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The European Farce: Part 2 -- How to Grow GDP


Without a growing GDP, the size of the deficit must shrink.

Editor's note: This is the second part of a two-part series. Be sure to read the first part, The European Farce: Part 1 -- ECB to the Rescue.

The EU economies have been in or nearly in recession since the financial crisis in 2009. Greece has had to be bailed out several times.  Spain, too, and in the case of Cyprus, bank depositors bore much of the cost.  Italy and Portugal are lucky they avoided such bailouts.  But, that doesn't mean they are healthy.  The table below shows the unemployment rates in the major European Union (EU) nations.  Except for Austria and Germany, the word "pathetic" comes to mind.

Country As of Date Unemployment Rate
Eurozone 4/14 11.7%
Austria 4/14 4.9%
Belgium 4/14 8.5%
Cyprus 4/14 16.4%
France 3/14 9.7%
Germany 5/14 6.7%
Greece 12/13 27.5%
Italy 3/14 12.7%
Netherlands 4/14 7.2%
Portugal 4/14 14.6%
Spain 4/14 25.1%
Meanwhile, Switzerland, right in the middle of the EU, has an unemployment rate of 3.2%.  The rate in the UK is 6.8%. 

In the aftermath of the financial crisis, most of the EU governments were forced to adopt austerity budgets because the recessions reduced tax revenues, while the social welfare payments grew.  They defined their budgets in terms of a deficit/Gross Domestic Product (GDP) ratio and all adopted targets and time frames in which to meet those targets.  In the recently held European elections, the anti-austerity parties made significant gains.  So, the politicians now have to adapt to take voter preferences into account.

Like all ratios, the deficit/GDP ratio has two components: the deficit and GDP.  The ratio can be impacted either by reducing the size of the deficit or by increasing the GDP.  Growing the GDP, of course, is the ultimate objective because a larger pie benefits all.  Without a growing GDP, the size of the deficit must shrink -- making that happen is probably the most difficult task for a politician.  But, let's not underestimate their ingenuity.

Italy and all of the EU countries have now found a way to reduce the deficit/GDP ratio without doing much of anything.  They are simply redefining what the GDP is.  Under an EU directive, Italy and all EU countries will count the "underground" economy as part of their GDP.  This includes the monetary values of prostitution, drug dealing, and any transaction where both parties in the transaction consent to the transaction and agree on a price. (For example, a stolen moped would count if the robber and the purchaser agreed on a price and the transaction occurred.) 

The reason for even thinking about the underground economy is the fact that the tax rates in the EU are so high that there is a lot of under-reporting (i.e., tax cheating).  Many small businesses don't report some of their cash transactions, and tourists who know can negotiate for a lower price, and often do.  The fact that certain formerly lurid or seedy activities (e.g., prostitution or drug dealing) are now counted as part of the economy would seem to justify and encourage such activities. (I wonder what the Pope thinks.)  After all, if they increase, the GDP grows!

One study entitled "Measuring the Underground Economy with the Currency Demand Approach" by Ardizzi (Bank of Italy), Petraglia (U. of Basilicata), Piacenza (U. of Torino) and Turati (U. of Torino) concluded that legitimate transactions in Italy's underground economy would increase GDP by 16.5%.  Criminal transactions were measured as 11% of GDP.  So, if criminal transactions are also included, the GDP would be 21.4% larger than currently reported. So, expect Italy's reported GDP to grow at double-digit rates this year!

Really, you can't make this stuff up. Rather than trying to solve the real problems, provide incentives to work, reduce tax rates, and legitimately grow the economy, the politicians would rather resort to redefining the GDP just to buy themselves a few more years, when, after they retire from public office, it will be someone else's problem. 

Editor's Note: Dr. Robert Barone is a Managing Partner / Portfolio Manager of Universal Value Advisors.
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