Economics and politics - comment and analysis

Fixed investment is the critical point – and the analyses on this are more than meagre

Now even the Federal Minister of Economics knows: Germany is facing a recession. But the recession, he says immediately, will not be so bad and in 2024 things will pick up again. That’s honest policy, we don’t sugarcoat anything, we look the harsh reality firmly in the eye, but then, we are quite sure, it will be good again very quickly.

Forecasts for one year are already extremely difficult to impossible, forecasts for the year after the first year are pure fantasy. But because they are so fantastic, things always go up. I have never seen a forecast where the second year went further down. So let’s forget about the second year! That leaves the recession. A recession at a time when the European and German economies have not yet fully recovered from the severe Corona shock is definitely a disaster.

Already this year is a lost year. The forecasters had promised a big upswing for this year, with GDP growth rates of up to five percent. That has failed before, for whatever reason. Now a recession, of which, crucially, no one knows how deep it will be and how long it will last. With his own forecast of minus 0.4 percent, the Federal Minister of Economics is largely following the institutes’ prognosis. In doing so, he is also making the grandiose analytical mistakes of the neoclassical economists – presumably without realising it.

Collapse of investment?

The big danger, which no one wants to write down, is a deep slump in business investment. For machinery and equipment in particular (but also for so-called other fixed investments), both the BMWK and the institutes are extremely optimistic. The institutes expect real growth rates of 2.7 and 5.7 per cent for equipment in the next two years, the BMWK even 3.6 and 5.8 per cent.

There is nothing to suggest that this will happen, unless you have a theory that suggests things are still going quite well for businesses. Many company leaders in Germany and elsewhere would be astonished to read in the Joint Economic Forecast that their financing conditions “measured primarily by longer-term real interest rates” are now “gradually” deteriorating (p.36).

And the IMF, which has just published its autumn forecast, also finds that real policy rates (i.e. interest rates set in real terms by the central bank) are still below the pre-pandemic level because high inflation rates have “outstripped” interest rate hikes (p. 5 and Chart 1.10). In the IMF’s chart, one can easily see that real short-term interest rates are still clearly in negative territory in Q4 2022, which means nothing other than assuming that companies not only do not have to pay interest “in real terms”, but get something extra when they take out a loan.

What is a real interest rate?

However, using the inflation rate in the way the institutes and the IMF do is not justified and must lead to great confusion and eventually to incorrect forecasts. To understand the context, one must remember what the statistical artefact inflation rate was created for. Its sole purpose was to measure the change in the purchasing power of selected average households. For a given money income, purchasing power is higher or lower depending on whether the prices of the basket of goods that the household typically buys go down or up. So far, so simple.

But when you “deflate” an interest rate, as it is usually called, the statement you are implicitly making is far less clear. A company that takes out a loan that has to be repaid in nominal terms and whose interest rate is expressed in nominal terms has to take into account various factors that make it possible for it to pay the interest and repay it. The general rate of inflation in the national economy is not one of them. Of course, the prices the investor hopes to obtain for his products play a role. But whether and how they are related to the general inflation rate is not important for the entrepreneur.

Of course, it can still be the case that the prices of domestic companies develop grosso modo like the domestic inflation rate. Then and only then can one “deflate” in order to get a feeling for the real burden of interest payments on enterprises, although even then many other factors, such as the general development of the economy, play at least as great a role as the general development of prices for the returns per unit of capital (i.e. what the investor compares with interest) for the mass of enterprises.

But we do not have such easy times right now. A large part of the current inflation rate, as has been widely described, is not attributable to price increases by domestic companies, but comes from outside. Germany’s terms of trade (and those of most industrialised countries) have deteriorated drastically, which means that for all economic entities in Germany, including German companies, goods from abroad have become more expensive than before, including all intermediate inputs that we buy from abroad and which, such as energy sources, cannot be replaced by domestic products in the short term. Inflation rates in the Western world have been driven upwards by the price increase of such imports. This affects all sectors of the economy and especially those that depend on expensive imports.

In this situation, the inflation rate is therefore precisely not an approximation for the possibilities of companies to increase their own prices. Consequently, there is no justification whatsoever for “deflating” the interest paid by businesses to banks. If, as is currently the case due to the interest rate hikes by the ECB, the interest that companies have to pay for loans rises significantly, there is nothing to prevent relief on the price front. On the contrary, the already high price increases are likely to make it more difficult than before for many companies to enforce the prices they would have to charge on the market due to their own cost situation, because customers’ purchasing power has shrunk. The current inflation rate then does not bring relief, but even a burden. Any kind of “deflation” in an economic analysis is then fundamentally wrong.

And what is a real wage?

I already pointed out in my last post (see the quote from the Joint Economic Forecast there) that it is just as unjustified (as the institutes and the IMF do) to argue that the price increases currently measured in the inflation rate relieve the burden on companies because “real wages” (i.e. deflated nominal wages) are falling while productivity is still rising slightly. The IMF is also completely wrong here. It writes:

“Although wage and price inflation picked up in a broad-based manner through 2021, real wages tended to be flat or falling across economies on average. This is an important aspect of the current conjuncture, since falling real wages can be disinflationary by lowering firms’ real costs.” (p. 66).

As the German Council of Economic Experts already knew in the 1970s, this means making this calculation without the so-called terms of trade effect, which is clearly wrong. For by far the largest part of the price increase used does not benefit German companies, but foreign suppliers of energy sources. Consequently, the terms of trade effect reduces the income available for distribution to the nationals. Consequently, companies do not feel a reduction in their real labour costs, but very much a reduction in demand for their goods if those who benefit from the price increases have a higher savings rate than those who, as consumers, are disadvantaged by the price increases.

In their joint diagnosis, the institutes additionally argued that because wages have fallen in real terms, companies will actually be relieved of wage costs and consequently their willingness to hire new employees will increase. The IMF uses a neoclassical equilibrium model to examine the consequences of supply shocks and is thus treading on the same ice.

However, a fall in real wages (if it occurred at all in the neoclassical sense, which it does not because of the terms of trade effect) never entails an increase in employment because the neoclassical conditions needed for it never exist. As shown  in the book “The End of Mass Unemployment” (in German), the fall in real wages leads directly to a collapse in demand and never to a substitution of capital for labour. All interested economists, but especially those at the IMF who were responsible for the Troika in Greece, should actually know this.

But in the “economic sciences” everyone simply always insists on their old prejudices and is never prepared to deal with an argument even if it has empirical evidence clearly in its favour. It is always about defending the age-old paradigm because that is the only thing that promises the political support that is obviously considered indispensable for “freedom”.

Distributional scope and terms of trade

Consequently, wage bargaining must be guided by the distributional margin, which has taken into account the deterioration of the terms of trade. Thus, in the current situation, what would tend to be decisive for the bargaining partners is what would be available without the massive increase in import prices, namely domestic productivity growth and the inflation rate that can be expected in the medium term – after the import price increases have subsided. These are, how could it be otherwise, the two per cent that the ECB has set as its target.

If one assumes, as the institutes do, nominal wage increases in Germany of six per cent in this and the next few years, then the clearly rising unit labour costs are clearly inflationary and one cannot explain how, after a normalisation of import prices, the two per cent inflation rate expected in the fantastic year 2024 will be reached again (unless one were to assume a dramatic decline in import prices, for which, however, there is no evidence).

It is also repeatedly argued that traditional inflation measurement is unsatisfactory because it does not take into account the price increases that can be seen in assets such as houses, companies or their shares, in shares. However, that is not what inflation measurement is about. It is merely a matter of measuring how much of a stream of nominal income remains to a given average private household as real purchasing power in the current period.

Statistics cannot and do not want to say whether and how additional stocks of assets are exchanged between households, how their prices change in the process and what effects this in turn has on the asset stocks of different households. It is also not interesting for the question that is ultimately at stake in inflation theory and in the fight against inflation.

Monetary policy is always a last resort

I have said it many times: in view of temporary supply shocks in the Western world, it is not meaningful to speak of “inflation” without further qualification. The inflation we mean when we speak of dangerous developments that can only be stopped by monetary policy is a completely open process in which almost all prices and wages rise. Because this process threatens to accelerate, at a certain point it is right to stop it with monetary policy even while accepting rising unemployment.

How high interest rates have to be in order to be effective depends on many circumstances and cannot be said in general terms. In a situation like the present, where even zero interest rates have not succeeded in stimulating investment activity, even small increases in nominal interest rates can lead to a massive stalling of the economy. It would be no wonder if there were a collapse in investment worldwide next year. Those who now recklessly turn the interest rate screw are playing va banque with the future of this society without necessity.

Those who simply equate temporary shocks with inflation, as the president of the German Bundesbank does again and again, for example, completely miss the point. He simply compares the current inflation rate with the interest rate and comes to the conclusion that interest rates must be raised significantly. The fact that the low interest rate has a history in the form of European investment weakness is not taken into account, nor is the clearly temporary nature of the price increases.

In any case, the trade unions are now the losers. If they succeeded in agreeing relatively high wage increases in view of the current inflation rate, the ECB, under pressure from Mr Nagel, would drive them into a deep recession. If they manage to agree  within a reasonable range with regard to the medium-term inflation target, the ECB and Mr Nagel will not thank them for it, but will still drive the European economy into recession, because the same neoliberal/neoclassical prejudices are cultivated at the top of the German Bundesbank as at the top of the institutes and the top of the IMF.

All in all, it should be clear to all involved that their game is one with enormous risks. A European economy that had already been weak for ten years, then fell into the Corona Valley and has not yet properly recovered from it, can fall over the cliff even with a minor push. I wonder who will actually be held responsible if the economy shrinks not by 0.4 but by 2.4 per cent next year and unemployment rises significantly. Which central bankers and which ministers will be sacked (of course without a pension entitlement ten times the average income in Europe) when right-wing parties are elected in even greater numbers, when blind nationalism and fascism run rampant?

But “actually”, I hear many people say, especially among the Greens, it’s not so bad: first a long Corona break, this year hardly any growth, next year a decline in growth, nothing better can happen to the climate. However, this is the worst of all nonsensical judgements. It is the other way round: nothing worse than a permanent economic crisis can happen to the climate. Unemployment and uncertainty about the future among the mass of people all over the world are pure poison for the attempt to give economic development a new direction. Those who constantly tremble for their jobs and income are not prepared to take the risk of structural change under high uncertainty.