Europe: caught in a trap

27 July by Michael Roberts


The major economies are moving closer to recession, if they are not already there; and yet inflation rates continue to rise (for now). The latest surveys of business activity, called Purchasing Managers Indexes (PMIs), show that both the Euro area and the US are now in contraction territory (i.e. any level below 50).

The composite PMIs (which put together both manufacturing and services) for the major economies in July show:

US 47.5 (contraction)
Eurozone 49.4 (contraction)
Japan 50.6 (slowing expansion)
Germany 48.0 (contraction)
UK 52.8 (slowing expansion)

Nobody should be surprised by the Eurozone score, given the impact of sanctions on Russian energy imports, which is severely weakening industrial production in the core of Europe (see below). Germany’s industrial production has been contracting for over three months.

The big shock was in the US. The US composite PMI also fell into contraction territory at 47.5 in July, down sharply from 52.3 in June to signal a solid fall in private sector output. The rate of decline was the sharpest since the initial stages of the pandemic in May 2020, as both manufacturers and service providers reported subdued demand conditions. So just as we enter the second half of 2022, US business activity is diving.

And according to the latest estimate of real GDP GDP
Gross Domestic Product
Gross Domestic Product is an aggregate measure of total production within a given territory equal to the sum of the gross values added. The measure is notoriously incomplete; for example it does not take into account any activity that does not enter into a commercial exchange. The GDP takes into account both the production of goods and the production of services. Economic growth is defined as the variation of the GDP from one period to another.
growth by the Atlanta Federal Reserve FED
Federal Reserve
Officially, Federal Reserve System, is the United States’ central bank created in 1913 by the ’Federal Reserve Act’, also called the ’Owen-Glass Act’, after a series of banking crises, particularly the ’Bank Panic’ of 1907.

FED – decentralized central bank : http://www.federalreserve.gov/
Bank GDP NOW model, in the three months to June, the US economy contracted at a -1.6% annualized rate, matching a similar fall of -1.6% in the first quarter. If this estimate is confirmed next week, it would mean that the US was technically in recession.

The current response to this claim is: how can the US economy be in recession or close to it, when the unemployment rate is near all-time lows and payrolls keep on rising? But this response is dubious to say the least. First, there are two measures of employment for the US: the payroll figures and the household survey (a survey of households with jobs). The latter is currently showing the opposite of the former, namely a fall in the number of Americans at work. On this household measure, the labor force shrank, declining from 164.376 million to 164.023 million, and the participation rate (those in work compared to the total working age population) dropped more than expected to 62.2% – graph below.

Also, the initial jobless claims (the number of people claiming benefits because they are out of work) are now on a steady rise.

And the number of new jobs available (called JOLTS) have peaked.

Second, and most important, unemployment is a lagging indicator in a recession. The leading indicator is the movement in corporate profits and business investment, followed by production and then unemployment. Employment comes last because it rises only when corporations stop taking on more labour and begin to reduce their workforce. And they only do this when profitability and production start to fall away. And, after reaching all-time highs, profit Profit The positive gain yielded from a company’s activity. Net profit is profit after tax. Distributable profit is the part of the net profit which can be distributed to the shareholders. margins have begun to fall.

During the COVID slump, profits rose sharply compared to wages and acted as the driver and gainer in rising inflation. Now that is beginning to change as profits are squeezed by rising components costs and weakening demand.

But it is in Europe that the evidence for an outright slump is most convincing. And it’s not just the data on economic growth that support that. In addition, Europe faces a huge squeeze on energy production and imports as the sanctions being applied on Russian gas and oil imports will not be sufficiently compensated for by imports from elsewhere.

Many German manufacturers are warning that they will have to close down production completely if energy inputs dry up. Petr Cingr, the chief executive of Germany’s largest ammonia producing company, and a key supplier of fertilisers and exhaust fluids for diesel engines, warned of the devastating consequences of the ending of Russian gas supplies. “We have to stop [production] immediately,” he said, “from 100 to zero.” According to UBS analysts, no gas for the winter will result in a “deep recession” with GDP contracting 6 percent by the end of next year. Germany’s Bundesbank has warned that the effects on global supply chains of any Russian cut-off would increase the original shock effect by two and a half times. ThyssenKrupp, Germany’s largest steelmaker, has said that without natural gas to run its furnaces “shutdowns and technical damage to our facilities cannot be ruled out.”

And it’s worse. Inflation Inflation The cumulated rise of prices as a whole (e.g. a rise in the price of petroleum, eventually leading to a rise in salaries, then to the rise of other prices, etc.). Inflation implies a fall in the value of money since, as time goes by, larger sums are required to purchase particular items. This is the reason why corporate-driven policies seek to keep inflation down. is still rising in most European economies. So the European Central Bank Central Bank The establishment which in a given State is in charge of issuing bank notes and controlling the volume of currency and credit. In France, it is the Banque de France which assumes this role under the auspices of the European Central Bank (see ECB) while in the UK it is the Bank of England.

ECB : http://www.bankofengland.co.uk/Pages/home.aspx
(ECB ECB
European Central Bank
The European Central Bank is a European institution based in Frankfurt, founded in 1998, to which the countries of the Eurozone have transferred their monetary powers. Its official role is to ensure price stability by combating inflation within that Zone. Its three decision-making organs (the Executive Board, the Governing Council and the General Council) are composed of governors of the central banks of the member states and/or recognized specialists. According to its statutes, it is politically ‘independent’ but it is directly influenced by the world of finance.

https://www.ecb.europa.eu/ecb/html/index.en.html
) has decided that it must act to raise interest rates Interest rates When A lends money to B, B repays the amount lent by A (the capital) as well as a supplementary sum known as interest, so that A has an interest in agreeing to this financial operation. The interest is determined by the interest rate, which may be high or low. To take a very simple example: if A borrows 100 million dollars for 10 years at a fixed interest rate of 5%, the first year he will repay a tenth of the capital initially borrowed (10 million dollars) plus 5% of the capital owed, i.e. 5 million dollars, that is a total of 15 million dollars. In the second year, he will again repay 10% of the capital borrowed, but the 5% now only applies to the remaining 90 million dollars still due, i.e. 4.5 million dollars, or a total of 14.5 million dollars. And so on, until the tenth year when he will repay the last 10 million dollars, plus 5% of that remaining 10 million dollars, i.e. 0.5 million dollars, giving a total of 10.5 million dollars. Over 10 years, the total amount repaid will come to 127.5 million dollars. The repayment of the capital is not usually made in equal instalments. In the initial years, the repayment concerns mainly the interest, and the proportion of capital repaid increases over the years. In this case, if repayments are stopped, the capital still due is higher…

The nominal interest rate is the rate at which the loan is contracted. The real interest rate is the nominal rate reduced by the rate of inflation.
sharply. It pushed up its policy rate by 50bp last week, more than expected, taking the rate into positive territory for the first time in a decade. The days of ‘quantitative easing’ have been replaced by ‘quantitative tightening’.

But this move comes at the worst time for countries like Italy, highly dependent on Russian energy. Last week, the technocrat former ECB chair, Italian prime minister Mario Draghi was forced to resign when several parties in his coalition government withdrew their support; some because they opposed his support for military aid to Ukraine; and some because they saw their chance to win an election. Italy has a very large public debt ratio to its GDP.

Up to now, the interest Interest An amount paid in remuneration of an investment or received by a lender. Interest is calculated on the amount of the capital invested or borrowed, the duration of the operation and the rate that has been set. costs of servicing that debt have been low because interest rates have been kept low by the ECB, which has also provided billions of credit to Eurozone governments. But now interest rates are on the rise and investors in Italian government bonds have become worried that Italy (especially one without a viable government) may find it difficult to service these debts. So the yield Yield The income return on an investment. This refers to the interest or dividends received from a security and is usually expressed annually as a percentage based on the investment’s cost, its current market value or its face value. on the Italian 10-year bonds surged to above 3.5%. The fall of the Italian government also threatens the distribution of billions of euros from EU Covid recovery funds, supposedly going to Italy next year to boost its economic growth.

So Europe’s economy is going down just as the ECB hikes rates to control inflation. As I have explained in previous posts, raising interest rates to control rising inflation caused by weak supply and productivity and the Ukraine war will not work, except to provoke a slump.

The ECB has now resorted to a desperate measure in introducing a transmission protection instrument (TPI), a new form of credit that will be doled out to governments like Italy if their bond Bond A bond is a stake in a debt issued by a company or governmental body. The holder of the bond, the creditor, is entitled to interest and reimbursement of the principal. If the company is listed, the holder can also sell the bond on a stock-exchange. prices collapse. However, this may never be used because it would mean the ECB would be providing open-ended financing of Italy’s fiscal spending, something likely to be against all the ‘Maastricht’ rules for the Eurozone.

The ECB is caught in what one analyst called a “nightmare scenario”. The deputy head of the Brussels-based Bruegel economic think tank, Maria Demertzis said, “The risk ahead of us is that because of the energy crisis, the euro area could end up in recession, while at the same time the ECB will have to keep raising rates if inflation does not come down.” Krishna Guha, head of policy and central bank strategy at US investment bank Evercore, said: “The combination of a brewing giant stagflationary shock from weaponised Russian natural gas and a political crisis in Italy is about as close to a perfect storm as can be imagined for the ECB.”




Michael Roberts

has worked in the City of London for over 30 years as an economist. He is author of several books on the world economy: The Great Recession, The Long Depression and World in Crisis. He blogs at thenextrecession.wordpress.com

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