Tuesday, 26 August 2014

A problem of demand which leaves us stuck in the mud

This article was published in The Malta Independent on Sunday - 24th August 2014

Eurostat has published worrying economic data for the second quarter of 2014.

Economic growth in Q2.2014 was zilch compared to Q1.2014 and only 0.7 per cent compared to same quarter last year. Inflation was down to 0.4 per cent which is a million miles away from the ECB target of close to but below two per cent.

Let’s get inflation out of the way first. Is it a good thing or a bad thing to have low inflation? I had tackled this in a contribution in this series on 4th May where I had written:

“Low inflation or indeed falling prices could be both a blessing and a curse.

“If low inflation or falling prices result from positive supply shocks then it is a blessing. Following the industrial revolution of the late 19th century, great leaps of productivity led to increased supply of consumer goods at cheaper prices giving consumers better choices and value for their money. That certainly is a blessing which stimulates consumer demand and leads to economic growth and job creation as a welcome bedfellow to falling prices.

“Take the drop in our utility rates. Surely these will eventually work their way to lower readings in our domestic inflation, but equally surely no one should be complaining about it. That is a positive supply shock, leaving purchasing power in consumer’s pockets which will be spent on other consumables, giving a stimulus to demand and leading to economic growth and job creation.

“On the other hand, if low inflation or outright deflation is a result of demand shocks, then that is the curse and if prolonged could be difficult to reverse. The lost decades in Japan following the bursting of the eighties’ speculative boom, clearly demonstrate as much.

“Countries in the euro area periphery, Greece, Ireland, Portugal, Italy, Spain, Cyprus and Slovenia have been forced to address their fiscal stress by crushing internal demand. Higher taxes and harsh expenditure cuts drained purchasing power from consumers’ hands. As a consequence, their economies shrank, unemployment exploded, especially among young people seeking their first job, and prices stagnated or indeed started to fall.”

According to Eurostat, Poland and Italy both registered zero inflation in the year to July 2014. But while Poland’s lack of inflation is virtuous, as it is in a context of real economic growth of 3.2 per cent, Italy’s zero inflation is vicious, set in a record of economic contraction of -0.3 per cent. Italy is in deflation and so are Greece and Cyprus. Spain is registering negative inflation but its economy has started to grow, albeit very moderately at 1.2 per cent.

I had barely switched on my mobile as I entered the airport following a summer holiday that I had a prominent journalist on the line. He was fishing for critical views about three consecutive months of negative inflation registered in our Consumers Price Index. Set in the context of real growth to the order of three per cent, this is virtuous price stability caused by supply shocks as lower utility rates work their way through our pricing mechanisms and an abundant fruit season pushes down food prices.

The problem with inflation is when it results from demand shocks; when it results in the context where the economy is not growing and consumers are keeping their purse strings tight as they are apprehensive about the future.

The shock in the Eurostat statistics is that Germany registered an economic contraction of -0.2 per cent in Q2-2014, and Italy yet again registered a similar negative growth, this being the third negative result in the last four quarters and exposing the Q4.2013 positive 0.1 per cent growth as a fluke rather than a turnaround.

How can we end this never-ending euro area recession or anaemic growth, which is now in its sixth year, if the key driver Germany also starts registering economic contraction? Why should Germany with ample space for fiscal manoeuvring to stimulate demand be registering economic contraction? And if countries in fiscal comfort and balance of payments surplus do not take action to stimulate internal demand to keep the growth momentum, how can Italy, France and Spain reap the benefits of their fiscal austerity programmes if they cannot find external demand for their increased production which cannot be internally consumed?

Mario Draghi, president of the ECB, had promised to do whatever it takes to save the Euro. He qualified the pledge by adding that it has to be within the mandate of the ECB, as conferred to it by the member states in the euro monetary system. That pledge had stabilised the financial markets but in no way has it solved the underlying problem. Indeed, it is doubtful whether monetary policy, even if more aggressive than what the ECB can do within its mandate, can solve the economic problems of the euro area. At most, aggressive monetary policy can gain time for the political forces to do whatever it takes, but it cannot replace the need for the political fiscal adjustments necessary to restore equilibrium in euro area countries.

Which means that it would be useless, indeed harmful, if the countries in distress continue to adopt painful restructuring and adjustment programmes if, simultaneously, the surplus countries fail to take steps to stimulate demand in order to address their structural surpluses and use the fiscal space at their disposal to counter-balance, through demand-led policies, the contraction in demand in countries undergoing fiscal restructuring.

The euro area problems are largely a problem of insufficient demand. It can only be resolved if countries that have been over-consuming and under-investing are assisted to succeed in their austerity programmes (programmes which shift resources from consumption to investments) by surplus countries that need to simultaneously switch from savings to consumption modes in order to fill the demand gap. Germany’s economic contraction shows this is not happening. That is leaving Italy Greece and Cyprus stuck in the mud, registering negative growth in spite of their harsh austerity adjustment programmes.

In Q2.2014, German consumers must have been shocked by the instability of curtailed exports to Russia resulting from trade sanctions imposed due to the Ukraine debacle. This is more reason why Germany must use its fiscal space to stimulate internal demand rather than continue to preach the false virtues of balanced budgeting in all circumstances.

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