The Recovery Is Stalling. We Need Pro-Market Reforms Now.Tags Free MarketsMonetary Policy
The Economic Sentiment Index of the European Commission for August shows that the recovery of the European economy is slowing down. Not only has the pace of recovery slowed significantly, but the data for Spain reflected evidence of being the only economy in the euro area where the index fell compared to July. If we look at the Organisation of Economic Co-operation and Development (OECD) leading indicator index, the evolution is also worrying. 60 Bloomberg also tracks the daily activity in most economies, and the evidence points to a deceleration in August in most developed and emerging economies. Only the United States seems moderately better in comparison, although the slowdown in the recovery process is also evident.
Many may say that it is normal to see a deceleration in the recovery after such a fast bounce in June and July, but when most economies’ outputs remain 10 to 20 percent below February levels after the reopening, we must be concerned. We also must warn about a rapid recovery in GDP (gross domestic product) that comes mostly from massive increases in debt and government spending. The reality is that for most businesses and households the economy remains far away from 2019 levels.
Why Such a Rapid Change in Trend?
The first and wrong analysis is usually to blame the slowdown on a bad tourist season affecting the travel and leisure sector. Of course, it is an important factor, but many other parts of the economy are showing an abrupt change in trend. Furthermore, the worsening of the indicators is clearly reflected in industry and consumer confidence, with manufacturing purchasing managers’ indexes (PMIs) slowing down in the eurozone and even entering contraction in Spain.
The forced closure of the economy by government decision and the lack of confidence in the future have a profound midterm impact on the economy.
Government shutdowns have created a solvency problem with severe long-term ramifications in large parts of the business fabric. One in five companies in the UK are considered “zombies,” almost 12 percent in the United States, and more than 15 percent in the eurozone. The Bank of Spain warns that 25 percent of Spanish companies are in a situation of technical bankruptcy and business closure.
Governments have ignored the fragility of the private sector for years, while corporate debt and solvency ratios reached new record highs. However, what is more important is that governments have not paid any attention to the weakness of the small business fabric, millions of companies with one or two employees that managed to survive day by day, that had no debt or assets and have been destroyed by the misguided and ineffective forced shutdown, not because their owners used the wrong strategies.
The excess of capacity built in the fake and indebted growth period of 2017–19 is also evident in the weak recovery. Small businesses’ death by working capital and so-called strategic sectors’ zombification through low rates and high liquidity are the collateral damage of the eternal stimulus we have seen in the post-2008 period, particularly in the European Union, where large conglomerates are viewed by governments as hidden social security systems and behave almost like state-owned enterprises in numerous cases. The August composite manufacturing index in the eurozone shows this slack. It worsened from 54.9 in July to 51.6 in August. Still expanding, but a massive slump for one month. Following the daily activity indices published by Bloomberg Economics, economic activity in the euro area is still 10 percent below February levels, and recovery slows after reopening.
The main problem is that all this occurs in the middle of the largest chain of stimuli since the creation of the eurozone. The balance sheet of the European Central Bank has soared from 39 percent of the GDP of the eurozone at the beginning of the year to 55 percent in August 2020, much larger than the balance sheet of the Federal Reserve (33 percent of US GDP) or of the Bank of England (32 percent), though still far from the monetary insanity of the Bank of Japan (120 percent). Negative interest rates, a European Central Bank that has bought more than 20 percent of the outstanding debt of most member countries, liquidity injections into the financial system via targeted longer-term refinancing operations (TLTROs), and a fiscal stimulus of almost 10 percent of GDP, yet the eurozone economy is not even close to February levels.
These stimuli do not solve a problem of solvency and falling sales. Most businesses that are closing are not doing so due to lack of access to credit or because interest rates are high (they are the opposite), or due to lack of public spending. They close because sales after reopening are nowhere near the levels needed to cover growing expenses and tax bills. Death by working capital, as I mentioned previously.
Europe and the rest of the world must learn that huge stimulus can disguise the risk of highly indebted countries with serious solvency problems but it does not solve it.
At some point we must begin to understand that periods like the current one are precisely the most dangerous. With the excuse of attending to a crisis, structural imbalances are increased while the productive sector is left abandoned.
When we read about the “support for businesses” in these stimulus packages the majority are just giving companies the opportunity to borrow more now to pay taxes in the future.
This chain of stimuli and government spending will not strengthen the economy. At best, it will zombify sectors that already had growth, productivity, and debt problems before the pandemic. There is some hope, however. Countries like France are recognizing for the first time that the measures they must take if they want to get out of this crisis are reforms that free the economy. These include serious tax-wedge and administrative reforms that attract investment, employment, and improve competitiveness. There must also be reductions of the tax burden on productive sectors, elimination of bureaucratic obstacles, reduction of so-called social charges and hiring costs, lifting of useless regulatory restrictions, incentivization of high-productivity sectors instead of subsidization of low-productivity ones, etc.
Structural reforms are urgent, but the eurozone and Japan have shifted from using monetary policy to buy time to implement those structural reforms to using such monetary stimulus as an excuse not to implement them.
Most developed economies face a dangerous dilemma: choose to follow the path of debt stagnation or strengthen the economy to exit the crisis in a stronger way. Unfortunately, the first alternative benefits a political sector that refuses to adjust, although in the medium term it destroys it by making debt and deficits unsustainable.