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Friday, March 27, 2015

Is Finland's Economy Suffering From Secular Stagnation?

"After the Great Depression, secular stagnation turned out to be a figment of economists’ imaginations........it is still too soon to tell if this will also be the case after the Great Recession. However, the risks of secular stagnation are much greater in depressed Eurozone economies than in the US, due to less favourable demographics, lower productivity growth, the burden of fiscal consolidation, and the ECB’s strict focus on low inflation."
Nick Crafts - Secular stagnation: US hypochondria, European disease? - In Secular Stagnation: Facts, Causes and Cures, Edited by Coen Teulings and Richard Baldwin
 Finland's economy has been attracting a lot of interest of late. And not for the right reasons, unfortunately. The economy in a country previously renowned for being highly placed in the World Bank's "Ease of Doing Business Index" has just contracted for the third consecutive year. Once famous for being a symbol of "ultra competitiveness" (it came number 4 in the latest edition of the WEF Global Competitiveness Index) the country is now fast becoming the flagship example of another, less commendable, phenomenon: secular stagnation.The origins of the theory of secular stagnation go back to the US economist Alvin Hansen (see here) who first used the expression in the 1930s. The hallmark of secular stagnation, he said, was a series of sick "recoveries which die in their infancy and depressions which feed on themselves and leave a hard and seemingly immovable core of unemployment." This seems to fit the Finish case to a T.

After the global crisis the economy seemed to recover, but after the second Euro Area recession the country's economy hasn't been able to lift its head again.

In fact GDP still languishes about 5% below the 2008 peak.

Unemployment, on the other hand, has remained stubbornly high, and - at 9.1% - has recently passed just above the crisis peak.

Hansen surmised that the big driver of US economic growth prior to the 1930s had been population growth. Given the fact that he expected US population to fall he, not unrealistically, came to the conclusion that "We are thus rapidly entering a world in which we must fall back upon a more rapid advance of technology than in the past if we are to find private investment opportunities adequate to maintain full employment. ..."

He thought technological advance could stimulate investment to fill a gap left by the lack of natural investment growth. Following Adam Smith he recognized that the "rate of investment" is conditioned by the extent of the market (or rather the rate of expansion of the "extent of the market"), but if population was falling rather than rising then the incentive to invest like before wouldn't be there, since the market wouldn't be increasing in "extent". So technology and innovation became more, not less important, just like the situation we face now.

Hansen was wrong about the demographic dynamics - he didn't foresee the post war baby boom, but then neither did the demographers he relied on. (For more on this see Richard Easterlin,"The American Baby Boomin Historical Perspective", 1962). But if we look at the situation we face today there is a lot less uncertainty about the population outlook over the next 10 to 20 years, especially when it comes to working age population dynamics. From the experience in Japan it seems it is working age population and not total population that really matters in terms of macroeconomic effects. Declining inflation/deflation correlates much more strongly with working age population dynamics than it does with monetary policy.(See Bank of Japan former Governor Masaaki Shirakawa here).

In fact, Finland's working age population peaked during 2010, and it has since been declining rapidly. So it fits the picture described by Hansen admirably.

And indeed the Finnish economy is now starting to flirt with deflation.

Loss Of Competitiveness.
"Finland’s economy has fallen behind its Nordic neighbors and euro peers, in what Prime Minister Alexander Stubb has called a “lost decade.” Pay increases are on hold after a wage boom during Nokia’s glory days opened up a salary gap of about 20 percent with the country’s main trading partners, Sweden and Germany. “We need to bridge the cost gap with our competition,” said Jyri Hakamies, who heads the Confederation of Finnish Industries, the main business group. “That will take years. At the same time, labor agreements must be made more flexible and productivity must improve to kick-start economic growth and create jobs”"
Bloomberg News: Nokia-Fueled Boom Years Leave Finns With Stagnant Pay
In 2007, when the countries export-led technology industry was booming workers representatives hammered out an 8.5 percent wage increase that was implemented over two years. That deal led to an upward spiral where other industries and then the public sector pushed for ever higher compensation. As a result of agreements like these unit labor costs have been growing sharply for more than a decade. They diverged from levels seen in Sweden and Germany in 2007, just as the woes of Nokia and the paper industry intensified and exports slumped.

Since 2008, Finland has lost competitiveness against all EU countries as its wage costs have rocketed. As the unit labour costs of Ireland and Spain have fallen, Finland’s have increased by about 20 per cent.  Productivity has suffered correspondingly. The Conference Board calculate that from 2007 to 2012 Finland’s unit labour costs in manufacturing rose by 6.3 per cent a year, faster than any of the countries surveyed except Australia and Japan. At the same time, Finland’s productivity fell by 3.9 per cent a year, far more than in any other country. Richard Milne (in an FT Op-Ed) produces the following chart to illustrate the situation.

The chart is slightly misleading, illustrating just one more time how there is no such thing as an economic "fact", since he has rebased the index to 2007, just when Spanish unemployment started to rise much more rapidly than measured GDP fell, provoking a substantial downward adjustment in ULCs.  So Spanish and Finnish ULCs have seriously parted company, but not by as much as the chart suggests, since in 2007 Spain's ULCs had grown to absurdly high levels.

Just to illustrate how in a pre-scientific, ideologically divided discipline like economics there are no (consenual) facts, only interpretations, I have rebased the ULC data to 2000 in the chart below. This still shows how serious the Finnish situation is, but puts the Spanish development in a rather different light. Finland wasn't THAT uncompetitive until 2011.

In fact Finland has transited from being a country with a significant goods trade surplus, to being one with a structural deficit.

Even the current account balance has now turned negative.

And the country's Net International Investment Position is also turning negative. This is an especially worrying phenomenon in the case of a country with a rapidly rising elderly dependent population, as income from external investments can help maintain living and welfare standards. Net negative income payments will only leave less money available for social policies.

 Housing and Consumption Boom

As in earlier similar cases, the loss of competitiveness and export prowess was compensated for in the short run by a modest consumption and housing boom. House prices rose sharply - possibly helped by the availability of low interest mortgages driven by ECB monetary policy - from 2008 to 2013. But now prices have begun to stagnate, and even decline slightly.

The number of building permits issued has slumped.

While the rate of demand for new mortgages has been steadily dropping off.

What To Do About The Situation?

The whole topic of secular stagnation is a highly controversial one at the present time. In the first place there is no general agreement that this is what is affecting a country like Finland. Those, like Prime Minister Alexander Stubb would argue that it is simply a question of the country having lived beyond its means, and hence lost competitiveness. Thus, in his opinion, what it now needs is a lengthy process of internal devaluation and austerity.  Curiously - in a country that was busy recommending sharp austerity to others - he blames rising debt and lax fiscal policies for the situation. Finland's economy could flat-line through the 2020s, he suggests,  if politicians fail to curb taxes and government debt.
The government debt of Finland has almost doubled since 2008, from 28 percent of gross domestic product to 48 percent at the end of 2014. Taxes have risen 3 percentage points over the same period as different administrations tried to preserve benefits without resorting to deep cuts. The jobless rate this year will rise slightly to over 9.1 percent, the government estimates. GDP languishes below its 2008 level - Bloomberg News.
Certainly, having not adequately analyzed what was happening, the country has been running a series of fiscal deficits which continued beyond the crisis as the momentum provided by the housing boom has waned.

Naturally, with no growth and low inflation the government debt level has been rising rapidly.The level is still low - the IMF forecast it will hit the 60% of GDP EU limit this year - but if it continues rising at this rate it won't stay low for long.

Another hypothesis could be that of a balance sheet recession, but with government debt under 60% of GDP, and total private sector debt only around 100% GDP, this hardly seems plausible. Neither, for the same reason, does the idea that the country is simply trapped in a liquidity trap.

So, what do you do about the problem of secular stagnation, if that is what it is? Again here there is divergence of opinion. Some still seek to treat the phenomenon as if it were a variant of the liquidity trap issue. Most notably Paul Krugman, who continues to hope that massive quantitative easing backed by strong fiscal stimulus will push economies like the Finnish one back onto a healthy path. But if the issue is secular stagnation, and the root is population ageing and shrinking, it is hard to see how this can be. The fact that Japan is just about to fall back into deflation 2 years after applying a monumental Quantitative Easing problem seems to endorse the idea that the problem may have no "solution" in the classical sense of the term. In Stagnation Without End, Amen, as if in response to this, Krugman contemplates the possibility that the natural rate of interest might be permanently negative, and concludes:

"I need to work a lot more on the mechanics of this paper; I’m wondering in particular whether there is a possibility of sustaining the economy with permanent fiscal expansion."

At first sight the idea of permanent stimulus seems weird, especially given the fact that it won't stimulate (in the normal sense) and also due to the longer term debt implications. But then, the possibility exists that secular stagnation is associated with constant deflation, in which case the central bank could print money for an extended period of time without causing inflation. I explore this possibility in my piece EuroGroup - Money For Nothing And Your Debt For Free?

Leaving the Euro - which I think no one is suggesting - wouldn't be an advantage, since apart from losing the firepower of a large central bank for the debt scenario, the country would be unlikely to achieve meaningful devaluation. All the other Scandinavian countries are currently having to fight hard to avoid revaluation - largely due to being neighbours of the ECB - as I explain in my post on negative interest rates. The old debate about having monetary policy sovereignty is a bit out of date, especially at a time when even Janet Yellen is hesisitating to raise rates due to concerns about the currency impact of ECB action. How much more would a small open economy like Finland be at risk?

Is There A Temporary "Free Lunch"

Nothing ever comes entirely free, and one of the issues which arises with permanent QE is that it may be applied only at the cost of generating bubble type problems elsewhere, and issue which I look at in Secular Stagnation - On Bubble Business Bound. But developed economies are in a bind, and they do need to find some path to move forward along.

Larry Summers - who was the first to use the expression secular stagnation in the current context - advocates infrastructural spending to overcome the investment shortfall, but I'm still not sure whether he recognises that this spending would need to become permanent, so we still end up with mounting debt. The Catalan economist Jordi Galí makes a similar proposal to the one Summers proposes, but again with a limited stimulus objective. However in one sense he does go farther. In "Thinking the unthinkable: The effects of a money-financed fiscal stimulus" he argues that the proposals he advances "contrast with the experience with quantitative easing and other unconventional monetary policies, which do not affect aggregate demand directly and which, as a result, have failed to jumpstart the depressed economies of many countries, especially in the Eurozone."

He goes on to say, "An additional advantage of a money-financed fiscal stimulus, particularly relevant for a monetary union, is that the associated increase in government purchases may be targeted at the regions with higher unemployment and lower inflation (or higher risk of persistent deflation)."

At the end of the day, only two things can be said with a fair degree of certainty: short term fiscal austerity won't make any significant improvement to Finland's situation, and it could help make things worse (this whole discourse is based on a misunderstanding about what the problem is) while, on the other hand, what short term stimulus won't do is stimulate.

Structural reforms - aimed to increase labour market participation rates, and extend working lives - can help. So can measures to improve the quality of education, and the effectiveness of investment into new technologies. But if we look at Japan, even these offer no simple panacea.

Finnish society, like many other European ones, is in the throes of a major transition. More debate needs to be held on what to do to facilitate the transition, and in the meantime deficit spending to make investments in future productivity improvements seems not to be a bad idea. Running deficits in order not to change, in contrast, would be.

Tuesday, March 17, 2015

When Will The ECB Start To Taper?

What matters isn't what you think should happen, it's what others think will happen that counts.

Funny days these, the world seems to be constantly turning upside down. I could be talking about the arrival of negative interest rates in many European economies, but I'm not. What I have in mind is the crossover that seems to be taking place in the perceived fortunes of the US and the Euro Area economies. At the end of 2014 it was all "Europe bad, USA good" to the point that most observers were expecting an imminent rate rise from  the Federal Reserve, even while the Euro was in such a bad state that ECB was being steadily pushed - kicking and screaming - towards a full blown programme of sovereign bond buying QE.

But now, only 3 months into 2015 everything is switching round, as investors become increasingly bullish of the Euro Area recovery outlook, even while doubts on prospects for the US continue to mount. To take just one example,  US retail sales fell for the third successive months in February (whatever happened to the boost from lower gas prices?).

Indeed such has been the flow of negative data in the US that the Atlanta Fed GDPNow indicator has been steadily sliding downwards, with this weeks projection for Q1 2015 reading coming in at a measly annual 0.3%.

Well if the actual result is anything like this one, just get ready for all those Euroland overtakes US headlines.

 Surprise, Surprise!

One of the most striking features of this turnaround is the way the the trend in the Citigroup Economic Surprise Indexes has inverted. These indicators measure economic surprises for the US, Europe, Japan etc. in terms of whether data exceeds or falls short of consensus expectations. The Indexes weight selected economic indicators based on their influence on movements in the foreign exchange market on the day of their release. The standard deviation of the actual release from earlier economists' estimates are used to calculate the weights. The final indicator represents a three-month average of the raw daily figure.

Such indexes are quite useful as they give some sort of "soft" reading on whether economies are accelerating or decelerating at any given moment in time. If surprises are tending to the upside this means that (by-and-large) data is coming in better than the economists models forecast, and vice verse if the opposite is happening. Models base their expectations on historic data, but each moment in time is unique, so deviations from model predictions do have some meaning. And if these deviations follow a pattern, then they can give you a reading on the state of play of the business cycle.

Well,  if we turn to the current trends in the US and Euro indexes, we get an interesting "surprise".

Euro-land is on a strong upswing, while the US economy is congenitally under-performing (relative to expectations). Meanwhile monetary policy divergence is accelerating, but in what appears to be the wrong direction. The Federal reserve is widely expected to raise US interest rates sometime in the next six months (although doubts are growing), while the ECB has just launched a version of QE which seems to have achieved most of its objectives before it got started. Eurozone bond yields are down, even negative, inflation expectations have started to rise, the Euro has devalued sharply, and now even Mario Draghi is telling us that "most indicators suggest a sustained recovery is taking hold."

 (Movement in the Italian 10 year bond yield over last 3 years)

Euro Area inflation expectations have even started to rebound, even as their US equivalents keep falling.

So When Does The Taper Debate Begin?

In theory it is the intention of the ECB governing council to continue the 60 billion Euros a month bond purchase programme until September 2016, but as became clear in the Q and A session which followed the last meeting, this "intention" is in part data dependent. A point which has been forcefully hammered home in an interesting recent article from the FT's ECB correspondent Claire Jones - Euro plunge tests ECB inflation forecast.

As Claire points out, "The projections assumed that the exchange rate would stay where it was in the middle of February, about $1.13, until 2017. On Thursday (12 March), the single currency traded at $1.06. According to the ECB’s own estimates, a euro that weak would leave policy makers facing a headache about whether to scale down bond buying just months after unleashing their €1.1tn quantitative easing package."

In fact, she was very quick off the mark in picking this aspect up, since she had the following exchange with M Draghi during the press conference session:

Claire Jones (FT): What are the core inflation forecasts based on? Is it due to the bounce back in oil prices, or, now that you're more bullish on the economy does it reflect this?

Mario Draghi: Our monetary policy decisions have stopped a decline in inflation expectations that had started at the end of July last year.... It is true that, as you said, our projections of inflation are based on oil price futures, but also there are other factors, which play a role for core inflation. One is, of course, our monetary policy stance, and its effects on the exchange rate. The second one is the closing of the output gap, that we foresee happening gradually between now and 2017.

So straight out of the horses mouth, ECB monetary policy affects the exchange rate, and this affects the inflation outlook. So if, as many analysts are predicting, the Euro were to move towards parity with the USD in the coming months that would give an upside nudge to the bank's inflation expectations, and this would surely provoke a renewed debate on the ECB governing council about the desirability of proceeding as planned with the bond purchases. Remember, Mario Draghi didn't have a majority for proceeding with the programme as recently as December last year. As Claire says:

"The ECB has welcomed the euro’s depreciation, which should provide a much-needed boost to the eurozone’s exporters. But a sustained weakening could lead hawks on the governing council to ask some awkward questions about whether policy makers were right to keep on buying €60bn-worth of public and private sector bonds a month. 

"With inflation forecast to reach 1.8 per cent by 2017 the ECB is heralding QE a success less than a week into its launch. However, under an alternative scenario outlined in the projections, a much weaker exchange rate would probably lead the ECB to miss its target, with inflation likely to rise above 2 per cent by the end of the forecast horizon. 

The trouble is that the alternative scenario is already in danger of being realised. Under it, the euro is projected to dip to $1.04 by 2017. If the single currency continues to plunge at the pace it has done over the past five days then it would reach that level early next week.

The next batch of forecasts are not due till June, but already some of those who would favour earlier termination are out there testing the water. In fact Governing Council member Bostjan Jazbec, who represents Slovenia, was arguing it could end early one month before it started. "I understand it this way ...Once the price mandate is fulfilled, we can end it earlier," he told the Wall Street Journal on 5 February.

Marcel Fratzscher, who is not on the ECB board, but who - as Director of the DIW economic institute - has an influential voice in Germany, agrees. "The idea  [in Germany] is that the ECB has been doing too much, and should really try to taper the programme rather sooner and before September 2016", he told Bloomberg TV on 16 March.

"Particularly in Germany the exchange rate is a big issue... the conflict over monetary policy will again intensify over the next couple of months.... The argument of Germany against QE was so far it will not be effective, now the complaint is maybe that it's too effective because it has been driving down 10 year yields in Germany to close to zero it has depreciated the Euro."
A journalist for the Boston-based eFX News also wrote in similar vein. In an article entitled "ECB Tapering Talk Precedes QE Launch" we read:
"It may seem absurd to discuss the conclusion of QE before a single government bond has been purchased, but it's equally worth remembering that the controversial programme was pushed through the Governing Council against the expressed wishes of some heavyweight members, including Bundesbank President Jens Weidmann, who warned that improving economic data would negate the need to artificially suppress government bond yields and add to Eurosystem risks."

"Should inflation begin its sustained rise towards the Bank's 'close to but below' 2% target next year in the wake of a modest economic recovery and a rebound in global crude prices, the myriad issues the Bank faces with its QE programme may give the Council enough reason to slow the pace of monthly purchases in order to demonstrate the "symmetrical" nature of its consumer price vigilance."

Low Entry Bar Makes QE Easier To End

The fact that Mario Draghi was able to convince his Governing Council to introduce QE on March 5 surprised many observers, who expected Germany to put up more resistance to the idea. In order to get it through the ECB the policy was explicitly tied to the mandate: maintaining price stability. This is the only meaningful objective of QE - not unemployment, not growth - and presented in this way (as Mr Draghi pointed out) not going ahead would have been illegal. 

But, in this life, things that come easy are just as easily lost, so the low bar on entry will mean there is also a relatively low one for exit, and as Claire Jones suggests the tapering debate could start as early as June, especially with the Euro Area economies looking likely to outperform in the coming months.

The problem - as we are seeing in Japan where it looks like they are about to fall back into deflation again - is getting a short uptick in inflation  through currency devaluation is one thing, and solving a problem of deep structural deflation is another. If Europe's first brush with deflation is connected with its demography and declining working age population - as I argue here -  then any tapering that does take place in the purchasing programme won't be the end of the matter, and the bank will probably be forced back into buying again soon enough. In addition Europe's present recovery is cyclical, but long term structural impediments to growth remain, so don't expect the wonders to last.

But one thing at a time: you will hear growing talk of ECB tapering as the months pass, and the only real unknown as far as I am concerned is how exactly periphery government bond markets will react to the news.  

The above arguments are developed in much more detail in the recently revised version of my book "Is The Euro Crisis Really Over? - will doing whatever it takes be enough" - on sale in various formats - including Kindle - at Amazon.

Tuesday, March 10, 2015

Why Is Spain's Population Loss An Economic Problem?

"Growth theory was invented to provide a systematic way to talk about and to compare equilibrium paths for the economy. In that task it succeeded reasonably well. In doing so, however, it failed to come to grips adequately with an equally important and interesting problem: the right way to deal with deviations from equilibrium growth……..if one looks at substantial more-than-quarterly departures from equilibrium growth……….. it is impossible to believe that the equilibrium growth path itself is unaffected by the short- to medium-run experience…….So a simultaneous analysis of trend and fluctuations really does involve an integration of long-run and short-run, or equilibrium and disequilibrium. "
Robert Solow, Nobel Acceptance Speech

When the IMF said last year that Spain's unemployment level was unacceptably high, I was pretty critical of the fact that they didn't spell out the consequences of this, or offer any substantial policy alternative. The most obvious impact of this failure to find an alternative is being seen right now, with the emergence of political movements which could well turn the country's two party system completely upside down, and the steady flow of talented young people out of the country in search of work.

According to the latest Metroscopia opinion poll carried out for the newspaper El País ( March 7 2015), four parties (Podemos 22.5%, PSOE 20.2%, PP 18.6%, Ciudadanos 18.4%) are in close competition for first place in the forthcoming election. The lastest arrival on the national political scene is Citizens (Ciudadanos), a movement which despite being difficult to pin down in terms of specific policy, seems to lie somewhere to the centre right, between PP and PSOE in terms of its political ideology. It is very hard to predict what the outcome of the coming general election (due at the end of this year) will be, but it seems clear that no one party will have a majority. So governmental arithmentic is about to get complicated.

The first indication of what the political landscape might start to look like should come in Andalusia, which has regional elections on March 22. Then in May there will be regional elections in Madrid and Valencia, and municipal ones in large cities like Madrid, Valencia and Barcelona.  Such elections will, however, only give a vague impression, since personality factors and local loyalties will also be important.

As for the concerns which are driving this earthquake, these are clear enough from the opinion surveys: unemployment, corruption and the issues related to their current economic situation are by a long way the most important issues in voters minds, indeed despite all the talk of recovery the vast majority of them continue to think the current economic situation is either bad (41.8%), or very bad (33.8%).

Forthcoming alliances are hard to predict. Ideologically Podemos and Citizens may seem far apart, but the voter concerns which are driving their rise are often surprisingly similar, even if the solutions they offer are quite different. Over the corruption issue, for example, the possibility must exist of a de facto alliance between the two movements  to force major reform on the two "traditional" parties.

Another issue which will probably unite them is that of debt. Many of Spain's citizens are badly indebted, and many still have difficulty paying their mortgages despite very low interest rates. In addition there is the notorious "full recourse" rule, which means people who can't pay can't simply return their home and liquidate their debt. There is a wide feeling of injustice associated with the fact that property developers received limited liability mortgages (many of which have now ended up with bad bank Sareb, with losses being met by taxpayers) while ordinary citizens were given no such "escape clause". "Rescue the citizens not just the banks," is a slogan you often hear these days.

 It is unclear what Citizens propose to do about the issue, but Podemos's opinion is clear enough, and on this stance they enjoy widespread popular support, going well beyond those who will actually vote for them: they will revoke full recourse. It's not a mere detail  that the point Pablo Isglesias stressed in his interview with CNBC's Michelle Caruso-Cabrera was, "we can have governments that work for people and not for the banks," As the interviewer commented, "One thing he's really got going for him is ... that in Spain they can kick you out of the house and you still keep paying the mortgage. It's a recourse loan".

The other big issue is austerity. Spain still runs a large fiscal deficit  - 5.6% of GDP in 2014 - the largest in the Euro Area. At first glance, with so many elections taking place it doesn't seem likely this will come down that much this year, and in 2016 it is hard to imagine there won't be a parliamentary majority in favour of prioritizing bringing down unemployment over reducing the deficit, making some sort of clash with the EU commission not improbable. Nevertheless, as long as ECB QE stays in place investors are hardly going to worry too much so yields wouldn't necessarily be affected. But what if the ECB wanted to taper?

The Price Of Doing Nothing

The social and political risks associated with Spain  having conducted a far from complete economic adjustment are now becoming apparent, but there are also long term economic consequences, ones which may not be very evident at this point. People are often too busy celebrating a short term return to growth to ask themselves the tricky question of where all this is leading.

The most obvious result of having such a high level of unemployment over such a long period of time - Spain's overall rate won't be below 20% before 2017 at the earliest - is that people are steadily leaving the country in search of better opportunities elsewhere. Initially this new development was officially denied, and since there is little policy interest in the topic we still don't have any adequate measure of just how many young educated Spaniards are now working outside their home country.  Anecdotal evidence, however, backs the idea that the number is large and the phenomenon widespread. All too often articles in the popular press are misleading simply because journalists have no better data to work from than anyone else. On the other hand work like this from researchers at the Bank of Spain (Spain: From (massive) immigration to (vast) emigration? - 2013) only serves to illustrate how little we know, especially about movement among Spanish nationals.

On the other hand, when it comes to migration flows among non Spanish nationals we do have a lot better quality information due to the existence of the  the municipal register electronic database. Everyone who wishes to be included in the health system needs  to register with it (whether they are a regular or an irregular immigrant), and non Spanish nationals need to re-register with a certain frequency (so the authorities know if they leave).

More than an economic phenomenon, Spain's property boom was a demographic one. Since births only just exceeded deaths, between 1980 and 2000 Spain's population rose slowly, by just over 2 million people. Then between 2000 and 2009 it suddenly surged by 7 million. This was almost entirely due to immigration, with workers coming to the country from all over the globe attracted by the booming jobs market. Then in 2008 the boom came to an abrupt end, and unemployment went through the roof causing the trend to reverse. Since 2010 more people have left the country every year than have arrived, with the consequence that the population is now falling. Given that in 2015 the statistics office forecast that for the first time deaths will exceed births, it is most likely that this decline will continue and continue.

In fact the overall migration number - a net 251 thousand people emigrated in 2013 according to official data - only tells part of the story. The majority of young Spanish people working abroad are not included in these numbers (unless they have explicitly informed the Spanish authorities they are leaving, and few do this, partly because they do not consider themselves "emigrants"), but just as importantly the net balance masks very large movements in both directions. According to the national statistics office over half a million people (532 thousand to be precise) emigrated from Spain in 2013, while 285 thousand people entered the country as immigrants. So the net migration statistic covers over what are really very large flows.

The number of annual births in Spain has been steadily falling since the mid 1970s. They accelerated again slightly in the first years of this century, partly due to the shadow effect of an earlier boom in the 1970s, and partly because the incoming immigrants had a slightly higher birth rate. Coinciding with the outbreak of the crisis births peaked again in 2008 (after an initial peak in 1976 - ie 32 years later, average age at first childbirth is now just above 30) , and now the statistics office forecast a continuous decline.

The statistics office estimate there were just 2,280 more births than deaths in the first six months of 2014, which suggests that for 2015 as a whole the balance will probably be negative, as it will be in the years to come since the birthrate is around 1.35 children per woman of childbearing age. The drill-down effect means that since every generation is smaller, and there is only a replacement rate of about two thirds, the base of the population pyramid gets smaller and smaller over time.

The current data we have for Spain show the share of the population aged 65+ currently stands at 17% (or something over 7 million people, Instituto Nacional de Estadística-INE, 2008), of whom approximately 25% are aged over eighty. Furthermore, INE projections suggest the over-65s will make up more than 30% of the population by 2050 (almost 13 million people) and the number of over-eighties will exceed 4 million, thus representing more than 30% of the total 65+ population.

International studies have produced even more pessimistic estimates and the United Nations projects that Spain will be the world’s oldest country in 2050, with 40% of its population aged over 60. At the present time the oldest countries in Europe are Germany and Italy, but Spain is catching up fast.

In their most recent long term population projections the national statistics office suggested that Spain's population would fall to 41.6 million by 2052 (a 10% drop over current levels). While the number of over 80s rises sharply the number of people under 15 is forecast to fall to just over 5 million, a drop of about 25%.
But these long term projections only give an us an indication of what might happen given that there could be major changes in trend. Population movements are governed by two factors: the birth/death difference and by net migration. Since we are unlikely to see any substantial movement in the birth rate, migration becomes the critical variable. And what does migration depend on? Evidently the job market. This is why this issue is so important.

At present the rate of outward migration from Spain seems to be slowing as the economy starts to create jobs. But just how stable and sustainable is this trend? This is why the issue of whether or not Spain has taken enough measures to ensure a better longer term growth rate (a growth outlook which moves beyond picking the low lying fruit after the recession) becomes important. In the short term population projections published in November 2013 by the statistics office, Spain's population was forecast to fall by 2.6 million (5.6% of the present population)  over the 2013-2023 decade. The largest population decline was expected to be in the 20 to 49 age group, which was expected to fall by 4.7 million (or 22.7%).

These are dramatic numbers, but it must be emphasized that they are very sensitive to emigration rates. For the moment the improving job market means the outflow numbers (while remaining large) are decreasing, although again it must be emphasized once more that we have very little knowledge about the actual migration rates of young educated Spanish citizens.

Whatever way you look at it this state of affairs is highly undesirable, and raises serious questions about the sustainability into the medium term of Spain's current economic recovery. If the level of unemployment is "unacceptably" high, this is partly because of the damage it will do to Spain's economic outlook in the longer term.

But won't they all come back? This is the answer I get time and time again. Such an outcome is far from guaranteed, even if it is what policymakers implicitly assume. As I am trying to suggest, whether those who are leaving come back or not depends on the state of the Spanish job market, and despite the fact jobs are now being created the size of the problem means the situation on the ground will remain difficult for many, many years to come. Some point to surveys, like the one shown in the chart below carried out by recruitment experts Hays, which show that a large majority of those leaving want to return. But wanting is not the same as being able. Few want to leave their home countries and their families to start a new life in a distant land, but many are now being forced to do so. Most initially don't see themselves as emigrants, but as time passes there is a growing possibility that that is exactly what they will become.

So What Are The Probable Economic Consequences of Doing Nothing?

What matters in Spain is not the fact that the economy is recovering. More important is how it is recovering, and how quickly the jobs market could get back to normal. Otherwise the risk exists that the longer run growth potential could fall even as the unemployment rate remains high.

It is a simple fact that as Spain's working age population falls so will the long term potential growth rate also fall.  And if growth is lower, then new jobs will be less. As can be seen in the diagram below (which illustrates how EU Commission calculates potential growth rates). There are three inputs which matter a) the existing capital stock, b) labour force growth (which is a function of working age population), and productivity.

Now it is clear that as working age population turns negative (which basically happened in Spain around 2012) the dynamic also becomes negative for potential economic growth, and the only real hope of sustaining it in the longer term is via (total factor) productivity growth. But this - the  "oh well, we'll raise productivity" argument - isn't as easy as it seems. The following chart which was produced by Fulcrum research based on Conference Board and IMF data and shows clearly how the trend towards lower productivity growth in developed economies is now decades long. It simply isn't credible to imagine that this trend is going to be turned around at the click of a finger.

So one of the obvious consequences of this population loss is a permanent fall in the long run trend growth rate. This situation is concealed at the moment as the very high unemployment rate means that in the short term an above trend rate of growth is possible, but this favorable situation won't last forever.

Housing Issues

The most obvious area of the economy to be affected by population decline is the housing sector. Spain has a very large stock of empty houses (well over a million, possibly two, between new and second hand), and the rate of home sales while rising is still very low.

During the boom years the fact that a very large "boom" cohort was in the household formation a group and then that a large number of immigrants arrived to set up their homes was a key factor in fueling the boom.

During 2007 474,000 new households were set up. In 2014 the equivalent figure was 117,000. Given this new dynamic it is very difficult to see how the outstanding stock of houses can be sold, how prices can recover, and how new building construction activity can take off again.

And Then, What Happens To Pensions?

Spain's pension system is on the rocks. Before the crisis it was running constant surpluses, but now the trend has reversed, and  it is in constant deficit, and the shortfalls look set to stretch forwards as far as the eye can see. The curious detail about this situation is that even as the crisis deepens the government keeps raising the real value of pensions being paid.

On the other hand household consumption is surging: it was up an annual 3.9% in the last three months of 2014, a phenomenon which is leading many to talk of "good deflation" in Spain. But what proponents of this argument tend to forget is that someone if paying for this "deflation boost" party. I the case of salaried workers the cost is carried by their employers, but in  the case of pensioners the "fiesta" is being charged directly to the account of future generations of pensioners, as Spain's mini boom becomes increasingly consumption driven.

 Shifting The Burden Onto The Reserve Fund

The fact that Spain's pension system was going to have problem maintaining the level of payments has long been known. In fact in recent years there have been two reforms which have tried to address different aspects of the problem. But it is really the huge loss of employment during the crisis that has really highlighted the chronic nature of the underfunding the system is being subjected to. Initially the then socialist government plugged the growing funding gap out of general government finances, but as financial markets started to focus on the size of the country's fiscal deficit this practice became increasingly problematic.

With the arrival of the PP there was a change in strategy and since 2012 the pensions deficit has been funded by drawing down on the Reserve Fund. This was established in 2000 and was meant to ensure the long term sustainability of the system, especially as demographic pressure mounted towards the end of this decade. The Fund had been accumulating the surpluses generated in the 2000 - 2007 boom years.

The financing switch has helped the headline fiscal deficit number, but the decline in the Reserve Fund that has been the result is starting to make a growing number of Spaniards increasingly nervous.

One part of the problem the system is having is simply the result of population ageing: the balance shifts as the number of pensioners rises and the number of contributors for each pensioner falls. Another part is the result of the recent economic crisis (since with so much unemployment less people contribute) while a third contributing factor are the recent changes in the labour market structure which mean that young people now earn a lot less than those retiring, leading average contributions to fall, while average pensions rise.

Some of the results of this sea change  can be seen in the chart below (sorry about the Spanish, but I think the main points are easily grasped). The number of contributors for each pensioner hit a high of 2.71 in 2007, since then it has been falling and was at 2.25 in 2014. The number of pensioners has risen from 7.6 million in 2007 to 8.4 million in 2014.

The average pension paid is also rising. In February 2015 the total amount paid out by the system in pensions was up 3.1% year on year. But the number of pensioners was only up 1.3%, so the average pension went up by 2.1% due to the fact that the most recent retirees have been earning more than earlier cohorts and are thus entitled to higher pensions. We don't have data on this year's pension system income yet, but at the end of last year it was rising at about 1.5% a year, leaving a growing shortfall for the system to cover.

As I said, under the former PSOE  the shortfall was funded out of the general government budget, and possibly 1.5 percentage points of the 9.6% 2011 fiscal deficit were the result of this financing. With the arrival of the PP in government this policy changed, and pension financing moved over to the Reserve Fund.

The attrition has been constant and the Fund is now starting to dwindle. In 2012 7 billion euros were withdrawn, in 2013 it was 11.6 billion euros and in 2014 15.3 billion euros (or 1.5% of GDP). If you want to compare apples with apples and pears with pears, you would need to add this 1.5% of GDP to the 5.6% fiscal deficit, giving a 7.1% deficit using the same accounting criteria as 2011. Put another way the deficit has really been reduced from 9.6% to 7.1% in 3 years, hardly dramatic austerity. Instead of paying the pensions gap out of current income the government are using a credit card issued by "future pensions" to keep payments up even though the situation is obviously getting worse, meaning it will be even more difficult to pay current pension levels in the future than it is now.

As a result of all these withdrawals the size of the  Reserve Fund has fallen from its 66.8 billion euro peak in 2011 to the current level of 41.6 billion euros. At the moment the government have budgeted for another 8.4 billion euro withdrawal this year, but this number could easily turn out to be larger.  So 2015 should close with around 30 billion euros outstanding - about 3 years more money at the current rate. It is clear that soon after the election changes will have to be made. Even though the number of contributors to the system is growing as the employment situation improves the rate of spending is rising faster.

There was a pension reform in 2013 which was intended to address the problem by making the system self financing. A complicated formula was introduced whose intention was to ensure that more money didn't go out - on a structural basis - than came in. But this was in the era when Spaniards still expected inflation as their economic default setting. As a result - and as a way of selling the reform - a minimum increase of 0.25% was set. Last December consumer prices were down 1.5% over a year earlier, and as a result the minimum rise was a generous "vote winning"  increase of 1.75% at a time when the system itself was running at a huge loss. Something similar will happen this year, giving at least one part of the explanation as to why retail sales are doing better - in part these increased sales are being paid for with future pensions.

Madrid Fiddling While The Future Disappears Under Its Feet?

In principle, the fact that people are moving around looking farther afield for work is a good thing isn’t it? Simple economic theory suggests it should be. Indeed one of the habitual criticisms made by outside observers about the way in which the Euro currency union operated during the first decade of its existence concerned the absence of labour mobility within the region. Labour mobility as an adjustment mechanism in the face of economic shocks has been a leading topic in the economic literature on currency unions, both in the United States and in Europe. More than 50 years ago, in his seminal paper on optimum currency areas, Robert Mundell stressed the need for high labour and capital mobility as a shock absorber within a currency union: he even went so far as to argue that a high degree of factor mobility, especially labour mobility, is the defining characteristic of an optimum currency area – i.e. one that works well. Thus, a key question when evaluating whether the Eurozone is an optimal currency area has always been: how important is labour mobility as an adjustment mechanism in Europe compared with, say, the United States?

So now that people are finally moving from one Euro Area country to another in search of work the currency union is working better, isn't it?

If only life were so simple. Two issues arise in the case of labour migration within the EU that make the situation different to that of movement from one US state to another. In the first place US states are inside one and the same country. This is important when we come to think about things like unemployment benefits, health systems and pension rights. In the second place US fertility still hovers round about population replacement level (2.1 total fertility rate). In most of the countries on the EU periphery fertility levels are significantly below 1.5 children per woman of childbearing age (Tfr), and have been for decades.

More recent evidence, however, suggests that things are now changing even there with 2011/2012 marking a turning point in migration patterns and population momentum all across the southern rim. The number of newly registered migrants into Germany from Italy and Spain, for example, rose by about 40% between the first half of 2012 and the first half of 2013. The number from Portugal rose by more than 25% over the same period and since then the process has accelerated. Numbers for London and Paris reveal a similar pattern.

Since unemployment in the Euro Area currently ranges from about 5% in Austria and Germany to over 25% in Greece and Spain there is plenty of potential for imbalance adjustment. Half-a-century after Mundell’s original article was published, the most ambitious attempt yet to create a single currency spanning a wide variety of national boundaries is about to see “optimal” labour mobility. But is it really so optimal? Is it as desirable as many assume to correct imbalances between countries through working age population flows rather than through devaluation? Is there any way to evaluate outcomes? Are there hidden costs in doing it in the former rather than the latter way?

As Nobel economist Robert Solow puts it in the quote with which I start this post, it is impossible to believe that the longer term path of an economy is unaffected by the trajectory taken during periods of deviation from trend - whether upwards or downwards. Emigration, and with it negative working age population dynamics, are being promoted by the ongoing labour market crisis in the worst affected countries. The question is just how far the longer term future of these countries is being put at risk by the form in which the adjustment is taking place. In allowing this to happen instead of addressing excessive indebtedness issues, are we simply replacing short term debt defaults with longer term pension and health system ones?

Young people are moving from the weak economies on the periphery to the comparatively stronger ones in the core, or even out of an ever older EU altogether. This has the simple consequence that the fiscal deficit issues in the core are reduced, while pressures on those on the periphery are only liable to get worse as welfare systems become ever less affordable. Meanwhile, more and more young people could follow the lead of Gerard Depardieu and look for somewhere where there isn't such a high fiscal burden, preferably where the elderly dependency ratio isn't shooting up so fast.

What impact are the migration trends within the Euro Area going to have on trend GDP growth and structural budget deficits in the respective member countries in the longer term? These questions are just not being asked.

As often happens in economic matters, solutions to one problem are inadvertently promoting the creation of another. Avoiding radical debt restructuring on the periphery, and going for a "slowly slowly" correction doesn’t necessarily mean that all other things remain equal. The Euro is being held together by allowing unemployment rates to adjust towards a narrower range via population flows.

The question is, is this good news? Obviously in one sense it is, if this is needed to make the Euro work it has to happen. But there is a downside: changes in the political process are lagging well behind developments in other areas, and especially in the migration one. It has been clear since the Euro debt crisis that a common treasury was a necessity for the good functioning of the currency union, that all participants would need to make sacrifices in this regard, yet progress towards this objective has been painfully slow, and full of bitter recrimination. At the end of the day the  migration problem might just the issue that brings this simmering problem right to a head.  


The above arguments are developed in much more detail in the recently revised version of my book "Is The Euro Crisis Really Over? - will doing whatever it takes be enough" - on sale in various formats - including Kindle - at Amazon.

Sunday, March 1, 2015

Does The Arrival Of Negative Interest Rates Change the Attractivess of Euro Membership?

This is the second in a series of posts (first one here) in  which I try to argue that the balance between costs and benefits of belonging to the European monetary union has shifted in the post crisis world, especially for heavily indebted countries such as those to be found on the European periphery.

The benefits of belonging (in terms of debt support given via ECB QE) have risen, while the disadvantages of being outside - as has been seen in countries like Denmark, Sweden and Switzerland - have also grown. This is not a complete cost/benefit balance sheet, but a limited exploration of just one area. That being said it is an area where exploration may help those who simply can't understand the recent determination shown by the Greeks to maintain their Euro membership, a determination which I think is difficult for those in London or the US (who are using a traditional deleveraging and monetary policy framework) to understand.

The key factor in tipping this balance has been the decision of the ECB to adopt a programme of sovereign bond purchasing QE. In the previous post I explained the situation as I see it about (existing and future additional) debt (low bond yields, free interest on debt purchased by central bank, etc).

The scenario I outlined is based on a number of simple  assumptions.

i) That the long term movement towards lower interest rates is demographically driven.

 ii) That an ongoing demographic transition offers the backdrop to the arrival of long term deflation in Japan and now a number of European countries. (See: Negative Interest Rates Are Here To Stay, by Tomas Hirst)
iii) Since the problem is demographic central bank quantitative easing will not generate long term and sustainable inflation. (See Maasaki Shirakawa: Is Inflation (or Deflation) "Always and Everywhere" a Monetary Phenomenon?
iv) Given this central bank interest rates are likely to remain near to zero indefinitely and some form or other of QE is here to stay. Indeed, with interest rates increasingly stuck on the zero bond (is it still a bound any more?) monetary policy is going to be all about how many non-standard measures you use, and currency levels and increasing function of how much, when compared with the other main players.

I would argue that my assumptions are both realistic and plausible, and of course have the advantage that they can be readily falsified, by the BoJ or the ECB being eventually able to "normalize" interest rates, for example. (On this see Larry Summers, "will there room the next time we have a downturn for a 4% point decline in rates?"). Such assumptions paint one possible scenario which is,  if you like, my baseline case. This scenario may not be realized, but can economic and policy agents afford to ignore the possibility that it will? And if it does turn out to be confirmed by a rapidly changing reality, would this not change how we should think about Euro membership before recommending to countries like Greece to either stay or go?

Greece is a clear case of what I am talking about, since its current 175% of GDP government debt level has been reduced to a convenient "fiction" (with little in the way of real cost to the country) backed by the appropriate accounting framework which satisfies various national parliaments and confuses rather than enlightens the average layman. Further, if Greece eventually qualifies for ECB bond purchases then this "debt for free" component will only be consolidated.

So while Greece could exit the Euro and devalue, any benefits gained in terms of increased tourism would need to be offset against the fact that it would have to pay (probably at significant rates of interest) for at least some of its debt.

But here I do not wish to dwell further on this aspect of the situation, rather I'd like to look at the impact of having only a mid-size central bank at a time when a large neighbour (the ECB) is about to embark on a sizable QE programme. 

The Arrival of Negative Interest Rates

The arrival of QE at the ECB is having substantial consequences all around the frontier of the monetary union. It is having identifiable impacts in countries as diverse as the UK (GBP hit a 7 year high against Euro this week), Switzerland, Denmark, Sweden, the Czech Republic and Poland.

While countries like Switzerland and the UK saw their currencies appreciate during the existential Euro crisis due to their "safe haven" status, what is happening now is a quite different phenomenon. In the first phase money was fleeing the currency union fearing conversion risk, now it is being driven out by an explicit policy of the central bank. At the very same moment Greece was being pushed near to the point of introducing capital controls to stop capital flight, Denmark was rumored to be near to introducing them to stop capital inflows.

The build-up towards ECB QE is the essential backdrop to all this. The ECB is implementing a policy which is intended - however much the bank denies they target any given currency level - to make the Euro weaker, based on the idea that this should stimulate growth by encouraging exports, and raise inflation by making imports more expensive. This is the process we have seen at work in Japan. One of the main channels through which QE achieves this effect is via the so called portfolio effect. The central bank action (or even the promise of it) lowers yields on the bonds since they become virtually risk free and it is going to purchase, making them less attractive for investors. Faced with this, and with the fact that as the Euro weakens the USD value of such investments weakens, the hope is investors offload the bonds they have in their portfolio to the ECB and put the money freed up to use elsewhere. In fact the bank even introduced a negative deposit rate for those commercial  banks storing money in its vaults to try to induce this effect.

In principle it is hoped that the additional liquidity generated ends up financing lending in the struggling economies of the Euro Area, but in practice it is more likely the funds move offshore (at least while the Euro is trending down), in the process weakening the Euro. The challenge for investors under these circumstances is to find currencies whose value is likely to rise as the Euro falls: enter the Swiss Franc and the Swedish and Danish Crowns.

The Swiss Cap

The Swiss National Bank hit the headlines in January when it unexpectedly removed the 120 cap on the Swiss Franc exchange rate with the Euro, a policy measure which has been kept in place over more than three and a half years. Within minutes of the announcement the CHF surged, and was up by 30% at one point during the day, although it did eventually settle down at a level of 0.98 to the Euro, a rise of nearly 20%.

At the same time the SNB lowered the deposit rate rate from -0.25% to 0.75% taking it deeper into negative territory. The decision caused havoc in financial markets and was widely criticized for its abruptness, although it is hard to see how, once you have such a measure in place, you can remove it other than abruptly.  The move hit those who had been foolhardy enough to borrow in Swiss Francs hard, and will probably hit Swiss exporters even harder over time, but given the relative sizes of the two central banks the country had little alternative. Now Switzerland will import some of the deflation the Euro Area wants to export.

Swiss bond yields soon followed the deposit rates into negative territory.

And it wasn't only the 10 yr bond, those of shorter duration went to ever lower levels. On the 22 January the 1 year bond yield hit -1.38%.

Negative rates have even started to reach corporate bonds, raising the possibility that companies could eventually be paid to borrow the money to proceed with share buy-backs.On 3 February a 20 month Nestle bond started trading below 0%.

Then Came The Danish Peg

Seeing the havoc - and trading opportunities - that were created in markets by the Swiss Cap removal investors did not need much convincing to  put themselves to work looking for other possible "volatility" candidates, and it didn't take them long to stumble upon the Danish Krona's peg with the Euro.

Voters in Denmark rejected Euro membership in a referendum at the start of the century.  As a consequence the Danish krone now forms part of the ERM-II mechanism, with an exchange rate which is tied to a band of plus or minus 2.25% around a rate of 7.46038 to the Euro. The question is, are the Danes enjoying this situation? Would they like, as many in London assume, to move to a free floating currency? Looking at the determination of the Danish central bank to resist the pressure of those who would break the peg, the answer seems to be no. The Danes, and especially their important export industries are anxious not to follow along the Swiss path. Yet the cost of trying not to do this is not negligible.

 In the first place, and despite having an already over-leveraged household sector, you can get paid in Denmark to take out a mortgage (and here, in Danish). Danish households owe their creditors 321% of disposable incomes, according to the Organization for Economic Cooperation and Development. "That’s the highest ratio in the world and a level that’s prompted warnings from both the OECD and the International Monetary Fund to rein in borrowing. Danish authorities have argued that households aren’t at risk thanks to high pension and household equity levels", according to Bloomberg. Meanwhile, even years after Denmark’s property bubble burst, house prices in the country’s biggest cities are already higher than at any point in recorded history.

The backdrop to the situation has been the Danmarks Nationalbank's constant lowering of the deposit rate (3 times in three weeks) to a current global record low of minus 0.75%.  “The main message is that we are ready to do whatever it takes to defend the peg," central bank governor Lars Rohde told the Financial Times, "We have unlimited access to Danish krone and we have no restrictions on our balance sheet.”  Asked how low rates could go, Mr Rohde replied: “We have to admit that we are in unmapped, uncharted territory. Of course, we are well aware there are negative impacts on the financial industry of negative interest rates. But our priority is simply to defend the peg and we will do what it takes.”

Another unusual result of the policy is that commercial banks are now starting to charge retail customers negative interest on their deposits. In times of negative lending rates "paying our customers zero or positive interest is very bad for profitability", Palle Nordahl, FIH Erhvervsbanks chief financial officer, told the Wall Street Journal. Denmark is itself experiencing very strong disinflation and the central bank is clearly concerned lest this becomes outright deflation, yet breaking the peg and floating would see the currency pushed up, not down as the country needs.

And Finally Sweden Sprints For The Bottom

On 11 February the Riksbank, the very selfsame one that Paul Krugman had referred to as "sado-monetarist" for its 2010/11 rate hikes, surprised everyone by announcing it was cutting its benchmark rate to minus 0.1%. At the same time the bank announced a QE style programme of bond purchases. In fact, those looking at what had been happening in Switzerland and Denmark should not have been so surprised: bets the country's currency would rise had been increasing at the same time as the country was sinking steadily into deflation. No other central bank has maintained a negative deposit rate as low as the Riksbank has. The bank reduced the rate for commercial banks to -0.85% in Feb after having maintained it at -0.75% since October 2014, just to keep one step ahead of the Danes.

In fact the central bank's monetary policy had been geared to steadily weakening the currency over the last two years, and Bloomberg have the currency down as the worst performer among nine major currencies, with a drop of some 12% over the last 12 months. Naturally all this was being put in jeopardy by the arrival of the big ECB neighbour onto the quantitative easing terrain. As central bank governor Stefan Ingves put it: “It’s like sailing in a small boat on a big ocean.That’s reality when you come from a midsize fairly open economy.

What makes the Swedish case such an striking one is that the economy is growing quite rapidly - it was up 1.1% q-o-q in Q4 2014, and by 2.7% y-o-y -  and the housing market is booming.  Credit growth was an annual 6.1% in December, while house prices in January were up 9% over a year earlier. And Sweden comes second only to Denmark in an international comparison, with mortgage debt running at around 80% of GDP. Yet such is the fear of what the backdraft from ECB might be that policymakers felt they had little choice but to go for what they clearly see as the "lesser evil".

Global Financial Accelerator

I think it is now reasonably obvious to all concerned that having a single size monetary policy that did not make allowance for the specific needs of individual countries played a significant part in blowing credit bubbles and facilitating competitiveness-loss on Europe’s periphery. So far so good. But having noted this, it’s worth remembering that the world we live in today is not identical to the world of the early 1990s when the essentials of the Euro architecture were first thrashed out.

In particular financial globalisation and mass migration flows have significantly changed the environment in which monetary policy operates. One of the first to draw attention to the way things were changing was the Danish economist Carsten Valgreen who coined the expression Global Financial Accelerator in the pre-crisis years to describe one of the most important of the new phenomena. Simply put normal standard interest rate policy had been weakened by the growth of non-linear currency effects. This point has still not gotten  home to many policymakers, a reality which was underscored by a recent interview given by the OECD's chief economist, Catherine Mann. “It’s actually strange that there’s such a pressure for appreciation,” she told Bloomberg's Peter Levring when asked about what was happening to the Danish Krona.

The economy isn’t that strong, it’s not very different from the euro area, so demand for appreciation shouldn’t be that strong,” she went on to say. It shouldn't be, but it is, and this is hard to understand using conventional models, although as we have seen it is perfectly comprehensible and even predictable. It's the forex factor that dominates yields, and if the peg breaks and the Krona spikes upwards as the Swiss Franc did there is plenty of money to be made by holding Krona denominated assets. Since the ECB is a lot bigger and a lot stronger there is little downside risk, and in addition Denmark is rated Triple A.

In fact, Allianz SE's chief economic Mohamed El-Erian clearly gets the key point in his recent  Bloomberg View article: investors aren't driven by yield, but by the possibility of capital gains if yields are driven even deeper into negative territory.
"The seemingly illogical willingness of investors to pay issuers to borrow their money is neither irrational nor driven by just noncommercial considerations (such as regulatory requirements or forced risk aversion). As the European Central Bank prepares to start its own large-scale purchasing program next week, some investors believe they could make capital gains on such negative yielding investments."
And this situation is not new. Already in the early years of this century Valgreen was drawing attention to just how powerless national monetary policy had actually become, especially in small open economies, in a world of fluid cross-border financial flows. The thought involved is really quite straight forward: real economic decision makers are increasingly insulated from local monetary conditions and more sensitive to global ones and transnational credit extension willingness (or, if you prefer, global risk sentiment).  In order to illustrate his point he selected two countries – Iceland and Latvia - both of which were later to gain a certain degree of notoriety. As it turned out neither the Icelandic nor the Latvian central bank were able, using simple recourse to conventional monetary policy tools, to control the rate of credit extension in their countries. The end result in each case was surprisingly similar, despite the fact one had a free floating currency and the other was on a peg.

The Icelandic central bank could control the interest rate on Icelandic Krona. But that did not matter much for households, non-financial companies or banks borrowing funds in foreign currency. As Valgreen argued in the Icelandic case, as long as the banks maintained a high credit rating and were perceived as sound by the international markets, credit flows easily to them in a liquid global environment. “Perversely”, he noted, “it even seems as if a stronger currency stimulated the Icelandic economy in the short run, as consumer spending reacts to increasing external buying power and as exports are concentrated in price insensitive commodity sectors.”

What seems to matter more than ever before is global liquidity, and global risk sentiment as can be readily seen at the present time in the growing market for European periphery government bonds.

While Valgreen was probably the first to identify this “perverse” rising-currency stimulating credit-growth (financial accelerator) phenomenon, it was later to gain much more attention following Ben Bernanke’s various attempts to put the pedal to the metal on US credit demand via systematic quantitative easing. His policy was most successful, not as he had intended in the United States, but in countries as far apart as Thailand, India and Brazil. Reserve Bank of India governor Raghuram Rajan's revealed his frustration when he went to Frankfurt last year and complained to his audience: "We seem to be in a situation where we are doomed to inflate bubbles elsewhere."

Thus the world of international macroeconomics has changed mightily over the last decade, and things are far from being what they used to be. Which should give us all some serious food for thought when it comes to arguing in favour of a simple return to the status quo ante in the case of the Euro Area countries.It should also help those living outside the Euro Area who to understand the strong desire shown by voters in Greece and elsewhere to stay in EMU despite all the evident disadvantages. On a worst case scenario Greece could become another Serbia, an outcome few either in Greece or outside would wish on the country, but on the best case one it would become a Denmark or a Sweden, with its monetary policy and its currency value essentially determined elsewhere. They would most definitely not be getting the ability to determine their own future since the days when international capital movements were characterized by simple models like Krugman's eternal triangle are now long gone.


The above arguments are developed in much more detail in the recently revised version of my book "Is The Euro Crisis Really Over? - will doing whatever it takes be enough" - on sale in various formats - including Kindle - at Amazon.