Edward.Hugh.Blog

Total Eclipse At The Heart Of Dubai's World

2009-11-27T04:20:00.000-08:00

Back in the heady days of 2006 some 30,000 cranes, roughly a quarter of total global capacity, were busy whirring away in Dubai. Today most of these devices have either left to find service in other parts of the globe, or lie silent, unused and unloved. In what is only the latest sign of the ongoing property snarl-up affecting the emirate Nakheel, Dubai World’s property developer subsidiary, asked on Wednesday for a delay in their next debt payment. The move was widely seen by investors as a technical default, raising concerns about investment in risky assets right across the globe. So while their company slogan may well be that the sun never sets over Dubai World, the fact is that Dubai World’s sun not only no longer shines, it is suffering from something more like a total eclipse.

According to the last reckoning, government owned Dubai World has some $59 billion in outstanding liabilities, making the company responsible for the lion’s share of the total $80-100 billion in estimated Dubai state debt. Up to now all maturing government-linked debt has been paid off in full, with government funds making up any shortfall in private funds. But the latest announcement suggests that weaknesses in the global property sector and vulnerability of the emirate’s economic model is leading the government to have second thoughts, and the clear impression is that Nakheel could be a very different story given the government's expressed intention of supporting only viable companies.

More than the scale of the issue, the problem this week in Dubai has been the uncertainty created, the underlying lack of transparency about the state of corporate and national finances and about exactly which debt will be honored, and above all about whether or not other countries – both within and outside the region - will be affected via the process known to financial analysts as contagion.

The consequences of the present payment standstill are wide ranging, as would be the impact of any eventual default. The repayment of Dubai World's $4 billion Nakheel bond was seen by investors as a key test for the emirate's ability to deal with the rest of the $80 billion or so owed by the government and its state-controlled companies. Dubai’s ability and willingness to do just this is what is now in doubt, and the way the process has been handled so far is leading to all manner of investor speculation.

The blow caused by the announcement was initially softened by news earlier the same day that the government had raised $5 billion from Abu Dhabi banks, but this optimism was soon dented as it sank in that the figure was considerably less than what the emirate had been hoping to attract from external investors and the sequencing of the two announcements is interpreted as suggesting that the Abu Dhabi money will not be spent on companies like Nakheel and Dubai World.

Indeed Dubai's growing problems had been evident for some time, with the credit rating agencies sharply downgrading Dubai government-owned corporations over the last year as expectations for the extent of likely government support have declined. Earlier this month Moody’s cut the ratings on Dubai Ports World, and Dubai Electricity and Water to Baa2 (junk status) from A3 and downgraded 4 other government linked companies, with the agency noting in its press release that the debt restructuring plan "highlights the government's intention to strictly adhere to its stated policy of supporting only those companies with viable long-term business prospects”

The question is, of course, now that the emirate's lop sided growth model has been shown to be completely dysfunctional, what are the viable long term business prospects in a city with so much excess capacity as far as property goes. According to the Dubai Statistics Center, the total population was 1,422,000 as of 2006, of which 1,073,000 were male and only 349,000 were females. Evidently activity associated with the construction industry can offer some part of the explanation for this massive gender imbalance. Just under 20% of the population are estimated to be UAE nationals. Approximately 85% of the expatriate population (and 71% of the emirate's total population) is thought to be Asian, chiefly Indian (51%), Pakistani (15%), Bangladeshi (10%). This impression of a large construction industry oriented population is reinforced by the economic data. Although Dubai's economy has been built on the back of the oil industry, revenues from oil and natural gas currently account for less than 6% of the emirate's revenues. It is estimated that Dubai produces 240,000 barrels of oil a day and substantial quantities of gas from offshore fields. The emirate's share in UAE's gas revenues is about 2%. But Dubai's oil reserves have diminished significantly and are expected to be exhausted in around 20 years. Real estate and construction account for about 23% of GDP and financial services for another 11%. Assuming many of the builders will now leave, it is hard to see what the future actually holds. Like countries a lot nearer to home - Spain, Ireland, the Baltics - it is hard to know what exactly to do with an economy which has been totally distorted by construction activity, and unsustainable building and price rises. And of course Dubai's problems are a lot larger than anything which is to be found in Europe.

Will We See Contagion?

Aside from the Dubai issue itelf the big worry now is possible contagion to other markets, with Central and Eastern Europe in the forefront of everyone’s mind, given the overlap in bank exposure. The announcement also lead to a sharp a drop in the value of the UK pound (hat-tip to Izabella Kaminska at FT Alphaville - see chart below) on the fear that the Dubai government could be forced into a rapid sale of its international real estate, since the emirate is perceived as having extensive UK property holdings which market participants (rightly or wrongly) think may be in danger of going under the hammer in a move which could clearly have implications for the UK property market, and the banks that have exposure to it.

In total European banks are estimated to have some $40 billion of exposure to Dubai with Standard Chartered leading the group according to research from Credit Suisse. HSBC Holdings, Barclays, Royal Bank of Scotland Group and Lloyds Banking Group also have some, significantly lower, exposure.

Since the decision to halt payments has raised fears of the largest sovereign default since Argentina 2001, most of the attention has been focused on sovereign debt issues, and these, of course, extend far beyond the Middle East itself. In particular European bond market worries grew over the ability of riskier government borrowers from Russia to Greece and Italy to pay back their debts in the longer run. And it is just here that one of the long term consequences of what happened this week in Dubai can be found, since with government after government pressing the accelerator pedal hard to the floor on the stimulus front, and digging ever deeper into the public purse to plug gaps in the bank balance sheets, the perception that paying back all the accumulated debt may be harder than expected, especially with ageing population problems to think about, is now gaining traction among investors. And once sovereign debt default fears really come up over the investor radar, it is going to be very hard work to remove them.

Greek sovereign debt in particular is attracting a great deal of attention, and this week one historic milestone has been passed, since the cost of insuring Greek debt for the first time equalled that of insuring equivalent Turkish debt. At first sight this is very shocking news, since as recently as 2007, the Turkish CDS spread was trading at about 500 basis points on perceived fiscal risks. The Greek spread, by contrast, was nearer 15bp. The country is, after all, a member of the European Monetary Union, and its euro-denominated bonds were considered effectively protected by other euro states. But over the past year the fiscal position of many emerging markets nations, Turkey among them, has become more favourable, while that of some Eurozone countries, including Ireland and Spain as well as Greece, has steadily deteriorated.

Evidently - as the Financial Times's Gillian Tett points out - such comparisons, apart from constituting a fairly bitter blow to Greek pride, raise a much bigger issue, one which goes straight to the heart of the Dubai saga. Two years ago, global investors generally did not spend much time worrying about the risk that seemingly remote, nasty events might occur. But the financial crisis has changed this perception. Having had their fingers badly burned once, investors are eager not to have it happen a second time, which is why what is happening in Dubai now makes them nervous, and why Europe’s governments would do well to think more about the future, and especially about ensuring that we don’t see Dubai like events starting to happen much nearer to home.

Are Russia's Consumers Getting "Carried Away" With Themselves?

2009-11-26T06:27:00.000-08:00

“Cutting rates by 50 basis points here and there is not going really diminish the appeal of the ruble,” said Manik Narain, an emerging markets strategist at Standard Chartered Bank Plc in London. “In terms of nominal interest rates Russia (at 9% as of 24 November) is still offering the highest yields in the emerging market space and in an environment where oil prices are remaining relatively well supported we think that the ruble will continue to be seen as an attractive way to position for global recovery,”

The world's central banks are having a hard time of it these days, having just gotten through the worst banking and financial crisis in living memory they now face a growing dilema between continuing to give support to the developed economies (which are yet to recover from those early hammer blows) and the danger of creating fresh global asset price bubbles in emerging economies, asset bubbles which could easily be being fuelled by low US interest rates and a weak dollar. The latest warning in this respect comes not from Nouriel Roubini (or even from me, but see this post, and this recent interview I gave on Forex Blog), rather it emmanates from Germany’s new finance minister, Wolfgang Schäuble. His comments - which were cited in last Saturday's Financial Times - highlight official concern in Europe that the exceptional steps taken by central banks and governments to combat the crisis carry with them a series of undesireable side effects.

Such openly expressed concerns only add further weight to recent statements made in China, where only a week ago the banking regulator Liu Mingkao explicitly criticised the US Federal Reserve for indirectly fuelling the “dollar carry-trade” – a process whereby investors borrow dollars at ultra-low interest rates in the United States and the invest them in higher-yielding assets abroad.

Wolfgang Schäuble went even further, saying it would be “naive” to assume the next asset price bubble would look just like the last one. “More likely today is a scenario in which excess liquidity globally creates a new [sort of] asset market bubble.” he said, and the fact “ that low interest rate currencies such as the US dollar increasingly being used as a basis for currency carry trades should give pause for thought. If there was a sudden reversal in this business, markets would be threatened with enormous turbulence, including in foreign exchange markets.”

As I argued in my last post on the carry trade, the danger of a short term sudden reversal may be being overstated at this point, since exit from emergency life support will be at best slow and measured in the United States, while ample funding will continue to remain available in Japan, where the central bank has now formally recognised that the economy is once more back in deflation (officially it exited in 2006, and the Bank did manage to summon up a full half percentage point worth of interest rate rise before falling back towards zero again, but in reality, if we strip out the oil price impact, the sad truth is that Japan never really left deflation).

However, regardless of whether or not we are running the danger of having an overly rapid unwind effect, untold damage is in fact being done, with the structural distortions being produced by the massive “wall of liquidity” which is currently sweeping the planet being evident enough, showing up as it is in some unexpected places, like Russia for example.

Ruble Once More On The Rise

On the face of it the idea that investors who were rushing for the Russian door following the Roki tunnel incursion back in August 2008 may now be rushing back in again may seem hard to believe, particularly given the serious economic recession which followed, and in reality it isn’t quite like this, but what is clear is that a steady and significant flow of funds is now most definitely heading in Russia’s direction - even if the immediate objective is not to increase what Russia most definitely needs, namely capital investment. A brief glance at the charts for movements in the ruble vis a vis the US dollar (see below) shows immediately what has been happening. After hitting a low of $31.39 on September 2 the ruble has been steadily rising, and was at $28.65 on November 11, since which time it has been hovering, as investors vacilate waiting to see where policy and the currency go from here.

At the same time, if we look at movements in the ruble-USD over a longer period of time (2 years in the chart below) it is plain the the ruble hit bottom on 4 February 2009 at $36.22 after falling steadily from 17 July 2009 when it touched $23.25.

In fact, as I say, while it is clear that Russia is on the receiving end of a steady inflow of funds, it is far from clear that these funds are of the kind she most needs at this point. Much of the money has been going into stocks, and Russian equity funds drew record amounts at the end of October, according to data provided by EPFR Global. In fact Bloomberg data show that the ruble has been the second-best performer among emerging market currencies after the Chilean peso over the past three months, gaining 8.7 percent in the period. And even foreign currency purchases from the central bank and lowering interest rates systematically to a record low (in Russian terms) has not worked. Indeed Russia's foreign currency reserves have now risen to $441.7 billion (as of Nov. 13) compared with the low of $376.1 billion reached on March 13. Whilethe Micex Stock Index has gained 116 percent this year, making the Index the best-performing benchmark equity measure globally since January (in local currency terms), again according to Bloomberg data.

In comparison Russia’s foreign direct investment plummeted an annual by 48.1 percent, the most on record, to just $10 billion in the first nine months of the year, while overall foreign investment, including credits and flows into securities markets, was $54.7 billion, down 27.8 percent when compared with the same period a year earlier,according to Federal Statistics Service data. Other foreign investments, including loans from foreign banks and Russian companies’ foreign divisions, were down 20.9 percent in the period to $43.7 billion. The consequence of all this is that the decline in investment activity has been - as can be seen in the GDP growth components chart below - perhaps the greatest single drag on the domestic Russian economy over the past twelve months.

But, as I am stressing this earlier overall impression of Russia as a country with problems of net capital flight now no longer gives us a precise up-to-date picture because, in a reversal of the earlier pattern Russia has seen, since mid September, significant capital inflows. In this sense some of the aggregate flow data is misleading, and even while the pressure from foreign lenders to repay sindicated loans continues and Russian borrowers continue to have difficulty rolling over their debt, the aggregate capital flow data to some extent masque a change in the underlying structure of Russian external debt - here, as ever, the devil lies in the details. As Guillaume Tresca, a Paris-based emerging market strategist with Credit Agricole’s Caylon Unit, argues the mounting weight of that huge wall of liquidity sweeping the planet means that something somewhere has to give, with the consequence that the Russian authorities are now under severe pressure to accept the inevitability of short term ruble appreciation since even though they “will try to do what they can to smooth the process, it’s very hard for them to go against the flow” since current “capital inflows are massive.”

In fact a growing consensus seems to be now emerging that Russia’s central bank will find itself forced to accept a stronger ruble next year as the devastating cocktail of rising commodity prices and abundant liquidity simply prove to be too powerful a force for policy makers to counter. So while representatives of the Russian administration have repeatedly asserted that they will do all they can to cap the ruble’s advance, all may well not be enough, despite Vladimir Putin's repeated declarations that his government won’t allow excessive appreciation in a bid to give some support to struggling exporters. The Canute like task of driving back the ocean is hardly an easy one, and, as the IMF itself recently warned, all efforts to fight the ruble’s advance may simply prove to be “unproductive.”

The problem has recently become even more complicated since, in the short term at least, letting the rouble rise also has its attractions for a Russian administration faced with simmering popular frustration with their inability to get the ongoing economic contraction fully under control. A rising ruble means slower inflation and more spending power for domestic consumers, consumers who have yet to get over the record 10.9 percent economic contraction which hit them in the second quarter. Given that the nine interest rate cuts introduced by the central bank since April have manifestly failed to unlock the credit flow to consumers as banks hold back their lending on concern borrowers can’t repay their debt (see chart below) a rising exchange rate certainly seems to be worth a second look as a way forward, since while a higher exchange rate coupled with near double digit inflation may cripple manufacturing competitiveness, it does transfer incomes directly into people’s pockets, something hard pressed politicians might see as quite beneficial.

Lending is still - as can be seen in the above chart prepared by the World Bank for its latest report - a problem, and corporate (or non-financial corporation lending) fell by 0.7 percent in September from August continuing the ongoing decline. Lending to households dropped 1.1 percent making the eighth consecutive monthly decline, with year on year levels now in negative territory, while non performing retail loans rose, climbing to 6.4 percent from 6.2 percent.

And the World Bank expect the many bank balance sheets will continue deteriorating as the share of non-performing loans increases. “In the environment of increasing credit risks, lending activities by the banks have remained limited despite improving liquidity conditions in the economy and continuing monetary loosening.” Bad debts in the banking industry may reach an average of 10 percent by the end of the year according to the Bank.

And when we look at ruble realities, as the IMF point out, efforts to stem the ongoing rise with intervention are far from being able to give the desired result. Bank Rossii bought a net $15.2 billion and 485 million euros in October, their largest foreign currency purchases since May, and went on to buy $6 billion during the first 17 days of November according to press reports citing central bank chairman, Sergey Ignatiev. Yet last week the Russian the ruble ended 0.1 percent higher at 35.0632 against the central bank’s target currency basket, its strongest level since December 23 2008. The ruble appreciated 3.4 percent in October against the dollar (for its second consecutive monthly gain) and has risen more than 1 percent so far in November. Thus the central bank has now moved on to use monetary policy to try and stem the rise, and said on October 29 that it would also use interest rates in an attempt to reduce the “attractiveness of short-term investments in Russian assets and stop the accumulation of risk”.

The recent rise follows ruble a 35 percent slump against the dollar between August last year and January, raising the cost of imports (which make up about 49 percent of the consumer goods sold in Russia) and, in theory, making Russia's domestic industry somewhat more competitive externally. However, without a sound institutional infrastructure, and a coherent monetary policy, short term devaluation gains can easily be turned into medium term inflation, thus defeating the purpose of corrective price devaluation.

The current problems are not of recent making, but are the logical end product of steady and systematic long term mismanagement of Russia's monetary policy, a mismanagement which has now created a veritable Procrustean bed of problems for both Russia's economy and the wider society. Warnings were frequent enough, but went unheaded, and the continuing failure to address the underlying inflation problem between 2005 and 2008 now means that large structural distrortions have been accumulated in the economy, including a massive one of commodity export dependence, a problem which effectively turned the country into a veritable disaster waiting to happen if ever there should be a protracted lull in the secular rise in energy prices. That lull has most definitely now arrived, since while it is obvious that Russia's short term future depends on energy prices, it is far from clear what the future holds for those energy prices themselves.

Weak global demand for oil has led to a sharp rise in excess capacity and OPEC's spare capacity has risen to levels not seen since 2002, when prices averaged USD25/barrel with OPEC’s pricing power staying very low. Up to now oil prices have remained in the USD70/barrel range, supported by OPEC output restraint and its stated desire to have prices reach what it calls "a comfortable level" - ie near USD75/barrel - as well as by expectations of rising demand. At its September 2009 meeting, OPEC left its production quotas unchanged but indicated it would take rapid action if prices dropped sharply. OPEC production, however, continues to edge higher, with compliance to its combined cuts of 4.2 million barrels per day falling to 66 percent in September from 71 percent in August. Thus there is evidence of OPEC strains and there is considerable uncertainty about real levels of 2010 demand, all of which makes for considerable uncertainty about prices. As can be seen in the above chart, World Bank oli price estimates (like their economic growth ones) have fluctuated, and have moved from a price estimate in March of around $62.95 for 2010 to the current (November) expectation of $75.29. While the earlier estimate may certainly be considered to be on the low side, the current one may well be too high, and a level of around $70 may not be an unrealistic forecast. It should be noted however that there are credible dissenters, and in a more or less reasoned analysis Capital Economics suggest that oil prices could well fall back again in 2010 to average somewhere around $50. If this forecast were to prove to be anywhere near correct, the Russian economy is going to be subject to major downside risks, due in particular to the difficulties posed by:

i) financing the fiscal deficit
ii) rising unemployment
iii) growing bad loans in the banking system
iv) refinancing external debt
v) the continuing high level of consumer price inflation and the difficulties this poses for monetary policy at the central bank

Added to all this, the economy will clearly not rebound as easily as many seem to foresee, adding to the risk element on all fronts.

A Return To Growth In The Third Quarter

Following the deep output drop sustained in the first half of the year (10.4% of GDP year on year), the slow recovery in global demand and rise in commodity prices has helped lift Russia’s economy up from its earlier lows. But the recovery has only been a modest one, since preliminary data indicate that the economy still registered a 9.4 percent year-on-year drop in the thrid quarter, indicating only a very small improvement (possibly a seasonally adjusted 0.6%) over the second quarter. More recent data also point towards a rather uneven progression, with the manufacturing sector falling back while rising real incomes means that consumer demand is producing stronger growth in the services sector.

As in other countries, investment (both foreign and domestic) took a severe hit on the back of the credit crunch, and gross capital formation was indeedthe main demand side factor dragging GDP down in the first half of the year (by 14 percentage points), followed at some distance by consumption, which contributed 1.2 and 3.0 percentage points to aggregate output contraction rates respectively in the first and second quarters. Net exports, on the other hand, made a positive contribution (5.1 percentage points in the first quarter and 5.9 percentage points in the second) although as elsewhere the drop in imports was the key factor. When imports are looked at in volume (price adjusted) terms we find that real ruble depreciation (the real effective exchange rate depreciated by 5.9 percent in the first nine months of 2009) meant that the import contraction was more severe than it seemed, especially in the second quarter of 2009 when the drop in imports meant that net exports increased by 66 percent according to World Bank calculations.

Unemployment Falls Back, But Problems Remain

Six million Russians were added to the government’s official poverty count in the first quarter of this year alone, and by the end of 2009, 17.4 percent of the population or 24.6 million people will be living beneath the subsistence level of $185 per month, almost 5 percent more than before crisis, according to World Bank estimates. Unicredit analysts forecast that the number of Russians with disposable incomes of more than $1,000 per month will fall 48 percent this year to about 13.6 million, or roughly 9.6 percent of the population. Thus this recession is likely to have lasting and important results.

On the hand, employment statistics from the Federal Statistics Service indicate that a sharp downward adjustment in the labour market took place up to February this year, before moderating and then reversing. Unemployment seems to have peaked in February at 9.5 percent following the sharp decline in output, and the severity of the blow was especially strong in the industrial sector.

Since the beginning of March 2009, however, with real level of economic activity bottoming out (see above chart), the labor market continued to show moderate improvement: by September the number of those in employment had increased by 2.6 million, and the rate of unemployment fell to 7.6 percent, down significantly but still much higher than in September 2008 (5.8 percent). According to the World Bank this steady improvement is rather misleading as it reflects significant seasonal gains in employment and a shift in labor adjustment towards labor hoarding in the manufacturing sector.

As the World Bank also notes, the long term regional differences in Russian unemployment rates are striking ranging from a low of 1.6 percent in Moscow to a high of 52.1 percent in Ingushetia in August 2009. Traditionally unemployment is largely concentrated in the Southern, Far Eastern and Siberian federal districts. However, the crisis related unemployment shows a different pattern, with the largest increases in unemployment being found in the North Western District (from 4.8 to 7 percent) and the Urals (from 4.9 to 8.1 percent). Regression analysis carried out by the World Bank revealed that unemployment levels were higher in those regions with higher levels of manufacturing, and where industrial production accounted for a larger share of GDP.

And while it is entirely possible that the economy will show a “modest” recovery in the second half of 2009, this is “unlikely to have significant impact on social indicators,” according to the World Bank. Unemployment will increase to 9 percent “as seasonal factors wane” from 7.6 percent in September and it may take three years before the number of Russians living in poverty falls to pre-crisis levels, the World Bank estimates. Indeed, in the short term real incomes are “likely to fall further".

Monetary Policy Mess

The political threat posed by growing unemployment and rising poverty must most certainly be one of the reasons behind Russia’s central bank recent decision to lowered its key interest rates for the eighth time in six months, in a bid to both stimulate lending and to stem the inflow of funds and the rise in the value of the ruble which is making the work of restoring competitiveness to the manufactured sector all the more difficult. Earlier this month Bank Rossii cut the refinancing rate to 9 percent from 9.5 percent and reduced the repurchase rate charged on central bank loans to 8 percent from 8.5 percent. Despite the reductions Russia still has the fourth-highest benchmark interest rate in Europe after Ukraine, Iceland and Serbia.

The best thing that can be said about Russian monetary policy instruments is that they are hopelessly ineffictive. Even October consumer-price growth at 9.7% annually, while well down on the 15.1 percent peak hit in June 2008, is still horribly unacceptable, and it is extremely hard to understand how economic mismanagement and incompetence can have reached such a level that an economy which has been contracting at the rate of nearly 10 per cent a year can still have this kind of price inflation. There is no other word for it, this is a mess.

The bank is caught on the horns of a large dilema, since cutting rates further to stem inflows and the ruble rise may only risk fuelling more inflation, yet First Deputy Central Bank Chairman Alexei Ulyukayev stressed only this week (following the latest in rate decision) that the central bank did not exclude the possibility of further cutting its rates since it sees “no inflationary risks” next year and an inflation rate “much lower” than 9 percent. This follows explicit remarks at the end of October that the Bank was ready and willing to use interest rate policy as required to stem speculative capital flows that "threaten to undermine currency stability".

Inflation Woes

One small consolation at least in this ongoing mess is that pressure on Russia’s producer prices have been easing, and factory gate prices have even been falling. According to the preliminary data from the State Statistics Service, the price of goods leaving factories and mines was in fact down an annual 10.8 percent in August following a record 12.3 percent drop in July. Evidently The with the 2008 spike in oil and energy prices the logic behind this is easy to see. What is not so easy to see is why domestic prices take so long in responding to general capacity utilisation signals and why the Economic Development Ministry still seems comfortable with the expectation that average inflation will range between 12 percent and 12.5 percent in 2009 only marginally down from last year’s 13.3 percent. Stunning!

And while consumer price inflation has been tame in recent months this good behaviour may not last long, since it could rise more than expected in November, according to Deputy Economic Minister Andrei Klepach, who does not seem to completely share Alexei Ulyukayev price optimism. Consumer prices could rise "by about 0.3% to 0.4%" in November, Klepach said in comments recently, and this prediction seems to be near the mark, since according to the latest data we have consumer prices rose 0.1% in the week to 9 November, bringing to an end a period of just over three months without inflation. Looking into the future price growth may be further spurred by an influx of budget spending in the fourth quarter, as well as by a planned 30% increase in pensions which is due to come into effect on 1 December.

In fact, despite the fact that inflationary pressures have been easing in Russia in recent months, chiefly due to collapsing consumer demand and outlfows of capital following the crisis that hit the country a year ago, the official outlook for Russia's inflation in January 2010 is only that it will be "significantly below "the level of January 2009. This kind of argument is hardly reasssuring, since inflation last January was at an annual rate of 13.4%, although the short term outlook is for only a mild acceleration, with consumer prices increasing by between 0.2% and 0.3% in November and by about the same amount in December.

Why Not Devalue?

Well, one way not to solve the problem, according to European Bank for Reconstruction and Development Chief Economist Erik Berglof, would be a ruble devaluation, since despite recognising that the country has a very difficult couple of years in front of it, Berglof argued recently that “this (devaluation) is the wrong way to think about the recovery in Russia”.

As he said, Russia’s failure to wean itself off its reliance on commodity exports has condemned the country struggling to find economic growth in the face of a large drop in demand for its key export products. “If you want to have a flexible exchange rate, you need to get out of this dependence on commodities,” Berglof said. “It’s a major concern that in the last 10 years Russia has become actually more dependent on commodities. Unfortunately, not much progress has been made.”

Well, this is exactly the point, and is why I have been arguing over the last two year about how all those wage increases which the Russian administration seemed to rejoice in (since they bought short term popularity, and fuelled consumption) simply stoked-up the domestic inflation bonfire and in the process did untold damage to domestic competitiveness. However it is evident Russia's industries cannot now simply be transformed overnight, and this is where I find a weakness in Berglofs argument, since some remedy is needed to straighten out the distortions and get of commodity export dependence. But what? If it isn't devaluation, then surely we will need to see very substantial wage deflation in order to attract the now much needed inward foreign investment. The current position whereby prices rise by an annual 10%, and living standards are maintained by a sharp rise in the value of the ruble (making imports cheaper) is quite simply unsustainable, for reasons which should be evident from looking at the chart below. If you look at the green line (which shows the Real trade weighted Effective Exchange Rate) we will see how this has risen sharply since 2003, with the exception of the drop in the value of the ruble in the second half of last year. If we then look at the blue line (which shows the non oil and gas current account balance) we will see how this has been steadily deteriorating (again with the exception of the short sharp shock occassioned by the crisis of last autumn). However, as we can also see, the green (REER) line has now once more resumed its upwards march - the consequence of all those financial inflows, and the associated rise in the ruble - and with the upward march comes the ongoing structural damage to the economy, precisely the can't of structural damage which Erik Berglof would like to avoid, and even unwind.

Of course not everyone agrees with Berglof, and the Russian Association of Regional Banks, whose 450 members include the Russian units of Barclays and Citigroup, has called for a devaluation of as much as 30 percent. Billionaire Vladimir Potanin, realist and owner of 25 percent of OAO GMK Norilsk Nickel, said in recent interview with the Russian Newspaper Vedomosti that the “interests of the economy” will lead the currency to depreciate in the “mid term,” allowing exporters to cut costs and modernize production.

Nonetheless energy, including oil and natural gas, accounted for 69.1 percent of exports to countries outside the former Soviet Union and the Baltic states during the first seven months of this year, according to the Federal Customs Service, while metals were responsible for another 12%. So the commodities dependency is massive, and this situation can't be turned round easily.

Getting Carried Away By Global Liquidity?

Bank Rossi are also not 100% convinced by the merits of Berglof's reasoning, as witnessed by the fact that they facilitated a 35 percent depreciation in the ruble during the second half of last year (see chart below), and as the collapse in raw material prices and the dramatic change in local credit conditions first pushed Russia's economy into recession the ruble’s trading range was widened to between 26 and 41 against the dollar-euro basket.

However, as I keep stressing, the central bank is now locked on the horns of a massive dilemma, since as risk appetite returns, with it comes the enthusiasm for buying the so called "high yield" currencies - like the South African Rand, the Russian ruble and the Hungarian forint. Instruments denominated in all these currencies offer investors substantial returns at the present time thanks to offering some of the highest interest rates among globally traded currencies.

Indeed buying Russian rubles was one of the key recommendations made by Angus Halkett, currency strategist at Deutsche Bank in London, in a research report published back in April, and the market seems to have followed his advice The so-called carry trade works by investors borrowing in currencies with low interest rates and good prospects of continuing depreciation (the USD at the moment, for example) in order to buy higher-yielding assets, in countries with high domestic interest rates and continuing prospects for ongoing appreciation.

In general, engaging in one or other form of the thousand-and-one-varieties carry trade is pretty standard practice during times when returns for real economic activity are low, and central banks hold down rates and supply liquidity. Indeed we may include here the kind of carry practiced by banks in borrowing from the central banks only to then lend - for a small, but very low risk, interest rate commission - to their national government, who at this stage in the business cycle will normally be running a fiscal deficit. So more than funding recovery, the watchword at the moment is very much "carry on carrying".

But for those on the receiving end, the consequences of so much carry are far from innocuous, since the process simply funds all sorts of economic distortions, and far from allowing normal market corrections to occur, it simply amplifies the problem. Things are now becoming very detached from the so called "fundamentals" (whatever those might be in the topsy turvy world in which we now live), since it simply is not plausible that the currency should be rising in this way in a country with nine percent plus consumer price inflation and which badly needs to move away from commodity export dependency. The only conclusion which could be drawn is that the Russian economy now needs massive structural reforms, and on any imaginable scenario in the world in which I live these are simply not going to be implemented.

On the other hand Russia’s central bank may have to accept a stronger ruble next year as rising commodity prices prove too powerful a force for policy makers to counter and as consumer demand plays a bigger role in the bank’s decisions. The authorities “will try to do what they can to smooth the appreciation, but it’s very hard to go against the flow,” said Guillaume Tresca, Paris-based emerging market strategist for Calyon, the investment-banking unit of Credit Agricole. “Capital inflows are massive.”

Policy makers have indicated they will cap the ruble’s gains and Prime Minister Vladimir Putin has said his government won’t allow an excessive appreciation as exporters struggle to tap into a global trade recovery. Even so, efforts to fight the ruble’s advance may prove “unproductive,” the International Monetary Fund warned on Nov. 12, adding that “underlying factors” justify its strength. There is a growing consensus that Russia’s central bank is now close to accepting the inevitable, and will allow the ruble to continue appreciating to help domestic demand and cap inflation. As Clemens Grafe, chief economist at UBS in Moscow puts it, “A higher exchange rate, because it transfers incomes into people’s pockets, could actually be more beneficial,”

Fiscal Resources Near To Running On Empty?

According to preliminary estimates from the Ministry of Finance, the federal budget deficit totaled 4.0 percent between January and September, slightly below the expected level, in part due to the under execution of budgeted expenditures in the first three quarters of 2009. The federal non-oil deficit (which excludes drawing on oil revenues) amounted to 11.0 percent. This is managable, especially given the comparatively low level of Russian sovereign debt to GDP. However, as the World Bank point out under the likely scenario of a sluggish global recovery and modest growth, Russia will face a tightening budget constraint and need to reduce expenditures and the fiscal deficit over the medium term. Further, funding the planned increase in social expenditures, mainly related to increases in pensions, may well requires spending cuts in other expenditure categories.

The Ministry of Finance baseline federal budget estimates with conservative oil assumptions icorporate plans to reduce the federal budget deficit from 8.3 percent of GDP in 2009 to 3 percent in 2012, but the medium term fiscal outlook also indicates an extensive drawdown of Russia's Reserve Fund to finance the deficit. Given the size of the anticipated deficit, the Reserve Fund is likely to be depleted by the end of 2010 and borrowing will be required to offset the gap. Estimates of the Ministry of Finance indicate that the combined external and internal borrowing to cover the fiscal deficit will amount to 1.0 percent of GDP in 2009, 1.6 percent in 2010, 2.5 percent in 2011, and 1.5 percent in 2012. All of this is manageble, but the depletion of the Reserve Fund does mean that if downside risks materialise, and in particular if there are more writedowns in the banking sector needing government support that there is now little in the way of a cushion between managed adjustement and unstable dynamics.

Outlook – A Hard Road To Travel

If one thing is clear hear it is that attaining a recovery in Russia's economic fortunes at this point is going to be no easy feat, as Trust Investment Bank put it in their latest report, October data for the world’s largest energy exporter suggest “an almost complete absence of clear signs of recovery” since industrial output slumped and capital investment fell. October capital investment was still down 17.9 percent while industrial output dropped an annual 11.2 percent in October worse than the September reading. Even unemplyment was up again, at 7.7%, although as the World Bank pointed out, this is the result of the same seasonal factors which lead to the fall in unemployment over the summer.

On the other hand, this is by no means a one way street, since disposable incomes climbed a monthly 6 percent in October and rose 3.9 percent compared with the same period last year, registering their biggest annual jump since September 2008, according to provisional data from the Federal Statistics Service, while wage declines eased with wages falling an annual 4.5 percent, compared with a 4.9 percent annual decline in September. And retail sales, which had previously fallen for nine consecutive months, the longest period of declines on record, suddenly sprang back to life, with October retail sales rose 3.2 percent from September and declined by 8.5 percent on an annual basis as compared with a 9.9 percent drop the month before.

Other data also show this mixed picture. Monthly GDP Indicator data from VTB Capital, based on the PMI surveys for the Russian manufacturing and service sectors, continued to show economic contraction on an annual basis in October, butthe rate of decline eased for the fifth consecutive month. The Indicator showed a 0.6% annual contraction, the slowest rate seen suring the current eleven-month period of continuous decline.

The seasonally adjusted Total Activity Index remained above the no-change mark of 50.0 for the third month running in October, indicating growth of private sector output. The Index improved fractionally over September, to 54.2, indicating reasonably robust growth (although it remained below its historic trend of 56.6). This was driven by a faster rise in services activity, while the rate of growth in manufacturing production slowed to a weaker pace. On a quarterly basis the indicator showed 0.4% q-o-q growth for the second month running.

Commenting on the survey, Aleksandra Evtifyeva, Senior Economist at VTB Capital, reported:

““The GDP Indicator continued to point to an improvement in economic activity in October. The manufacturing sector’s performance deteriorated slightly while activity in the services sector is approaching pre-crisis levels. This might be one of the consequences of higher oil prices and a stronger rouble as low export orders were the main drag on manufacturing. Another encouraging development highlighted by the October surveys was the deceleration in the pace of job cuts: the employment sub-indices now stand at around 47, which is already higher than last autumn.

The GDP indicator reading was based on manufacturing sector survey findings which confirmed that overall Russian manufacturing business conditions deteriorated in October. Although output, new orders and input purchases all continued to grow, the rates of expansion slowed compared to September. Moreover, manufacturers shed jobs at a faster pace than in September.

The headline seasonally adjusted Russian Manufacturing PMI fell from 52.0 in September to 49.6 in October, signalling an overall deterioration in the business climate at the start of the fourth quarter. It was the first month-on-month fall in the headline index since it plummeted to a record low (33.8) in December 2008, although the latest figure was indicative of only a marginal rate of decline. Of particular note, the new export orders index posted a strongish decline to 47.8, evidently reflecting the recent ruble appreciation. The input price index continued to point to strong rise in costs associated with metals, energy and oil-related items while output prices index pointed to a moderating growth in price charged.

In contrast the rebound in Russian services activity rose continued in October, supported by a record fall in charges, and Russia's services sector, which accounts for about 40 percent of the economy, rose for the third consecutive month, reaching its highest level since September 2008, although the reading of 54.3 still remained significantly below the long-run series average.

So Where Do We Go From Here?

In contrast to the most recent PMI data and the opinions of analysts like Neil Shearing at Capital Economics and Trust Investment Bank , Russia's political leaders are markedly more optimistic. Russia’s economy may expand as much as 4 percent in the last quarter of 2009 following a timid return to growth in the third quarter, according to Deputy Economy Minister Andrei Klepach speaking at a conference in Moscow recently. The economy may show “quite strong growth” of between 3 percent and 4 percent in the fourth quarter over the previous three months, Klepach said. This is an interesting claim, and doubly so given that Klepach has been quite cautious so far this year in his claims. However, as Neil Shearing at Capital Economics points out Klepach’s claim that growth could rise to an annual 4% at some point is perhaps not as wild as it first sounds. Shearing estimates that output fell by over 9% between Q4 2008 and Q1 2009, which means that given the sizeable base effects which will exist the Q1 2010 year on year growth rate might well look look quite impressive.

But this may be a kind of "mirage effect" since if the global recovery slows towards mid-2010 (and with it the level of energy prices) then Russian annual growth could easily fall back sharply over the second half of next year and into 2011. Thus the prospect of a renewed fall in energy prices would imply that the risk a double-dip recession in Russia is quite a real one.

But this is all for the future, while here in the present the rising price of oil and the return of some financial flows into Russia continues to fire-up optimism, as do the numbers for retail sales, so we had better just grit our teeth and hope they don't also fire up the inflation process again, although with lending to households still stuck in gridlock, perhaps the dangers here should not be overstated. More worryingly, inflation may fail to fall significantly from its current high level, even as the central bank reduces interest rates in a bid to stem the ruble rise.

Klepach's optimism is not shared, however, by the World Bank who in their latest report argue Russia’s economy will suffer a deeper contraction than they previously estimated this year even after a series of central bank interest rate cuts which have manifestly failed to ease the “prolonged” credit drought. The World Bank now expect the Russian economy to contract by 8.7 percent this year, compared with their June forecast for a 7.9 percent decline. The government is currently predicting the economy will shrink 8.5 percent this year and grow 1.6 percent next year.

“We expect that the central bank will continue lowering its policy rate in the near future to facilitate credit to the real sector,” the World Bank said. “The impact, however, appears to be limited. The policy rates are mostly indicative, while the cost of credit remains very high.”

The OECD, on the other hand, seems rather more positive, arguing that Russia’s economy will enjoy a stronger commodity-driven rebound than first estimated, although, they hasten to add, authorities should avoid a sudden removal of stimulus measures to ensure the domestic economy keeps up the pace of its advance. They now expect the Russian economy to expand by 4.9 percent in 2010, compared with a June forecast for 3.7 percent growth, although output is still expected to contract 8.7 percent this year (broadly in line with the World Bank), more than the 6.8 percent estimated in June. The 2010 figure seems very optimistic in the light of the problems here identified, and more than adding to our appreciation of the Russian situation such numbers may rather cast doubt on the methodology being applied, and raise questions about some of the numbers being seen for other countries.

“Although recovery is in prospect, the large output gap and subdued inflation suggest that policy stimulus should not be removed too hastily,” the OECD said. “Fiscal policy should be managed to avoid dislocative demand effects from a surge of expenditures in late 2009 followed by a tightening in 2010.”

According to the OECD, Russia’s economy will enjoy a stronger commodity-driven rebound than first estimated and “Fiscal and monetary stimulus and the recovery of global demand should result in a strong rebound of output towards the end of 2009". The basic OECD argument is that “A large part of the policy stimulus will be felt only late in the year, as fiscal expenditure is back-loaded and a series of interest rate cuts began only in the second quarter.”

Long Term Impact On Russian Growth

But let us not underestimate the difficulties. According to the World Bank Russia’s real GDP will likely return to pre-crisis levels only in late 2012. And, the Bank says, without a more productive, diversified, and competitive economic base, its long-term growth is likely to be slower than in the past decade and than the pre-crisis expectation

Russia’s pre-crisis decade of prosperity was built on strong capital inflows, rising consumer and corporate credit, and significant capital investment. The post-crisis world will look very different: Russia will need to implement fiscal adjustment and diversify its economy in the context of sluggish global growth, low capital flows, and more limited access to foreign financing. So it is now time to look towards a new growth model based on increases in productivity and know-how and on more efficient allocation and use of investment, labor, and FDI. Next generation reforms should be geared to make Russia's monetary policy instruments much more effective, the Russian economy much more productive, diversified, and open—and more able to respond to future shocks. The success and duration of the transition from the current model of heavy dependence of natural resources to a more sustainable growth model depends, according to the World Bank on maintaining a competitive exchange rate, sustaining a prudent fiscal stance, improving the investment climate, more mobile capital and labor, making the financial sector deeper and more efficient, investing in infrastructure to eliminate key bottlenecks to growth, and strengthening governance and fighting corruption as part of the overall effort to improve the effectiveness of the public sector.

The OECD more or less agrees: “Laying the foundations for sustained rapid growth will require unwinding some of the distortive consequences of the crisis". And, may I add, unwinding some of the distortive processes which lead the crisis to be such a severe one in the first place might not be such a bad idea either.

The Dollar As A Funding Currency

2009-11-05T12:36:00.000-08:00

Nouriel Robini is not a man who is known for mincing his words. “We have the mother of all carry trades,” he tells us, “Everybody’s playing the same game and this game is becoming dangerous.” There is a “wall of liquidity” sweeping the planet, pushing asset prices ever higher in one country after another. I wholeheartedly agree.

Investors across the globe are taking advantage of the ultra low interest rates on offer at the US Federal Reserve to borrow in dollars in order to buy assets like government debt, equities and commodities, in the process, as Nouriel says, fueling “substantial” booms that if not checked in time may sow the seeds of yet another financial crisis. This is a classic example of the so called “carry trade” in which investors borrow in countries with low interest rates to invest in higher-yielding assets.

The dollar has fallen by about 12 percent (in relation to a basket of six major currencies) in the last year as the Federal Reserve has cut interest rates to a record low of around zero in an effort to lift the U.S. economy out of its worst recession since the 1930s. The problem is that this has created what Professor Roubini rightly terms the mother of all carry bets against the US dollar, and lead to all kinds of speculation that we are at the dawn of a new era, one which will have the “death of the dollar” as its defining characteristic, and where in the dollar will no longer serve as the world’s reserve currency of preference.

Well, as someone once said, rumours of my imminent demise are somewhat exaggerated. The greenback is still alive and kicking, and will be for many years to come, although we also need to be realise that structural changes are underway. So while in the short term we should not really be in doubt that the decline in the dollar will eventually “bottom out” as the Euro-USD crossover reaches ever more painful levels for the eurozone’s heavily export dependent economies while the Fed will at some point begin to hint that it is considering raising borrowing costs and start to with draw some of the “quantitative easing type” stimulus measures, including, of course, those large scale purchases of US government debt. But this is not likely to happen rapidly, or in a disorderly fashion, so in many ways investors will have time and space to reorganise their betting card.

This was once more made plain this week, when Federal Reserve decision makers signaled quite clearly that a simple return to economic growth alone won’t justify higher interest rates on their part, stressing that any future increase will depend on the labour market and inflation trends, and indeed the Fed’s rate-setting Open Market Committee resasserted its pledge to keep rates “exceptionally low” for an “extended period.” Following these comments traders began to pare back their bets that an increase in borrowing costs will come in the first half of 2010, the dollar weakened and short-term Treasury yields fell.

The impression that the Fed will not be the first out of the box among the major central banks was only reinforced today as the European Central Bank seems to have hesitatingly taken its first step toward removing emergency stimulus measures by indicating it won’t be continuing to provide commercial banks (and of course the governments whose debt they are buying) with the current 12-month loans as 2010 advances - although no timetable for phasing them out has so far been provided. Nor has it been made plain what structure will replace them. Jean Claude Trichet seems to have contented himself with enigmatically teasing the assembled journalists by stating “Not all our liquidity measures will be needed to the same extent as in the past” and pointing out that since market sentiment didn’t expect the ECB to prolong its offer of 12-month long term funding beyond December he was going to “say nothing to dispel this present sentiment.”

Assessing what exactly is happening here is difficult, since in the world of central bankspeak it would be a mistake to think that expressions mean what they actually normally mean in everyday discourse. So it is not clear whether or not the strategy between the Fed and the ECB is coordinated at this point or not, and if it is, to what extent. Certainly despite Timothy Geithners insistence on the US Treasury's strong dollar policy, it is hard to imagine that anyone (not even the Chinese) actually take him at face value here, and indeed, if you read the reports carefully, Trichet is only complaining about excessive volatility, and not about the level of the Euro in and of itself. This impression, that those taking decisions accept that the dollar needs to stay down to allow the US economy to correct itself is only reiforced further by concerns expressed only today by Kenneth Rogoff, Raghuram Rajan and Simon Johnson (all economists who have previously worked for the IMF) as to whether the IMF and the G20 actually had the wherewithal to address the global imbalances problem. It should not escape our notice that this "concern" was expressed just one day before G-20 finance ministers and central bankers, including U.S. Treasury Secretary Timothy Geithner and European Central Bank President Jean-Claude Trichet, are to start two days of talks in St. Andrews, Scotland.

In fact, there is some evidence of progress being made, since the U.S. current account deficit narrowed in the second quarter to its lowest since 2001, and I'm pretty sure a solid majority of Europe's leaders accept the need for the deficit to be allowed to correct further if future growth is to be put on a more solid footing.

This having been said, however, it is not at all clear how the issue of weaning the banks of the one year funding is going to be conducted, especially in a year where most European governments are going to have very large borrowing requirements indeed. Again, Trichet was at pains to stress the need for the Commission to police the Stability and Growth Pact effectively, even allowing himself to go so far as to say that a 0.5% point annual reduction of the structural deficit after 2011 simply wasn't sufficient. But, when push comes to shove, it is hard to see the ECB willingly precipitating a financial crisis in a major eurozone country - like for example Spain. According to the latest EU Commission forecast, Spain will have deficits of 11.2% of GDP this year, 10.1% of GDP in 2010 and 9.3% of GDP in 2011, and even in 2011 they do not expect the Spanish economy to grow by more than 1% (optimistic even this on my view), while they still expect the unemployment rate to be running at 20.5%.

As can be seen in the chart below, a very large part of the recent borrowing by the Spanish government to fund this years deficit has been financed by issuing short term bonds.

And at the same time the dependence of Spain's banks (who have in one way or another acquired many of the short term securities) on the one year funding has been considerable (see chart below).

And so of course in 2010 much of this debt will need to be "rolled over" and next years deficit will need to be financed as well, and it is almost impossible to see how this can be achieved without inflating the spread again (which has been brought down considerably of late) unless the ECB lends a willing hand.

Of course, what Nouriel Roubini is worried about is none of this, since he isprincipally concerned about how a future seismic shift in the perception of the dollar may force investors to reverse the existing carry trades and how this may produce a further mini financial crisis as there is “rush to the exit”. Evidently there are precedents here, since the rapid unwinding of the Japanese carry trade last autumn only added to the general feeling of financial chaos following the collapse of Lehmann Brothers.

So what are the risks of a repeat performance on this occassion? We, the risks are certainly there, but perhaps we have the key to understanding why the Japanese carry trade unwinded so violently is to be found in the last paragraph, since the Yen carry went west so quickly due to a decline in risk sentiment, and the safe-haven surge in both the Yen and the USD was a response to this decline in sentiment, and not its cause. Yet presumeably, and at least in the short term, any move by Ben Bernanke to raise Federal Reserve interest rates would be a signal for a further rise in risk sentiment, and not a response to a decline, and as such it should in theory trigger another surge in carry appetite, and not its dissapearance. Unless, of course, the dollar rise was precipitated not by the Fed's rate tightening programme, but by perceived risk elements in the "other" currency in one of the pairs - that is the euro. Personally, I consider the situation in Spain to be much less of a "side-dish" in the current financial crisis than many seem to feel it is, and indeed I would take Spain as the largest and potentially most dangerous of the loose cannon we have floating about on deck as we try to steer our way forward and away from the storms.

Not that the announcement of a future tightening in monetary policy in the United States (which would presumeably be underwritten by a series of positive and glowing reports that the US economy was finally and without a shadow of double-dip doubt emerging from its deepest recession since WWII, that its to say it won’t be coming soon) would not present technical issues about the future dynamics of carry – closing USD positions only to reopen them in Yen, Swiss Francs, or (why not) even Euros if despite Trichet's optimism today Europe’s economies prove unable to stage an early exit from recession. It would still be carry on up the Khyber time whichever way you look at it.

But lets go through some of this step by step.

The Dollars Fall – Cyclical or Structural?

As noted above, the USD has particularly weak in 2009, falling by 15% on a trade-weighted basis since in had a local peak in March. March it will be remembered is not a coincidental date, since many emerging markets stated to climb precisely in that month (see Brazil MSCI Chart).

But as I am also suggesting the dollar’s recent fall is more cyclical than structural. The massive injection of liquidity by central banks has created an environment which is favourable to equity and commodities markets in some key emerging economies, together with the associated commodity and emerging currencies, and since the depth and accessability of the US markets is evident, then much of the associated trade has been taking place at the expense of the greenback.

The dollar’s recent decline has been accompanied by repeated forecasts of its terminal demise, accompanied by ever louder calls for the creation of an alternative reserve currency. However, I personally believe that the current fall in USD is more temporary than permanent, and that the structural factors often cited as the raison d’être for the dollar’s decline have – so far - played only a limited role. Which is not to say that these factors won’t come into play at some point, and hence we are in the mother of all complex situations – but it is just, as I said, that news of its imminent demise is rather premature and greatly overstated.

Much of the brouhaha from the structural dollar bears has of course been associated with the issue of the sustainability of the US fiscal deficit, and although, of course, the current double-digit U.S. government budget deficit is extraordinarily large in historical terms, it is nonetheless comparable to those being sustained in a number of other major economies (Japan, the UK, Spain, etc). At the same time there is still little significant evidence of foreigners becoming totally disenchanted with buying US debt – in fact on aggregate (including both the private sector and central banks) they are still busy buying Treasury bills and bonds, even if at a rather reduced pace ($287B in the past six months compared to $490B in the second half of 2008). Indeed, the most recently available figures (oh Brad Setser, wherefore art thou?) do point to a fall in the proportion of the world’s FX reserves held in US dollars, but this fall in my view is prudent and cyclical (due to the dynamics of the dollar decline) and fairly likely to reverse as and when the the dollar turns. And it should be remembered US households are now saving at a much faster rate than they were – so the domestic market for US government debt is proportionately greater. In addition gross government debt levels for the overall U.S. public sector are not that different from those to be found in comparable countries like the U.K. and Germany (as a % of GDP), and well below those to be found in countries like Italy and Japan. Which doesn’t mean to say that the US hasn’t got a long term structural debt problem associated with the liabilies entailed by population ageing, it is just if that anyone is going to be the first to go bump in the night, then Japan or Italy are the obvious candidates.

At the same time (and as I already argued here some months ago – see my summary of the Krugman/Ferguson debate here) there is little serious risk of runaway inflation undermining the dollar (or indeed any other major currency) in the short term. We are not all Zimbabwe on toast (yet awhile) – and those who suggested this as an imminent short term possibility got something, somewhere, seriously wrong. And the reason is not hard to fathom, since - as can be seen in the accompanying chart – despite the massive increase in base money, growth in the broader monetary aggregates remains severely constrained. Narrow money growth across the OECD has accelerated significantly in recent months, reaching 12.9% year on year in August (see chart below).

In large part the acceleration in base money reflects the very stimulative monetary and liquidity stance adopted by the major central banks across the globe - the Federal Reserve, the Bank of England, the Bank of Japan, the European Central Bank, etc. In contrast, growth in broader money measures has actually slowed significantly in recent months, to just 6% year on year for the OECD by August 2009. Such broad money aggregates differ from base money in that they reflect not only the actions of central banks, but also those of commercial banks and other financial institutions operating within the broader economy. The fact that broad money growth is slowing even as narrow money measures accelerate suggests that the cash injected by central banks into the banking system and money markets is not circulating around the economy as one might typically expect.

Put another way that so called “high powered” money simply isn’t what it used to be, and certainly isn’t packing either “heat” or sufficient clout.

And again the explanation for this is clear enough, since the global financial shock has left capacity utilization rates at a very low level while rising jobless rates restrain cost pressures, at least in the near-term. So while the issue of the inflation impact of all this over the longer term is still an open question, at least in the short run we are alive, but we are not yet kicking. But one day we will be, and since it is extraordinarliy unlikely the world’s central banks will knowingly allow inflation to become entrenched over the medium to longer-term, all attention know is focused on the exit strategy dynamics.

What has evidently surprised many market participants and observers is just how much of this ‘new’ liquidity appears to be finding its way into emerging market assets. Emerging market government bond spreads vis a vis U.S. Treasuries have now narrowed to around 300bp (from around 865bp at the peak of the crisis), the CRB commodities prices are up 40% from their low, while global equities markets have surged 55% from their low point – a much stronger rebound than might have been considered consistent with current or prospective global GDP growth. Ben Bernanke and his Federal Reserve colleagues have, it seems, been pumping liquidity in through one door, only to seek it “leak out” through another.

And all the tell tale signs are there is we look at which currencies have in fact benefited - at the expense of the U.S. dollar – from the surge in liquidity. The commodity sensitive Australian and New Zealand dollar are both up around 30% year-todate, and have started to close in on pre-crisis peaks. Among the emerging markets, the Brazilian real (34%), and the South African rand (26%) have enjoyed particularly large year-to-date gains. 2009 has also been characterized by an especially prominent correlation between stronger equity markets and a weaker dollar as funds have been diverted towards these asset markets. The MSCI World Index of advanced-nation equities has surged 65 percent from this year’s low on March 9, while the MSCI Emerging Markets Index has jumped 96 percent. The Reuters/Jefferies CRB Index of 19 commodities has added 33 percent.

This relationship between global liquidity, global asset markets and the U.S. dollar is likely to remain a key theme for the foreign exchange market during 2010. However, as we move further away from the peak of the global financial crisis and the trough of the global economic recession, central banks (and governments) will start to remove some of the stimulative policy measures put in place over the past couple of years. This policy tightening is not necessarily designed to restrain growth or head-off inflation, but rather to remove ‘emergency’ measures that are no longer appropriate as financial markets show some stabilization, and as economies show a return to growth. The trend towards less policy accommodation has only just begun with a rates hike from Australia earlier this month and from Norway only last week. But the looming question is who, among the G7 central banks will be the first to be able to raise, or threaten to raise, or even start to take off the emergency liquidity and fiscal measures, and in which order will this be done. In any event, despite the suggestive hints from Jean Claude Trichet at the latest ECB rate meeting my expectation is still that the US Fed will be the first to take serious steps, and at that stage we should expect, as I say at the start, the epicentre of the global carry trade to shift yet one more time from New York to Tokyo, but the show will be far from over, and in some ways it may well be only just begining.

Norwegian Wood

2009-11-03T07:30:00.001-08:00

Well, if John Lennon had still been around today he would undoubtedly have entitled his song Norwegian oil, but whatever way you want to put it Norway is back in the news, and this time not because of adolescents who find themselves with no alternative to sleeping overnight in the bath-tub, but rather because its central bank has been put in a position where it has little alternative but to raise interest rates, even if in fact it would be more comfortable for it not to do so. So, not being in the habit of looking for a quiet life, decision makers over at the Norges Bank decided last week to put themselves in the hot seat by lifting the banks main rate by 25 basis points to 1.5 per cent and in this inauspicious and modest way entered the history books as the first European central bank to raise interest rates since the financial crisis started to ease.

As I say, in doing so the bank put itself straight into the cockpit, since by raising interest rates it became a leading target of interest for that curious but ever growing band of enthusiasts who practice what has come to be known as the “carry trade” whereby investors borrow in countries with low interest rates to invest in higher-yielding assets.

And at this point, with risk sentiment surging there can be little doubt that carry practitioners are simply chafing at the bit to get started. An early warning of what was coming was seen when New Zealand’s dollar climbed to its strongest level in 15 months following a recent report on Radio New Zealand that Reserve Bank Governor Alan Bollard had said that a strengthening currency wouldn’t deter him from increasing borrowing costs. As Sonja Marten, currency strategist at DZ Bank Frankfurt put it: “Bollard’s comments have led to more intense speculation about when the RBNZ will start hiking rates, and have opened the way for more currency gains”. And it didn’t take long for this “intense speculation” to show up in the forex data as the US dollar slid by as much as 1.8 percent against the New Zealand’s one in the wake of the wave of publicity which surrounded the report.

In fact, both the Australian and New Zealand dollars have gained (4 percent and 2.8 percent, respectively) versus their U.S. counterpart since the 6th of October when the Reserve Bank of Australia lifted its cash target by a quarter-percentage point to 3.25 percent, becoming the first central bank among the Group of 20 nations to raise interest rates since the financial crisis began. Indeed Australia raised its benchmark interest rate for a second time only this week - by a further quarter percentage point to 3.5% - thus becoming the only nation to increase borrowing costs twice this year. However Australia’s dollar and bond yields then fell, as traders pared back their bets on a further increase in December when Reserve Bank Governor Glenn Stevens cautioned that higher rates would only come “gradually.”

Signs of Renewed Growth

Norges bank justified its decision by citing “signs of renewed growth” in the global economy, and signalled more increases lay ahead thus giving an indication of the nervousness which now abounds among central bankers about identifying exit strategies from the exceptional monetary measures which remain in place, even as some parts of the world economy start to rebound. Having been accused of being responsible for allowing the recent asset price to develop, they certainly are not eager to go straight off into a repeat performance.

The decision, which had been widely expected, means three of the world’s leading central banks have now embarked on monetary tightening, following rate increases in Israel in August and Australia earlier in October.

According to the statement from Svein Gjedrem, the Norges Bank governor: “The global economy is in a deep downturn but there are signs of renewed growth. Activity in the Norwegian economy has picked up more rapidly than expected.” Just for good measure, and to try to deter hordes of would be krone investors from jumping on board, the Norges Bank quickly stressed that its main rate will likely now remain between 1.25 and 2.25 per cent until next March and will probably only be “raised gradually” thereafter. Governor Svein Gjedrem is on record as saying that a “natural” key interest rate level is around 5 percent, but the last time the benchmark was at that level was in October 2008.

Norwegian fiscal and monetary policy decisionmakers are evidently now busying themselves looking for exit strategies, since Norway’s finance minister Sigbjorn Johnsen joined the exit strategy debate recently by underlining that the government needs to reduce spending as the economy recovers following having more than the normal recourse to the country’s €306bn oil fund over the year in order to to offer support to the domestic economy in the wake of the shock it received from the global crisis. According to Johnsen: “Monetary and fiscal policy must work together to contribute to a stable development in the Norwegian economy.”

What the authorities seem to have in front of them is a difficult trade-off choice between the need for higher rates to curb the acceleration in home prices and the growing strength of private consumption in the context of a tight labour market versus the effect of a rising krone exchange rate on the manufacturing sector.

Central Bank governor Gjedrem also expressed the opinion in September that asset prices “have risen sharply and probably excessively,” in a context where policy rates are “extremely low.” However the stress and tension he is under is pretty evident, since only a few days earlier he had been saying that the strengthening of the krone “suggests that the key policy rate should be kept low for a period ahead.” He is caught in the proverbial monetary policy bind between the rock and the hard place bviously, with just this type of change of nuance from one speech to the next being the stuff on which investors thrive.

In fact the krone has gained 7.8 percent against the euro since the end of June, making it the second-best performer out a list of 16 major currencies and any further strengthening would evidently hurt exporters including Norsk Hydro, Europe’s third-largest aluminum producer, and Norske Skogindustrier, the world’s second-biggest newsprint maker.

Oil Cushion

The Norwegian government has used quite successfully used the cushion provided by its accumulated oil wealth to shield the country from the worst of the global downturn but the Norwegian economy is now rebounding more strongly than the rest of Europe after its first recession in two decades, and new policy measures are now needed. The sudden (and not oil-driven, although in part oil financed) improvement in the Norwegian economy has revived long-standing concerns about the risks of inflation and currency appreciation that have bedogged other oil and gas-rich nations, a danger that Governor Gjedrem has strongly reiterated.

Norway's government have presented a 'slightly expansive' 2010 draft budget that aims to spend more of oil wealth next year compared to 2009 to help the economy maintain momentum as it emerges from what has been a quite mild recession. The budget is based on an anticipated structural deficit (a measure of how expansionary the budget is) which will increase by 0.5 percentage points in 2010. The government said the budget should be seen as 'slightly expansionary' for the economy, and justified the continuing deficit by citing weaknesses in the labour market, weaknesses which are, frankly, not that easy for the outsider to identify, and hence given the issues involved with raising interest rates, perhaps tighter fiscal policy would be a preferable alternative, but still, who would dare to tell those who are running a country which is doing as well as Norway is to do otherwise.

In fact Norwegian policy is based on what is effectively a large annual fiscal surplus, since in order to avoid excessive overheating, Norway invests all of its oil and gas revenues in an offshore fund. In normal years, it spends only 4 percent of the value of the fund, but this year it has dug deeper to try to avoid the worst of the global downturn.

The budget put forward by the governing coalition estimated the 2010 structural non-oil deficit at 148.5 billion Norwegian crowns ($26.35 billion), an increase of 14.6 billion from 2009. This means spending 44.6 billion crowns extra from the oil fund compared to a 'neutral year' for the economy, when it would spend about 4 percent of the oil revenues. Norway's government - like many commodity producers - runs large surpluses including petroleum revenues, surpluses which turn into deficits when the oil and gas money is excluded. Thus, if we take the cash deposited in the Fund into consideration, the budget of what is the world's number six oil exporter is projected to produce a 2010 surplus of 172 billion Norwegian crowns. Make of that what you will.

Norway has, as I have been saying, suffered a comparatively mild recession, and mainland Norway resumed growth in the second quarter, even if, once you take the oil and gas component into account, total economic activity is still contracting (see chart).

Mainland Norway GDP was up by 0.3 per cent in the second quarter after falling in the previous two quarters, according to seasonally-adjusted figures. According to the statistics office increased household and government consumption expenditure contributed significantly to the growth, while gross fixed capital formation oil and gas extraction had a particularly negative impact on the GDP.

Increased activity in service industries, particularly in business services, wholesale and retail trade, post and telecommunications – as well as in general government – were the principal contributers to the growth in Mainland Norway GDP.

For the fourth quarter in a row, value added in manufacturing fell, and in the second quarter output was down 1.4 per cent, even if, when compared with the two previous quarters, the decrease was less pronounced. Thus the future value of the krone is not a trivial item here, if it leads to a long term secular decline in manufacturing.

Adding in the extraction industries, total GDP was down by 1.3 percent in the second quarter largely as a result of reduced value added in extraction of oil and gas. This is basically an academic item however, since the oil fund exists precisely to protect the economy from such shocks. Household consumption expenditure, on the other hand, was up by 0.6 per cent. Increased consumption of cars accounted for nearly 60 percent of the rise in household consumption of goods. The growth in household consumption of services was up by 0.4 percent. Final consumption expenditure of general government was also up sharply - by 2.0 percent.

Manufacturing Slump

Industrial production fell by 1.1 per cent in the June to August period as compared with the March to May one (seasonally adjusted figures). The decline was, however, below that registered in the two previous three-month periods.

Output in refined petroleum, chemicals and pharmaceutical products were down by 7.0 per cent over the previous quarter. Fabricated metal products and ships, boats and oil platforms were also down, by 3.2 and 2.5 per cent respectively. On the other hand, following a sharp drop in output in the two previous three-month periods, production in basic metals was up by 3.8 per cent in June to August compared with the previous three-month period, while wood and wood products and food products increased by 6.5 and 1.0 per cent respectively.

Month on month output in Norwegian manufacturing increased by 0.8 per cent between July and August 2009 (again seasonally-adjusted figures), so, following a continuing fall since April 2008, industrial output has now risen two months in a row. On the other hand, looked at on a year on year basis, manufacturing output decreased by 7.9 per cent in July 2009 over July 2008 ( working-day adjusted figures).

Housing Boom Coming?

House prices have also rebounded, and have now returned to a peak reached in the summer of 2007, not taking inflation into account, according to Finance Ministry data. House prices rose a quarterly 1.8 percent in the three months ended September, after gaining 5.3 percent in the previous quarter.

Flats in blocks had the largest price increase from the second to the third quarter, rising by 3.9 per cent. The prices of terraced and detached houses were up by 2.5 and 0.8 per cent respectively. Overall, prices increased by 1.8 per cent from the second to the third quarter of 2009, which means that the house prices are now 3.8 per cent higher than in the third quarter last year. While prices of flats in blocks became 6.6 per cent more expensive than in the third quarter of 2008, the prices of terraced houses and detached houses increased by 3.9 and 2.8 per cent in the same period.

Indeed, house prices continued to rise even while the economy was technically in recession since unemployment, which fell to 2.7 percent in September, remained the lowest in Europe throughout the entire credit crisis. Households also received early and rapid benefit from monetary easing earlier this year, since about 90 percent of mortgage holders having mortgages with variable rates. That flexibility boosted demand, with retail sales rising steadily, but also means that rising borrowing costs will bite quite quickly, another reason for preferring fiscal to monetary policy to contain accelerating demand.

Inflation Comes Back To Life

The central bank target for price growth, adjusting for the effect of energy and taxes, is 2.5 percent, and inflation accelerated to 2.4 percent in September from 2.3 percent in Augustt on the banks preferred measure, the CPI-ATE - the consumer price index adjusted for tax changes and excluding energy products - even though year-to-year growth in the standard CPI was just 1.2 per cent, and actually fell 0.7 percentage points from the August annual figure .

Inflation has now exceeded the bank’s target in six out of nine months this year. The bank expects underlying CPI-ATE inflation, adjusted for energy and taxes, to average 2.75 percent this year and 1.75 percent in 2010. They are also forecasting that the mainland economy will shrink 1.25 percent this year and grow 2.75 percent in 2010. The key rate will average 1.75 percent this year and 2.25 percent in 2010, rising to an average 4.25 percent by 2012, according to the bank.

The Krone

Norway's strong growth outlook has helped the krone outperform other regional currencies - like Sweden’s krona - against the euro since the end of March, making the Krone-Krona cross a very attractive one for the carry traders (since Sweden's interest rates are being held at zero). In fact it is precisely this upward pressure on the currency which limits the room for the central bank to hike interest rates going forward, since the non-oil export sector is still struggling and a stronger krone will only weaken make the problem worse. Yet the problem is likely to get worse, since the krone will almost certainly continue to strengthen as the global economy recovers, and especially as risk appetite strengthens

So while the signs of an overly strong recovery may support a rapid reversal of monetary easing, the central bank must balance the needs of the domestic economy against the risks presented since if they don’t respond there will be an overshooting of the inflation target, but if they adjust monetary policy to the fact that fiscal policy is very loose, you will get a stronger krone. As I say, maybe the solution here is to move over to fiscal policy, but still.

Surprise, Surpri-i-se

The problem Norges Bank are going to have can be seen by looking at the chart below, which contrasts an inverted USDNOK with some Citigroup Economic surprise indexes . A surprise index is an instrument which attempts to quantify the extent to which economic indicators in a given country or region surpass or fall-short-of consensus estimates - and this is what really matters, it seems, and is why you get all that additional detail about what "economists" expected to happen in so much of contemporary economic journalism. It is not to help you see whether they were right or wrong, but to help investors and traders see how their peers might respond.

An economic report with better-than-expected data news is assigned, for example, a value of 1, while a report with worse-than-expected data news is assigned, again for example, a value of -1, while a report which just meets economists expectations gets a 0 value. Tally up the values of the reports for any given week, and you have the Surprise Index reading for that week.

Anyway, if you look at USDNOK (inverted, so north on the chart = NOK strengthening), vs the economic surprise indices for US, Eurozone and Norway, you should be able to see - without squinting too hard - how the US and Eurozone indexes show an unsurprisingly good correlation with USDNOK from early this year as the economic data started to turn, and sentiment returned to the markets. Simply put, as US data exceeded expectations, people felt more like borrowing to play around with "risky" (or not so risky really, but then the return isn't too big) assets like debt instruments denominated in Krone. Of course, they were also borrowing to get their teeth stuck in to some more more risky (but attractive) assets like those denominated in Hungarian Forint, or Ruble, or Ukranian Hyrvnia, but I think we can safelyb leave that story for another day. Also what happens to all this the day (which will surely one day arrive) that the indexes start to head south with economic data systematicallty underperforming expectations could also be put to one side for the moment.

The 2009 year to date correlations between inverted USDNOK and the US, Norwegian and Eurozone Eco Surprise indices as 72%, -46%, 77% respectively. Both the US and the Eurozone surprises seem to have been highly correlated to the US and the eurozone data outperformances. But if you look at the chart closely enough, and examine the Norwegian surprise index in particular, you should be able to see that the USDNOK was driven by sentiment derived from upside US and European data, rather than domestic data (so called fundamentals) for most of the year. But now, of course, Norway has been wheeled onto the inflation/interest rate ramp, so it will be interesting to see if the cross starts getting driven more by the domestic side - as investors respond to upside and downside surprises, and their potential impact on central bank monetary policy, and how the consequent decision making process may influence their investor peers. To my largely untrained eye, it looks to me more like things have been moving more this way since Norway started to make central bank headline news at the start of October.

Exports Under Threat

Norwegian exports - like everyone else's - are expected to recover more slowly than consumer demand, according to the main government forecasts, only rising 0.1 percent in 2010 after slumping 6.5 percent this year. In September, goods exports were running at NOK 59.4 billion and imports at NOK 36.8 billion, so the trade balance came in at NOK 22.6. Both exports and imports were up on August, but are still well down on last year.

Imports increased by NOK 3 billion from August, and compared with September 2008 the imports went down by NOK 9.6 billion. Exports increased by NOK 1.4 billion from August, and compared to September last year the exports were down by NOK 13.7 billion. The reduced price of crude oil is the main reason for the decline.

Compared to August, the mean price per barrel of crude oil fell from NOK 445 in August to NOK 402 in September. The exported number of barrels of oil went down 2 million, and crude oil exports declined NOK 3 billion. The price per of a barrel of oil is down NOK 154.6 from September 2008. Although the number of barrels exported rose by 2.1 million or 4.5 per cent compared with the corresponding period last year, the export value of oil decreased by NOK 6.4 billion and ended at NOK 19.8 billion making for a 24.5 per cent reduction.

A similar picture can be observed for the value of natural gas exports which came in at NOK 11.3 billion, or down NOK 594 million from August. The export value of natural gas declined by 1.7 billion compared with September 2008 despite the fact that the quantity of exported natural gas in gaseous state increased by 21.4 per cent. At the same time Norway has a huge current account surplus as a result of the commodity exports and the investments made by the oil and gas fund.

According to preliminary figures, the Norwegian current account surplus was NOK 95 billion in the second quarter of 2009, down NOK 30 billion from the second quarter of 2008. In part this was a result of the drop in the balance of goods and services which at NOK 78 billion was down NOK 54 billion compared to the second quarter last year. There was also a positive net balance of income and current transfers of NOK 18 billion in the second quarter of 2009, compared to a deficit of NOK 6 billion in the same quarter in 2008. The improvement can largely be explained by a rise in net dividends paid from abroad.

Tight Labour Market

One of the Bank's principal areas of concern (and hence one of the key areas of investor interest) is the state of the labour market - “It appears that unemployment over the next few years will remain lower and wage growth somewhat higher than previously projected. This suggests higher inflation, indicating that the key policy rate should be raised somewhat more rapidly than previously projected.”, according to the Norges Bank in its statement. The bank thus projects the key inflation rate will average 4.25 percent in 2012, compared with a June forecast for 3.75 percent.

In fact, despite the use of unemployment as an argument for not withdrawing fiscal stimulus, the government has already lowered its unemplyment forecast for 2010 to 3.7 percent, down from the 4.75 percent seen in May. But such rates are considered high, and are politically sensitive in Norway, since the country has one of the lowest trend unemployment levels in Europe.

Certainly domestic employment has been falling, and from May to August the number of employed persons decreased by 22 000. The unemployment rate was 3.2 per cent of the labour force in August. The reduction in employment is mainly within the age group 16-24. The seasonally-adjusted unemployment increased by 1 000 persons from May (as measured by the average of the three months from April to June) to August (as measured by the average of the three months from July to September).

Favourable Demographics

Noway's underlying demographic dynamics are actually quite favourable - the Total Fertility Rate, for example, stood at 1.78 in 2008, and population momentum is still quite strong, increasing by 13,400 in the second quarter. In part this increase is due to an excess of births over deaths of 6 400, but there is also a net migration component of 7 000. Compared to the same quarter last year, there were 2,400 fewer immigrations and 550 more emigrations. The migration surplus came to 7,000, which was 2,950 less than in the second quarter last year. The largest migrant group is from Poland, and compared with the second quarter last year, 45 per cent (or 1 700) fewer Polish citizens went to Norway. Other large migrant groups come from Germany, Sweden, Lithuania and Eritrea.

During the first six months of the year, 29,700 persons immigrated to Norway, 2,700 fewer than last year. In the same period, 13,150 emigrated from Norway, 3,100 more compared to last year. This adds up to a net migration of 26,300 for the whole country, which is 5,800 lower than the previous year. As can be seen, one way to take some of the pressure off the labour market, is by facilitating inward migration, and the Norwegian authorities seem to be well aware of this. It is also a good way to make the health and pensions system much more sustainable as population ageing takes its toll.

Uneven Global Recovery

As we are seeing, one of the problems Norway faces, as a small open economy, is the very unevenness of the global recovery. I would even go so far as to say that this is going to be one of the defining characteristics of the stage we have now entered, where differences will be more important than similarities between economies. As we have seen in the case of France, and as we are now seeing in the case of Norway, one critical factor is who can generate autonomous domestic demand, since it is this that will offer the key to successful stimulus programmes.

The monetary tightening process is likely to be slower in countries with more fragile recoveries while other central banks become well advanced in thinking about “exit strategies” and how to unwind exceptional measures taken to combat the crisis. Now Carsten Valgreen, Chief Economist at Danske Bank in an important (but rather neglected) paper in 2007 (The Global Financial Accelerator and the role of International Credit Agencies) put some of the problems Norway is facing like this:

The choice major countries have made in the classical trilemma: ie, Free movements of capital and floating exchange rates has left room for independent monetary policy. But will it continue to be so? This is not as obvious as it may seem. Legally central banks have monopolies on the issuance of money in a territory. However, as international capital flows are freed, as assets are becoming easier to use as collateral for creating new money and as money is inherently intangible, monetary transactions with important implications for the real economy in a territory can increasingly take place beyond the control of the central bank. This implies that central banks are losing control over monetary conditions in a broad sense. Historically, this has of course always been happening from time to time. In monetarily unstable economies, hyperinflation has lead to capital flight and the development of hard currency economies based on foreign fiat money or gold. The new thing this paper will argue is that we are increasingly starting to see the loss of monetary control in economies with stable non-inflationary monetary policies. This is especially the case in small open advanced or semi-advanced economies. And it is happening in fixed exchange rate regimes and floating regimes alike.

Valgreen's paper presented two examples to illustrate the issues, and these examples - Iceland and Latvia - are not without their own significance. In both cases local central banks had trouble controlling developments in monetary conditions, as lending from foreign sources in local and/or foreign currency crowded out the efficacy of domestic monetary policy. Despite the differences between the two countries, there was a common story - in both cases monetary policy became increasingly impotent as the central bank money monopoly got to be an increasingly hollow tool. It is no accident that the two examples are small open economies with liberalised financial markets. Being small makes the global financial markets matter more. As we are seeing now a country such as Norway is among the first to notice that the agenda for monetary policy has changed, as both the current and capital accounts are naturally very large and important for the economy.

Clearly, given Norway's very sound fundamentals, and the huge Current Account surplus the country enjoys, there is little likelihood of it becoming an Iceland or a Latvia, but this does not mean there are not monetary policy problems and risks, and it does not mean there is not much to be learnt from studying the Norways of this world, as following them might well show us something of what is in store for larger economies as the global economy recovers. Ignoring the issues which Norway presents would be little better, why not say it, than simply knocking on wood.

A New Spectre Is Haunting Europe, A Spanish One

2009-11-03T06:19:00.001-08:00

A spectre is haunting Europe, but this time it is not the spectre of revolt by the popular masses, or even one of yet another wave of bank bailouts. No, the spectre which is currently stalking the corridors of Europe's most prestigous institutions is one of a Spanish economy which stays on a flatline while Europe's other economies, one by one, start to struggle back to life. And the main reason that this particular ghostly image is giving everyone so many sleepless nights is because Europe's current institutional structures, and especially the monetary policy tools available at the ECB are scarcely prepared for such a nighmare eventuality.

France Is Recovering, And The Rebound Is Robust

First it was just a rumour, then it was a possibility, and now it has become a reality - some of Europe’s economies are springing back into life. But only some. It all began quietly, with a barely noticeable 0.3% quarterly growth in French and German GDP in the second three months of this year. France and Germany will have maintained their modest growth into the third quarter , while Italy has now joined them, leaving only Spain among the Eurozone big four, registering yet another quarter contraction, and, more importantly, showing no evident sign that an early return to normal activity is anywhere near to the horizon.

In fact Spanish gross domestic product fell 0.4 percent quarter on quarter in the third quarter following a 1.1 percent drop between April and June , according to the Bank of Spain monthly bulletin. Spain's GDP also contracted 4.1 percent year on year in the quarter, after a contraction of 4.2 percent in the second three months.

'This is the least pronounced contraction since the beginning of the recession ... and this improvement is linked to state-backed measures with a temporary effect,' the bank said.

To this government stimulus effect, I would also add the net trade effect which is being felt as a result of the strong fall in imports, and the consequent closing of the current account deficit. With imports falling faster than exports (on an annual basis) the net impact is positive growth in the headline GDP number, and the Spanish CA deficit was closing very rapidly indeed in the third quarter (see chart below).

The impact of the stimulus package can also be seen in the seasonally adjusted unemployment numbers supplied to Eurostat by the Spanish Statistics Office (INE). Unemployment (which hit 19.3% in September - see chart below) has been rising continuously since mid 2007, but the sharpest increases were registered during the fourth quarter of 2008 and the first quarter of 2009.

It is very hard to see any real difference in the trend rate of increase between the second and third quarters of 2009, and we should expect this trend job attrition rate to continue until it once more accelerates under the impact of either the government being unable to continue funding the stimulus, or the banking sector having a financial crisis (possibly induced by someone being forced into trying to sell some of the housing units they are accumulating only to discover that there are no buyers, since the market is effectively dead).

Life, Unfortunately For Spain, Is Elsewhere

But for all our preoccupations growth in 2009 is now no longer the issue. All eyes are gradually moving towards the outlook for 2010, and it is here that those little red lights have suddenly started flashing over at the European Central Bank.

And the problem is a real and growing one, since according to a series of reports which have been published during the last week, while activity in the export dependent German economy remained very fragile, the French one has really starting to hum. The first sign of this came on Tuesday, with the initial reading for the October Purchasing Manager Index which showed that while the Eurozone economy in general entered the fourth quarter on a strong note, with growth accelerating in both manufacturing and services sectors, the private sector in France started to earn alpha grades by clocking up a third successive month of accelerating growth, leaving us with the impression that France is now seeing its steepest output expansion in nearly three years.

Then on Wednesday the ECB presented its monthly bank lending data, which showed that lending to the euro area private sector shrank by an annualised 0.3 percent in September, the first such contraction since the series began in 1992. But looking a little more closely at a lending activity on a country by country basis, we find that while lending continues to contract in Spain, in France the credit cycle has turned, and indeed lending to households is now once more rising steadily (see chart below), indeed it never fell below an annual 4% rate of increase and the annualised quarterly growth rate in lending has been rising since the end of the first quarter.

That is to say, credit is once more starting to flow freely round the French economy, while here in Spain banks continue to accumulate reserves, lending generously to the government, while money for struggling small companies and for young people looking to buy homes is hard to find. What is more, if we look at the chart below (which was prepared by Dominique Barbet and Martine Borde for PNB Paribas) we will see that the stock of unsold new homes – which was in any event never very high in France, maybe 100,000 in the spring – is down by 20% as sales steadily pick up again, while here in Spain we continue to play a guessing game to decide just how many (more than a million surely) such properties there are here, and the number is growing, not declining, since real new sales to private individuals (as opposed to newly completed properties contracted two years or so ago, or exchanges between developers and banks) are almost non existent at this point. Everyone knows prices will fall further, and are waiting for them to go down.

Then on Friday we had the key piece of information, which confirmed what many of us already suspected, since Markit PMI data for October retail sales made plain the presence of very divergent trends across the Eurozone, with ever more robust growth in France contrasting with falling sales in Germany and Italy. As Jack Kennedy, economist at survey organisers Markit Economics said “While the sense of growing optimism should be treated with some caution – it appears the increase in sales was also supported by widespread discounting and the continuation of the government’s car scrappage scheme – the outperformance of France relative to Germany and Italy offers further evidence that it is France that is leading the Eurozone recovery.”

And here, with this very outperformance comes the problem, since the ECB policy rate will be set to target average eurozone inflation, which will certainly be lower than inflation in France, and possibly significantly lower. Which means the ECB policy rate will be below the one which the French economy will, in reality, need.
Between 2000 and 2008 the structural dynamics of the Eurosystem were different from now. Spain was the "exceptional student", with above-average growth, and inflation which was consistently over the Eurozone average, and for long periods above the ECB policy rate. This had the consequence, of course, that French inflation was nearly always below the average. Now things have changed. We are coming out of recession with a eurozone divided into three groups. French growth is becoming robust, while Germany and Italy are dependent on exports and just keeping their head above water. Spain, on the other hand, fails to recover and continues to contract. This is what makes the current situation critical, since starting in 2010 France will have an inflation rate over the EU average, and in all probability over the ECB interest rate. Which means that if something isn't done, and soon, to force the situation in Spain, and produce a recovery, France will have negative interest real rates during a sharp economic rebound, with all the risks that that implies.

Only last Wednesday Norway became the first western European country to raise interest rates since the start of the financial crisis after its central bank reported finding “signs of renewed growth” in the global economy. Central bankers from across the global, from Washington, to Sydney, to Delhi and to Oslo are all now busily telling us they are going to take increasing account of future accelerations in asset prices in an attempt to avoid repeating policy mistakes that are presumed to have inflated two speculative bubbles in a decade – and left the entire Spanish economy in a lamentable state. If France had its own monetary policy I have no doubt La Banque de France would be itching to follow the Norges Bank and raise rates, but there is one small problem, La Banque de France has no capacity to decide on monetary policy in this way, and herein lies the heart of what is now Europe and the ECB’s greatest dilemma.

What Exactly Is Going On In Finland?

2009-10-29T16:07:00.000-07:00

Finland, we have recently been told, is the world's most prosperous nation, and it is deemed to be prosperous not only in monetary and financial terms, but also in terms of the implicit wealth of its democracy and governance. This striking assessment is to be found in the latest edition of what is known as the "Prosperity Index", an initiative launched by the Legatum Institute, a London-based think-tank. In fact Finland took first prize - up from third last year - and was closely followed by Switzerland and the other Scandinavian countries (Sweden, Denmark and Norway - also see Doug Muir's "debunk" of all this brouhaha here).

Finland was also notable for its recent second-place showing in the latest edition of the Tech-competitiveness index released by the Economist Intelligence Unit. The Index, which is commissioned by the Business Software Alliance, analyzes data on 66 countries around the world in an attempt to determine which of them have the most competitive information technology sectors. The study, now in its third year, examines variables like the overall business climate, the pervasiveness of the tech infrastructure, the strength and transparency of its legal system,and the availability of a well-educated and technologically literate workforce. As I say, Finland came in second to the United States, displacing last year's runner-up, Taiwan.

And if these accolades weren't enough already enough Finland this year took 6th place in the World Economic Forum's Global Competitiveness Report (having been number one on earlier occasions). The Global Competitiveness Report purports to identify the world’s most competitive economies in terms of their prospects for economic growth.

Given all of this, you would really expect Finland to be doing pretty well during the current global recession, wouldn't you, what with all that fabulous prosperity and those stupendous growth prospects? So is it? Well unfortunately it isn't, indeed during the second quarter of 2009 Finland (which was way out in front of Ireland, another of those previous ECB "poster boys", which only managed to clock up a 7.4% annual contraction ) had the worst recession in the entire Eurozone, well behind the so called "PIGS" who everyone suspected previously suspected would be the ones to drag the common currency area to its downfall and ruin.

So in order to find out what is actually happening in Finland, and to take an inside look at the harsh reality that lies behind all those gleaming reports, let's take a leap across to the Finnish Statistics Office, just to see what is really going on right now in what some consider to be the world's most prosperous nation.

On our arrival we will calmly be told that, according to their latest revised data, the office found that GDP output (as measured by their ongoing working day adjusted index) fell in June by 8.9 per cent from June 2008. An 8.9% drop eh, that sounds pretty substantial, even to a hardened GDP watcher like me, accustomed to having my stomach turned by the latest releases to come from Ukraine and Latvia. So even if our Finnish were feeling pretty prosperous earlier this year, they would evidently seem to be feeling rather less so now. So why is this, and just what the hell is going on in Finland?

Sharp Drop In GDP Due To Export Dependence Vulnerability

Finland has in fact had the misfortune to fall into what is currently one of the deepest recessions to be found anywhere in the eurozone, a fact which I guess must strike some people as at least odd, given all the attention which people like me have been lavishing on those all too evident problems you can find in Spain or Southern Europe, or even Austria. But Finland, why is it that the deepest of deep recessions is to be found in Finland? This is the question I will try to answer in this brief report.

Steady Loss Of Competitiveness

To anticipate my findings rather, the culprit does seem to be, yet one more time, the poor old euro, since the availability of cheap finance and relatively easy and accessible growth markets during the years from 2000 to 2008 did see the country's industry steadily lose competitiveness and thus its quite large trade surplus, while membership of the monetary union today does mean there is no home currency left to devalue (and this is an important difference with Sweden) and this, of course, means that not only Ireland and Spain but even Finland will problably need a period of (in this case mildish) internal devaluation - rather similar perhaps to the one Germany went through from 1998 to 2005 - if it is to bring the ship right-side-up again. In the meantime, an early return to the country's former prosperity is not to be expected.

Sharp Fall In GDP In The First Half Of 2009

According to data from Eurostat, the Finnish economy shrank by a record 9.5 per cent in the second quarter when compared with the second quarter of 2008.

The drop represents the country's largest year on year decline in any single quarter since comparable figures first started to be compiled in 1990 and the fall is significantly worse than the 7.6 per cent year-on-year drop registered in the first three months of this year. Finland's economy contracted 2.6 percent in the second quarter of 2009 compared to the first quarter, when the economy shrank by a revised 3.0 percent over the last quarter of 2008.

Finland's economy is heavily export dependent and the country's key export markets - Russia and Germany in particular - have evidently been badly hit by the sharp reduction in the volume of world trade. In the second quarter, the volume of private consumption declined 3.4% on an annual basis, while investments decreased 11.7%. Exports fell by more than 30 percent and imports by some 28 percent on the year.

Seasonally adjusted GDP peaked during the first half of 2008, and has since fallen very sharply. In the first half of 2009, Finland’s economy contracted as strongly as it did at the start of the 1990s recession. At that time the biggest single drop occurred in the first quarter of 1991 (minus 2.7 per cent quarter on quarter). The biggest year-on-year drop in the 1990s was minus 8.0 per cent during the last quarter of 1991. So this is now more severe than the very severe early 1990s recession. In addition, as I have been suggesting, Finland’s economy is currently also contracting much faster than EU average. According to preliminary data compiled by Eurostat, in the second quarter of 2009 GDP in the EU area contracted by ony 0.2 per cent from the previous quarter and by 5.6% year on year.

Quarterly Contraction Slightly Slower in Q2

The economy shrank by a seasonally adjusted 2.6 percent in the second quarter over the first, compared with a revised figure of minus 3.0 for the equivalent first quarter drop, indicating the force of the recession only eased very slightly. Among European Union members, only the economies of Estonia, Latvia and Lithuania saw deeper negative growth than Finland in the second quarter.

Explaining the decline in Finland, Pentti Forsman, an economist at Bank of Finland, said that exports now account for around 35 per cent of the Finnish economy from around half last year and the percentage will continue to fall into 2010. The problem is, it is very hard for Finnish domestic demand to take up the slack, given the age structure of the population.

Betweem April and June exports fell 30.2 per cent over the year earlier period, while investments dropped 11.7 per cent. Falling exports mean companies have been forced to cut jobs to adapt to their new output levels. In turn, rising unemployment means consumers are cutting back on spending - household consumption was down an annual 3.4 per cent in the second quarter.

Russia, Finlands top trading partner has also seen strong negative growth - around 10 per cent year-on-year in the second quarter.

Nokia has seen a quarter of its revenues wiped out, while paper producers Stora Enso and UPM-Kymmene are sharply cutting back production and jobs owing to the decline in worldwide newspaper sales and advertising revenue. Rautaruukki Oyj, Finland’s biggest producer of carbon steel, and Cargotec Oyj, the world’s biggest maker of container-lifting gear, have both suffered export-led losses. Cargotec said it expects sales to plunge 25 percent this year. And Konecranes Oyj, the world’s largest supplier of industrial cranes, is cutting production by as much as 30 percent and may close factories as miners, ports and manufacturers reduce spending on new material-handling gear.

Raw materials and capital goods account for about 80 percent of Finland’s exports while consumer goods and durables account for 12 percent of sales abroad.

Finland's finance ministry now expect the economy to shrink 6.0 percent this year before rebounding in 2010 with a 0.3 percent expansion - according to the latest forecast issued last week. Unemployment, could reach 9.0 percent this year and 10.5 percent in 2010 the forecast said.

The ministry said it expected the economy to pick up in conjunction with those of its biggest trading partners - Sweden, Germany and Russia - that is they do not anticipate an autonomous domestic recovery. But what will happen if the economies of those three countries are not on the road to recovery in quite the way the Finnish government expects?

"There are good grounds to expect that Finnish exports will strengthen in the latter half of the year," the government statement said.

And what if demand does not strengthen sufficiently to pull the national economic cart out of the mud tip which it is mired in?

Exports accounted for 47 percent of gross domestic product last year. They have currently dropped back to around 35 percent. And indeed the Finance Ministry now expects exports to sink to around 22 percent of GDP this year, downgrading a forecast of 18 percent from June, but grow again by 1.8 percent next year.

Not surprisingly the finance ministry warned that the much needed stimulus spending would weigh heavily on government finances - with the general government deficit-to-GDP ratio next year to breach the 3 percent EU stability and growth pact limit for the first time.

Finland has enjoyed public finance surpluses seen since 1998 but these will turn into a sizeable deficit this year (4.6% well over the 3% of GDP which is theoretically permitted) and we will more than likely see an even bigger one - 6.1 % according to forecasts - in 2010 As a result Finland’s gross government debt will be up by almost 50 percent next year, hitting 43.9 percent of gross domestic product in 2010 from 29.4 percent last year. While debt to GDP will still be comparatively low, the rapidly rising costs associated the very rapid ageing which Finland's population will now undergo means that the room for manouevre is less than it seems.

Sharp Output Falls All Round

The economic decline has been noted in all sectors, although manufacturing and investment have seen much sharper declines that private consumption. The drop in construction activity has been sharp, and output fell by 19.2 per cent in the second quarter of 2009 when compared with the corresponding quarter in 2008. The situation has improved somewhat and by July construction output was only down by 13.1 per cent from the previous year. The contraction was largest in the construction of buildings where turnover fell by an annual 16.8 per cent in July.

New building permits are also down, and in August were 25% below the level of a year earlier. And this is not the complete extent of the fall, since as can be seen in the chart these peaked towards the end of 2007. Indeed the level of new building activity would seem destined to fall quite substantially yet awhile.

House prices are down, but not massively to date. In the second quarter of 2009, the prices of dwellings in new blocks of flats and terraced houses fell by 1.0 per cent from the previous quarter across the whole country. In Greater Helsinki prices went up by 1.6 per cent, meanwhile in the rest of Finland prices went down by 2.4 per cent. The average price per square metre of new dwellings was EUR 2,738 in the whole country, EUR 3,525 in Greater Helsinki and EUR 2,454 in the rest of Finland.

From previous year the prices in new blocks of flats and terraced houses went down by 4.5 per cent. In Greater Helsinki the prices went down by 0.7 per cent and in the rest of country 6.5 per cent. According to the statistics office the data are based on the price information from the largest building contractors and estate agents, and as we have seen in Spain these are not always the most reliable sources for such information. Certainly the earlier rise in prices has been impressive.

And it is not only the construction industry, since manufacturing is also sharply down, and was 30.1 per cent lower in the second quarter of the year than in the corresponding quarter of the year before. Domestic sales contracted by 27.8 per cent and export turnover by 32.0 per cent from one year earlier. The decline was steepest in the chemical (-36.4%) and metal (-33.4%) industries.

Services have also taken a big hit, and total turnover in service industries fell by 7.4 per cent in the April to June period of 2009 when compared with the respective three-month period of the year before. Turnover in transport and storage fell by 17.7 per cent, reflecting to some extent the impact of the decline in Russian economic activity.

Retail sales are also down, but only moderately so. In retail trade, sales in January-August diminished by 2.5 per cent. Over the same time period, motor vehicle sales were 32.9 per cent and wholesale trade sales 19.8 per cent down on the year before. In total trade sales fell by 17.2 per cent in January-August. However, the deterioration does seem to be accelerating, since according to Statistics Finland, for August alone retail trade sales fell by 3.4 per cent from August 2008. Wholesale trade sales fell by 21.3 per cent and motor vehicle sales by 40.6 per cent.

Exports Are The Big Drag On The Economy

But it is the export sector that the pain is really being felt. Between April and June, the volume of exports shrank by 30.2 per cent when compared with the same period in 2008, although they only fell by 0.7 per cent compared with the previous quarter. Exports of goods decreased by 31.7 per cent and those of services by 24.7 per cent year-on-year. The volume of imports fell by an annual 27.7 per cent and by 6 per cent from the previous quarter. Imports of goods were down 31.9 per cent and those of services by 14.3 per cent year-on-year in the second quarter.

Unemployment has risen, but not drastically so. So the government stimulus programme is working to this extent. According the the latest labour force survey employment was down by 75,000 in September over September 2008. There were 192,000 unemployed persons in September 2009, i.e. 34,000 more than in September 2008. This meant that at the end of the third quarter the unemployment was 7.5 per cent, up 2.0 percentage points from the same time last year, but down slightly from the level in June and July.

But uncertainty over the pace of economic turnaround has increased, and the government expects unemployment to rise to 10.5 percent next year.

Deflation Not Inflation The Issue

The year-on-year change in consumer prices as calculated by the Statistics Finland methodology fell to -1 per cent in September. In August it was -0.7 per cent. In September, consumer prices were largely brought into negative territory by ongoing reductions in interest rates - the Finnish donestic CPI uses a different methodology from the EU Harmonised one, and captures changes in housing costs to some extent, a feature which arguably means it better captures the ongoing impact of the global financial crisis on living standards and household expenditure . Falling prices of liquid fuels, telephone calls, owner-occupied dwellings and real estate, and used passenger cars also lowered inflation. In contrast, consumer prices were pushed up most by year-on-year increases in rents, restaurant and café prices, food prices, retail prices of alcoholic beverages and tobacco.

In fact the deflationary trend is still not clear, since between August and September, consumer prices went up by 0.2 per cent, primarily due to increases in the prices of clothing. And indeed, using the EU Harmonised Index of Consumer Prices, the rate of inflation for Finland was still running at an annual 1.1 per cent in September.

Producer prices and naturally falling, and those for manufactured products fell by an annual 8.6 per cent in August. Export prices were down by 9.6 per cent and import prices by 10.7 per cent from August 2008 . The basic price index for domestic supply fell by 8.7 per cent over the year. The year-on-year change in the wholesale price index was -9.5 per cent.

The main reasons for the drop in producer prices was obviously the reduction in the price of oil products and metals, but again between July and August producer prices for manufactured products rose by 0.7 per cent. The rise in the prices came especially from increased prices of oil products, with the monthly rise in prices restrained somewhat by reductions in the price of paper and paper board. But all of this begs one important question - would price deflation in Finland be a good or a bad thing? Evidently Europe's monetary authorities are divided on just this question. For output to recover from the global financial shock mild inflation is certainly much better than mild deflation, but what about Finland's competitiveness issue? Finland needs some sort of price correction, to get back onto a positive export path, even if not of the order of the one which is needed in Spain and Ireland. This is the big disadvantage of sharing a common currency and not having one of your own to devalue. But clearly ongoing deflation will only weaken domestic consumption (as people put off purchase decisions into the future) and will compound any indebtedness problems there may be in the private sector.

It's The Difference That Matters

This post really needs to be taken in comparison with my recent piece on Sweden, since for some time now I have been scratching my head trying to see just what could be learnt from making a comparison between Finland and Sweden. Some of the differences are obvious - one is in the euro, and the other isn’t, once can adjust monetary policy and currency values, and the other can’t. Others are less so. Finland’s goods trade surplus has been declining steadily since joining EMU while Sweden’s has remained relatively constant. And Swedish males live on average three years longer than their Finnish counterparts. So what is important here, and why? And if convergence theory has anything positive to be said for it, shouldn’t we be able to observe so sort of convergence going on here.

First, and just to remind ourselves, here is the chart from Claus Vistesen which shows what the relation between population ageing and current account balance might look like. The key point is that as populations age beyond a certain point, a tendency to run a current account surplus emerges, as domestic demand steadily weakens, and becomes insufficient to drive growth. Evidence for this phenomenon can be found in Germany, Japan and Sweden.

The idea is that as median population age rises the current account dynamics of a country change. The last ageing phase shown to the right of the diagram is purely speculative at this point, although theory suggests that if the underlying momentum of ageing is left unaddressed it may well be what happens. But it is a development which is to be strongly avoided since although we do not yet know what happens when a society starts to dis-save at an advanced median age, the longer we can put off finding out, the better.

Which is why looking at Finland is important, since unlike the three aforementioned “ideal type” agers, Finland has in fact seen a deterioration in its external position over the last decade, and even though it has, up to now, remained a surplus country, the trend is certainly towards deficit, and this trend needs to be halted and reversed. Indeed this is the most pressing policy problem facing the Finnish authorities during the current recession.

Now let’s look at Finland. Once more the mid 1990s “transition” is clear. Finland moves from deficit to surplus. But unlike the Swedish case the surplus peaks around the turn of the century, and since then has been steadily weakening.

There can be a number of explanations for this. The pattern of ageing could, for example, be different in Finland. Or the euro might be a factor, with the loss of control over monetary policy leading to a steady deterioration in the level of international competitiveness. As we will see below, some part of the explanation may be provided by each of these, but first, lets take a look as some of the empirical aspects of Finland’s present recession, since it is evident that Finland, like many other countries, has entered a strong recession on the current back the global crisis.

According to the Bank of Finland, the current account balance stood at 444 million euros in July, slightly up from the June surplus of 442 million euros. This compares with a surplus of 585 million euros in July 2008. The July current account surplus was driven by the service trade balance, which converted a June deficit of 43 million euros into a surplus of 48 million euros in July. The income surplus stood at 258 million euros in July, up from 145 million euros in June.The goods trade surplus, on the other hand, contracted to 260 million euros in July from 429 million euros in the previous month, while the deficit in current transfers widened to 122 million euros from 89 million euros in June.

As mentioned previously, the goods trade balance has been deteriorating, and the earlier positive balance now needs to be restored.

Finland’s economy faces important challanges in both the short and long terms. Finland’s state debt is low at the present time, which gives the capacity for short term stimulus and bank bailouts. But it is rising, and reached a record high of 70.6 billion euros by the end of the first quarter of 2009. General government debt, calculated according to Eurostat methodology, grew by 7.5 billion euros in January-March, and reached 38 percent of 2008 gross domestic product (GDP). Still, there is plenty of stimulus ammunition left, the important thing is to use it wisely, and try to engineer an economic transition.

Overall, the government has pledged about €60 billion in guarantees, loans and investments, and is expecting a boost of €45 billion in corporate financing. Prime Minister Vanhanen described the decisions as ‘massive, even gigantic’. The largest sums of money are in the bank support package, which aims to secure the continuity of corporate credit. In fact, the Finnish parliament has already approved guarantees of €40 billion to help banks to raise capital.

But in the longer term the issues raised in the course of this post need to be addressed. Competitiveness needs to be restored to the Finnish economy, and exports boosted, as illustrated by the REER chart below. In particular the situation pre 2007 needs to be restored. The change is not massive (maybe only 5% or so), so it is doable, and it needs to be done, especially since the Swedish Krona has been significantly devalued.

One of the things that stands out is Finland’s differential preformance vis a vis Sweden. Using data prepared by Eurostat which shows the volume indexes of GDP per capita as expressed in Purchasing Power Standards (PPS) (with the European Union - EU-27 - average set at 100) it is apparent that a gap exists (see below) and that it is not being closed. In fact, after 1998 the two lines move tantalisingly in tandem, but with Finnish per capital GDP stuck just short of the Swedish level. Any reading on these indexes of over 100 implies that the country’s level of GDP per head is higher than the EU average and vice versa, and relative movements in the indexes imply that the rates of change in GDP per capita are either improving more or less rapidly than the EU average. The basic data behind the charts is expressed in PPS which effectively become a common currency eliminating differences in price levels between countries making possible meaningful volume comparisons of relative GDP per capita. Since the index is calculated using PPS figures and expressed with respect to EU27 = 100, it is only valid for cross-country comparison purposes and not for individual country inter-temporal comparisons, nonetheless charts based on such data are extraordinarily revealing.

And what of all those prosperity and competitiveness indexes we started with. Clearly they have been missing something here. A focus on institutional quality is fine, and I have nothing against it, but there is surely more to economic growth processes than simply having sound and effective institutions. Other forces are at work, and one of these is our demography, and as we can see in the Finnish case, simply leaving these out of our analysis won't help us avoid the problems that excessively rapid ageing presents for our economic system. I wish it would.

There Is Another Shoe To Drop In The Global Economic and Financial Crisis - And The Focus Will Be On Europe's Perifery

2009-09-11T10:59:00.000-07:00

'As far as I am concerned, this is ... the most complex crisis we've ever seen due to the number of factors in play'
Spanish Economy Minister Pedro Solbes speaking to the Spanish radio station Punto Radio September 2008

“‘The global imbalances have to add up to zero and so, if the US is going to be less the consumer importer of last resort, then other countries are going to need to be in different positions as well."
Director of the US president’s National Economic Council Larry Summers, speaking over lunch with the FT’s Chrystia Freeland.

Basically what we now have before us - as Pedro Solbes pointed out before being uncerimoniously defenestrated from the inner circle of the Spanish government - is an extremely complex situation and problem set. The background has evidentally been an unprecedented global financial and economic crisis, but this crisis has affected countries unequally, and it is noteworthy just how many people in what could be called the "weaker" countries have often sought refuge in the global nature of the crisis, rather than asking themselves just what it is exactly about their own particular economy that makes them "weaker", and more vulnerable, and why the crisis has struck more severely "here" rather than "there". Thus there is a great danger that people take refuge in the fact that the crisis is global in order to avoid thinking about the actual reality that faces them. This danger becomes even more of an issue as some countries begin timidly to return to growth, leaving others stuck in the mire - and possibly in danger of bringing the whole pack of cards tumbling down on top of them again. One such danger is evident in China (for which see the numerous warnings from Andy Xie) but others are for me somewhat nearer home, on Europe's periphery. A number of countries in Eastern Europe immediately come to mind - not only the Baltics, but also Russia, Ukraine, Bulgaria, Romania, Hungary, Serbia and Croatia. And in Southern Europe Spain and Greece stand out as in particular need of what Jean Claude Trichet would undoubtedly call "extreme vigilance".

If we leave out Russia (which is arguably a rather special case due to its dependence on energy revenue), then the simple fact of the matter is that what all of these countries had in common during the bubble years was that they were all running large (unrealistically large) current account deficits, which were produced to fuel strong credit driven housing and consumption booms. The crisis has struck all these countries like a shot of lightening for the simple reason that under present conditions such current account deficits are now no longer sustainable.

Now, the only way forward for such countries, as Paul Krugman points out (citing Reinhardt and Rogoff) is to export their way back to growth, and to demonstrate how this might work Krugman produced a simple chart in his Lionel Robbins lectures, which although rather rough and ready does serve the purpose adequately well.

So the central point I wish to make is that all these countries now need to run current account and trade surpluses to generate headline economic growth and to start paying down the external debt they accumulated during the heady years of the boom. Countries are no different to households in this sense. And the wider the current account deficit at the height of the boom, the bigger the correction needed. Without the much needed correction these countries simply will not recover, and we will see the famous "L" shaped recovery. If people think otherwise they are simply deluding themselves.

The situation in the US and the UK is, of course, not that different structurally from that which is to be found in some parts of Eastern and Southern Europe, but it is less extreme, in that the Current Account deficit peaked at between 5% & 6% of GDP. This is still large, and correcting it is going to be one of the very good reasons that the global economiy ISN'T going to return to any kind of strong growth anytime soon, given the strategic importance of the economies concerned.

The UK and the US do, however, have one large and significant advantage over the worst affected countries in South and East of Europe, and this lies in the fact they can issue debt in their own currency, and they can allow that currency to devalue, and that in fact is the road that both these countries are now going down. But remember, the result of this is that US and UK consumers will now play little part in facilitating headline growth in the global economy, since they themselves will now be net savers. But most of the worst affected East European economies are either locked-into currency pegs with the euro (the Baltics and Bulgaria), or cannot devalue very far due to the strong dependence on forex loans (Romania and Hungary) or both. Nor can these countries realistically expect to issue debt in their own currencies. So they are in effect in a very parlous situation, on financial life support from the EU and the IMF, while unable to make sufficient adjustments sufficiently quickly to stop unemployment rising out of hand, and non performing loans piling up in the banking sector.

Which brings us to Southern Europe. Italy is a case apart - since it is "simply" suffering from a kind of ageing-related terminal slow death "Venice style", and thus has a different problem set - in particular, while the Italian government is heavily in debt, Italian households are strong net savers, and thus any eventual default would be largely a "home team" issue. Portugal, Greece and Spain, on the other hand, were all running large CA deficits between 2000 and 2008, and these are deficits are now being forceably closed. But of course, and here comes the rub, these countries don't have their own currency - they have to issue debt in euros, and they can't simply fuel inflation (like they did in the past) since they can't print money, only the ECB can do that, and the ECB is a multi-national not a national institution.

Now people over at the ECB are well aware of this problem, and the bank is facilitating all the liquidity these countries need in the short term, but it is so very important important to understand this only aids liquidity, it does not resolve the solvency-related issues (which the individulal countries have to sort out for themselves) and in fact the short term palliative only adds to long term accumulated debt problem if the breathing space offered is not taken advantage of. And, here comes the problem, since all the available evidence suggests that the correction the ECB would like to be funding is either not taking place, or is taking place too slowly to be of much use. That is, the ECB has the funding capacity, but it does not have the necessary political clout.

Take Spain for example - Spain's external debt is continuing to rising even as I write, while at the same time GDP is falling, and will continue to fall untill we get back to export competitiveness. Worse, nominal GDP (that is current price GDP) is now falling faster than real (inflation-adjusted) GDP, so the value of the debt remains - in money terms - where it is, while GDP shrinks in relation to this absolute reference point - both in real terms, and even more so in nominal terms. I have been following this problem in Japan for the best part of a decade now, and the solution is evidently not an easy one, since - if you take the core core price index - Japan never really came out of deflation after 1998, and land prices are now back at the levels of somewhere in the early 1980s. Needless to say, if this repeats itself in Spain, the mess will not be a pretty one, and the problem for the ENTIRE global financial system will be substantial, due to the counterparty risk element.

So we are really caught on the horns of a dilema here, Spain and other EU periphery countries have to deflate (willingly or unwillingly, they need to carry out what has now come to be known as "internal devaluation") but so long as they fail to do this and to attract sufficient investment for new export industries to turn the economic dynamic around AND as long the rest of the global economy doesn't recover strongly enough with some countries starting to shoulder significant deficits again, then we are all only going to plumb the bottom. Worse, unemployment will continue to mount, and bad debts pressurise the banking system, which is where the next shoe might then not only drop, but be forced right off the foot first.

The only way in which it would be possible for these countries to attract the necessary investment to be able to start to create employment employment again would be to restore competitiveness, and over the time horizon we should be thinking about this is impossible for them to do via productivity improvements alone: hence the pressing urgency for the "internal devaluation" solution.

And let's not be fooling ourselves here - the main reason those famous government bond "spreads" have all tightened so impressively recently has been the willingness of the ECB to discount the national government bonds which are first purchased by local financial entities and then passed on for discounting at the ECB - a practice one of my Spanish friends calls the "truco del almendruco" (that is, you sell the 10,000 euro new car for 9,995 euros thus changing the key headline digit, giving everyone the impression there has been a large and significant discount, and, oh yes, first of all you need to dump a wheelbarrow load of cash on the banks - in this case on a one year financing basis).

"Between October 2008 and April 2009 MFIs’ net purchases of debt securities issued by the euro area general government sector totalled €217 billion in the context of rapidly declining short-term interest rates. This entirely reversed the net sales of €191 billion observed between December 2005 and September 2008 in the context of rising short-term interest rates."
ECB Monthly Bulletin, June 2009

So what I am saying is that the ECB is effectively conducting expansionary fiscal policy in the Eurozone countries - by buying a large part of the new government debt, a state of affairs which is in fact equivalent to conducting Quantitative Easing via the back door, while the EU/IMF tandem is offering similar support to the key countries in the East. Anatole Kaletsky made a similar point in the Times back in June, when the ECB announced its €442 billion of new cash into the euro money markets in what was the biggest long-term lending operation in the history of central banking and roughly equivalent to half the Fed’s entire monetary expansion in the past 18 months.

The Fed has “monetised” roughly $1 trillion of US Government debt since 2007, if we combine its Treasury and agency bond buying. Meanwhile, the ECB has lent $1.5 trillion to the euro-area banks. But what have the euroland banks done with this new money? They have lent most of it straight to their governments. Indeed, the governments in Ireland, Greece, Portugal, Spain and Austria would long-since have gone bust had it not been for the willingness of the commercial banks in these struggling economies to buy unlimited quantities of government bonds with money borrowed from the ECB. And these bond purchases have, in turn, been used as collateral for more ECB borrowings, which could be used to buy more government bonds.

In effect, therefore, the ECB has been lending money by the shed-load to governments, with commercial banks acting merely as a fig leaf for what would otherwise be seen as a blatant monetisation of the most insolvent European countries’ public debt.

Now Anatole only has it half right here, the objective is not to finance dubious government debt in semi-bankrupt countries (Italy, for example), but to enbale those countries who had been running extraordinarily large current account deficits (Spain, Greece and Portugal) to close the deficits gradually (ie without precipitating a dramatic implosion in their economies) by facilitating government borrowing to fill the gap left by domestic and corporate deleveraging. The situation I am trying to describe is perhaps best illustrated by the following chart on Financial Balances prepared by PNB Paribas Chief European Economist Dominic Bryant for a recent research report on Spain.

As households and companies desperately try to save, to put some sort of order back into their balance sheets, government steps in (Krugman's push button "G") to help ease the transition. Such a policy is, of course, all well and good and totally justified (since there is effectively no alternative), so long as the structural transition which such support is meant to facilitate is actually carried through. And this is a big if, especially since most of the evidence we have seen to date suggests it isn't.

And then there is the Irish case, and the proposal to create a "bad bank" (NAMA). According to Minister of Finance Brian Lenihan the Irish State plan to buy up toxic property loans with a current face value of €60 billion and investment property loans with a book value of €30 billion, all in exchange for Government bonds. And how will the Irish government finance a possible €90 billion (or two thirds of 2008 GDP) in bonds? We the government plans to pay the banks in bonds which they can then redeem for cash over at the ECB. Obviosuly there is little other way, with such a high proportion of GDP, but has anyone started to think what will happen if the Spanish exchequer is faced with an equivalent proportional sum to clean up bad loans in Spanish banks. Spain, remember is the only major country where there was a property bubble where the banks have not had a substantial capital injection.

And in my humble opinion the ECB will only be willing and able to continue with this kind of policy for a limited period of time, since they will not be in a position to keep accumulating Irish, Austrian and Southern European bonds ad infinitum, and the sovereign governments won't be able to keep increasing their debt load for ever. Just look, for example at the kind of dynamic Spanish public finances have entered in 2009 (see the acceleration in the cash basis deficit shown for 2009 in the chart below - the evolution is almost exponential, and it still hasn't stopped the haemorrage of jobs out of the economy).

We also need to think about the risk the ECB is running of accumulating substantial capital losses if there is a sovereign debt problem (which there most likely will be at some point if the correction is not carried out) in one of the member states as the size of the ECB position simply grows by the day, and ultimately the German and French taxpayers will have to pay the losses being steadily accumulated, something I feel they will be very reluctant if those in the worst case scenario countries continue to harp on about a global economic and financial crisis whilst effectively doing nothing to put their own house in order.

Precisely this point was raised a while back by Willem Buiter on his Mavercon Blog:

The first vacuum is that there is no single fiscal authority, facility or arrangement which can re-capitalise the ECB/Eurosystem when the Eurosystem makes capital losses that threaten its capacity to implement its price stability and financial stability mandates.

The second related vacuum is that there is no single fiscal authority, facility or arrangement which can re-capitalise systemically important border-crossing financial institutions in the EU or the Euro Area, or provide them with other forms of financial support.

When the Bank of England develops an unsustainable hole in its balance sheet, Mervyn King knows he only needs to call one person: Alistair Darling, the UK Chancellor of the Exchequer. If the Fed were to become dangerously decapitalised, Ben Bernanke also needs to call just one person: Tim Geithner , the US Secretary of the Treasury. It is possible that no-one in the US Treasury will pick up the phone, as none of the senior political appointments below Geithner are in place yet, but Geithner clearly would be the man to call.

Whom does Jean-Claude Trichet call if the Eurosystem experiences a mission-threatening and mandate-threatening capital loss? Does he have to make 16 phone calls, one to each of the ministers of finance of the 16 Euro Area member states? Or 27 phone calls, one to each of the ministers of finance of the 27 EU member states whose NCBs are the shareholders of the ECB? I don’t know the answer, and I doubt whether Mr. Trichet does.

Maybe one day all those phones will be ringing, only for the caller to hear that old Elvis automated operator resonse - "no such number, no such zone".

The G20 Needs A Real Rethink And A New Plan

So, coming back to where we started, growth in Germany and France. Such growth is unlikely to be anything like as strong as most commentators and analysts seem to be expecting. France will most likely do rather better than Germany, given that the German economy can't really move forward till other key economies move, due to export dependence. The German economy may well even ultimately contract over 2009 as a whole by more than the Spanish economy, and I expect Germany's problems (like Japan's) to continue well into 2010, simply because both these countries are now very high median age societies which are completely dependent on exports to grow - which means that now that the UK, US, Eastern and Southern Europe are no longer running current account deficits, Germany and Japan are very hard pressed to get the level of trade surplus they so badly need for achieving sustainable headling GDP growth, which brings us back to Krugman's joke about which planet is going to do the importing?

Structurally the previous drivers of growth will now fail to work, since as Krugman suggests, all the former CA deficit countries now need to export and run trade surpluses to grow and straighten out their financial imbalances , and it is not clear which countries can buy all the added output, especially when countries in general are still reducing imports, and certainly not about to open up deficits which would soak up all those new surpluses.

Essentially, I would close by emphasising that I am not a complete catastrophist, since I think there is a mid term solution out there - and that the answer lies in steadily unwinding the global demographic and wealth imbalances, through the economic development of a number of key emerging economies - in a way which would perhaps be similar to the implementation of the Marshall Plan which is what really brought the first great global depression to an end.

The problem is that I think we are still some years away from being able to get any sort of agreement on such a programme - as everyone will have noted the G20 isn't really talking about this yet, although I think they eventually will. In the meantime we all have to stagger forward. And it is the risk of further "events" occuring in countries like Latvia and Spain that make all this staggering onwards and downwards ever so dangerous. In all the key countries involved - the Baltics, Bulgaria, Romania and Hungary in the East, and Portugal, Greece and Spain in the South - government support is simply not sufficient to arrest the contraction in Krugman terminology simply hitting the "G" button will not work, and these economies are steadily "imploding" in on themselves, with the result, as I keep stressing, that unemployment inexorably rises, and bad debts simply mount up in the banking system, and if nothing is done to change course the outcome is surely a foregone conclusion.

The principal difference between the East and the South is that in the East governments no longer have the capacity to continue to sustain large deficits, while in the South they continue to be able to do so, though even here they cannot hold out indefinitely. Sometime in late 2010 or early 2011 all of this will, with a horrid and almost deterministic inevitability, all come to a head.

And this is why, I personally take the view that the global financial and economic crisis is far from over. There is another stage yet to come, and the focus of the problem will be Southern and Eastern Europe.

From Original Sin To The Eternal Triangle - Lessons From Central Europe

2009-08-14T02:02:00.000-07:00

The non-biblical concept of original sin, as Claus Vistesen notes in this post, when propounded in its standard Obstfeld & Krugman textbook version refers to the situation where many developing economies who are not able to borrow in their own currencies feel forced to denominate large parts of their sovereign and private sector debt in non-domestic currencies in order to attract capital from foreign investors - as evidenced most recently in the countries of Central and Eastern Europe. Well, piling insult upon injury, I'd like to take Claus's point a little further, and do so by drawing on another well tried and tested weapon from the Krugman armoury, the idea of the "eternal triangle".

As is evident, the reality which lies behind the current crisis in the EU10 is complex, and has its origin in a variety of causes. But one key factor has undoubtedly been the decisions the various countries took when thinking about their monetary policy and currency regimes. The case of the legendary euro "peggers" - the three Baltic countries and Bulgaria - has been receiving plenty of media attention on late, and two of the remaining six (Slovenia and Slovakia) are now members of the Eurozone, but what of the other four, Romania, Hungary, Poland and The Czech Republic? What can be learnt from the experience of these countries in the present crisis.

Well, one convenient way of thinking about what just happened could be to use Nobel Economist Paul Krugman’s Eternal Triangle” model (see his summary here), which postulates that when it comes to tensions within the strategic trio formed by exchange rate policy, monetary policy, and international liquidity flows, maintaining control over any one implies a loss of control in one of the other two.

In the case of the Central Europe "four", Poland and the Czech Republic opted for maintaining their grip on monetary policy, thus accepting the need for their currency to "freefloat" and move according to the ebbs and flows of market sentiment. As it turns out this decision has served them remarkably well, since the real appreciation in their currencies which accompanied the good times helped take some of the sting out of inflation, while their ability to rapidly reduce interest rates into the downturn has lead to currency depreciation, helping to sustain exports and avoid deflation related issues.

The other two countries (Hungary and Romania), to a greater or lesser degree prioritised currency stability, and as a result had to sacrifice a lot of control over monetary policy, in the process exposing themselves to the risk of much more violent swings in market sentiment when it comes to capital flows. Having been pushed by the logic of their currency decision towards tolerating higher inflation, they have seen the competitiveness of their home industries gradually undermined, and as a consequence found themselves pushed into large current account deficits for just as long the market was prepared to support them, and into sharp domestic contractions once they were no longer disposed so to do.

A second problem which stems from this "initial decision" has been the tendency for households in the latter two countries to overload themselves with unhedged forex loans, a move which stems to some considerable extent from the currency decision, since in order to stabilise the currency, the central banks have had to maintain higher than desireable interest rates, which only reinforced the attractiveness of borrowing in forex, which in turn produced lock-in at the central bank, since it can no longer afford to let the currency slide due to the balance sheet impact on households. Significantly the forex borrowing problem is much less in Poland than it is in Hungary or Romania, and in the Czech Republic it is nearly non-existent.

The third consequence of the decision to loosen control on domestic monetary policy has been the need to tolerate higher than desireable inflation, a necessity which was also accompanied by a predisposition to do so (which had its origin in the erroneous belief that the lions share of the wage differential between West and Eastern Europe is an “unfair” reflection of the region’s earlier history, and essentially a market distortion). The result has been, since 2005, a steady increase in unit wage costs with an accompanying loss of competitiveness, and an increasing dependence on external borrowing to fuel domestic consumption.

So, if we look at the current state of economic play in the four countries, we find two of them (Hungary and Romania) undergoing very severe economic contractions - to such a degree that in both cases the IMF has had to be called in. At the same time both of them are still having to "grin and bear" higher than desireable inflation and interest rates. In the other two countries the contraction is milder, the financial instability less dramatic, and both inflation and domestic interest rates are much lower. Really, looked at in this light, I think there can be little doubt who made the best decision.

Appendix

Here for comparative purposes are charts illustrating the varying degrees of economic contraction, inflation, and interest rates. GDP contraction rates actually present a little problem at the moment, since one of the relevant countries - Poland - still has to report. However Michal Boni, chief adviser to the Prime Minister, told the newspaper Dziennik this week that the economy expanded at an annual rate of between 0.5% and 1% in Q1. So lets take the lower bound as good, it is still an expansion.

The economy in the Czech Republic contracted by an estimated 4.9% year on year in the second quarter.

The Hungarian economy contracted by an estimated 7.4% year on year in Q2.

While the Romanian economy contracted by an estimated 8.8% year on year.

Inflation Rates

Poland's CPI rose by an annual 4.2% in July.

The CPI in the Czech Republic rose by an annual 0.3% in July.

Romania's CPI rose by an annual 5.1% in July.

Polands CPI rose by an annual 5.1% in July.

Interest Rates

The benchmark central bank interest rate in Poland is currently 3.5%.

The benchmark central bank interest rate in the Czech Republic is currently 1.25%.

The benchmark central bank interest rate in Romania is currently 8.5%.

The benchmark central bank interest rate in Hungary is currently 8.5%.

"Advances in Development Reverse Fertility Declines" - Science or Hocus Pocus?

2009-08-09T01:29:00.000-07:00

According to a once-upon-a-time post on the Economist's Certain Ideas of Europe Blog Edward Hugh “was very cross” about some of the journalism they were serving up over at that prestigious journal. Well, not to worry, since this time he is hopping mad. And the issue which lies behind his wrath is essentially the same one, how to interpret and understand the demographic processes which are currently so evidently affecting our societies. In what is simply the latest episode in a long and sorry saga (if you want documentation, please see the comments Claus Vistesen and I nailed to their "Wall" in the above linked post) this week's print issue contains a research review from their science and technology correspondent who is evidently not backward in coming forward with headline grabbing claims. According to the said corresponedent the demographic transition (a process which has been ongoing for over two hundred years now) has finally and definitively gone into reverse gear:

"One of the paradoxes of human biology is that the rich world has fewer children than the poor world. In most species, improved circumstances are expected to increase reproductive effort, not reduce it, yet as economic development gets going, country after country has experienced what is known as the demographic transition: fertility (defined as the number of children borne by a woman over her lifetime) drops from around eight to near one and a half. That number is so small that even with the reduced child mortality which usually accompanies development it cannot possibly sustain the population.

If Mikko Myrskyla of the University of Pennsylvania and his colleagues are correct, though, things might not be quite as bad as that. A study they have just published in Nature suggests that as development continues, the demographic transition goes into reverse."

Well quite a strong claim is being made here. The idea that a group of researchers have come up with a finding that shows the "rule....that people have fewer children as their countries get richer...no longer holds true" is certainly not one to be sniffed at. Such a strong claim needs some very heavy backing you would think, given all the research that has gone into the topic in recent years.

In fact, the research makes no such direct claim, since Myrskylä et al simply find statistically significant evidence for a reversal in the relationship between the human development index (HDI)
and the total fertility rate (Tfr) at HDI levels around 0.85–0.9. The rest is only interpretation. As we will see, to move from a simple statististical correlation to formulating a hypothesis you need an explanatory framework, and you need to be able to make falsifiable predictions. The Nature letter from Myrskylä et al is far from being at this stage of development. They have simply found an interesting correlation, and the rest is in the eye of the observer.

"Back in 1975, a graph plotting fertility rate against the Human Development Index fell as the Human Development Index rose. By 2005, though, the line had a kink in it. Above an HDI of 0.9 or so, it turned up, producing what is known in the jargon as a “J-shaped” curve (even though it is the mirror image of a letter J). As the chart shows, in many countries with really high levels of development (around 0.95) fertility rates are now approaching two children per woman. There are exceptions, notably Canada and Japan, but the trend is clear."

However, according to the Economist the trend is clear. But is it? Edward has been doing some digging.

In fact the problem goes beyond the Economist, since the source behind the article is a letter published in Nature. Below you can read that letter.

"During the twentieth century, the global population has gone through unprecedented increases in economic and social development that coincided with substantial declines in human fertility and population growth rates. The negative association of fertility with economic and social development has therefore become one of the most solidly established and generally accepted empirical regularities in the social sciences. As a result of this close connection between development and fertility decline, more than half of the global population now lives in regions with below-replacement fertility (less than 2.1 children per woman. In many highly developed countries, the trend towards low fertility has also been deemed irreversible. Rapid population ageing, and in some cases the prospect of significant population decline, have therefore become a central socioeconomic concern and policy challenge10. Here we show, using new cross-sectional and longitudinal analyses of the total fertility rate and the human development index (HDI), a fundamental change in the well-established negative relationship between fertility and development as the global population entered the twenty-first century. Although development continues to promote fertility decline at low and medium HDI levels, our analyses show that at advanced HDI levels, further development can reverse the declining trend in fertility. The previously negative development–fertility relationship has become J-shaped, with the HDI being positively associated with fertility among highly developed countries. This reversal of fertility decline as a result of continued economic and social development has the potential to slow the rates of population ageing, thereby ameliorating the social and economic problems that have been associated with the emergence and persistence of very low fertility."

Here is the chart (reproduce from Nature data) which the Economist presents to illustrate the 'J curve' relationship.

Nice, isn't it? Nature even go to the lengths of a putting up a special "event" podcast featuring an interview with Hans Peter Kohler (click here for link) as if to underline the importance of the "finding") But does any of this have any compelling validity?

Methinks not as much as the authors of the letter, or those who are covering it in the media, are trying to make out. There are many issues which are raised here, but I would just like to mention three.

The first is the decision of the research team to work with a period based fertility measure which is known to be very unreliable for "tempo" reasons (the Total Fertility Rate- Tfr) as the basis for a longitudinal study. And let us remember, the authors only really claim to have found a correlation between HDI levels in the 0.85–0.9 range and movements in the Tfr, and there could be many explanations for this. Indeed the authors themselves even offer one of them in their supplementary information - "countries at development levels near the critical level HDI = 0.86 might have a more rapid postponement of childbearing than more advanced countries.. " - a possibility which, in fairness to the authors, they try to test for.

And you don't have to rely on me for the suggestion that the Tfr is hardly the most desireable measure for what they want to do, since the authors themselves point this very fact out in the supplementary information (and the only thing which surprises me is that nobody else who has reviewed the research seems to have twigged the implications of this). So the very title of the Letter is totally misleading, they have not found that "Advances in Development Reverse Fertility Declines" -since in the first place the direction of causality is not adequately determined (it might be that reverses in fertility decline advance development, as I try to show in a piece referenced below) and in any event the research only shows movements in the HDI correlate with movements in the Tfr (and not with "fertility").

The recent literature on low fertility in developed countries has pointed to the important role of delayed childbearing, that is, the ongoing postponement of childbearing to increasingly later ages. In the context of this paper, delayed childbearing is potentially important because the postponement of childbearing can distort the total fertility rate as a measure of the quantum (or long-term level) of fertility. “Tempo effects”, or the reductions in the total fertility rate resulting from a postponement of childbearing, have been shown to partially explain the very low fertility rates observed in some European countries.

So this is the first issue. Due to the phenomenon of birth postponement, the Tfr is a hopelessly unreliable indicator, and what is often called "the birth recovery" is in fact a statistical issue produced by the fact that the Tfr first sinks to very low levels (the birth dearth) and then recovers as women reach the new (higher) childbearing age. Since all of this is simply so obvious, I am absolutely astounded that two such well known and highly respected demographers - Hans-Peter Kohler and Francesco Billari - have placed their name on a piece of research that could almost be described as a publicity stunt. I am even more astounded by the way Nature appear to have been hoodwinked.

Basically, I don't think that there can be any doubt that if they used a more comprehensive measure of fertility - say completed cohort fertility - they wouldn't get the correlation they claim to have found, since CFRs never fell so low, and have not bounced back in the same way. This is essentially because this indicator removes the temporal component found in the TFR (older first birth ages among women in developed societies) and only focuses on quantity. True, they did carry out a robustness test using an adjusted Tfr, but the results are much weaker, and the sample far from satisfactory (at least for the claims being made), and the authors well know this (see below).

In their longitudinal study the authors look at Tfrs for a number of countries over the period 1975 to 2005 and compare these to the lowest Tfr reading observed while a country's HDI was within the 0.85–0.9 window. For all countries considered, the HDI in 2005 was found to be higher than the HDI in the reference year. For 18 of the 26 countries that attained a HDI 0.9 by 2005, the Tfr in 2005 was found to be higher than the TFR in the reference year. As I say, this is hardly surprising, given the tempo impact on Tfrs. The "2005 18" are Norway, the Netherlands, the United States, Denmark, Germany, Spain, Belgium, Luxembourg, Finland, Israel, Italy, Sweden, France, Iceland, the United Kingdom, New Zealand, Greece and Ireland.

Perhaps it is more surprising (and interesting) to learn that they found six countries where the HDI was over 0.9 but where the Tfrs didn't pick up: Japan, Austria, Australia, Switzerland, Canada and South Korea. Clearly the absence of "rebound" in even the Tfrs is something of a cause for preoccupation in these countries, and examining the background to what is happening in these countries could at the end of the day turn this research into something quite interesting. That is to say, if for their level of development we might have expected the tempo effect to be more or less over, why do some countries continue to have very low fertility levels?

Basically, to shoot a hole straight through their hypothesis (falsify it that is, surely in science things should be falsifiable), I would say it is only necessary to find a significant number of countries in the first group where fertility as measured by a better indicator didn't rise. Unfortunately we don't have a really good time series for such an indicator, but Eurostat have published statistical estimates for Completed Cohort Fertility Rates (Cfrs) for EU countries up to the 1989 cohort. That is, estimates of what fertility is likely to be for women who were 30 in 2009. Looking at this data, the following countries would appear to offer no evidence whatever for a rebound in cohort fertility in what we know to dat: Norway, Netherlands, Denmark, Germany, Italy, Finland, Sweden, France, Iceland, the UK, Greece and Ireland. That is to say, as far as I am concerned, the whole hypothesis falls till at least subsequent data confirm it.

I haven't been able to check foir the US (but the Cfr is probably up) Israel (also) or New Zealand. Belgium has little available data. So the only two European countries which you could say with some degree of security actually could confirm the hypothesis would be Luxembourg and Spain - but if you just look at the increases in Spain - from 1.34 to 1.35 - and think about the fact that 5 million new migrants arrived (mainly in childbearing ages) between 2000 and 2009, then the result is hardly dramatic, and if you look what just happened to the economy, it is more than likely that GDP per capita is plummeting, and and household income (which has a weighting of more than one third in the HDI) with it. Which brings me to the second question, the reference year. But before I move on to that, as I say above, the authors are perfectly well aware of the issue with using Tfrs.

In particular, one could speculate that tempo effects might be—at least partially—responsible for the observed change in the development–fertility association. For example, countries at development levels near the critical level HDIcrit = 0.86 might have a more rapid postponement of childbearing than more advanced countries. If this were the case, tempo effects would reduce the TFR more strongly at intermediate than at advanced HDI levels, and the positive association between HDI and TFR in Figures 1–2 could be partially explained by differences in the pace of fertility postponement, rather than by variation in levels among advanced countries.

The authors therefore carry out a robustness test which effectively amounts to a cross-sectional study (cross-sectional note, not longitudinal) of the relationship between the total fertility rate with and without adjustment for tempo effects, and the human development index in 1975 and 2005. Tempo adjusted TFRs are not available over the period in question so they simply took data for 2005 (for those countries for which it is available from the ’European Demographic Data Sheet 2008’ (published by the Vienna Institute of Demography, Vienna, Austria) and from McDonald P, Kippen R. The Intrinsic Total Fertility Rate: A New Approach to the Measurement of Fertility (Population Association of America Annual Meeting 2007, New York, 2007). What they can then show is that the HDI–TFR relationship at persists at advanced development stages persists even after adjusting the total fertility rate for tempo effects. But, as I say, this is cross sectional, not longitudional. What does this jargon mean? It means there is no clear causal relationship, since equally it could be better HDIs which is driving better fertility, and hence you can use the HDI to explain differences between countries if you wish, but not the evolution of fertility in individual countries. The 2005 result is show as a black line in the chart below, where you can see that as HDI goes up, Tfr also seems to be higher.

Which is very much to the point, and brings me to my second issue, since in my blog post "Taking Solow Seriously - Does Neoclassical Steady State Growth Really Exist?" (which you can find here) - I demonstrate using a few simple charts that the evolution in GDP per capita (which accounts remember for one third of the HDI) may well be a function of underlying population dynamics, since three countries with stronger population growth and higher fertility (the US, the UK and France) evidently perform much better than three will low-to-negative population growth and very low fertility (Italy, Japan and Germany).

Also, it should be remembered, as I mention, we need to think about base years. 2005 was the mid point of a massive and unsustainable asset and construction boom. I think there is little doubt that if we took 2010 or 2011, the results would be rather different.

Finally, the piece in the Economist article that I personallyfind most interesting is the following:

"Dr Myrskyla’s data, however, suggest the ultimate outcome of development may not be a collapsing population at all but, rather, the environmentalist’s nirvana of uncoerced zero population growth."

I want to stress, I certainly think this stationary population idea is certainly one possibility in the more highly developed nations - but if we move to stationary populations, with higher and higher proportions of the population in the older age groups the result is - as we know - a rising median population age. It is the economic impact of the abrupt rise in median age that I personally am focused on, and how just this rise, and the resulting fall in living standards for many young people, might feedback in a negative way on fertility and thus produce ever more rising median ages. In recent days, some have been asking why people like myself are so focused on what is going on in Latvia, which is after all, a pretty small country. Well, I think here in the issues raised by the Nature letter we have just one more reason why that country is important, since in a sense it is conducting a "live" experiment.

Finally, I want to say, none of the above should be read as suggesting that there isn't a great deal of interest and material to talk about in the study the authors have carried out. Nor would I hold them entirely responsible for the way in which others have used and abused their work. I just the reserach doesn't demonstrate what they want it to demonstrate, and that the study doesn't deserve the kind of high media profile it has been receiving, since it is going to mislead the general public more than it will enlighten them, given the important methodological issue which are still to be clarified.

The heart of the problem is twofold. The excessive reliance on a rather problematic indicator (the Tfr) and the causality issue when it comes to GDP per capita and higher fertility (which way does the arrow point?). In fairness the authors do attempt to construct their own combined time series based on a mixture of tempo-adjusted Tfrs and Tfrs, a procedure which seems at the very least to be somewhat problematic if you want to reverse fifty years of academic consensus. And they do get the same sort of result, but the outcome is much weaker and is based on a much smaller sample of only 25 countries. But even this result is at the very least odd, since, as I argue above, cohort fertility hasn't really increased in most of thecountries concerned. So I think we really all need to see more details of how the authors actually constructed the time series to be able to form a better judgement.

But all this being said, and whatever the original intentions of the authors, serious scientific debate does seem to have been turned here into something of a media circus. Wasn't it blogs that were supposed to do that?

Appendix

Below I offer a series of charts showing estimated completed cohort fertility rates based on data compiled by Eurostat using the distribution of births by parity (first and second or higher order births) and mean age of mothers at respective parities to carry out the calculations. Evidently, the most recent data for hard data on completed cohort fertility comes for the 1960 - 1965 cohort. These charts should not be treated as hard data, but a rule-of-thumb type quick visual inspection suggests that it is hard to accept the case for a substantial fertility rebound in many European countries.

To The Finland Station And Back Again

2009-07-14T12:37:00.001-07:00

This post accompanies my recent piece on Sweden. I have been scratching my head and trying to see what could be learnt from making a comparison between Finland and Sweden. Some of the differences are obvious - one is in the euro, and the other isn't, once can adjust monetary policy and currency values, and the other can't. Others are less so. Finland's goods trade surplus has been declining steadily since joining EMU while Sweden's has remained relatively constant. And Swedish males live on average three years longer than their Finnish counterparts. So what is important here, and why? And if convergence theory has anything positive to be said for it, shouldn't we be able to observe so sort of convergence going on here.

First, and just to remind ourselves, here is the chart from Claus Vistesen which shows what the relation between population ageing and current account balance might look like. The key point is that as populations age beyond a certain point, a tendency to run a current account surplus emerges, as domestic demand steadily weakens, and becomes insufficient to drive growth. Evidence for this phenomenon can be found in Germany, Japan and Sweden.

The idea is that as median population age rises the current account dynamics of a country change. The last ageing phase shown to the right of the diagram is purely speculative at this point, although theory suggests that if the underlying momentum of ageing is left unaddressed it may well be what happens. But it is a development which is to be strongly avoided since although we do not yet know what happens when a society starts to dis-save at an advanced median age, the longer we can put off finding out, the better.

Which is why looking at Finland is important, since unlike the three aforementioned "ideal type" agers, Finland has in fact seen a deterioration in its external position over the last decade, and even though it has, up to now, remained a surplus country, the trend is certainly towards deficit, and this trend needs to be halted and reversed. Indeed this is the most pressing policy problem facing the Finnish authorities during the current recession.

Now, as in Finland, Sweden's external position underwent a structural shift in the mid 1990s, just as Claus's model predicts. First positive balance - the submarine breaks water - in 1994, meadian age 38.4 (quite young in international comparisons so interesting). So so far so good.

So Sweden is a sort of normal case, now let's look at Finland. Once more the mid 1990s "transition" is clear. Finland moves from deficit to surplus. But unlike the Swedish case the surplus peaks around the turn of the century, and since then has been steadily weakening.

There can be a number of explanations for this. The pattern of ageing could, for example, be different in Finland. Or the euro might be a factor, with the loss of control over monetary policy leading to a steady deterioration in the level of international competitiveness. As we will see below, some part of the explanation may be provided by each of these, but first, lets take a look as some of the empirical aspects of Finland's present recession, since it is evident that Finland, like many other countries, has entered a strong recession on the current back the global crisis.

Strong Decline In Finland's GDP

In the first three months of this year GDP was down by 2.7% when compared with the last three months of last year (an 11.2% annualised rate of contraction).

And it was down by 7.5% when compared with the first quarter of 2008 (Eurostat data).

One significant difference which can already be noted between Sweden and Finland is that while the last three months of 2008 were definitely much worse than the first three months of 2009 in Swedan, in Finland, as in many other Eurozone economies, Q1 2009 was definitely much worse than Q4 2008. And indeed, while Sweden's economy shows some definite signs of small green shoots in Q2 2009, as far as we can see, Finland's economy still remains deeply mired in recession. Finland does not have a local variant of the ubiquitous Purchasing Managers Surveys, but the statistics office does maintain a monthly gross domestic product (GDP) indicator. Now, while the methodology is very different (the PMI composites are survey based and qualitative, and much more reliable) for what it is worth Finland's GDP indicator fell 9.2 percent in April in comparison with April 2008, that is to say, the year on year contraction was greater than in the first quarter, but it is difficult to draw any definitive conclusion from this, since there are many statistical factors at work here.

According to Statistics Finland building and manufacturing industry were the hardest hit.

The April data showed production in construction and manufacturing - both key contributors to the Finnish economy - down around 17 percent year-on-year. Production in April was down 0.6 percent from March. Output in agriculture and forestry showed slight growth on an annual basis of just below two percent, while services fell six percent.

And the outlook for the rest of this year does not look much brighter. The OECD forecasts growth in the Finnish economy will fall by 4.7 percent in 2009 with a return to 0.8 percent growth next year. Significantly the OECD also stressed that uncertainty in the evolution of international trade poses the greatest risk in the outlook for the Finnish economy.

The IMF currently expects the economy to shrink by 5.2 percent this year and again by 1.2 percent next year, while the latest finance ministry forecast is for a 6.0 percent shrinkage this year followed by 0.3 percent growth next year. All the 2009 forecasts seem to be subject to downside risk, while the 2010 ones are no better than guesses, since the level of uncertainty is so high, and Finland is so dependent on external trade, but further contraction seems more probable than growth at this point.

Short Term Indicators

Industrial output fell again in May (year on year) for the seventh consecutive month, and was down by 23.2 percent over May 2008. This follows a revised fall of 21.3 in April.

Month-on-month, industrial production also fell - by 2.2 percent from April when it fell by 3.8 percent over March. So the industrial situation is deteriorating, not improving at this point. Output fell in all main sectors, with metal industry reporting the biggest decline around 28 percent, while the paper industry production also shrank by nearly 28 percent year-on-year.

Over the January to May period, industrial output decreased by close on 22 per cent from the corresponding period in the previous year. And there seems to be little improvement on the horizon. According to Statistics Finland, the value of new orders in manufacturing was 39.6 per cent lower in May 2009 than in May 2008, slightly above the January to May average decrease of 38.9 per cent year-on-year.

As in earlier months, the decline in new orders was strongest in the metal industry (47.5 per cent). In the chemical industry new orders fell by 30.7 per cent, in the textile industry by 28.5 per cent and in the manufacture of paper, and paper and board products by 19.4 per cent.

Construction activity is also well down, falling by 14.4% year on year in March (the latest detailed data we have), and by around 17% in April according to the GDP indicator.

Finland did not have a massive construction boom. The construction of new dwellings shows no obvious surge in the first decade of the century.

On the other hand rate of household indebtedness is up, with the ratio of debt to disposable income rising to 101.4 percent in 2007, from 70.3 percent in 2002. Significantly, the rate of indebtedness among households composed of persons in the key 25 to 34 age range reached 189 percent in 2007. House prices seem to be a story of one long steady march upwards since 1995, but prices did start to fall in 2008, and this trend now seems set to continue.

Retail sales, which give us a measure of domestic demand, are also falling, if still only moderately. According to Eurostat, retail trade sales fell by 2.99 percent year on year in April. According to the Finnish Statistics Office, sales between January-April were down by 1.6 percent over a year earlier. During the same time period, motor vehicle trade sales were down 31.8 percent and wholesale trade sales down 17.5 percent.

Finland's unemployment rate continues to rise, and at an accelerating pace. The increase in those unemployed from April to May alone was greater than that in the whole of last autumn, according to Statistics Finland. From January to May the seasonally adjusted jobless rate was up by two percent and there were more than 300,000 people recorded as without work in May, 60,000 more than in May 2008, taking the national unemployment rate as measured by Finland Statistics to 10.9 percent.

Using the EU (ILO compatible) methodology, Eurostat report the May unemployment rate as 8.1 percent. The OECD expect unemployment to continue to rise in Finland, and forecast an unemployment rate of 8.7 percent this year, rising to 10.8 percent next year (ILO methodology).

The OECD is also worried about employment in Finland in the longer term, and point out that while the country has taken important steps to remove the barriers to employment of older workers (see the OECD publication Ageing and Employment Policies in Finland) more needs to be done. Since the early 1990s, Finland has introduced programmes to support the employment of older workers, notably the National Programme on Ageing Workers. It has also recently undertaken a major reform of the old-age pension system and will phase out early retirement schemes.

However, Finland’s median age is rising steadily (see chart above) and the old-age dependency ratio (population aged 65 and over as a proportion of the population aged 20-64) is projected to increase from 25% in 2000 to 43% in 2025 compared with an OECD average of 22% in 2000 and 33% in 2025. This is a very steep rise, and raising employment rates among the older population is going to be the key to meeting the challenges presented by the need to find export lead growth.

According to the OECD, only around 30% of people aged 61 are currently working – a drop of more than 50 percentage points compared with 51 year olds. This steep drop in employment rates can primarily be explained by the fact that Finland has too many pathways to early retirement, notably unemployment benefits, unemployment pension, disability pension and individual early retirement pension. Already at the age of 50, 18% of individuals are receiving either unemployment or disability benefits, increasing to more than 46% by the age of 60. Moreover, in the age group 60-64 most unemployed persons transfer to the unemployment pension with a further 20% relying on disability benefits and about 10% rely on the individual early retirement pension.

Deflation dynamics

Like Sweden, the inflation data also throws into the limelight the disparity between the EU HICP measure (which does not include housing interest) and the national CPI (which does). Year-on-year inflation, calculated by Statistics Finland dropped to 0.0 per cent in May, while in April it was still 0.8 per cent. According to Statistics Finland the drop was primarily due a fall in food prices and interest rates. Between April and May, consumer prices fell by 0.2 per cent. On the EU HICP index, however, year on year inflation is currently running at 1.5 percent. Thus, in a time of falling house prices and lowered interest rates, the HICP totally underestimates the deflation danger.

It is important to remember here that two-thirds of Finland’s housing stock consists of owner-occupied homes, and home ownership is widespread in all forms of housing, including apartments as well as detached houses and row houses. Normally falling interest rates would produce rising house values, due to the affordability effect, but under current conditions we are observing the opposite. I can't help feeling that European monetary policymakers need to think more about this type of thing.

More evidence for deflationary headwinds is offered by producer prices for manufactured products, which fell by 8.1 per cent year on year in May. Export prices were down 9.8 per cent and import prices fell by 11.7 per cent. The year-on-year change in the wholesale price index was -8.9 per cent.

So Where Are We?

Finland's economy faces important challanges in both the short and long terms. Finland's state debt is low at the present time, which gives the capacity for short term stimulus and bank bailouts. But it is rising, and reached a record high of 70.6 billion euros by the end of the first quarter of 2009. General government debt, calculated according to Eurostat methodology, grew by 7.5 billion euros in January-March, and reached 38 percent of 2008 gross domestic product (GDP). Still, there is plenty of stimulus ammunition left, the important thing is to use it wisely, and try to engineer an economic transition.

The severe contraction in the Finnish economy is also likely to take its toll on bank credit fundamentals, according to the credit rating agency Moody's. The agency recently reaffirmed its negative outlook for the Finnish banking system. Up until now the Finnish banking sector - lead by Pohjola Bank and local branches of Nordea and Danske Bank - appear to have been weathering the storm without undue difficulty due to minimal exposure to toxic assets and a focus on traditional banking activities, according to Moody's. However:

"Given that the crisis on financial markets has now spread extensively into the real economy, Moody's expects Finnish banks to be adversely affected," according to the latest report. Moody's said an increase in bankruptcies was indicative of the weakened credit environment.

Corporate bankruptcies increased 33 percent in January-May from a year ago, according to Statistics Finland.

The Finnish government has already approved one supplementary budget for 2009 including a special stimulus package. The overall impact is estimated at around €2 billion (although new spending is estimated at only €1.2 billion), and includes about €140 million in transport infrastructure projects. The government has committed itself to implementing a guaranteed pension from the beginning of March 2011. This will cost around €111 million a year, and will raise the lowest pensions by about €100 a month - affecting about 120,000 people.

There have also been a number of measures aimed directly at helping corporate finance. The government now offers banks operating in Finland both deposit guarantees and capital, and will also invest its pension funds in corporate bonds, offer companies financial support through the specialised state-owned finance company, Finnvera, and provide partial financing for the construction of thousands of new homes through the state-owned credit institution Kuntarahoitus (Municipal Finance).

Overall, the government has pledged about €60 billion in guarantees, loans and investments, and is expecting a boost of €45 billion in corporate financing. Prime Minister Vanhanen described the decisions as ‘massive, even gigantic’. The largest sums of money are in the bank support package, which aims to secure the continuity of corporate credit. In fact, the Finnish parliament has already approved guarantees of €40 billion to help banks to raise capital.

But in the longer term the issues raised at the start of this post need to be addressed. Competitiveness needs to be restored to the Finnish economy, and exports boosted, as illustrated by the REER chart below. In particular the situation pre 2007 needs to be restored. The change is not massive (maybe only 5% or so), so it is doable, and it needs to be done, especially since the Swedish Krona has been significantly devalued.

As mentioned previously, the goods trade balance has been deteriorating, and the earlier positive balance now needs to be restored.

One of the things that stands out is Finland's differential preformance vis a vis Sweden. Using data prepared by Eurostat which shows the volume indexes of GDP per capita as expressed in Purchasing Power Standards (PPS) (with the European Union - EU-27 - average set at 100) it is apparent that a gap exists (see below) and that it is not being closed. In fact, after 1998 the two lines move tantalisingly in tandem, but with Finnish per capital GDP stuck just short of the Swedish level. Any reading on these indexes of over 100 implies that the country's level of GDP per head is higher than the EU average and vice versa, and relative movements in the indexes imply that the rates of change in GDP per capita are either improving more or less rapidly than the EU average. The basic data behind the charts is expressed in PPS which effectively become a common currency eliminating differences in price levels between countries making possible meaningful volume comparisons of relative GDP per capita. Since the index is calculated using PPS figures and expressed with respect to EU27 = 100, it is only valid for cross-country comparison purposes and not for individual country inter-temporal comparisons, nonetheless charts based on such data are extraordinarily revealing.

So the real reason is why (given some sort of loose convergence expectation) this gap is not being closed. There can be several explanations. One may be differences in institutional quality (education systems, for example), another might be the impact of euro membership: it could be, for example, that, as OECD economists Jorgen Elmeskov and Romain Duval argued in a suggestive paper (Structural reforms in product and labour markets) presented at the 2005 ECB conference "What effects is EMU having on the euro area and its member countries?", that membership has up to now slowed down rather than accelerating the reform process. Thirdly, the issue could be differential demographics. Few economists seem willing to investigate this possibility in any depth, despite mounting evidence that it may be important.

One demographic indicator that springs to mind immediately when I think about these two countries is the differential in life expectancy. Swedish males live on average around 3 years longer than Finnish males (see below). Now this may be important, although no one has started to calibrate this effect yet. The economic intuition for the importance would be, think of investment in a machine (physical capital), then obviously the value of the investment is greater (other things being equal) if the machine keeps running five years longer.

Things cannot be that much different with human capital. The education and on the job training costs are similar, but the person is able to work three years less. Is it mere coincidence that labour market exit at 61 is so typical if the health outlook is worse? Here are the relative labour force participation rates for me between 55 and 65. It is my contention that this alone accounts for a substantial part of the GDP per capita difference between the two countries.

But the solution to this problem is not an easy one, and the OECD and others really need to think much more seriously about this phenomenon when they indisciminately propose raising higher-age participation rates across the board as a solution to the declining workforces problem.

What is involved here is a complex mix of health provision, lifestyle and genetic differences, and any response needs to take account of all of these.

Raising the health and life expectancy of the Finnish population would be one sure way to raising GDP per capita, another way (in the longer term) would be raising fertility back up to replacement levels, and a third path would be extending the younger labour force by encouraging immigration (which interestingly has been on the rise in the Helsinki area in recent months, although if many of the newcomers simply arrive from equally affected Estonia this is nothing more than moving the deckchairs around). Whichever way you look at it though, in both the short and longer term the deterioration in Finland's trade surplus needs to be addressed. If it isn't the outcome will not be a pleasant sight.

Sweden's Economy At A Glance

2009-07-14T12:35:00.000-07:00

Basically this post accompanies the Swedish monetary policy and devaluation post I have recently put up on the Global Economy Matters Blog. But first some theoretical structure from Claus Vistesen.

As we can see above, the idea is that as median population age rises the current account dynamics of a country change. The last ageing phase of the diagram is purely speculative at this point. Basically we simply do not know what happens after a society starts to dis-save at an advanced median age. We have, as yet, no experience with this phenomenon.

Now, as is well known, Sweden's median population age has been rising steadily, and reached 41.3 in 2009 according to the latest estimates from the US Census Bureau. This makes it a little younger than Germany and Japan (ma circa 43) but still over the critical 41 threshold (which is itself a tentative first estimate, and still needs calibrating from case to case).

Also as can be seen below, Swedens external position underwent a structural shift in the mid 1990s, just as Claus's model predicts. First positive balance - the submarine breaks water - in 1994, median age 38.4 (quite young in international comparisons so interesting). So so far so good.

Now for the empirical side. The Riksbank said the economic outlook had worsened further since its previous meeting, in April, and gave this as its justification suggesting the repo rate will now be held at 0.25 percent until autumn 2010. The central bank now forecasts the economy will contract 5.4 percent this year and return to growth of 1.4 percent next year. As can be seen in the charts below economic performance was weak throughout 2008, and the contraction was very strong in Q4 2008, but showed some evidence of weakening in force in Q1 2009.

However, we have seen a number of signs of stabilisation in recent months. Consumer confidence is now off the lows hit in the first quarter of this year, increasing for the second consecutive month in June (to minus 9 from minus 11 in May). The confidence indicator was minus 21 in April. Sweden's business confidence indicator also improved - for the third straight month - in June, rising to minus 19 from minus 24 in May. Retail sales are also perking up, and according to Eurostat (harmonised) data sales rose 2.2 % year-on-year in May, slower than the 4.3 % rise in April, but still fairly healthy when compared with the very lacklustre performance between September 2008 and March 2009. Month on month, retail sales fell back a seasonally adjusted 1.1% in May when compared with April.

Industrial output is also performing less badly than it was. Output has stabilsed, although at around 85% of its 2005 level, and was contracting between January to May at around a 20% annual rate.

According to the Swedish Statistics Office during the three months from March to May, production decreased by 6.9 percent compared to the previous three months of December-February. Total industrial production (NACE B+C) was down by 2.7 percent in May as compared to April, while in April production decreased by 2.1 percent compared to March.

However, the recent improvements in the PMI reading have been very positive, and indeed the June manufacturing PMI was in expansion territory. Registering 50.5, following 43.7 in May.

Exports continue to be well down, even if there is still a net trade surplus (SEK 9.5 billion in May, up from SEK 8.8 billion in April, and only very slightly down from the SEK 9.6 billion reported in May 2008. Exports fell 24% year-on-year to SEK 78 billion, while imports dropped 26% to SEK 68.5 billion. On a seasonally adjusted basis, the net trade surplus amounted to SEK 8.3 billion in May, up from SEK 8.1 billion in April.

Inflation is now seen by the central bank as less of a threat to the Swedish economy than deflation. Annual consumer prices have declined for two consecutive months and fell 0.4 percent in May. Prices will fall 0.2 percent on average this year, according to the Riksbank. Year on year, headline consumer inflation is still holding in positive territory however, and was still up by 1.7% (still shy of the Riksbanks 2% target) thanks largely to the sharp knock administered by last autumns devaluation.

Curiously the inflation rate as measured by the Swedish statistical office methodology fell to -0.4% in May (-0.1 % in April), while the price index rose by 0.1% from April to May. The main difference in methodologies seems to relate to housing costs, with lower prices for repairs (-4,5 %) due to the introduction of a subsidy for home repair and maintenance and lower interest rates (-3,2 %) each contributing a negative impact of 0.1 percentage points according to the statistics office.

Also producer prices, which have been falling since August 2008 give some indication of the deflationary pressures which are now in the pipeline, and year on year they were up by only a threadbare 0.9% in May.

Rising unemployment is another indicate of the weak demand problem which is building up, and the seasonally adjusted rate hit 8.9% in May, according to Eurostat data.

Basically nothing here is easy, as we are all caught in a rather awkward place. Sweden's Economic Activity Index - which gives a rough and ready measure of activity in the Swedish economy - decreased sharply again in May 2009. The trend decreased 0.4 percent compared to April, which corresponds - according to the statistics office - with an annual contraction rate of almost 5 percent.

As in April, the decrease of the Activity Index in May can mainly be explained by the decrease in exports of goods and industrial production. Indeed, even if the net trade situation is stable, both imports and exports are still falling (see chart below).

But Sweden does seem to have the advantage over many EU countries in that it has a group of people at the central bank who take the deflation threat seriously, and it is hard to disagree with the assessment from UBS economist Sunil Kapadia, when he says that Sweden’s economy will recover faster than those in the euro area. Capital Economics's Ben May is also to the point, Sweden is the place we should look to find green shoots in the EU, if we are to find them anywhere that is.

Cliff Hanging In Bulgaria

2009-07-13T04:25:00.000-07:00

The International Monetary Fund this week forecast the recession in Bulgaria would be deeper than it previously predicted. Such a decision should come as no surprise to anyone, since the country's economic dynamics in both the short and long term look extremely unstable, and Bulgaria is now almost certainly headed towards a series of more or less hair-raising roller-coaster rides. Even the briefest of glances at the population chart above should lead all but the most sceptical among us to stop and think a little about the possible economic implications of such an appauling demographic outlook. As can be seen, the opening to the west brought a sharp outflow of people in the late 1980s (mainly ethnic Turks), but the important thing to note is that the decline has continued almost continuously ever since. That is, the decline was not a one-off demographic "shock", but rather it has become a way of life (or, if you prefer, of death, since deaths constantly outnumber births, even before you consider emigration). And it is this "terminal style" dynamic which virtually guarantess that the coming ride will be a bumpy one, not only in the short term (guaranteed by the size of the current account deficit - 25% - which Bulgaria needs to correct) but in the longer term, since according to any known growth theory there is simply no way any country can sustain headline GDP expansion with potential labour force and population contractions of this magnitude.

Sharp Recession in 2009

Well, to come down to earth with a bump, let's now get into the immediate situation, and return to the fact that the IMF now expects Bulgaria’s economy to shrink by 7 percent in 2009 (previously they were forecasting a 3.5 percent contraction). They also upped (or downed) their 2010 outlook to an anticipated 2.5 percent contraction, from an earlier 1 percent one, although such an adjustment at this point this is now better than mere guesswork. The point is we are in for a severe contraction, and it isn't going to be any laughing matter.

The IMF revision also follows last weeks announcement that it now expects a “sluggish” global economic recovery and its 2009 forecast reduction for central and eastern European, which went to a 5 percent contraction from an earlier 3.7 percent one.

The heart of the Bulgarian problem at the moment stems from the need to correct a current account deficit which reached 25pc of GDP in 2008, the highest of the 80 emerging markets around the world tracked by Fitch Ratings. Gross external debt reached 102 percent of GDP.

Bulgaria faces a drastic process of external adjustment process which with the shadow of the current international economic crisis hanging over it will surely be far from painless. Vulnerabilities accumulated during the boom period - a marked rise in private sector external, debt along with a rapid increase in credit growth and widespread FX-denominated borrowing - will make demonstrating unwavering commitment to the currency board arrangement very hard work indeed. Neil Shearing at Capital Economics estimates Bulgaria’s external financing needs at $25 billion this year, including the current-account deficit, short-term private foreign debt payments and interest payments. Foreign investment has fallen by almost half over the last year. Meanwhile private debt is up to just shy of 100 percent of gross domestic product, while the government budget revenue fell 6 percent in May.

Plummeting GDP

The Bulgarian economy contracted 3.5 percent in the first quarter when compared with the first quarter of 2008, according to the most recent figures from the National Statistics Office. The turnround is massive when you consider that the economy actually grew by 3.5 percent year on year in the last three months of 2008. In fact, GDP actually shrank by 5 percent from the fourth quarter (or at an annual 20% rate), when it contracted 1.6 percent, according to quarterly data which the statistics institute published for the first time (although these are not seasonally adjusted, so we need to be careful in drawing conclusions). At this speed, I would say even the IMF estimate may well fall significantly short of the final outcome, and we could well be looking at a double digit contraction in 2009. Basically make this kind of current account correction without any sort of currency adjustment is extremely costly in short term GDP, as we are seeing in the Baltics.

Domestic consumption fell 5.4 percent in the first quarter from a year earlier after a 1.4 percent increase in the previous three months. Industrial output, which makes up 31 percent of total GDP, plummeted an annual 12.4 percent in the first quarter, after a 3.7 percent decline in the fourth quarter of 2009. Agricultural output, which accounts for 4 percent of the economy, dropped 4 percent after rising 26.7 percent in the fourth quarter. Services, which make up 65 percent of GDP, rose an annual 2.5 percent after a 3.8 percent gain in the previous quarter, although it is obvious that on a quarter over quarter basis even services are now contracting.

First-quarter exports dropped 17.4 percent, while imports dropped 21 percent, meaning that the net trade impact on GDP was positive.

Short Term Indicators

Bulgarian industrial production continues to fall and was 22.1 percent from a year earlier in May - the eighth consecutive monthly decline. Output was also down month on month - by 1 percent over April. Retail sales dropped an annual 10.4 percent in May.

Construction activity is also well down, falling by 9 percent in April, over April 2008 according to Eurostat data.

Domestic demand is in full retreat, as evidenced by retail sales which were down by 3% year on year in May, with the pace of decline steadily increasing.

Unemployment is also rising, and hit 6.5% in May, according to the EU harmonised methodology. This is still comparatively low, but the rate will continue to rise sharply throughout the rest of this year.

With all this contraction going on, deflation must surely be looming for Bulgaria, but given the very high levels which inflation hit in the second half of last year, the annual rate of inflation continues in positive territory, and what we are seeing for the time being is (not so rapid) disinflation. Bulgaria's annual inflation rate only fell to 3.9 percent in June from 3.9 percent in May. This is the lowest level since July 2005, and there is surely much more to come, even if the pace of disinflation raises issues about the ability to maintain the currency peg.

More evidence of the deflationary pressures which are now about to arrive can be found in Bulgarian producer prices, which slumped the most in more than a decade in May, led by falling manufacturing, mining and quarrying costs. Factory-gate prices dropped 3.2 percent on an annual basis after a 2.3 percent decline in April. Producer prices rose 0.3 percent in the month, after April’s 0.8 percent decline.

Mining and quarrying producer prices slumped 13.4 percent in the year, reflecting a global decline in commodity prices, after a 15.7 percent drop in April. Metal producer prices plummeted 30.9 percent in year, after a 29 percent decline in the previous month.

Another Candidate For Internal Devaluation?

Many supporters of the continuty of the current Currency Board Arrangement aregue that while the adjustment process is likely to be a bumpy one the CBA should be able to ride out the storm. I severely doubt this, for many of the reasons I have already offered in the case of the Baltic Countries (here, here, here, and here). Advocates for maintaining the peg argue the CBA is solidly based and able to weather adverse shocks, given the substantial buffers accumulated in the fiscal reserve account (around 15.0% of GDP) and the existence of large foreign reserves. Bulgaria’s "safety margin" - the sum of international reserves and the domestic currency component of the government’s fiscal reserve account — is estimated to be around 48% of GDP. This compares favourably with the rating agencies’ estimate of contingent liabilities from the financial sector under a reasonable worst case of around 30% of GDP (Standard and Poor’s, 2009). Also, as in the Baltics there is strong feeling of national identification with the CBA, which, coupled with the solid backing of all potential stakeholders (the EU and the IMF in particular), could be consided to offer a robust anchor to the CBA. But as with the Baltics, this kind of support may not be sufficient. Lets have a look at why not.

The first and most obvious issue is the competitiveness one. Since Bulgaria's domestic construction, borrowing and spending bubble has now most definitely burst, and since government spending will be brought under a tight lease by the IMF (when they inevitably arrive) Bulgaria is now (like the Baltics) destined to live by exports (not only live, but also pay down some of the accumulated debt) and this is just where we hit a snag. If we look at the chart for Bulgaria's Real Effective Exchange Rate, then we will see that the country has experienced a significant drop in international competitiveness since the end of 2005, due largely to the high level of inflation the country has suffered.

Wage costs have risen significantly, and even as recently as the first quarter of this year total hourly labour cost rose by an annual 19.2%. The total hourly labour cost was up by 18.5% in industry, by 16.3% in services and by 32.2% in construction according to the statistics office.

Basically then, in order to maintain the CBA Bulgaria will need what is called an "internal devaluation" (generalised reduction in prices and wages) of something like 20%, and seeing the pace at which this process has progressed in the Baltics, there are serious questions about whether Bulgaria would be able to implement such an internal devaluation (ecen with IMF support) before it gets caught in a vicious and painful spiral of falling GDP, falling tax income, falling government spending and even more rapidly falling GDP. Also, unlike the case of the Baltics, where the other Scandinavian countries have been able to render assistance to some extent, there is no obvious external supporter for the Bulgarian peg, and indeed the banking system in some of the countries involved in Bulgaria (Greece in particular) may be nothing like as strong or willing to maintain funding as their Swedish counterparts.

Nonetheless the Bulgarian central bank rejects devaluation, saying the country’s reserves of $16 billion is sufficient to protect the peg, and favours an “internal devaluation” byforcing down domestic wages and prices, a process which will weaken domestic demand, trigger deflation and prolong recession in my view.

Further, since there is no realistic prospect of Bulgarian euro membership in the short term, sticking to the peg for the sole purpose of quickly adopting the euro is a non sequitur, and there is no obvious exit strategy in sight.

On the other hand, while a devaluation would obviously close the current account gap far less painfully, it would not help improve Bulgaria's external financing picture owing to adverse balance sheet effects and the likely rise in bankruptcies. But as has been amply discussed in the Baltic case, the difference with an internal devaluation does not exist from this point of view, and indeed the internal devaluation path may be even more damaging given that even those with loans in Lev would be affected.

The current account will adjust in either case, since it has to, as financing is no longer viable, but this can either be done more painfully, or less painfully, and this is the real question. On the face of it Bulgaria’s incoming government, led by Sofia Mayor Boiko Borissov, advocates taking a loan from the IMF and the World Bank, and following in the footsteps of Latvia, Romania, Hungary, Serbia and Ukraine. The outgoing Socialist government ruled out any international loans. Negotiations are expected to start shortly after the new Cabinet takes office, with the loan itself would probably coming at the end of this year or during the first quarter of 2010, according to Bisser Boev, an economist in the election winning GERB party, in an interview last week.

Neil Shearing, an emerging Europe economist at Capital Economics, goes further, and says Bulgaria’s next government faces a deepening recession and an “imminent” loan agreement with the International Monetary Fund. Basically I agree with Neil: the loan will come sooner rather than later, since having the "bad cop" of the IMF to wave is the only way the new government will be able to govern and implement the internal devaluation, which it is likely will be attempted for a time, even if a breaking of the peg is the most probable medium term outcome.

Neil Shearing also forecasts Bulgaria’s economy will contract by 5 percent this year and 4 percent in 2010. My own feeling is that Neil is a bit to cautious here, and looking at the Q1 contraction and the pace of the decline since, we may well be in for a double figure (10 percent plus) 2009 contraction. Evidence from the Baltics would also tend to confirm this view: struggling to maintain a currency peg in this environment can be very costly in terms of lost GDP, since almost all the burden of current account correction falls on reducing imports, with exports falling rather than rising due to short term competitivity issues, especially when a number of other countries - Poland, Romania, the Czech Republic and Hungary may either devalue or see their currencies fall through sell-offs if they try to lower the currently punitive interest rate firewall (Hungary and Romania).

The markets also appear to be far from convinced, and credit-default swaps linked to Bulgarian five-year bonds are up in the region of 400 basis points from the one year low of 290.4 hit on May 20, as perceptions of credit quality deteriorate.

The coalition must work immediately to shore up revenue, which may fall as much as 3 billion lev ($2.1 billion) this year, said Boev, who was part of the team that mapped GERB’s economic policies and has been suggested by daily Dnevnik as the top candidate to run the Economy Ministry. “We’ll urgently revise the budget and cut what we can, postpone or freeze spending where we can,” said Boev. “This is our first task.” Bulgaria can only afford to co-finance infrastructure projects to bring roads and railways to EU requirements, Boev said. Restoring access to EU funds, which were frozen in 2008 over suspicions of graft, is crucial, he said. Bulgaria stands to receive 11 billion euros ($15.3 billion) in EU subsidies by 2013 to bring living standards closer to EU levels. Boev said the government would be “prepared” to cut investment spending and administrative costs, though it will leave social spending alone because reductions would generate additional unemployment.

The IMF forecast a budget deficit of 1 percent of gross domestic product this year and urged the previous government to cut spending by 20 percent. Ousted Prime Minister Sergei Stanishev froze public sector wages less than a month before the elections.

The Risk Of Spillovers

"The macro-situation in Bulgaria is dire," said Lars Christensen, emerging markets chief at Danske Bank.Foreign investment has plummeted. The downturn in the economy accelerated in May and June. While the new government is an improvement, I would not rule out a drop in GDP of 15 to 20pc from peak to trough," he said. My concern is that this is going to spill over into other countries. If you look at the main lenders, they are Greece, Hungary (OTP bank), and Italy."

The danger of a messy ending in Bulgaria adds another twist to the contagion worries which is facing Eastern and Southern Europe in the wake of the global crisis. A break in the Latvian peg (now, not in six months time) would be a blow, but it would, in my opinion, be containable. Estonia and Lithuania would have to correct in line, and pressure would come on Hungary and Romania, but if the Bulgarian peg goes, not in a managed devaluation but as part of a financial crisis inspired rout, which associated political chaos then the problems could rapidly escalate, immediately to four other countries in the west Balkans (Serbia, Croatia, Macedonia and Albania) and more indirectly down into an already weakend Southern Europe via the Greek and Italian banking systems.

But, you might ask, aren’t the Balkan economies too small to be a potential problem for Europe? This is true, but we need to bear in mind that all four of these nations, despite being outside the European Union, are in fact effectively euroised economies - in all cases their currencies are pegged to the euro. In addition all the Balkan countries have very close economic ties with southern Europe via the channel of expatriate remittances. And the economic problems which currently exist in Greece and Italy only serve to further weaken the nations of the Western Balkans, due to the strong trade linkages that exist within the region. These impacts will in their turn work their way back negatively into Greece and Italy due to their role in funding the region. South Eastern Europe could therefore, be quite literally at risk of economic seize-up.

And we should never forget that the political consequences of economic and currency reversals in the Western Balkans are potentially far greater than the Baltics simply because the former region has a population three times greater than that of the latter.

To be precise, maintaining Balkan GDP involves significant currency corrections. These corrections can take place by formal devaluations, or via the so-called "internal devaluation" process. The slower the Balkan currencies correct, the greater the depth and length of the recession. Basically, under these circumstances, I think that the incentive to devalue will, in the end, be too great. The immediate impact of such devlaluations will be most painful for countries like Croatia, which has a large proportion of euro-denominated loans.

When it comes to the short term dynamics of the looming currency crisis in Emerging Europe, one of the Baltic Three, probably Latvia, will be first to concede its peg. When it does others are almost bound to follow. Everything depends on whether the EU Commission and the IMF are proactive or limit themselves to a mere reactive, problem containment role. If the Latvian currency realignment is done in an organised and systematic fashion, then it may, even at this late date, be a containable process. If the situation is left to fester, and the country falls into the grip of a growing political anarchy, then containment will be much more difficult, since panic will more than likely set in.

A similar situation pertains in Bulgaria. Absent a Latvian devaluation, it is not unthinkable that the Lev peg may be maintained for another year or so. But if the authorities do go down this road, then we face the severe risk of a raggedy ending, since the problem is not one of sustaining the peg, but of restoring competitiveness and economic growth, and this is much more difficult without a formal devaluation. And if Bulgaria does go hurtling off that cliff on which it is currently perched, then just be damn careful it doesn't drag half of South Eastern Europe careering after it.

Facebook Links

2009-06-20T02:48:00.000-07:00

Quietly clicking my way through Bloomberg last Sunday afternoon, I came across this:

Facebook Members Register Names at 550 a Second

Facebook Inc., the world’s largest social-networking site, said members registered new user names at a rate of more than 550 a second after the company offered people the chance to claim a personalized Web address.

Facebook started accepted registrations at midnight New York time on a first-come, first-served basis. Within the first seven minutes, 345,000 people had claimed user names, said Larry Yu, a spokesman for Palo Alto, California-based Facebook. Within 15 minutes, 500,000 users had grabbed a name.

Mein Gott, I thought to myself, if 550 people a second are doing something, they can't all be wrong. So I immediately signed up. Actually, this isn't my first experience with social networking since I did try Orkut out some years back, but somehow I didn't quite get the point. Either I was missing something, or Orkut was. Now I think I've finally got it. Perhaps the technology has improved, or perhaps I have. As I said in one of my first postings:

Ok. This is just what I've always wanted really. A quick'n dirty personal blog. Here we go. Boy am I going to enjoy this.

Daniel Dresner once broke bloggers down into two groups, the "thinkers" and the "linkers". I probably would be immodest enough to suggest that most of my material falls into the first category (my postings are lo-o-o-ng, horribly long), but since I don't really fit any mould, and I am hard to typecast, I also have that hidden "linker" part, struggling within and desperate to come out. Which is why Facebook is just great.

In addition, on blogs like this I can probably only manage to post something worthwhile perhaps once or twice a month, and there is news everyday.

So, if you want some of that up to the minute "breaking" stuff, and are willing to submit yourself to a good dose of link spam, why not come on in and subscribe to my new state-of-the-art blog? You can either send me a friend request via FB, or mail me direct (you can find the mail on my Roubini Global page). Let's all go and take a long hard look at the future, you never know, it might just work.

Taking Solow Seriously - Does Neoclassical Steady State Growth Really Exist?

2009-06-14T00:25:00.000-07:00

Discussions of the population problem have always had the capacity to stir up public sentiment much more than most other problems....In fact, the discussion of the population problem seems at all times and in all places to be more strongly dominated by the volitional elements of political ideals and interests than any other part of the established body of social and economic thinking. Here, as in perhaps no other branch of social theorizing, the wish is very often father to the thought.
Gunnar Myrdal, The Godkin Lectures, 1939.

All theory depends on assumptions which are not quite true. That is what makes it theory. The art of successful theorizing is to make the inevitable simplifying assumptions in such a way that the final results are not very sensitive.' A "crucial" assumption is one on which the conclusions do depend sensitively, and it is important that crucial assumptions be reasonably realistic. When the results of a theory seem to flow specifically from a special crucial assumption, then if the assumption is dubious, the results are suspect.
Robert Solow, A Contribution To the Theory of Economic Growth, 1956

What is Neo-Classical Growth?

As everyone who has ever thought about economic processes and social development is only too well aware, the last two centuries have been characterised above all by extremely rapid increases in living standards in a number of countries (generally known as the developed, or "advanced" economies), and this phenomenon, which is more or lest unprecedented in the whole of human history has given rise to extensive debate, together with a most voluminous quantity of literature, about what exactly the factors are which lie behind what this modern growth phenomenon. The objective of what follows is not to offer a general evaluation or even an overview of the corpus of work which has come to be collectively known as "growth theory", but rather to attempt go straight to the heart of the issue, and following in the most venerable footsteps of Federal Reserve Chairman Ben Bernanke, try to take Solow seriously, or at least try to take one of his crucial assumptions (one of the ones which intuition suggests might be plausible if "not quite" true) in order to examine just to what extent this assumption still appears "reasonable" in terms of fitting the facts as we now know them (rather than the facts as Solow could, in his day, see them), or if you prefer, to try to see if what may have been nearly "true" at the time Solow wrote his pathbreaking paper still remains so, on any reasonable interpretation of the meaning of the word "true". What we will here investigate is whether or not it is a reasonable starting point for growth theory to postulate ( in order, as it were, to start the ball of analysis rolling) that modern economies may move towards some sort of steady state growth rate (even if only as a theoretical construct), and whether indeed such and idea forms a useful concept with which to try to explore and model the growth process which characterises modern "mature" economies. We will investigate this assumption, in good Popperian fashion by examining the assumption in terms of the validity of what is conventionally considered to be one of the key predictions which may be extracted from its use of this in neoclassical growth models of the Solow type.

Ready, Steady, Go.....

But before going any farther, what exactly is steady-state growth? If we are to decide whether such a crucial assumption is indeed realistic or not, we first need to get a handle on what it is, since reading through the literature which surrounds the topic, you might be forgiven for saying that it wasn't exactly clear. In order to help us ease us into the problem, one useful place to start might be start with an examination some of what Nicolas Kaldor would have termed the "stylised facts" of the situation.

As is well known, on any generally accepted measure the process of wealth creation in the developed world has been a massive and extensive one over the last couple of centuries. According to most estimates GDP per capita in the United states is at least ten times higher today than it was 125 years ago, and if we allow for a growth mismeasurement (underestimate) of only one percentage point per year, the factor in question could easily be more than thirtyfold (Brad DeLong, 1998, see reference at foot of this post). Equally remarkable is the relatively brief time span (when compared with the entirety of human history) during which this rapid growth has occurred. Since we normally assume humans to have been distinguishable from other primates for at least a million years, it is possibly surprising to find that it was not until the agricultural revolution - some 10,000 or so years ago - that the long march to the modern era really beagan, and even more to the point, that it has only been during the last two hundred years or so that we have been able to find that steady and continuous increase in economic growth which so characterises our era and which we so tend to take for granted.

In fact the average GDP per capita growth rate in the United States has been estimated at something in the region of 1.8 percent per year since the start of the 19th century. However such growth has been far from uniform, and it normally used to be thought that (aside from some special periods like the 1930's, or the Solow "computers everywhere except in the productivity numbers" 1970s and 1980s) as the years have passed there has been a general acceleration in growth capacity. Perhaps the most recent, and most famous, exposition of this view is to be found in the 1990's sustainable growth acceleration postulated by Sir Alan Greenspan, and perhaps the most noteworthy questioning of this view has come from Paul Krugman who asks the not entirely unreasonable question about, if what we have had in the United States since the late 1990s has been a "twin" internet and construction bubble, how much of that "accelerated" growth was real, and how much was simply the product of unsustainably bringing forward consumption (Krugman, 2008). Evidently this is an empirical question for later growth accounting researchers, but we might like to note in passing that the present crisis does at least leave open the possibility that the "growth acceleration" which has followed the Solow slowdown may not be quite the acceleration we used to think it was.

However, even allowing for the volatile periods, and the exaggerations, there is considerable evidence to support the existence of some sort of ongoing long term acceleration in US growth, at least during large parts of the twentieth century. Using data taken from Angus Maddison (1995), Charles Jones (2002) estimated that the growth rate of the US economy between 1950 to 1994 was an annual 1.95 percent, which was slightly higher than the rate he derived for 1870 to 1929, which was 1.75 percent. Even these these highly aggregated numbers conceal a considerable degree of variance, since the growth rate registered in the 1950’s and 1960’s - 2.20 percent - was considerably higher than that found during the Solow productivity slowdown of the 1970s and 80s, which was a "mere" 1.74 percent.

Be all this as it may, the existence of such aparent stability in U.S. growth rates over such a long period of time has given considerable support to the "common sense" and conventionally view accepted view that the U.S. economy is, and has been, running at close to what is considered to be some sort of long-run steady-state (or balanced growth) path, as can be seen in the charts below. GDP growth is of course always volatile, but when you strip out some of the volatility the smoothness of the US path really is quite remarkable, making it hardly surprising that many US economists have found the idea of steady state growth a fairly plausible one.

This traditional view of the modern growth phenomenon is often supported by reference to a number of what have come to be termed growth "constants" - one of which would be the absence of trend movement in the U.S. capital-output ratio - constants which were emphasized most notably by Nicholas Kaldor (1961), who proposed a series of stylized facts about economic growth which have, over the years, been fairly influential in casting the debate. Kaldor's " facts" went as follows:

1. Per capita output grows over time, and its growth rate does not tend to diminish.
2. Physical capital per worker grows over time.
3. The rate of return to capital is nearly constant.
4. The ratio of physical capital to output is nearly constant.
5. The shares of labor and physical capital in national income are nearly constant.
6. The growth rate of output per worker differs substantially across countries.

Now it is not my intention here to examine each of the above "facts"in turn, but rather address a much more specific question, one which essentially focuses on the first presumed constant on the list. What I wish to examine is whether it is indeed the case that per capita output grows continuously over time, and further, that its growth rate does not tend to diminish.

To be more explicit, I do not wish in any way to question the view that US economic growth has been not only constant, and even possibly accelerating slightly, rather what I would like to do is ask whether this characteristic is shared by all (or even a majority of) the advanced economies, and if it is not, to move on to ask why it may be that this seeming property of US growth is not a shared one, and indeed what the implication is for a theory whuch takes the existence of such a state as one of its critical assumptions.

In order to carry out this rather straightforward exercise I would like to return to the founding father of modern neoclassical growth theory (Solow) and ask one very simple question: is Solow's "critical" steady state growth assumption "realistic", or put another way, does it appear as realistic today (given what we now know) as it did at the time he made it. And if it isn't, I would like to ask what the implications of coming to realise this are for how we think about modern growth.

The core of the problem here lies in the decision Solow took in setting up his model to consider both rates of saving and population growth as exogenous variables (ones which are determined outside his model). The rate of growth of any economy in the longer run is simply determined by the rates of growth of the labour and capital inputs which are themselves assumed to grow at a constant rate. And once that steady state growth rate is achieved any external perturbation which sends the economy off its growth path will only have a temporary (or transitional) impact before the homeostatic mechanisms which are assumed to be at work send the economy back on course. In more conventional language, once the equilibrium growth rate is achieved, it should be stable, since regardless the initial value of the capital-labor ratio, the system will develop toward a state of balanced growth at the steady state rate. The system can adjust to any given rate of growth of the labor force, and eventually approach a state of steady proportional expansion.

At one point in his paper Solow does examine whether the model could be applied to a case where population movement was endogenous rather than exogenous. His conclusion was that it could, but the explanation he offers is indeed interesting.

Instead of treating the relative rate of population increase as a constant, we can more classically make it an endogenous variable of the system. Suppose, for example, that for very low levels of income per head or the real wage population tends to decrease; for higher levels of income it begins to increase; and that for still higher levels of income the rate of population growth levels off and starts to decline.

What Solow postulates here is a kind of U shaped function, part of which roughly corresponds to what we could call the "Malthusian era" when population levels fluctuated as real wages (or income per head fluctuated), and part of which offers a first approximation to the modern growth era, in the sense that fertility (and hence population levels) tends to decline as income rises. But between these two fertility "regimes" there would seem to be a clear break, since what has not been observed (anywhere) is that as incomes fall back subsequent to the transition from one regime to another then fertility rises. Normally we find (in post Malthusian population environments) that as living standards fall, even in the longer run fertility also itself tends to fall. Eastern Europe following the end of communism would be one clear example of this.

The point here, however, is not to enter into any kind of extended discussion of the factors which influence fertility (and thus population movements), but rather to point out that they do not seem to follow the kind of straightforward function which Solow imagined, and that this difficulty will confront any kind of growth model (whether population is exogenous or endogenous) which postulates the idea of steady state growth, since the kind of homeostatic corrective mechanisms (which would lead an economy back to some kind of equilibrium growth rate) to not appear to be in operation.

Returning however to the substantive issue, what I would like to ask is whether in fact the assumptions of exogenous savings and population growth, and constant steady state growth are as plausible as they seemed to Solow? What if both population growth and saving rates were both more plausibly to be considered as endogenous variables (ones which are influenced by the working of the process itself), what would this do to the foundations of neo-classical growth theory? And indeed if movements in population size and age structure are found to exert a significant and non-stochastic influence on key growth variables (that is are found not to be mere random shocks) then what really is the current serviceability of a model that assumed them to be so? This is a question we should at least be prepared to ask ourselves, and in particular we need to ask it since most our contemporary forecasting models (and indeed even the core of real business cycle theory on which many of them are based) are constructed on at least some sort of loose assumption that neoclassical growth theory is itself a well-grounded and solid edifice.

Of course, and touching for a moment some of my conclusions before I even present them, there could be a number of reasons why Kaldor's first "fact" may not be a fact, and one of these, evidently, could be that the modern growth epoch is just that, modern (rather than post-modern) and an epoch. That is, the period Kaldor was referring to may be a historically bounded one, with a begining and an end, and Kaldor's facts may fit the empirical reality which typified that particular period (when per capita output grew at a constant of even increasing rate), but not the period which it now seems might be the posterior one, the post modern-growth era, when per capita output grows at a declining (and even possibly negative) rate. If this were to be the case it would, of course, fit quite well with the pessimistic mindset of many pre-Solow growth theorists, who although they held assumptions which were in many ways similar to Solow, felt that a process of diminishing returns would eventually grind down output growth (see, for example, Jones, 2001).

What both Solow and his immediate predecessors (Harrod, Domar etc) had in common was the assumption of stable and growing populations, with more or less constant age structures (the demographic transition in age structures being thought to have belonged to the pre modern-growth period), and what we now know (that they didn't) is that such assumptions are unrealistic as we move forward across a century where populations will start to age and decline in one country after another, with radical implications not just for labour force size, but also for age structure and the shape of the population pyramid.

So to put all this another way, what I seek to do here is ask one very simple question, and this is whether there are still sufficiently good empirical reasons for continuing to believe that there is such a thing as a long term steady state trend growth rate for economies whose population size and structure is changing rapidly and constantly. This state of affairs is already a current reality for a number of limit societies (Japan, Germany and Italy would be the obvious "stylised" examples, but many East European countries are already hazardously near the point of entering the group) while for most other advanced economies it still remains only a theoretical possibility, although it is one which, given the demographic data and forecasts we have to hand, we can hardly afford to ignore. So instead of making the kind of assumptions about population change and economic growth which form the basis of the Solow neo classical theory, is it more "reasonable" to assume that growth rates tend to fluctuate over time following a more or less orderly pattern of rise and decline, and - putting the issue even more stridently - should we not be asking ourselves whether it may it not in fact be the case that growth rates fluctuate as the age structure of a population steadily moves across the whole sweep of the demographic transition - from a state of ultra-high to one of ultra-low fertility. Or, if you prefer, could all of this simply be a non-linear process in the classic and most straightforward sense of the term?

Steady State Growth?

In attempting to assess the validity of the "crucial assumptions" which underlie neo-classical growth theory we would do well to keep Kaldor's stylised facts in the forefront of our minds, and in particular ask ourselves how it could possibly be that - in those societies where fertility has now fallen to well below replacement level and labour forces look set to decline and decline - the shares of labour and capital in gross national output could be expected to remain more or less constant. After all, doesn't standard theory tell us that as labour supply comes under greater pressure, wages should rise and technical change should occur? But - and I offer this as simply a throw-away point a this juncture - in the most affected economies like Japan and Germany this does not seem to be what has been happening, since due to recent labour market reforms labour force growth has resumed (after stagnating or falling back) as more and more people in the older age groups have either been reabsorbed or have continued to work, but the value added by the additional work performed does seem to have tended to decline. Put another way, even as employment levels have risen and labour markets tightened in these two countries, the level of real wages has not budged, and on some readings may even have fallen.

Balanced Growth Or Transitional Dynamics?

As Charles Jones points out something funny is evidently going on here, since even in the best case scenario socities growth rates have not performed as Kaldor would have lead us to expect. Even in the case of the US economy some of the core processes we have been observing for some 50 years or more now seem to contradict what we would expect to happen on the conventional account.

For example, time spent accumulating skills through formal education - which we could think of as some form or other of human-capital investment - has increased substantially over the last half century. In 1940, less than 25 percent of adults in the United States had completed high school, while only about 5 percent had completed four or more years of college education. By 1993, more than 80 percent had completed high school, and more than 20 percent had completed at least four years of college.

In the second place, the search for new ideas has intensified, and as a result an increasing fraction of the United States workforce - and indeed of workforces throughout the OECD - is now composed of scientists and engineers engaged in research and development. In 1950 the fraction of the US labour force engaged in such work was in the region of 0.25 percent. By 1993, this fraction had increased threefold to more than 0.75 percent.

Now the point here is, as Jones is only too willing to point out, on the assumptions of virtually any of the standard growth models, both these changes should lead to long-run increases in rates of per capita GDP growth, yet (despite the "acceleration" debate) such anticipated increases have not been observed.

Under standard neoclassical models, changes like the ones Jones mentions should generate what are known transition dynamics in the short run and “level effects” in the long run. Put simply the growth rate of an economy should rise temporarily (during the transition, the "transition" effects) and then return to its original (steady state) value, while the income level of the population should remain permanently higher as a result (the "level effect"). On the other hand, under assumptions which are typical of endogenous (new) growth models, such changes should lead to permanent increases in the growth rate itself. However, as we have noted above, the growth rate of U.S. per capita GDP has been surprisingly stable over the last 125 years with the level of per capita GDP being reasonably well represented by a simple time trend. So what is going on here?

One distinction which may help get address the problem is the one Jones himself makes between a constant and a balanced growth path. Along both such paths, growth rates remain constant over an extended period of time, but in the former case constant growth is simply the (coincidental) by-product of a process which is effectively driven by series of transition dynamics while in the latter what is involved is stable and self correcting since what we have is a steady state.

A balanced growth path is normally defined as a situation in which all variables grow at constant geometric rates (possibly zero). (Jones, 2002 )

Now one possibility (discussed by Jones) is that the apparent steady state growth exhibited by the US economy over so many decades has been associated with a very complex set of transitional dynamics, dynamics which "just happen" to have produced this particular outcome. But if this were the case then one very natural question arises. If a large part of U.S. growth in recent years has been associated with transition dynamics, then why do we not see the traditional signature of a transition path, e.g., a gradual decline in growth rates to their steady-state level? Why is it that U.S. growth rates over the last century or more appear to be so stable?

So we might like to consider one further possibility at this point. Could it be that the "as a matter of empirical fact" transition dynamics associated with the various factors of production in the United States have worked in some strange way to precisely offset one another, and in so doing leave the growth rate of output per worker fairly constant? We will return to this issue below, but since it is an explanation which may not be so easy to discount as many may imagine it to be at first glance, we now need to make a short detour and - in order to examine one of the factors which may be involved - take a more general look at some empirical data concerning the interaction between population dynamics and economic growth.

Demographic Components in Growth

Now obviously national economies differ from one another in a large number of ways, but one of these is the population structure and its underlying dynamic. One reasonably concrete starting point for addressing the issue of population age structure and whether it has an impact on economic performance could be via a comparison of GDP growth rates and population change in a number of the countries most immediately affected by ageing population dynamics. It is interesting to examine the dynamics of more "elderly" societies (in terms of population median ages) since the growth process in "younger" ones (ie those in earlier stages of their demographic transition) have been reasonably well studied under the rubric of what has come to be known as the "demographic dividend" (Bloom et al, 2003).

Simply put the demographic dividend idea suggests that as birth rates decline from previous high levels of fertility, and the age structure of a population changes so that a higher proportion are to be found in the working ages, economies experience a "growth spurt", or a period of what is often termed catch-up growth. This pattern, under the neo-classical view would constitute some form or other of transition dynamic. So the presence of a transition is not in doubt, what is really in question is whether the process settles down in to some form of ultimate steady state.

Now, as we have already noted, it is a key postulate of neo-classical growth theory that each economy has its own long run steady state growth rate. One of the consequences of making this sort of initial assumption (albeit as a purely hypothetical and theoretical one) is not in fact that hard to see, since the steady state assumption would seem to imply that as the demographic transition which produced those earlier "transitional dynamics" is left steadily behind (the demographic transition remember is associated with large fluctuations in levels and growth rates of population) then a steady growth rate in the labour force (achieved in part via institutional efficiencies in the labour market) and a supply of savings regulated by effective monetary and interest rate policy, should mean that any given economy would have its own given balanced growth rate, irrespective of key population variables like fertility rates and life expectancy.

This neo-classical long run steady state growth rate needs, of course, to be understood as a theoretical postulate, a sort of ideal limit case, but nevertheless the concept continues to orient and inform a good deal of conventional economic thinking about economic growth. It also informs the way most people conceptualise and approach the present global economic crisis, since underlying one rescue and stimulus package after another is the idea that there is a long term trend growth rate out there somewhere, just waiting to be "recovered".

So the idea of "trend growth" far deeper roots than are normally taken into account in the simple Solow-derived offshoots of neo-classical theory, and indeed seems to form part of some kind of collective "ideal type" folk wisdom which are deeply embedded in the mindset when it comes to thinking about business cycles and growth prospects (in some form or another such assumptions normally enter the thinking of the Real Business Cycle tradition, to name but one example) . Thus the growth rate which people normally anticipate will be "recovered" following a recession is normally derived from a model based on some version or other of a long run steady state (or constant equilibrium path). The question we are left with though is really, does the idea of convergence to steady state growth constitute one of those suppositions which are assumed - in Solow's words - to be nearly true, and what are the consequences for the theoretical edifice of modern macro economics if the idea turns out to be not quite as "nearly true" as was previously thought to be the case.

Linear Or Non-linear Growth Patterns?

The idea of steady state growth is also often closely associated with the idea of that changes in the long run rate of growth are largely determined exogenously to the economic system, and this idea is typically associated with the Solow model of economic growth, since here long-run economic growth is seen as being determined by such exogenous factors as technical change, aggregate saving rates, schooling rates, and the rate of growth of the labor force. Indeed this is the issue which largely attracted the attention of the new (or endogenous) growth theorists, since it seemed to run against certain basic economic intuitions that this should be the case, although, as Solow argued in his reply to some of the critics, things are by no means as simple as they seem in this context, and most of the newer generation of models have run into what seem to be insoluable difficulties due to certain key, "knife edge" assumptions they need to make (Solow, 1994).

It was in some sense with this kind of issue in mind that Mankiw, Romer and Weil wrote what has since become a highly influential paper - A Contribution To the Empirics of Economic Growth (see bibliography below) - since they clearly felt the need to try to put neo classical theory onto a somewhat more stable footing. In their paper the authors outline what they see as the core of the Solow thesis using following words:

This paper takes Robert Solow seriously. In his classic 1956 article Solow proposed that we begin the study of economic growth by assuming a standard neoclassical production function with decreasing returns to capital. Taking the rates of saving and population growth as exogenous, he showed that these two variables determine the steady-state level of income per capita. Because saving and population growth rates vary across countries, different countries reach different steady states. Solow's model gives simple testable predictions about how these variables influence the steady-state level of income. The higher the rate of saving, the richer the country. The higher the rate of population growth, the poorer the country.

The first thing to notice about the argument is that the Solow model clearly predicts two pretty straightforward and neatly linear relations: more population-less growth, and more saving-more growth. Now, we are immediately presented with an important difficulty here since, as we will see below, there is now a considerable and accumulating body of empirical evidence which seems to suggest that among "mature" developed economies, those who have the fastest rates of population growth are also those who experience the highest rates of per capita income growth (the United States is the most obvious example, but as we will see this is also the case of France and the United Kingdom), while in those countries where population momentum has slowed, even to the point where their populations may now decline (Italy, Japan, Germany, for example) do not seem able to achieve their former high rates of economic growth, and, even worse, seem to be losing ground in per capita income terms with those economies whose populations continue to grow reasonably rapidly. Now I do not seek here to explore this question in all its intricate detail, I simply wish to make one clear and central point, and that is that the relations involved between population growth and per capita income growth do not seem to be simple linear ones, and arguably it is this property which has thrown many previous researchers off track since in running growth correlations they have normally tended to treat them as if they were.

Indeed the whole idea that economies tend to converge towards some sort of balanced growth path is a highly questionable one which, with the notable exception (as I suggest above) of the US, seems to enjoy fairly limited empirical support over the longer term. Economic performance, it seems, tends to fluctuate, but the big question we have in front of us is: do such fluctuations conform to any kind of identifiable pattern?

Arguably they do. To start with one very simple example, let's take a look at the Japanese case. Below you will find a graph of Japanese economic growth from 1955 to the present prepared using statistics made available by the Japanese statistics office.

What is obvious from looking at this profile is that Japanese growth has been far from uniform over the last 50 years or so. And indeed far from converging to a steady state growth rate, Japans growth seems to have peaked in the 50s and 60s, and have been steadily reducing ever since. Arguably, after peaking, there may be a trend there, but this trend would seem to be towards ever lower annual rates of economic growth. And there is no evidence at this point to justify the supposition of a steady state rate - or hypothetical "homeostatic fulcrum" - around which Japanese growth would stabilise and fluctuate. As far as can be seen at present the process of decline is secular and ongoing. To be clear, the argument is not that Japanese GDP growth does not exhibit some sort of trend, arguably it does, the argument is that this trend does not conform to our current conception of a balanced growth path, and indeed is not homeostatic, in the sense that there is no self correcting mechanism, hence the trend may well be one of gradually declining (and eventually negative) growth with no end point in sight. Put like this the prospect is evidently rather alarming, but I can see no other reasonable and responsible way of putting it.

Nor is Japan a unique case, a reasonably similar pattern can be observed if we come to look at long term growth rates for the Italian economy.

Again, Italian growth seems to have peaked, and then entered decline. In Italy's case the peak seems to have been in the 1970s (but it may have been earlier, since I don't at this point have data for the pre 1970 period), and indeed since 1990 Italian GDP growth has only managed an average of something like 1.4% growth per annum, while as far as we can see at the present time, over the decade from 2001 to 2010 it may well turn out (depending on the depth and duration of the present recession) that Italian GDP may well have been nearly stationary.

Age Structure and Productivity

Curiously enough, in this neoclassical speculation on population the factor of age distribution was for a long time not studied, and it was never studied intensively as to its economic implications. It is remarkable, because this factor could to a large extent be taken care of in a stationary model of theory. When a certain trend of the population development is maintained for such a long period that a stable age distribution has been reached, the difference between a progressive, a stationary, and a regressive population -- apart from a different development of population numbers -- is that in the first more than in the second, and in the second more than in the third, the number of children is relatively large and the number of old people relatively small. A corresponding difference rules even within each major age group taken by itself. If we thus compare a regressive population with a stationary one, we find that in the first young children are relatively fewer than older ones and that the center of gravity is also higher in middle age as well as in old age.Now people in different ages are productive in different degrees, and -- within a given standard of living -- their consumptive demands, their cost of living, also differ. Here intensive empirical studies ought to set in...........to ascertain the average productivity and the cost of living in different age groups.
Gunnar Myrdal, Godkin Lectures, Lecture Six, 1939.

So why exactly is it that national growth rates rise to a peak, and then seemingly steadily peter-out again. Well the explanation - while it may prove to be a little disagreeable - should not actually be so surprising if we start to think about economic theory a little. In fact I am far from being the first researcher to have raised this issue, since as early as the 1930s the Swedish Economics Nobel Gunnar Myrdal was raising what are essentially similar issues, and was struggling, just as I am now, to make sense of the neo-classical growth assumptions in just the same way as I am now. What Myrdal argued so cogently (see quote above), in a series of lectures which have unfortunately been long neglected, was that existing neo-classical theory appears to be severely limited when it comes to its capacity either to explain the ongoing changes in age structure which have now become so evident, or to incorporate the impact of such changes into its general theoretical structure.

Essentially, on whichever type of growth model you use, the key to the problem of long term movements in levels of GDP per capita is no great mystery, it is a function of two parameters: a)the proportions of the total population who are working, and; b) the kinds of activities they are engaged in. If we look, for example, at the early section of the above graphs showing GDP for Japan and Italy it is not hard to see that these economies exhibited very high growth rates during their "take off" point (a phenomenon which we can also find today in emerging economies like China and India ). Such "strong" growth rates are basically the result of two factors, a rapid increase in the proportion of the total population who become involved in economically productive activity, and the process of technological 'catching up' which takes place as these economies move ever closer to the "state of the art" technological frontier and thus engage in activities with ever higher components of value added. Since emerging economies start at some considerable distance from this frontier then evidently the growth rates they achieve can be extremely rapid as they close the gap, and this would almost certainly be one form of what is known as "conditional convergence", as techological levels and institutional structures become more uniform.

But there is another dimension to growth, and in this sense societies almost certainly do not converge (except possibly over the very, very long term, where we might postulate that all societies could converge to a similar - and very high - median age, although even this theoretical idea would need to be treated with some caution, since so many features of this situation may ultimately turn out to be "path dependent"). This second dimesion revolves around age structure related productivity and consumption patterns.

The thinking behind the idea I am presenting here would run as follows. In a first moment, emerging economies take off due to a rapid process of input accumulation (Krugman, Asian Tigers), and the resulting growth is simply a result of "more" rather than of "more productivity", as ever higher proportions of the population are economically active in support of total output. I take it as self evident that under such circumstances growth in output per capita has a natural tendency to rise. However, with the passage of time, this intial "input accumulation" driven growth wave starts to slow. Fortunately, under "normal" circumstances this loss of momentum is largely offset as emerging economies move up the value chain (sectoral shifts). These sectoral shifts are also accompanied by a steady upward movement through the median age brackets as the impact of lower fertility and higher life expectancy makes its presence felt. Not only do these movements produce more workers, they also produce more experienced and better educated ones - as the impact of learning by doing and increased investments in education come to be noted.

Also we see a rising proportion of what have come to be known as 'prime age workers' active in the economy. The exact definition of who exactly such prime age workers are may be something of a moveable feast, and in any event the variable needs to be empirically determined for any given society at any moment in time. Essentially prime age workers are those whose productive activity is at its lifetime maximum. Evidently the higher proportion of such workers who are present in any given economy the higher the aggregate output of that society is likely to be, and in this sense there must be a maximum point here. But the essential idea being advanced here is that this maximum is not attained and then sustained, but rather reaches a peak, before the proportion subsequently starts to decline. This phenomenon should be one of the principal reasons why we might consider the idea of "steady state growth" to be, prima facie, a rather implausible one.

The prime age wage/productivity effect can be seen in the chart below which shows how the age related earnings structure has altered in Japan over the years between 1970 and 1997 (the chart was prepared by Wolfgang Lutz, see Lutz et al 2005).

Now one very significant and revealing detail to be noted above, is the fact that while the shape of the hump has changed slightly over the years there has been little noticeable drift to the right, which is what we would expect to see were the extension of life expectancy to be associated with an upward movement in peak performance ages. The absence of such drift should alert us to the possible existence of an age-related productivity problem in high population median age societies and again constitutes some sort of prima facie evidence that there is at least a phenomenon here worthy of investigation, even for those working in the ethereal world of neo-classical tradition where there is no good reason why long term growth rates should be subject to such fluctuations.

Of course, I making here the generally accepted assumption that wage levels bear some statistically significant relation to productive output levels (ie wages can serve us here as a proxy for something, if they can't, and in the longer run, then it would be hard to see why we are talking about neo-classical economics at all). What can be easily seen from the chart is that Japanese wages generally peak somewhere in the 50-54 age range, even though many workers in Japan currently continue to work to 75, while multilateral organisations like the OECD and the World Bank (see "From Red To Grey", for example) continue to rather simplistically offer higher participation rates in the over 55 age groups (and extended working lives generally) as a sufficient condition to offset the inevitable decline in numbers in the traditional working age groups. Far from wishing to claim that such a policy will not help, I merely wish to draw attention to the possibility that things may be more complex than many assume, and also to highlight the theoretical implications of this undoubted empirical reality.

A good deal of the argumentation in this essay is based on the experience of only three countries: Germany, Japan and Italy. This is not simply a coincidence, or a question of random selection, since these three are the highest median age societies on the planet at the present time. In this sense, if we wish to advance conjectures about what the impact of population ageing may be on growth the three of them do offer us a somewhat special opportunity. As we have seen, in both the cases of Japan and Italy, growth has tended to rise to a peak and then steadily decline as the population has aged. Japan has, through very strong export competitiveness maintained some degree of positive economic resilience up to this point - although the 2009 economic collapse has to raise serious issues about the longer term sustainability of such a high level of export dependence. The same cannot be said of Italy, which due to its much weaker competitiveness profile cannot expect the export vibrance that a Japan (or a Germany) can attain.

Turning now to the German case, what we find is that whilst it is significantly better than the Italian one, the growth characteristics are not fundamentally different. According to the Federal Statistics Office:

Measured in terms of gross domestic product changes at 1995 prices, the rates of economic growth in the former territory of the Federal Republic of Germany and - since 1991 - in Germany have continuously declined since 1970. While the average annual change was 2.8% between 1970 and 1980, it amounted to 2.6% between 1980 and 1991 and to 1.5% between 1991 and 2001.

Since 2001 the performance of the German economy has in fact been worse rather than better, much to the consternation of those who hoped that many years of sacrifice in the form of wage deflation and structural reform would lead to a rebirth of the country's former economic prowess. In reality the German economy shrank (0.2%) in 2003, and grew by only around 1% in both 2004 and 2005. And while the German economy picked up notably in 2006 and 2007 (with growth rates of 3.2% and 2.6% respectively) and many talking in terms of such grandiose notions as global uncoupling and "Goldilocks" type sustainable recoveries, the most striking feature of the recent German dynamic has been the way that internal demand failed to respond to the externally driven export stimulus. Of course, all the speculation came to an abrupt end in 2008 when the German economy once more entered recession as world trade expansion slowed and exports collapsed (with GDP only growing by 1% over the year), while 2009 looks set to be a lot worse (with the IMF currently forecasting a contraction somewhere in the region of 5%, and forecasts of up to minus 7% not seeming exaggerated).

So some part of the traditional mechanism of economic transmission seems to have been broken, a phenomenon which has lead Claus Vistesen (using rather traditional Keynesian terminology) to talk about "engine failure" rather than mere magneto problems (Vistesen, 2009). Long term GDP growth rates in the German economy are clearly falling, and the decline looks clearly set to continue.

Population Growth and Economic Growth

But let us return now to our central concern here, which is Solow's critical expectation that as population growth rates decline economic growth rates should increase. And in order to do this let us look at some more charts. This time the charts are based on data prepared by Eurostat, and show the volume index of GDP per capita as expressed in Purchasing Power Standards (PPS) (with the European Union - EU-27 - average set at 100). A reading on the index of a country over 100 implies that the country's level of GDP per head is higher than the EU average and vice versa, and relative movements in the indexes imply that the rates of change in GDP per capita are either improving more or less rapidly than the EU average. The basic data behind the charts is expressed in PPS which effectively become a common currency eliminating differences in price levels between countries making possible meaningful volume comparisons of relative GDP per capita. Since the index is calculated using PPS figures and expressed with respect to EU27 = 100, it is only valid for cross-country comparison purposes and not for individual country inter-temporal comparisons, nonetheless these charts are extraordinarily revealing.

As can be seen in the above chart for the period 1995 to 2006, comparative US PPS per capita GDP, after correcting somewhat post 2000, as the value of the dollar fell vis-a-vis the euro and the pound sterling, maintained a reasonably steady path, while UK comparative per capita GDP rose, and the French dropped (in both cases comparatively slightly). When we come to look at Italy, Germany and Japan, a very different profile is evident.

All three have steadily been losing ground vis a vis the EU 27 average benchmark. Now evidently the classification process I have used here is far from being an arbitrary one. The first chart shows a relatively high-population-growth (near replacement fertility) group of countries, while the second shows a low-to-declining-population growth (lowest-low fertility) group. In each case the economies in question are developed ones, and, as it happens, all are members of the G7. As we can see, in PER CAPITA income growth terms all three of the former hold their comparative position much better than all (or any) of the latter three.

When we come to look at population growth (see the three comparative charts below, which are only classified for visual convenience according to population size), we find that in all three members of the former group of countries (the US, the UK and France) population is rising, and sharply so, while in the latter group (Germany, Japan and Italy) population levels are virtually stationary (with the slight uptick in Italian population in the 2004 - 2006 period being entirely due to the rapid regularisation of a large irregular migrant population). Prime facie then, all of this is in conflict with what Solow would have expected, but then Solow never started to think about movements in age structure, and rising median population ages, which is hardly surprising since he was thinking about the problem as he saw it over half a century ago.

The reason why we should be seeing this difference is not that hard to get at, given all that has been said above, since the UK, France and the US are all ageing much less rapidly than Germany, Japan and Italy. This comparative measure is interesting, I would argue, since while - for the sort of catch-up growth reasons I touched on earlier - it is hardly surprising that developed economies should lose their relative standing vis-a-vis some key emerging ones (conditional convergence), it should raise more than the occassional eyebrow to find that one group of countries among the more established economies should be losing impetus in comparison with another group, and all the more so if we are prepared to entertain the possibility that this difference is reasonably correlated with both population growth and rates of ageing in a way which seems to go right to the heart of some of the most basic predictions of traditional (consensus) neo classical growth theory.

Conclusion - What I Hope (And What I Cannot Hope) To Have Achieved Here

Basically, simple visual inspection of some basic charts hardly counts as strong evidence for anything, especially when we are talking about accepting or rejecting some of the most highly prized (and most generally common sense accepted) core components of our modern economic edifice. But as has so often been found to be the case in the history of scientific thinking, common sense expectation and securely grounded scientific reality are surely not necessarily co-extensive, and when a few easily produced charts can apparently throw so much sand into the highly tuned and greased works of mainstream growth theory, then there should at least be cause for thought, reflection and further research.

On a first pass interpretation I think I would wish to claim to have made some sort of case that population median age does seem to matter, and, even worse for the predictions of standard neo-classical theory, rising population is not necessarily a negative factor for economic growth. As already mentioned, at the present time Germany, Japan and Italy leading the global rising median age charge, but many more countries are soon destined to move up along the trail they are blazing. By median age the next in line are basically Finland (41), Slovenia (41), Sweden (41), Austria (41), Belgium (41), Bulgaria (41) Greece (41), Croatia (41) and Switzerland (40). And the presence of names like Slovenia, Bulgaria and Croatia should really be ringing alarm bells here, since these three belong to a group of countries who have been marked by a very special political and social history, and as such have experienced a very special economic and demographic transition, one which means, if the kind of rising-median-age loss-of-economic-thrust case presented here has any validity, then we may be facing a the first batch of what may becoming a growing band of countries who share the common feature that they grow old before they grow rich.

Now, and going back to where we started, Mankiw, Romer, and Weil (MRW, 1992) carried out an empirical evaluation of a textbook Solow growth model using a multicountry data set for the years 1960-1985 and found support for the Solow model's predictions that, in the long-run steady state, the level of real output per worker by country should be positively correlated with the saving rate and negatively correlated with the rate of labor-force growth. Interestingly Bernanke and Gurkaynak (in their examination of their work) suggest that MRW's basic estimation framework is broadly consistent with almost any growth model that admits a balanced growth path, and adds that this category includes virtually all extant growth models in the literature. In which case, one could argue argue that MRW do not only address the Solow model, in the sense of distinguishing it from possible alternative models of economic growth, but addresses the whole corpus of growth literature, since it almost without exception assumes the potential property of a balanced growth path.

As Bernanke and Gurkaynak say, there are two and only two possibilities here: either the long-run growth rate is the same for all countries (that is, g(i) = g for all i), as maintained (following Solow) by MRW, or it isn't. Even more to the point, "explaining" growth by assuming that growth rates differ exogenously (or for factors which lie outside the model) across countries is not particularly helpful, especially since such changes in the growth rate seem to be systematic and not incidental. Once it is allowed that long-run growth rates not only differ across countries, but that growth processes in individual countries often do not exhibit properties which are normally associated with a balanced growth path ( that all variables do not grow at constant geometric rates, for example) then we are naturally pushed to consider explanations for these differences, and towards a fresh approach in our models. Making evident the need for this consideration is all I can reasonably hope to have achieved in this short essay. As someone once said, at least knowing what it is you don't know is one step beyond knowing nothing.

Bibliography

Bernanke Ben S. and Refet S. Gurkaynak, "Is Growth Exogenous? Taking Mankiw, Romer, and Weil Seriously," NBER Macroeconomics Annual, Vol. 16. (2001), pp. 11-57.

Bloom, David, David Canning and Jaypee Sevilla, "The Demographic Dividend, A New Perspective on the Economic Consequences of Population Change", Rand, 2003.

DeLong, J. Bradford, “Estimating World GDP, One Million B.C. - Present,” December 1998. U.C. Berkeley mimeo.

Jones, Charles I, "Was an Industrial Revolution Inevitable? Economic Growth Over the Very Long Run" Advances in Macroeconomics (2001) Volume 1, Number 2, Article 1.

Jones, Charles I, "Sources of U.S. Economic Growth in a World of Ideas", American Economic Review, March 2002, Vol. 92 (1), pp. 220-239

Kaldor, Nicholas, “Capital Accumulation and Economic Growth,” in F.A. Lutz and D.C. Hague, eds., The Theory of Capital, St. Martins Press, 1961.

Krugman, Paul, "The Return Of Depression Economics And The Crisis Of 2008", W. W. Norton, 2008.

Krugman, Paul, "The Myth Of Asia's Miracle", Foreign Affairs, November 1994

Lutz, Wolfgang, Vegard Skirbekk and Rosa Maria Testa, "The Low fertility trap hypothesis", presentation at the Postponement of Childbearing in Europe Conference, held at the Vienna Institute of Demography, December 2005.

Mankiw, N. Gregory, David Romer, and David N. Weil, “A Contribution to the Empirics of Economic Growth”, Quarterly Journal of Economics, 107, May 1992, 407-37.

Solow, R. M. (1956). A contribution to the theory of economic growth. Quarterly Journal of Economics 70(February):65-94.

Solow, Robert M. (1994). Perspectives on growth theory. Journal of Economic Perspectives, Winter 1994, 45-54.

Vistesen, Claus, Japan - Engine Failure? Japan Economy Watch Blog, March 2009.

World Bank, From Red to Gray - The "Third Transition" of Aging Populations in Eastern Europe and the Former Soviet Union, 2008.

Young, Alwyn, "The Tyranny of Numbers: Confronting the Statistical Realities of the East Asian Growth Experience," Quarterly Journal of Economics, 110, August 1995, 641-80.

Appendix: Some Extracts From Solow's Original Paper

One way to close the system would be to add a demand-for-labor equation: marginal physical productivity of labor equals real wage rate; and a supply-of-labor equation. The latter could take the general form of making labor supply a function of the real wage, or more classically of putting the real wage equal to a conventional subsistence level. In any case there would be three equations in the three unknowns K, L, real wage. Instead we proceed more in the spirit of the Harrod model. As a result of exogenous population growth the labor force increases at a constant relative rate n. In the absence of technological change n is Harrod's natural rate of growth. (Solow, 1956).
Once we know the time path of capital stock and that of the labor force, we can compute from the production function the corresponding time path of real output.
If the capital-labor ratio r* should ever be established, it will be maintained, and capital and labor will grow thenceforward in proportion.......Thus the equilibrium value r* is stable. Whatever the initial value of the capital-labor ratio, the system will develop toward a state of balanced growth at the natural rate.
If the initial capital stock is below the equilibrium ratio, capital and output will grow at a faster pace than the labor force until the equilibrium ratio is approached. If the initial ratio is above the equilibrium value, capital and output will grow more slowly than the labor force. The growth of output is always intermediate between those of labor and capital.
The basic conclusion of this analysis is that, when production takes place under the usual neoclassical conditions of variable proportions and constant returns to scale, no simple opposition between natural and warranted rates of growth is possible. There may not be -in fact in the case of the Cobb-Douglas function there never can be -any knife-edge. The system can adjust to any given rate of growth of the labor force, and eventually approach a state of steady proportional expansion.
In general one would want to make the supply of labor a function of the real wage rate and time (since the labor force is growing). We have made the special assumption that L = Lo, i.e., that the labor-supply curve is completely inelastic with respect to the real wage and shifts to the right with the size of the labor force. We could generalize this somewhat by assuming that whatever the size of the labor force the proportion offered depends on the real wage.
Up to now, whatever else has been happening in the model there has always been growth of both labor force and capital stock. The growth of the labor force was exogenously given, while growth in the capital stock was inevitable because the savings ratio was taken as an absolute constant. As long as real inc.ome was positive, positive net capital formation must result. This rules out the possibility of a Ricardo-Mill stationary state, and suggests the experiment of letting the rate of saving depend on the yield of capital. If savings can fall to zero when income is positive, it becomes possible for net investment to cease and for the capital stock, at least, to become stationary. There will still be growth of the labor force, however; it would take us too far afield to go wholly classical with a theory of popu1:ition growth and a fixed supply of land.

Instead of treating the relative rate of population increase as a constant, we can more classically make it an endogenous variable of the system. Suppose, for example, that for very low levels of income per head or the real wage population tends to decrease; for higher levels of income it begins to increase; and that for still higher levels of income the rate of population growth levels off and starts to decline.

David Takes On Goliath and Loses: The Ferguson - Krugman Exchange

2009-06-09T23:39:00.001-07:00

"As long as excessive debt is not digested, both monetary and fiscal policies are inefficient. There is not much of an alternative. Either to let the economy collapse, in order to reduce debts, and then use fiscal policy to revive it, or inundate the insolvent economy with public credit, to avoid the collapse, and loose the ability of fiscal policy to pull it out of a prolonged lethargy. Either a horrible end or an endless horror."
After the Crisis: Macro Imbalance, Credibility and Reserve-Currency: André Lara Resende

Well, I think the title to this post makes my view on the high-profile shenanigans we are currently witnessing on the part of two widely respected contemporary intellectuals clear enough, even if Paul would probably respond that he is perfectly well able to take care of himself, thank you very much. Nonetheless, looking at the way the tone of his most recent and most public debate with Niall Ferguson has deteriorated (yes, it is Niall I'm talking about here, and not Sir Bobby, although sometimes even I have my doubts), let me confess, I am not entirely convinced on this point (Niall Ferguson's argument can be found summarised in his Financial Times Op-Ed here, and in his rejoinder letter to Martin Wolf reproduced by the FT Alphaville's ever interesting Izabella Kaminska here, while Paul Krugman's "input" to the debate can be found here, here, and here).

So, since the thunder and lightening that such high profile exchanges generate tends to obscure more than it reveals, let me be so bold as to add my own 2 centimes worth - even if, apologies in advance, the whole affair ends up being most terribly "wonkish". If you want to save yourself a good deal of trouble, and heart searching, the central point is a simple one: are long term US interest rates rising because investors are worrying about having to buy so much public debt (as K would point out, what else were they thinking of doing with the money - which isn't really "money" at all, but, oh, never mind), or are they rising because investors expect the time path of US short term interest rates to move steadily upwards? It's as easy, or as hard, as that. So now, you decide!

Someone To Watch Over You

Amidst so much disagreement one point is, at least, agreed common ground: Paul Krugman is a macro economist, while Niall Ferguson is a historian, one who believes, if we are to take him at his word, that cats may sometimes look at kings, and live to tell the tale. Let's see if he's right.

The other point we are all agreed on, I think, is that yields on 10 year US treasuries have been rising of late, and this phenomenon lies at the heart of the debate. Indeed, if I read him aright, this is Niall's main point of current concern.

On Wednesday last week, yields on 10-year US Treasuries – generally seen as the benchmark for long-term interest rates – rose above 3.73 per cent. Once upon a time that would have been considered rather low. But the financial crisis has changed all that: at the end of last year, the yield on the 10-year fell to 2.06 per cent. In other words, long-term rates have risen by 167 basis points in the space of five months. In relative terms, that represents an 81 per cent jump.

Where we are not agreed - the economists and the historians among us that is - is over the significance to be placed on this evident fact. Although, having said this, Niall does rather seem to suggest that the development is some sort of litmus test for his view, since he argues it "settled a rather public argument between me and the Princeton economist Paul Krugman". Now what was it they used to say about rushing in where angels fear to tread!

Of course, Niall is no fool, he is an excellent historian, and I greatly enjoy reading his books, but he really, really should know better than to get himself involved in the kind of technical argument which his experience and background ill equips him for. Citing the Chinese central bank as authority for your monetary views (see below) may go down well with the after dinner port-and-stilton set, but it is hardly rigorous argument, and Niall must surely well know that.

It's The Expectation On Long Term Yield, Silly!

The Fed probably won’t make any adjustments to the size of the Treasury purchase program before its next policy meeting on June 23-24, in part to avoid reinforcing perceptions policy is reacting to swings in yields, according to Jim Bianco, president of Chicago-based Bianco Research LLC.

“The Fed wants to operate in predictable ways,” Bianco said. “They are also trying to not just look arbitrary, which makes people think ‘I can’t ever go to the bathroom because there could be a press release that the Fed changed the buybacks.’ That’s been a real concern: ‘Wow, I just went to the bathroom and lost $2 million dollars.’”

The thing you should always bear in mind when you enter the fray in areas where others have the benefit of the expertise is that there may be more than one available interpretation for the phenomena, and, as is so often the case in science, the counter intuitive explanation may have more going for it than the layman may grant at first sight (wasn't that the sun I just saw hurtling past across the sky). In this sense, the recent rise in long term US treasury interest rates has just provided some of us with a fascinating example of a phenomenon that those economists who have busied themselves studying the use of quantitative easing in Japan have been flagging for some time, and that is, that long term interest rates may indeed be unduly influenced by longer term inflation expectations, but not necessarily in the way laymen Niall and others may imagine they are.

Longer term inflation expectations - or so it is argued by a broad spectrum of monetary economists - may work against the fluid operating of a quantitative easing regime in or on the boundary of a liquidity trap, not because investors fear that a country like the United States is about to become the new Zimbabwe, but precisely because they know it won't. Indeed, as I frequently find myself saying of late, the United States is not Argentina, gee, it isn't even Italy, by which I mean that investors know perfectly well how Ben Bernanke and his colleagues over at the Federal Reserve will react to a situation where inflation is perceived as rising above their target range - they will start to raise short term interest rates, and it is this expectation of future increases in short term rates which ironically cause longer term interest rates to rise, in just the way they are doing right now, in what is almost a text book case study in the United States. As Krugman's former PhD student Gauti Eggertsson put it in one highly relevant paper (Eggertsson and Ostry: 2005, see references below).

A central bank following a Taylor rule raises interest rates in response to inflation above target and output above trend. Conversely, unless the zero bound is binding, the central bank reduces the interest rate if inflation is below target or output is below trend (an output gap). If the public expects the central bank to follow the Taylor rule, it anticipates an interest rate hike as soon as there are inflationary pressures in excess of the implicit inflation target. If the target is perceived to be price stability, this would imply that quantitative easing has no effect, because commitment to the Taylor rule would imply that any increase in the monetary base would be reversed as soon as deflationary pressures had subsided.

Indeed talking of the Taylor rule, none other than John Taylor himself recently came out and argued that -applying his rule - the Federal Reserve would need to start once more to raise interest rates in the near future, “My calculation implies we may not have much time before the Fed has to remove excess reserves and raise the rate,” he said recently at an Atlanta Fed conference. And if John can do the calculations so too can other investors.

Of course the United States Federal Reserve is not at this point following a Taylor-type rule (although Bernanke is a known supporter of some sort of inflation targeting) but let us not get bogged down in that minor, rather technical detail, the key issue is that long term interest rates are influenced more by the expected time path of short term rates than by any other single factor, and if, instead of beating about the bush, we go right to the heart of the matter, what do we find, well Lo & Behold, only last Friday:

The dollar advanced the most against the yen in more than three months and rose versus the euro as economic data showed evidence the U.S. recession is easing, boosting demand for the nation’s assets. The greenback climbed this week as a government report indicated slower deterioration of the labor market, supporting bets dollar-denominated assets will gain as the U.S. leads the global economy out of its slump.....

The dollar also gained against the yen on speculation the Federal Reserve will raise interest rates later this year, reducing the advantage of borrowing in the U.S. to fund purchases elsewhere. Traders added to bets the central bank will increase its target rate for overnight loans between banks by its November policy meeting, according to futures traded on the Chicago Board of Trade. The contracts show a 66 percent chance of a rate increase by then,compared with 24 percent odds a week ago.

Well, there you are, investors (I have no idea whether they are being rational or not) simply act as theory predicts, and chaffe at the bit (sometimes called "getting ahead of themselves") to take positions in anticipation of expected future hikes in US interest rates, something which sends rates rippling upwards all along the yield horizon. Incidentally, can someone kindly tell me where I have to write to become a formal member of the "Thank God For Bloomberg" brigade, since where would we really be without those dedicated scribes, who will, incidentally, obviously provide so much material for future generations of historians? (Incidentally, you can find a very good summary of just what a headache the volatility in US government bonds is proving to be for Bernanke in this Bloomberg article, from which the Bianco quote above was taken).

So, far from the position being as Niall imagines it is, with investors demanding enhanced premiums for holding US assets due to their fear of impending inflation, what we have here is a kind of see-saw process, whereby bad economic data, which leads investors to anticipate interest rates being held low in the US for some considerable time, raises risk sentiment (see this post: Don't Get Carried Away Now) and sends them off into riskier emerging market assets (with Big Ben playing sheet anchor) in the process sending the grenback to ever lower levels, while positive economic news makes playing carry with the USD as one of your currency pairs increasingly riskier, and thus leads the punters themselves to retreat, sending the dollar cruising back up again. All of which is very counterproductive, since given the knife edge character of the current US "recovery" all it does is slow things down (since the cheaper USD is good for exports) and ramp up the deflationary pressure.

But this story about investors being nervous about holding US Treasuries due to the high inflation risk, well, as far as I am concerned, go tell it to the marines, or at least to the those people over at the Chinese central bank (you know, the ones who have been running up all those dollar reserves) who Niall seems to regard as his economic authority in these matters.

"Monetary expansion in the US, where M2 is growing at an annual rate of 9 per cent, well above its post-1960 average, seems likely to lead to inflation if not this year, then next. In the words of the Chinese central bank’s latest quarterly report: “A policy mistake ... may bring inflation risks to the whole world.”"

What we have here, is what the late Niklas Luhman would have termed a "narrative discourse". Repeating the same arguments ad infinitum may produce a pleasing to sensation among those who have convinced themselves they are right, but that does not make them "true", nor is it a substitute for rigourous economic analysis, or a basic understanding of what is actually going on. As I say, it does go down well with the port and stilton set though, and would undoubtedly make one VI Ulyanov (aka Lenin) turn merrily over in his mausoleum, since evidently he was right: "every cook can and does govern".

But back to the basic thread, putting all this pressure on public officials at this point is a completely counterproductive exercise, since the surge in long term interest rates - produced by the rise in expectations that the central bank will move to reign-in inflationary pressures sooner rather than later, simply leads to further signs of weakness in the US economy, which means the expectation once more grows that rates will stay lower longer, and on and on we go. But of course, as Niall Ferguson points out, it is none other than Bernanke himself who has most recently and most evidently been expressing concern about the future size of the Federal deficit, and again this would seem to me to be a reflection of the political pressure that this mistaken narrative is exerting. Accodring to the Wall Street Journal:

The Fed must decide, perhaps as soon as its June 23-24 policy meeting, whether to increase its purchases of Treasury bonds. It is on course to buy $300 billion worth of bonds by September. If investors perceive the Fed's actions as an effort by the central bank to facilitate bigger deficits, they could conclude inflation is coming and flee Treasurys, pushing interest rates up. Mr. Bernanke's comments were aimed at thwarting that perception.

Counter intuitively, the only real way to break this spiral is for Bernanke to commit to holding rates near the zero bound for an extended period of time - or to "commit to being irresponsible" in the immortal words of Eggerston and Woodford. At this point I find myself asking if it isn't the whole suite of Princeton monetary economists - including Lars Svennson - that Niall doesn't like (but remember, Bernanke also came from Princeton, and is certainly no Keynesian, so the simple version of the discourse doesn't work) rather than his simply holding Krugman in bad rather odour, which I could have understood more as a dislike of his fairly well known political views than as a rejection of a far more technical corpus of economic analyses, which I am sure Niall would have to admit he has not enetered into sufficiently to be able to pass judgement on. Arguing against what has to be the strongest group of academic monetary economists on the planet (and leaning on the "savants" of the Bank of China for support) may appeal to basic anti-intellectual gut instincts, but there's the rub: Niall is himself an intellectual.

Personally, I have no idea whatsover as to the properties semi-conductors may exhibit at temperatures below absolute zero, but then I would not join issue with a theoretical physicist who mentioned preposterous sounding processes by starting off saying "well when I heat milk in a saucepan, eventually it boils" Still, if you are foolish enough to stick your neck in the noose, in the noose it will go!.

As Eggertsson points out in the Japan context long-term interest rates depend on expectations about future short-term interest rates and the risk premium, and neither of these depends on the quantity of long-term bonds in circulation or on the monetary base at zero interest rates (my emphasis thoughout), and this is a technical finding - which may ultimately be right or wrong, but I doubt that the opinion over at the Chinese central bank counts as evidence one way or another, nor does it seem reasonable to strongly assert as evidence of inflation risk that a growth in M2 of 9 per cent a year "seems likely to lead to inflation if not this year, then next", since this is just the theoretical issue economists are struggling with at the moment (to what extent an increase in base money feeds through to an increase in economic activity such that the "output gap" would start to shrink). Without a much more rigourous technical analysis, and some examination of recent history, you just can't make this sort of claim, but in any event if Niall has good reason for being so sure about this, then the people over at the Bank of Japan would almost certainly like to hear from him.

And then, getting horribly wonkish, we have the whole debate about the so called "portfolio channel", and how expectations for increases in short term interest rates can even undermine the efficacy of one of Bernanke's most beloved tools -government purchases of long term bonds to lower rates at the longer end of the yield curve in the short term (see Bernanke and Reinhart: 2002), since according to the findings of Eggertsson and Woodford (2003), and basing themselves on assumptions implicit to any general equilibrium model, purchases of long-term government bonds have no effect on long-term yields if expectations about future interest rates remain constant. While discussing the experience of quantiative easing as used by the Bank of Japan (BoJ), Eggertsson already foresaw the liklihood of the kind of evolution in long term bond rates which Niall feels provides such strong evidence in support of his case.

It has been suggested that the irrelevance results outlined above can fail due
to a portfolio channel (see, e.g., Meltzer, 1999; McCallum, 2000; and Coenen and
Wieland, 2003). If the monetary base is expanded by purchasing assets other than
short-term governments bonds, the BoJ may be able to change the prices of those
assets. One example is purchases of long-term government bonds, a policy the BoJ
has in fact adopted. Eggertsson and Woodford (2003), however, cast doubt on the
effectiveness of such a portfolio channel, arguing that in a general equilibrium
model, purchases of long-term government bonds have no effect on long-term
yields if expectations about future interest rates remain constant.

The reason is that the long-term interest rate depends on expectations of future
short-term interest rates and a risk premium. Neither of these, however, depends on the quantity of long-term bonds in circulation or on the monetary base at zero interest rates. Open market operations involving purchases of long-term bonds, but which provide no credible indication about the duration of the quantitative easing policy, are thus unlikely to be effective.

Of course, all of this is highly obscure and technical. Fortunately the debate does have its lighter moments, as for example when Niall cites Krugman as the point of reference for the savings glut idea:

"Did I not grasp that the key to the crisis was “a vast excess of desired savings over willing investment”? “We have a global savings glut,” explained Mr Krugman, “which is why there is, in fact, no upward pressure on interest rates."

In fact, as those of us who have been following the liquidity debate over the last years well know, the global savings glut thesis is famously an idea which was first initially advanced not by Krugman but by none other than Ben Bernanke, and even more to the point the whole issue goes back well before the onset of the present crisis. Indeed the "savings glut" issue lies at the heart of the whole "imbalances" debate, that is, it is one of the possible explanations for how we got here in the first place, and not some rabbit conveniently drawn out of a hat Paul Krugman to gain the advantage in the current debate about bonds. But if you do understand the role the savings glut thesis plays in explaining how we generated the imbalances which are now correcting, then you may see why there may not be any special problem in "placing" the large quantity of government bonds which will hit the marekt next year. But then, maybe I just hit on the core of the problem: perhaps Niall doesn't see that the US economy is correcting, and that the large current account deficit we have gotten so used to is about to become, what else, history!

The we have this:

"It is hardly surprising, then, that the bond market is quailing. For only on Planet Econ-101 (the standard macroeconomics course drummed into every US undergraduate) could such a tidal wave of debt issuance exert “no upward pressure on interest rates”."

Well I'm sorry Niall, but there is another place where a tidal wave of debt issuance has exerted “no upward pressure on interest rates”, and that place is planet Japan.

Even A Stopped Clock Is Right Twice a Day

Which takes me over to the rather historical issue of stopped clocks, and what has now been happening to Japan over the last decade and a half. At times even Daily Telegraph economics correspondent Ambrose Evans Pritchard has something interesting to say, since, of course, even stopped clocks are not wrong all the time. The point he makes here is very, very relevant:

"It is striking how many of those most alert to the deflation danger are either veterans of Japan's Lost Decade or close students of it: Albert Edwards at Société Générale, Russell Jones at RBC Capital, Nobel laureate Paul Krugman, the Fed's Ben Bernanke, and Athanasios Orphanides, who helped draft the Fed's study on the Japan trap. "People always thought Japan's bond yields had to rise, but they kept falling and Japan is still not really out of deflation," said Mr Edwards. Indeed, 20 years after the Nikkei peaked at over 39,000 it stands today at 9,280. Interest rates are 0.01pc. The yield on two-year state bonds is 0.34pc. Still there is not a whiff of inflation."

And guess what, Japan gross debt to GDP is about to push its way skywards through the 200% mark in the next year or two, which makes this retort to the FT's Martin Wolf (who had the temerity to question Niall's arguments):

Mr Wolf blithely writes: “Historically well-run economies are certainly able to support higher levels of public debt very comfortably.”His favourite macroeconomics textbook may make this claim. But the annals of history provide very few cases of economies with public debts in excess of 100 per cent of gross domestic product that were either well-run or very comfortable.

look frankly quite ridiculous, since while it may well be the case that Japan is neither well run nor a comfortable place to be (no comment, I have no opinion), it is still the world's second largest economy, so hardly an irrelevant comparison, and the Japanese government has been shoveling JGBs onto the market for years without the much predicted surge in interest rates (which doesn't mean that the US has to be the same as Japan, but it does mean that there is more to discuss here, and you can't have it so easy as Niall would like).

Well, the bottom line in all this surely is, what exactly are we being offered here, an empirically testable prediction, or just another load of old waffle?

At the end of the day what I think is, if I were a historian and not an economist, then I might like to be just a bit more modest in what I had to say (and even more modest in how I said it), be a bit more prepared to listen to those who have spent a lifetime studying these sort of problems, and then if, having done this, at the end of the day if I still found I wanted to differ from the experts I would at least try to make sure I understood what exactly it was they were trying to say first. Otherwise, I might find myself worrying that I was being more of a Xenophon than a Thucidydes, since while both were reputedly excellent generals, the latter stuck to what he was good at (namely writing history) while the former offered us (in his life of Socrates) the kind of philosophy which frankly reduced the both the author and his subject to the realm of port and stilton bufoonery. And, frankly, it would personally worry me to think that over two thousand years after the event people might still be remembering me more for what I was bad at than for any more positive contribution I might have made to the world.

Appendix

Extract From - Monetary policy with a zero interest rate, Lars E O Svensson, speech at SNS, Stockholm, February 17, 2009

Why not just increase the money supply in order to create expectations of a higher future price level? As long as the interest rate is zero then households and firms, as we have already seen, are indifferent about the choice between money and securities such as Treasury bills or bonds. An increased supply of money will then have no effect other than households and firms holding more money and fewer bills and bonds. However, at some time in the future the economy will return to normal, the interest rate will be positive and households and firms will no longer be indifferent when choosing between money and these securities. Somewhat simplified, we can say that the money supply will once again become approximately proportional to the price level. A larger money supply in the future will lead, all else being equal, to a higher price level in the future. If the central bank could thus credibly commit to a permanent and lasting increase in the money supply, the expected future price level would rise. The problem here is, however, that there is no way for the central bank to make a credible commitment to a larger money supply in the future. There is nothing to prevent the central bank from reneging on such a commitment and reducing the money supply in the future in order to reduce future inflation and keep it in line with the inflation target.

Experience from Japan's period of "quantitative easing" also shows that the extreme expansion of approximately 70 per cent of the monetary base between March 2001 and March 2006 did not noticeably affect expectations of inflation and the future price level.17 For example, the yen did not depreciate as it should otherwise have done. Firms and households clearly believed that the expansion of the monetary base was temporary and not permanent, which subsequently proved to be true. The monetary base fell back to normal levels when the interest rate was later raised to above zero.

Even if short-term interest rates are zero or close to zero, bond rates at longer maturities may still be positive. If the central bank therefore buys long-term bonds it may perhaps be able to squeeze down the long-term interest rates somewhat, which should stimulate the real economy. The central bank can also promise to keep the policy rate at zero for a prolonged period in
order to create expectations of lower future interest rates and a more expansionary monetary policy in the future.

Bibliography

Paul Krugman: It's Baaack! Japan's Slump And The Return Of The Liquidity Trap

Ben S. Bernanke and Vincent R. Reinhart, Director, Division of Monetary Affairs, Federal Reserve. Conducting Monetary Policy at Very Low Short-Term Interest Rates. Paper Presented in the form of a Lecture at the International Center for Monetary and Banking Studies , Geneva, Switzerland, 2002.

Ben S. Bernanke, Japanese Monetary Policy: A Case of Self-Induced Paralysis?, University of Princeton, Working Paper, 1999

Athanasios Orphanides, Board of Governors of the Federal Reserve System, Monetary Policy in Deflation: The Liquidity Trap in History and Practice, December 2003.

Kobayashi, Takeshi, Mark M. Spiegel, and Nobuyoshi Yamori. "Quantitative Easing and Japanese Bank Equity Values.", Journal of the Japanese and International Economies, 2006

Oda, Nobuyuki, and Kazuo Ueda. 2005. "The Effects of the Bank of Japan's Zero Interest Rate Commitment and Quantitative Monetary Easing on the Yield Curve: A Macro-Finance Approach." Bank of Japan Working Paper Series, No. 05-E-6.

Baba, Naohiko, Motoharu Nakashima, Yosuke Shigemi, Kazuo Ueda, and Hiroshi Ugai. 2005. "Japan's Deflation, Problems in the Financial System, and Monetary Policy." Monetary and Economic Studies 23(1), pp. 47-111.

Gauti Eggertsson and Jonathan D. Ostry, Does Excess Liquidity Pose a Threat in Japan?, IMF Working Paper, April 2005.

Gauti B. Eggertsson, How to Fight Deflation in a Liquidity Trap: Committing to Being Irresponsible, IMF Working Paper, March 2003

Gauti B. Eggertsson, and Michael Woodford, 2003, “The Zero Bound on Short-Term Interest Rates and Optimal Monetary Policy,” Brookings Papers on Economic Activity, No. 1, pp. 139–
211.

Paul Krugman: It's Baaack! Japan's Slump And The Return Of The Liquidity Trap

Lars E.O. Svensson, "The Zero Bound in an Open Economy: A Foolproof Way of Escaping from a Liquidity Trap,", Monetary and Economic Studies 19(S-1), February 2001.

Latvia - Devalue Now or Devalue Later?

2009-06-07T07:31:00.000-07:00

The Latvian economy is certaily stuck in a hard and not especially pleasent place at the moment, and really one chart tells it all, since as we see above the local interbank overnight interest rates have been storming upwards and through the roof over the last two weeks. As a result of this unfortunate state of affairs the country has attained a higher profile in the international news media than most Latvians would ever have dreamt possible, or even, probably, considered desirable. Ever since Claus Vistesen's last post, my inbox hasn't stopped filling up with reports, analyses, forecasts etc. (apart from Claus, FT Alphaville's Izabella Kaminska has had a steady stream of posts - here, here, here and here - while RGE analyst Mary Stokes is a regular follower of the issues - and see again here for some thoughts on the contagion question).

The first issue that hits you is, can such a small country really be that important? The answer is, yes it can, and for a variety of reasons, although among these one is paramount, the so called "contagion" risk. As Danske Bank put it in their latest Emerging Markets Europe analysis:

Increasing concerns regarding a possible devaluation in Latvia yesterday spilled over into other countries in CEE. Although the direct link between the Baltic markets and others such as Poland, Hungary and Romania is very limited it is only natural that concerns over the situation in Baltic States triggers renewed concerns regarding the position in Central and Eastern Europe where many countries to a greater or lesser extent face problems similar to those in the Baltics. Those most at risk from negative spill-over effects are Latvia’s neighbours Estonia and Lithuania although we would expect contagion to affect countries in the region most like Latvia in terms of macroeconomic imbalancessuch as Romania and Bulgaria.

Personally, I think it possible that the immediate contagion risk may be being a little overdone at the present time. Certainly there will be immediate implications from any eventual Latvian devaluation for Baltic neighbours (and co-peggers) Estonia and Lithuania, and well as for more distant Bulgaria. A Latvian decion to break loose will, effectively, be the end of the road for the pegs, even if the unwinding may not necessarily be immediate. And beyond the Baltics and Bulgaria pressure will inevitably mount on other countries facing longer term economic and financial difficulties like Hungary and Romania (which may leave you asking just who exactly there is left inside the EU but outside the Euro - Poland and the Czech Republic to be precise), but my personal feeling is that while we may see everyone placed under stress we are unlikely to see dramatic short term "negative events". If I were looking for these it would rather be towards Russia I would be looking, and to the future path of oil prices, since if things were to go the wrong way on that front then the shock waves from Russia could easily destabilise all the rest of Central and Eastern Europe at one foul swoop.

But then, my relative lack of alarm on the contagion front stems from my perception of the present crisis in the East as less one of short term liquidity and balance of payments pressures, and more one of a longer term sustainability issues, given the relative poverty of the region when compared with West European neighbours, and the rapid population ageing and decline issues it is facing.

Ideological Lock-in?

Latvia is certainly hemmed in on all fronts at the moment, what with the 18% year on year GDP contraction registered in the first quarter, the projected 9.2% of GDP fiscal deficit for 2009 (if more cuts are not made), the rise of overnight interbank interest rates into the high teens, soaring credit default swap rates - Latvia's five-year credit default swap rose to a high of 721.1 basis points on Thursday - and almost vanishing Lati liquidity inside the country.

But over and beyond the immediate concerns, and contagion risk Latvia is currently a test-bed for a number of issues with implications which extend well beyond the borders of this small Baltic country. In particular three questions stand out.

a) The rather counter intuitive idea - which I call the new orthodoxy in this post - that even during strong recessions a fiscal contraction could turn out to be expansionary, if it signals a long term determination towards fiscal rectitude. The IMF put the idea thus:

In emerging market countries with debt overhangs, the “Keynesian” effect of fiscal adjustment is likely to be outweighed by “non-Keynesian” effects related to expectations and credibility. Non- Keynesian effects have to do with the offsetting response of private saving to policy-related changes in public saving. In particular, if fiscal adjustment credibly signals improved public sector solvency, a fiscal contraction could turn out to be expansionary, as private consumption rises based on the view that future tax hikes will be smaller than previously envisaged.
IMF - Hungary, Request for Stand-By Arrangement, November 4, 2008

b) The idea of "internal devaluation" as a viable strategy for carrying out a substantial correction in relative wages and prices for a country with a currency peg and large balance sheet exposure to foreign exchange loans. Now it may well be that currency peggars are likely soon to become an extinct species, given the difficulties they tend to produce when such pegs unwind, but the Baltic countries may still be considered as test cases for others who don't (for whatever reason) have an independent currency and thus a serviceable monetary policy. Countries like Ireland and Spain, for example, who are facing a sharp correction, but being inside the eurozone currency area have no local currency of their own to devalue and are hence now destined to follow a similar path to the one being pioneered in the Baltics.

c) The idea that structural reforms can - in the context of a country with long term low fertility, declining working age populations and rising elderly dependency ratios - free up sufficient growth potential to offset the underlying population dynamic and, as the IMF put it in the above citation, credibly signal the possibility of future public sector solvency.

So Latvia is at the heart of a massive experiment, of the kind which lead me to lament on my about page that "Economists hitherto have tried hard enough and often enough to change the world, the real difficulty however is to understand it." Since the question I cannot help asking myself in the Latvian context is: to what extent do we really understand what we are doing here?

The thing is, all of the above mentioned theories - "internal devaluation", "stimulatory fiscal tightening" and structural reforms to offset declining working age population - sound splendid enough, but are the the theories themselves actually valid? How do we test them? And do the measures adopted on the basis of "believing" in them actually work? And are there sufficient grounds for accepting both the validity of the thoeries and the efficacy of measures based on them to ask for sacrifice on the scale that is currently being demanded from the Latvian people? And do we have any consensually agreed benchmarks which would enable us to decide whether the measures are working? Do we indeed - and by "we" here I mean the EU Commission and the IMF - have any inspectable performance indicators against which to measure progress?

Certainly, for every inch of success that is painfully clawed forward (the positive CA balance, for example), we seem to be constantly thrown back a yard by a host of additional problems (the growing fiscal deficit issue, etc), and not for the first time, we - the economists - find ourselves playing with fire, when we, of course, aren't the ones who risk getting burnt in the process!

Plethora Of Statements.

Both the European Commission and InternationalMonetary Fund (IMF) have been busying themselves over the last week making extensive statements on Latvia's 2009 budget amendment process - which is, after all - what lies at the heart of the issue. What has been notably absent however in all these public declarations, is any indication about when exactly the much needed money will arrive. And this is not a request for information simply at the convenience of Latvian lawmakers, it is the sort of information market participants badly need to receive in order to take the kind of decisions which would bring the situation more back under control for the Latvian authorities, and meantime the ambiguity continues.

European Economic andMonetary Affairs Commissioner Joaquín Almunia said in his prepared statement he believes the new budgetary proposals to be a step in the right direction. But how much of a step are they, since he also stressed that more was still needed to contain the rapid increase in the budget deficit. So again, just how much more is needed, and are Latvia's politicians capable of delivering? Or is the pain simply too much to stand?

"Sadly, the economic recession is proving more severe than expected inLatvia
bringing hardship for many and increasing the deficit to higherlevels than
expected. Latvia needs to reduce the deficit in asustainable way with
significant budgetary and structural measures,although I acknowledge that the
original fiscal targets in thegovernment's economic program are no longer within
reach. I alsounderstand there are limits on how much the deficit can be reduced
toallow some breathing space for the economy and for the people ofLatvia,
especially the sections of population most in need. I takenote that the
authorities want to control government debt and maintaintheir exchange rate peg.
The supplementary budget presented this weekis a first step. The Commission
wants to support government's efforts.I am looking forward to seeing additional
steps adopted during the second reading of the budget, as announced by the
government,"

On the other hand, Caroline Atkinson, the IMF's director of external relations, restricted herself to saying the fund agrees with the comments made by Joaquin Almunia to the effect that the supplementary budget presented by the government this week represents an initial move in the right direction. "The government's budget is a first step, and there is more work to be done," she said. Again, how much more work?

When directly asked the key question as to whether the IMF would support a depegging of the lat from the euro, she simply stated that the fund hasn't changed its stance. "We have commented before that the situation is challenging and that there is a need for action, and I think the authorities have stressed the importance of controlling the government debt and deficits and maintaining the peg," she said. That is to say, the Fund's position is that on this topic the government decides. On the other hand, with Latvia's financial and currency markets coming under increasingly evident stress, and Prime Minister Valdis Dombrovskis saying the country needs the second portion of the loan by early next week, the Fund remains meticulously silent on when exactly the next tranche will be paid, and on what it would take for them to release the money. Of course, negotiating in public is not the most desireable of things, but then having hoardes of market participants speculating on what you might be saying isn't exactly a comfortable situation either.

Marek Belka, head of the European Department at the International Monetary Fund, also limited himself on Friday to saying Latvia may need to make further spending cuts as well as increase taxes if it is to stabilize the economy.

The Latvian central bank, for its part, noting all the emphasis on "the government decides" side, and obviously not wanting to be forgotten, issued, for its part, a statement openly defending the currency peg, and warning of "dire losses" for Latvian citizens should the currency be devalued. The bank effectively ticked off public officials and advised them to be more careful what they say when speaking and the national currency and its stability in future. It also took the unusual step of underlining that the central bank was an independent institution, and is the only body empowered to take decisions about changing the currency rate. This was notable, as it could be seen as suggesting that someone else thought they had the ability to take such decisions, and it could also be read as a warning to anyone tempted to think they had such powers.

Meantime the recession goes on, and on.........

Industrial Output Stabilises

Latvian industrial output was in fact up in April over March - by 4.8% on a seasonally adjusted basis. Mining and quarrying were up by 1.8%, manufacturing by 5%, and electricity and gas by 4.6%. Some sectors were up sharply, clothing output, for example, rose 14.6%, pharmaceuticals by 11.6%, and chemicals by 9.7%. On the other hand electrical equipment was down on March by 19.5%, while other transport equipment (defined as ships and boats, railway locomotives and rolling stock) was down 13.2%. Such stabilisation was consistent with what we have been seeing in other countries, and at this point does not enable us to draw and longer term conclusions.

As a result of the improvement in April the year on year output drop fell to 16.9% (after adjustment for calendar effects). The fall was thus weaker than the 23.4% year on year drop in
March and a 24.2% one in February.

The core of the problem is exports, since with domestic demand now sunk into a deep hole, and fiscal austerity the "ordre du jour", exports are the only hope for growth. I mean, this is evident from a simple formula:

Changes in GDP = Changes in private domestic demand + changes in government spending + changes in the net trade impact (exports minus imports)

Clearly Latvia's economy is not condemned simply to shrink forever, but it can come to rest at quite a low level, and for it to rebound something needs to drive growth. What I am arguing is, other things being equal, and relative prices being right, that a combination of new investment for greenfield sites directed to axports (which is a plus for private domestic demand) plus the exports themselves could provide the stimulus which starst to turn the motor over. Devaluation is half of the answer here, with the other half coming from having a responsible government, a serious reform programme which encourages confidence in the country and economic and political stability. End all the speculation which surrounds the continuation of the currency peg would be one way to move forward on the second half of the agenda.

The Latvia statistics office have yet to give us detailed data for Q1 GDP, but they initially reported that the 18% annual decline was broad-based, with manufacturing down 22%, retail trade down 25% and hotel and restaurant services output 34% lower (all from a year earlier). "The economic situation is of course very serious," Latvian Prime Minister Valdis Dombrovskis reportedly told a press conference in Stockholm recently, and who could disagree.

Latvian exports are also well down, falling 23% year on year in March, an improvement on the 29% drop in February, but still substantial. Going by the April industrial output numbers we could expect a further improvement in April too, nonetheless far, far more will be needed to start to turn this situation around.

In fact, Latvia still ran a goods trade deficit of just under 400 million Lati in the first three months of the year, down significantly from the 650 million Lati in the last three months of 2008, but still large, especially since GDP is shrinking fast.

Lavia's current account has however improved spectacularly, and was back in surplus (although only marginally) as of January this year according to central bank data. This transformation is entirely logical and anticipated (even if the speed of the correction was not), since Latvia is now about to become a net saver, with a current account surplus, and with an economy which is driven by exports, which at the end of the day is what the whole devaluation debate is all about.

In fact, the headline current account surplus number is a bit illusory, since it has been produced by a combination of two factors, neither of which are totally desireable in and of themselves. This is why we could say that the surplus is a forced one, and that Latvia is being forced to become a net saver. In the first place there is the improvement in the goods trade deficit, which as I say, is more produced by a the fall in imports (which follows the decline in domestic spending power and living standards) than it is by any improvement in exports (which have of course been falling):

And secondly we have movement in the income balance, from deficit to surplus, and this, ironically, is produced by the fact that the internal collapse in economic activity means that the income return on Latvian investments (equities, profitability of enterprises etc) has dropped much more than the return on investments made by Latvians outside the country (where things may also be bad, but not as bad as they are in Latvia). Thus ironically, Latvian's who have had the foresight to borrow funds from the Latvian branches of Swedish banks to invest in economic activities in Sweden may well be faring rather better than those very banks themselves who lent money to be used in Latvia.

Retail Sales

Apart from the drop in imports, perhaps the best short term indicator of the contraction which is taking place in internal demand is to be found in the retail sales numbers. These were actually up slightly in March compared to March - by 0.3%, on a constant price seasonally adjusted basis. The improvement was largely in the sale of food products, which increased by 2.7% on the month, while sales of non-food product fell by 1.1%.

Compared to April 2008 however sales were down by 29.6% (working day adjusted, constant price data), following a 27.3% fall in March. Since April last year seems to have been the peak month, we can expect the annual drops to reduce, although the actual level of sales may well keep falling (see chart below).

Apart from the credit crunch and the consequent difficulty in borrowing money, the other factor which is producing the slump in retail sales is the dramatic rise in unemployment, which according to Eurostat data has surged from a low of 6.1% in April 2008 to the present 17.4%. And it continues to rise.

The Eurostat numbers are rather different from the Latvian Labour Board ones, since the latter is based on a different methodology (and is thus not part of any "sinister conspiracy" to hide the facts - for a full discussion of the issues involved see my recent post on the same issue in Spain), but if you compare the charts, the undelying trend is evidently similar, a sharp upward climb.

Restoring Competitiveness

The principal conclusion we can draw from all this then is that it would be foolish to expect any recovery in economic activity to come from Latvian domestic demand, and this problem will only be added to by the impact of debt deflation on houseowners who, according to Global Property Guide, have just seen their properties fall at the fastest rate anywhere on the planet - it wasn't that long ago that Latvia and Estonia were leading everyone up - with prices down by 50% year on year in the first quarter, and the drop over the last quarter of 2008 being an incredible 30%.

So we need to look to exports. But this is where we hit a problem, since all the inflation which took place during the boom side of the boom-bust have made Latvian prices and industries totally uncompetitive when it comes to its main trading partners. If we look at the latest Real Effective Exchange Rate Data (curiously enough released by Eurostat last Friday), it should not surprise us to learn that the worst loss in competitiveness occured in 2008.

The above chart compares Finland and Latvia, and gives us an idea of just how much competitiveness the Latvian economy has lost since the index was set in 1999. In fact the graphs are even more interesting, since we can see that there was a period - between 2002 and 2005 - when, despite the fact that living standards were rising, productivity was rising faster, and Latvia actually improved its competitiveness vis-a-vis Finland. It is that earlier dynamic which now need to be recovered.

But as we can see from the sharp upward rise the the Latvian REER post 2006, the structural damage has been substantial, and this large scale of the correction needed makes the "internal devaluation" path - even if it were working, and even if markets were accepting it, which in neither case is true - particularly onerous. Prime Minister Dombrovskis himself estimated only last week that any devaluation would need to be of the order of 30% (and looking at the chart it is hard to disagree), and this is already much larger than the 15% "adjustment" in the trading band the IMF were considering during the original loan negotiations.

Ideally improvements in competitiveness can be achieved in two ways, through productivity enhancements which can be attained via structural reforms, and through changes in the wage and price level. Unfortunately the former needs time to work, and time is now absolutely something Latvia hasn't got, with the recession biting deeper by the day, and the markets hot on the heels of the government. So we need the wage and price correction. Well, people have supposedly been working on this for some six months or so now, so just how far have we got? Let's take a look.

Well, if we look at average gross wages and salaries, they fell 1st quarter of 2009 by 6.2% over the last quarter, but when compared with the first quarter of 2008 they are still up - by 3.5%. Of course, given the rise in unemployment the actual volume of wages and salaries paid is down even more - by 10.9% on the year, and by 17.2% over the last quarter. But this is a dop in living standards produced by the recession, and not a fall in unit labour costs.

In fact, according to data from the Latvian Statistics Office, the level of gross wages and salaries has so far only fallen back to the level of August 2008. This contrasts with a lot of anecdotal evidence I have been receiving in comments which speak of far larger reductions, but there you are, that is what the data says.

But restoring competiveness via internal devaluation is about reducing wages and prices in like measure, it is not simply about reducing wage costs, since slashing wages without reducing prices is only to cut living standards, and this in and of itself serves no evident purpose, and indeed causes untold hardship.So how are things going with prices?

Well, not much better. According to the statistics office, as compared to March, the average consumer price level in April was down by 0.4%. The average prices of goods decreased by 0.3%, but compared to April 2008, consumer prices still increased, and were up by 6.2%. In fact both the general and the core idexes (by core I mean ex energy, food, alchohol and tobacco) were still above the January level, so on the consumer prices front we have yet to take even the first step into attacking the loss of competitiveness reflected in the 2008 REER.

What about producer (or factory gate) prices then? Well, here the situation is a bit better, since as compared to March, April producer prices were down by 0.9%, while as compared to April producer prices fell by 2.6% (the first month of year on year drop). In the case of export prices, the situation was even better, since these were down by 9% year on year in April. In fact in both cases (domestic and export) prices have been falling since last July, which is hardly surprising since energy costs (which were a major component in the recent producer price spike) have fallen sharply. And remember, what interests us here is competitiveness, and energy prices have been falling everywhere. What Latvia needs is to improve its relative prices vis a vis its main reference markets.

Money Supply Problems

One indicator of the degree of stress which the Latvian economy is currently experiencing is the way in which bank lending (which fuelled the earlier boom) is now falling across the board. Year on year the numbers are still in positive territory, but the annual lending growth rate is steadily heading for zero - it decelerated to 4.3% in April (of which lending to non-financial corporations fell to a 9.2% growth rate while lending to households was down to 1.3% year on year). But month on month lending is contracting, and has been so doing since October. Loans to resident financial institutions, non-financial corporations and households contracted by 115.9 million lats or 0.8% in April alone.

Commercial credit and mortgage lending are both falling (by 3.4% and 0.8% respectively) and the negative momentum continues.

Money supply data show a similar tendency, even if in April M3 increased by 67.4 million lats and M2 by 63.6 million lats over March. Nevertheless the annual rate of decline in both measures of money supply continued to accelerate (to 8.2% and 8.1% respectively).

M1 - which consists of currency in circulation + checkable deposits (checking deposits, officially called demand deposits, and other deposits that work like checking deposits) + traveler's checks (ie assets that can be used to pay for a good or service or to repay debt) - has been falling now since December 2007.

Net foreign assets held by the Bank of Latvia fell by 218.7 million lats in April. According to the central bank the decrease in foreign reserves was a result of Bank of Latvia interventions (selling euro) and a reduction in foreign currency deposit held by the government as it drew down what remained of the last tranche of the international loan. Latvia has now spent about 503 million euros buying lats so far this year to support the currency. The bank had previously spent about 1 billion euros in 11 weeks last year defending the currency prior to the 7.5 billion-euro IMF-lead bailout.

Reserves had to some extent been boosted by currency swaps made available by the Swedish and Danish central banks. Indeed only in May Sweden’s central bank raised the amount of euros available for its Latvian counterpart to swap for lats to 500 million euros and extended the term of the agreement. The swap agreement dates back to last December, and allowed the Latvian central bank to borrow up to 500 million euros for lats. Under the original agreement the Riksbank was to provide 375 million euros and the Danish cb 125 million euros. However, according to the most recent statement from Swedish Finance Minister Anders Borg the Swedish government have now decided: so far and no further (see below).

Deteriorating Liquidity Conditions

As noted at the start of this post, Latvia is now suffering from a major Lat liquidity squeeze. And the shortage of lati on the internal market lifted has steadily been lifting interbank rates. One indication of the shortage was the inability of Latvia’s Treasury during the week to sell bills at a first auction at which 50 million lati (35 million euros) were offered. The Treasury did finally manage to sell a much smaller quantity (2.75 million lats - 4 million euros) . The problem is not one of price (yield) but of liquidity - there is simply a shortage of lati in the system overall as those who have the local currency sell and buy euros to protect against possible devaluation.

The lack of liquidity pushed Latvian interbank lending rates to their highest levels on record on Friday as the central bank removed lati from the market in an attempt to stem speculation. The six-month Rigibor rate rose to 16.00 percent. The three-month rate rose to 17.92 percent while the overnight rate rose to 19.6 percent. Obviously with levels like this devaluation becomes inevitable, but as Dombrovskis stresses: “This was a momentary situation and the moment when we have an agreement with the international lenders the market will calm down,” - for the time being at least. The critical question at this point is not whether a new agreement with the EU and the IMF is possible (it surely is), but rather whether it is worth the effort, since the government may well be in a situation were it is forced to agree to a series of extremely painful cuts only to find itself in the very same position three or six months from now.

Deficit Connundrum

As we can see, the Latvian people are being asked to make a bet in support of an economic idea, the idea (as presented above) that a fiscal contraction under present circumstances could turn out to be expansionary. Personally I am absolutely not convinced of the validity of this argument. What will convince lenders and investors to return to Latvia is:

a) a convincing commitment to structural reform and fiscal rigour in the longer term
b) a serious adjustment in relative wages and prices which converts Latvia once more into an attractive destination for export oriented investments.

At the present time we have the worst of both worlds here, since all the government's time, energy and attention is being focused on short term fiscal objectives, while the rate of price adjustment is far too slow. That is, the existing programme is NOT working, and I find myself wondering, do the IMF representatives have performance criteria, and if so what are they? And are these (assuming they exist) being in any way fulfilled, since the only visible positive outcome at this point is the recovery of a current account surplus, but if this is being achieved at the price of generating a massive fiscal deficit, then it is hard, really, to cry victory.

The general government consolidated budget showed a deficit of 190.8 million lats in April, with an accumulated deficit since the start of the year of 332.8 million lats). According to the central bank, the deterioration in the general government consolidated budget was largely the result is two processes: a) a revenue fall of 24.7%; and b) an increase in expenditure of 15.9%. Tax revenues were sharply down in all tax groups, with corporate income tax, VAT and personal income tax revenues dropping most (by 84.9%, 26.9% and 15.5% respectively).

The expenditure surge was primarily fuelled by payments of subsidies and grants which expanded by 70.3%. Rising expenditure for social benefits (by 26.2%) and the growth in interest expense (84.7%) were other significant contributors. General government gross debt increased by 143.2 million lats in April (to 3 119.0 million lats).

The consensus is that the current budget as agreed in a first reading before Latvia’s parliament last week implies a deficit of 9.2% of gross domestic product. It is anticipated that spending will be cut further via ammendments in the second reading scheduled for June 17 and that these should be sufficient to obtain additional disbursements from the European Commission and the International Monetary Fund. The question is not really (at this point) whether the Latvian parliament will pass the ammendments, but whether Latvia can hang out that long in the absence of stronger verbal and substantive support, and whether the measures if implemented will have the anticipated results.

On the latter point, as I have already indicated, I am extremely sceptical, and on the former, as we have seen statements from both the EU and the IMF have been much softer than might have been hoped for, while one leading ally (the Swedish banks and government) have now taken a much more ambiguous stance.

Swedish Finance Minister Anders Borg described the situation in Latvia as “markedly worrisome” in a statement on the Swedish government website at the end of last week. However, when it came to practical measures Borg was a lot less forthcoming, limiting himself to stating that Sweden would not offer Latvia any additional bilateral loan over and above the current contribution to the international bailout, adding the in his opinion the most important step forward was a show of determination by the government to rein in the budget gap. “They have to show that they have control over their public finances”. It is of the “utmost importance” that Latvia take “concrete and well-defined” additional measures to limit its public deficit to ensure that the IMF and the European Commission resume loan payment, he told reporters last week.

Swedbank, the largest bank in the Baltic states, has also stressed that they are fully prepared for a possible currency devaluation in Latvia. “We feel comfortable about our action preparedness regardless of which way the Latvian government chooses to go,” Chief Executive Officer Michael Wolf wrote in a statement published on the bank’s Website last week. As he also indicates, he gets the main point about the debt default problem:

“It’s not given that an external devaluation, over a longer period of time, will lead to larger credit losses for the banks,” Swedbank said. “But an external devaluation would give bigger credit losses during a shorter period of time as it directly hits the payment capacity for the many customers who have loans in euros.”

So What Happens Next?

Well , this is very hard to say, but certainly the omens - and especially Friday's Rigibor overnight reading - do not look good.

There is now evidently a growing consensus among observers that some sort of devaluation is well nigh inevitable, with the only real question being when. Certainly the trading community seem to be anticipating such a move, and forward contracts now price the lat some 53 percent below its current spot rate of 0.7073. Bloomberg quote fund manager Paul McNamara , from Augustus Asset Managers, as stating that “There seems to be a reasonable market consensus that Latvia will devalue", and I think this is a fair view.

Caroline Atkinson, director of external relations for the IMF, limited herself to describing the economic situation as “challenging", adding that there was clearly "a need for action.” She also pointed out the need for flexibility, which could refer to the IMF and the budget limit, or could refer to felixility on the part of the government, given the fact "the authorities have stressed the importance of controlling the government debt and deficits in maintaining the peg."

The problem is not that the IMF and the ECB would cease to support the Latvian government if they choose to continue down their chosen path, the question is really will they be able to continue down their chosen path, and indeed does it any longer make sense for them to do so?

No Exit Strategy

During this whole process one thing has become abundantly clear from the IMF statements, for the Latvian government's chosen path to be viable, there needs to be an exit strategy. Really it is very well worthwhile everyone reading the recent interview with IMF Survey Magazine (end of May) given by the IMF’s new mission chief for Latvia, Mark Griffiths, and Christoph Rosenberg, advisor in the IMF’s European Department and coordinator of the IMF’s work in the three Baltic Republics, since it makes a number of things very clear.

Particularly of note are Rosenberg's insistence (which has been a constant on his part throughout the process) that ownership of the adjustment program rests with the Latvian government:

"Let me first stress that this is the authorities’ program—they have very strong ownership of the policies that underpin it."

and secondly, having a viable exit strategy is central to success.

"The alternative strategy—abandoning the peg—would also be associated with large economic short-term costs. That is clearly one reason why there is such a strong preference in Latvia for maintaining the peg. Latvia also has a clear exit strategy in place: meeting the Maastricht criteria and adopting the euro by 2012."

But really, we now need to ask, is this exit strategy still viable? Certainly on the current path it may be possible (on the back of very considerable sacrifices on the part of the Latvian people) to bring the deficit down below the 3% limit in 2011 (although whether the EU Commission and the ECB would regard this as a sustainable process is another issue), but what about the 60% gross debt to GDP ratio? In their April forecast the EU commission pencilled in debt to GDP at 50.1% in 2010 (up from 9.0 in 2007 and 19.5 in 2008). That is debt to GDP is rising very fast (indeed some might say exploding). At the same time this 2010 estimate, which already makes being within the 60% limit in 2011 a reasonably close call (too close for my comfort anyway) is based on GDP contractions in 2009 and 2010 of 13.1% and 3.2% respectively, and we already know that the contraction in 2009 will be significantly greater than the EU forecast.

But it is worse than this, since not only is GDP contracting, prices are also falling (in fact, under the "internal devaluation" scenario this is what we want). But what this means is that nominal (or current price) GDP will fall faster than real GDP, with consequent negative consequences for the debt to GDP ratio (since as GDP falls, the money value of the debt remains constant). In fact the more successful the price correction the higher short term debt to GDP will rise. At the present time the EU forecast GDP deflators of only minus 2.2% in 2009 and minus 3.6% in 2010. But as we have seen above, for growth to return to the Latvian economy prices need to correct by far more than this, and hence debt to GDP will inevitably rise more than forecast - either because prices don't correct fast enough, and hence GDP contracts more (worst case) or that they correct rapidly (but with negative consequences for debt to GDP. This looks suspiciously like a Maastricht lose-lose to me.

That is, the simple fact of the matter is that there is no exit strategy. The programme simply doesn't work. It is "overdetermined", since whichever way you look at it, there is always one more problem than there is solution. Gentlemen. I think its time to give up. Honourably, but to give up. Come on out of the bunker, white flags and hands in the air will not be called for. There's a world out here waiting for you, it's on your side, and there will be a tomorrow.

Exports And Investment Drag German GDP Down In First Quarter

2009-05-28T05:19:00.000-07:00

German exports and investment spending plunged in the first quarter, dragging Europe’s largest economy into its deepest economic slump on record.

Exports were down 9.7 percent from the fourth quarter and company investment declined 7.9 percent, according to the Federal Statistics Office. The Office reported that gross domestic product fell a seasonally adjusted 3.8 percent from the previous three months, confirming an initial estimate from May 15. That’s the largest drop since quarterly data were first compiled in 1970.

From October to December 2008, the German economy had already contracted by 2.2%, and by 0.5% in each of the the second and third quarters.

According to the statistics office, the decline in economic performance was mainly due to movements in the balance between exports and imports of both goods and services. As in the fourth quarter of 2008, German exports fell much more than German imports in the first three months of this year. While exports declined 9.7 % year on year, imports were down 5.4%, so that the chnaged balance of exports and imports contributed minus 2.2 percentage points to the decline of GDP.

The negative first quarter evolution was also characterised by a notable decline in investments (– 7.9%, quarter on quarter). Capital formation in machinery and equipment, in particular, was much lower than in the last quarter of 2008. Companies invested 16.2% less in machinery, equipment and vehicles than in the last quarter of 2008.

The decline in capital formation in construction was small in comparison with a drop of 2.6% on the quarter. Inventories were also run down considerably during the quarter, thus reducing growth by 0.5 percentage points. Growth was positive only only for household consumption and government consumption, which up by 0.5% and 0.3% respectively.

Year on year, German GDP was down by 6.7% in the first quarter of 2009. After calendar-adjusted, the figure is 6.9% , since there was half a working day more in the first quarter of 2009 than there was in 2008 (easter impact minus the leap year effect).

39.9 million people were employed in Germany during the first quarter, an increase by 48 000 persons (or 0.1%) on a year earlier. The number of unemployed (ILO definition) was just under 3.4 million, 7.8% of the entire economically active population.

The recession in Germany has hit industrial activity (including energy) particularly hard, and output was down 20.2% over the first quarter of 2008. Marked declines in real gross value added were recorded also by construction (– 8.9%) and by trade, transport and communications (– 6.4%). Financial, real estate, renting and business activities fell much less - by 0.9% compared with the first quarter of 2008.

In contrast to the bleak picture for investment, fixed capital formation and German exports, final consumption expenditure was ever so slightly up quarter on quarter - by 0.1% - and even did slightly better than in the last quarter of 2008 (– 0.0%).

On a year on year basis, household consumption was marginally down though - by 0.1% (following a 0.5% drop in the fourth quarter of 2008), but general government consumption expenditure was up by 0.8%.

The Long Term Outlook

The first-quarter drop in GDP marked an unprecedented fourth successive quarterly contraction for Germany’s economy. The government expects the economy to contract 6 percent this year, while ECB council member Axel Weber said earlier that while “rays of light” are positive, there’s “no reliable indication that the global economy is past the worst.” The euro-region economy may only “gradually stabilize during the latter part of 2009.”

The longer term decline in German GDP performance is now pretty clear (see chart below).

According to the Federal Statistics Office:

Measured in terms of gross domestic product changes at 1995 prices, the rates of economic growth in the former territory of the Federal Republic of Germany and - since 1991 - in Germany have continuously declined since 1970. While the average annual change was 2.8% between 1970 and 1980, it amounted to 2.6% between 1980 and 1991 and to 1.5% between 1991 and 2001.

Since 2001 the performance of the German economy has in fact been worse rather than better, much to the consternation of those who hoped that many years of sacrifice in the form of wage deflation and structural reform would lead to a rebirth of the country's former economic prowess. In reality the German economy shrank (0.2%) in 2003, and grew by only around 1% in both 2004 and 2005. And while the German economy picked up notably in 2006 and 2007 (with growth rates of 3.2% and 2.6% respectively) and many talking in terms of such grandiose notions as global uncoupling and "Goldilocks" type sustainable recoveries, the most striking feature of the recent German dynamic has been the way that internal demand failed to respond to the externally driven export stimulus. Of course, all the speculation came to an abrupt end in 2008 when the German economy once more entered recession as world trade expansion slowed and exports collapsed (with GDP only growing by 1% over the year), while 2009 looks set to be a lot worse (with the IMF currently forecasting a contraction somewhere in the region of 5%, and forecasts of up to minus 7% not seeming exaggerated).

What we seem to have here is "engine faliure" rather than mere "magneto problems" (using Claus Vistesen's memorable phrase for a very similar situation in the Japanese economy, and it would be nice if the current crisis could serve as the stimulus for an open, and "in the real world" debate about why this is. So some part of the traditional mechanism of economic transmission seems to have been broken, and the "second leg" of the economic cycle, the domestic consumtion driven one, seems no longer to work. Long term GDP growth rates in the German economy are clearly falling, and the decline looks clearly set to continue. Now falling and ageing population couldn't have anything to do with it, could it?