Recently, the Union Bank of Switzerland, UBS, issued a stagflation warning for Europe:
Eurozone is headed toward “stagflation” as efforts to stamp out a surge in inflation will bring growth to a near halt in the second half of the year, UBS said on Thursday, while trimming its 2022 economic forecast for the region.
The UBS forecast is not entirely clear: what policies do they say would cause stagflation? If it is fiscal policy, they are correct: the inflation we have now is monetary in nature and cannot be brought under control with fiscal policy.
Stagflation can only happen when inflation is monetary in nature, i.e., when the central bank has been printing way too much money for way too long, and that money has made it into the economy through perennial deficits in the government budget. This is the type of inflation we see now in both Europe and America, but while the Federal Reserve has started tightening its money supply, the European Central Bank has barely just stopped the excesses of its monetary expansion.
The absence of policy countermeasures from the ECB is almost a guarantee that inflation will continue. But what signs do we have that we are heading for stagflation, as the UBS claims? After all, the European labor market is doing well. More than 155 million men and women In the age group 20-64 are employed—the highest number since Eurostat started its monthly labor-market database. Fewer than 11 million are unemployed, which is a record low number for the euro zone. With a workforce at a record 166 million, this comes out to a record-low unemployment rate of 6.4%.
The UBS has its own models for forecasting; in the following I am going to give my reason for predicting stagflation. I am going to use an unusual set of data: the difference between inflation numbers with “actual” tax rates, and inflation numbers where tax rates are assumed to be constant.
I know this sounds so technical that it is almost off-putting right out of the box. But bear with me—you don’t have to be an economics nerd (like me) to understand this. All I am asking for is a little bit of patience, and what comes out on the other end is going to be unique information that conventional-wisdom economists will never provide. Most economists, namely, are too conventionally minded to even look for it.
First, a simple theoretical tool that helps us understand the data we are about to explore. Our stagflation forecast is centered around the tax system—and the one simple principle upon which the tax systems of most modern, mature welfare states are built: when you make a lot of money, you pay a larger share in taxes of your income and of the money you spend than you do when you don’t make a lot of money.
Two examples illustrate this point:
- Personal income taxes are higher on high incomes than on low incomes;
- Every EU member state except Denmark has a lower value-added tax on some items, typically the goods and services that weigh heavily in the consumption basket for low-income households.
In other words, we tend to pay a larger share of our incomes in taxes—through income taxes and taxes on consumption—when our incomes grow, and vice versa:
Normal inflation, caused by the ebb and flow of the free market, rises and falls with the business cycle. When the economy is growing strongly, inflation rises somewhat; when there is a recession, it cools off or is even replaced with deflation. When people make more money, they are often bumped up into a higher tax bracket (a phenomenon the Germans ominously refer to as cold progression); when consumers have more money, they spend more on items that are taxed at higher VAT rates; and vice versa.
When inflation increases the tax burden, it actually increases inflation itself (since higher taxes increase the cost of living). Therefore, if we statistically isolate the rise in the tax burden from inflation itself, we get two inflation rates: the actual inflation rate, and the constant-taxes rate. Fortunately, we don’t have to do this, because Eurostat—the statistics agency of the European Union—has already done the work for us.
For the reasons we just discussed, actual inflation is almost always higher than constant-rate inflation. Mild recessions usually do not bring the economy into the second segment of Figure 1. However, as we will see below, that happens in a serious recession like the one Europe went through a decade ago.
Figure 2 below reports inflation data for the euro zone as a whole. (The raw data behind it consists of monthly price-index numbers from 2005 through the first five months of 2022.) The difference between actual inflation and constant-rate inflation, which is what Figure 2 displays, is the “tax impact” on inflation. When the columns are blue, the tax impact is positive, i.e., taxes increase inflation. The effective tax burden on our incomes and our consumption rises.
By contrast, in hard economic times the tax impact is negative—a declining effective tax burden reduces the burden of inflation, just as in the second segment in Figure 1 above. We see the same situation in Figure 2, represented by the red columns:
The first example of a negative tax impact on inflation is number 1 above. This was the Great Recession in 2008-2010. The second example is, of course, the artificial economic shutdown in 2020 and part of 2021.
As we will see in just a moment, in the first two examples with “red” columns, actual inflation was low to begin with. This is important for our conclusion regarding stagflation.
Since actual inflation has been low in the past when the tax impact is negative, it would be logical to expect the same to happen the third time the impact goes “red”—would it not?
Yes, it would. Common sense and economic theory both prescribe as much. However, when we plot actual inflation rates on top of Figure 2, something weird happens. We reproduce Figure 2, but with gray columns instead of blue ones, and with a blue line added for inflation:
The blue line, which represents actual inflation, is measured on the left vertical axis. In the Great Recession, inflation is well below 2% and even becomes negative (deflation) for a couple of months. The same thing happens during the pandemic-related economic shutdown.
But look at what happens at the end of the timeline in Figure 3: a negative tax impact—but rapidly rising inflation.
This should not be happening. The red columns are symptoms of an economy where personal income and consumer spending are weakening and when, as a result, tax revenues decline.
There is only one explanation for this situation: stagflation.
Inflation in the euro zone started increasing toward the end of the summer in 2021. In August that year, the inflation rate reached 3% for the first time in ten years. In October it passed 4% and broke through 5% in January. By March, it was above 7% and exceeded 8% in May.
During this period of time, the tax impact indicator shifted from positive (gray columns) to negative (red columns). The shift, which happened in January, would have been of no consequence had it only lasted for a month or two. But not only has it been negative for five straight months: it has increased for every month.
Let us step away from the technical analysis for a moment and see what this means in practice. As we saw in Figure 1, the tax impact on inflation is negative when the economy is in a recession. Therefore, logically we should be in a recession now, should we not? And what better way to measure that than to look at how the labor market is doing?
Unfortunately, neither Eurostat nor any other high-quality statistics agency produces comprehensive labor-market data for Europe on a monthly basis. Therefore, we cannot make direct comparisons between labor data and inflation numbers. The best we can do is to look at the labor-market numbers from the first quarter of this year.
This is still helpful, though.
As mentioned earlier, from a general viewpoint the European labor market is doing well. However, there are three reasons to believe that stagflation is coming. The first reason is a set of general macroeconomic conditions that are not favorable to economic growth. High inflation is an obvious problem, another is a perennially unreliable energy policy in many European countries, with Germany and Sweden as storefront examples.
In addition, there is the European Central Bank’s low-key drumbeat about a looming new sovereign-debt crisis. Experience from the last one a decade ago suggests that hard-hit member states will resort to harsh budget cuts and sharp tax hikes; since monetary policy is tapped out—there is no room to cut interest rates—those fiscal measures will be deployed much earlier in this crisis than the last one. We may see the first ones as early as this fall.
The labor market itself also gives us reasons to expect a real-sector downturn (while inflation stays high). One of those reasons is the often-overlooked ratio between gross domestic product and workforce employment. In plain English: the amount of economic value produced by the average employee in an economy. Adjusted for inflation, this per-employee GDP grows at 1-2% per year. It shrinks in recessions and then temporarily bumps to much higher values during a recovery.
We saw precisely this happen in 2020 and 2021, with the “rebound” coming to an end in the second quarter last year. The GDP-per-employee ratio has continued to grow at unusually high rates since then, much like it always does for a little while after a recession. That extra growth rate, though, is due to come to an end; we don’t yet have numbers to calculate GDP per employee for the second quarter this year, but if it fell (as it should based on historic experience) then we can expect GDP growth to slow down considerably.
Another reason for the labor market to be recession bound is in the ratio between full-time and part-time employees. In low-skill jobs, those who work part time tend to get more done per hour, but workers who put in a full day’s worth of work tend to build more skills. This increases their productivity over the long term.
Since the Great Recession, Europe has seen a relative decline in full time employment. Before the Great Recession of 2008-2010, the euro-zone economy had approximately 450 full-time workers per 100 part-time workers. During the recession, employers laid off full-time staff to a larger extent than part-timers: when the euro-zone recovered, its economy had about 370 full-timers for every 100 individuals working part time.
This ratio ticked up a bit in the rebound from the 2020 shutdown. There are no real economic reasons why this ratio should have gone up, which means that we can expect a decline again in the near future. With that decline comes a lower GDP-per-employee ratio, which contributes—albeit modestly—to a slowdown of the economy as a whole.
All in all, then, we have good reasons to believe that Europe is on the doorstep of a tough episode of stagflation—if it has not already begun. Once we have full data for the second quarter of this year on the labor market and on the economy as a whole, we will have more definitive evidence. However, the current signs of stagflation are worrisome. If I were a policy maker, a business leader or an investor of higher rank, I would take precautionary action and prepare for an extended period of low economic activity, high inflation, and quite possibly monetary turbulence.