Tuesday, 2 July 2013

Long-term Stagnation or Recovery in the Eurozone: Best Case Scenario


The current crisis, with its extension, duration, and its severity, shows how the analytical techniques used by economists and analysts are incapable of producing credible forecasts not only of business failures or of markets but also dramatic events of a global scale. One may wonder at this point if these techniques, so enormously sophisticated, are conceptually correct and if they are based on a solid foundation from the point of view of science and philosophy. It would seem not. Other approaches are needed. In this article we examine a new technique of analysis that is based on a fundamental concept in science - complexity. Complexity, for many years, was something extremely difficult to "catch", to describe, to define, even if all of us perceive intuitively its meaning. We know, for example, that due to the evolution in our biosphere, we have evolved from single-celled organisms to reptiles, mammals, to humans. The fact is that to grow, to expand, implies an inexorable increase in complexity. The degree of evolution can be "measured" by the complexity within a system. This applies not only to the biosphere but for all systems in general. Take, for example, tribes of humanoids around the world that have given rise to magnificent and complex civilizations. Consider how we grew and evolved markets, economies, systems of laws, traffic networks, communication, art. Everything that grows inevitably becomes more complex. Similarly, it is easy to imagine, given that evolution is "measured" by complexity, a gradual reduction of complexity can certainly reflect a system that is "deflating" or shrinking. This is, in fact, the case. Since 2005, when a rational way to measure the complexity has been discovered, thousands of experiments have been conducted with systems of all sorts which have confirmed this fact. For example, using data published by the World Bank, which takes into account multiple aspects of a country, such as the economy, production and consumption of energy, education, health, transport, telecommunications, agriculture, etc., for a total of over 1500 parameters, countries and markets have been analyzed. The trend of the complexity of the Eurozone in the period 1971-2010 is shown below.

It is obvious that, as mentioned, economic growth is reflected in a tendency to increase complexity. The frequent discontinuities in the curve are due to crises or significant events, such as the energy crisis of the 70s, the fall of the Berlin Wall, the introduction of the Euro, the dotcom bubble and, of course, the crisis of 2007. And it is interesting to note that every crisis is characterized by a rapid increase in complexity, and then by a fall which is more or less gradual. The thing that distinguishes the current crisis is its duration and amplitude. Compared with previous crises, today's began in about 2000, at the height of dotcom bubble, to be unleashed in 2007 (note the corresponding peak). As stated before, when a system loses complexity, it is "shrinking", just as the Eurozone economy. The area of the peak, in correspondence of 2007, is illustrated in detail in the chart below.

It should be noted that the trend of complexity does not foresee a quick recovery. Indeed, the graph flattens, suggesting a possible and long phase of stagnation. However, making the assumption of an immediate recovery, commencing in 2013 and with the same speed as that of the crisis, is quite clear that we could return to 2007 levels in around 2017 or so. In essence, based on complexity, we can say that due to the current crisis, and based on the data available today, we have lost about ten years of development and growth. The graph below illustrates the concept.

What is surprising about this curve is almost "theoretical" continuity. In essence, this means that the response to the Eurozone crisis is quite mild, reflecting the fact that on the one hand there is no clear political will to implement structural reforms and on the other a series of  transitions of national sovereignty in favor of financial powers which want to maintain the status quo. One factor which will be key to the type and speed of the recovery will be sovereign ratings. These, in virtue of an almost certain series of downgrades, will complicate the situation further by playing at the same time in favor of the United States and China. The rating agencies on the one hand, together with the self-imposed austerity measures on the other, could be regarded, respectively, as the main exogenous and endogenous factors that could hinder recovery. What, then, are the prospects for recovery of the Eurozone? The recovery, unless there are dramatic events on a large scale, will come, but it will probably be very gradual and accompanied by high turbulence and uncertainty that will never abandon us again. The speed of our globalized economy ensures that not only the market turbulence can propagate at the speed of the internet, but this turbulence will become an integral part of our lives. So, recovery instead o being smooth and gradual will probably look like the dotted blue line in the plot below:

Europe, therefore, should try to limit the power of the rating agencies - a very timid attempt has been made by a recent reform  - and reduce at the same time, the austerity pressure itself has imposed on its own economies
. Based on the trend shown in the graph above it appears that 2014 may be the first year of real recovery while in 2016-2017 the economy will, potentially, return to 2007 levels. Of course, the basic assumption is that the trend is as shown by the dark blue dotted line. As we know, it is very difficult to predict, especially the future. And, of course, the projection of a return to 2007 levels around 2017 is made on the assumption that construction is as easy as destruction. A very bold assumption indeed.