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Three Reasons Why The Eurozone Recovery Will Be Poor

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The Eurozone economy is expected to collapse in 2020. In countries like Spain and Italy, the decline, more than 9%, will likely be much larger then emerging market economies. However, the key is to understand how and when will the eurozone economies recover.

There are three reasons why we should be concerned:

  1. The eurozone was already in a severe slowdown in 2019. Despite massive fiscal and monetary stimulus, negative rates, and the ECB balance sheet above 40% of GDP, France and Italy showed stagnation in the fourth quarter and Germany narrowly escaped recession. The eurozone weakness started already in 2017 and disappointing economic figures continued throughout the next years. Many governments blamed the weakness on the Brexit and Trade War cards, but it was significantly more structural. The eurozone abandoned all structural reforms in 2014 when the ECB started its quantitative easing program (QE) and expanded the balance sheet to record-levels. Manufacturing PMIs were already in contraction, government spending remained too high and the elevated tax wedge weighed on growth and jobs. In 2019, almost 22% of the eurozone GDP gross added value came from Travel & Leisure, a sector that will unlikely come back anytime soon, while the exporting sector is also likely to suffer a prolonged weakness.
  2. The banking sector is still weak. In the eurozone, 80% of the real economy is financed via the banking channel (compared to less than 15% in the United States). Eurozone banks still have more than 600 billion euro in non-performing loans (3.3% of total assets vs 1% in the U.S.), an almost unprofitable business with a poor return on tangible assets (ROTE) due to negative rates, and a significant challenge ahead, as most of the growth investments, in LatAm in particular, may reduce capital strength significantly in the next months. Most of the eurozone governments are relying on leveraging the banks’ balance sheets in their “recovery plans”. A massive increase in loans, even with some form of state guarantee, is likely to cause significant strains on lending capacity and solvency in the next years, even with massive TLTROs and capital requirement reductions.
  3. Most of the recovery plans go to government current spending, and tax increases will surely impact growth and jobs. The eurozone tax wedge on jobs and investment is already very high. According to the Paying Taxes 2019 report, the majority of eurozone economies show widely uncompetitive taxation levels. As most governments will massively increase deficits to combat the Covid-19 crisis, there is a high likelihood of a massive increase in taxes that will make it more difficult to attract investment growth and jobs. Most of the recovery plans are also aimed at bailing out the past and letting the future die. There are massive bailout packages for traditional conglomerates and industries, but investment in technology and R&D continues to have high burdens and no support. Considering that the eurozone was already in contraction in the middle of the massive Juncker plan (that mobilized more than 400 billion euro in investments) and the large green policies implemented, it is safe to say that relying on a Green New Deal will unlikely boost growth or reduce debt. The main problem of these large investment plans is that they are politically directed and, as such, have a large tendency to fail, as we saw with the Jobs and Growth Plan of 2009.

Almost 30% of the eurozone labor force is expected to be under some form of unemployment scheme, be it temporary, permanent, or self-employed cessation of activity. After a decade of recovery from the past crisis, the eurozone still had almost double the unemployment rate of its large peers, the US, or China. Germany may recover jobs fast, but France, Spain or Italy, with important rigidities and tax burdens on job creation may suffer large unemployment levels for longer.

The eurozone also faces important challenges into a recovery due to its lack of technological and intellectual property leadership. Those two factors will help China and the U.S. recover faster, as well as the reality of having more flexible jobs market and higher support for entrepreneurial activity through attractive taxation. Considering the severity of the crisis, the eurozone is likely to need at last 10% of its GDP o rebuild the economy, but that figure is almost completely absorbed by the traditional sectors (airlines, autos, agriculture, tourism). Furthermore, the New Green deal initiative includes severe restrictions to travel and energy-intensive industries that may act as a brake on future growth.

The ECB policy was already unnecessarily expansionary in the past years, and now it runs out of tools to address the unprecedented challenge of recovery post-Covid-19. With negative rates, targetted liquidity programs, asset purchases of private and public debt, and a balance sheet that exceeds 42% of GDP of the eurozone, the best it can do is to disguise some risk, not eliminate it. We should also warn of adding massive monetary imbalances when demand for euros globally is acceptable but shrinking according to the Bank of International Settlements, and risk of redenomination remains in a politically unstable eurozone.

Our estimates show that, even with large fiscal and monetary stimulus, the eurozone economy will not recover its output and jobs until 2023, and rising debt to record highs as well as monetary imbalances due to massive supply of euros in a diminishing demand environment, may cause significant problems for the stability of the eurozone.

The eurozone needs to understand that if it decides to increase taxes to address the rising debt due to the Covid-19 response, its ability to recover will be irreparably damaged.

Banks Will Not Bail Out The Economy

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These days, we hear a lot that banks were the problem in the 2008 crisis and now they are the part of the solution. 

Banking was not the main problem of the 2008 crisis, but one of the symptoms that indicated a more serious disease, the excess risk taken by public and private economic agents after massive interest rate cuts and direct incentives to take more debt coming from legislation as well as local and supranational regulation. Lehman Brothers was not a cause, it was a consequence of years of legislation and monetary policies that encouraged risk-taking.

The second part of the sentence, “now banks are the solution,” is dangerous. It starts from a wrong premise, that banks are stronger than ever and can bail out the global economy. Banking may be part of the solution, but we cannot place, as the eurozone is doing, the entire burden of the crisis on the banks’ balance sheet. I will explain why.

When economists in Europe talk endlessly about the differences in growth and success of monetary and fiscal policy between the United States and Europe, many ignore two key factors. In the United States, according to the St Louis Federal Reserve, less than 15% of the real economy is financed through the banking channel, in the European Union, it is almost 80%. In addition, in the United States, there is an open, diversified, more efficient and faster mechanism to clean non-performing loans and recapitalize the economy that adds to its high diversification in private non-bank financing channels. 

It is, therefore, essential that in periods of crisis countries, particularly in Europe, do not relax risk analysis mechanisms, because the economic recovery may be slowed down by ongoing problems in the financial sector and even lead to a banking crisis in the midterm. The worst measure that countries can take in a crisis is to force incentives to take a disproportionate risk.

European banking is stronger today than in 2008, but not as healthy as governments would like to believe. In recent years, the banking sector increased its top-quality capital ratios (CET1) at a rate of almost 1% per year despite the difficult economic environment in Europe, poor growth and, above all, negative interest rates that have decimated the sector’s margins and profits. However, a large part of that capital improvement has been achieved by issuing hybrid bonds (CoCos), which should be taken into account when considering hidden risks. CoCos can create a domino negative impact on the financial sector as a coupon on these instruments is paid only if core capital remains above a certain level. If the coupon is cut, the fragile capital structure of eurozone banks can deteriorate rapidly.

More than EUR104 billion of hybrid bonds (CoCos) are included in the calculation of eurozone banks’ core capital.
European banks have been able to strengthen their balance sheet and reduce risk in an environment of margin destruction via negative rates and suffocating regulation. The impact, according to Scope Ratings, has been very high, more than 25 billion euros in lost profits between 2014 and 2018. Analyzing the earnings of the financial sector (SX7E Index) between 2014 and 2019, the net income margin has fallen by 30%, earnings per share have fallen an average of 13% and the capitalization of the sector in the stock market is at record lows.

In such a difficult environment, the sector has reduced its non-performing loans (NPLs) by half to 636 billion euros according to the European Banking Association, that is 3% of total assets (as compared to 1% in US banks) while highest quality capital ratio (CET1) is at 14.8% and total capital ratio at 18.4% with leverage of 5.68%.

In the face of the Covid-19 crisis, European states have launched huge economic programs aimed at businesses and individuals, but the common denominator of all these programs is to exponentially leverage the balance of banks.

In my study “Monetary and Fiscal Policies In The Covid-19 Crisis. Will They Work? ” I explain how most of the European governments have made the decision to massively leverage the banks’ balance sheets through partially or totally state-guaranteed loans. However, we cannot forget that these are loans and that the vast majority go to businesses with enormous difficulties due to the forced closure of the economy, which in some cases means doubling the risk of banks.

Germany, for example, has taken fiscal measures equivalent to 4.5% of its GDP, but bank leverage measures via liquidity lines and loans equivalent to 24% of its GDP. In the case of France, fiscal measures of 2% of GDP and bank leverage ones of 14% of GDP. In Italy, 1.4% and 20% respectively, and in Spain, 1.4% and 8%.

I think the disproportion is obvious. European states are trying to bail-out the economy, closed by government decision, via a huge increase in debt and multiplying the risk on the banks’ balance sheet. The fact that governments guarantee part of these figures neither eliminates the risk nor moderates it, because these guarantees, if executed, will be paid with more debt and more taxes and, with it, less growth and investment.

European governments want banks to sip and blow at the same time. They require them to strengthen their balance sheets in an environment of negative interest rates and burdensome taxation, and at the same time, disproportionately increase credit taking a greater risk with lower profitability. Europe may face a bigger financial problem in the future because, contrary to what most governments expect, the probability of a rapid and V-shaped recovery of the eurozone economy is very low. If the economic recovery is weak and uneven, as is most likely, the rise in non-performing loans and weakening of banks will be substantial, and the impact on the real economy, severe.

Large stimulus is targetting the wrong sectors. Most of the massive loan plans is being absorbed by sectors that were already weak before the crisis due to obsolescence, technology and consumer pattern changes as well as overcapacity.

Another important factor to consider in these huge bail-out plans is the risk of allocating liquidity and capital to those who do not need it in the first place or, worse, to those who should not receive more credit. The vast majority of aid via loans granted by European states focus on sectors that were already “zombified” and with difficulties in 2016-2019, huge conglomerates and so-called strategic sectors that have never had a problem of credit. While zombie sectors are bailed-out, small businesses are dying at a rate of thousands per month. Spain, for example, has lost 122,000 businesses in March 2020, while billions of euro of grants were provided to traditional sectors that had overcapacity before the crisis.

The solution cannot come from huge loans to pay taxes in the future while praying for a V-shaped recovery. It must come through short-term liquidity lines without recourse and tax exemptions during the crisis added to a radical adjustment of non-essential budget items.

Governments cannot ask the real economy to hibernate and drown in debt, or demand large adjustments from the private sector while they keep unnecessary public spending and bloated budgets. 

Countries need to use the fiscal space they have to preserve the productive business fabric, not adding massive leverage, creating a problem in the financial sector in the medium term.

The reader may think that the solution would be a huge public bank that would bail out all sectors. 

The vast majority of productive sectors do not need to be rescued, they need governments to eliminate taxes during the lockdown and lift it quickly. Businesses are not falling due to mismanagement or bad strategies, they are collapsing due to the government-imposed shutdown.

The world has plenty of capital to finance the recovery and strengthen the economy. What the world does not need are politically directed recovery plans. Just allow investments to be channeled efficiently and quickly, not hinder it.

International studies show that public banks have worse solvency and liquidity ratios, in addition to political management. We do not have to remind anyone that two public entities, Freddie Mac and Fannie Mae, inflated the subprime bubble by lending without control and with political criteria to citizens without resources. 

European banks can survive the risks of the Covid-19 crisis, manage the loss of value of their current assets and the rise in non-performing loans, but the banking sector bail-out the entire eurozone economy from the mistakes in health and economic planning of governments.

Fighting the pandemic and preserving the productive fabric are not exclusive objectives. Burdening banks with multiplied risks can create a bigger, long-term problem.

The U.S. Labour Market Can Heal Quickly, the European, Less So

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This article was published at The Epoch Times here.

The jobless claims figures of the past two weeks have been unprecedented and alarming. However, knowing that the data will continue to be concerning, we need to analyze how quickly the economy can can heal and go back to the previous path of record job creation.

The United States economy starts from a comparatively stronger base. Unemployment reached a five-decade low in February and, despite the extremely weak March jobs figure, it stood at 4.4 percent in the first week of April. This compares to a 7.3 percent unemployment figure in the euro area and 6.5 percent in the European Union. In countries such as Spain and Greece, unemployment stood at 13 percent and 16 percent, respectively.

The underemployment figure is also significantly better in the United States. The unadjusted U-6 unemployment rate measure was 8.9 percent in March, and a comparable underemployment rate in the European Union would be an estimated 15 percent, and 12 percent in the eurozone, according to Eurostat figures.

The expected rise in unemployment from the forced shutdown of major economies due to COVID-19 containment measures is simply staggering. The International Labor Organization reported that potential job losses worldwide could amount to 36 million. Unfortunately, this figure may be underestimated.

The figure of unemployed in the second quarter of 2020 in the United States could rise to 52 million, a 32 percent unemployment rate, according to the Federal Reserve Bank of St. Louis. In Spain alone, the figure could rise by 5 million, and reach an unemployment rate of 35 percent in our estimates, while temporary and full unemployed could rise to 57 million in the European Union.


The key to a strong recovery lies in the dynamism of the labor market and the strength of the business fabric, but also on a diversified and open mechanism of financing of the real economy.

The United States could recover the entire job losses of a month in a period of one to three months. In the eurozone, this would take a minimum of five to six months, particularly in Germany, which also started the shutdown crisis with an all-time low unemployment rate, at 3.2 percent. Considering countries with higher labor market rigidity, such as Greece, Spain or Italy, this recovery could take between 14 months and two years.

The key to recovering jobs quickly and efficiently is the combination of a flexible labor market, an attractive investment framework, and solid policies to preserve the business fabric of the country. These are the main reasons why the United States traditionally reduces unemployment faster and with better wage growth than the eurozone.

There’s also the issue of disincentives. In the eurozone, excessive intervention in the labor and business environment adds to many entitlement programs that may be counterproductive in a recovery. The European Union spends about 1 percent of GDP per year in “active employment programs” and subsidies, yet the unemployment rate is almost double that of leading economies.

Excessive regulation works as a barrier to investment and job creation in growth times and generates negative incentives to recover after crisis periods. This was evident during the last crisis. The European Union delayed its recovery by four years due to the increased intervention and regulatory hurdles.

The financing mechanism is also key. In the United States, the real economy relies less on bank financing than in most of Europe. The real economy dependence on bank financing in the European Union is close to 80 percent, according to the European Central Bank, compared to 17 percent in the United States, according to the Federal Reserve Board.

This dynamism and openness in financing of business opportunities has traditionally helped the United States boost its economic recovery from a recession, achieving faster growth and more job creation than its peers.

An attractive taxation system is essential to recovering quickly. Unfortunately, in the European Union governments tend to raise taxes on businesses and capital in recession periods, which significantly hurts the recovery process. Legal and investment security are also fundamental in a sustainable and rapid recovery, and, unfortunately, interventionist messages coming from governments generate less inflow of foreign investment and lower growth in gross capital formation.

The recent decision of the Italian and Spanish governments to make dismissals forbidden by law and to intervene in prices will likely prove ineffective, as unemployment will soar anyway due to the destruction of businesses forced to close and will likely harm future investment inflows.

Shutting down the economy may cause long-lasting damage to job creation and businesses that can’t be unwound in a few months; that’s why it’s essential to contain the virus spread with effective measures, but we can’t forget that each month of lockdown means millions of unemployed and thousands of business closures.

The best course of action to tackle the health crisis, as well as the economic collapse risk, is to follow the South Korea and Singapore strategy, which is to implement strict prevention and testing measures, preserve the business fabric, provide safety equipment and health protocols for businesses to survive, and ensure that the economy continues to work while controlling the health crisis.

We can’t forget the difficult time that millions of workers and thousands of businesses are going through, and that’s why it’s imperative for governments to preserve the business fabric to avoid an economic depression of long-lasting social consequences.

The United States can recover the recent dramatic jobless figures in a few months if the government tackles the health crisis effectively and prevents an economic depression.

Health and jobs are not mutually exclusive. The United States will recover faster and stronger if the government puts both as the main objectives of policy.

U.S. Budget: Spending Is The Problem

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Every time there is a budget debate, politicians from both parties will discuss the deficit and spending as if the first one did not matter and the latter could only increase. However, the main problem of the US budget in the past four decades is that total outlays rise significantly faster than receipts no matter what the economic growth or revenue stream does. For example, in the fiscal years 2018 and 2019 total outlays rose mostly due to mandatory expenses in Social Security, Medicare, and Medicaid. No tax revenue measure would have covered that amount.

Total outlays were $4,447 billion in 2019, $339 billion above those in FY 2018, an 8.2 percent increase. No serious economist can believe that any tax increase would have generated more than $300 billion of new and additional revenues every year.

The idea that eliminating the tax cuts would have solved the deficit is clearly debunked by history and mathematics. There is no way in which any form of revenue measure would have covered a $339 billion spending increase.

 

 

No serious economist can believe that keeping uncompetitive tax rates well above the average of the OECD would have generated more revenues in a global slowdown. If anything, a combination of higher taxes and weaker growth would have made the deficit even worse. Why do we know that? Because it is exactly what has happened in the Eurozone countries that decided to raise taxes in a slowdown and it is also what all of us witnessed in the United States when revenue measures were implemented.

The US was maintaining a completely uncompetitive and disproportionately high corporate income tax (one of the highest in the world) and all it did was to make it similar to other countries (the Nordic countries have corporate income tax rates of 21.4% Sweden and 22% Denmark, for example).

What happened to corporate tax receipts before the tax cut? The evidence of a weakening operating profit environment: Corporate tax receipts fell 1% in 2017 and 13% in 2016. The manufacturing and operating profit recessions were already evident before the tax cuts. If anything, reducing the corporate rate helped companies hire more and recover, which in turn made total fiscal revenues rise by $13 billion to $3,328 billion in the fiscal year 2018, and rise by $133 billion in 2019, to $ 3,462 billion, both above budget, according to the CBO. Remember also that critics of the tax cuts expected total receipts to fall, not increase.

Mandatory spending is now at $2 trillion of a total of $4.45 trillion outlays for the fiscal year 2019.  This figure is projected to increase to $3.3 trillion by 2023. Even if discretionary spending stays flat, total outlays are estimated to increase by more than $1 trillion, significantly above any measure of tax revenues, and that is without considering a possible recession.

Any politician should understand that it is simply impossible to collect an additional $1 trillion per year over and above what are already record-high receipts.

For 2020, tax receipts are estimated at $3,472 billion compared to $4,473 billion in outlays, which means a $1,001 billion deficit. With outlays consistently above 20% of GDP and receipts at 16.5% average, anyone can understand that any recession will bring the gap wider and deficits even higher.

Deficits mean more taxes or more inflation in the future. Both hurt the middle class the most. More government spending means more deficit, more debt, and less growth.

When candidates promise more “real money” for higher spending they are not talking of real money. They talk of real debt, which means less real money into future schools, future housing, and future healthcare at the expense of our grandchildren’s salaries and wealth. More government and more debt is less prosperity.

Anyone who thinks that this gap can be reduced by massively hiking taxes is not understanding the US economy and the global situation. It would lead to job destruction, corporate relocation to other countries and lower investment. However, even in the most optimistic estimates of tax revenues coming from some politicians, the revenue-spending gap is not even closed, let alone a net reduction in debt. The proof that the US problem is a spending issue is that even those who propose massive tax hikes are not expecting to eliminate the deficit, let alone reduce debt, that is why they add massive money printing to their magic solutions.

Now, let us ask ourselves one question: If the solution to the US debt and deficit is to print masses of money, why do they propose to increase taxes? If printing money was the solution, the Democrats should have massive tax cuts in their program. The reality is that neither tax hikes nor monetary insanity will curb the deficit trend.

No tax hike will solve the deficit problem. Even less when those tax hikes are supposed to finance even more expenses. No amount of money printing will solve the financial imbalances of the US, it only increases the problem. If money printing was the solution, Argentina would be the highest growing economy in the world.

If the US wants to curb its debt before it generates a Eurozone-type crisis that leads to stagnation and high unemployment, the government needs to really cut spending, because deficits are soaring due to ballooning mandatory outlays, not due to tax cuts.