The IMF recently reported concerns with excess debt. Conversely, economists and publications report Europe’s public infrastructure deficit is setting back the Old Continent’s productivity gains relative to the frontier. Others argue otherwise, that investment and regulatory reform should combine to favour a Renaissance of European industry and innovation.
Historically high Financial Account surpluses and low Central Bank rates reduced the real return rate of portfolio investment within the EU.
Whether European legislators choose to strengthen investment and otherwise, the role of other factors such as improvement to management processes that induce TFP.
Europe should consider how it invests where TFP is not tracking GDP growth. Spurts of growth far and beyond TFP may indicated overheating economies, even if “masked” by low real interest rates.
UPDATE: @LJKawa just notice how low this return can go “Federal Reserve officials and Wall Street are ramping up their warnings about an inversion of the Treasury curve. When long-term yields dip below shorter-term counterparts, it’s usually been a sign that a recession is nigh.”
Newspapers and blogs are crammed with stories about the dismantlement of world’s multilateral value chains. The world’s current commerce setup results of the need to restore the currency peg after WWII.
White’s idea of restoring the peg through limited loans and redistributive commerce opposed Keynes’ capital controls and an effectively unlimited Fund. By safeguarding the dollar’s contribution to the clearing mechanism, White effectively let commercial exchanges clear current account deficits.
Gavin Davies reports this morning that Eurozone readings several measures of economic pace are slowing down. Mr Davies notices that either ECB stimulus effects are waning or the economy is returning to its long term growth trend below 2%.
Either way, it’s the wrong news – the main question is what were the Member-States growing faster than supposed?
The IMF has recently advanced a very substantial draft of what could become a European capital re-allocation fund. It is, as usual, excellent in presenting sound economics achievable in policy terms (even if in political terms the case is not so clear).
The fund indirectly addresses the Triffin dilemma that is characteristic of currency Unions. Within the currency union that does not intend to become the reserve currency but rather a surrogate commodity, a deficit must be created if the Union as a whole is to achieve a current account surplus.
American-Belgian Robert Triffin rightly observed that the reference currency of the world must be so abundant that, bar unpegging, the country issuing it must run a current account deficit that effectively makes that currency available to importers. The dilemma was unravelled by President Richard Nixon by unpegging the USD and effectively instating fractional banking that converted currency from a banking liability to an asset payable in upcoming years. Debt ballooned.
As the chart above illustrates, when goods’ exchanges between countries are considered, the Euro is the world’s currency. Hence, whereas the Triffin dilemma was solved neatly with fractional banking for the USD (the linked WTO paper estimates about half the world’s transactions, including interest rate swaps, are denominated in USD), it remains significant for the Eurozone.
The main implication of Triffin’s Dillema is that is that a current account surplus is equivalent to a capital account (now financial account) deficit. As the economics 101 link clearly presents, the Euro area banking system must effectively outflow capital abroad to finance purchases of Euro goods. For banking purposes, lending is an asset (repayable in upcoming years) – yet whereas the production of goods is integrated across the EU (with partial spatial concentration except for industries where labour cost is a significant portion of value added such as the automobile industry) commodity capital’s allocation is not distributed with the same rules.
Compared with other manufacturing industries, compensation in the auto industry is high relative to value added. Or, put another way, other manufacturing industries show higher value added per unit of worker compensation.
Before considering how capital is allocated, a word of caution on inter-industry and inter-industry integration (cf Box 2.1 for a clear definition of both): it’s difficult to properly disentangle both, particularly between vertical and horizontal intra-industry integration (IIT). As Ricardo hints, when capital and labour move freely, allocations of each equate and single-good exchanges fade – the EU leads to IIT to a greater or lesser extent.
Expectably, as industry is integrated across the EU regardless of individual Member-State initial emdowments, it becomes plausible that both the EU as a whole and individual Member-States produce what countries elsewhere want to purchase – hence the persistent current account surplus is observable not only in aggregate but also in (most) individual Member-States.
Conversely, as expected, the net foreign asset position is negative for the EU
as an accumulated measure of negative capital account flows
What is retainable from these charts is that
The balance of the current capital accounts balance determine the exposure of an economy to the rest of the world, whereas the financial account explains how it is financed. Ideally, the balance of the current and capital accounts should equal the total net of the financial account, otherwise net errors and omissions were recorded.
Expectably, the financial account is positive in most countries while only a few Member-States outflows/inflows compensate others’ CA+CapA – namely Germany and France, whose outflows/inflows compensate others’ surplus/deficits.
The financial account presents outflows corresponding to the current account surplus
but the distribution of financial outflows and goods/services surplus is not the same. That is, Member-States are typically earning more from inflows through the current account than exporting capital through financial account. Either way, the concentration of capital is significant as small exporting Nations typically retaining capital while small importing Nations further erode their Net Foreign Assets Position.
Furthermore, the net position of current, financial and capital accounts is a good (if insufficient) explanatory variable of net foreign assets year-on-year.
Excluding Finland and the Czech Republic, the weight of current account in net foreign assets indicated an equal sign change in net foreign assets.
The financial effect shouldn’t be disregarded when considering these figures:
Capital gains/losses are influenced by exchange rates, but also by the relative price developments in domestic and foreign assets, especially equities, although bond prices may also play a role in the event of substantial interest-rate increases.
Hence within a current account surplus currency Union that fully issues currency to fund goods and services sold abroad, as is the case of the Euro Area, changes in net foreign assets are a good indicator of inequalities within the system.
The unevenness of current and capital account attests to the mobility of capital compared with other input factors. Most European Union Member-States do not report on net foreign assets owned or owed within the Union. It seems significant that 6 out of the 28 report smaller financial account than current account flows; except for Germany and Austria, these 6 Member-States hold negative net foreign assets positions, implying an effective subsidy (rather than an intra-EU loss of competitiveness) to other current account surplus Member-States. Finland and Ireland are amongst acute cases that effectively sell abroad and “free-ride” on other Member-States’ funding through financial account outflows.
Central Fiscal Capacity
These observations are pertinent as the IMF anchors the fiscal capacity (following a Neo-Keynesenian model) instrument in unemployment. Following Kaldor-Verdoorn the growth of employment is inextricably linked to GDP hence it serves as an adequate proxy to impending output contractions. The IMF suggests a negative difference to the seven-year moving average indicates an imminent output contraction and links this indicator to capital flows from the Central Fiscal Capacity (CFC) instrument to the Member-State (or States) where it is observed.
The indicator does make sense if it weren’t for the relatively low labour mobility rate within the EU. Either endogenously or exogenously, a contraction in output should draw down on net foreign assets considering effective automatic stabilisers. As the ECB explains
When the global financial crisis erupted, many euro area debtor countries witnessed a “sudden stop” of private capital inflows. International investors were no longer willing to finance the large current account deficits in these economies or to roll over legacy debt. This was only partly cushioned by official financial inflows, such as EU-IMF programme loans and changes in TARGET2 balances.
The CFC “would improve stabilization through contributions and transfers that counterbalance fluctuations in revenue and cyclical spending. It would help countries adhere as smoothly as possible to their medium-term spending plans. Contributions to the CFC would come from national budgets.” (Source: A Central Fiscal Stabilization Capacity for the Euro Area) What is questionable is whether unemployment is a cause or a consequence of economic malaise – I argue the latter.
A different indicator
The purpose of a fiscal stabilisation instrument is adequately justified when observing what happened after 2010
and further attested by initiatives such as InvestEU.
Cuts in investment are preferred by Governments for financial reasons as firm-level productivity improvements resulting from infrastructure spending do not drastically increase government revenues.
Yet with only 14% of employment being self-employment firms’ reaction to exogenous or endogenous shocks is bound to significantly impact Government revenues. Concurrently, Government consumption and expenditure represents a quarter of the economy thus its impact on firms, and the propensity for a virtuous cycle, is significant.
From the previous section, it is possible to understand firms’ exports are inextricably linked to exogenous factors both intra-EU and extra-EU. Government spending is thus vital to smooth the economic cycle when exogenous factors inhibit firm growth.
Furthermore, the current net foreign asset position, assessed in conjunction with financial account flows, anchors Member-States’ budget contribution to macroeconomics. As an expenditure item, fiscally neutral contributions to CFC could only result of either current account surpluses or productivity improvements (following Kaldor-Verdoorn’s correspondence between output and employment growth).
This reasoning is strengthened by the low probability of a demographic shock compared with the high probability of a financial or economic shock. Considering most Member-States’ do not directly control their firms’ ability to export (from either a macro or microeconomic perspective), containing borrowing interest rates through both growth and downturn becomes of paramount importance. The CFC’s cycle smoothening indirectly contains borrowing costs – yet intervening when these impair firms’ activities would directly contain cyclical unemployment.
Modelling the CFC’s unemployment indicator
The difference to the seven-year moving average of the unemployment rate can be easily plotted for the United States, courtesy of the St. Louis Fed. Using US data is a comfort rather than methodological choice as datasets are easily accessible in the same interface, FRED.
Differences with the seven-year moving average of unemployment and GDP plot an inverted signal relation. While CFC serves its purpose as a fiscal top-up, it would’ve not acted counter cyclically in 2005.
To increase the forecast value of the instruments’ disbursement mechanism, an indicator that exhibits high correlation with GDP would have to be employed – for instance investment intensity of GVA. The firms’ GVA to Investment ratio renders an image of both supply and demand shocks when considering its microfoundations.
Firms investing more than previously are likely to subsequently reap benefits by increasing returns. Conversely, forefront returns without investment are unlikely to last without a recession, hinting at high indebtedness and low productivity. Furthermore, it binds with the macroeconomic asymmetry of the EU’s current account surplus in that financial account inflows impair primarily investment but also GVA through higher interest rates of both firms and Member-States.
The 1979-2017 average is plotted for each unemployment and investment intensity. Considering the US downturns of 1980, 1981-2, 1990-1, 2001 and 2007-9, the indicator would’ve been most valuable in anticipating a downturn in both 2001 and 2007. The prolonged and pronounced downturn of returns to investment from above the 1979-2017 average was an index to investment inneficiency. It forecast an increase of unemployment by at least 4 years in 2001 and 2 years in 2007. Pronounced decreases or increases seem positively correlated with unemployment. The unemployment indicator tracked investment intensity of GVA by a year in 2000 and two years on 2017.
What does it tell us about today?
So far, not much. As investment increases, unemployment shall continue it’s downward trend. When GVA becomes more pronounced in the ratio and inverts its trend (tapering was announced in 2013 and became effective in 2014, compensated by interest rates increases in December 2015 that consolidated firms’ returns from term deposits and Treasuries) a burst of unemployment should follow in 4 to 8 quarters.
Similar charts for the Euro area (data is available from 1995 onwards) plot the same quality of GVA/I in forecasting unemployment. The Euro area seems to follow the same downward trajectory for both indicators the US followed in 2012.
In a nutshell
Compensating social transfers is good, preventing them from being needed is better.
If Member-States’ financial account netted current account, even capital allocation would ensure investment increases with capital inflows, leading to higher employment and GVA. As productivity increased, exports and financial account outflows would follow, increasing interest rates and containing employment growth. Exports would attract FDI, reducing the capital account deficit and netting the current account surplus. Persistent current account surpluses lead to lower interest rates.
Yet, the financial account deficit (and lower domestic interest rates) exert pressure in the opposite direction as domestic capital (and hence opportunities for return) become scarce. Lower domestic investment would reduce productivity gains and lower export competitiveness, netting out the current account surplus.
By keeping both current and financial account surpluses, European exporting Nations are effectively lowering domestic interest rates and anchoring them with more capital inflows.
Mallaby identifies Europe’s challenges with the lack of fiscal transfers between surplus and deficit Member-States, and an insurance against bank failures. Both assume markets are inneficient in allocating capital and we could safely assume so when considering Target (the ECB-managed set of accounts that depicts the unequal transfers between Member-States).
Mallaby also suggests labour costs won’t adjust considering Europe’s significantly cross-border lower labour mobility.
We’ve known since Ricardo markets clear in currency Unions whenasset endowments and prices are free-float. With fiat currency, that means either currency issuance or factor allocation is free – hence Mallaby’s worry about capital mobility (between successful and less successful countries, through banks) and labour mobility (that Mallaby contrasts with the US).
It just so happens DGSE models applied to Europe miss the crux of firm growth in the Old Continent: how we understand welfare to be maximised and how we defend through our competition policy.
European competition laws are thought so as to stimulate welfare maximising asset allocation. State Aid, for instance, epithomises exactly why competitive taxation is tolerated: State size matters and so does State’s capacity to influence capital within it’s jurisdiction.
Bruegel’s Event on Inclusive Growth in the European Union was an excellent opportunity to learn more about growth asymmetries and factors leading to it. The second session was particularly relevant to those looking into macroeconomic factors of inequality.
The session reflected upon technology and its role in shaping labour markets and wages. Professor Dalia Marin presented interesting research on how the United States and Europe contrast when automating manufacturing. Professor Marin presented how wage convergence in some countries in Europe regardless of skills, and low-skill premium in other countries, contrasted with increasing inequality amongst low-, medium- and high-skill labour in the United States. Professor Marin concludes the skill premium in Europe is declining because Europe has invested more in education than the US, where the technology premium is higher. Thus in Europe it would not make sense to push for more Higher Education as the premium for attaining it is quite low – thus redirecting the issue from skilled-labour/unskilled-labour to capital/labour.
I couldn’t help but ask: how may firms endogenise these benefits? And is the role of Government in this redistribution?
In her reply, Professor Marin was explicit in saying the replacement is between capital and labour. And that the United States epitomise the phenomenon. And that governments have as much leeway in regulating the change.
I made my case poorly – and so here goes a clearer reasoning for the question.