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Sunday, October 6, 2013

Can demography explain Portugal's growth slump before the crash?

The above still comes from a recent Financial Times video entitled "Portugal's Brain Drain", which can be found here, and which I encourage everyone to watch. The issue being raised revolves around the current acceleration of emigration from countries on the EU periphery, largely towards the EU core. Typically the emigrants are young educated people who can't find work. There is nothing especially surprising in this, since the tendency has long existed for people to move from more depressed areas to economically more dynamic ones. The exodus from Detroit in the United States immediately comes to mind. Or Scottish people getting on the bus to make the fateful journey from Edinburgh or Glasgow to London. The Schengen accord simply extends this process which used to take place within nation states to single market zones, or currency unions. But does this extension have consequences for the participating states which were not anticipated at the outset, and are these consequences all benign?

In addition, this time round in an important sense something is different since these movements are occurring in the context of a long and difficult economic adjustment, indeed one could almost argue that the people leaving form part of that adjustment. What's more it is hard to accept that this is the kind of adjustment that countries like Spain and Portugal really need. Renovation in these countries implies these people and their talent are injected into the local economy to dynamise it, and not shot out the side like water from a high pressure hose with holes in it. So the big question I want to ask here is whether the economic programs which are being implemented in these countries take sufficient account of the demographic impacts they are inducing, and of the fact that the population loss involved - which most likely will become permanent - is going to cast a long shadow over the history of the countries concerned.

In earlier generations, migrants used to leave behind them what were comparatively high fertility societies. There were more children being born than the local economy could absorb.  We can still see this phenomenon in the world around us, as highlighted by the recent tragedy near Lampedusa, Italy. But the EU periphery case is rather different becuase - as the article I publish below indicates - the countries people are leaving are going to be short of working age population in a not too distant future.  Again, as blogger Valter Martins argues, maybe the impact of stagnating working age populations was already being felt before the global crisis broke out. Certainly, as I argue here, a case can be made that in Latvia it was the labour force limitation which lead to the excessive overheating and then the roller coaster landing that hit the country in 2008.

True, all these countries are suffering excessive levels of unemployment. But unlike the case of, say, Nigeria or Ecuador, this is not because there are too many young people for the economy to absorb, it is because the economy is stuck in a bad place and can't grow. Structural reforms are needed, but some of the reforms simply don't make sense. What is the point, for example, in lengthening the working life of older, less productive, workers while going to the airport to wave goodbye to their innovative and educated grandchildren who are forced to leave as a result. Surely a better solution would be sustainability in the pensions system - what goes out in total can be no greater than what comes in - and no reduction in the retirement age in the short term. Yes, this will mean lower pensions, but if the young leave the lower pensions will be even lower in the long run. There's a problem of priorities somewhere, and a generational imbalance in how the adjustment is being implemented which is not only unfair, it will lead to far from optimal outcomes in the longer run.

As it happens, just a couple of weeks ago three IMF economists (including chief economist Olivier Blanchard) presented  a paper to the Brookings Institute which  reviewed the performance of the Latvian economy since the EU-IMF intervention. It was a kind of informal post program evaluation. Interestingly enough, during the course of that paper they raise the very point I am raising here. “The question," they say, "is whether this emigration [from Latvia, EH] is, in some sense, a failure of the adjustment program."

They are right. This is exactly the question we should be asking ourselves. And in Portugal, Spain and Greece too. Their answer -  from an economic point of view emigration raises overall welfare:

 "In the United States, migration rather than unemployment is the major margin of adjustment to state specific shocks ….. These adjustments are typically seen as good, indeed as the main reason why the United States functions well as a common currency area: If there are jobs in other states, and if moving costs are low, it is better for workers to move to those jobs than to remain unemployed.”

This is the typical "non answer" we keep getting to this issue in the EU context. Obviously, from the point of view of optimal output, and the maximizing resources across a continent,  most probably such movements are beneficial. But to whom are they beneficial? Which "collective" community is it whose overall welfare is being raised here? Arguably not those in Latvia and Portugal. EU countries are not US states, and a United States of Europe does not exist. Again, this point is obvious, and agreed on by all, but when the problem this raises in terms of emigration from countries who have been running birthrates well below the replacement level  is put on the table all we get is silence.

Now assuming policymakers are not simply stupid this silence suggests that the whole issue touches on some very fundamental raw nerve. There is no answer in terms of sustainability for those countries who are net losers unless there are reverse direction transfers, as under the US Federal system, and that no one wants to talk about, at least in public. As the IMF economists admit in their paper - “the largely permanent departure of the younger and more educated workers may indeed be costly for those who stay”. So the question they pose - could things be done differently? - remains, at least from the demographic point of view, unanswered.

Portugal isn't Latvia, but it does have a very serious demographic problem. In Latvia  the total population declined by about 14 percent (340 thousand people) between 2000 and 2011. Emigration was responsible for about two thirds of this decline while low fertility accounted for the remainder. An estimated 200–215 thousand people left, mainly young people - roughly 9 percent of the population. Obviously Latvian emigration long predates the crisis. The average net emigration rate was 0.5% from 2000-2007. It increased to an average 1.3% from 2008 to 2011, but by 2012, was roughly back to its pre-crisis average. So emigration isn’t a product of the crisis, it was simply made worse by it. But the basic underlying reality is - given the ongoing fertility shortfall - even with the pre-crisis rate of emigration the population pyramid isn't sustainable.

Portugal's case is not so severe, but the pattern is similar. Between 1998 and 2008  about 700,000 Portuguese nationals left their home country according to research carried out by the former Economy and Employment Minister Álvaro Santos Pereira. In the pre-crisis years the outpouring was to some extent offset by an inflow of immigrants from other countries, but now the migrants are leaving too so the country's working age and total population are both declining.

Which conveniently brings me to the second guest post I would like to present from the Portuguese blogger Valter Martins. As Martin's coherently argues below, the drying up of Portugal's labour supply was already affecting sustainable trend output before the crisis set, so what I am suggesting we might like to ask ourselves is one very simple question  - how is an adjustment which accelerates the longer term decline in the country's workforce, and leads some of its younger and abler members to abandon the country, possibly for good, going to help raise the country's long term growth rate? Instead of alleviating this problem it seems to me it is likely to make the long term situation worse.

Can demography explain Portugal's slump before the crash? 
Is the Eurozone suffering from a “Shortage of Japanese”? 

Guest post by Valter Martins

In Portugal, unlike other countries now experiencing economic difficulties in the Eurozone - Spain, Greece and Ireland, for example - anemic economic growth was all too evident well before the financial crisis of 2007-08.  Accession to the Euro club brought a significant reduction in interest rates in those countries that had experienced historically high ones, triggering real estate bubbles (in Ireland and Spain), and public overspending (in Greece) this cheap money allowed these countries to maintain rates of economic growth above their long term potential and also above the European average. Portugal, on the other hand, suffered a mild housing bubble and government overspending,  yet growth was much weaker and more in line with countries that  have had fairly lackluster performances in the European context:, like Germany or Italy. (See chart below)

So what lies behind the relatively low growth that took place in Portugal when compared with other  countries that are now in the same situation? To put it another way, what’s the factor that differentiated Portugal from the other countries before the crisis of 2007-08? A number of recent papers and articles have attempted to explain the causes of this relative weak performance, but although some of the factors mentioned  surely contributed to the weak Portuguese growth  they do not fully explain it since many of them  were also present in the other - higher growth - countries before the crisis.

So we need to look a bit deeper. Essentially, long term economic growth can be split into labor force growth and productivity growth.  Invariably, the main cause cited for the Portuguese low growth has been productivity growth, or the lack of it, but although this certainly has been a problem in the last decade, it was not so much of a problem before, and it hardly appears sufficient on its own  to explain the relative weak performance. The differences in productivity gains don't seem large enough to justify the sizable difference in GDP growth, even in the cases of Ireland and Greece (where productivity growth was higher than Portugal), and certainly not vis a vis Spain since productivity growth there was lower than Portugal, as can be seen in the chart below. In the last decade, productivity growth in Portugal was threefold that of Spain but its growth was less than half.

As such, we can safely conclude, that productivity on its own cannot explain the differences in economic growth between Portugal and the other group of countries. On the other hand, the stagnation and decline of the working-age population can not only help explain the weak economic growth that afflicted Portugal, but also the GDP growth differences between several countries in the Eurozone before the crises.

As explained in the previous post, between 2003 and 2008, working-age population growth in Portugal was negligible and as such the “workforce effect” - contribution of labor force growth to GDP growth - was non-existent, as can be seen in the chart above.  Starting in 2008, working-age population growth became negative and thus the “workforce effect” began to act as a drag on the economy. To maintain a strong rate of  economic growth Portugal needed to gradually increase its productivity growth, and/or alternatively increase its labor participation rates - to compensate for the declining workforce - but given that this is not easily attainable trend growth will surely steadily fall. Therefore, when the labor force starts to stagnate or decline it is likely that economic growth begins to stall. This phenomenon may well explain the relatively weak economic growth seen in a number of  European countries over the last decade. In particular, it explains why Portugal and Spain had very different economic performances before the 2007-08 financial crises and how the two began to converge subsequently. 

Population change is comprised of natural growth, the difference between births and deaths, and net migration, the difference between immigration and emigration. Natural growth, both for Portugal and Spain, had been barely edging positive at the turn of the century since in both countries the total fertility rate fell below replacement level in the early 80’s. In Portugal, natural growth turned negative in 2007, the year that for the first time there were more deaths than births. On the contrary, Spain experienced a slight recover of its natural growth in recent years, as a result of an increase in its total fertility rate, as can be seen in the chart below, although this is due almost exclusively to foreigners, who have a higher fertility rate than the native-born.

As a result, both in Portugal and Spain, population growth in the last decades depended almost exclusively on having a positive net migration, and this resulted in a large influx of immigrants. But while in Portugal this growth started to slow down beginning in 2002, in Spain immigration exploded until the boom burst in  2007, as can be seen in the chart below. "No modern country on Earth experienced such a massive increase in its immigrant population as Spain. In 1990, one in 50 people in Spain was an immigrant. Today, it's one in seven."

Portugal not only received fewer emigrants from 2000 onwards, but also witnessed a massive exodus of its nationals.  As Edward Hugh pointed out, the entry in the European Union was accompanied by steady emigration flows, which clearly sets Portugal apart from the other countries, Spain in particular (see map on page 11), and resembles more the path that would be later trodden by Eastern Europeans countries when of their accession to the European Union.  Consequently, and according to the Instituto Nacional de Estatística (Statistics Portugal), during the inter-census period, the resident population of Portugal increased by only 1.9% while in Spain, the increase was 12.9%. (Chart below)

With the accession to the European Monetary System and later the Euro, interest rates declined significantly for both Portugal and Spain and as a result the two increased their debt levels. According to the McKinsey report, Debt and deleveraging (see page 14), in the second quarter of 2011 Portugal and Spain had total debt of 356 and 363 (as % of GDP), respectively. The consequence of cheap and easy credit was to create a housing bubble, both in Portugal and in Spain, but while the Portuguese began to deflate in 2002, the Spanish continued to inflate until 2008. This outcome was the result of the substantial increase in Spain’s population as a result of immigration, many of them Portuguese, while the increase in immigration in Portugal was just enough to replace the ones who were leaving. This population growth allowed the housing bubble to continue for much longer in Spain, while in Portugal there were no longer enough people to buy the excess homes being built, and so prices didn't skyrocket; but the housing units were built regardless. As such, rather than a classical bubble with inflated house prices, in Portugal, it was more a case of oversupply, given that 800,000 homes were built in the last decade while the population only grew by 200,000. On the contrary, in Spain, in addition to the excess construction, prices went through the roof, with migration pressures making a substantial contribution to both. It is estimated that the immigration inflow increased house prices by about 52% and was responsible for 37% of the total construction of new housing units between 1998 and 2008. Between 2002 and the 2007-08 financial crises the growth of the Portuguese economy started to fall more in line with the growth of economies where the labor force was stagnant or declining, namely Italy and Germany, as can be seen in the chart below.

The chart above is easier to understand if we group countries into two groups: countries with weak economic growth – Portugal, Germany and Italy-, and countries with more healthy growth - Spain, Ireland and Greece.  With the exception of Greece, countries with sound economic growth before the recession were also the countries with higher labor force growth in the same period, as shown in the graph below.  By contrast, in countries where economic growth was weaker, the labor force growth was also more moderate or even negative, as in Germany. (Chart below)

However, the dynamics changed completely with the onset of the 2007-08 recession. In Spain, where working-age population growth depended exclusively on immigration, the rates of labor growth collapsed, only matched by the plunge of its GDP growth, and its workforce has actually started to shrink. In Ireland, despite a more abrupt fall, growth nonetheless remained positive, this was due to the fact that its population growth did not depend only on net migration but had an important natural component as well.  In fact, Ireland has the highest fertility rate amongst European countries and therefore, unless emigration returns to numbers only seen in previous centuries, growth of its working-age population should stabilize in positive territory, although at a level well below the pre-crisis one.

In Portugal and Greece, even before the 2007-08 recession, labor force growth already showed clear signs of a slowdown, as growth came to a standstill in 2005, and despite a slight recovery after, more pronounced in Greece than Portugal, working-age population went into decline with the onset of the recession.  Italy, which had reversed the decline of its working-age population initiated in the 90’s, appears to have once again slid back into negative territory. On the other hand, in Germany, the workforce began to grow for the first time since 1998 due to an increase in immigration, many of them Portuguese, Spanish, Italian and Greek.

As explained by Daniel Gros, when comparing economic growth performance between countries with very different rates of population growth, the best indicator is undoubtedly GDP per Working Age Person (GDP/WAP).

Hence, if we compare the per working-age person GDP growth between the various countries in the last decade, as such taking working-age population growth out of the equation, it can be said that growth in Spain and Ireland was not so spectacular as it looked on paper, nor was growth in Portugal, Germany and Italy so dire when taken in comparison. In fact, only Greece seems to have had a spectacular growth, which would be in line with its productivity growth before the recession, but Greece’s population statistics might be underestimated, as Greece has not only a large population of illegal immigrants but some weakness in data collection that have also been highlighted. Anyway, a part of Greek growth was probably due to other - unrepeatable - factors, like the Olympic Games. It also should be highlighted the economic growth which was achieved in Germany despite the decline of its workforce, proving that growth is possible with a declining population.

Despite some regional variation as a result of internal migration, the reality is that working-age population in the Eurozone as a whole has now initiated a long downward trend that will have major repercussions in terms of its economic growth, as explained in the previous post, and therefore, we can also conclude that Europe is starting to suffer from a "shortage of Japanese" as shown in the graph below.

As such we cannot fully comprehend the situation that Portugal, Spain and Greece face at the moment without looking into their adverse demographics.  This already exerted an disproportional role in the last decade, namely in Spain,  whose migration-induced working-age population growth  goes a long way explaining its outstanding economic growth, while for Portugal the contrary it’s true, as the lack of population growth made its economy  lose steam  as it joined the Euro. More worryingly tough, is that working-age population in Europe as a whole has started a long, perhaps irreversible, path of decline that will act as a drag on its economic growth, making the economic recovery for these countries even more difficult.

Sunday, September 29, 2013

As Good As It Gets In Latvia?

For Maurice Pialat, champion of the marginal centre.
"This raises a final question, which, while not central to the issues of this paper, is nevertheless intriguing: How can a country with a low minimum wage, weak unions, limited unemployment insurance and employment protection, have such a high natural rate [of unemployment]?"

"To summarize, the actual unemployment rate is still probably higher than, but close to the natural rate of unemployment. Latvia may well want to take measures to reduce its natural rate, but the recovery from the slump is largely complete."
Boom, Bust, Recovery Forensics of the Latvia Crisis, Olivier Blanchard, Mark Griffiths and Bertrand Gruss

With these words three IMF economists (hereafter BGG) effectively signed off on their study of "what just happened on Latvia" and, they hoped, drew to a close a debate which has been going on now for some 6 years. In fact, far from closing the debate, what they may have done is effectively extend it into new terrain, since these apparently harmlesss words - "the recovery from the slump is largely complete" - have far reaching implications, as does the methodology they use for reaching it. These implications reach well beyond Latvia, and even far beyond the Baltics and the CEE in general, despite the conclusion that everyone seems to be reaching that Latvia was just a "one off". Possibly without intending to do so, they have drawn onto the clinical investigation table issues which have been mounting  up in the theoretical lumber rooms of neoclassical growth theory for some time now, issues which begin to assume a paramount practical importance in the context of our rapidly ageing societies. What, for example, do we understand by the term "convergence" these days? And if "steady state" growth can no longer be understood as implying a constant growth rate (trend growth in developed economies is now systematically falling) should we be considering the possibility that headline GDP growth will at some point turn negative, even if GDP per capita may continue to rise, due to the fact that populations are steadily starting to shrink. And if the answer to the former question is "yes", then what are the implications of this for the financial system, for the system of saving and borrowing, and for the sustainability of legacy debt? Not little questions these, but ones which will need to find answers and responses in countries like Latvia over the next couple of decades.

And again, returning to a question I raise about Ukraine (here), while Latvia's recovery may be complete and thoroughgoing, what satisfaction can we really take  from our knowledge of this when - according to the country's President Andris Berzins - the end state leaves the very survival of the country as an independent entity ten years from now as an open question? The problem - the country's population is falling, along with its workforce, and young educated Latvian's continue to leave looking for a brighter future elsewhere, even if they now do so at a slower rate than they did during the height of the crisis.

This is the first time I have written anything on Latvia in some time. In 2007 and 2008 I argued for Latvian devaluation, but refrained from continuing to do so in 2009 since the will of the Latvian people was so obviously against taking this path. I think policy has to work in the real world and not in the one we - like visitors to Andrei Tarkovsky's "room" - might wish we were in. But more than the going back over the debate  about whether or not it would have been better to devalue - we will never know the answer to this one, although although the viewpoint still seems to me a more defensible view than many imagine - what I would like to stress here are the reasons which lead me to arrive at the conclusion is was a good option, along with the factors which influenced me in getting there. These are set out in my June 2007 monster post: Is The Latvian Economy Running Out Of People?. The post is a long one, extraordinarily so as I say there, even by my standards. But going back over it, and with more than six years of hindsight to benefit from, I can't help feeling there is not a great deal I would change or even add. As I say in the introduction to that post:
"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."

Measuring Trend Growth

The facts of the crisis in Latvia are by now more or less well know. As BGG outline it the story runs as follows:
"The basic and striking facts to be explained are given in Figure 1 (see chart reproduced above - EH): An increase in GDP of almost 90 percent from 2000:1 to 2007:4, followed by a decrease of 25% from 2007:4 to 2009:3, and a recovery, as of 2013:1, of 18 percent. A mirror image in terms of unemployment, with a decrease in the unemployment rate from 14% in 2000:1 to 6% in 2007:4, followed by an increase to more than 21% in 2010:1, and a decrease since then, down to 11.4% in 2013:2."
For anyone seeking more background BGG gives an excellent and informative summary. What went on in Latvia was not a fiscal overspending issue (which is not to say the administration should not have been running a higher surplus during the latter part of the boom), but an accelerated credit-driven consumer demand and (housing) investment boom financed by external borrowing. This boom massively structurally distorted the economy, in the process taking output to levels well above those which were sustainable in the longer run. As BGG point out, "the ratio of private consumption to GDP (in constant prices) increased from 62% to 72%, [and] the ratio of investment to GDP (also in constant prices) from 22% to 36%." Now you don't have to be a mathematical genius to spot that 72 and 36 add up to 108, ie consumption and investment total more than 100% of GDP. How can that be, you may ask. The answer to the apparent inconsistency is that the difference is made up by imports (or the trade deficit), ie the Latvians were consuming all their own GDP and part of someone else's, with the difference being made up by external borrowing. BGG put it more elegantly:
"As a matter of arithmetic, the result of increasing consumption and investment ratios was a steady deterioration of the current account balance, with the ratio of the current account deficit to GDP increasing from 5% of GDP in 2000 to peak at a very large 25% in mid-2007."

So it is clear the Latvian economy was running above capacity, but how much above capacity? This is really what the present debate is about, since depending on the answer you give to that question the estimated current trend growth level of the country will be either higher or lower, as will the non-inflationary unemployment rate. Using various vintages of output gap estimates taken from real time EU Commission economic forecasts (12% positive  in 2007 as estimated in  2013) the authors derive a series of cyclically adjusted fiscal balances which show how, at least from the current vantage point, the size of the output gap, and hence the degree of laxity in the fiscal stance, was systematically underestimated. In 2007, for example, the EU Commission only thought the positive  gap (ie degree of overheating) was some 3%. Well its always easier to see things more clearly with hindsight might be the common sense response. Would that things were so simple!

An Interlude Concerning Production Function Metaphysics

What is involved here is a really important and hard to resolve methodological (and even, god help us, epistemological) issue (especially in countries which pass thorough a deep and protracted economic slump) - what is the special privilege of the present as a valid vantage point, when compared with the virtual infinity which time will eventually offer us?

After all, in the "present" which was 2007 things did look very, very different. Perhaps our current evaluation of our own "present" is just as conditioned as earlier perceptions of earlier "presents" were. The problem is we are using our present appreciation of the way things are to reach conclusions about the past which may look very different in some other, future, present. Yes, you're right, there is an element of circularity in the kind of argument that is used by BGG. As the people in the trade put it, potential output is an unobservable latent variable, you know, a bit like the Higgs particle, something you can't see or measure, but which you have to assume to exist for everything else in your theory to make sense.

As one of the IMF authors, Bertrand Gruss, puts it in his paper on the topic, there are "many different methodologies" which can be used "each of them encompassing a different precise definition of potential output and entailing advantages and disadvantages". All of them have, however, one thing in common:  "potential output estimates are subject to substantial uncertainty." As he also notes, in the case of a country like Latvia, emerging from a substantial slump, the degree of uncertainty is especially large. So those who would use the arguments in BGG to argue something simplistic, be chastened, the room for error is large. But then "substantial uncertainty exists over the past and future" doesn't make for good headlines, and, perhaps more importantly, doesn't inspire confidence in the policymakers who admit this.

So does each historical moment have its own special "truth" as far as potential output goes? This point - present moment bias - is described by Paul Krugman like this: "These methods automatically interpret any sustained decline in actual output as a decline in potential, and they cause that re-estimate to propagate backward through time." This approach could be described as "present moment reductionism" in the sense that events in the past are viewed and evaluated from the standpoint of the present, in a way which makes them explicable and comprehensible only in terms of the present they give rise to. The German philosopher Liebniz once put it this way,  we live in "the best of all possible worlds", if not in the best of all imaginable ones (back to Tarkovsky's room).

Basically, it is difficult to avoid the bad performance generated during the slump  "contaminating" the data. What we really need is information on Latvia's future performance, then we could situate the present. We need a time series from the future, then we could see much more clearly what is happening now. Unfortunately for us we can't have access to one. The "set up" (or world) we live in has this characteristic.On some views this is precisely what makes it interesting.

At the same time recognising this reality doesn't make the problem simply go away. As macroeconomists we are constantly forced to make what come near to being ad hoc judgements, and we need to do so time and time again, as we go forward and on the fly. As the Spanish poet Antonio Machado put it, "el camino se hace andando" - we make the path we walk along as we walk. The difficulty is that we are in a bit of a "garden of forking paths" here, since the decisions taken in 2008 and 2009 are the reason we have reached reach the endpoint we are at now, and it is this (momentary) endpoint which conditions our judgement about the initial conditions we set out from. And this is the case even though, had we taken another path  at the outset we would surely have arrived at another "now" from whence the starting point would have been seen differently.

That master of neo-classical growth theory Robert Solow put it thus in his Nobel acceptance speech:  
Growth theory was invented to provide a systematic way to talk about and to compare equilibrium paths for the economy. In that task it succeeded reasonably well. In doing so, however, it failed to come to grips adequately with an equally important and interesting problem: the right way to deal with deviations from equilibrium growth........if one looks at substantial more-than-quarterly departures from equilibrium growth........... it is impossible to believe that the equilibrium growth path itself is unaffected by the short- to medium-run experience.......So a simultaneous analysis of trend and fluctuations really does involve an integration of long-run and short-run, or equilibrium and disequilibrium. 
As he says, it is impossible to believe that the longer term path of the economy is unaffected by the trajectory taken during the deviations from trend - whether upwards or downwards.

(Incidentally, I used the comparison with Liebniz above because it seemed appropriate, because it seemed to me that Liebniz's "rationalisation of the real" was exactly what is going on here. This attitude was famously satirised by Voltaire in his Candide. Curiously when I went back to the Solow speech to dig the above extract out what else did I find - a reference to Candide. Happy to be in good company).

Now in fairness our IMF authors are well aware of this issue, although I'm sure they'd like to put it all very differently. Indeed, while they cite the EU Commission output gap estimates, they also carry out their own calculations (at least one of them Bertrand Gruss (as mentioned above) does, with the results being published in the 2013 edition of IMF Latvia selected issues). As his says in his commentary on the study findings:
"Many different methodologies have been used to estimate potential output, each of them encompassing a different precise definition of potential output and entailing advantages and disadvantages. No specific approach can be taken to be “the” correct one and potential output estimates are subject to substantial uncertainty. This uncertainty is probably even larger for countries like Latvia, a transition economy still going through substantial structural changes and coming out of a severe crisis that has likely rendered obsolete a significant part of the economy’s productive capacity."

For technical reasons which we don't need to go into here, BGG decide to use a production function methodology broadly similar to the one in the diagram above (click on image for better viewing), which is in fact the one they use over at the European Commission (Roeger, 2006) where they got the 12% 2007 output gap result.  In fact the IMF variant isn't identical. Their result (at least as of last January when the study was reported):  "Output was probably about 5–10 percent above potential before the crisis, although the extent of overheating at the pre-crisis boom is particularly uncertain."

[For the wonks, the benchmark PF model they used suggested the output gap peaked at around 5 percent of potential output before the crisis - well below the 12% level suggested by the EU Commission. Then, since they were worried about possible cyclical contamination of the TFP input, they used an alternative potential TFP series (cleaned up by applying an HP filter) and this gave them a gap estimate of about 9.5% much nearer to the EU Commission figure, which ain't that surprising since it is Roeger's preferred technique (see right hand path in diagram).]

Just to give us a feel for the kind of range of certainty involved here, Bertrand Gruss concludes his results by stating the following, "While acknowledging the uncertainty of estimates, staff believes output was significantly above potential before the crisis, but probably in the 5–10 percent range rather than in the 15–20 percent range".

More important than the actual result in my opinion is how they achieved it. A quick inspection of the left hand path in the diagram will reveal that a very significant part of the calculation revolves around labour inputs which ultimately depend on demographic dynamics. Indeed Gruss justified his preference for the production function approach precisely for this reason: "The emphasis on a production function approach reflects both staff view that it represents an adequate framework for Latvia (where, for instance, population dynamics and structural unemployment play an important role in potential labor and potential output estimates)....".

Put simply the only real positive impetus to trend growth we can expect in the future from Latvia will be on the TFP side, since the labour input component will turn negative at some point (if it hasn't already done so). Bertrand Gruss in fact puts it quite bluntly: "Labor is not expected to contribute to potential growth in the coming years."

Demographic Destiny?

Now, quite coincidentally, the IMF is finally getting round to thinking about the demographic side of the European periphery problem (not sure why it took them so long since they've been using the kind of production function methodology described above  for years). Well, at least in the Latvian context it is. I say "finally" because for whatever reason there seems to be some sort of resistance among fund economists to thinking about demographic issues (including migration flows) as part of the core macro picture, yet as can easily be seen above it really is, and Robert Solow wouldn't doubt it for a moment.

Anyway, their current thoughts on the Latvian demographic outlook can be found in the form of an appendix to their 2012 Latvia Article IV consultation report. Coincidentally this report was published at the same time as the second part of their program monitoring reflections, ie the signal being given would seen to be that while demography is important, it is an "issue pending" which can be safely passed over to the post program environment. This is in complete contrast with the methodology being advocated here which is that the program should in part have been designed with this central issue in mind. I have been advocating this since 2007 and I will continue to do so.

Be that as it may, as they inform us in their appendix, Latvia’s population is shrinking rapidly.  

During 2000–11, the population declined by about 14 percent (340 thousand people). Emigration was responsible for about two thirds of this decline while natural change due to low fertility accounted for the remainder: 

Emigration: an estimated 200–215 thousand people, mainly young people—roughly 9 percent of the population—have left Latvia during 2000-11 (Hazans, 20111; and Central Statistics Bureau); and 

Low fertility: the decline of the population for natural reasons was about 125–140 thousand people (5 percent of the population). The number of births has halved since the early 1990s—from around 40,000 annual births to around 20,000—falling below replacement levels.

In fact saying that fertility has fallen below replacement levels is putting it mildly, since the Latvian fertility rate is currently around 1.3 (one of the lowest in the EU) and has been effectively below replacement since the country came into existence. The number of births has been falling more rapidly since the onset of the crisis due in part to the harsh economic conditions but also aided and abetted by the fact that the majority of the women emigrating are of childbearing age.

So Latvia is facing a massive challenge. A combination of low fertility and emigration mean that the population is shrinking rapidly and at the same time ageing. The proportion of over 65s is set to surge between now and 2030 as it is all over Europe. Naturally with the hole in the pyramid left by the "missing births" and the working-age-population migration-loss the country is bound to be an example of one of the worst case scenarios, far worse than Japan, since Japan has only been resisting immigration, it has not lost population through emigration. Fortunately, the country has a possible solution - it belongs to the EU, is about to join the Euro, and the possibility exists that the Euro Area will become a transfer union over the next decade. At least that's the theory, I don't doubt the reality could well be different. But really the creation of this transfer union is Latvia's only hope now, and obviously it would be a substantial net beneficiary, since otherwise it is hard to see how the country will be able to offer its elderly population modern minimum standard welfare services like health and non-poverty-inducing pensions.  

Emigration and the IMF Program

Actually BGG do try and address some of these issues. They do so since, as they say, "an important part of the adjustment has taken the form of emigration". As they also point out Latvian emigration long predates the crisis. The average net emigration rate was 0.5% from 2000-2007. It increased to an average 1.3% from 2008 to 2011, but by 2012, was roughly back to its pre-crisis average. So emigration isn't a product of the crisis, it was simply made worse by it, but still, and going back to Solow  ( it is impossible to believe that the equilibrium growth path itself is unaffected by the short- to medium-run experience.) how far was Latvia's longer term future being put at risk by the form in which the adjustment occurred.

[Just as a side issue it is worth noting that exactly the same question arises in the context of the Greek adjustment. Had the IMF forced the EU to accept debt restructuring and an EFF rather than the initial SBA, the pace of the fiscal adjustment could have been slower, and the loss in output lower. Mein Gott, we might not now be talking about a current estimate of a Greek output gap of plus 10% in 2007 (if you follow the logic of the argument advanced earlier). See my "Second Battle of Thermopylae" post].

In fact BGG do attempt to address this issue:
"The question however is whether this emigration is, in some sense, a failure of the adjustment program. In the United States, migration rather than unemployment is the major margin of adjustment to state specific shocks ..... These adjustments are typically seen as good, indeed as the main reason why the United States functions well as a common currency area: If there are jobs in other states, and if moving costs are low, it is better for workers to move to those jobs than to remain unemployed."
This is an argument that it commonly advanced in the context of Euro Area issues (let's leave aside for the moment the fact that Latvia wasn't in the Euro) - in an optimal common currency area this sort of labour mobility is a good thing. In addition let's leave aside the question that Europe isn't the United States, that it is a continent made up of nations, and that these nations form part of our identity as Europeans in a way which is hard to quantify economically and in a way which can't simply be wished away by waving a magic wand (or paying another visit to Tarkovsky's room), the fact of the matter is that the Euro Area isn't an optimal common currency one. At least institutionally it isn't. To become one of those it would need to have a common treasury and a common unemployment benefit and pension system, etc.

Unfortunately, this is an issue which BGG, like so many before them, simply slide silently past - "the largely permanent departure of the younger and more educated workers may indeed be costly for those who stay" -  like a ship in the night looking for open water while at the same time carefully evading the enemy  minefield.
"Is the answer [to the above question:EH] different for a small country than for a US state? Some economic aspects are different: Some of the costs of running a country are fixed costs, and thus may not be easy to support with a smaller population. In the United States, many of those costs are picked up by the Federal government (although, as we have seen for Detroit, the remaining fixed costs per capita may become too large for a state or a city to function). This is not the case for a country, which must for example finance its defense budget alone."
The reference to Detroit is of course salutory (this is exactly the problem), although it is curious that the example they take for the fixed costs of having a separate state is defence, an area where Latvia obviously benefits from the existence of external institutions like NATO and the EU. Again, the extent would be hard to calculate, but one of the factors which must have influenced Latvian's in their decision not to offend their EU partners by devaluing the Lat must have been a consideration of just this issue.

Still, the question remains, from a demographic point of view could things have been done differently? It's very hard to give a conclusive answer. My argument in favor of devaluation was always based on the potential demographic dynamics  which it might induce. Obviously there would have been a large drop in output, but Latvia had one of those in any event. Would less people have migrated out? That is very doubtful, and indeed, as BGG point out, people were emigrating even at the height of the boom. But then again, would the post crisis potential growth rate have been higher? Would the country still have had to face a non inflationary unemployment rate of 10%, or would the additional international competitiveness achieved have meant it was much lower? Would immigrants be arriving to do some of the lower skilled work?

The thing about this last point is, more than just ending the emigration what Latvia really needs (like Japan, like South Korea) is immigration to shore up the population pyramid, to make the welfare system sustainable in the longer run, especially since although the country's future currently depends on the creation of an EU transfer union there is no guarantee there is actually going to be one.

It is unlikely that the emigration hemorrhage would have been avoided even with devaluation - large numbers of Argentinians, for example, arrived irregularly in Spain in 2002 and 2003 and the two countries weren't in any kind of bilateral Schengen arrangement. But would the natural rate of unemployment have been different following the adjustment? We will now never know.

However,  an argument from two of my Economonitor colleagues - Andris Strazds and Thomas Grennes - should give us some food for thought. According to these authors, when it comes to emigration dynamics "Unemployment Matters Much Less Than Relative Income Levels". Now despite the fact that one might have some reservations about the actual methodology they use (they seem, for example, to confound the migration component in population dynamics and the birthrate one where in fact these are quite distinct channels) they are certainly digging in the right area, as the following chart which comes from a pre crisis IMF report makes clear.

The problem, of course, isn't only relevant to Latvia. Despite the fact that Spain's unemployment rate is currently around 27% immigrants continue to arrive in the country (often risking their lives to do so), a fact which puzzled the Financial Times demography correspondent Norma Cohen when we spoke about this article. "Why on earth," she asked me "would people want to come to Spain with such a high rate of unemployment?" Because salaries are better than in their home countries would be the simple answer, and because they are willing to do work which many Spaniards are reluctant to do, at least at the salaries which are on offer. So economic migrants continue to arrive, an estimated 300,000 of them last year, even though the net migrant flow reversed since more left (both native Spaniards and immigrants) with Spain's population falling for the first time in modern history as a result.

The idea of "centre and periphery" seems like a useful analogy here, since more than simple emigration or immigration what we seem to have is a steady displacement of population with migrants of lower skill entering one side of a country while higher skilled natives exit across the other. In this sense one can truly speak about "population flows". Naturally the net human capital loss involved  is substantial. Italy had some three million immigrants during the first decade of this century, but the overall annual rate of growth was not much above zero.

Beyond implementing the maximalist programme of a completely federal Europe with population moving in one direction and transfers moving in the other  it is hard to see what the solution is here.


"Do these lessons extend beyond Latvia? The evidence from adjustment in Euro periphery countries suggests great caution." - BGG

"I’m not sure I believe this [BGG] story but if you do, what lessons does Latvia hold for other countries, and the euro in general? And the answer, in brief, is none. Latvia’s story as I’ve just told it looks nothing like anything we’ve seen in the past, and probably not like anything we’re likely to see in the future – including, by the way, Latvia’s future." Paul Krugman, Latvian Adventures

The general consensus seems to be that Latvia is an interesting case study, but one where the lessons learned have little application beyond the country's frontiers. I'm not sure I buy this. Let's start at the beginning.

We all know what happened in Latvia - the country's economy massively overheated - but are we so sure why it happened? The answer isn't as obvious as it seems. The quick synthesis explanation offered by BGG runs as follows:
In short, the anticipation of a large scope for catch up growth, together with cheap external financing, led to an initially healthy boom. As time passed, the boom turned unhealthy, with overheating leading to appreciation and large current account deficits, with lower credit quality, and with balance sheet risks associated with FX borrowing.
Yep, but why was there so much external financing available, and why did it continue even after it was obvious to all bar the Latvian government that the accumulating imbalances were putting the country at risk of disaster? Paul Krugman puts my question in a little more elegant fashion:
 First of all, on a conceptual level, how does an economy get to operate far above capacity? We understand operating below capacity: producers may fail to produce as much as they want to if there isn’t enough demand for their products. But how does excess demand induce producers to produce more than they want to?
I think part of the answer here is that we all generally thought that in an epoch of large scale globalisation with extensive migrant and fund flows "open" really did mean open, in the sense that to erect a well functioning economy all you needed was a large strip of land (of which Latvia has plenty), cheap tax rates and flexible labour laws, then the entrepreneurs, the capital and the labour would all flow in. The problem in Latvia's case was they didn't. The capital was there, so were the entrepreneurs, but one of the other factors was in short supply, and indeed instead of flowing in it was flowing out. Then bang!

That's over-simplifying a bit, but it is the bare bones of the situation, a situation which surely has lessons to be learnt for other CEE countries (or far flung places with similar underlying demographics like Vietnam). In particular the word "Ukraine" comes into my head.

But beyond this, why was all that capital flooding in to finance something which to the careful eye was evidently not working? My reply would be, and taking us back to the literature of the time, the operation of the Global Financial Accelerator, a term coined by the Danish economist Carsten Valgreen to describe what was happening in Ireland and Latvia before the crisis actually hit. Essentially, in an environment of ample global liquidity being generated by central banks in countries which don't have the capacity to absorb all the liquidity phenomena like Latvia and Iceland simply happen, as we have been seeing in recent months as the Fed tapering debate lead to a sudden stop in one Emerging Market after another. Fortunately on this occasion the liquidity was being withdrawn before the kind of massive imbalances we saw in both Latvia and Iceland had time to occur. I for one, at least, think it's worth considering what happened in Latvia, and what can be learned, in the context of the current EM debate.

Another issue worthy of note, as I say in the introduction to this post, concerns the issue of convergence. Historically it has been assumed that per capita incomes in countries forming part of the EU would tend to grow at faster rates than those in richer economies with the result that all member state economies should eventually converge to some common living standards band in terms of per capita income. This now seems unlikely to happen, especially given the demographic and growth outlook on the periphery, Latvia included. The economy is growing well right now, but as we can see it is labouring under severe structural problems (the unemployment rate) and the demographic outlook suggests that growth will now steadily weaken. What we have is as good as it gets.

Ironically GDP per capita has been performing well in relative terms since the bust, and in ways the textbooks never envisaged - through a drop in the population numbers. Despite the fact that output is still well below the pre crisis level, as BGG note, Eurostat estimates PPP GDP per capita to now be at 9% above its 2008 peak.

Finally there is the point about how the adjustment took place. As BGG explain, the majority of the internal devaluation took place not through wage and price reductions, but through productivity - the mysterious factor X. But is it that mysterious? What happened was that there was massive labour shedding, as unemployment shot up to 22%. Then, as growth resumed, employment didn't follow (mirroring a pattern which arguably we are seeing in a milder form elsewhere, in other countries which are recovering from sharp housing busts). So while output recovered employment didn't which simple arithmetic tells you results in a strong productivity boost. As BGG explain, there was a strong underlying improvement in TFP taking place due to the "catch up" effect, and this undoubtedly helped Latvia in ways we don't yet fully understand. More study would be useful, since again I do think there are things to be learnt.

As a last word I would say that if you are reading these lines you have probably struggled your way all through this inexcusable indulgence in  verbiage. In which case thank you. You may also have noticed I haven't referred to the issue of fiscal austerity once. Not even a teensy weensy bit. There is a simple explanation for this, the Latvia debate was all about whether or not to devalue, it never was a for or against austerity one. As Paul Krugman puts it: "if we were really looking at an economy with a double-digit inflationary output gap, even the most ultra-Keynesian Keynesian would call for fiscal austerity". For reasons I have outlined above, I don't fully grant the whole inflationary output gap estimate, but still I think the point holds, this was never about for or against fiscal austerity, since among other reasons it was never about public sector debt.


The paper published by Blanchard, Griffiths and Gruss relies heavily on the work of the Latvian demographer Mihail Hazans whose groundbreaking studies effectively forced the Latvian authorities to amend their population and migration estimates. I had the pleasure of meeting Mihail when I shared a platform with him in a colloquium organised in 2012 by the American Chamber of Commerce in Riga. The title of the gathering was, not surprisingly, Latvia's Demographic Future (you can find my presentation here).

Basically every country on the EU periphery needs its Mihail Hazans, since we have no accurate or systematic system for measuring these important migrant flows.

In response to what I perceive to be a major lack of knowledge and information I have established a dedicated Facebook page in a vain attempt to campaign for the EU to take the issue of  emigration from countries on Europe's periphery more seriously, in particular by trying to insist member states measure the problem more adequately and having Eurostat incorporate population migrations as an indicator in the Macroeconomic Imbalance Procedure Scoreboard in just the same way current account balances are.

If we don't have the necessary information then how can we hope to formulate the adequate policy responses. If you are willing to agree with me that this is a significant problem that needs to be given more importance then please take the time to click "like" on the page. I realize it is a tiny initiative in the face of what could become a huge problem, but sometimes great things from little seeds to grow.

Wednesday, September 11, 2013

Is The Perfect Always And Everywhere The Enemy Of The Good?

Against a backdrop which offers an eerie parallel with events which took place somewhat to the North more than 30 years ago, Catalonia is now threatening to separate from Spain. In so doing the region seems to be putting at risk both the future of the host country and beyond that the outlook for the Euro currency and the process of European unification.

The parallel is of course with the drive for Baltic independence and its impact on Mikhail Gorbachev’s ill-fated attempt to peacefully reform the disintegrating Soviet Union. In the words of Aleksandr Yakovlev, one of his closest associates at the time, the ideas of those seeking independence were ''out of touch with reality'' and any expectation that the Baltic republics could regain the independent status they had before Soviet annexation in 1940 was ''simply unrealistic.'' As late as February 1991 Gorbachov himself was still describing the Lithuanian vote – described by the countries leaders as simply a non-binding opinion poll - as illegal, and this a matter of days before it was actually held.

Sound familiar? It should do, since these very same arguments are now being played out in another pole of Europe. Not only is the Spanish administration taking precisely the view that any vote in Catalonia on whether or not to separate from Spain would be illegal, the attitudes of those outside the country are largely being conditioned, not by the merits or otherwise of the Catalan case, but by the fear of what might happen to Spain if Catalonia left.

While Catalans busy themselves assuring each other that any new state would be economically viable, few on the outside doubt that this would be the case. To give but one example, former chief economist at the IMF Kenneth Rogoff recently commented that Catalonia taken on its own constitutes one of the richest regions in Europe. This is simply stating the obvious. What has external observers really worried is the subsequent viability of Spain, and with it the future of the Euro. If Spain is too big to be allowed to fail, then Catalonia is too small to have inalienable rights the argument seems to run.

It is for this reason, I feel, that the Catalan cause is attracting little sympathy beyond the confines of what is often called “The Principate”.

Many feel that Catalonia is being selfish – just as they felt in their day that the citizens of the Baltics were - in putting their own particularist interests (a better fiscal distribution, the right to a national football team) before those of the collective (economic recovery, closer political union in Europe, etc.). But this way of looking at things is essentially flawed, just as it was in Estonia, Latvia and Lithuania. The movement for Catalan independence is primarily, and at its core, a democratic one. So what should matter to the outside world is not whether the vote will be considered legal by the central government in Madrid, or whether the Catalans have a good case. If the Catalans vote peacefully and democratically, and by a significant majority, that they want to form a separate state, then it is clear that the region's days inside the frontiers of the Kingdom of Spain are numbered. Unless that is the Catalans be retained within those frontiers by the use of force, in which case some of the fundamental principles of the Treaty of Europe will be put in question. Hence the fundamental dilemma which the Catalan independence drive presents to the whole European Union.

Under these circumstances what outside observers should focus on is what the result of the vote, when it does finally take place, will be. After all what the Catalans are demanding at the moment is “the right to decide”, and at the end of the day it is they who will decide. My country, as the saying goes, right or wrong.

Nothing here is either unavoidable or inevitable. As in the case of Greek Euro exit, beyond the expedient there are no ex ante juridical limits to the bounds of the possible. What is important for everyone is that the eventual solution be an orderly one. In this context messages that the new country, should one be created, would need to apply for membership of the European Union constitute nothing more than mere hot air, just as the suggestions from the Spanish administration that any such application would be met with a veto on their part is no more than an empty threat. Such talk is not in the realm of the real, or the realistic. It is simply an attempt to alter the outcome of the vote, and a bad and ineffective one at that. Not for nothing does Catalonia’s President Mas describe the speechwriters of the Partido Popular as running a production line for manufacturing separatists.

If Spain’s sovereign debt is already on an unsustainable path, then how much less sustainable would it become if the country suddenly had its GDP reduced by 20%? Common sense dictates that negotiations would be held, negotiations in which Catalonia would be asked to accept a proportion of the legacy debt, just as common sense suggests that Catalonia’s financial system, which has assets of around 500 billion Euros (i.e. it is much larger than the Greek equivalent) would be allowed to remain in the Eurosystem. The alternatives – and their consequences well beyond the frontiers of Europe – are simply unthinkable. Naturally sometimes the unthinkable happens, especially when a majority of the key players assume it won’t. Catalonia has now decided to hold some sort of “consultation” or “opinion poll” during 2014. As in the Lithuanian case the outcome may not be binding, but few should draw comfort from that single fact and assume that the result will not be significant and even decisive for the short term future of Europe.

As I say, nothing here is inevitable, or foretold in advance. But avoiding predestination involves facing up to the facts, and not, as the IMF director general Christine Lagarde recently put it in the Greek context, engaging in wishful thinking. And the facts in this case are that dialogue between Catalonia and the rest of Spain has now broken down. Catalans feel themselves to be tired of not being listened to, while the rest of Spain feels itself tired of the Catalans and their constant demands for more autonomy. At one pole there is “Spain weariness” and at the other “Catalonia exhaustion”. Matters have now past the point where orderly solutions will be sought out and found internally.

Most external observers expected some sort of offer to be made by the central government after the last Catalan elections, but reading the result as a setback and defeat for President Mas the only “offer” which has been sent in the direction of Barcelona is one which involves “Hispanicising” children via the reform of the Catalan education system, a move which has effectively united the Catalans behind their new government. That is why a decisive intervention on the part of Europe’s political leaders is now crucial. Whether they like it or not they have no alternative but to become intermediaries in the search for viable solutions, if not neglect will only produce the result everyone seeks to avoid.

It is no accident that the Baltics saw their chance just in the moment of maximum Russian weakness, and that Catalans see their only realistic possibility of achieving their objective of having their own state just when Spain is effectively on the ropes, and possibly in terminal decline. Some, comforted perhaps by the writings of Francis Fukuyama, feel that what is happening to Spain is simply an unfortunate setback on the bumpy road to becoming a mature democracy, but darker readings are possible. The current economic crisis is not simply cyclical or conjunctural and there is a real possibility that the country’s problems are so complex that it will become impossible for Spain’s leaders to fix them without recourse to an Argentina style default. It is precisely the loss of confidence in the capacity of the Spanish political class to resolve the country’s dire economic situation, and the mounting frustration with their perpetual insistence that all will be well starting tomorrow that has the Catalans running for the exit door. If the building is about to burn down they don’t want to be trapped inside when it happens. As Janice Joplin once put it freedom is sometimes “just another word for having nothing left to lose”.

In the critical weeks and months that are to come, I think it important that all participants bear in mind that once the Baltic vote was taken, and once the demise of Gorbatchev became inevitable, attitudes towards the new countries rapidly changed. All three are now consolidated members of the European Union, and the past is simply that, what is over. Many Catalans tell me they are doing what they are doing, not for themselves but for their children and their grandchildren. Measured on such a timescale a few years of economic turbulence seem as nothing. In the interest of the common good solutions need to be found - solutions which are able to both satisfy the aspirations of the Catalans and guarantee stability in Europe. If this search is not initiated soon, then time will ineluctably run out and the likely will steadily become the inevitable, simple application of the rules of game theory tell us that. There isn’t a day to lose. You know it makes sense.

The above is a short chapter I wrote for the book "What's Up With Catalonia" published earlier this year by the Catalan Press.

Q&A: The Catalan Way explained

Why are Catalans taking part in a human chain this Wednesday? The Catalan newspaper Ara has produced a series of questions and answers in English which should explain everything you want to know about why the human chain is taking place today.

What is the 'Via Catalana'?

The 'Via Catalana' (The Catalan Way) is a political demonstration which will take place this September the 11th. Inspired by the Baltic Way — a human chain formed by up to two million people on August 23 1989 across Estonia, Latvia and Lithuania — its aim is to create a 400 km long chain which will cross Catalonia from north to south. 400.000 people have signed up to take part in the human chain, although organizers hope that the actual turnout will be at least twice that figure. People will be asked to join hands at exactly 17:14 (15:14 GMT). The chain, which runs along highways, roads and city streets, will come to an end at 18:00 (16:00 GMT). If successful, it will be one of Europe's largest ever demonstrations, following in the footsteps of last year's march in Barcelona, when up to 1,5 million people walked through the streets of the capital asking for independence, the country's most massive rally ever.

What is Catalonia?

With more than 7,2 million inhabitants Catalonia is a country in the northeastern corner of the Iberian Peninsula. At a crossroads between different cultures and civilisations, it once formed part of the old Crown of Aragon, which merged with the Crown of Castile to create what later became Spain. What in medieval times was a powerful nation which extended its influence across and beyond the Mediterranean, is now an autonomous region within the Spanish State posessing restricted powers, devolved as seen fit by the central state. It has its own language, Catalan, and institutions, amongst them one of Europe's oldest Governments and Parliaments.

Why is the Catalan Way taking place today?

Catalonia was a party in the War of Spanish Succession (1701-1714), where the old crowns of Castile and Aragon fought, alongside their European allies, over who should be crowned as king of Spain following the death of Charles II. Catalonia, which favoured archduke Charles as successor, lost a war which ended with Europe recognising Philip V as the new king of Spain. The long war ended with a prolonged siege of Barcelona, Catalonia's capital, which was systematically bombarded by Spanish troops fighting for the Bourbon candidate, Philip V. After months of resistance Barcelona finally surrendered on September 11 1714. Modern Spain was born, but Catalonia was to pay a heavy price for its support for the Austrian candidate: Catalan language was forbidden and Catalan institutions abolished. Every year, on September 11, Catalans commemorate the day on which Barcelona fell, honouring those killed defending the country's laws and institutions [See video: A trip to Barcelona].

Why do many 21st century Catalans want independence?

Since the defeat of 1714 Catalonia has never been allowed to rule itself again [a Catalan history of Spain]. The old nation was forcefully transformed into a mere Spanish province. This state of affairs did not change until 1931, when the proclamation of the Spanish Republic gave Catalans the freedom to regain their old institutions. Catalan was taught in schools, the Parliament reopened, the Government was once more established... Unfortunately the situation was not to last. The end of the Civil War, with the subsequent establishment of the Franco dictatorship, meant a new blow for the country, crushed once again by a centralist state, administered directly from Madrid.

Following Franco's death, and with a new democratic regime in place, Catalonia regained its old institutions, and it was once more allowed to rule its own affairs in a number of key areas. But the centralist inertia of the Spanish state, always resisting to the last all devolved powers and continually meddling in matters which are close to the heart of all Catalans — like respect for the Catalan language — has left Catalonia’s citizens with a deep sense of frustration. This frustration was brought to a head in 2010 when an appeal by the Partido Popular over some of the clauses in the newly approved Catalan Statute (which won majority votes in both the Catalan and Spanish Parliaments) lead the Spanish Constitutional Tribunal to rule it was unconstitutional to use the term “nation” to refer to Catalonia in the document’s preamble.

Since that time the feeling of alienation from Spain has only grown, with many previously apathetic citizens suddenly becoming separatists. More fuel has been added by the economic crisis, and the gross incompetence which has been demonstrated by Spain’s political and financial leaders. This, along with the record levels of unemployment with no end in sight, has given a new impulse to Catalonia's demands, since it has left the Catalan Government in a critical financial situation, unable to access the international financial markets and totally dependent on the such funds as the Spanish Government to forward to it. This unjust situation reached its most bizarre moment when the Spanish government raised the VAT rate last year to help improve funding. The Catalan government actually lost out, since it had to pay the new rate to all its suppliers but received no refund or additional funding from the central government which was, of course, much better off.

This, in a country which contributes to Spain far more than it gets in return: figures vary, but it is reasonable to suggest that Catalonia loses between 10,000 to 16,000 million euros per year, because of this fiscal deficit. The accumulated deficit between Catalonia and Spain for the period 1986-2010 reaches a total of 213,933 million euros, five times Catalonia's current debt. The economic imbalance between what Catalans pay in taxes to the Spanish state and what they get in return, is a major contributing factor to the sense of anger and frustration felt by many [opinion: Spanish Prisoners]. It has been very hard for Catalans see their school and hospital services deteriorate under the sever cuts that have been administered while those in other regions which are arguably subsidized from Catalan taxes go virtually unscathed. [See NYT OP-ED: Spanish Prisoners]

What do the Catalan political parties say?

Since the death of Franco all Catalonia's main parties have argued for a theoretical right to self-determination, but have never taken steps towards achieving that goal. Following slow and painstaking negotiations with Madrid, only a fragile, unstable compromise has been reached: the Spanish state has devolved powers in some key areas, from education to health or police, but it still is unable to recognise Catalonia as a nation. This has left Catalan parties divided on the issue of which course of action to take. Traditionally, Catalan parties have asked for more powers to be devolved from Madrid to Catalonia, but the recent rise in strength of the pro-independence movement — which originates in social, rather than political organizations — has taken some aback [See video: Catalonia push for economic independence].

Centre Right Nationalist CiU, Catalonia's current governing political coalition, has evolved from a pro-autonomy stance to being more clearly inclined towards independence. It is, though, a coalition of parties with different views; officially, it wants a referendum on independence, but stresses the need to reach agreement on this with the Spanish Government. The once powerful Socialist party PSC, which has strong ties with the Spanish Socialist PSOE, is torn too between conflicting approaches. In theory, it recognizes Catalans the right to self-determination, but rather than asking for independence, it wants Spain to move towards a more federal political structure. The left republicans ERC, for years the only party actively seeking independence, are the rising star in the current Parliament and, according to some surveys, could become the country's main party if elections were to take place now; they want to hold a referendum as early as 2014.

Left-wing ICV, political successors of the old communist party, support the idea of a referendum, although their views on independence are not so clear. Finally, the Popular Party, which is now in power and Spain, and Ciutadans, are both opposed not only to independence but even to an eventual referendum on the issue. However, they are a minority in the Catalan political landscape: the Catalan Parliament has passed a declaration which states that Catalonia is a country with the right to decide its own future. The declaration was passed with 104 votes in favour of a referendum, for only 27 against [See video: Will Catalonia say adios to Spain?].

What does the Spanish Government say?

The Spanish Government bitterly opposes the organization of a referendum in which Catalans can choose whether they are in favour or against an independent Catalonia. The official position is that the government has to abide by the Spanish Constitution, which states that there is only one nation, the Spanish one, and that sovereignty is exclusively held by the Spanish people in its entirety; this means that what is seen as being simply one part of the Spanish nation cannot on its own decide on matters which affect all, effectively denying the principle of the right of peoples to self determination. Since, according to the Constitution, only the Spanish Government can organize a referendum, the Catalan demand faces an insurmountable barrier. Spanish main parties — PP, now in power, and the socialists, the main party in opposition — do not want Catalans to express their views on a referendum [See video: Should Catalonia seek independence?].

What is the position of the EU?

The official position of the EU is that it is not for the institution to take into consideration hypothetical declarations of independence following the possible breakaway of part of an existing member state. The official line of the EU Commission is that Catalonia's independence demand is a Spanish internal affair and, as such, they cannot comment on the issue. This has proved to be a controversial idea, though, since the Spanish Government has tried to influence the debate by assuring that an independent Catalonia would be automatically expelled from the EU, and should start from scratch new negotiations with Brussels to rejoin the institution. Some commissioners have denied this, stating that there is no precedent for a situation like this, and that Europe could not possibly deny membership to 7,2 million people who are now EU's citizens.

Why is Scotland holding a referendum, while Catalonia is not?

Because they are both nations without a state Scotland and Catalonia have often been compared, and the fact that both countries are engaging in an open debate about their possible future as sovereign states has only increased the parallels being drawn between them. Yes, they are both old European nations, with institutions of their own, but the similarities end here. It was not until recently that Westminster Parliament devolved some of its powers to Scotland, but the UK has a tradition of decentralised power in many areas. Citizens are used to the fact that laws — from smoking to gay marriage to university taxes — are different on both sides of the border. This is not the case of Spain, which for most of its history has been a heavily centralized state. However the main and most glaring difference is to be found in the very different approach to recognizing a separate identity: whereas the UK – as a plurinational society - has no real problem in acknowledging that Scotland is a nation, Spain as a whole has been unable to move beyond the idea that Catalonia is simply just one more autonomous region. Unlike Scotland, Catalonia cannot take part in official sports competitions around the world, which leaves Barcelona football club as the unofficial national symbol [See Video: cry for Catalan independence during the 'classic' Barça – Real Madrid]. The consequence of this different approach is that, while the British Government is allowing the Scottish government to organize a referendum on independence, the Spanish government is completely opposed to allowing the Catalans to be consulted about an eventual secession and has promised to fight any move by the Catalan government to organize a referendum [Catalonia and Scotland: how they compare to EU nations and Europe's other separatists]

What is Catalonia's level of autonomy?

Catalonia has a restricted autonomy. The Catalan Parliament has the power to pass laws on all sort of issues, from education to housing, but this theoretical autonomy has many strings attached. To begin with, the Spanish Government is unwilling to hand over some key powers, from allocating student grants to administering pensions, and tries to legislate on areas of devolved power, a situation which leads to constant conflicts between the governments in Barcelona and Madrid, with the Spanish Constitutional Court deciding which of the two is entitled to legislate the disputed area. Crucially, all main taxes are collected by the Spanish Government, which is then responsible for distributing the money raised between the various receiving institutions. In practice, Catalonia's Parliament is legislating on affairs without having the money to implement its laws.

How strong is the popular support for independence?

Surveys vary significantly, but they show two consistent trends. First, support for independence has been growing year after year. Second, from being the option favoured by a minority of Catalonia's citizens, independence is now supported by the majority of the population. The latest official figures show that, in an eventual referendum, 55,6% of Catalans would vote in favour of an independent state, with those against being 23,4% and roughly a 20% showing no clear preference or saying that they are not interested. When asked which form of relationship with Spain do they prefer, 47% favour an independent state, 22% want to maintain the current status quo, and 21% would like Spain to become a federal state.

What happens next?

A Council for the National Transition, with academics and experts from a number different fields, is working on the establishment of a timeline for an eventual referendum. Catalonia's main political force, CiU, which governs thanks to the support in Parliament of pro-independent ERC, argues that a referendum should take place before the end of 2014. The problem is that, according to the Spanish Constitution, only the Spanish Government can authorize the referendum, something the ruling PP party is firmly opposing. Other options include organizing a referendum without Spanish Government consent — which would make it technically illegal — or dissolving the Catalan Parliament and organizing new elections, with pro-independent parties sharing part of their manifestos. After months of bitter disputes, the Catalan president, Artur Mas [profile], is holding discrete talks with his Spanish counterpart, Mariano Rajoy, to try to find a way out of the current deadlock.

Could an independent Catalonia become a viable state?

As with all the other aspects of the argument, the viability of a future state is a contested issue. Those opposing independence argue that a Catalan state would inherit a huge deficit which would make it very difficult to pay pensions or salaries. Besides, they take for granted that Catalonia would be expelled from the European Union, depriving Catalan companies from the benefits of a single market. On the other side of the debate, those in favour of independence argue that, without the burden of the huge deficit which results from the difference between what Catalans pay in taxes to Spain, and what they get in return, Catalonia — Spain's most vibrant economy — would have a GDP level in line with some of Europe's wealthiest nations, and its government could reduce the current debt and improve the quality of public services. In addition they doubt that Catalonia would find itself outside the frontiers of the EU, pointing among other precedents to the fact that the EU Treaty held that national bailouts of member states were illegal, until in fact one was urgently needed. [Keys on the independence of Catalonia].