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Sunday, June 24, 2007

Is The Latvian Economy Running Out Of People?

Something is afoot in Latvia. Being alerted by reports which have appeared in the press in recent days to the very rapid rate of wage increases they have been experiencing there I decided to dig a little deeper, and in the process I came across this recent IMF statement on Latvia, where I read the following:

"Latvia, like other recent EU entrants, has benefited from an accession-related boost to income convergence....."Recently, however, fast credit and wage growth has caused the economy to diverge from a balanced and sustainable growth path, with domestic demand outstripping Latvia's supply capacity. As a result, overheating has intensified, bringing higher price and wage inflation, a sharply wider current account deficit, and greater external indebtedness. Rapid credit growth in euros has left large currency mismatches on the balance sheets of households and corporates and a boom in housing prices that has diverted resources from the tradable sector. A pervasive "buy now-pay later" mindset has settled in and is heightening systemic risk. These developments, if not tackled firmly, will thwart a recovery of export growth."

"There is an urgent need for decisive action to unwind overheating pressures and narrow external imbalances by sharply curtailing domestic demand. Notwithstanding actions by the Bank of Latvia to raise risk awareness, recent pressure on the lats signals growing investor impatience with the limited policy response so far. A comprehensive strategy is therefore needed to curb domestic spending and wage growth, and moderate real estate prices to rebalance incentives for investing in tradables sectors."

What now follows is a long (very long, even by my recent standards) post which examines the core features of Latvia's current economic malaise. It is generally recognised by most external observers that this malaise has its origins in structural problems in the Latvian labour market, and it will be argued here that these structural problems have their roots in recent characteristics of Latvian demography (namely high out-migration and a sustained low birth rate). As such there is no easy solution. Even in the longer run the position will inevitably be difficult, since demography almost inevitably casts a long shadow. This does not mean, however, that we should be complacent. There are steps which can be taken to address the issues which Latvia faces in the short term, and it is important that such appropriate measures are enacted. These measures clearly include policies to reduce the dramatic overheating which is taking place, but they also should include policies to loosen the labour supply, not only by encouraging increased labour market participation and mobility, but also by actively encourage inward migration. Such policies may be seen as short term measures which are vital to move Latvia away from an unsustainable and towards a sustainable economic path.

The Measure of the Problem

As I have said, and previously noted in this post, according to the latest Eurostat data, wages and salaries in Latvia rose in Q1 (as compared with a year earlier) by an astonishing 32.7%. This rate of increase is, in and of itself a symptom of something important, and is clearly unsustainable.

For a simple coverage of recent developments this recent Bloomberg article gives a useful summary of the underlying dynamic involved.

According to Alf Vanags, director of the Baltic International Centre for Economic Policy Studies, and Morten Hansen, an economist at the Stockholm School of Economics (in this BICEPS report) "Latvia's inflation, the fastest in the European Union, will continue to erode the competitiveness of the country's' exports as it shows no sign of slowing"

In fact Latvia's inflation rate (CPI, see Graph below) reached a 10-year high of 8.9 percent in April 2007, largely driven by growth in wages and producer-prices.

(please click over image for better viewing)

As a consequence of this wage and price growth the competitiveness of Latvia's exporters has been so eroded, and the trade balance so negatively affected (see graph below), that the economy is now destined either to go through a very long period of deflation, or to undergo a substantial devaluation of the currency in order to put the ship back on an even keel. But if the Latvian government were to opt for the latter course we would hit a problem, since the traditional route for correcting such a deficit - letting a currency freely float (the Lats has been loosely pegged* to the Euro since early 2005) and raising interest rates - is not so obviously open here. In today's perverse world of global liquidity and international capital flows it could well be that any increase in central bank interest rates would simply suck-in even more funds in a steady and ongoing search for yield. Appetite for risk might not be reduced by the appearance of non-sustainability since - and this would be the big initial difference from say Turkey in 2006 - the EU and the ECB are ultimately seen as guarantors of the last resort for the Latvian economy. So effectively the situation could turn into a battle of wills between speculators looking for yield and the EU institutional structure.

( *The Latvian currency, the Lats, is allowed to move by plus or minus 1 percent around a midpoint against the euro. The lats is currently worth somewhere around 1.43 euro).

As can be seen from the graph below, Latvia's current-account deficit has more than doubled over the last two years, and the quarterly current-account deficit, for example, grew from around 10% of GDP in Q1 2005 to 26% of GDP in Q1 2006.

(please click over image for better viewing)

Thus Latvia now has the somewhat dubious merit of having the fastest growing economy, the highest inflation, and largest current-account deficit in the 27-nation EU. Since the country has a fixed exchange rate (which could be made more flexible, although, as we will, doing this in itself raises as many problems as it could solve, since the currency could just as easily be lead to float up as down), and raising interest rates may well only draw even more liquidity into an economy where the majority of consumer credit expansion is now in non-Lats denominated loans (70% of domestic credit is now denominated in euros), the Latvian government is really only left with fiscal policy as the major instrument with which to try to correct the growing internal and external imbalances.

As Lars Christensen, senior economist at A/S Danske Bank (who is quoted by Bloomberg) says: "Money supply and credit growth have created a property bubble. What has fueled growth and credit has been cheap liquidity, globally rather than locally."

An Anti Inflation Programme?

So what do we have here? Well, despite considerable talk and concern, the inflation problem in Latvia has not gone away in recent months, if anything has intensified. The Latvian government do seem to be as concerned as anyone, and on the back of the problem have set up a working group on inflation, which published its current anti-inflation plan in March, and which, according to the Bank of Lavia, "continues to monitor the situation". Despite strong prodding from the IMF, the aims of Latvian government policy as contained in the report - and summarized by the Finance Ministry here - are surprisingly modest given the severity of the situation, namely:

i) to maintain a balanced budget (ie, neither deficit nor surplus) for 2007, and attempt to attain a surplus by 2009/10.
ii) to impose a real estate tax on properties sold which have been owned for less than 3 years;
iii) to attempt to make it more difficult to obtain credit by, for example, requiring commercial banks and leasing companies to better determine the purchasing power of customers and to make loans available exclusively on the legal income of clients;
iv) to exercise better control over energy prices
v) to introduce measures aimed at increasing labour market participation and increasing productivity, as well as product-market-competition reforms. As the summary says, these last items are by their very nature long term, and as such hardly appear to form a core part of the "crisis" short term package.

All in all then, an extraordinarily relaxed programme it would seem under the circumstances.

Now (as indicated above) both wages (32.8% growth y-o-y in Q1 2007) and producer prices (16% - 18% growth y-o-y in early 2007) have been accelerating recently with wage growth being estimated to feed into producer prices with a lag of approximately 15 months. This increase in producer prices in turn then feeds into export prices, and the consequence is a continuing and sustained loss of international competitiveness.

Now the existence of this evident feed through between wages and producer prices means that there is now a wide consensus (both inside Latvia itself and among international observers) that the inflation problem cannot be addressed separately from the imbalances which exist in Latvia's internal labour market (imbalances to which outward migration in the early years of this century and many years of below replacement fertility - see below - have contributed in no small way). Since the recent surges in producer prices and wages point to further inflation in the pipeline, and no easy end in sight the BICEPS report authors referred to above conclude that we face the possibility "that the Latvian economy has shifted from a position of simple overheating to something more serious in structural terms".

Monetary Policy

Nowhere are the difficulties facing the Latvian authorities better illustrated than in the field of monetary policy. The Bank of Latvia has been steadily raising the refinancing rate, especially after it became apparent that Latvian economy was continuing to grow very rapidly, and that part, at least, of the reason for this was the boom in bank lending,. The rate was raised to 4.5% in July 2006 and to 5% last November. As of May 2007 the rate is 6%. At the same time the ECB has also been lifting its refinancing rate, from 2.25% to 3.5% in 2006, to the current (June 2007) rate of 4%, and this level now appears to be not too far from the peak. What this effectively means is that there will not be too much further room for increases from the BoL without taking the risk of precipitating substantial speculative inward capital flows, and in the process putting upward pressure on the euro peg (an indication of how this might work can be found in the fact that in the week of 18 June 2007 the Bank of Latvia found itself forced to intervene and sell Lat to buy Euros (28 million euro worth in that week) to try and take some of the upward pressure of the peg. This process has effectively been taking place off and on all year).

Of course, since Latvia's new inflation targets now lie well above the ECB criteria for some time to come (see the chart below, which comes from the Ministry of Finance summary of the anti-inflation package), the close alignment with the euro could be considered to be unnecessary at this point, and indeed a substantial devaluation in the currency might be thought to be a more palatable alternative to a hefty dose of deflation, were such a devaluation possible.

(please click over image for better viewing)

Now I say were such a devaluation to be possible, since it isn't exactly clear whether, as long as the EU institutional structure and the ECB maintain their effective underwrite guarantee of Latvian solvency, the funds inflows which followed any loosening of the peg (or even hint of its possibility) might not well have the counter-productive effect of pushing the Lat even higher. In this situation what would effectively result would be a battle of wills between EU institutions and the international financial community, and I imagine that everyone (at least at this point) would rather avoid this eventuality.

Given the clear difficulties which the Latvian government face in using currency and interest rate measures many observers have reached the conclusion that, at the end of the day, the only measures which are now available to the them effectively boil down to fiscal ones. What this implies is that the Government's inflation plan can only generate a larger or smaller contraction of domestic demand depending on the severity of the fiscal contraction introduced. This whole position was more or less explicitly accepted by the IMF staff team who visited Latvia in April 2007 (see full reference below):

"Against the balanced budget targeted in the anti-inflation plan, we consider that a headline general government surplus of 2.25 percent of GDP in 2007 and 4 percent of GDP in 2008 is appropriate. This could be achieved by saving in full revenue overperformance, restraining current and capital expenditures, and abstaining from cuts in taxes, including the personal income tax."

So what the IMF are effectively recommending is a budget surplus of between 2.25% and 4% of GDP. This is pretty hefty, but, even if it were to be implemented, would it be enough? This I think is very hard to say at this stage, but there are reasons for thinking it may well not be, in particular given the strength of consumer demand for credit from external sources (to give some idea of the strength of this, it may be worth noting that M2 was increasing at an annual rate of around 38.5% in 2006). At the same time if it is sufficient to give the shock which is evidently required, is there not the danger at the other extreme of overshoot, and that the impact of administering this non-lethal dose might still render the patient unconscious semi-permanently?

I ask the "would it be enough" question in a somewhat obtuse way above, since it is apparent that the Latvian government, which is hardly keen on inducing large scale unpopularity for itself by curtailing the perceived benefits of a booming economy by using deflation to - even temporarily - sharply lower living standards, remains reluctant to tighten fiscal policy in the way the IMF recommends. This I think would be the key point to note about the "anti-inflation" programme mentioned above. For the time being they are content to settle for a neutral balance budget, and this almost certainly will not be enough to quench the fire.

Thus it is not clear at this stage what institutional architecture there is in place to constrain any Latvian government at this point. Certainly the IMF itself no longer carries any real clout, and the EU Commission may also have cut Latvia adrift in a way they never intended when they pushed back over the horizon Latvia's euro membership (and here). Devil-may-care heterodox policies it seems are not only possible in Brazil and Thailand these days.

Government Spending and the Consumer Boom

An examination of the following chart may well help us put things in perspective insofar as the ability of a fiscal surplus of the magnitude being recommended by the IMF to achieve it's intended result.

(please click over image for better viewing)

As can be seen government expenditure was running at something just under 900 million Lats per quarter in 2006, while GDP was running at something just over 2000 million Lats per quarter, which gives us a figure of around 45% of GDP for government spending. As such a 4% GDP surplus is large, since it amounts to either a tax increase of 8 to 10% of total revenue, or a reduction in spending of an equivalent order, or a combination of the two. This constitutes a relatively large shock to the economy. In addition, in the short term continuing producer price inflation will reduce exports, which constituted 48.1% of GDP in 2006 (so Lavia is relatively open and exposed in this sense) and this can also be expected to slow growth. In the opposite corner, and pushing the other way as it were, we have the future path of remittance flows and bank lending.

Taking remittances first, the World Bank Development Group estimates that remittances into Latvia were flowing at an annual rate of 381 million US dollars in 2005 (or 2.4% of GDP, see table below), but as they note the real numbers are likely to be significantly larger, and looking at growth across 2003-2005 the 2006 and 2007 numbers are most likely up (an estimate of a share of between 4% and 5% of GDP seems not unreasonable).

(please click over image for better viewing)

So this push will continue, and indeed it is even not unreasonable to imagine that if "bursting" the overheating starts to have serious consequences in terms of distress at the individual level in Latvia, then we may well see more money coming in to try and help out family members.

On bank flows, bank’ borrowing from abroad remains by far the largest source of foreign financing for Latvia. If we look the current account deficit we will see it has been growing rapidly (see chart below, data 2004and Q1 2005 through Q3 2006).

(please click over image for better viewing)

By Q3 2006 it was running at a negative rate of 1,269 US$ million, but as can be seen this is effectively covered by other items in the capital and financial account. During the first three quarters of 2006, “for example, other investment” (which is predominantly bank borrowing) arriving in Latvia came to US$3.3bn, which was some US$560m more than the entire current-account deficit for the period.

Evidently such foreign borrowing by Latvian banks ’has increased the external debt position substantially, and at the end June 2006, Latvia'’s net international investment position was some US$11.1bn in deficit, a quantity equivalent to around 80% of nominal GDP. Obviously an inward funds flow running at this level puts a significant cap on the ability of the fiscal measures to achieve their desired effect, and hence the emphasis from the IMF on institutional measures to get the levels of bank lending under control. According to the Bank of Latvia "parent banks of Latvian major commercial banks in Scandinavia have expressed their readiness to reduce the lending growth gradually", however, in Q1 2007 "net loans to Latvian banks reached 23.9% of GDP, a 4.2 percentage point increase over the average of 2006". Well, as they say, it is early days yet.

One of the implications of the structural diagnosis that is being offered (both here, and at the IMF, and by the BICEPS authors) is that implementing the anti-inflation plan will not allow Latvia to simultaneously achieve acceptable inflation, acceptable growth and a positive external balance. It would appear that Latvia has become strapped on the horns of a what is called in the literature a Tinbergen policy dilemma, simply put, and with or without the existing peg to the euro, it simply has too few instruments available with which to achieve its policy targets. (A classic explanation of the Tinbergen dilemma from none other than euro-intellectual father Robert A Mundell - I don't know whether to laugh or to cry at this point - can be found here, while another, and now rather outdated, version of the underlying idea - and one which became pretty fashionable in economic circles in the 1990s - is Krugman's eternal triangle. Obviously in the light of recent developments in the global financial and migration systems this whole literature is now badly in need of an update).

Interestingly - and again according to the BICEPS authors - the latest surge in inflation can neither be blamed on a low initial price base, on EU accession, or on unfavourable exchange rate developments, but is rather the direct result of overheating in the labour market coupled with an ongoing cycle of ever-higher inflation expectations. What the expectations problem means in the present context is that Latvia has become a country with very high (and rising) continuing inflation and Lavia's citizens are now fully aware of this and factor-it-in to wage demands, which in turn add to the production costs of firms and end up in higher prices, which of course then fuel higher wage demands. This is the classic wage-price spiral.

The East-West Wages Gap

Latvia's employment continues to rise, and unemployment remains on a downward path. Employment has been boosted by strong economic growth, and in the third quarter of 2006 the number of people employed reached 1,118,800, up by 7.2% compared with the same period a year before. Employment growth has accelerated, from 4.2% in the second quarter, and currently almost 62% of Latvians between the ages of 15 and 74 are employed"the highest level of employment since 1991. Conversely, the unemployment rate has continued to fall. In the third quarter of 2006 the unemployment rate"calculated according to International Labour Organisation (ILO) methodology"was 6.2%, down from 8.7% in the same period of 2005. Labour shortages are most acute in the capital, Riga, where registered unemployment is below 4%.

In the Latvian case there is one additional dilemma that is not current to the normal Tinbergen policy debate: the wage differential with say the UK or Ireland, and the problem of out-migration. The chart below, which compares the Irish and the Latvian wage distributions may be helpful in seeing the problem:

(please click over image for better viewing)

Now this situation - namely that a period of restrained wage growth may produce yet more out-migration which in turn makes the domestic wage pressure even greater (another kind of 'vicious loop') - is by no means easy to address and as the October 2006 IMF staff report authors note:

Some analysts called for expanding inward migration to alleviate shortages and dampen wage pressures. However, policymakers generally considered that this would have the effect of replacing domestic low-cost workers with imported ones, thereby holding down wages and promoting further emigration.

That is, one solution to the wage increase problem might be to open the frontiers to some extent to migrant labour, but policymakers worry that any resulting flow - being possibly mainly of unskilled workers - might only serve to push down unskilled wage rates and push more Latvian nationals over towards the UK and Ireland. Certainly the Economist Intelligence Unit in its most recent report also noted this issue (January 2007):

The government argues that rapid wage convergence with western Europe is needed to check emigration. On the latest estimate from the Bank of Latvia (BoL, the central bank), some 70,000 Latvians, or around 6% of the labour force, are currently working abroad, mostly in the UK and Ireland.

Of course there is no single clear remedy here, but I think we need to say strongly that this attempt to stem the migrant out-flow by being lax on the wage inflation front is to invite disaster, serious disaster.

Fertility, Migration and the Labour Supply

So the Latvian government is yet one more time here on the horns of a dilemma, and one this time which means they need to run, and keep running, in an ongoing chase to try and catch their own shadow. But how big is their demographic problem? Well to try and get some sort of appreciation we could think about the fact that during 2006 Latvian employment was increasing at an annual rate of around 70,000, while if we look at live births for a moment, we will see that since the early 1990s Latvia has been producing under 40,000 children annually (by 2006 this number is down to 21,000 (as the chart below makes clear).

Indeed ex-migrant flows, the Latvian population is now falling (by 0.648% annually according to the 2007 edition of the CIA World Factbook), and at a significant rate (the birth rate is at a very low level, 1.3TFR in 2006 according to the Population Reference Bureau). Taking into account uncertainties about out-migration (which is almost certainly greater then is reflected in the official statistics) in fact the rate of decline might be even greater.

At the same time the internal employment situation is becoming ever tighter, with unemployment levels becoming ever lower (see chart below, data 2005, and Q1 2005 through Q3 2006).

(please click over image for better viewing)

As can be seen in Q3 2006, employment was increasing at a rate of 7.2% (y-o-y), while the unemployment rate was down to 6.2%. Put another way, an increase in employment of some 75,000 had produced a reduction in the unemployment rate of 2.5% (or about 30% of the registered unemployed). It doesn't take sophisticated mathematics - or "robust" models - to see that this cannot last.

One solution is obviously to try and increase the level of labour market participation, but - and it is interesting that almost no-one here seems to be talking about the need for labour market reforms - it is hard to estimate just how much potential in reality there still is for this. According to the Latvia Statistical Agency Q2 2006 labour force report:

In Q2 2006 more than a half (63.8%) of residents in the age from 15 to 74 were economically active – this indicator was 68.9% amongst males, and 59.4% amongst females. in the 2nd quarter of 2006, the number of economically active population, in comparison with the corresponding period of 2005, increased by 2%.

These numbers, since they include everyone up to 74, and many under 20 - an age where education may still be taking place in many cases - are really very hard to interpret. But whichever way you look at it there is certainly a problem, since wage increases of this order would normally be considered to motivate more labour to come into the market, were it available. However, before going into this labour market structural bind in greater depth, let's take a look at some more of the details of the general economic dilemma.

Producer Prices and Wages

The Producer Price Index measures changes in the price level of most of the manufactured goods produced in a country. The major difference for present purposes between the CPI and the PPI is that the latter excludes imported goods. The recent dramatic upward path which the PPI has followed can be seen in the following graph (Source Biceps report):

(please click over image for better viewing)

In the Latvian case imported goods constitute an important component in CPI since imports account for over half of Latvia’s GDP. Now as we know, inflation in domestically produced goods is very high indeed - currently approaching 20% - while CPI inflation, even though it is now at the highest level for the last decade, is significantly lower due to the low inflation component for imported goods (which is naturally eased, of course, by the way the Lat has been tending to rise in tandem with the euro). The difference in trend for CPI and PPI can be seen in the figure below (source: Biceps report), and it is clear that PPI inflation has been surging much more dramatically than CPI inflation since January 2006.

(please click over image for better viewing)

Now all of this presents rather a large problem when thought of in terms of the international competitiveness of the Latvian economy since a position where the price path of externally produced goods is considerably lower than the price path of Latvian produced goods is evidently not sustainable. And if, as seems reasonable to assume, inflation is being affected by higher expected inflation which workers factor-in to their wage demands, aided and abetted by a perceived tolerance from the Latvian authorities given the migration constraints mentioned above, then the key to all this is clearly the structural issue of the presence of a very tight labour market, and the constraint which this puts on capacity growth moving forward. The result is again very evident: a strong upward pressure on wages which can be seen in the following chart (Source Biceps report):

(please click over image for better viewing)

As the BICEPS authors note, the high degree of similarity (correlation) in the movement of the two graphs (wages and PPI) is striking and suggests that wage growth "is passed on in the form of price increases with a time lag of around 15 months". Again as the BICEPS authors conclude:

"The implication is quite sinister: The current surge in wages has still not shown up fully in inflation but we should expect it to do so later i.e. PPI inflation is very likely to increase and with it to some extent CPI inflation, too. If this is believable, inflation will thus rise before the government’s antiinflation plan may kick in and dampen inflation......The recent surges in wage growth, PPI growth and CPI growth are also worrying in the sense that they seem to indicate a shift in the economy from simply overheated to potentially structurally imbalanced."

So a relatively simple analysis is all that is needed to see clearly that the Latvian inflation problem cannot be addressed separately from the current imbalances in the labour market. As the next section will demonstrate the inflation problem cannot be addressed separately from the imbalance in the external sector either.

Recent Latvian Current Account Deficits

Moving on now to the external position, many things might be said, but one thing is for sure: Latvia’s current account deficit at 21.3% of GDP in 2006 is not a sustainable position. Only 10 countries in the world had higher current account deficits in 2006 than Latvia, and most of these were small island economies with populations of less than 1m (and some of them even as low as 40 000). So it is clear that Latvia’s deficit has become excessive, even by EU8 standards (see chart below).

(please click over image for better viewing)

Latvia in fact was running fairly high current-account deficits throughout the late 1990s (at an annual average of 6.8% of GDP in 1996-2000), but these were mainly financed by inflows of foreign direct investment (FDI) as Latvia steadily sold-off most of its state-owned assets. Since 2001, however, the burden of financing the deficit has moved increasingly towards borrowing (FDI covered 84% of the current-account deficit in 1996-2000, but just 30% in 2001-05), and Latvia's external debt has soared from just 22% of GDP in 1996 to an estimated 112% of GDP in 2006.

But what lies behind the recent substantial deterioration in the current account? The figure below shows developments in the real effective exchange rate (REER) in terms of producer prices against Latvia’s main trading partners:

(please click over image for better viewing)

The key point to note here is the rapid and seemingly accelerating loss of competitiveness which has been taking place in Latvia since mid-2005. This loss of competitiveness is dramatically reflected in the most recent developments in export and import volumes as can be seen in the chart below.

(please click over image for better viewing)

The disconnect that is being produced here is pretty clear even at a simple glance. What is not so clear are the mid term consequences of this evolution.

In the fourth quarter of 2006 the current-account deficit seems to have momentarily peaked at 26.3% of GDP, with the very high reading being mainly the result of a deterioration in the trade balance. According to the Bank of Latvia, the current account deficit in Q1 2007 was running at 25.7% of GDP (see chart below).

(please click over image for better viewing)

Again, as the Bank of Latvia note:

"In the first quarter, total direct investment in Latvia grew by 7.3% year-on-year, covering one third of the current account deficit. The largest part of the current account deficit was financed by borrowing from foreign banks. Reserve assets increased by 45.5 million lats."

Internal Consumption and the Housing Dimension

As we are seeing the Latvian economy is currently expanding at a breathtaking rate, driven by a variety of mechanisms, including negative real interest rates, EU grants, and strong real wage increases. GDP growth averaged just under 12% during 2006, up from just over 10% in 2005. In particular the trend reflects the very rapid increase in household credit as well as sizable spending on EU-related projects and transfers (which nearly doubled to 3.25% of GDP in the first full year of EU membership in 2005). While external demand did contribute positively to growth in 2005, this was really a one-off, with the subsequent strengthening of imports and weakening of exports producing a negative net exports balance from early 2006 onwards.

Rapid financial deepening continues, and with it increasing bank exposures to credit and market risk. Credit to private sector residents grew nearly 65 percent in 2005, and the loan to GDP ratio reached 70 percent, triple the level in 2000, becoming in the process the highest in the EU8. New loans are disproportionately skewed towards household mortgages - which have almost doubled to constitute 20 percent of GDP (although this is still well below the EU15 average of 48 percent) - and such mortgages are increasingly denominated in euros. As a result, housing prices have grown sharply (at an annual rate of about 50 percent through mid-2006: see graph below) and are now at very high levels.

(please click over image for better viewing)

At the end of September 2006 lending to households was up by 80% year on year. It is entirely possible that a housing price bubble has now developed, and one interesting comparison is that while in Estonia and Lithuania house prices did start to stabilise somewhat in late 2006, in Latvia they have continued to rise by about 2% a month. According to the Q1 2007 y-o-y Knight Frank Global House Index, Riga (Latvia's capital) was the global price increase champion, with a staggering 61.2% increase over Q1 2006.

So while the financial soundness indicators for the banking sector remain strong - there are for example very few nonperforming loans (NPLs) and high levels of profitability are being maintained - these measures are in-essence backward looking. With the real estate sector now accounting for around half of total loans, and direct and indirect euro exposure having risen sharply (reflecting both the lifting of limits on open euro positions following the repeg of the lats to the euro and the rapid expansion in euro-denominated loans to mostly-unhedged households) risks have obviously increased.

Migration As A Solution?

Well given that a strategy of relying exclusively on fiscal tightening and strong deflation is fraught with risk, another possibility which should be seriously considered would be to apply a determined policy mix of both decreasing the rate of economic expansion and increasing capacity by loosening labour market constraints somewhat via an open-the-doors policy towards inward migration and with the active promotion and encouragement of an inward flow of migrants from elsewhere in Eastern Europe (or further afield). This would seem sensible, and even viable given the fact that Latvia is a pretty small country. However, as Claus Vistesen notes here, this can only be thought of as an interim measure, since, as the World Bank has recently argued, all the countries in Eastern Europe and Central Asia are effectively condemned to face growing difficulties with labour supply between now and 2020 (so in this sense what is now happening in Latvia may be an extreme harbinger of the shape of things to come). But given this proviso it is clear that a short-term inward migration policy may help Latvia escape from the short-term vice it seems to be in the grip of. This short term advantage may be important, since longer term solutions like increasing the human capital component in the economy and moving up to higher value activity need much more time, and what is at issue here is transiting a fairly small economy from an unsustainable path to a sustainable one.

However Latvia certainly faces difficulties in introducing a pro-migrant policy. One of these has already been mentioned: that this may ultimately put downward pressure on unskilled workers wages in a way which only sends even more of the scarce potential labour Latvia has out to Ireland or the UK. A recent report by the US Council of Economic Advisers made some of the issues involved relatively clear. The report cited research showing immigrants in the US on average have a “slightly positive” impact on economic growth and government finances, but at the same time conceded that unskilled immigrants might put downward pressure on the position of unskilled native workers. Now in the US cases these US workers are unlikely to emigrate, but in Latvia they may do.

A further difficulty is the lack of availability of accurate data on the actual scale of either inward or outward migration in Latvia (this difficulty is noted by both the IMF staff team and the Economist Intelligence Unit). On the latest estimate from the Bank of Latvia some 70,000 Latvians, or around 6% of the labour force, are currently working abroad - mostly in the UK and Ireland - but the true number is very likely considerably higher (IMF Selected Issues Latvia 2006, for example, puts the figure at nearer 100,000).

Several recent surveys also suggest that the potential for outward migration remains substantial. For example, a survey conducted by SKDS (Public Opinion on Manpower Migration: Opinion Poll of Latvia’s Population) in January 2006 revealed that about 22 percent of Latvian residents see themselves as being either “very likely” or “somewhat likely” to go to another country for work “in the next two years”. Based on the current estimated population, this translates into between 350 and 450 thousand residents (between 15 and 20 percent of the 2005 population). The survey also indicated that these respondents were significantly skewed toward the relatively young (15-35), which would significantly reduce the working-age population and labor force in the near future. These respondents were also slightly more likely to be male, less educated, low-income, employed in the private sector, or non-Latvian.

But there is a second issue which immediately arises in the context of projected in-migration into Latvia, and that is the situation vis-a-vis the presence of large numbers of Russophone Latvian residents who are non-citizens. The issue can be seen in the table below.

(please click over image for better viewing)

Essentially out of a total population of 2,280,000, only 1,850,000 are citizens. Of the remainder the majority (some 280,000) are Russians. And these Russians are not recent arrivals, but they are a part of a historic Russophone population which build up inside Latvia during the period that the country formed part of the Soviet Union.

In fact, if we look at the chart below, we will see that during 2003 the rate of out migration from Latvia seems to have increased substantially, as membership of the European Union loomed.

(please click over image for better viewing)

But what happened in 2003/4 wasn't simply an increase in the volume of migration, it was also a change in the direction of migration, and much of this has to do with the Russophone population who are not Latvian citizens (and therefore logically at this point not EU citizens either). The majority of the pre 2004 out-migration was actually towards the CIS, and it is reasonable to assume that many of these migrants came from the Russian speaking population. And this process is not over as this recent article from Itar-Tass about a joint project to settle Russian speaking Latvian residents in Kaliningrad makes clear.

So clearly the fact that the Latvian authorities may still be actively considering encouraging the resettlement of Russian speaking Latvian citizens elsewhere gives an indication of just how unprepared the collective mindset in Latvia is for all that is now about to come upon them.

Yet one more time the difference with Estonia couldn't be clearer. According to the Baltic Times this week, Estonian Economy Minister Juhan Parts is busy working on a set of proposals - which before Parliament by November - which will attempt to address Estonia’s growing shortage of skilled workers. The quota of foreign workers will be doubled to about 1,300 and the bureaucratic paperwork slashed . Now it is true that Parts is still to bite the bullet of accepting the need for unskilled workers too, but in the present situation a start is a start.

Towards A Policy Driven Exit

So what is the remedy? Well, lets look again at the IMF proposals:

a) Fiscal policy: Against the balanced budget targeted in the anti-inflation plan, we consider that a headline general government surplus of 2¼ percent of GDP in 2007 and 4 percent of GDP in 2008 is appropriate. This could be achieved by saving in full revenue overperformance, restraining current and capital expenditures, and abstaining from cuts in taxes, including the personal income tax.

b) Credit and prudential policies: Sharply curtailing and improving the risk profile of new lending is essential to mitigating macroeconomic and financial stability risks. Rebalancing incentives governing credit growth is therefore essential. The mission supports the effective implementation of the credit-restraining measures in the anti-inflation plan, including fully documenting legal income to secure a loan, establishing a comprehensive register of all loans, and requiring a 10 percent minimum downpayment. We also welcome the recent reimposition of limits on banks' open positions in euros. Additional regulatory measures are also needed to slow credit growth and induce banks to internalize systemic risk in real estate and currency markets. The FCMC, working with the Bank of Latvia, should increase its emphasis on monitoring systemic risk through more frequent on-site inspections of large banks and ensuring that foreign banks tailor their credit-risk models to the Latvian context.

c) Real estate policies: Rebalancing the structure of the economy away from the nontradables sector, especially real estate, is essential to underpin needed current account adjustment. The mission welcomes the increase in real estate taxation envisaged in the anti-inflation plan, as well as the periodic reassessment of cadastral values, beginning in 2007. To be effective, however, enforcement of real-estate related taxation should be stepped up. To further relieve overheating in the construction sector, it will be necessary to significantly scale back government capital expenditure (planned at 5 percent of GDP for 2007)."

d) Labor market policies: Efficient labor utilization is critical to expand aggregate supply and contain surging wage costs, which are contributing to overheating and undermining Latvia's competitiveness. The greater flexibility allowed in the use of fixed-term employment contracts introduced in the 2006 Amendment to the Labor Law is welcome, and further steps to facilitate mobility between jobs and regions are needed. The recent decision to allow unfettered labor market access to the newest EU members may help relieve bottlenecks, and wider temporary access should also be considered.

The above IMF package is clearly a big move in the right direction. My principal worry is that the severity of the shock produced may have a significant longer term impact in a negative direction than is desirable, especially if the package is followed by a bursting of the housing bubble which could in itself precipatate yet another outward stream of migrants. However, as we have seen above, the Latvian government is itself far from accepting the need for the totality of the package, and in particular as regards the fiscal dimension. But I think the big missing issue which is not being addressed here is the labour supply one. A systematic move to apply the fiscal braek, to tighten lending conditions and to facilitate an increased supply of labour would seem to offer a better possibility of bringing about the necessary correction without completely upsetting the apple cart in the process, so I therefore think that such labour supply measures should now be considered as a matter of urgency.

Hard landing?

Of course debating the niceties of the policies we would like to see is one thing, and addressing the economic realities of the policies we have is another. If domestic demand does not abate steadily now, a hard landing could well result. Under this kind of scenario, one or two more years of GDP growth in excess of an annual 10% rate would probably lead to such pressure on the labour market (remember the unemployment rate was dropping in 2006 by about 2.5% a year) and thus to such an acceleration in inflation that the impact on competitiveness and external liabilities would become unbearable. Under these circumstances attracting the necessary external financing would become increasingly difficult, and a sharp slowdown would probably result as the underlying accumulated output gap was corrected in an unduly short space of time. The most worrying point about such a scenario is that we really don't know the long term consequences it might induce. Latvia - like many East European and Central Asian societies is about to experience a severe demographic challenge, and it would be better to face that challenge with the wind behind you rather than the wind in your face, and certainly better to try and chart your own course than head off in the direction of "destination unknown".

Latvia Economy Watch Blog

Incidentally, just in case anyone reading this is interested, I have now established a Latvia Economy Watch blog, to accompany my Hungary Economy Watch one.


Inflation in Latvia: Causes, Prospects and Consequences, by Alf Vanags, director of the Baltic International Centre for Economic Policy Studies, and Morten Hansen, an economist at the Stockholm School of Economics.

Statement by IMF Mission to Latvia on 2007 Article IV Consultation Discussions
, May 2007.

Republic of Latvia: 2006 Article IV Consultation - Staff Report
; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for the Republic of Latvia, October 2006

Republic of Latvia: Selected Issues, IMF October 2006

Language Use and Intercultural Communication in Latvia

Inese Ozolina

"Changes of Ethnic Structure and Characteristics of Minorities in Latvia"
by Peteris Zvidrins

'Exit' in deeply divided societies : regimes of discrimination in Estonia and Latvia and the potential for Russophone migration. Hughes, James (2005) Journal of common market studies, 43 (4). pp. 739-762. ISSN 1747-5244

Estonian Report on Russian Minority

Aksel Kirch

Latvian Naturalization Board, Statistical Information on Acquisition of the Citizenship of Latvia as at May 31, 2007.

Monday, June 11, 2007

Macroeconomic Adjustment in the Euro Area and Italy's De-Facto Dependence On Exports

Early warning. This is a monster post. I hope it is worth the ride.

In fact this is the second post in a series I started here (and unfortunately it is also a monster one, so again watch out). Essentially I am taking Chapter 2 of the recent European Economic Advisory Group (EEAG) report on the European Economy 2007 - which is entitled Macroeconomic adjustment in the Euro Area: the Cases of Ireland and Italy - as a starting point for a much more general reflection on how the euro system works, and as a pretext for continuing the search for the structural drivers of the European economies (and here and here). The current post will largely deal with the Italian case, but will attempt to draw out parallels and comparisons. A third post will look at the role of exports in the German economy, while a fourth one will attempt to draw together the threads and examine what may be learnt.

So coming to Italy, as the report notes, GDP growth in Italy has been very sluggish over the last decade or so. As can be seen from the chart below, GDP growth since 2002 has been well below the EU average:

(Please click over all images to get a better view).

This is not, however, a recent phenomenon, since as the next chart shows, Italian GDP growth has been low since the early 1990s:

In fact Francesco Daveri and C. Jona-Lasinio - in a most interesting paper on Italy's relative economic decline entitled Italy's Economic Decine, Getting the Facts Right (of which more below) - say the following:

Italy’s per-capita GDP growth was 5.4% in the 1950s, 5.1% in the 1960s, 3.1% in the 1970s, 2.2% in the 1980s and 1.4% in the 1990s. A rough-and-ready extrapolation of this decade-long continued slowdown would lead to expect no more than 0.5% in the 2000s (so far we are at some 0.6% over 2000-05, if per-capita GDP stays constant in 2005). In any case, nowadays, the miracle years of the1950s-1960s seem quite far away in time.

They also produce this chart which puts Italian long term growth in context:

And the situation becomes even clearer if we look at this chart they produce, where it can be seen that per-capita GDP in Italy has only rosin more quickly than the combined rate of France, Germany, the UK and Spain in six years since 1980, and in none in the last decade (during which time, it should be remembered, German per capita GDP growth has itself been very low).

as Daveri and Jona-Lasinio comment:

"(The chart)...concisely shows that Italy, being much poorer than Europe (poorer than France, Germany and the UK, but richer than Spain) in 1950, has been catching up fast until – roughly - the early 1990s. This process of convergence has reversed its course since then, however. In the 1950s and the 1960s, Italy grew faster than Europe six times in each decade; in the 1970s and the 1980s this occurred four and five times respectively. In the 1990s, instead, this occurred only twice, in 1991 and 1995. Since 1995, then, Italy’s per-capita GDP has grown less than (the other big countries in) Europe’s GDP."

they also add this rather intriguing comment:

"Altogether, the long-run data suggest that the bad performance of the Italian economy is not the figment of the currently unfortunate business cycle contingency. This is why speaking of decline may not be totally unwarranted. With one caveat to add, though: given that the rest of Europe has been and is still growing at a positive pace, Italy’s alleged decline is of a relative, not an absolute type. Italy’s per-capita GDP has simply grown not as fast as Europe’s GDP, but has not diminished over time (yet)"

That "yet" word seems to be looming rather ominously, since with the growing age-related dependency issue just over the horizon, such a decline in the future can certainly NOT be ruled out given current trends. More importantly though, Daveri and Jona-Lasinio seem to give little credence to the idea that Italy's problems can be simply placed at the door of an immediate business cycle conjuncture, or shock (although such shocks may well be exacerbating the problem).

Going back now for a moment to the first chart it is clear that, despite a relatively relaxed monetary stance from the ECB, Italian inflation has been trending down in recent years. This is undoubtedly in part associated with the relatively sluggish rate of growth in internal demand from which Italy has been suffering - and it should also be noted that this drop in inflation has come despite a steady fall in Italian unemployment and a continuing rise in wage costs. The contractual hourly earnings index rose by 3.3% year on year in October, November and December 2006. Over this period the largest annual wage increase was recorded by public-sector workers, whose salaries rose by 5% y-o-y, continuing a longer-running trend. In general - and despite lower productivity rates, government workers have been getting higher pay increases than private workers during the last five years. Wage inflation was at its lowest in the services sector, with a rate of 1.9% y-o-y in October and 1.8% in November and December. In industry (excluding construction), wages rose by an average 3.7% y-o-y over the three months. (Overall hourly earnings rose at 3.3 % in 2004 and 3.0% in 2005).

Of course the recent drop in energy prices does form part of the inflation picture, and it will be interesting to watch what actually happens if energy costs resume their upward trend. It should be noted, however, that despite this downward trend in the rate of price increases, and despite the lackluster growth, the Italian inflation rate has remained stubbornly around, and often slightly above, the euro area average, as can be seen from this chart:

Now turning to the constituents of GDP, we can see from the chart below that, whilst domestic consumption did gain some momentum during 2006, the general picture has been one of very slow growth in domestic private demand (please click over chart to read). In 2004 private consumption grew by only 0.5%, and in 2005 it was absolutely flat (0% growth). This position is now increasingly being mirrored by Italian government consumption which is quite tightly constrained due to the growing deficit problem. Indeed what evidence we have to date from 2007 suggests that the underlying weakness in domestic consumption continues.

Now, as can be seen from the next chart, public consumption in Italy is relatively important, since private consumption only constitutes some 60% of GDP (as opposed to nearly 70% in the USA), so given the relatively weak export performance of the last decade (of which more below), and the weak growth in private consumption, government spending has been playing a significant role in maintaining what growth there has been. This will now have to change if Italy is to bring the deficit (which is currently around 107% of GDP) down.

Returning to the EEAG report, as the authors say:

Our analysis focuses on Italy as an example of slow adjustment in response to shocks reducing foreign demand. The creation of a common European currency coincided with a strong crisis in competitiveness and productivity in Italy, exacerbated by the appreciation of the euro since 2002.

In addition they also note:

The Italian export crisis has not erupted suddenly but has been developing since the mid-1990s. Between 1995 and 2005, the share of Italian exports in world exports at constant prices fell from 4.6 to 2.7 percent, a 40 percent drop. The comparison with Germany...is striking: Over the same period, the German export share grew by 15 percent. If exports shares are instead calculated at current prices, the share of Italian exports in world exports fell from 4.6 to 3.7 percent (see De Nardis and Traù 2005). Of course, Italy is not the only developed country to lose market shares over the period, as there is a trend shift in favour of the emerging market economies.

Well the comparison with Germany is here frankly interesting, since quite simply, in terms of their demographic profile, Germany and Italy have a lot in common, a lot more in common with each other, than either have with say the UK, or France, or Spain, or - indeed - Ireland. Both Germany and Italy have suffered from ongoing weaknesses in their domestic consumption (and neither of them, of course, have recently had housing 'booms', of which more later), and both need to address this structural issue in internal demand - which seems to be related to population ageing - by becoming more competitive in their export sectors. But what differentiates these two economies is that while Germany GDP growth has increasingly come to depend on a very efficient export sector, in Italy shortcomings in exports and domestic consumption have rather been compensated for by increasing public spending and growing government indebtedness.

The accompanying chart makes the relative export evolution clear:

So Germany has done immensely better than Italy in the export sector, and indeed, much better than many others internationally, since Germany's share in global exports started from a relatively high initial level. The comparison shown in this graph is revealing:

It becomes even more revealing when we look at how closely the Italian path mirrors the French one. Yet France has not had anything like the same low growth problems that Italy has had, basically due to the relatively better health of domestic consumption. And the question many might like to be asking themselves at this point is why should this be, why this difference in internal consumption between Italy and France?

And it is here that I find myself parting company somewhat from the general approach of the EEAG report, since they tend to focus on what they take to be a shock-induced external competitiveness problem which they argue may have developed in Italy since 2002, whilst I think it is important to try to situate Italy's recent problems in a much broader historical and evolutionary perspective:

Nonetheless, the Italian competitiveness crisis substantially worsened after 2002, coincident with the appreciation of the euro. It is apparent that the Italian export crisis became acute after 2002. The index of industrial production for the exporting sectors lost approximately 6 points relative to non-exporting sectors from 2003 on. A similar gap can be detected for capacity utilisation. In response to the large external shock to export demand, adjustment would require real depreciation.

Now certainly there is no doubting the fact that the Italian export sector has been suffering from a competitiveness problem, and while there were signs that export growth was once more picking up again at the end of 2005, growth once more turned negative in the 3rd quarter of 2006. An indication of the competitiveness problem can be found in this chart which compares real effective exchange rates (or if you prefer relative movements in unit labour costs):

Indeed the general poor productivity performance achieved in Italy in recent years is highlighted in the chart below (which comes from the OECD 2006 factbook) where Italy can readily be seen to have been the worst performer in the OECD in the years between 2002-2004.

So there seems to be no denying this part of the argument, Italy's productivity performance has been lamentable. Italian economists Francesco Daveri and C. Jona-Lasinio - in a paper entitled Italy's Economic Decine, Getting the Facts Right - examine the Italian productivity 'problem' and come to three conclusions:

We reach three main conclusions. First and foremost, most of Italy’s economic decline stems from decreasing labor productivity (not hours). Second, the standard decomposition of industry productivity trends shows that the bulk (80%) of Italy’s productivity slowdown originates from a generalized within-industry slowdown (or outright declines), mainly in durable and non-durable manufacturing. Diminished inter-industry reallocation from agriculture onto market services contributed the remaining 20% of the slowdown. Third, the labor productivity slowdown was mostly accounted for by a marked deceleration of TFP, which was not the result of an unfortunate cyclical contingency (the current slowdown is worse than in any former downturn in the last twenty years).

So, essentially, there has been a within-industry slowdown (ie TFP has not risen fast enough as industries have not transited to higher value activities) AND there has not been a rapid enough movement into the new market services areas.

In some ways this is very compatible with the story the EEAG highlight in the following chart:

What we can see is that activity has been maintained much more in the non-export than in the export-related sectors, and much of this domestically oriented activity may be in more traditional, low-value-added activity, increasingly staffed, possibly, by newly arrived migrants with low skills and education (see below).

But noting this, and leaving matters there is in many ways to remain on the surface, and not to get to the heart of the matter. As Daveri and Jona-Lasinio so cogently argue, Italy's decline is a much longer term phenomenon, and we need to get through to the underlying structural issues here. In this context we may think that comparing Italy and Ireland is rather like comparing apples and pears, the two economies are fundamentally different structurally, but why are they different?

If instead we compare Germany and Italy - which are from many points of view much more alike - we can see that the fact that Italy has been much slower - for internal political reasons - to bite the bullet of the reform process, means that it has been public spending and not the export sector which has been the growth driver on the margin, but this still leaves us with unsolved issues.

What is it that separates BOTH Germany and Italy from France, and why is it that the former cannot rely on dynamic internal consumption, while the latter can? The answer to this apparent conundrum may come in one word: housing, and in the different ways in which the different eurozone economies responded to one and the same nominal rate of interest in terms of the presence or absence of construction booms.

So what determines whether or not there is a construction boom in any given country? Well strangely enough the answer to this seems to be relatively (indeed perhaps deceptively) simple: median age. I have yet to find a society whose population has a median age which is substantially over 40 which has had a construction boom over the last five years which has been of anything like the magnitude of those which have been seen in those societies with median ages in the 35 to 40 bracket.

And why is this important? Well quite simply, developed economies are becoming more and more services driven, and an important component in this whole shift to services economies has been a growing importance for the construction share in economic activity.

Italy is, of course, like most other OECD economies, making the transition to becoming a services, rather than an industrial society, and the share of services in GDP is growing constantly. In the Italian case the services sector clearly constituted the main driver of growth in gross value added in the third quarter of 2006, despite slowing compared with the first half of the year. Services expanded by 0.3% in July-September compared with the previous quarter, down from quarter-on-quarter growth of 0.9% in the first and second quarters. Financial services and real estate, which had been flat in 2005 showed the sharpest rise, growing by 0.6% in the third quarter compared with the second.

So there is some dynamism in the real estate sector, but has there been a boom? And what exactly has been happening to the housing sector in Italy over recent years?

Well the first thing to note - looking at the comparative graphs below, which show trends in EU house prices - is that from the late 80s to the early 90s Italy had quite a significant housing boom, following which prices flattened out, subsequently remaining either static or even falling slightly until the early years of this century:

The graph below shows the position in even more detail, since it gives annual movements in real house prices for Italy from the mid 90s to date, and here we can see how, while at the end of the 90s prices were actually dropping, they did start to rise in the early years of the century, but they subsequently peaked again, and started and have since started to flatten out again, running at a rate somewhere around the annual shift in Italy's CPI, that is they are more or less flat in real terms.

The above graph has been produced by the Royal Institution of Chartered Surveyors as part of their European Housing Review 2007. In that review they have this to say about the current state of the Italian housing market:

The housing market continues to be fairly flat. Prices in 2006 again rose by around 4% in nominal terms and sales dipped somewhat. Prices, in fact, were flat in most of the major cities and it was in suburban and smaller town localities where the market was strongest. So, the revival seen in the economy does not seem to have filtered through to the housing market as yet. The impetus from it was probably offset by rising interest rates in a country where variable mortgage interest rates predominate. It is expected that the market might slow even further in 2007 with continued pressure from rising interest rates. However, no actual fall in prices is anticipated.

The following comments from the RICS report also seem interesting and relevant:

The mortgage market is fairly recent. Outstanding mortgages were only 18% of GDP in 2005, although this was up from 6% in 1990.10 Outstanding mortgage debt per capita is almost nine times less than in heavily mortgaged Denmark, for instance. Surveys suggest that only around half of purchasers use mortgage facilities, despite the apparent tax benefits of doing so.

At present, Italy has an exceptionally low level of personal borrowing for an affluent society. The overall ratio of longterm household debt to household disposable income was only 41% in 2004, less than in any other of the world’s major economies.

The introduction and growth of mortgage lending interestingly has paralleled similar developments in central and eastern Europe. The Italian experience highlights the fact that a country does not inevitably experience a major house price boom just because a new mortgage market rapidly develops.

This last point, that a country does not necessarily experience a housing boom simply because a new mortgage market rapidly develops seems especially important. The question is why not, what are the sensitivity factors? As I keep stressing willingness to borrow on aggregate, which is in part a function of the overall age structure, does seem to be one of the important indicators.

Of course, as the report also notes, demography not only influences the demand for credit, it also influences the long term demand for housing:

The total population is virtually static, because natural declines are being just offset by immigration. Household numbers are also static at 20.5 million. Overall, population is decreasing in the major cities and increasing in the smaller centres. Moreover, there has been a long-term trend, as elsewhere, for residents to move away from the city centre to the suburbs – although this trend is now associated with a counter inwards movement towards the city centres.

In the absence of increased immigration, the total population is expected to stabilise, and then decrease by around 4%, over the next 15 years. Moreover, the population is ageing. There was a very high birth rate in the 1960s but there has been a subsequent demographic transformation, which gives Italy the lowest birth rate amongst OECD countries. As a result, the population is expected eventually to fall significantly, by 6.6. million between 2020 and 2050; by that latter date the population will be a full 15% less than now.

Life expectancy is also high and rising. The result of these changes is that the country is experiencing one of the greatest demographic shocks of all advanced nations. People over 65 years old currently equal 10 million - about 18% of population - and the number will grow steadily to reach an estimated 16 million by 2040. By 2050, 31% of the population will be 65 or over. Such a transformation is likely to have profound effects on the housing market.

Both the decline in population and increasing share of the elderly in it are also stronger trends in the northern regions than elsewhere. In the absence of significant inter-regional or international migration, significant housing surpluses may begin to arise in Northern Italy a decade from now onwards.

So an ageing and potentially declining population (Italy's natural rate of population growth went negative back in 1992, and population has subsequently only risen due to inward migration) would seem to logically exert an influence on demand for the total housing stock, with the one wild card here really being immigration, to which topic we will now move on.

Now the most recent comprehensive study of migration into Italy to appear online is a paper presented by Giuseppe De Bartolo of the University of Calabria: Immigration in Italy, The Great Emergency. The paper makes a useful read, and this despite the fact that the tone and title of the paper is at times rather alarmist - and despite the fact that he clearly overestimates Italy's relative position in the migrants league when he states that "Italy with an annual migratory total of 300 thousand people is preceded only by the United States, whose total is of about a million people". Numerically speaking this latter statement is clearly false, since with an inward flow of somewhere between 500,000 - 600,000 annually Spain obviously has been receiving more migrants than Italy (as, possibly, has the UK in 2004 and 2005 with so many East Europeans arriving), whilst proportionately certainly Ireland (and probably Greece) have almost certainly had rates of inward migartion which have exceeded the Italian inflow. And this has been the case despite the fact that Italy is ageing much more rapidly than any of these other societies, and thus could arguably be more in need of younger migrants. So the fact that Italy has lagged behind in all of this is not without significance. The question is that even if you need migrants, they may not come, and what we need to look at here is what the actual drivers of migration are.

Well, according to the Italian National Statistics Office (ISTAT), on January 1st 2006 there were 2,670,514 resident foreigners legally in Italy, which constituted an increase of 268,357 (or 11.21%) in relation to the same population in 2005.

Now rather than focusing on the absolute numbers of foreign born population in Italy, what is more interesting for us to focus on here are the flows of migrants into Italy over the last decade or so. As the chart below clearly shows these "official" flows tend to rise and fall in relation to the various "regularisations" which have taken place. It should always be remembered that this data only gives a partial view of the actual rate of flow at any moment in time, since during a "regularisation" immigrants who are already in Italy suddenly "appear" as and when they become legal. This is rather different from the situation in Spain, for example, where immigrants - despite having no legal status in the country - normally register directly with their local town hall since subsequent legalisation often depends on the date of this initial registration. As a result we normally have reasonably reliable data on the migrant presence in Spain. Turning to the chart, we can clearly identify the regularisation peaks:

(Source: Blangiardo G. C. & Molina S. (2006). Immigrazione e presenza straniera. (In Fondazioni Giovanni Agnelli (Ed.) Generazioni, famiglie, migrazioni. Pensandoall’Italia di domani. Torino.)

These correspond to the four major regularisation processes in Italy, as Giuseppe De Bartolo explains:

Between 1990 and 2002 the Italian governments passed four regularisation acts: with the law n. 39 of 1990 (the so-called Martelli's Law) regularised 218 thousands of unauthorised migrants, most of them were Africans and Asiatics. In comparison to the following regularisations, with the Martelli law there was the greatest number of irregulars in comparison to the legal component (120.9 rectified for every 100 regular foreigners - limiting ourselves to the immigrants that originate from the countries of strong migratory pressure). This is to be attributed to the circumstance that the law imposed for the regularisation, which was only to show to have already been in Italy on the date of December 31st 1989. On the occasion of the regularisations favoured by the DL (Decreto Legge - Law Decree) 489/95 (Dini decree) and with the DPCM (Decreto del presidente del Consiglio dei Ministri – President of Council of Ministers decree) of October 16th 1998 the rate of irregularity appeared less because of the greater rigor of the norms. With the first provision (Dini decree) 244 thousand people were regularised, while with the second 217 thousand irregulars were regularised. With the two provisions the citizens of central eastern Europe profited the most because of the increase of the illegal flows coming from Albania and Romania. The law n.189 of 2002 (the so-called Bossi-Fini) can be considered the most important legislative measure in this matter. This law has allowed 647 thousands to be regularised; a number just less than the residence permits emitted altogether (680 thousand) on the occasion of the previous provisions since 1990 (Istat 2005)

The table below also provides a convenient summary of the flows across the years.

In this context it is perhaps worth noting that the most recent data on migration into Italy comes from the national statistical office (ISTAT) in the form of three relevant reports:

Popolazione residente e stranieri residenti nei comuni italiani (April, 2007), and

La popolazione straniera regolarmente presente in Italia (April, 2007), and

Indicatori demografici (March, 2007)

These reports are unfortunately only available in Italian.

What they reveal is that (and as previously noted) on 1st January 2006 there were 2.670.514 foreign nationals legally resident in Italy, and this was an increase over 2005 of 268.357 (+11.2%). The 2006 increase was, however, considerably below the increase experienced between 1st January 2005 and 1st January 2004 (+411.998, or +20.7%) and that of 1st January 2004 over 1st January 2003 (+440.786, or +28.4%).

Thus between 1 January 2006 and 1 January 2003 there was an increase of legally present foreign residents of 72% (or + about 1,120,000 people). This gives a flow roughly 350,000 people a year, and this may give us some idea of the real rate of flow. As a result on 1 January 2006 this population constituted some 4.5% of the total Italian population (which was 58,751,711) a level which was still well below the general "Old EU" average.

Again this increase can perhaps be seen in the chart below:

One of the most significant impacts of this immigration will have been to nudge the Italian median age slightly down (but only slightly) since the median age of the foreign born population is 30.8 while the median age of the is possibly around 43. ISTAT estimates the median age of the whole population (nationals and foreign born) at 42.6 on 1st January 2006.

The impact of all of this on the Italian population pyramid can be seen below (again remember to click if you want to see better).

So the arrival of migrants has had some small impact on the Italian age structure, and in particular in the large 30-40 age group, but again as can be seen from the pyramid cohort size is about to decline rapidly and to exert any notable impact on the ageing process these migrant inflows will need to increase dramatically. Otherwise, as is clear from the pyramid, Italy is likely to suffer a grave shortage of younger workers over the next decade or so, especially given that a significant percentage of the existing migrants are in the 30-40 age group, and a decade from now these will be in the 40 - 50 age group.

However inward migrant flows do not constitute the whole picture here. Italy (just like Germany) is also experiencing a significant outflow of qualified and educated young workers:

since the mid-1990’s the share of college graduates among emigrants from Italy has become larger than that share among residents of Italy. In the late nineties, between 3% and 5% of the new college graduates from Italy was dispersed abroad each year. Some preliminary international comparisons show that the nineties have only worsened a problem of ”brain drain”, that is unique to Italy, while other large economies in the European Union seem to experience a ”brain exchange”.

This state of affairs is a pretty significant one, especially in the light of the fact that Italy's population has not been replacing itself since the early 1990s (ISTAT, latest data, PDF link). Since that time there has only been a continuing population increase as a result of inward migration. But, as this Lavoce article stresses, the balance in human capital terms is hugely negative here. That is to say, the inward-migration that is currently taking place in Italy is extremely important in labour force terms, but this added man- and woman-power can only serve to make the path of the Italian economy a sustainable one if at the same time young educated Italians stay and enter the labour force in much more productive, higher-value activities. This position becomes especially important when we bear in mind the large cohort size reduction Italy is about to experience in the 30-40 age group.

Now, if we turn to the Spanish case, we can see from following chart the rapid increase in the foreign born population in Spain in recent years:

Source, INE, Spanish national statistical office.

Now what we can see is that since 1st January 2000 (and rounding out just a little) the foreign born population resident in Spain has increased from nearly 1 Million, to around 4,150,000 on 1st January 2006. This is a total of 3,150,000 in 6 years, or an average of a little over 500,000 a year.

Now it is important to keep in mind that this increase comes from 2 sources, the migrants themselves, and residents from other parts of the EU who have bought homes in Spain during the construction boom (the greying northern population phenomenon). While it may be important for analytic and compositional reasons to distinguish between these two populations (eg for growth accounting purposes), for our present concerns they are a by-product of one and the same phenomenon: Spain's construction boom (Italy could and should, after all, have been attracting these potential clients for her services).

So the question is, do we here have a measure (or rough proxy) for the differences between having and not having a construction boom at a critical moment in your history. As I estimate above, Italy has been attracting migrants at the rate of around 300,000 a year, while Spain has been attracting something more like 500,000, and it should be noted that the Spanish population is (or rather was) only approximately two thirds of the Italian one, so to have had the "Spanish disease" maybe Italy should have been attracting migrants at a rate of around 650,000 a year, or more than double what she was attracting. Since these two countries are quite comparable culturally (that is, it is in principle no more difficult for an undocumented migrant to arrive in Italy and stay than it is in Spain) the differences in the flows most probably relate to differences in the underlying dynamics (ie the creation of employment) and these differences can also be seen in the relative growth rates of Spain and Italy.

But again, Italy's problem doesn't end here. Having such a strong inflow of migrants has clearly revolutionized the whole Spanish employment situation, and creating work for unskilled migrants at the bottom of the ladder has lead to increasing employment of more qualified Spaniards higher up (and note here the OECD productivity chart above, since these different retention and employment creation profiles for the young and educated are probably one of the features in the Spanish productivity performance, which while not outstanding is certainly much better than Italy's).

One key data point here tells all. In the world there are approximately 3.5 million people who live outside Italy and hold Italian passports. Many of these live in Latin America and are the descendants of earlier Italian immigrants. Yet, what we have noted here in Spain is a constant stream of young people entering from LA using Italian passports (young educated Spanish people are not - other than for external experience reasons - leaving in any significant numbers). Strangely this is not happening in Italy, and the young and educated are not arriving in significant numbers, in fact precisely the opposite is happening, young Italians are leaving, and in growing numbers.

So I conclude with a question: is there yet another inflection point to be looked for here, the one between a level of migrant flows which helps you just keep going (and even produces only horizontal growth in activity terms) and one which accelerates the rate of increase in domestic consumption to such a rhythm that it eases a rapid transition to a services economy (ie vertical growth), and in doing so not only gives employment to the native young and educated but even attracts such people from outside in growing numbers (the Spanish phenomenon)?

What I am saying is that everyone would clearly like to attract educated migrants, but not everyone can. Is the difference a function of your overall growth rate, and is housing here a key factor? That, I think, is the question. To be, or not to be (built).