Facebook Blogging

Edward Hugh has a lively and enjoyable Facebook community where he publishes frequent breaking news economics links and short updates. If you would like to receive these updates on a regular basis and join the debate please invite Edward as a friend by clicking the Facebook link at the top of the right sidebar.

Saturday, June 20, 2009

Facebook Links

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.

Sunday, June 14, 2009

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

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.


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.

Tuesday, June 9, 2009

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

"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!

Sunday, June 7, 2009

Latvia - Devalue Now or Devalue Later?

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

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.