European Commission sees permanent decline in euro area’s potential output

 

As so often, it is best not to read the media coverage, but the original documents. The European Commission’s Quarterly Report on the Euro Area contains a rare bombshell – a special essay on the long implications of the financial crisis, which says that the crisis will cause long-term damage to the euro area, and turn its feeble long-term economic growth prospects into something altogether more sinister.

The financial crisis affects both component of productivity – capital accumulation through lower investment rates, and total factor productivity through the credit crunch – and this is likely to have a lasting negative long-term impact on potential output.

In the short run, the effect on potential output growth is a fall of 1.6% in 2007 to 0.7% in 2010. After the crisis, the potential output growth should grow again, but it may never reach its pre-crisis level again. On page 34 it says:

“In other words, the crisis will entail a permanent loss in the level of potential output. One of the factors that will shape the size of this loss is the speed at which the economy reverts to long-term trends. The slower the adjustment to long-term trends, the greater the final loss in potential output level compared with a pre-crisis expansion path. The risks that the adjustment process will be protracted appear unfortunately to be high due to the specific characteristics of the current crisis, including its duration, its global nature and underlying changes in risk behaviour.”

The essay is also highly critical of government action to concentrate economic support on ailing industries (as is clearly happening in France and Germany).

“One of the factors that will shape the size of this loss is the speed at which the economy reverts to long-term trends. The slower the adjustment to long-term trends, the greater the final loss in potential output level compared with a pre-crisis expansion path. The risks that the adjustment process will be protracted appear unfortunately to be high due to the specific characteristics of the current crisis, including its duration, its global nature and underlying changes in risk behaviour.”

 

 

US jobs data tells us that crisis is not even close to ending

US and euro area unemployment now stand at 9.5%, but it was the 467,000 rise in the June US payrolls data that shocked the market, with the S&P down 2.9%, as the reality sinks in that there is no recovery, not even close. After the more positive May employment report, market participate had hoped that the recession would end soon. The news was predictably good for government bonds, as the prospects of a near-term spike in inflation are no longer seen as very strong. See the FT’s report on this story.

 

ECB tells banks to lend, or else the ECB will compete with them

This was not a boring ECB meeting after all. After the €442bn capital injection in the previous week, Jean-Claude Trichet yesterday made an appeal to the banking sector to pass on the liquidity to the economy. Axel Weber threatened that if banks should fail to do so, the ECB would bypass and lend directly to companies, for example through the purchase of commercial paper. FT Deutschland remarked that Trichet did not use the same terms, but left do doubt that the ECB would intervene if the credit crunch were to continue.

 

 

Europe’s car industry is collapsing

The German media have details of an alarming study about the car industry, which shows that the industry cannot expect to get back to the 2007 of sales for another five or six years. Currently the industry loses €1800 per car sold on average. It has used up all the liquidity reserves, which it built up until 2007. To get back to health, the industry requires a very large degree of concentration. Further problems loom in Germany in particular, after the expiry of the car wrecking premium. It led to a short spike in increase motor sales, by over 30% for most manufacturers. But many customers have pulled forward car purchases. Once the premium is gone, one should expect a corresponding drop in sales, on top of the slow economy, on top of the structural problems. For Germany alone, it is feared that 10-15% of car industry jobs will disappear. See Spiegel Online, FT Deutschland or any other newspaper for this story.

 

EU wants to follow US into central clearing

The EU wants to adopt similar legislation to the US in the form of central counterparty clearing for all derivatives dealings, FT Deutschland reports. This includes credit derivatives, but also other type of derivatives, such as swaps. The basic idea is to prevent a situation whereby a single financial company, like AIG, is concentrating all risks. In addition, the Commission wants to push the market onto regulated exchanges in the long-run, which requires a high degree of standardisation.

 

Posen and Veron an banking resolution

Adam Posen and Nicolas Veron argue in the FT that it is well impossible to carry out European-wide bank restructuring with EU-wide fiscal transfers. To solve the problem, they propose a financial Treuhand structure, a fiduciary entity or trustee that would be created jointly by those countries where the main continental European banks are headquartered. It would have three tasks. First, it would apply triage to all large or heavily cross-border banks, assess their balance sheets, publish what it found and thus signal where capital is required and how much.  Second it would serve as a catalyst for the inter-governmental negotiations necessary to recapitalise those banks, and third, it would manage those assets and institutions thus brought into public ownership on behalf of the owning national governments.

 

Now  Paul Krugman is getting really gloomy

This is about America, but the same logic applies to the euro area. Paul Krugman says the Obama has vastly underestimated the depth of this crisis, and urgently needs to enact another stimulus to prevent a depression scenario. The latest US jobs data show that the economy is on the brink of another downturn. The need for the states to run balanced budgets now becomes a pro-cyclical enhancer, and he also criticises his own profession for peddling the lie that the US is about to suffer a period of high inflation. He says Obama had better get his political and economic teams to work on another stimulus, or else he might his own version of 1937.

In his blog, he also makes the point that the rate of wage changes is heading towards zero, and since inflation tends to be a bit lower than wage growth due to productivity increases, we may well be heading towards to a Japanese deflation scenario.

 

So is Joachim Fels, for the opposite reasons

Unlike Paul Krugman, Joachim Fels fears a rise in inflation, not right now, after after some time. In the FT, he advances three reasons. He says the gap between actual and potential output is much smaller than economists estimate, as is its importance to inflation; second, the secular forces that kept inflation low, are reversing; and third and most importantly, central banks will not correct their policies in a recovery with sufficient speed.

 

 

How to reform

This is an interesting piece of research, the kind that yield the answer you would not expect. Writing in Vox, Daron Acemoglu , Davide Cantoni,  Simon Johnson and  James A Robinson ask whether external agents can successfully impose significant institutional reforms? Many economists are sceptical. They look at major reforms the French imposed upon their conquered European neighbours in the years after the French Revolution. The reforms, imposed suddenly without concern for being “appropriate to local conditions”, appear to have spurred significantly faster economic growth.

 

“Auf Wiedersehen Deutschland”

Eric Le Boucher has a strong article Les Echos about the deteriorating relationship between Germany and France. Germany under Merkel is no longer interested in common European policy actions. “Chacun pour soi”, even if the ailing German banking sector is postponing the European recovery by two to three years. Worse still, if a Landesbank were to default, it could take whole Europe into a recession in 2010. On fiscal policy responses the two countries go in complete different directions. Sarkozy, untroubled by rising debt, is planning for his big investment projects while Germany includes a non-deficit rule in its Constitution.  The worst is that both countries have stopped to communicate and comment on each other, as if the divorce of the Franco-German couple were already a fait -accompli.

 

Chacun pour soi

In the same direction argues Helen Rey in Les Echos.  France decided to blow up its debt, without a credible strategy on how to reduce it in the medium term. Germany is right to be concerned, but its unilateral choice to constitutionally force public debt down to practically zero has huge repercussions for Europe. The two examples only show the complete inexistence of European macroeconomic coordination. While politicians praise the virtue of concerted action, in practice everyone pursues a “chacun pour soi” strategy.

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