

A necessary consequence was that domestic monetary policy was subordinated to the necessity to maintain the fixed exchange rate. A fall in the market exchange rate below the official one led to exchange of the national currency for gold, and a run on the gold reserves. Tying the issue of paper currency to gold reserves, interest rate changes, and other measures, ensured that domestic monetary policy operated within parameters set by the gold denominated exchange rates. As all major currencies were tied to gold at inflexible rates, and as gold had a uniform international price, fixed exchange rates existed between every participating currency — including all major European ones.

The gold standard and European currencies

The gold standard differed from an international payments system directly based on gold in that different interest rates could exist on financial instruments denominated in different currencies — for example due to measures designed to stabilise the exchange rate. However, given fixed exchange rates, sustained divergences were small. Furthermore if, for any reason, a desire did not exist to hold a national paper currency, the option existed to exchange it for gold — thereby automatically reverting to a pure gold system.

While the gold standard did not automatically constitute a common European currency, as did payment in precious metals, it had far more of the attributes of one than present exchange rate systems — notably, fixed rates and the ability to revert, at fixed ratios, to a universally acceptable, and uniform, means of payment.

The transition to flexible exchange rates

The gold standard collapsed in the early 1930s and, for the first time, the world entered, outside ‘emergency situations,’ a system of significantly changeable exchange rates. Such rates were subsequently partially stabilised by the post-war Bretton Woods system — in which currencies were tied to a dollar which was itself linked to gold. But this system accepted the reality of significant, if infrequent, changes in parities between major currencies (e.g. devaluations of the Pound, revaluations of the Mark). In the early 1970s, Bretton Woods collapsed, and the system of variable exchange rates between major currencies was formalised.

Dynamic of exchange rate systems

The actual historical dynamic of exchange rate systems, over four centuries, has therefore been from fixed to increasingly variable rates. A major issue which arises from this historical trend, and is prior to the question of ‘how to establish a common European currency’, is, therefore, why exchange rate systems far more closely approximating to a single European currency than current ones were abandoned? As this progression from fixed to increasingly flexible exchange rates was universal, operating over a long period, and affecting all major countries, it evidently cannot have trivial roots, but must reflect powerful economic processes. Indeed, as will be seen, this trend was not primarily a ‘monetary’ phenomenon at all. It reflects the transformation of the core nature of a 20^th century economy — compared to any which preceded it, and the revolution in economics which accompanied it.

The issues involved in the proposal to create a single European currency become transparently clear when the reasons for this historical transition from a ‘pure gold’ system, to the ‘gold standard,’ and to floating exchange rates are grasped

2. Exchange rates and inflation

All periods in history, and the 20^th century in particular, experience constant pressures to changes in prices created by technological changes, uneven rates of increases in productivity, shifts in wages etc. No monetary system can eliminate this ‘endless sea’ of fluctuations. What different monetary/exchange rate systems do is to drastically affect the way in which these underlying shifts in the real economy manifest themselves. In particular, briefly contrasting the former fundamental monetary unit, gold, to the purely paper currencies of the 20^th century, brings out clearly the essential nature of the latter.

Gold has a real, substantial, cost of production.³ This determines the money supply under a gold based system. If the price of gold rises above its cost of production, including the average rate of profit, the consequent higher than average profit results in previously unprofitable deposits being mined, or new resources flowing into the industry, or both. The quantity of gold, i.e. the money supply, therefore expands in response to the increase in the price of gold — and the gold price reflects the new cost of production. In either a pure gold, or a gold standard, system all prices are therefore ultimately expressed in relation to gold’s production cost. Except in the case of a change in the production price of gold, the price standard is fixed.

Pre-20^th century inflation

This fact that, prior to the 20^th century, all major monetary systems were based on precious metals had decisive consequences for prices. Sustained inflation, that is a general rise in the price of other goods and services relative to money, was possible only when either the cost of producing gold decreased (spectacular examples being following the first European voyages to America, and the ‘gold rushes’ of the 19^th century), or if the average cost of all other commodities rose relative to the cost of producing gold. As the latter is unlikely, monetary systems based on gold are, except in period of sharp drops in the price of the latter’s production, characterised by relative price stability.

Indeed, under a gold based monetary system, prices, particularly in specific branches of production, frequently fall — this regularly occurred throughout the 19^th century.⁴ Under pre-20^th century monetary systems dramatic economic and technological advances were not accompanied by rising prices, but reflected in relatively stable, or falling, prices. Prior to the 20^th century, therefore, the monetary unit remained relatively invariable, and changes in prices were largely reflected in shifts in the real economy.

Inflation and the 20^th century

In the 20^th century economy the exact opposite principle to formerly has operated. Except in the most limited spheres, for example computers, even dramatic increases in productivity are not reflected in reductions in prices. Instead, sharply increasing productivity, throughout the 20^th century, has been accompanied not by falling but by drastically rising prices. Inflation in the 20^th century vastly exceeds, by a factor of thousands of per cent, the total price rises previously accumulated in human history. Whereas, in pre-20^th century economies the monetary unit remained relatively stable, and the adjustments took place in the real economy, in the 20^th century the most severe fluctuations took place in the monetary sphere.

These unprecedented monetary phenomena was, in turn, accompanied by a revolution in economics — the development of ‘Keynesianism.’ As the upward shift in inflation is as striking and universal as the trend to flexible exchange rates, only the most profound economic processes can explain it — particularly as, prima facie, inflation cannot be regarded as desirable. This historically unprecedented phenomenon of sustained inflation, indeed, flows from the same underlying causes, and is inextricably linked to, the shift from fixed to flexible exchange rates.

3. Money and the productive economy

At a technical level the reason for sustained inflation in the 20^th century is easily explained. It reflects universalisation of the use of paper money. Whereas gold has a real, high, cost of production, expansion of paper money requires trivial, essentially nil, outlays. In this aspect, its quantity may be expanded indefinitely. By elementary supply and demand, its value, therefore, may fall infinitely — this theoretical possibility being verified by hyperinflation.

This technical fact, however, merely raises another, more fundamental, question. Why did the universal change from gold based to paper based money take place? After all, at a first glance, it might have seemed more reasonable to maintain a gold based currency, and therefore avoid inflationary possibilities.

Once universalisation of paper money took place, exchange rates, necessarily, took a central place in economic relationships. Whereas the quantity of gold in circulation was ultimately limited by its cost of production, expansion of paper money required no outlay. Countries could, at will, create entirely different supplies of it — thereby creating variable ratios (i.e. varying exchange rates), between its values. The fundamental reason for this universal transition from gold to paper money in the 20th century may be seen clearly via examining the link between the money supply and the physical economy. The connection between these two is not imprecise, but an exact quantitative one, expressed through the formula usually, although inaccurately, referred to as the Quantity Theory of Money. The inaccuracy lies in the fact that this is not a ‘theory’ at all, but merely a necessarily true quantitative relation expressing that, in a monetised economy, every transaction has simultaneously an (exactly equivalent) monetary and real component.

The quantity of money

In mathematical terms the relation between the money supply and the productive economy is expressed in the famous formula MV=PT (Mass of money (money supply), times Velocity of circulation is equal to the Price level times the number of Transactions in the economy). As this quantitative relation is necessarily true, it applies in any economic framework — whether monetarist, Keynesian, or a la carte. All that can change in different economic systems is not the quantitative relations, but the factors which determine the equation’s components.

Within this formula, monetarism asserts that velocity is essentially constant — this, for the sake of illustration, will be accepted here.⁵ The number of economic transactions, in turn, is closely related to the level of output, and the latter is typically taken as a surrogate for the former — a practice that will be followed here by referring to ‘transactions/output.’

Using this fundamental frame work, the significance of the historical evolution of monetary and exchange rate systems, and the importance of the proposal to create a single European currency, may be clearly seen.

Relations between the monetary and productive economies

In one crucial aspect, the transition from gold to paper currencies did not alter the character of money. By its nature, money is homogeneous (every unit is interchange able), and essentially entirely divisible — i.e. money is infinitely flexible.

The productive economy, however, is radically different in character. The infinitely elastic character of money has its parallel in only one possible structure of a productive economy — that known to economics textbooks as ‘perfect competition.⁶ Perfect competition, among other things, assumes that there exists an infinite (in practice extremely large), number of producers; that the Out puts they produce are homogeneous; that production may take place at an infinitely gradable output of units etc.

Perfect competition’s closest physical approximation is a large number of farms producing a standard commodity such as wheat, or a large number of factories producing a relatively uniform product such as wool or cotton thread. Such physical counterparts are unsurprising, as the concept of perfect competition was developed in the context of the 19^th century economy — when production on the modem large scale did not exist.⁷

If a very large number of producers is assumed, it immediately follows that none has the ability to influence prices.⁸ An attempt by a firm to prevent prices falling, for example due to a decline in costs, will merely lead to the market being fully supplied by other producers. In such an economy, therefore, as each producer has no ability to set the market price, technically they are ‘price takers.’ As producers cannot control prices the latter may move both up and down. In such an economy, that of the 19^th century, the infinitely flexible character of money is paralleled by pliable prices in the productive economy.

4. Monetary dynamics in the 19^th and 20^th centuries

If , in ‘perfect competition,’ the features of money and the productive economy, discussed above, parallel each other, in the case of monopoly or imperfect competition, where a small number of firms dominate an industry, this symmetry between money and the productive economy collapses. Flexibility in prices in the productive economy, does not apply. Entry into an industry is restricted by a minimum efficient scale of production limiting the number of possible firms in the industry, by costs of initial investment, by the ability of existing producers to force new entrants out of business by temporary predatory pricing, by technological factors, or other means. Under such conditions, firms are not simply price takers, but price makers. As firms have the ability to influence prices, and therefore the possibility to resist reductions (and can meet a contraction in the market by maintaining prices and decreasing their quantity of production), such prices are ‘sticky’ or ‘administered.’

It is clear that this situation of imperfect competition/monopoly corresponds to the economy of the 20^th century, just as ‘perfect competition’ did to that of the 19^th (and earlier ones). In particular, in the most advanced, and therefore decisive, economic fields, modem scales of production make it impossible for more than a few producers to exist within an industry — not merely nationally but internationally.

There is, for example, only one fully competitive producer of microprocessors — Intel. Only one major producer of personal computer operating systems, and increasingly, application programmes — Microsoft. There exist only two competitive producers of large civilian aircraft — Boeing and Airbus Industry. The $15 billion production cost of the ‘Eurofighter’ is impossible to finance by any single West European aerospace company. In the 1960s Siemens had to win only half the West German market to finance the cost of development of an electromechanical switch, today it has to capture 20% of the world market to make such an investment worthwhile. Such examples may be multiplied.

The revolution in modem economics, the development of Keynesianism, therefore was not about self-sufficient developments in logic. It occurred because the concepts, and policy prescriptions, developed to analyse the classically competitive economy of the 19^th century were not adequate to, because they no longer reflected, the real economy. They could not deal with the imperfect competition/monopoly of the 20^th century. Attempts to apply 19^th century theories, as with the Treaty of Maastricht, to 20^th century realities necessarily lead to disasters.

Trade unions and perfect competition

Before returning to the central issue of monetary union, the situation of one crucial market, that for labour, should be noted. It is frequently neglected that the labour market is by far the largest in the economy — wages and salaries account for over 62% of UK GDP. In the 19^th century it may have been adequate to consider that the market for labour corresponded to that of perfect competition — tens of millions of units of production (aka human beings), with few jobs which could only be carried out by a very small number of people. But this situation is radically altered both by the enormous costs of producing a modem skilled labour force, which thereby creates huge expenses in substituting labour, and, in particular, by the existence of organisation of the labour force — through trade unions and other mechanisms.

As has been frequently noted, this creates a situation of imperfect competition in the labour market. In a modem economy, therefore, both capital (firms) and labour no longer exist in a situation of perfect competition. This is decisive for monetary policy.

Monetary dynamics under perfect and imperfect competition

Returning to the fundamental monetary issues discussed above, the different dynamics of perfect and imperfect competition directly relate to, and explain, the shifts in exchange rate systems which have already been analysed. To show this, consider first the case of a downward shift in the supply of money — or a fall in its rate of increase.⁹ From the fundamental monetary formula, MV=PT, it follows that if the quantity of money (M) falls, then either the price level (P) or the number of transactions (T) must decline. Which fall, that of prices or that of output, will predominate? That depends on the structure of the supply side of the economy, and the competitive conditions which exist within it.

Under conditions of perfect competition, those of the 19^th century, producers have no ability to control prices. A contraction in the money supply, therefore, may potentially cause the price level to fall, while the number of transactions/output remains constant. Indeed a combination of falling prices and rising output was frequently seen in the 19^th century. Under imperfect competition/monopoly, however, producers have the ability to significantly influence prices — most particularly, for present concerns, the ability to resist declines in prices. If, however, prices cannot decline in response to a fall in the money supply, then this must be compensated for by a decline in output/transactions. Therefore, in a 20^th century economy, reduction in the money supply will lead to a sharp decline in output.

Furthermore, the fundamental situation is worse. Imperfect competition/monopoly gives firms the ability to administer prices upwards. However, from the fundamental quantitative relation between the money supply and the economy, it follows that if prices increase, and the money supply does not, output/trans actions must fall. Therefore, in conditions of imperfect competition/monopoly, the money supply must constantly increase merely to accommodate the upward shifts in prices created by the fact that firms are no longer price takers but price makers.

Once this transition from the economic structure of the 19^th century to that of the 20^th is understood, then the reasons for the profoundly inflationary bias of the last ninety years is evident. A constant increase of the money supply became necessary to accommodate the ability of producers to administer prices upwards — that, in turn, reflecting the collapse of classical competition. This constant upward expansion of the money supply, in turn, necessarily required abandoning gold as the monetary unit because: (i) it was impossible to expand a money supply based on gold sufficiently rapidly to adjust to such upward pressures on prices; (ii) the relative price of gold compared to other goods and services, that is the general price level, in any case depended on the relative cost of production of gold. Sustained inflation was thereby limited within the bounds by which the costs of production of other commodities could fall relative to gold — a rate much too small to accommodate the upward pressure on prices created by the new economic structure.

The transition from perfect competition to imperfect competition/monopoly therefore required a transition to a new unit — paper money. The universalisation of the use of paper money in the 20^th century is just as much a reflection of inflationary pressures as it was its cause.

The reason for the historically unprecedented inflation of the 20^th century is therefore also evident — it represented the transition to a new economic structure. However, as the structure of the productive economy had changed, any attempt to fit 19^th century monetary policies onto it would necessarily end in disaster. Keynes genius, in the monetary field, was to define the new policy necessary to deal with the transformed structure of a 20^th century economy.

5. UK Exchange Rates in the 20^th Century

The issues involved in the new monetary framework of the 20^th century may be practically, and vividly, illustrated by Britain’s two most important exchange rate episodes so far this century — prior to the decision whether to join a single European currency. These were the return to the gold standard, in the 1920s, and membership of the ERM in the early 1990s. Not merely do these experiences have direct lessons for a single European currency, but the former was the direct context in which Keynes formed his economic ideas. As both had an identical outcome — deep recession, disastrous financial crisis, and final collapse of the attempted exchange rate policy — which are exactly the phenomena accompanying the current attempt to introduce a single European currency — not merely their theoretical but practical relevance is evident.

The return to the gold standard

The process involved in the UK’s return to the gold standard was evident. The government was aware, and Keynes pointed out, that after World War I British relative prices were higher, compared to its competitors, than in the pre-war period. By returning to the gold standard, at the pre-war exchange rate the government established, therefore, competitive constraints creating sharp downward pressure on nominal prices. If the economy had operated according to perfect competition this would not have constituted a great problem. Tight money would have led to a de crease in the price level, and output would not have declined.

In fact, the economy no longer operated in that fashion. First wages had to be reduced in the main industry of the period — coal. The decisive element of ‘stickiness’ in this sphere was the National Union of Mineworkers. The result was the general strike of 1926. However, even after the price of labour had been made ‘unsticky’ — via deunionisation, starving the miners back to work, general reduction of wages, anti- trade union legislation, and other ‘humane’ methods — the economy did not behave as the government had anticipated. Capital responded not by cutting prices, and maintaining its output, but by maintaining its prices and limiting its output. UK economic growth, therefore, lagged behind the rest of the world in the 1920s even before it was hit by the maelstrom of the 1930s depression.

To its shame, and culminating in its destruction, the 1929-31 Labour government did not take the only way out of this situation — abandoning the gold standard. Only when the fetish of the exchange rate was abandoned, by a Conservative dominated government, did recovery begin. This experience of the 1920s illustrated devastatingly what would result from the attempt to impose monetary policy derived from the 19^th century model onto the imperfect competition/monopoly of a modern economy.

UK Membership of the ERM

The fundamental economic development of the UK during its period of ERM membership, in the 1990s, repeated, with tedious exactness, the pattern of the return to the gold standard. The theory of ERM membership, to use the litany of the Treasury, was to ‘bear down on inflation.’ To maintain competitiveness, and prevent a balance of payments crisis, UK companies would not be able to raise prices by more than other countries within the ERM. The underlying problem in this, as analysed by Socialist Economic Bulletin in 1990, in Why Recession Based on ERM Membership Cannot Solve the Problems of the UK Economy, was that UK productivity growth lagged behind that of other economies in the ERM - due to Britain’s inadequate level of investment. If the UK were in a 19^th century world, this would not have led directly to a crisis — UK costs, i.e. wages and profits, would simply have fallen in price relative to rivals.

Indeed, both wages and profits were ‘born down on’ during ERM membership — more precisely real incomes and profits fell sharply. But in instead of output remaining constant, while prices declined, Britain entered its most prolonged and severe recession in post-war history — interest rates soared, the balance of payments remained stubbornly in deficit despite deep recession. The consequences of this economic disaster have still not been fully overcome six years later. In both cases - return to the gold standard, and membership of the ERM - applying a monetary theory based on the 19^th century to a quite different economic structure did immense damage.

6. A Single European Currency

While the effects of the return to the gold standard, and membership of the ERM, were disastrous they had one saving grace — they could be brought to an end. The effects of a single European currency, of course, cannot. Joining it, in the form proposed by the Maastricht Treaty, would be as though Britain had been forced to pass through the 1930s while still on the gold standard, or it had not been able to withdraw from the ERM. The damage done, in short, would be on a scale exceeding the two greatest disasters of 20^th century British economic history. Examining in more precise detail what is involved, will both show what is wrong with the methods of Maastricht, and under what conditions a single currency can be created.

The trend to flexible exchange rates

The economic processes analysed above make clear why the world economy has historically shown a progressive shift from fixed exchange rates systems to flexible ones. In classical competition prices are pliable — i.e. they can move both up and down. The developments of unevennesses in productivity, cost movements etc. can, therefore, be absorbed, and equilibrium maintained, by the monetary unit remaining fixed and price shifts taking place in the real economy. Under imperfect competition/monopoly prices are not flexible — they may move up but not down. The necessary process of adjustment, therefore, cannot take place in the real economy, but must take place via flexibility, more precisely inflation, in the monetary unit. As a consequence, the rise of the structure of a twentieth century economy necessarily led progressively from a regime of totally fixed exchange rates to increasingly flexible ones.

If this historical trend towards flexible exchange rates exists, however, why is Europe appearing to go in the opposite direction, and striving to create a single currency? Furthermore, why is this necessary? The answer lies not primarily in relatively minor issues which are sometimes stressed, such as eliminating the transaction costs in exchanging currencies, but in the same processes which created the transition from the economy of perfect competition to that of the 20^th century.

Why a single European currency?

If the features of modern large scale production are considered — i.e. the real world economy of the Intels, Microsofts, Boeings etc. — one thing is immediately obvious. The huge scale of production required for efficiency means that the products which result require an international market for their absorption. The 10 largest companies in the world, alone, in 1995 had a turnover of $1,495 billion — 35% larger than the entire UK economy. The 500 largest companies had an income of $11,378 billion — more than 50% larger than the economy of the U.S.¹⁰ As a result, even the largest economy in the world, the United States, has during the post-war period moved away from being self-contained to its companies exporting, and producing, on an international scale.

The well known result is that almost every large firm has become a multinational company — the requirements of huge scale production which produced the transition from classical competition to imperfect competition/monopoly, also produced the internationalisation of markets and production. Breaking up such internationalisation, limiting the practical scale of production, via tariffs or other means, to the scale of a single state would qualitatively throw back efficiency, and make many types of production literally impossible (Boeing and Airbus Industry would simply not produce the models they do if they were restricted to their domestic markets). As is widely understood, it is the requirements of the scale of modern production that it take place for an international market that was a fundamental driving force creating the EU.

Conditions for ‘free trade’

Tory Eurosceptics, or at least the more intelligent ones, have no objections to this. They oppose a return to a Europe of tariffs, which would radically reduce the scope of markets. They support moves to create a single European market — as did Thatcher. They merely believe that this should take place in a ‘Europe of nations,’ without a single European currency, without centralising decrees from Europe etc. The problem is that while proclaiming the words they fail to realise the practical con sequences of even a ‘free trade area’ — including that for a single currency.

A ‘level playing field’

Consider one of the few roles the Tory Eurosceptics assign to the state — ‘creating a level playing field’ within which the market can operate. What does this mean? Consider for example a hypothetical single British city, which for convenience we will refer to as ‘Slumsville’ — although it might also be called ‘Perfect Tory Model.’ Slumsville announces that all health and safety regulations will be abolished — funeral benefit will not be paid for workers burnt to death in sweatshops as a result; it will operate its own health regulations on food (particularly lowering standards for beef); trade unions are illegal; prisoners will be set to work producing for the market, but paid at prison rates; apprenticeships are abolished — but skilled labour is welcome to move in from other areas; the school leaving age will be reduced to eight — but those with higher education, financed by other regions, are welcome to move in; a tax haven is to be established; the city will operate according to its own (secretive and lax) banking laws etc. If this were permitted, costs would be drastically lower than in the rest of the UK and companies would invest in the area — Slumsville might be able to proudly proclaim itself a leading recipient of ‘inward investment.’

All other regions, however, would justifiably claim that a level playing field did not exist. That Slumsville was driving down health and social standards, and pay, throughout the country; that firms based in Slumsville were benefiting financially from its dreadful health and safety record, and prohibition of trade unions; that it was parasitically benefiting from labour whose education was financed by other regions; that it was undermining the profit ability of the entire country’s agricultural system, through creating a new pocket of BSE; that it was diverting investment from other regions due to its low standards, that it was artificially attracting banking business to the detriment of other regions etc. In short this would not be tolerated. At most, the government might, to tackle a regional imbalance, introduce certain of these privileges, in the form of a ‘special economic zone’ but this would be subject to decision by the national government. It could not be unilaterally ‘proclaimed’ by a single region without negatively affecting the whole country. A level playing field could not be created though a ‘Britain of cities,’ but only via a national state.

This equally applies to any ‘free trade’ area in Europe — and, increasingly, to the world economy. If common standards do not exist in labour practices, banking, health standards, regulations for safety at work etc. no ‘level playing field’ exists. One region can exploit lower standards to undercut, and undermine, others while, as with lax British standards leading to BSE, potentially threatening the prosperity of all. To maintain a ‘level playing field’ in a free trade area, without which it will not be maintained, the authorities are forced to intervene in its standards.

Large scale production and exchange rates

Even more powerful in their consequences for trade, however, are the effects of exchange rates. While the word is distinctly unfashionable in certain political circles, nevertheless firms have to avoid vagaries of fashion in pursuit of money. They, in short, have to plan. In which country, for example, should they establish a factory? A firm can take into account wage costs, laws etc. However, calculations based on this are completely bypassed if, for example, that country’s exchange rate devalues or revalues by 20%. A plant which is profitable at one exchange rate becomes nonviable at another. Worse, a firm may decide to supply the European market by exports from one country — indeed, it may be forced to do so by the necessary scale of production. But if that country’s exchange rate revalues, the company loses not only that market, in which it will be undercut by imports, but the entire European one — because exports to the latter are now uncompetitively priced.

None of the nostrums of perfect competition can deal with this situation confronting large scale production. A firm cannot ‘flexibly’ relocate from one country to another, in response to shifts in exchange rates — because the costs of initial investment are too high. It cannot diversify, by producing in all major countries, because the scale of modem production means that all markets can, and for efficiency frequently must, be supplied from one or a few sources.

Britain, Italy and the ERM

To consider the practical implications of this, consider the situation following Britain and Italy’s withdrawal from the ERM. As long as these two countries were within the ERM their situation was one of growing, and finally intolerable, losses — due to their costs rising more rapidly than Germany and France. However, for Germany, France, and their companies, the situation was excellent — they were constantly improving their competitive position relative to Britain and Italy.

With the withdrawal of the UK/ Italy from the ERM, and their subsequent devaluations, the situation re versed. The British and Italian economies began to grow, and their balance of payments sharply improved. German/French companies now began to scream as their exports to Britain and Italy became uncompetitive — and as British and Italian exporters undercut them within their domestic markets. It was for this reason that, following the partial disintegration of the ERM, large German and French firms became even more vociferous advocates of EMU, and began to propose ‘sanctions’ against countries which carried out devaluations.

Kohl and Chirac

Chancellor Kohl and President Chirac may, or may not, have deep pacifistic commitments to ensuring the peace of Europe, which they believe requires a single European currency, but their enthusiasm cannot be dampened by the fact that this measure directly corresponds to the interests of Mercedes, Siemens, Renault, Thompson etc. Large firms are quite correct when they state that a Europe of variable exchange rates is a casino in which it is impossible to plan for the future, and in which, therefore, the most effective organisation of large scale, and necessarily international, production will be impossible.

The hidden assumption of the EEC

Indeed, it is clear that when the EU was created, as the old European Economic Community (EEC), it had, in fact, a hidden assumption, little noticed at the time. When the EEC was formed, the Bretton Woods system was still in operation, and exchange rate shifts were extremely infrequent. The barrier to free trade, and scales of production sufficiently large to be competitive, was constituted by tariffs. The main activity of the early EEC, in order to create a truly European scale of production, was therefore devoted to eliminating this problem.

But exchange rate fluctuations of 10 or 20%, which are what has been experienced in Europe, are just as effective as tariffs in affecting intra-European trade — indeed they are more generalised in their effect.

The hidden assumption of the EEC, in short, was fixed exchange rates. This merely wasn’t emphasised at the time because of the operation of Bretton Woods. As soon as the latter collapsed then, merely in order to organise an ad equate scale of production, it became necessary to try to fix European exchange rate — first through the currency ‘snake,’ then through the ERM, and finally through EMU.

What scale of economic unit is required?

It is empirically quite easy to make a rough estimate of the scale of market required for modern efficient production.

The world economy is dominated by three blocs — the US, Japan, and the EU. The size of all three is in the range $4-7 trillion. Excluding internal trade within the EU, all are relatively, although not absolutely, self-contained — exports and imports being less than 12% of GDP. It is wholly improbable that this convergence in the proportion of exports and imports, at this size of market, is accidental.

It may, therefore, be taken that $4 trillion is the minimum size of market required for rounded development of a modem economy — although some sectors of production can only operate efficiently in a larger, purely world, market. But the largest European economy, Germany, is less than half this size. If effective organisation of production cannot be organised at an all European level, then Europe will be unable to achieve US and Japanese levels of efficiency. However, as already noted, the organisation of a ‘free market’ at a European level requires not merely absence of tariffs, and a ‘level playing field’ in terms of standards and regulations, but also stability between its currencies.

The idea of a single European currency arises not out of sinister plots of Eurocrats to undermine British sovereignty — to deprive of us of our ‘cricketing friends around the world,’ as John Redwood put it in the Financial Times — but from the practical necessities of organising a single European market.¹¹ By arguing for ‘free trade’ in Europe, without understanding its practical implications, Tory Euro sceptics are rather like a general who declares himself in favour of total war provided there is no killing — once you accept the end, you have to accept the means. All the efforts of little Englanders will not succeed in stuffing the genie of large scale production back into the bottle of unrestricted national sovereignty.

7. Conditions for a Single European Currency

It is now possible to summarise the economic and political factors that must be brought together if an economy capable of operating on a large enough scale to be efficient/competitive is to be created. On the one hand, a modern economy no longer operates on a model approximating to perfect competition. As a consequence, imperfect competition/monopoly means that adjustments can no longer be handled via an unvarying monetary unit and flexible shifts in prices in the real economy — as vividly demonstrated for the UK, in this century, by the disasters of the return to the gold standard and membership of the ERM. As prices in the real economy have lost downward pliability, the strain of the adjustment was taken, instead, by a flexible monetary unit. At the national level this produces the 20^th century phenomenon of sustained inflation, and at an international one it required the substitution of flexible exchange rates for fixed ones — in both cases, it is the monetary unit which takes the strain of adjustment, either via a change in the exchange ratio between money and goods (inflation) or via shifts in the ratio between different monetary units (exchange rates). However, the European economy, to function on the necessary scale of production, requires fixed exchange rates.

How can this apparent circle be squared?

Fundamental errors of the Maastricht Treaty

Maastricht, in essence, attempts to solve the problem of creating a single currency by grafting a 19^th century monetary system, with the same rigidity in exchange rates as a gold based one, onto a 20^th century economy. By irrevocably fixing the ratios between national currencies (i.e. abolishing them), adjustments between different levels of productivity, and other factors affecting costs, can no longer take place via exchange rates — this, incidentally, would occur with any attempt to introduce a single currency, and not simply under the Maastricht Treaty. The only issue is ‘what type’ of adjustments will take place in the real economy.

If there existed a 19^th century productive economy, to correspond to a 19^th century concept of exchange rates, the price system could take the strain of adjustment. Regions falling behind in productivity, for example as with the UK due to low rates of investment, would reduce their prices relative to those in other regions. In order for relative prices to fall in these regions, firms would have to accept reductions in profits, labour would accept reductions in wages etc. In reality, of course, this will not occur — because the 19^th century economy no longer exists. Firms engaged in imperfect competition/monopoly will respond, just as textbooks de scribe, and as the history of the 20^th century demonstrates, not by reducing prices but by reducing output. Labour will not react with favour to reductions in wages. Recessions will multiply, regional imbalances will intensify, racism and xenophobia will spread, the trade unions will be attacked to attempt to reduce wages, the welfare system will be eroded to drive down costs, crime will soar as unemployment rises etc. The experience of the UK re-joining the gold standard, or of its ERM membership, will be repeated on a European scale.

All the phenomena, in short, experienced with the move to implement the Treaty of Maastricht will intensify to a qualitatively higher level. The mismatch between 19^th century money and a 20^th century economy, while an interesting ‘theoretical’ experiment, will be most unfunny to witness in practice.

The conditions for a single currency

There is only one way round this. There is nothing mysterious, either theoretically or practically, about organising economic areas embodying very large scale production but possessing a single currency. From a single currency it flows, necessarily, that the adjustments to shifts in relative productivity, and other costs, cannot take place, in such economic areas, via changes in the exchange rate. They must take place via changes in the real economy. However, these shifts in the real economy cannot adequately take place via the price mechanism — for the reasons analysed above. The only solution, therefore, is that the shifts in the real economy take place, to a substantial degree, by mechanisms other than the price system.

In national states there is a well-known mechanism for dealing with this. It is the budget — i.e. taxation and state expenditure system. Money and resources are transferred/redistributed not via prices but by state transfers.

It is clear from the above that this use by the state, in the 20^th century, of transfer payments (taxes, subsidies, pensions, benefits, regional policies etc.) — whether between individuals, firms, or areas — is rooted not merely in morality, or political expediency, but in fundamental economic realities. It is, undoubtedly, no longer generally regarded as socially acceptable (except by sections of the Tory and Republican right), that mothers should ‘price themselves back into work’ by doing without the costs of housing, and living with their children in shop doorways. Neither has it escaped the attention of European governments that if regional pockets of mass unemployment, or appalling housing, are allowed to develop, particularly if these correspond to national/ethnic divisions, the result will be riots, terrorism, separatist movements etc. But the economic processes noted above, create a much more substantial and widespread economic basis for the rise in transfer payments. These are the only way to deal with a situation where adjustment cannot take place either through the exchange rate or, without tremendous economic losses, through the price system.

Britain, Italy and the ERM

To see the implications of this, consider the situation confronting Britain and Italy towards the end of their period of ERM membership. Due to the shifts in relative costs between themselves and Germany! France, their economies were forced into increasing unacceptable recession and financial crisis. They eventually escaped via devaluation — i.e. a shift in the monetary unit carried out the adjustment which the price mechanism had been unable to achieve. However, if Britain and Italy had been within a single currency zone with Germany/France, this would have been impossible. The British and Italian economies would have become more and more depressed compared to Germany/France — Britain would have come to occupy the same relation to Europe as the North East did to En gland during the 1930s. At the political level racist (‘the blacks have taken our jobs’) and xenophobic (‘the Huns and Frogs have pushed us into poverty’) sentiments would soar. The resulting combination would probably have exploded the system — Britain withdrawing from the common currency, and the EU entering the greatest crisis in its history.

The only way out of this situation, as adequate flexibility will have been removed in the exchange rate by the single currency, and in the price mechanism by the entire economic development of the 20^th century, is regional transfer payments — i.e. a regional budget of the EU. That is, part of the benefits gained by German/French firms from the single currency would be taxed and redistributed to regions which lost. Such a mechanism is, in principle, no different to a progressive income tax, or regional transfers, within a national economy. This type of flexibility within the real economy, for reasons outlined above, is the only means of adjustment possible in a large economic space in which a single currency operates.

The EU, of course, possesses regional transfer funds/budgets. But these are on a scale, capable of coping only with depressed regions of individual countries, or small states, and not with the scale of redistribution between major states which would be required by the economic! social consequences of a single currency.

Within national economies, the economic realities analysed above, are, of course, expressed. They explain the apparent paradox that despite, endless rhetoric (at least in the US and UK), about reducing the role of the state, transfer payments have continued to substantially rise as a proportion of the economy. Even in the U.S., government receipts, as a proportion of GDP, rose from 27.0 per cent in 1960 to 37.3 per cent in 1995 — the latter being higher than the 32.4% when Reagan was elected in 1980. In the UK, government receipts rose in the same period from 28.9 per cent of GDP to 37.6 per cent — the latter figure being virtually identical to the 37.7 per cent when Thatcher was elected in 1979.¹² The problem is that while the mechanisms of transfer between different parts of national economies, including government decisions on final expenditure, are well advanced, no such mechanism exists on a European level.

8. Politics and Economics in EMU

The fundamental relation between economics and politics, in the process of creation of a single European currency, may now be summarised. The 20^th century saw the transition from small scale production, to that on an enormous scale. This simultaneously replaced classical competition with imperfect competition/monopoly, and required markets larger than nation states for efficient reduction of costs. A necessary accompaniment of this, in the monetary sphere, was inflation — technically organised via substituting paper for gold based currencies. This, in turn, necessitated flexible exchange rates. The necessary flexibility, which had been driven out of various aspects of the productive economy, was se cured through the monetary sphere. This then required a new system of economic management, Keynesianism, with its concomitant of large scale state intervention in the economy, to replace the 19^th century economic regulation of subordinating national economies to fixed exchange rates based on gold.

The fundamental errors of the Treaty of Maastricht are that it attempts to reverse the economic history of the 20^th century. Adjustments based on exchange rate changes will be eliminated. But no budget adequate to large scale transfers via the state will exist. An attempt is to be made to organise a single currency area, almost as large as the U.S. economy, without anything like the U.S.’s federal budget. The entire weight of adjustment, in consequence, will have to be taken by the price mechanism. But both economic theory, and history of the this century, shows that it won’t work. For the reasons outlined above, the prices will jam, huge imbalances and inequalities will multiply, and the process will fall into deep crisis. An attempt will, therefore, be made to make real prices in the affected regions downwardly flexible by breaking up trade unions, cutting welfare benefits, attacking democratic rights — i.e. the entire process which has already started across Europe. However, even these measures, while destroying the quality of life, will not work, and economic stag nation will grip Europe — the losses via the errors of the Treaty of Maastricht will be far greater than the disadvantages of flexible exchange rates.

Maastricht is rather like king Canute telling the sea to halt its advance. If the real economy had remained as it was in the 19^th century, there would never have been the necessity to go through the rigmarole of sustained inflation, paper currencies, flexible exchange rates, and the ‘Keynesian revolution,’ in the first place.

The only way out of this situation is that if flexibility via the monetary unit, the exchange rate, is removed, and flexibility via the price system will not occur on an adequate scale, then pliability in the real economy must be carried out via non-price means — i.e. by introducing transfer payments between regions of the single European currency area. The creation of a single European currency will only not have the most serious negative economic effects if it is accompanied by the creation of a European budget, with large enough resources to make substantial transfer payments between countries.

Who will control a European budget?

But the above leads directly to the sphere of politics. Who will control such a budget? It cannot be any of the individual countries — otherwise the budget will simply end up benefiting the states which control it. It must, clearly, be a supra-national body, composed on some proportionate basis from the EU member states. Whether this is called a federal European body or not (for fear of shocking Europhobes of a nervous disposition), is not important. Any institution controlling a substantial European budget, on a scale capable of overcoming the inflexibilities that will be produced by a single European currency, is, in reality, a European federal body. The existence of such a body, in turn, will produce all the normal political questions of control of a budget — the well rehearsed problematic of ‘taxation and representation’. A powerful European parliament would be required to supervise this budget. In short, the creation of a single European currency, if economic disaster is to be avoided by its introduction, requires substantial steps towards the creation of a single European state.

This returns to the starting point. Maastricht tries to have its cake and eat it. It wants a single currency, but without significant steps towards a single state — in the form of a substantial European budget. One half of the cars will drive on the left hand side, of inflexible exchange rates, and the other half will drive on the right hand side of no state transfer payments. The traffic lights, known as prices, which are supposed to direct the resulting chaos won’t function adequately because, in a twentieth century, imperfectly competitive economy, they are significantly jammed, give green lights only in one direction, and work either too slowly or inadequately. Traffic will move increasingly slowly, and the passengers will become increasingly angry. Fights will break out between some of them, and the traffic jam will be coming increasingly overrun by pickpockets and criminals. An increasingly authoritarian police, originally called in to try to get the traffic moving, will try to do so by beating up increasing numbers of the drivers. All these symptoms are already present.

As for the UK, the problem will be far more serious than for the core states such as Germany, France or the Netherlands. These have far less unevennesses between each other, because they have relatively equal rates of investment. However, the UK, due to its far lower rate of investment, has a far greater uneven ness compared to the core economies, and the strain placed on the jammed price system will be far greater — as the debacle of UK, and Italian, ERM membership demonstrate. In the absence of a European budget, with regional transfers, the results of the UK joining a common European currency would be disastrous.

The ‘democratic deficit,’ therefore, turns out not to be a small mark on the cloth after all. It is the point from which the whole fabric will unravel — a fatal lagging of political structures behind economic processes. For it is not possible to introduce, without immense damage, a single European currency without a significant European budget. And a real European budget requires democratic control of it.

There are, as stated, and for economic reasons analysed at length above, only two viable ways for ward. The long term one is the creation of a European federal state. The transfer payments this makes possible will introduce, by different means, the flexibility which the unchanging exchange rate will block off. But if this political step is rejected, and no such budget established, then it is vital that the flexibility of variable exchange rates be maintained.

Maastricht has to be rejected, not in the utopian and reactionary name of little England, but because it is based on erroneous principles which reject the entire historic development of the 20^th century economy. The huge scale of production which determines the specific character of our century’s economy, both creates the internationalisation of production and the drive towards a single European currency. Its consequences for prices and money, simultaneously, make it impossible to beneficially create a single European currency by the means Maastricht proposes. Maastricht is, in the last analysis, the attempt to impose a 19^th century monetary framework on a 20^th century productive economy.

That is why it is so dangerous.

Notes

This article originally appeared in Ken Livingstone's Socialist Economic Bulletin in September 1996.

1. Silver was also, during various periods, and in various countries, used as a primary basis of money. However, the overall historical primacy of gold is clear.

2. The main problems which exist are created by phenomena such as adulteration of the currency.

3. Given gold’s universal acceptability, national costs of production cannot significantly affect its price

4. Such price reductions were inevitable if an industry’s cost of production, for example due to technological progress, fell, under competitive conditions, relative to the cost of producing gold.

5. Introducing changes in velocity, for present purposes, merely complicates the argument without changing anything essential. However, this is not a general acceptance that velocity remains constant.

6. The theoretical counterpart of the latter within economics is technically known as general equilibrium theory, but more popularly as ‘classical/neo-classical’ economics.

7. It is by well established that even if the assumptions of perfect competition are made the associated neo-classical economics is theoretically incoherent, and cannot be accepted. However, for present purposes, what is crucial is not the theoretical refinements but the practical conclusions regarding price levels.

8. A proof of this may be found in any economics textbook.

9. In all analyses below, it would, strictly speaking, be more correct to utilise rates of change rather than reductions and increases in money supply. This would, however, require introducing differential calculus rather than simple arithmetical examples. Nothing in the fundamental relationships is altered by this simplification.

10. ‘The Fortune Global 500,’ Fortune 5 August 1996.

11. Nigel Spivey, ‘Hungry, but not for food,’ Financial Times 17 August 1996.

12. OECD Economic Outlook June 1996.