The European Central Bank, ECB, raised interest rates again at its Governing Council meeting on May 4th. This means, technically, that the bank is continuing with its somewhat conservative monetary policy, i.e., a more modest growth in money supply compared to the years before and during the pandemic.
At the center of the ECB’s policy making is inflation. The rate has been declining slowly in the euro zone since its peak at 10.6% in October last year, but the decline is slow and a little bit unconvincing. According to Eurostat,
- In December the euro-zone inflation rate was 9.2%;
- In January and February it was 8.6% and 8.5%, respectively;
- In March and April it was 6.9% and 7.0%, respectively.
Inflation is declining steadily in smaller euro zone economies like Croatia, Portugal, Cyprus, and the Baltic states. At the same time, it is showing signs of persistence—also referred to as ‘stickiness’—in the bigger economies of Germany, France, and Italy.
With a mixed picture of where inflation is headed, it is understandable that the ECB wants to continue to tighten its money supply. That said, I maintain my prediction from April that they will soon reverse course. As the euro zone economies get stuck in slow growth and unemployment begins rising again, the ECB will be faced with yet another round of growing budget deficits. That in turn will raise fears of another round of fiscal crises—a phenomenon we just got an early warning of when Fitch downgraded France’s credit rating.
So far, there are no signs of concern from the ECB, not even from their chief economist Philip R. Lane, who recently gave an interview with French news outlet Le Monde. In the interview, which the ECB published on its website, Lane gives his take on the current state of the European economy. He does not mention with one word the looming threat of another public finance crisis in Europe.
This choice of focus is all the more puzzling since Lane happily talks about the very macroeconomic context in which such a crisis would erupt: low GDP growth, persistent unemployment, and inflation stickiness.
To start with growth, when asked about the ECB’s recent forecast for the euro zone economy, Lane confirms that an inflation-adjusted 1% expansion in GDP “remains reasonable” for now. This is the number that the ECB put out in its Economic Bulletin Issue 2 for this year. He conditions that statement with a reference to “significant uncertainty” in the outlook, in other words, he opens for the possibility of this forecast being too optimistic.
His caution is wise, but he should have elaborated on the broader aspects of Europe’s GDP growth problem. The European economy is permanently weak, and the government response to the pandemic did not make things better. On the contrary, as of December 2022 only 14 EU member states had an economy that was at least 5% larger (adjusted for inflation) than it was in 2019. Five countries were 1% or less ahead of 2019, among them France, Germany, Italy, and Spain, the four pillars of the euro zone. The Spanish economy was actually 1.3% smaller in 2022.
We can easily identify the sluggishness of GDP growth in the latest national-accounts data from Eurostat. Their numbers for the first quarter of 2023 corroborate Philip Lane’s caution about the growth outlook. Eurostat has just released its first set of data on Q1, and although the set is incomplete—they don’t have numbers for all member states yet—the published data carry enough information to point out the direction of the European economy.
For the EU as a whole, GDP expanded by 1.26% over the first quarter 2022. The rate was a bit higher for the 19-member euro zone (Croatia joined in January) at 1.32%.
Of the ten member states for which Eurostat has released data, only Spain has a good growth rate: 3.79%. Ireland logs an acceptable second-best with 2.65%. Austria and Italy follow suit at 1.79%. Three more countries have positive growth: France (0.83%), Sweden (0.42%), and Latvia (0.27%). Behind them with shrinking economies are Germany (-0.14%), Czechia (-0.21%), and Lithuania (-3.56%).
For all these ten countries, their latest growth rates are worse than a year earlier, in the first quarter of 2022. For Czechia, Germany, France, and Sweden, the GDP growth rate for Q1 of this year marked the second quarter in a row below 1%. Lithuania has now had two consecutive quarters with shrinking GDP, a conventional way to define a recession. The euro zone as a whole is not there yet, but its GDP growth has slowed down every quarter for a whole year. The latest figure of 1.32% is a good amount below the 1.58% average for the years 2013-2019.
These numbers are not the raw data GDP figures that give us a fully accurate picture of the economy. They are seasonally adjusted, which puts them at some distance from the real world. Eurostat is unfortunately slow in releasing new data, and the agency has a habit of saving the ‘best’ numbers for last. Once the non-adjusted numbers are out, we will have a sharper picture of the European economy; until that happens, we will make do with the seasonally adjusted figures.
In his Le Monde interview, ECB chief economist Philip Lane gets the question if the euro-zone economy is stagnant. This is also an important question with regard to the future of Europe’s government finances. A stagnant economy typically triggers more payouts from welfare state benefit systems, while tax revenue falls behind government spending. Stagnation is the pathway to a structural budget deficit.
Again, Lane chooses not to mention government finances, not with one word. His reply is succinctly negative: the European economy is not stagnant.
Perhaps his reluctance to tie stagnation to government budgets has to do with his definition of stagnation. Arithmetically, Lane is correct, but that definition has no practical meaning, especially not when it comes to fiscal policy. Furthermore, from an economic viewpoint, Lane is actually wrong in his definition of stagnation: an economy does not fall into stagnation once it reaches 0% growth—it stagnates long before that.
The concept of stagnation is tied to the fundamental definition of the purpose of an economy. This purpose, which applies to the economic system as an organic, dynamic component of human society, is to produce an acceptable standard of living for its population. Put in principled terms, the purpose is to satisfy human needs by means of scarce resources, subject to uncertainty.
By using this definition, we naturally tie the stagnation concept to public finances. This tie runs through our understanding of needs as a comprehensive concept: needs of all kinds change over time. The evolution of needs is a product of human advancement in many areas, including but not limited to ethics, engineering, and economics.
From a policy viewpoint, this declaration of the purpose of the economy leads to a discussion of how those needs are satisfied, and whether or not it should be done by means of economic redistribution. Leaving that debate for another day, we can at least conclude that in a free society, the growth in human abilities and aspirations is the driving force of societal evolution. Therefore, the economy continuously addresses new levels of needs, and produces new levels of prosperity.
It is in the context of this definition that we should understand the concept of ‘economic stagnation’. The arithmetic measurement of a standstill economy is meaningless; it is only when we understand stagnation as the antithesis to evolving prosperity, that ‘stagnation’ as an analytical term gains economic meaning. Understood accordingly, a state of economic stagnation is reached when there is no evolution in the satisfaction of needs; comprehensively, there is no growth in prosperity.
If we choose to use economic redistribution to satisfy human needs, the point of economic stagnation (again defined dynamically) becomes a critical point for the ability of the welfare state to deliver on its promises to satisfy human needs. Therefore, the arithmetic point where stagnation becomes a public finance problem lies higher than the 0% Philip Lane refers to.
How much higher? Unfortunately, the economics literature is sparsely populated with attempts to answer that question. My own addition to the austere pile consists of the theory of industrial poverty: a country is in economic stagnation when the standard of living does not advance for an extended period of time. As a quantitative proxy, I proposed an adaptation of something known as Okun’s Law (Industrial Poverty, p. 58):
Named after prominent economist Arthur Okun, this law suggests a regular relationship between unemployment and GDP growth. When GDP grows at a certain percent per year, or less, unemployment will not fall and might go up instead.
By the same token, due to quality advancements in consumer goods (from food to automobiles), as well as quality advancements in services (from house cleaning to health care), it takes a small but steady growth rate in GDP to maintain our purchasing power on par with such advancements.
Based on my adaptation of Okun’s Law (explained in chapter 3 of my book) I approximate that growth rate to 2%, adjusted for inflation. Therefore, when an economy fails to exceed 2% real growth over at least one business cycle, it also fails to advance its standard of living. It becomes stagnant.
This definition of economic stagnation is unlikely to make it into the mainstream of the conversation on economic policy. It is simply too value-laden and therefore too contentious to fit the technically charged normal economic discourse. However, for policymakers, especially outside the central bank sphere, this comprehensive concept of economic stagnation is far more useful than Philip Lane’s arithmetically confined version.
Next, Le Monde turns to unemployment and asks Lane:
One of the positives is that euro area unemployment has remained quite low, at 6.6%. Does this partly explain the resilience of the European economy?
To which Philip Lane replies:
I would point out that the strength of the labour market has been associated with a strong return of immigration into the euro area. We were concerned that there might be less immigration after the pandemic, but it looks like it has come back. It is a source of labor for all of those industries that have been experiencing worker shortages.
Wait—say what? Le Monde explains that “unemployment has remained quite low”, to which Lane replies that high immigration has helped.
To say that unemployment is low because labor supply has increased is to turn the most basic elements of economic theory upside down. Unemployment is low because demand for labor is high relative to supply. If labor supply increases—the very consequence of working-age immigration—unemployment goes up. Demand for labor does not rise because there is more immigration; when immigrants take open jobs, all that happens is that the number of employed persons goes up. However, since the workforce grew by the exact same amount of people (assuming all immigrants are hired), the number of people without a job remains unchanged.
Regardless of why Harvard-educated Philip Lane is ignorant of the mechanics of the labor market, or whether he is just playing pro-immigration politics, his official rhetorical somersault on the matter of immigration only reinforces the impression that he does not see a looming recession as a threat to government budgets. If he did, he would have brought it up at least once during his interview.
His omission of government finances from his answers during the interview could be a matter of communications strategy: the ECB does not want to stir worries about a new fiscal crisis until there is one at hand. If this is the case, though, the central bank is doing itself as well as euro zone governments a big disservice. The sooner we can start working on preventing a new fiscal crisis, the more likely that we actually can avoid it.
