Eurostat published their latest National Account estimates for the Eurozone on Wednesday (February 15, 2012) – Flash estimate for the fourth quarter of 2011 – which allows us to complete the picture for the 2011 calendar year. Overall, the results are appalling. Many nations are now double dipping and even the European powerhouse, Germany contracted last quarter. Over the Channel, the British economy also contracted in the 4th quarter 2011. None of this should come as any surprise. An economy cannot grow when the private sector is deleveraging and is in constant fear of unemployment and the public sector deliberately refuses to step in and provide fiscal support. It is even worse when the government further undermines the capacity of the private sector to spend (by harsh cuts in pensions etc) and cuts its own net spending into the bargain. As one commentator noted yesterday “it makes no sense to drive an economy into recession where it stops people from working and thus paying more taxes” if the goal is to reduce budget deficits. The political leadership in Europe and the UK is deliberately sabotaging their economies. The same mentality is gathering pace in the US. Spare us!



The following table is constructed using the Eurostat flash estimates of real GDP growth as at the December quarter 2011 (released February 15, 2012). The trend is relatively uniform across the EMU and for the UK as fiscal austerity imposes a significant constraint on aggregate demand.

While no quarterly change data was published for Greece, the annualised growth (last four columns) paint a very grim picture.

One might conclude that while the World avoided a repeat of the Great Depression as a result of the fiscal stimulus packages (and low interest rates) that governments around the world managed to implement before the deficit terrorists started chanting about austerity, Greece did not.

Since 2009, the Greek economy has shrunk by around 8 per cent in real terms with worse yet to come. In real terms, GDP is now around the size it was in 2006.

The Table shows that many EMU nations are now back in recession (2 successive quarters of negative GDP growth). The list includes Belgium, probably Ireland (no data was released the December quarter yet), probably Spain, Italy, the Netherlands, and Portugal.

Other EMU nations are heading that way – for example Estonia, Germany and Austria are now contracting.

Overall, the broader EU contracted very sharply in the December quarter (-3% in real terms) and the Euro area also contracted.

On the same day, the UK Office of National Statistics released the latest – Labour Market Statistics – for February 2011 which indicates that:

The employment rate for those aged from 16 to 64 was 70.3 per cent, up 0.1 on the quarter … The unemployment rate was 8.4 per cent of the economically active population, up 0.1 on the quarter … The unemployment rate has not been higher since 1995. The inactivity rate for those aged from 16 to 64 was 23.1 per cent, down 0.2 on the quarter.

One might conclude that this is not all bad news. As the UK Guardian editorial (February 16, 2012) – Employment and the euro crisis: bringing it all back home – said:

For the day after inflation was revealed to be easing off fast, there were – on the face of it – signs of employment stabilising, too. The total tally of jobs inched up, inactivity fell, and – even as benefits policy cajoles disabled people and carers into signing on as jobseekers – the dole queue lengthened relatively modestly. This is, to be sure, stabilisation of a dismal sort.

But a closer look at the data suggests a different interpretation consistent with the view that austerity (which is yet to fully impact) is damaging job prospects in the UK.

The following graph is produced from ONS data – EMP01: Full-time, part-time and temporary workers – and shows the changes (in thousands) since December 2007 in the major employment categories (full-time, part-time and total).

You can see that in the last two quarters, full-time employment growth has been negative and all gains in employment in the current period are attributed to part-time work.

The next graph provides a longer view of the labour market and depicts the ratio of part-time to total employment (in percent) since 1992. The graph shows that this ratio rose during the recession in the early 1990s and then was relatively stable at the higher level. During the current recession, the ratio has accelerated upwards.

This is a common pattern across many countries. During recessions there is usually a marked switch from full-time work to part-time work for both males and females resulting in a greater proportion of workers in short-duration and unstable jobs.

During recessions and subsequent recovery, the ratio typically rises rapidly before stabilising at the higher level with the underlying trend towards increased part-time work then reasserting itself.

That pattern is clearly evident in the UK.

UK Guardian editorial puts an appropriate degree of gravitas to the data release:

Employment blackspots such as the north-east continue to darken; twice as many as before the recession now work part-time for want of a full-time post; and there is still no hope in sight for youngsters struggling to find a first footing in work.

Spatial disparities – where some areas have relatively low unemployment and good employment growth while other areas represent the proverbial train wreck – also tend to widen during a recession and its aftermath.

Taken together, the EU data and the British labour force data accentuate what was always going to happen – Austerity begets austerity – despite the denials of the political leaders and their chorus of mainstream economists.

Every day, the austerity merchants and their chorus attempt to cast doubt in the public minds about budget deficits – that they are harmful and the private sector is better off without them.

What the public is not told is that budget deficits drive growth but also drive private business profits. This becomes especially so when the other determinants of profits vanish.

One of the reasons the public debate is so vacuous and that scoundrels can hold fort is that the public do not know how to reason in macroeconomics terms. They are continually being led to think in a micro way and are not warned that such thinking leads to erroneous conclusions when we transcend to the macro level.

To help make the transition into macroeconomic reasoning consider the following graphs. They use US data for convenience (good data availability) but the relationships depicted can be found in most countries where data is available.

The following graph shows the US federal budget deficit as a percentage of GDP (data from the US Bureau of Economic Analysis) and the US Domestic Company profits after tax from 1930 to 2010. The shaded areas represent the nearest annual spans of recession as estimated by the NBER Business Cycle Analysis.

Similar graphs would be constructed for most nations at present.

The interpretation of the relationship is that when the budget deficit line is below the domestic profits line, the other determinants of profits are playing a positive role. But in 2009 and 2010 the US federal budget deficit was more than 100 per cent of domestic profits which means the other determinants were netting to a negative number.

There have only been three times in the history shown when this has been the case – the Great Depression and World War 2 years, the Reagan years (after a very deep double-dip recession) and during the current recession.

If the US government had have invoked austerity measures along the European and/or UK lines, then profits would have been much lower (maybe negative) given that the other determinants have been largely missing in action.

The graph provides a very powerful reminder that budget deficits are a crucial driver of business profits, which in turn, helps (in a capitalist system) to drive employment. The downturn would have been much worse in the US than it actually was (and it was bad enough) had the US government followed the advice of many economists and resisted expanding its budget deficit.

The following graph shows the proportion of Company profits accounted for by the US Federal budget deficit. From 1950 to 2007, this proportion averaged 43.3per cent. If we took out the Reagan years then this average drops to 19.1 per cent. In 2008-2010, the average proportion was 122.7 per cent. The current period is quite exceptional in the historical span shown.

You might ask what was happening with the other major driver of corporate profits – private investment spending. The following graph shows US net investment as a per cent of GDP from 1930 to 2010. Over the entire sample (1930 to 2010) this ratio averaged 8.1 per cent of GDP.

In 2009 it was 1.3 per cent of GDP and only 3 per cent in 2010. The interpretation is that the main private driver of capitalist profits (private capital formation) was largely missing in action during the recession and had the US federal government not introduced the stimulus measures and expanded its budget deficit significantly then domestic corporate profits would have plunged more than they did.

What would have happened if the fiscal stimulus had have been more targetted to direct public sector job creation? The conclusion with respect to profits would not be much different. The major difference would have been that unemployment would not have risen by as much.

How might we understand the economics underlying the movements shown in these graphs?

I provided the theoretical development to understand these relationships in this blog – Why budget deficits drive private profit.

That blog is about macroeconomic reasoning. To demonstrate what I mean by that ask yourself the question: what determines the level of profits in the economy?

Most people will start by considering a business firm and articulating the revenues they receive and the costs they incur in doing so. For an individual firm, the difference between the two is the profits it receives (or loss).

It is also clear that for most firms, wages represent the most significant cost. Accordingly, it is tempting to conclude that the economy can increase profits if the individual firms can contain wage costs.

If business investment is sluggish and constraining economic growth, one might be tempted to extend this logic and advocate cutting money wages to reduce costs overall so that overall profits will rise and spur growth in investment.

Once you start thinking in these terms – from specific to general or from micro to macro – you cease to be able to explain aggregate profits. The graphs presented above will make no sense to you.

The question we are seeking to answer is not how much profit an individual firm makes in any period but

what determines the total volume of profits in a monetary economy in any given period. Marx focused on this question as did Polish economist Michal Kalecki among others.

It is a central concern of Modern Monetary Theory (MMT) and once we understand the answer we gain an appreciation of why budget deficits are usually essential.

The reason the earlier intuition about a firm’s profits would not be helpful in answering our aggregate question relates to what happens when a change at the individual level is applied to the general level.

If wages are cut at the individual firm level, then other things equal, the firm will likely be more competitive and be able to gain a larger market share and increase its overall profits. We can assume that the firm’s revenue will not fall sharply when its costs are reduced.

But we cannot sustain the other things equal assumption (revenue constant in this case) when we apply the wage cut at the aggregate level. It is a fallacy of composition to do so.

When wages are cut across the economy, costs fall for all firms but it is likely that revenues will also decline because wages typically drive consumption.

It is highly likely that overall profits will fall in this generalised situation.

This sort of reasoning forms the basis of Kalecki’s general model of profit determination (sometimes called the Kalecki Equation).

Kalecki initially used a very simple two-sector model (households and firms) to demonstrate that under simplifying assumptions about workers’ saving, economy-wide (gross) profits (P) is equal to the amount that capitalists spend on their own consumption plus gross investment.

Kalecki said that capitalists “get what they spend”.

I won’t repeat the derivation of that model – see Why budget deficits drive private profit.

So he could now analyse how the major components of aggregate demand (expenditure) impacted on corporate profits at the aggregate level.

He began with the familiar national income accounting identity (that is, it must hold as a matter of accounting:.

Total national income or GDP (Y) is given as:

Y = C + I + G + NX

where G is government spending and NX is net exports (total exports minus total imports). C is the aggregate of capitalists’ consumption (Cp) and workers’ consumption, which is total worker income post tax (Vn) minus workers’ saving (Sw). We assume no depreciation of capital.

So we could write this model as:

Y = Cp + (Vn – Sw) + I + G + NX

to recognise the different sources of total consumption.

Total income claimants on national income (Y) are:

Y = Pn + Vn + T

where P and V are as before (profits and total wages and salaries) but the subscript n denotes these flows are net of taxes paid, and T is total taxes.

This equation thus tells us about the distribution of national income between the government (who takes out taxes), workers (wages) and capitalists (profits).

We can integrate these two perspectives (or views) of GDP by setting the expenditure components of total income equal to the claims on total income to get:

Cp + (Vn – Sw) + I + G + NX = Pn + Vn + T

You will note that Gross Profits after tax (Pn) is in this equation and we can isolate it on the left-hand side (by re-arranging terms) as follows:

Pn = I + (G – T) + NX + Cp + Vn – Sw – Vn

So:

Pn = I + (G – T) + NX + Cp – Sw

which says in English, that gross profits after tax (Pn) equals gross investment (I), plus the budget deficit (G – T), plus the export surplus (NX), plus capitalists’ consumption (Cp) minus workers’ saving (Sw).

So gross profits after tax in the economy will be higher:

1. The higher is gross investment (I).

2. The larger the budget deficit (G – T).

3. The higher is capitalists’ consumption (Cp).

4. The lower is workers’ saving (Sw).

This model provides an array of useful insights into the dynamics of profits in the economy and how the external and government sectors impact.

There are many interesting distributional complexities that emerge which help us bring together microeconomic insights into a consistency with the macro constraints that this model demonstrates hold for the economy as a whole.

For example, when there are positive net exports and/or budget deficits, then gross net profits (Pn) will rise higher than the level that would be generated by gross investment and capitalist consumption.

When workers increase their saving, gross profits fall because less of the workers’ income is coming back to the firms as consumption spending. When, in Kalecki’s words – the workers spend what they get – that is, in his simple two-sector model workers are assumed not to save at all (Sw = 0), then the capitalist profits are maximised from this source (other things equal).

Also an individual domestic capitalist may be able to increase their net exports and will then be able to glean extra profits “at the expense of their foreign rivals”.

Kalecki said (in his 1965 book noted above, page 51):

It is from this point of view that the fight for foreign markets may be viewed.

The model also helps us understand the evolution of the data shown in the above graphs.

Budget deficit generates profits via their impact on national income. The budget deficit means that the private sector is receiving more flows from the government than it is returning via taxes.

Budget deficits provided an increased capacity for capitalists to realise their production because they expand the economy.

Kalecki said that budget deficits allow the capitalists to make profits (net exports constant) over and above what their own spending will generate.

The converse is also true – budget surpluses undermine private profits because firms revenue falls (if government spending is cut) and/or their costs rise (if taxes go up)

When the government runs a surplus it reduces profits via its squeeze on aggregate income.

This insight alone is why the business should be opposing fiscal austerity moves by various governments.

It doesn’t make any sense, for the business lobby groups to be calling for cuts in the budget deficits.

The only time that a rising budget deficit will not add to profits (in real terms) is if there is full capacity and the rising deficits push nominal aggregate demand beyond the real capacity of the economy to increase output and real income.

The fact that the business groups often lead the charge against budget deficits reflects the triumph of ideology over good judgement and the triumph of ignorance over understanding.

Conclusion

I am giving a presentation this afternoon (that is, Thursday afternoon New York time) at Bard College (where the Levy Institute of Economics is located) entitled “why Italy should meet the Eurozone”. I’m going to make the obvious points that a nation cannot grow in normal circumstances without some support from budget deficits. At present, given the state of private spending and a huge stockpiles of private debt outstanding, that fiscal support has to be very low in relative and historical terms.

The political leadership of the Eurozone are clearly intent on denying the nation access to this fiscal support. The latest Eurostat data is a stark testimony of what happens when the nation is choked by deficient aggregate demand. Fiscal austerity is another of the failed doctrines that has emerged from mainstream macroeconomics.

There can be no growth when both the private and public sectors are refusing to fuel the growth appropriate spending choices.

The UK Guardian article by Simon Jenkins (February 14, 2012) – Austerity fails, yet we’re too shy to think outside the box – provided some sobering commentary to finish this blog on:

It makes no sense to drive an economy into recession where it stops people from working and thus paying more taxes. Growth starts not with bank investment but with demand. It starts with more money flowing down the high street. Here the curse is not Weimar but a bank-obsessed Treasury, fighting war with antique weapons such as quantitative easing that disintegrate in their hands. They can bring themselves to print money for banks, but not for ordinary people – through scrappage schemes, vouchers, corporate job-creation projects and other such off-budget stimuluses tried abroad. These methods need have no more impact on budgetary austerity than does money given to banks. The failure to take economic management beyond the diktats of austerity has become the great intellectual treason of today. For three years it has trapped governments, economists, bankers and media in a collective miasma of panic about inflation. Thousands of citizens across Europe are having their lives ruined and their children’s prospects blighted because a financial elite, once burned, is too shy to think out of its box. It refuses to stimulate demand merely because that is not the done thing to do.

More journalists should follow this lead and start attacking the basis of this neo-liberal assault on decency.

The mainstream economists will laugh and make all sorts of rote-learned but empirically bereft accusations. Ignore them – they had their day in the sun – and in failing to see the crisis coming – they lost their right to a voice in this debate.

Saturday Quiz

The regular Saturday Quiz will be back sometime tomorrow. I might make it so hard that the demoralising effect will mean that readers won’t want to do it any more and then I won’t have to prepare it. (-:

And while you are doing the Quiz I will be flying long distances! I think I would rather be doing the Quiz.

That is enough for today!