Europe's Sophie's Choice: Taxes or Debt to Stimulate Consumption

It is a safe assumption that most market participants understand the deflationary pressures in European industrial production capacity and underutilization. In case one has been lost in the pristine snow-glazed peaks of Davos, here is a quick snapshot of industrial capacity utilization of the 3 most important producers in Europe both in terms of quantity and strategic importance of goods produced.

The objective of this article is not to pile on the demand woes but to converge towards a politically acceptable solution to stimulate consumption and preserve the value of the existing industrial production capacity. While talking about efficiency we tend to forget that the economy has a consumption variable as well and if that variable is not performing then any increase in production efficiency reduces the value of the production infrastructure.

Most decision-makers in the world are far past the bottom tier of Maslow's hierarchy of needs and just like everyone else they also act in self-interest. Here is a very short pitch on why one should really care about demand:

• Asset value deflation: The value of any asset is practically determined by the dividend it can pay or the incremental price for which it can be sold to the next person. One must understand that value is a notional concept. The value of an asset remains as long as there is a utility of the asset or the next person has enough purchasing power to buy it for a higher price. If consumers don't have the purchasing power to consume, the value of the asset receives a non-linear deflation of value. Political power and benefits are an abstraction of the asset value of the nation and are a function of the same. It is absolutely in the self-interest of the decision-makers of the world to preserve the real value of industrial production capacity to maintain and increase the political personal benefits derived thereof. If asset values deflate so would special advisor & board member positions that come with it.
• Attrition in Political Positions: Stability (not absolute value) of the purchasing power of an electorate has a direct correlation to the tenure of political appointees. The volatility of the purchasing power of the electorate generally creates the sentiment to simply change the political appointees irrespective of a better or worse outcome. In conjunction with the asset values from which power is derived, attrition of positions creates the perfect set of incentives to seriously care about consumer demand.

In general, it is clear to most politicians that domestic demand needs to be stimulated in a high tariff environment in which exports would suffer. This is especially true for European economies which are built on the back of multiple layers of value addition to any molecule that is extracted out of the earth or enters its borders via import. Even though there is a rough political consensus on the need to stimulate domestic demand, the means to actually achieve it is not clear.

Stimulation requires a war chest and the problem is everyone wants a problem solved without paying a price, that is always the case with the collective intelligence of the electorate. The asset owners of the world must understand that if the purchasing power of the common consumer is severely challenged the same would reflect in the value of the assets via slow markdowns. Thus from the left or the right pocket one must pay a fee to prevent a non-linear decline in the value of assets which would be far greater than the actual fee paid.

Central bank policy rates have lost correlation with real rates and reducing policy rates would have increasingly deiminishing return on consumption.

ECB rate policy stance has had little to no effect on stimulating consumption. Even though it is easier for lenders to arbitrage the cost of funds between sources (central bank refinancing options & cost of deposit) and consumers, the risk is warehoused by the lender. The lender underwrites the cash flow projection of the consumer as such when the cash flow of the consumer is challenged, the banks can't lend more even though the arbitrage of cost of funds and real rates are only expanding. This time, there is no hyper-financial solution to a real problem. The liquidity coverage ratio of the lenders is not high because the central banks want it so but simply because lenders are sitting on deposits that can not realistically deploy with a rational PD-adjusted yield.

If the central bank policy rate does not stimulate demand, the only option left on the table is to raise a liquidity war chest to be deployed towards consumption by direct means and not via the plumbing of the banks. It is completely a broken window economic way to kick start an economy but let us be clear that the window is definitely broken. We must make lemonade when the economy has lemons.

Taxes are the most expensive way to raise funds for a nation. It has exponential negative effect on the sentiment of domestic demand.

Every economy in the European Union has a different revenue breakdown from sources and as such is not easy to compare. Let's take the example of Germany and try to understand the sensitivity of direct taxes to GDP per capita of Germany.

It can be observed that when market forces are not strongly distorted by changes in ECB rates (note: only changes matter, not the absolute rate), changes in the absolute value of direct taxes do seem to have an increasing effect on the GDP per capita of Germany. This means if one chooses to raise a stimulatory war chest by raising direct tax revenue, it would have a disproportionate influence on the GDP per capita, which would translate to the revenue of the next year. This conjecture can also be extended to other industrial nations of Europe.

The only relatively lower-cost alternative left to raise a stimulatory war chest is by raising debt. Since the debt market right now is not in a great mood for sovereigns, it would enforce discipline upon any nation trying to raise debts. The only variable left to stimulate consumer demand in nations with relatively lower debt to GDP would be to push the much contentious debt ceiling and actually test the emerging market appetite for relatively safer debt at a lower cost than the US dollar.

How the liquidity would be deployed is a question for another day. The current problem is to find a relatively low-cost method of collecting the funds required to stimulate demand, which would preserve the industrial capacity value of some of Fortress Europa's powerhouses.