Inflationists are happy. Prices rise to five-year highs and some rub their hands with the idea that their grand plan to create inflation by decree is going to be a success.

Inflation, the tax of the poor, applauded by no consumer anywhere ever.

The discourse of inflationists is simple and, therefore, farcical. If inflation increases, the debt “deflates”, entering into a process of deleveraging as liabilities of states, companies and families loses value each year. “If inflation rises to 4%, every year, we have 4% less debt,” I was told in a television program. I thought “great, and if it’s 50% in two years we have no debt.” A joke.

The problem of the Eurozone is very different and will not be “solved” by inflation.

New Eurozone debt issuances in 2017 are estimated at €20 to €40 billion, a total of € 885 bn to €900bn in 2017, according to ING and Morgan Stanley, respectively.

The Eurozone´s debt repayment capacity, according to Moody’s, has reduced to 2007 levels due to accumulated deficits, deterioration in cash flows and the creditworthiness of public and private agents.

The problem with the simplistic argument of consensus inflationism is that it does not happen. From Deutsche Bank to Morgan Stanley, many are warning of the risk of “trusting” in an inflationary exit to the liquidity trap.

– With rising inflation, real interest rates and interest expenses rise, in countries that do not reduce debt in absolute terms.

– Tax revenues do not grow with inflation because overcapacity remains – 20% in the Eurozone -, most of the inflation increase comes from higher energy costs, and this creates weakness of margins and revenues. Anyone who thinks that real wages are going to grow at or above inflation with the stock of unemployment that still exists in the eurozone, must be joking.

– Input costs increase more than sales, because of overcapacity, aging population, and higher imported oil and gas prices. Imports rise, and ability to pass-through to final prices diminishes.

– “Existing” debt -stock- reduces its value due to inflation, but deficits and interest expenses rise.

If we take the refinancing needs of the Eurozone, close to € 1 billion a year, and assume an increase in inflation to double from current levels (2.2%), any serious analysis that takes into account the particularities of the European economies can easily see that the effect on the cost of financing of economic agents and the increase in deficits exceeds, by a ratio of 1.05 to 1, the alleged “benefit” of devaluing the stock of debt.

In fact, low prices have been a very relevant factor in cementing the Eurozone recovery. If it were not for low CPI, it would have been much more challenging for families to endure the bubble-led crisis and subsequent real salary decrease and unemployment rise. Anyone who thinks that inflation would have prevented the crisis is ignoring the factors behind the Eurozone recession. The questionable Phillips curve link between CPI and unemployment was debunked decades before.

Of course, the inflationist alchemist is confident that these risks – which they cannot deny – will be canceled-out by the European Central Bank’s monetary policy, which will have to repurchase everything that is issued to prevent real rates from rising alongside inflation.

Welcome to the recipe for stagflation.

When artificially manipulated rates fall below real inflation, credit growth collapses, real productive investment falls and, with it, the velocity of money. In fact, the only investment and credit that is encouraged by this policy is high risk and very short term oriented to compensate for the difference between reality and manipulated rates.

The truth is that the Eurozone cannot get out of the liquidity trap when 90% of net funding needs are used to cover deficits that pay for current expenses. We saw it when inflation in the Eurozone was 3 to 5% … But then, debt and annual structural deficits were much lower.

Expenses rise, due to inflation, but revenues don´t increase the same way, due to structural circumstances of productivity and weak margins.

SMEs, 90% of companies in the Eurozone, cannot transfer these price increases to their margins – and thus their tax payments- because inputs rise more than revenues. The same happens with wages.

If we add a structure of “big companies” in Europe comprised of industrial conglomerates with very low productivity, poor returns and high external indebtedness due to foreign acquisitions, their sensitivity in profits and tax payment to inflation increases is very low. The estimates of the Tax Foundation and other studies show that inflation increases has a very poor translation to profits. Almost zero, even negative.

Families in Europe have managed to reduce their indebtedness admirably in these years. And the vast majority of their wealth is in deposits. If we think that an aging population is going to buy more in real terms because prices rise, we have not learned anything from the evidence of the past. But some will say that this time is different.

The problem with the Eurozone is that it is trying to solve structural problems with any measure except the one that fixes the perverse incentive that perpetuates stagnation. The constant transmission of wealth from the efficient and the saver to the indebted and inefficient.

The EU tries to fix the economy without touching the mechanisms that slow it down. High government spending, low productivity and poor competitiveness.

The European Union is increasingly burdened with fixed costs and unproductive spending, putting stumbling blocks to the economy in favor of more white elephants and bureaucracy. Inflation by decree is not going to change it. It will extend it.

But many will tell you that it is for your own good.

Daniel Lacalle is PhD in Economics and author of “Life In The Financial Markets” and “The Energy World Is Flat” (Wiley)

Article published in Spanish in El Espanol

Graph courtesy of Market Realist

As details of the US president’s economic policy unfold, interesting analysis begin to emerge.

So far, the World Bank estimates that Trump’s tax cuts could be a boost for the global economy to recover growth, while Deutsche Bank’s team of economists mention these are fiscal measures that should be carried out in the European Union. They estimate that Trump´s tax cuts and infrastructure boost could double real GDP growth in the United States. Of course, we must always be cautious about estimates, but Nobel laureate Michael Spence, also expected a similar impact last week.

The evidence of tax cuts to boost growth is unquestionable. The example of more than 200 cases in 21 countries shows that tax cuts and spending reductions are much more effective in boosting growth and prosperity than spending increases. In the studies of Mertens and Ravn (2011), Alesina and Ardagna (2010), or the IMF, all conclude that in more than 170 cases the impact of tax cuts has been much more positive for growth.

In Trump’s case, these cuts imply that citizens earning less than $ 25,000 annually do not pay any income tax, those with less than $ 75,000, only 10%, from $ 75,000 to $ 225,000, 20% and,  for the rest, 25%. The largest tax cut in US history would mean that the lowest earners almost double their current disposable income.

The Corporate Tax, at 15%, would be added to an incentive for repatriation of capital at a rate of 10%. Goldman Sachs estimates that the US would be able to repatriate more than 1 trillion dollars (almost equivalent to the GDP of Spain) with this policy.

How would it all be financed? With increases in efficiency in healthcare spending, eliminating and replacing the disastrous cost of the Affordable Care Act (Obamacare), even as social aid increases by $600 billion. How? Reducing administration costs by eliminating unnecessary regulation and red tape. The infrastructure plan, at least what we know so far, would not increase public spending because it would be financed by the private sector via tax deductions and revenues from tariffs and tolls. But the evidence of large infrastructure plans on growth is debatable, as seen in past decades, so there is sound logic in avoiding putting the cost in taxpayers’ pockets.

When I was able to comment on these cuts with the Mulvaney team, they explained to me that the fiscal deficit effect would be zero with a further increase of 1% in annual growth of the economy – slightly less than what the IMF or Mertens and Ravn show in the studies I mentioned.

Some analysts question the impact. And that is good for debate. The Peterson Institute estimates lower tax revenues of $ 2.85 trillion due to the fiscal reform and higher defense spending of nearly $ 1 trillion over 10 years. A 25% increase in debt. With the details we have of the new budget, these estimates seem exaggerated. The budget assumes no increase in debt by eliminating duplicate programs and the “deep state” bureaucracy created in the past years.

Other studies (from the CRFB) actually estimate that debt may, in fact, fall. Cutting between 10 to 20% in annual spending from plans that had skyrocketed in the past eight years would generate an additional $ 750 billion over 10 years. Income from Corporate Tax would not fall thanks to higher investment and increased economic activity as well as the repatriation of investments. A long-overdue meaningful increase in real wages would reduce the cost of income tax cuts by 35%. This would lead to a zero increase in nominal terms of the country´s debt.

But how would the debt be reduced relative to  GDP? With the effect of a slightly higher inflation than currently expected, better real growth and, more importantly, achieving energy independence in 2019. The energy revolution in the US created more than 2 million direct and indirect jobs while adding 1% to GDP and boosting capital expenditure. Unconventional oil and gas producers, including suppliers of equipment and materials, and energy-related chemical production already added about 1.8 percent of the workforce in new -and highly paid- jobs. By 2025, an estimated additional 3.9 million jobs could be created.

Disposable income per household already improved by about $1,500 due to lower gas and power bills. Eliminating obstacles to exploration and production also triggers massive investment. Capital outflow from emerging markets into the United States would explain a stronger dollar that boosts citizens’ wealth -80% in deposits- and consumption. Trumponomics´secret is that trillions of dollars of capital that went to emerging countries since 2009 with the Fed´s “cheap money” will return to the country looking for stability and growth.

Many uncertainties remain, and time will tell. But what the past has proven is that spending more and raising taxes does not reduce debt. The US increased debt by 121% and real investment in the economy declined.

Concerns about protectionism remain. Messages from Trump have greatly moderated the risks because he is not talking of less trade, but more fair trade and fighting barriers lifted by others. In any case, it has been proven that the President’s real ability to take massive anti-trade executive measures is very limited – just as limited as they were for Obama in so many ways.

But let’s not forget that the Obama administration was the one that imposed most protectionist measures in the past eight years. More than any other country … And nobody complained . It led to the poorest growth of any economic recovery in the past decades.

TRADE WAR?

Those who read me since 2007 know that I have tremendous respect for Rex Tillerson’s vision and common sense, and this week he surprised many with a comment on China, which proves that he says what he thinks, anywhere. His comments criticizing China for the Pacific Islands and warning that the Asian giant should not be given access to such islands. Tillerson always distrusted China’s “bubble” growth and, in Exxon, he repeatedly refused to invest significantly and enter into major alliances with Chinese companies.

Is it the prelude of a trade war with China? I do not think so because everyone knows the impact of a global trade war. A crash of consumption up to 3% per year, an average drop in investment of 10%, recession and more unemployment (Peterson, OECD and WTO studies).

The reality is that for some members of the Trump team it is not a matter of trade war but fair trade. It is about China’s disproportionate trade surplus with the United States. The highest in the world.

China exports to the United States about $ 483 billion (2015) and the United States only $ 116 billion to the Asian giant, attributed by many to the inability to export due to blocking actions from regulatory authorities, state enterprises, and the Chinese government.

However, a significant part of these imports are electronic products, machinery and clothing that US companies manufacture in China and then ship to the United States. With lower taxes and less regulation, many might return their activities to the US.

We have to monitor all risks, but the evidence of the past shows that these economic policies are not disastrous, as some are saying. They work. And no business or family has ever complained about having better public services at lower costs or more of their own hard-earned money in their pockets.

Daniel Lacalle is PhD in Economics and author of “Life In The Financial Markets”, “The Energy World Is Flat” (Wiley) and “Escape from the Central Bank Trap” (BEP).

@dlacalle_IA

Picture courtesy of Google Images

Theresa May´s Tuesday speech on Brexit was clearly firmer and more aggressive than many expected.

The pound’s reaction, triggered by May’s words, was the clearest example of a rebound caused by the previous buildup of short positions in the currency -particularly vs Euro- into the speech. As soon as messages of support for investment and global trade were launched , many of these short positions were undone, causing a squeeze. In addition, Anthony Scaramucci in Davos announced that a US-UK trade agreement could be completed in six months, which for many was a positive shock. But the pound fluctuations are not so relevant. It has been trading close to 10% of the average levels of the past eight years.

It is clear that Theresa May has made a strong and confrontational speech, showing no flexibility with respect to the European Union, because she perceives a strong support from the US post Trump, as well as a vast opportunity as a global trade power force. In my opinion, it would have been hard to hear sentences such as “to continue in the single market would not be a Brexit at all” without a strong view of trading opportunities with the US, Asia and the Commonwealth.

May launched a battery of proposals that were clearly targeted to her electorate and the advocates of Brexit . If it had been more conciliatory, brexit supportes would have felt very disappointed, and remainers as well, because they do not accept “half Brexits “.

I would like to highlight the words of Scaramucci at Davos. He is a great fund manager and Trump advisor with whom I shared a couple of slots at CNBC in London. His words are very important, because one of the negative arguments regarding Brexit has always been how slow and difficult it is to close bilateral treaties. Obama even threatened with years of negotiations. Trump, on the opposite side, promises an agreement in a few months. Carl Icahn has always said that the only reason why bilateral treaties are delayed is because there are many committees to pay.

Theresa May might have another ace up her sleeve when she announces her “no single market, thank you”. The vast majority of the countries of the European Union have a massive trade surplus with the United Kingdom, especially Germany. That is, they export much more than they import from the United Kingdom. This is why many assume that closing bilateral agreements will have to be easier and quicker than feared. Although the idea has merit, it is not that easy. The European Union is not solely guided by economic benefits and trade, and in this particular case, it could be one of those moments in which Brussels prefers to lose a few billion in commercial activity than to give up power.

May’s speech shows that the overriding priority is to have independence with respect to any and all EU bodies, and that any other consideration is secondary.

When she commented that the parliament would decide on the agreement, many thought that this would lead to a negative vote and no Brexit. However, there are numerous analysts who believe that in the next months, the reasons for wanting to remain in the European Union may continue to weaken -immigration, interventionist populism growing, low growth, banking crises- while the reasons to get out will strengthen. I, personally, believe no one is fully right and that neither Europe will worsen nor the UK collapse. But the fact is that many are convinced of a pro Brexit victory in parliament if the deal is good for the country, especially after recent comments from the Labour leader, Mr Corbyn, defending sovereignty in immigration.

Additionally, May puts an important proposal on the table. To have full control of regulation and taxes that would make the UK a global investment and capital attraction centre.

On many occasions we have discussed in this column that Brexit is an opportunity for Europe to eliminate barriers for growth and lower taxes to boost the economy. When we analyze, we must be aware that the risk is twofold, as businesses could also decide to leave the EU if conditions for investment worsen. That is why I prefer to believe in this process as a growth opportunity for everyone than a zero-sum game where one loses what the other gains, as some want to paint it. There are, of course, very important possibilities for business and attracting talent to Europe, but only if we are able to show that we compete in ease of doing business and job creation.

Analysts have been horribly wrong about the negative effects that the referendum outcome would have on the UK economy . All macroeconomic data, consumption, employment, etc. have been much better than estimated and miles away from the debacle anticipated before the vote. But the fact that catastrophic predictions were embarrasingly wrong does not remove very important challenges from an unfriendly negotiation.

Europe cannot sit down looking away, thinking the rest of the world is wrong. It is a golden opportunity to understand the challenges that Trump and Brexit mean and the importance of tax cuts that Draghi, companies and families demand. It is a golden opportunity for Brussels to reconsider and understand that the EU can suffer from substantial capital outflows. Nomura estimates a loss for the EU of 63 billion dollars just from the repatriation of funds to the United States. Imagine if business conditions and regulation are proven to be uncompetitive.

The UK proposes a 17% corporate tax cut, the US as well. Israel will lower it to a range of 4% to 12%. Seriously, if we think that there is no risk of capital flights from the EU with 25% to 34% tax rate and more than 12,000 limits and barriers for trade, we are very wrong.

Let us hope that everyone involved sees these challenges and proves to the world this is an opportunity to learn from past mistakes, improve competitiveness, business attractiveness and employment. That will be the victory for all of a process in which we can all win if we focus on growing, not on “beggar thy neighbor” strategies.

We need to be alert, because the European media talks only about a Brexit where companies and capital movement is in one direction, and it may well be the opposite. Let us show that all economies can be strengthened from supply-side measures, fiscal expansion and economic growth, not growth of bureaucracy.

Daniel Lacalle is PhD in Economics and author of “Life In The Financial Markets” and “The Energy World Is Flat” (Wiley)

@dlacalle_IA

Picture courtesy of Google Images