By Christopher Briem, on September 7th, 2012
So not the normal place to find urban stuff, but Foreign Policy has an issue dedicated to cities. They cite a list of the world’s 75 most dynamic cities. Don’t get excited. No, we are not on it. I suspect that measuring city size or region size every place on that list is just a lot bigger than we are.
One interesting thing though is that the list does include a place called “Rhine-Ruhr” as #51. There used to be a cottage industry comparing and contrasting the steel-post steel histories of Pittsburgh and the Greater Ruhrgebiet region. Lots of shared industrial decline history between the two regions. The comparison is not perfect. The Rhine-Ruhr region is clearly not any one ‘city’ but several. Duisburg, Dortmund, Düsseldorf, Essen, Heidelberg and others; the essence of a ‘conurbation’ to use the 75 cent word (inflation you know).
Duisburg may ring a bell with long time readers here. I mention on occasion Duisburg, one of the Ruhr cities that has an awful lot of similarities to Pittsburgh past, Pittsburgh present and arguably Pittsburgh future at this point.
By Ajay Shah, on November 18th, 2011
How did it happen?
The worst financial crisis in the western world for nearly 80 years broke in September 2008.
It required banking/financial systems to be supported and recapitalised by governments across the EU and in the US.
In June 2009 it became apparent that the peripheral countries of the Eurozone (Greece, Portugal, Spain and Ireland) were grossly over-indebted.
Yet in some instances (Spain) their public debt to GDP ratios happened to be lower than those of the US, France, the UK and Germany.
The continued viability of their public finances depended entirely on markets being willing to refinance them with cheap money.
But, when markets scrutinised the sustainability of their fiscal positions, they baulked from refinancing except at punitive rates.
CDS spreads (against Germany as a benchmark) of peripheral Eurozone countries (PIGS or Club Med) debt began widening relentlessly.
Global financial markets began to price in an escalating risk of partial/full voluntary/involuntary default on PIGS bonds since December 2009.
Contrary to first impressions, except for Ireland, that was a result not just of the financial crisis and bank recapitalisation demands on the fiscus.
It became apparent instead that bank recapitalisation demands on public finance were only the last straws that broke the camel’s back.
Greece, Portugal, Spain and Italy, as a direct consequence of joining the Eurozone, had been running up unsustainable fiscal deficits since 2000.
Ireland had not. It suffered because the bailout of its disproportionately large banking system caused its public debt to rise astronomically.
PIGS became over-indebted despite the supposed self-imposed discipline adopted by the Eurozone of prohibiting fiscal deficits >3% of GDP.
That discipline was violated by almost all Eurozone members, beginning with France and Germany, but more egregiously by the PIGS.
To make matters worse, however, the PIGS were also running increasingly large current account deficits (with Germany, France, China).
Though countries like France (and to a lesser extent) Germany were fiscal sinners, they were at least running current account surpluses.
PIGS had access to excessively cheap public and private money available on terms totally inappropriate to their economic circumstances.
Given their inherent risks, which markets mispriced completely, their borrowing costs should have been 300-500 bp higher than Germany’s.
Instead, they were virtually the same for nearly a decade. That relieved market-induced pressure on PIGS’ governments to behave responsibly.
Consequently, their public expenditures after 2000 ballooned out of all proportion to their intrinsic capacity to fund them from tax revenues.
Such expenditures became almost wholly dependent on access to increasing amounts of cheap public borrowing from capital markets.
In response to access to excessively cheap money, wages in the PIGS rose across the board as did growth in public sector employment.
With the financial crisis triggering bank recapitalisation needs, on top of this unsustainable structure, the edifice began to crumble.
The first early warning signals became apparent in December 2009 but the dam broke in mid-2010 with the first Greek bailout.
How has the Eurozone crisis been handled?
Extremely ineptly; indeed very foolishly, by sophisticated Eurozone authorities (political, fiscal and monetary) that should have known better.
Eurozone leaders learned nothing from the preceding debt crises in Latin America (1982-87, 1994-95) and Asia (1997-2000).
They went through avoidable phases of serial denial that there was a structural debt (solvency) crisis that could spread via contagion.
They treated it as a liquidity crisis that could be dealt with by temporary patch-ups of additional money combined with fiscal restraint.
They reiterated their commitment to ensuring there would be no default – partial or full, voluntary or involuntary – by any Eurozone member.
They believed that their remedial measures would stop the crisis from ballooning beyond the first bailout package for Greece.
They were totally wrong. That package did nothing to convince markets that Eurozone leaders understood the nature/severity of the problem.
In fact, the inadequacy of that first bailout package — which did not provide enough money for sufficiently long – became quickly apparent.
Eurozone leaders were fixated on debt-affected PIGS being forced to live within their means through indefinite austerity without end.
Debt recovery/sustainability models did not provide sufficient new money, or permit debt restructuring, in ways that would restore stability.
Least of all were bailout packages designed to restore growth in a conscionable period of time that would be socially/politically acceptable.
Without financial system (and borrowing cost) stability, and absent growth, debt problems can never become better. They can only worsen.
Instead, as a result of poor design, all the bailouts did (except for Ireland) was to add new debt to bad debt and reduce growth prospects.
To exemplify: In mid-2009 the debt/GDP ratio for Greece was 115% of GDP and the debt service ratio about 11% of GDP.
But, by October 2011 the debt/GDP ratio for Greece was 161% of GDP and the debt service ratio nearly 20% of GDP.
It is projected with the third bailout to rise to 185% of GDP (although debt service will be lowered to 16%) before it comes down again.
In the meantime, over the last 32 months, the Greek economy has shrunk in size by almost 17% in nominal terms. It will be 1/5 th less in 2012.
Such inane ‘remedies’ do not solve debt problems. They only aggravate and exacerbate them.
While behaving in this absurd fashion Eurozone leaders repeatedly asserted for two years that they would do everything in their power to:
- Maintain the credibility of the Euro while ensuring that every member stayed in the Eurozone
- Not allow any default of publicly issued bonds to occur; and
- Do everything possible to avoid contagion spreading beyond PIGS (even as it became clear that markets were worried about Italy.
Instead they achieved the exact opposite of all three objectives through their inability to understand the implications of what they were doing.
Though now contrite and claiming to have learnt a few lessons from their serial bungling over 30 months Eurozone leaders have no solution.
The EFSF facility they created is woefully underfunded. It can barely deal with financing the third Greek bailout.
The idea of leveraging it or using it as a partial guarantee facility is absurd since it would add to risk and uncertainty not resolve them.
Yet over-indebted governments (including France and Germany) would have to issue more public debt in order to fund the EFSF properly.
That would simply mean requiring their fragile, near-bankrupt, banking systems (or the ECB) or global markets to buy more Eurozone debt.
Except for Germany (and even that will be in doubt soon) the market has no appetite for taking on more Eurozone debt given its risks.
Contagion has spread from the periphery and now lodges at the core of the Eurozone economy in which Italy is the third largest member.
What could have been resolved with about 300 billion euro in additional financing in mid-2010 is now a problem that may require 2 trillion euro.
Where are we now?
Over 35 EU/Eurozone summits in 30 months have resolved nothing. They have made matters worse; despite Herculean exertions!
Right now Greece is in ‘effective’ default; though markets are overlooking that because of the implications of CDS contracts being triggered.
Its borrowing costs for refinancing its debt would exceed 30% if it had any access to private markets; which it does not.
Any refinancing of, or addition to, Greek debt can now only be financed by the ECB; which the Germans will not permit the ECB to do.
Meanwhile the Greek banking system is bankrupt. Indeed the entire Eurozone banking system’s credibility/stability/solvency is in doubt.
Today an outstanding portfolio of about 11-12 trillion euro in Eurozone debt – of which about 80% is held by EU firms – is souring relentlessly.
About 7 trillion euro of that portfolio is sufficiently affected by contagion to require provisioning (France and Belgium may soon be added).
About 5 trillion euro of Eurozone high-risk-debt is currently held by EU banks, insurance companies, pension funds and individuals.
That sovereign debt, which is supposed to constitute the ’safest’ component of any asset portfolio, now constitutes perhaps the riskiest element.
That reality inverts the whole basis of banking/financial system soundness and stability across Europe (including the UK).
It compounds the problem of calculating capital adequacy requirements for these banking systems and puts regulators in a quandary.
Ireland’s bailout programme is working but could be derailed by what is happening in the rest of Europe.
Portugal’s programme is not working as intended. But nobody is talking about it because it pales in comparison with Italy and Greece.
Italy’s outstanding public debt will soon cross 2 trillion euro (120% of GDP) and its debt service payments amount to around 300 billion euro per year.
That is made up of about 120 billion euro in interest payments and 180 billion euro in principal repayments. Average duration is 5 years.
Public debt service in Italy now amounts to around 17% of GDP and will rise to 20% unless Italy’s debt is dramatically restructured.
Italy now needs to borrow about 40 billion a month euro (gross) and about 28 billion euro a month net in private markets to refinance its debt.
The world is holding its breath with every auction of Italian public debt (3-8 billion euro per week) any of which could trigger accidental default.
The cost of refinancing Italy’s public debt has risen from around 4% a year ago to around 7% now. That adds 20 billion euro a year to
its debt.
Meantime the Italian economy is flat-lining and its capacity to service additional debt is diminishing despite its running a primary balance.
Banks around the world are dumping their holdings of Italian public debt but there is no buyer other than the ECB because of the risk.
The ECB’s capacity to refinance Greek, Italian and Portuguese debt is limited and constrained by Germany’s unwillingness to consider
that.
Contagion from Italy is now beginning to affect Spain and France which is supposed to be a bulwark for the EFSF’s borrowing capacity.
The resulting gridlock is pushing the entire Eurozone system toward a catastrophic denouement with a binary outcome. Either:
- Crisis-induced progress toward fiscal union with national sovereign bonds being replaced by a single Eurozone bond with a joint/several guarantee, or
- Sudden disorderly collapse of the Eurozone with unimaginable fallout and consequences that would trigger a global double-dip
recession.
Such a recession would last for a minimum of 2-3 years and would probably be quickly followed by a similar debt crisis in the US.
The resulting fallout of disorderly Eurozone break-up could trigger a break-up or restructuring of the larger EU as well.
So where do we go from here?
With the foregoing in mind it seems absurd that the world is waiting with bated breath to see what the new technocratic governments
in Greece (Papademos) and Italy (Monti) will actually achieve by way of structural reform and increased debt servicing capability in coming months.
These technocratic governments inject new credibility but lack political and social legitimacy. They have been appointed not elected.
It remains to be seen how long their technocratic legitimacy holds out without the backing of gradually earned political/social legitimacy.
The risk is that if the ministrations of these technocratic governments (which their societies believe have been imposed on them
from the EU above) do not work and bear fruit relatively soon (the probability is that they won’t), public patience with them will melt.
Will they be able to convince electorates to accept the inevitability of austerity without growth for the indefinite future?
The next Greek crisis is perhaps 10-12 weeks away.
The next Italian crisis could be triggered by any one of the upcoming weekly auctions of Italian government debt.
Despite these rather obvious realities, global markets deem to be reacting in dream-like hope and optimism that all will be well.
There is of course a solution at hand; and the only one that will work because all the other options seem to have been exhausted.
That option requires Germany to reconsider its refusal to bear its large share of the fiscal burden that will come with Eurozone fiscal
union.
It requires political/social willingness on the part of rich northern Eurozone members to finance fiscal transfers to poorer
southern members through an exponential expansion of structural funds, currently applied to help develop more rapidly the poorer regions of the EU.
Reciprocally, it requires other Eurozone countries to relinquish fiscal, and a great deal of political, sovereignty immediately; in
order to assure global markets of their commitment to structural reform, restoration of competitiveness, and relentless pursuit of fiscal/monetary discipline.
It requires all unwanted national sovereign bonds of Eurozone members to be replaced by a single Eurobond that is jointly and
severally guaranteed and underpinned by the weight and ability of the ECB behind it to print money if necessary to ensure that such bonds are honoured.
This solution would resolve both the over-indebtness problem of the Eurozone and the problem of banking system collapse at a single stroke.
If it were adopted the need to provide for risky Eurozone debt and recapitalise (yet again) the EU banking system would disappear.
Yet, this is the one solution that keeps being discarded because of legitimate German constitutional, judicial and political constraints.
They inhibit movement in such a direction regardless of the consequences for the Eurozone, the EU, and mostly Germany itself.
It is like witnessing a repeat of 1939; not of conquest but of mindless destruction. But, this time with money rather than tanks being involved.
If that only workable solution continues to be discarded, the other possibility that will manifest itself is the disorderly break-up of
the Eurozone; simply because its orderly break-up defies contemplation and imagination.
Talk of Greece being ejected from the Eurozone, or of Germany departing from it voluntarily, is fanciful simply because neither can
afford to bear the costs of the consequences that will follow, regardless of what their populations and political leaders may believe
or think (though ‘thought’ seems to be conspicuously absent from the process just now). Neither can their neighbours, regardless of what they may think.
Yet it is not unimaginable that a break-up will be forced on Eurozone members by global markets if the only workable solution
continues to be ruled out as it seems to be repeatedly by the German Chancellor. But she has changed her mind so often the hope is she will yet again.
A disorderly break-up may result in a reversion to national currencies; which would be better than members trying to retain some
semblance of the Euro through separate residual monetary unions of more compatible economies.
That would probably require four different Euros (for the super-efficient Northern economies a Baltic Euro, for the relatively efficient middling economies a Franco-Euro; for the newly acceding countries an Eastern-Euro and for the inefficient, uncompetitive Club-Med economies, a PIGS-Euro). Other than the first, none of the others would be credible for holding as reserves, or for trading significantly in global currency markets.
Finally, bear in mind that we have spoken of only the public debt problem in the Eurozone.
Should the unthinkable (but increasingly likely) disorderly break-up happen, the public debt problem will be accompanied by an unresolved private debt problem throughout the Eurozone of equally monumental proportions! That really will break the system and the banks!
By Ajay Shah, on June 27th, 2011
Suppose we go back to 1870 and think of four interesting and promising countries.
Britain was the incumbent, the pioneer of the industrial revolution, home of Newton and Darwin, with a head start on building institutions, with sound economic policy and deep integration with a global empire.
Germany, the rising power of Europe, rapidly catching up with the frontier (and ahead of Britain in some fields). More centralisation of power, which perhaps gave an edge in certain things.
The US, a vast country blessed with a great constitution, inhabited by a cast of characters made up of the mavericks, misfits, nutcases and adventurers of Europe.
Argentina, a vast country with boundless prospects, sound policies after 1852, and tightly integrated into the London capital market.
Today we think `Argentina?’. But in the middle of the 19th century, there were many people who thought that Argentina had better prospects than the US. From 1850 to 1930, Argentina did astonishingly well. In particular, from 1880 to 1905, GDP growth averaged 8 per cent over 25 years, which was unheard of in those years.
With the benefit of hindsight, we know what happened. We know that Argentina collapsed into illiberal populism (first into socialism/fascism (1930) and then into Peronism (1946)), that Germany collapsed into militarism, and that the US and the UK managed to build liberal democracies.
So with this framing, let’s ask about how India and China will go.
Will India make it to good institutions, like the UK or the US? Or will India collapse into illiberal populism, much like Argentina did?
All too often, the Indian elite tends to take good outcomes in the deep future for granted, but I am not so sure and it is worth worrying about the foundations of liberal democracy and a market economy. Given the weak foundations of liberal ideas in India, political freedom is not something to take for granted. Given the weak foundations of market economics in India, economic freedom is not something to take for granted. Argentina’s binge of welfare programs and populism is uncomfortably close to the instincts of most Indian politicians.
Will China make it into good institutions, like the UK or the US? Or will China descend into chauvinism and militarism, much like
Germany did?
The story of Argentina and Germany, from 1870 to 1914, reminds us that what works in a country for a few decades is often not enough to carry the country through to a happy ending. Germany did very well from 1870 to 1914 (44 years). Argentina did very well from 1850 to 1930 (80 years) of which 50 years were really high growth. To many people, sustained success (a la India) has generated complacence: we have started trusting in our governance DNA, thinking that it has delivered results. This hinders the process of identifying incipient problems, criticising the status quo, and changing course.
But the fact that a economic/political recipe worked well for a few decades does not mean that this recipe will continue to deliver. For a country to work out in the long run, it has to constantly renew the foundations of liberal democracy and the market economy, and
repeatedly reinvent itself.
In the late 19th century, growth rates were low in absolute terms, other than outlandish episodes like Argentina (1880-1905). Germany was the star performer of Europe over 1870-1914, with GDP growth of 2.9 per cent. The UK did just 1.9 per cent in this period. At 2.9 per cent growth, GDP doubles each 24 years. In other words, the economy and the political system need to be reinvented in each generation.
At 7 per cent growth, in India, we are getting a doubling of GDP every decade. This requires a reinvention of the economy and the
political system every decade. We have a stark contrast where we have grossly failed on modifying laws, government agencies, policy
frameworks and world views at a rapid pace.
By Claus Vistesen, on November 30th, 2010
So, the butcher’s bill on Ireland is in and stands at 85 billion Euro jointly financed by the EU (the European Financial Stability Fund (EFSF) and the European Financial Stability Mechanism), the IMF and bilateral loans from a number of countries including Sweden, Denmark and the UK. Of course, it only worked a couple of hours and today markets are reeling again in the face of the Eurozone crisis which seem to have no end. Worryingly, markets seem to be contend on going for all together larger game this time around with Spanish bonds bearing the brunt of the attention.
In principle and fact I agree with RBS’ Harvinder Singh (via FT Alphaville’s Neil Hume) that the only possible end game at this point is that things get so bad that some form of fiscal unity and/or a joint Eurozone pooling of risk through the issuance of an EMU bond. Illuminati’s Jim O’Neill is a little more sanguine although he ultimately also invokes the point that the core and especially Germany must go all in, in its effort and comittment to keep the Eurozone in one piece.
I know that all this may come of as scaremongerings, but the farther we move forward into this mess, the more it is beginning to look like calm and calculated analysis rather than prophecies of doom.
So, Can Germany Pay?
On that note, I thought that I would highlight an issue which has not yet been debated much in the context of the Eurozone debt crisis. In this sense, we always hear about CDS or yield spreads to Germany and still; to the extent that we are talking “EU money” we know that it is the German taxpayer who must foot the majority of the bill.
So, can Germany really pay all this?
The recent economic narrative on Germany suggests that it can. In fact, Germany has been hailed as the rock onto which all other shipwrecked European economies must turn to in the hour of need with GDP growth rates in Q2 and Q3 (2010) exceeding expectations. And with the German export machine back in full swing, there seems to be nothing standing in the way of Germany saving the world, let alone Europe.
Now, this is not entirely true of course and one major part of the difficulties encountered in the course of the past months has been the obvious (and natural) resistance of the German taxpayer in simply accepting to pay for the mistakes and overspending of others. And one would assume that the reluctance to do so stems not only from a feeling of unfairness, but also from a genuine fear that Germany simply won’t be able to pay even if the good intentions can be mustered in the first place. As such the following point emphasized today by a friend of mine is important;
Spain’s external debts, have exploded without a significant offset of external assets. On net, Spain owes the world about 80% (closer to 90% today) of GDP more than it has external assets. As a frame of reference, the degree of net external debt Spain has piled up in a currency it cannot print has few historical precedents among significant countries and is akin to the level of reparations imposed on Germany after World War I. We don’t know of precedents for these types of external imbalances being paid back in real terms.
So, when Merkel notes that bondholders must also share the losses she is naturally referring to the fact that Germany cannot be expected to bailout all the Eurozone’s periphery’s international investors. However, what she is perhaps forgetting is that Germany itself holds a non-neglieble amount of those very same net external assets that Spain, Greece, Ireland and Portugal have built up.
However, even considering this point, the reality is still that as the economic conditions of the periphery has deteriorated and morphed into a calamity so it seems that the well known structural problems of the so-called core have been forgotten. Beauty, wealth and economic travails are as most other things a relative entity it seems.
On that note, allow me turn the tables on the discourse a little. Consequently, the Economist recently ran a special report on Japan essentially focusing almost entirely on the fact that Japan is the most rapidly ageing economy in the world and this represents the main challenge for Japan as an economy and as a society. I am a demographic fan boy, I know, but still the analysis in the Economist makes sense. Deal with the demographic challenge or else …
So, which economy might then be the second most rapidly ageing economy in the world? Right, you guessed it; Germany.
(click on pictures for better viewing)
I should think that these charts are rather self-explanatory and note in this context that the German debt/GDP has gone from about 63% of GDP in 2007 to 84% in 2010. Further, according to the IMF this will increase to just hy of 90% in 2014. Naturally, none of these calculations factor in any extra liabilities Germany will have to assume to keep the Eurozone together in that period, so your guess is as good as mine as to the final figure in 2015.
The question which seems to whisper in the wind (and which may sooner rather than later turn into a roar) is then just how Germany is going to be able to shoulder all those bailouts when the real bailout it needs to think is the one of its own welfare state as the weight of population ageing sets in. Of course, Germany could in principle sacrifice any build up of assets in Asia, Latin America and the rest of the emerging world and devote its entire surplus powers to financing excess investment and consumption in the Eurozone periphery and Eastern Europe ad infinitum. But somehow, this does not strike me as a viable long term solution since this has already been tried and well, it got us into this mess in the first place.
I guess, the contrarian Masters of the Universe might immediately see this as a case for buying German CDS in a punt on the event that the benchmark itself came under pressure. I think this would be premature, but there is definitely a narrative and discourse missing in the current Eurozone debacle not about whether Germany is willing to pay, but indeed, whether she will be able too.
By Rok Spruk, on November 1st, 2010
The central aim of my bachelor’s thesis is to demonstrate the unsustainability of public pension system in OECD countries in the longer run through the lens of a rigorous theoretical and empirical analysis.
The origins of contemporary public pension schemes date back to 19th century when Bismarck Germany in 1881 first adopted a universal old-age public pension system based on pay-as-you-go (PAYG) funding principle. The principle itself captures full advantages of high (stationary) population growth rate. In the simplest form, PAYG pension scheme is based on the notion of generational solidarity upon which current generations pay mandatory social security contribution into the public scheme. Aggregate contributions are then paid out to current retirees. The cycle is then expanded through generations. However, PAYG funding scheme is sustainable as long as the population growth is high and above the marginal productivity of the capital. Back in 19th century, public pension schemes were adopted under unrealistic assumptions about future population prospects. In 19th century, advanced countries experienced high population growth rate, high fertility rate and an extremely low share of dependent old population that was receiving universal old-age support from PAYG pension schemes. These set of assumptions was crucial to the stability of government-provided old-age support embodied in the public pension schemes.
The sustainability of PAYG pension system requires the equivalence of population growth rate and real interest rate. In the early 20th century, the advanced world shifted towards aging population, declining fertility rates and lower labor market entry rate. In broad terms, a growing old-age dependency ratio led to the pure disequilbrium effects. In a theoretical framework, I re-examined the neoclassical framework of lifecycle hypotheses embodied in Samuelson and Cass-Yaari models of life-cycle utility maximization. The lifecycle hypothesis is based upon the assumption of the three-period model where individuals maximize the consumption in the course of a lifetime. In the first period, individuals do not discount the future consumption since, in this period, individuals acquire the human capital. In the second period individuals enter the working age and discount the future consumption. Hence, in the third period, individuals retire consume the output produced in the working-age period. Since future discounting is compounded, the lifetime consumption increases geometrically. In purely analytical terms, the individuals maximize the utility of consumption through time preference rate.
Considering the abovementioned equivalence between population growth rate and real interest rate, the stability of the equilibria requires the period discount rate to equal the population growth rate. If population growth rate decreases, the stability of the equilibria requires that individuals decrease the future discount rate by the same rate to keep the PAYG pension system within the theoretical limit. The rigorous theoretical formulation of the neoclassical model of lifetime consumption, which essentially captures the necessary conditions for equilibrium stability of public pension schemes, had been put forth by Paul A. Samuelson in his seminal contribution to the theoretical foundations of stationary “PAYG” public pension scheme .
In the course of the last decades, OECD countries have experienced a significant drop in fertility rates, population growth and, under the political climate of social democracy, a widespread adoption of early retirement schemes and generous social security benefits. In addition, labor market exit age dropped significantly, initiating a trend towards the unprecendent growth of generational indebtedness.
The OECD estimated that between 2000 and 2050, old-age dependency ratio is forecast to increase to the largest extent in Japan (193 percent), Spain (136 percent), Portugal and Greece (135 percent). The astonishing increase in the estimated old-age dependency ratio directly reflects the declining fertility rate in OECD countries from 1960s onwards. I estimated the ratio of fertility rate between 1960-1970 and 2000-2006 for OECD countries at around 2, which means that average fertility rate between 1960-1970 was twice the fertility rate between 2000-2006. The highest fertility ratios were found in Spain (2.23), Italy (1.96), Ireland (2.00) while the lowest ratios were found in Denmark (1.37), Netherlands (1.72) and the United States (1.46).
High and stable effective retirement age is the main assumption underlying the stationary stability of PAYG pension system. In the 20th and 21st century, OECD countries have experienced an unprecendent decline in effective retirement age. Blöndal and Scarpetta (2002) estimated the decline in labor market exit age for OECD countries between 1960 and 1995. The female labor market exit age had declined significantly in Ireland (10.7 years), Spain (9.1 years) and Norway (8.8 years). Male labor market exit age exerted persistent decline in all developed OECD countries except for Iceland. The exit age declined significantly in the Netherlands (7.3 years) and Spain (6.5 years).
In a large part, declining labor market exit age has confluenced the rapid growth of unemployment and disability benefits and early retirement incentives from the second half of the 20th century onwards. As the OECD correctly contemplated, in a number of countries, disability pensions and unemployment benefits can be used as de facto early retirement schemes. In a large part, widespread growth of early retirement schemes and implicit incentives for moral hazard in retiring too early via unemployment and disability schemes is held responsible by generous welfare states in the aftermath of the World War II.
When I examined various features affecting early retirement choices, I came across an interesting finding. I regressed labor market exit age and marginal tax rate in a cross section of 23 OECD countries in 2007. I estimated the relationship between exit age and marginal tax rate using a classical OLS linear regression model. The estimate suggests that, holding all other factors constant, if marginal tax rate increases by 1 percentage point, average labor market exit age decreases by 1.88 months. Surprisingly, 51.74 percent of sample variation is explained by marginal tax rate alone. The sample constant is statistically significant, suggesting that if the hypothetical marginal tax rate were zero, the average labor market exit age in randomly chosen country from OECD sample would be 69.65 years. The sample constant is consistent with a prior theoretical expectations since it concurs with the “substitution effect” hypothesis that higher marginal tax rate leads to lower labor supply and fewer working hours.
The cost of early retirement in OECD countries
Source: T.T. Herbertsson & J.M. Orszag, The Cost of Early Retirement in OECD, 2001. OECD, Pensions at Glance, 2009.
Fiscal imbalances arising from unsustainable PAYG public pension systems in OECD countries cannot be assessed without a sufficient estimate of economic costs of unfunded pension liabilities. I approximated the cost of early retirement using Auerbach-Kotlikoff-Gokhale (1999) methodology that directly estimates the size of generational imbalances created by public social security systems. Large and rapidly unsustainable net pension liabilities occured in late 1980s. Van den Noord and Herd (1993) estimated the size of net pension liabilities in seven major OECD countries. The results suggest that continental European countries have had the largest net pension liabilities in terms of GDP. The size of pension liabilities in France and Italy had been about 2.5 times the size of their respective GDPs and twice the stock of the public debt.
Gokhale (2008) directly estimated fiscal imbalances arising from unfunded pension liabilities to current and prospective generations. The size of generational fiscal imbalance, as a share of the GDP, is extremely large and rapidly unsustainable in all OECD countries. In fact, the size of the imbalance is the most severe in Greece (875 percent of the GDP), France, Finland and the Netherlands (500 percent of the GDP) while it is more than twice the size of the GDP in all OECD countries except for the United States, Canada, Australia and New Zealand.
Fiscal imbalance in OECD countries
Source: J. Gokhale, Measuring Unfunded Obligations of European Countries, 2009.
I built the econometric model of public pension expenditure for a cross section of 23 OECD countries in 2007 to assess which variables might explained the cross-country variation in public pension expenditures. I’ve been aware of the possible drawbacks of choosing a cross-section model since it might be vulnerable to specification errors and the unbiasedness of regression coefficients. To account for possible specification bias, I conducted Kolmogorov-Smirnov, Shapiro-Wilk and Jarque-Bera normality tests. By performing normality tests, I have examined whether the normality assumption of normally distributed error terms is valid in the studied sample of 23 OECD countries considering error terms as identically and independently distributed.
In the set of explanatory variables that might yield consistent and robust estimates of regression coefficients I chose 10 various demographic, economic and institutional independent variables. Apart from demographic and economic variables, institutional variables are dichotomous since the institutional features can be captured by binary modes of choice. The dependent variable is the size of public pension expenditures in the share of the GDP.
The results suggest that public pension expenditures are positively correlated with the share of population aged 65 and older (0.746**), difference in life expectancy after age 65 between 1960 and 2005 (0.477*) and dichotomous variable for continental European countries (0.697**) where * and ** indicate the statistical significant of the sample correlation coefficient at the 5% and 1% level. The estimates suggests that the probability of higher pension expenditures in the share of the GDP is likely to occur in a continental European country known for a relatively large share of older population and a high difference in life expectancy after age 65 between 1960 and the present. On the other hand, public pension expenditures are negatively correlated with average effective retirement age (-0.475**), private pension funds as a share of GDP (-0.658**), labor market exit age (-0.523**), dichotmous variable for Anglo-Saxon countries (-0.544**) and a dichotomous variable for private pension system (-0.672**), where ** denotes the statistical significant of the sample correlation coefficient at the 1% level. Again, the estimates suggest that the probability of lower pension expenditure is likely to occur if a randomly chosen country from the OECD sample is Anglo-Saxon and has a high effective retirement age, large private pension funds as a share of the GDP, high labor market exit age and a mandatory private pension system. The coefficients suggest that in repeated sampling, the estimated sample correlation coefficient will include the true or correct population value in 99 percent of cases.
I conducted the econometric model which consisted of 8 regression specifications. I chose double-logarithmic model which yields direct elasticities as regression coefficients. However, I added two exceptions. In regression specifications 5 and 6, I chose a mixed specification mostly due to the inclusion of private pension funds (assets) variable in the regression specification. Unfortunately, but the share of private pension funds in Greece in 2007 equals 0 percent of the GDP which does not enable the researcher to apply double-logarithmic model as the basis of regression specification.
The estimates suggest that the share of population aged 65 and older is statistically singificantly positively related to the share of public pension expenditures in the GDP. Hence, the elasticity of public pension expenditures with respect to effective retirement age ranges from -1.465 to -4.935, suggesting that an increase in effective retirement age by an additional year leads to per unit increase in public pension expenditures by more than a unit increase in the share of the GDP. The coefficient of private pension funds is highly statistically significant. The elasticity of public pension expenditures with respect to private pension funds (as a share of the GDP) ranges from -0.34 to -0.38 and is statistically significant at the 1% level. The elasticity suggests that a 10 percentage point increase in the share of private pension funds reduces the share of public pension expenditures in the GDP, on impact, by 3.4-3.8 percent, holding all other factors constant. In addition, the estimates of coefficients for dichotomous variables suggest the following: the probability of higher public pension expenditures (as a share of GDP) is likely to occur in continental European countries with mandatory private pension system. Five estimates of dichotomous coefficients are statistically significant at the less than 10% level.
The significance of dichotomous (dummy) coefficients has been tested by beta coefficient analysis to rank the magnitudes of separate effects of explanatory variables on public pension expenditures as dependent variable. The results suggest that continental European countries are significantly more likely to face higher public pension spending in the share of GDP compared to Anglo-Saxon countries.
Earlier I mentioned the necessity of normality assumption in yielding robust, consistent and unbiased estimates of regression coefficients. The assumption has been questioned by conducting Kolmogorov-Smirnov test (K-S), Jarque-Bera test (J-B) and Shapiro-Wilk (S-W) normality test. The aim of the testing the normality assumption is to observe whether error terms distribute normally so that estimated test statistics, standard errors and confidence intervals are reliable. In setting test statistic, I set the normality assumption as null hypothesis. The results from K-S, J-B and S-W tests show that the null hypothesis cannot be rejected at 5% level, suggesting that the normality assumption is valid in the studied sample. Hence, test statistics, standard errors and confidence intervals are both valid and reliable.
The meaningful question to evaluate the prospects of the coming public pension crisis is how to reverse the growth of fiscal imbalances and reform public pension system as to avoid erratic generational indebtedness. Aging population and the growth of old-age dependency ratio trigger an enormous future burden on public finances in OECD countries. Lower fertility rate and population growth shall place an incurable burden on the stability of PAYG public pension systems. The estimates suggest that life-expectancy after the age of 65 is likely to increase by 2050 and gradually approach the age of 90 for both male and female. Assuming the effective retirement age is 65, the remaining life expectancy is 25 years or almost one-third of the average lifetime. As Alemayehu and Warner (2004) suggest: “Old-age health care costs thus will impose increasingly severe pressure on private finances and government coffers. Indeed, applying our age-specific estimates to the age distribution anticipated for the year 2030, we find that if nothing is done to alter current patterns of health care, per capita health care expenditures will rise by one-fifth due to population aging alone.“
The long-term pension reform that aging societies of the West should undertake is a complementary measures of three key policy features of the reform.
First, the transition to fully-funded retirement savings accounts is the only viable and sound pension reform that can alleviate the damage generated by the growing fiscal imbalances. The theoretical foundation of the transition from public pension systems to fully-funded pension system has been laid down by Feldstein and Liebman (2001). The authors derived an algebraic solution which suggests that keeping a PAYG public pension system does not attenuate the persistence of a growing demographic pressure on the stability of public pension system. As I discussed earlier, PAYG system crucially depends on three key assumptions: high fertility rate, very low share of population older 65+ and high population growth. These assumptions are incompatible with actual demographic parameters and, hence, OECD countries should undertake a drastic transition towards fully-funded pension systems based on individual savings accounts. Otherwise, the growing demographic pressure will inevitably result in the exponential growth of generational debt, creating an enormous deadweight loss for current and prospective generations.
Fully-funded pension system is based on the premise of investing pension contributions into the capital market, earning a compound interest over time. The stock of individual’s lifetime earnings is paid in the form of annuities upon individual’s withdrawal from the labor market. In addition, there is a growing disparity between the implicit return of PAYG public pension system and real rate of return in the capital market. Under realistic assumptions, such as that the marginal product of capital (MPK) is below the welfare-maximizing level and the real rate of return exceeds the implicit return from PAYG system, fully-funded pension system would not create a deadweight consumption loss to the working-age population. In fact, Feldstein and Liebman (2001) derived an analytic solution for the transition to fully-funded pension system in which the transition induces a short-term consumption loss in the next period while, at the same time, it creates a geometrically-growing future consumption for both retired and working-age population.
The only remaining question is whether the real rate of return would compensate the consumption loss of working-age population and, hence, increase the stock of future consumption to all generations. According to Feldstein and Liebman (2001), assuming 6.5 percent inflation-adjusted rate of return, the payroll cost of fully-funded pension system would represent only 27 percent of the payroll cost incured under PAYG public pension system. Tax rate, required to bear the cost of current stock of pension liabilities is 12.4 percent respectively.
According to Congressional Budget Office, the average real rate of return for large-company stocks between 1926 and 2000 is 7.7 percent, 9.0 percent of small-company stocks and 2.2 percent for long-term Treasury bonds. Feldstein (1997) estimated that PAYG implicit rate of return is 2.6 percent.
Assume an individual wants to maximize the lifetime earnings in the capital market. An individual is offered 2.6 percent implicit return from PAYG system. The individual enters the labor market at certain age, say 25, and intends to retire upon the age of 65. Assume he invests $10.000 annually in the capital market to create retirement annuities upon labor market withdrawal. Assuming the implicit rate of return (2.6 percent), the stock of overall annuity would be 10 times the initial investment in 90 years. Assuming the average long-run real rate of return from large-company stocks (7.7 percent), the the overall annuity would be 10 times the initial stock of investment in 31 years. Therefore, the individual would reach the desired level of lifetime earnings at the age of 56 or 9 years before the targeted retirement age.
I assumed the distribution of lifetime investment portfolio is weighted average of availible asset types: large-company stocks (33 percent), small-company stocks (19 percent), long-term corporate bonds (20 percent), long-term Treasury bonds (20 percent) and 3-month Treasury bills (8 percent). According to the average annual real rates of return in the United States (1926-2000), I calculated the weighted average real rate of return (5.247 percent). Investing $10.000 annually at the age of 25 would buy $100.000 annuity at 5.247 real rate of return in 45 years (the age of 70) compared to 90 years (the age of 115) under the PAYG implicit rate of return (2.6 percent). Of course, the time to buy the annuity would shift alongside the changing composition of portfolio.
In addition, OECD countries should immediately increase the effective retirement age. I believe the solution suggested by Gary Becker is both meaningful but sustainable in reversing the growth of generational debt. Becker (2010) suggested “One simple and attractive rule would be to raise retirement age by an amount that makes the ratio of years spent in retirement to years spent working equal to the ratio that existed at the beginning of the social security system.“
When President Roosevelt signed the notorious Social Security Act in 1935, the normal retirement age was 65. However, life expectancy after the age of 65 was significantly lower than is today. In 1940, average life expectancy after 65 in the U.S was 13.7 years. In 2006, it stood at 18.6 years, according to OECD. In 1935, the average life expectancy at birth in the United States was 61.7 years. We assume that individuals in 1935 worked for 35 years and spent 12 years in retirement. The ratio is thus 0.4 (12/ 35=0.34). Today, if individuals retire at the age of 65, they can expect further 18.6 years in retirement. To equalize the ratio to the 1935 level, (18.6/x=0.34), individuals should spend 54.7 years working. The estimate time is an equivalent measure of years required to spend working if PAYG public pension system is left intact. Assuming the individuals enter the labor market at the age of 25, then the expected effective retirement age is the age of 80.
In the long run, PAYG public pension system is unsustainable since demographic parameters do not suffice the assumptions under which the PAYG system is possible without distortions of labor supply incentives. The future of OECD countries will be marked by aging population, lower fertility rates and a growing demographic pressure on public finances. Without bold and decisive pension reform, OECD countries will experience increasing pension deficits and, hence, an explosive growth of generational indebtedness.
Parametric pension reforms are not a substitute for the postponement of paradigmatic pension reform. Thus, implementing the transition to fully-funded pension system essentially requires higher effective retirement age. A comprehensive pension reform cannot be made possible without these measures. At last, but not least, the major challenge in the systematic pension reform in OECD countries to address the burden of global aging, is whether political courage will withstand the pressure of interest groups to maintain the status quo of early retirement incentives. Nonetheless, eliminating early retirement incentives is the essential step towards creating retirement system without perverse incentives to retire too early. Unless political leaders encourage a transition to fully-funded pension system, OECD countries will be unable to withstand the deadly consequences of an enormous generational indebtedness.
By Claus Vistesen, on September 8th, 2010
The financial and economic discourse is a funny beast really; it can, if harnessed properly, shed light on future investor and market performance, it can give a diversified and detailed picture of any given economic or financial topic, and it is a place where stories, no matter how counterintuitive and misplaced, can linger and grow for a long time.
I am focusing on the last aspect and in doing so moving in alongside Edward (here, here and here) as well as Wolfgang Munchau in pondering just why it is that people are so excited about the fact that Germany continues to experience stellar growth rates largely driven by exports. Moreover, in his latest piece, Edward once again opens up the discussion for just what it is that we are supposed to do with those global imbalances and it is here that I will also spend my time.
Of course, just what it is that is misplaced here is definitely a matter of opinion and not everyone seems to be content with neither Munchau’s point (comments section) nor Edward’s take on the situation. Not surprisingly, I will come out in favor of Edward’s take here but I do so arguing on the basis of fact and not on the basis of some inherent hate towards Germany, Spain or any other of European economy for that matter. I would hope that this, at least, is clear for all to see.
The Problem
The fact that Germany does well is not the issue here (indeed, in isolation this unequivocally good news), but the fact that Germany is still driven by exports and the fact that Southern Europe continue to languish in uncompetitiveness tells a cautionary tale that some of the most important prerequisites for a sustainable trajectory of the global economy have not been met. So, while Edward opted to tell the same story with a chart, I will do so in words.
Before the financial crisis, the world was characterised by structural surpluses in Japan, Germany and the rest of Asia [1] to match a growing US/Anglo Saxon current account deficit. Europe as a whole was running an overall balanced current account which, however, masked notable intra-European imbalances between Southern and Eastern Europe (with external deficits) and Germany as the main supplier of credit to this expansion[2]. So, before the crisis we had export dependent Germany and Japan coupled with USD peggers in Asia (where China will soon become export dependent herself) to match current account deficits in the US/Anglo Saxon world and Eastern/Southern Europe.
This system was clearly unsustainable, but it worked as long as it did especially because of the US economy’s remarkable resilience despite the huge load put on its shoulders offering capacity to the credit supplied by the surplus nations. The system however famously buckled as a result of the subprime mortgage debacle which had its origins, ironically enough, exactly, in the mortgage debt binge made possible by the flow of cheap credit to the US economy.
As a result (and most economists would agree here I think), the recovery that had to follow the crisis was closely tied to a resolve of global imbalances. Yet, the recent narration of the German economic performance on account of its strong export performance shows us that we have not really gotten anywhere.
This brings us to the problem.
Leading up the crisis, the global economy was populated by two outright export dependent economies in the form of Germany and Japan as well as a batch of USD peggers in form of China et al and the petro exporters. Today, as we all hope to muster some form of recovery we are in a situation where not only Japan, Germany and China rely on exports to power their economies so must now the US and, in effect, Europe as a whole since there is no more juice left in either Southern, Eastern or, for that matter, Anglo-Saxon Europe to run respectable current account deficits. Indeed, the continuing talk about how this and that country is now going to rely more on exports or is about to become an export powerhouse strikes me as extremely odd since no one seems to be asking the real question of who exactly are to run the corresponding deficits?
Economists trained in the art of general equilibrium would immediately point out that it does not matter much since if there is one thing that we can be sure off it is that at all points in time the sum of external deficits will equal the sum of external surpluses. I cannot but agree, but this also means that speaking of surplus nations as the good guys and deficit nations as the bad guys does not make sense. What we really need here is economies with ability to run sustainable external deficits; this basically means economies who need to borrow to maintain trend economic growth and a proper rate of investment given the intrinsic return of the economies investment pool. As such, if we look at the structural forces at play there is not so much that we can do in the near term about a number of key issues.
- There is nothing that we can do about the great demographic shift and the fact that we are all rapidly ageing and soon will hit the threshold where we effectively become dependent on external demand in order to achieve economic growth, pay pensions, build roads etc. Germany and Japan shows us where we are headed and while timing will differ markedly it is towards their current structural setup the entire OECD is drifting
- The US and many of the other Anglo-Saxon economies have pretty sound demographics [3], but they have overspent and over -borrowed to the extent that demographics become secondary to the massive force of deleveraging. Consequently, and while the US economy should, theoretically, be capable of providing, in a sustainable manner, some excess demand through a current account deficit the amount of private sector and, now, public sector leveraging means that they are simply tapped out. In addition, deleveraging is a slow and structural process which will take a long time and also engender behavioural changes in US consumers. In short; we cannot rely on the US consumer anymore and actually; the US economy now needs to export more than she imports in order to turn the boat around.
Old Maids who won’t play Anymore
An integral part of any discussion of global imbalances has to involve a suggestion as to on whose shoulders rebalancing is supposed to occur. In this context, the debate has focused on intra G3 rebalancing as well as the need for China to loosen the peg towards the US dollar. On the former account I have called this a game of Old Maid since the real question was never which of these economies that could contribute to global rebalancing, but to whom they were going to sell their exports and thus how they would compete with each other for export market share.
Old Maid is a card game where the simple task is to avoid holding a given card (often the queen of spades) at the end. Even in the company of good friends however, holding Old Maid at the end is not fun. Often, you have to buy the drinks, drop a piece of clothes, or endure other travails. And as it turns out, the global FX market is not unlike this good old game of cards where the Old Maid is proxied by having a strong currency on whose shoulders the correction of global macroeconomic imbalances must invariably fall.
In this context and while nominal exchange rates is not the best proxy for export market share the G3 fx edifice has been characterised by change of baton between the G3 currencies in terms of who is holding Old Maid*.
So far in 2010 there has been two stories. Initially, the main focus was one of a sharp depreciation of the Euro as the sovereign debt woes of Southern Europe sent the single currency reeling. That trend reversed in a nasty short squeeze which saw the EUR/USD bounce very quickly from 1.18 to 1.30 (still down on the year). From here it seems as if the EUR/USD has resumed its old ways of trading on the risk on/risk off themes. The second story which has recently gotten a lot of traction is that of the ascend of the JPY especially in relation to the USD/JPY which has recently been very close to the lows of 1995. These two stories are captured in the chart above where the JPY has appreciated notably against the USD and the Euro while the Euro (against the USD) has weakened considerably since the beginning of 2010. Among other things, this has spawned an almost endless stream of commentary concerning the possibility for BOJ/MOF intervention in the currency market through direct purchases of the USD.
In so far as goes the idea of an old maid, Japan seems to be holding it in the first half of 2010 (against the Euro and the USD) while the USD holds it against the Euro. Curiously, and just as to ram home the real economics behind this strange metaphor, it is worthwhile emphasizing how it was precisely Japan’s economy that seems to have hit the breaks in H01-2010 while the European economy stormed ahead aided by a very strong Q2 performance in Germany.
Ultimately however, the idea of the Old Maid remains a trading theme with one important real economic implication. Whoever holds the Old Maid among the G3 currencies is losing market share relative to the two others vis-a-vis the emerging world and others willing or able to muster a respectable external deficit. The bottom line remains however that in the context of global rebalancing it cannot occur along the G3 axis (e.g. with German and Japan providing a boost through domestic demand). In short; these Old Maid cannot and will not play anymore
The Solution
I am not a big fan of one-off solutions and especially not when it comes to complicated problems like this. However, in relation to global currency alignments I think one big issue revolves around the need for big emerging markets such as e.g. India, Brazil and China to let their currencies go, as it were, simultaneously against the G3.
The chart above needs some explanation. First of all, 1999 = 100 and up means appreciation of the emerging market currency versus the g3 basket [4] and down means depreciation. As we can see, there has been no meaningful appreciation of big emerging market currencies vs the G3 when using 1999 as the benchmark (I use nominal exchange rates). This is exactly what has to change.
Surely, pushing those lines upwards would not solve the underlying problem in the G3 but it would address on very important obstacle to global rebalancing. In essence, it would put the burden on the broadest shoulders not because of some political/economic disdain for current account deficits in the OECD or because we should “exploit” the emerging world’s increasing aggregate demand, but simply because it is what makes economic sense. In this context, I have always agreed with the now silenced blogger Brad Setser that a global currency alignment is needed. What we have debated however was rather the importance attributed to China relative to other EMs as well as the importance of demographics as an underlying driver of the shift in aggregate demand growth and/or decline.
In conclusion there are two points to take away here. Firstly, the game of old maid will continue as a trading theme and as always you want to buy whoever gets to hold it among the G3. In addition, any currency moves in an intra G3 context also constitute shifting of market share vis-a-vis global high growth economies who will, whether it be kicking and screaming or willingly, be dragged into providing more of global aggregate demand through external deficits. For this to happen sustainably however, we need to see joint appreciation of emerging market currencies against the G3 or, more intuitively, the appreciation of a basket of emerging market currencies versus the G3. Continuing to believe that domestic demand can be a growth driver in the G3 let alone the OECD is the same thing as calling on Old Maids to play a game cards which they won’t and can’t play anymore.
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[1] – For simplicity, I will leave out pegging oil exporters here, but their role in this game is not fundamentally different.
[2] – Again, considerable complexity is left out. For example, the credit expansion in Hungary originated mainly from Switzerland (and by proxy through the Austrian banking system) and in the Baltics the Scandinavian economies supplied most of the credit (Sweden in particular).
[3] – Yes, I know the baby boomers will now become a drag and this is important but that is a bulge moving through an otherwise pretty stable population pyramid as a result of healthy immigration rates and replacement level fertility. In short; demographics in Japan are deflationary (and also in Germany), but I am not sure this is the case, strictu sensu, in the US.
[4] – This basket is created using share of global GDP of the G3 which is obviously inadequate, but let us just assume that we are dealing with economies that are either already relatively open or are going to become more open as we move forward (e.g. India).
* All data is from St. Louis Fed.
By Claus Vistesen, on April 12th, 2010
After a week where the deck of cards that make up the Eurozone got its so far largest jolt and where there is now not only an imminent danger of a total economic collapse in Greece but also, much more worryingly, signs that Germany herself are beginning to tire of a common monetary union I thought it would be nice to take a longer term and structural perspective on the global economy. And what better way to do this than to dig into the world of academia.
As some of you may know I recently earned my degree from the Copenhagen Business School and on that occasion I also produced a thesis which I’d like to share here.
This thesis is built upon two core arguments. The first is the notion that the demographic transition should be narrated through the perspective of ageing rather than population growth and the second is that ageing on a macroeconomic level represents a strong driver of international capital flows. These two arguments are used to discuss the standard prediction in a life cycle framework that ageing leads to dissaving in the aggregate and thus how old economies should tend towards running current account deficits. Using Japan and Germany as the subjects of analysis, this thesis develops the idea that rapidly ageing societies are not, in the main, characterized by dissaving but rather by the fight against it. Finally, a small empirical exercise acts as a perspectivation on the results to suggest why ageing might lead to a reliance on exports and foreign asset income to achieve growth and what this means in a global context.
In many ways, the ideas, thoughts and arguments that have gone into this work are shaped by the discussions and the activity here at this space and my interaction with the people I have come to know through my online presence. In this way, it is only apt that I present it here I think.
I believe that works such as this (and any other academic/economic piece of research) should be judged on two separate accounts. One is its contribution to the methodology, discourse and lingo of its specific academic field which in my case is international macroeconomics and the second is on its contribution to the more market and policy oriented aspect of its topical sphere which in this case is the international economy and in particular global current account imbalances. I believe my thesis has something to offer on both accounts.
On the first, I will immediately disappoint the purists in announcing that my thesis does not develop a new model although I believe there are clear pathways from the arguments for anyone who likes to tinker with neo-classical modelling. In stead, I think there are two important points that I would like to emphasize as future reference and working points for my academic colleagues.
The first is that economists need a much more broad and dynamic theory of demographic changes than is the original idea of a demographic transition. In my thesis I present this through an attempted coup de grace of the notion that demographic changes should be seen through the perspective of population growth. As an alternative I propose a focus on population ageing. In itself this is not controversial and is already an inbuilt narrative in many (if not most) macroeconomic studies that deal with demographic change [1]. However, my aim here is more fundamental. What I consequently want to establish is the simple fact that the demographic transition is not over and not only that, it is non-linear and path dependent. Once we realize this, it opens up a whole new area of research in which macroeconomics is fused with anthropology and life course theory (sociology) in a way which I believe is crucial in order to truly understand what the macroeconomy, as we tend to call it, actually is.
Second, I raise and discuss the issue of dissaving as a function of old age. Specifically, I imply (although I do not show formally) that what may appear obvious on the microeconomic level may not be so obvious on the macroeconomic level. In other words, there is a an aggregation problem [2] here and it is exactly tied to the fact that while dissaving may seem imminently rational and inevitable in a microeconomic perspective it is not all obvious to me why societies as a whole should want to dissave in the context of persistently low fertility rates and rapid population ageing. Realizing that dissaving will at some point be a binding constraint for e.g. an economy such as a Japan in which ageing simply continues relentlessly, I develop the idea that rapidly ageing societies are not, in the main, characterized by dissaving but rather by the fight against it which has come to represent the key proposition of my thesis. I show this in relation to Germany and Japan as the two oldest economies in the world and try to build frame of reference on which to examine and judge other economies who will inevitably move in the same direction as these two economies.
Finally, and on the second overall account it is with no hesitation whatsoever that I claim how my thesis goes a long way to frame the Gordian knot currently facing the global economy as it exits its worst recession since the great depression. In short, if ageing economies find it difficult to create growth based on domestic demand and momentum and if they are reluctant to rapidly dissave into a very uncertain future where they would rely on foreign credit, the logical consequence is that they must be dependent on exports to grow. Now, the onset and path of this export dependency may vary from country to country, but in a world where all economies are ageing and where, worryingly, a large host of economies are converging to very low levels of fertility, it creates an obvious and practical problem. Who is going to run the deficits to match the desired level of savings of all these ageing economies?
Naturally, not everybody can export at the same time but just take a look at the discussions currently characterising the global economy. Everyone who is claiming a recovery is claiming one on the basis of growth in external demand, but this obviously cannot be true. So, you get the trade wars between China and the US, you get internal squabbles in the Eurozone over whether Germany should sacrifice its competitiveness and just how Greece, Spain etc are suppose to pay down their debt while seeing some form of growth at the same time. All this is about a lot of economies feeling the real and future pressure of deleveraging while only a few brave souls dare to proclaim that they seek growth through domestic sources. Something has to give and one obvious result will be lower trend growth quite simply because there will be lower accumulation of debt either because the capacity to pay off debt has shrunk or because the current level of liabilities disallows any further rapid debt accumulation. However, another consequence will also be an externality represented this higher level of desired external savings present in so many economies at the same time and behind it all, as a the underlying current, I believe is demographic change and how it affects the working of modern capitalist systems.
So, am I going for an early catch of the nobel here?
Hardly and thus the thoughts above represent my attempt to take the conclusions of my work as far as possible (and possibly way too far) on an overall conceptual level. Consequently, if you care to leaf through the thing, you will see lots of concrete empirically rooted points and arguments which are more down to earth than the barrage you have just worked your way through above.
In the end and because of my desire to continue my studies on a PhD level, I have (unconsciously I think) written my thesis with an open end and with many strings that can and should be picked up later. This is naturally what I hope to do in the future. For now, I invite you to have a look and by all means do not read it all, but you may just find some it interesting. Comments of all kinds are naturally welcome.
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[1] – After all, it goes back to the idea of a life cycle and more formally the notion of overlapping generations which are two classic methodological concepts in macroeconomics.
[2] – Aggregation problems are not new of course and have haunted macroeconomic representative agent modelling for a long, long time. However, I think that the specific issue in the context of the life cycle in many ways represent the original sin in the context of aggregation problems (but I may be wrong here).
By Claus Vistesen, on April 1st, 2010
It was hard not to sense that part of the IMF’s recent inquiry into Germany’s economy was also aimed at asking the country to eat a little bit of humble pie in the context of the ongoing difficulties facing the Eurozone. Consequently, Germany has been the poster child for the good pupil in class and an example to follow as the world seemed to have come to a near end in Greece, Spain and elsewhere. Today’s hint from the IMF should alert us to the fact that all is not well in the so-called engine room of Germany.
(quote Bloomberg)
The International Monetary Fund cut its growth forecast for Germany after a recovery in Europe’s largest economy came to a halt, and said the government needs a “credible” plan to reduce its deficit. The IMF expects the German economy to expand 1.2 percent this year and 1.7 percent in 2011, the Washington-based lender said in a report published today. In January, the fund forecast growth of 1.5 percent in 2010 and 1.9 percent next year.
(…)
The IMF urged the German government to foster domestic consumer spending. “Strengthening domestic sources of growth will help cushion the German economy against external shocks as well as benefit the euro-area countries and the global economy by reducing trade and payments imbalances,” according to the report.
(…)
Germany mustn’t lose sight of its goal of fiscal consolidation, and policy makers must be careful as they exit from the economic support measures put in place during the global financial turbulence, the IMF said in the report.
“The authorities face the challenge of sustaining recovery while preparing to exit, as part of an international coordinated strategy, from the extraordinary measures introduced during the crisis,” it said. “Over time, fiscal policy will have to transition from support to credible consolidation.”
There are two concrete points of note above the first about how Germany should see to it that it expanded domestic demand has already gotten plenty of air time not least in the context of Merkel’s continuing nein to any suggestion that Germany should aid Southern Europe in their plight through giving a little back in terms providing demand for imports.
The problem is of course that Germany is structurally positionend to be a supplier of a excess savings to the global economy through an external surplus. And the reason, well try almost four decades worth of below replacement fertility and next to non net migration, but I guess most of you know my rant here.
More importantly, this points us to the real underlying issue in the context of a global economy. In a recent very astute comment, Martin Wolf coined the concept Chermany to signify the folly of Germany and China in believing that they can demand that hitherto prolifigate deficit nations scale down while they continue ramping up external surpluses. This simply does not add up. Wolf really manages a home run with the following observation;
Behind all this is a fundamental divide. Surplus countries insist on continuing just as before. But they refuse to accept that their reliance on export surpluses must rebound upon themselves, once their customers go broke. Indeed, that is just what is happening. Meanwhile, countries that ran huge external deficits in the past can cut the massive fiscal deficits that result from post-bubble deleveraging by their private sectors only via a big surge in their net exports. If surplus countries fail to offset that shift, through expansion in aggregate demand, the world is inevitably caught in a “beggar-my-neighbour” battle: everybody seeks desperately to foist excess supplies on to their trading partners. That was a big part of the catastrophe of the 1930s, too.
So, Germany suffers from a bit of delusion here. However, what caught my eye in particular was also the IMF’s subtle but firm indication that Germany also has to tend to its public finances and now that growth seems to be less vibrant than initially assumed, it is all the more important that Germany takes proactive action sooner rather than later. And herin lies of course the rub since Germany is only surpassed by Japan when it comes to demographic ageing and thus the future liabilities of Germany are substantial.
True; Germany is moving into this with an overall lower level of debt/gdp and if there is something the Germans take pride in, it is their ability to impose self-inflicted pain and austerity to correct and to increase competitiveness and achieve growth from external sources. Yet, this brings us right back smack into the wall here since this is exactly where we don’t want Germany to go, but exactly because of the demographic prospects, it is where Germany must go. In this way, Germany needs an external surplus for the same reason that Japan needs one; the expected return in the German economy and the underlying future government liabilities would not allow Germany to finance an external deficit at “acceptable” yields. This is curious in light of that that the yield on German bonds are used as benchmarks for the obvious reason that Germany is a net external lender, but what if this changed?
Of course, this is not only about Germany, but also about the majority of the Eurozone edifice which leaves, yet again the tricky question of just how we are to find those brave economies willing to stand on the opposite part of the scale as ageing and overleveraged economies crowd the savings surplus side.This is really the question we must answer (c.f. Wolf above) even if it is indeed tempting to rely on Germany to do the heavy lifting. So far, the signals from Germany have suggested that this won’t happen with the good will of the German government, but ultimately it won’t happen because Germany is fundamentally unable to step up to the plate and provide the capacity for the surplus of others.
One would hope that as Germany slowly wakes up to this reality and the limitations of its own economy, it will hopefully bring the country and her politicians back down to earth.
By Claus Vistesen, on February 18th, 2010
GDP releases are, by nature, lagging indicators and thus do not say a whole lot on the current momentum in the economy. Moreover, the immediate attention span when it comes to the Eurozone remains, and rightly so, focused on the situation in Greece (and Spain) and what plan exactly that is to emerge from the busy meething schedules of Eurozone and EU finance ministers and heads of states. Yet, GDP remain the basic economic output figures we have and with the Q4 2009 GDP print we are able to put an interim conclusion [1] on an abysmal 2009, but more importantly also on a recovery which just do not seem to be materialising much to the chagrin, I am sure, of Eurozone policy makers (click for better viewing)
Color me smug but I, for one, am not surprised to see that France is all over this reading and basically it is thanks to France that the Eurozone is seeing growth at all. I would venture the claim that this is the beginning of a trend. In terms of the figures, the Eurozone (EU16) grew 0.1% from Q3 when the economy pulled out of recession by growing 0.4% qoq. The figure was primarily held down by continuing contractions in Greece and Spain (-0.8% and -0.1% respectively) as well as of course the stagnation in Germany where the growth rate was flat at 0% qoq after a strong showing in Q3. In Italy, the strong rebound in Q3 GDP at 0.6% qoq was somewhat given back in the form of a -0.2 contraction in Q4.
Year on year, Eurozone output fell by 2.1% with Germany, Greece, France, Spain, and Italy contracting 2.4%, 2.6%, 0.3%, 3.1 and 2.8% respectively.
The biggest losers with respect to national output remain Spain and Greece who, in volume terms over the quarters, have lost 4.8% and 2.4% respectively worth of GDP since the third quarter of 2008. Yet, the rest, save France, do not seem to be able to take up the slack for the these two hitherto sources of demand. The Economist pinpoints the order du jour quite adequately;
The main problem is a familiar one: consumers within the euro zone are not spending enough and the strong currency is making it hard to tap demand in the rest of the world. The best hope for a home-grown stimulus is Germany, where firms and consumers had practised thrift when the rest of the world indulged in a spending boom. Sadly Germany still relies too heavily on exports. Consumer spending and investment both fell in the fourth quarter and were it not for a boost from foreign trade, the German economy would have shrunk. This week Axel Weber, the head of Germany’s central bank, gave warning that cold weather could mean that GDP falls in the current quarter.
Other countries are tapped out. Spain was once a rich source of internal euro-area demand but its consumers are now weighed down by debts accumulated during a long housing boom. The unemployment rate is perilously close to 20% and its rigid jobs markets mean it is unlikely to come down soon. Bond-market pressures mean Spain’s government is having to withdraw some of its support to the economy sooner than it would like. The wonder is that Spain is not in a deeper funk. GDP fell by 3.1% in the year to the fourth quarter, not much worse than in Germany.
Basically, this is like a relay race where the change of baton has gone horribly wrong. Consequently, we were supposed to see a rebalancing of intra-Eurozone growth whereby the consumers of Spain, Greece etc were given a much needed break with those of particularly Germany taking over. This has not materialised and while France is still standing strong it is hardly enough to propel the entire Eurozone economy let alone its export dependent economies growing rapidly in number. I have argued several times that this exactly is now set to be an enduring feature of the Eurozone as an economic entity which of course makes it even harder for those intra-Eurozone imbalances to be resolved in an orderly manner.
Additionally, Eurozone growth or the lack of an even more catastrophic contraction in some member countries is still driven by large fiscal deficits. In this way, it does not take much economic intuition to see that if 2010 is set to be the year of the big fiscal scare (in a global context) the natural and inevitable retrenchment of fiscal deficit spending is going to reveal, in all certainty, just what the underlying growth momentum is. Personally, this is where I think the biggest negative surprise will come in terms of overall activity measured by national output.
More generally something, naturally, has to give here and according to the FT’s Martin Wolf, Germany needs to return the favor as he puts it, or more specifically; the Eurozone needs German consumers.
(…) Germany was able to offset extreme domestic demand weakness with robust external demand, from both inside and outside the eurozone. Indeed, as much as 70 per cent of the increase in Germany’s GDP between 1999 and 2007 was accounted for by the increase in its net exports.
Germany needs to return the favour. More precisely, the only way for eurozone countries to slash huge fiscal deficits, without their economies collapsing, is to engineer another private-sector credit bubble or a huge expansion in net exports. The former is undesirable. The latter requires improved competitiveness and buoyant external demand. At present, none of this is available. It is difficult to regain competitiveness when the euro is strong, partly because Germany is so competitive, and eurozone inflation also so low.
This argument is similar to one Mr. Wolf made recently on Japan and in the context of which he and I had a tête-à-tête on just what the possibilities are for Japan’s economy and its consumers to stage a recovery driven by domestic demand. My argument and beef with Mr Wolf is the same here. Thus, it is not because I think that Wolf is wrong and certainly not because I cannot see the fundamental need for Germany to attempt a rebalancing of its economy. However, the key question here is not what Germany needs to do, but whether it is feasible to expect Germany to pull forward the Eurozone through growth in domestic demand? I think it is not and I think you need to take a long hard look at the increasingly ageing German population and how this feeds into the ability of the economy to generate growth based on domestic demand.
Yet, as Martin Wolf adequately pointed out to me during our bataille on Japan that argument hardly brings anything to the table in terms of solution. I concur that it does not in the state that I present here. Yet, the consequence of the argument (and thus in some sense the solution) is very clear I think. If the Eurozone before the financial crisis had economies that were able, or who were allowed/pushed onto an unsustainable growth path where domestic demand/credit flourished it does not have these economies anymore (save perhaps France). It follows logically from this that while Germany (and Italy) was the main export dependent economy in the Eurozone before the financial crisis, the whole Eurozone is now effectively dependent on exports to grow. Notwithstanding the Economist’s point that this means the recent weakening of the Euro is actually a blessing, it also provides a very important perspective to the discourse on the global imbalances and how to unwind them.
Post script:
It is all about the Eurozone at the moment of course and not so much about the Q4 reading but more fundamentally about the Eurozone/EU itself in the wake of the growing economic crisis in Spain and most notably Greece. My good friend Edward Hugh is pretty much pushing forward the discourse at the moment (on Spain and in general) with his recent piece in La Vanguardia (in Spanish!, see also this) as well as his amusing yet important post on Chart Wars featuring as prominent a cast as the recent economics nobel laureate Paul Krugman and the Kingdom of Spain itself. Meanwhile, in a different media another good acquaintance of mine, Jonathan Tepper from Variant Perception, has an interview on the economic situation in Spain which is also much worth a look. Finally, I had a piece this week on the Guardian’s Comment is Free edifice which got a host of interesting comments.
So, enjoy reading!
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[1] – We don’t have a detailed break-up yet on country and Eurozone wide level.
By Claus Vistesen, on December 30th, 2009
Now this is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning.
Churchill 1942
Summary
- The extent, so far, of the internal devaluation process depends on the time period used for analysis. Using Q3-2007 as the beginning of the economic crisis suggest that Greece and Spain have not corrected relative to Germany as a benchmark. However, if we look entirely at the world in a post-Lehmann context the picture is different with Greece and Spain having observed excess deflation relative to Germany to the tune of -1.7% and -4.5% respectively for unit labour costs and -5.4% and -1.7% respectively for the PPI.
- The correction observed in the context of unit labour costs appears technical as German unit labour costs have increased sharply since Q4-2008 due to a large reduction in working hours and an increase in short time work. In comparison, the relative correction in the PPI looks more solid.
- The internal devaluation has not yet trickled down into the overall price level represented by the CPI. Both using the period Q3-07 to Q3-09 and Q4-08 to Q3-09 as the relevant time horizon reveals that there has been no meaningful internal devaluation in Greece and Spain measured on the CPI.
- While the analysis presented here may go some way to quantify the intra-Eurozone imbalances and the course of the internal devaluation so far it is impossible to say precisely how far (and for how long) Greece and Spain (and indeed Latvia, Hungary etc) have to go here. More importantly, it is impossible to say exactly which measures that must be taken albeit that they have to be severe in the context of reigning in public spending and, ultimately, the public debt and ongoing deficit. Likewise, it is difficult to quantity just how high unemployment should drift and for how long it should stay there in order to grind down past excess.
As 2009 is fast approaching an end it is worth asking whether this also means an end to the financial and economic crisis. Even if 2009 will be a year thoroughly marked by a global recession it could still seem as if the worst is behind us. Most of the advanced world swung into positive growth rates in H02 2009, risky assets have rallied, volatility has declined to pre-crisis levels, and interest rates and fiscal stimulus have been adeptly deployed to avert catastrophe. However and precisely because the last part has been a crucial prerequisite for the first three and as policy makers are now adamant that emergency measures must be scaled back or abandoned either because of necessity or a balanced assessment, it appears as if Churchill’s well known paraphrase is an adequate portrait of the situation at hand. In this way, what is really left in the way of global growth once we subtract the boost from fiscal and monetary stimuli and what is the underlying trend growth absent the crutches of extraordinary policy measures?
This question is likely to be a key theme for 2010.
Nowhere is this more relevant than in Greece and Spain who, together with Eastern Europe, have slowly but decisively taken center stage as focal points of the economic crisis. With this change of focus a whole new set of issues have emerged in the context of just how efficiently (or not) the institutional setup of the Eurozone and EU will transmit and indeed endure the crisis.
I won’t go into detail on this here mainly because I would simply be playing second fiddle to what Edward has already said again (and again) in the context of his ongoing analysis of the Spanish and Greek economy to which I can subscribe without reservations. It will consequently suffice to reiterate two overall points in the context of Spain and Greece.
Firstly, the main source of these economies’ difficulties, while certainly very much present in the here and now, essentially has its roots in population ageing and a period, too long, of below replacement fertility that has now put their respective economic models to the wall. It is interesting here to note that while it is intuitively easy to explain why economic growth and dynamism should decline as economies experience ongoing population ageing, it is through the interaction with public spending and debt that the issue becomes a real problem for the modern market economy. Contributions are plentiful here but Deckle (2002) on Japan and Börsh-Supan and Wilke (2004) on Germany are good examples of how simple forward extrapolation of public debt in light of unchanged social and institutional structures clearly indicate how something, at some point, has to give. Whether Spain and Greece have indeed reached an inflection point is difficult to say for certain. However, as Edward rightfully has pointed out, this situation is first and foremost about a broken economic model than merely a question of staging a correction on the back of a crisis.
Secondly and although it could seem as stating the obvious, Greece and Spain are members of the Eurozone and while this has certainly engendered positive economic (side)effects, it has also allowed them to build up massive external imbalances without no clear mechanism of correction. Thus, as the demographic situation has simply continued to deteriorate so have these two economies reached the end of the road. In this way, being a member of the EU and the Eurozone clearly means that you may expect to enjoy protection if faced with difficulty, but it also means that the measures needed to regain lost competitiveness and economic dynamism can be very tough. Specially and while no-one with but the faintest of economic intuition would disagree that the growth path taken by Greece and Spain during the past decade should have led to intense pressure on their domestic currencies, it is exactly this which the institutional setup of the Eurozone has prevented. I have long been critical of this exact mismatch between the potential to build internal imbalances and the inability to correct them, but we are beyond this discussion I think. Especially, we can safely assume that the economists roaming the corridors in Frankfurt and Brussels are not stupid and that they have known full well what kind of path Greece and Spain (and Italy) invariably were moving towards.
Essentially, what Greece and Spain now face (alongside Ireland, Hungary, Latvia etc) is an internal devaluation which has to serve as the only means of adjustment since, as is evidently clearly, the nominal exchange rate is bound by the gravitional laws of the Eurozone. Now, I am not making an argument about the virtues of devaluation versus a domestic structural correction since it will often be a combination of the two (i.e. as in Hungary). What I am trying to emphasize is simply two things; firstly, the danger of imposing internal devaluations in economies whose demographic structure resemble that of Greece and Spain and secondly, whether it can actually be done within the confines of the current political and economic setup in the Eurozone.
On the last question I personally adamant that it has to since failure would mean the end of the Eurozone as we know it but this is also why I am quite worried, and intrigued as an economist, on the first question. Specifically and as Edward and myself have been at pains to point out (and to test and verify) this medicine while certainly viable in theory has three principal problems. Firstly, it takes time and may thus amount to too little too late in the face of an immediate threat of economic collapse. Secondly, an ageing population spiralling into deflation may have great problems escaping its claws, and thirdly, because of the pains associated with the medicine the patient may be very reluctant to acccept the treatment. Especially, the last point is very important to note from a policy perspective and was made abundantly clear recently in the context of Latvia where The Constitutional Court ruled that the very reforms demanded in the context of the IMF program to reign in costs through cutting pensions would violate the Latvian constitution. And as Edward further points out, the situation is the same in Hungary where voters recently (and quite understandably one could say) decided to reject a set of health charges that were exactly proposed as part of a reform program designed to reign in public spending. We are about to see just how willing Spain and Greece are in the context of accepting the austerity measures that must come, but similar dynamics are not alltogther impossible.
Consequently, and while I agree with Edward as he turns his focus on the inadequacy of the political system in Spain and Greece to realize the severity of the mess; it remains an inbuilt feature of imposition of internal devaluations through sharp expenditure cuts that they are very difficult to sustain given the political dynamics. This is then a question of a careful calibration of the stick and carrot where the former especially in the initial phases of an internal devaluation process is wielded with great force.
Internal Devaluation, What is it All About Then?
If the technical aspects of an internal devaluation have so far escaped you it is actually quite simple. Absent, a nominal exchange depreciation to help restore competitiveness the entire burden of adjustment must now fall on the real effective exchange rate and thus the domestic economy. The only way that this can happen is through price deflation and, going back to my point above, the only way this can meaningfully happen is through a sharp correction in public expenditure accompanied with painful reforms to dismantle or change some of the most expensive social security schemes. This is naturally all the more presicient and controversial as both Spain and Greece are stoking large budget deficits to help combat the very crisis from which they must now try to escape. Positive productivity shocks here à la Solow’s mana that fall from the sky may indeed help , but in the middle of the worst crisis since the 1930s it is difficult to see where this should come from. Moreover, with a rapidly ageing population it becomes more difficult to foster such productivity shocks through what we could call “endogenous” growth (or so at least I would argue).
With this point in mind, let us look at some empirical evidence for the process of internal devaluation so far.
In order to establish some kind of reference point for analysis I am going to compare Greece and Spain with Germany. This is not because Germany, in any sense of the words, stands out as an example of solid economic performance as the burden of demographics is clearly visible here too. However, for Spain and Greece to recover they must claw back some of the lost ground on competitiveness relative to Germany. This highlights another and very important part of the internal devaluation process. Spain, Greece etc will not only be fighting their own imbalances; they will also fight a moving target since they may not be the only economies who face deflation or near zero inflation as we move forward.
Beginning with the simple overall inflation rate measured by the CPI we see that the level of prices (100=2005) has risen much faster in Greece and Spain than in Germany. Compared to 2005 the price level in Germany stood 7.1% higher in Q3-09 which compares to corresponding figures for Spain and Greece at 11.5% and 10.3% respectively. However, this does not tell the whole story about the build up of imbalances since the inception of the Eurozone. Consequently, since Q1-00 the price index has increased some 15% in Germany whereas it has increased a healthy 29.3% and 27.2% in Greece and Spain respectively.
 
Turning to the bottom chart which plots the annual quarterly inflation rate a similar picture reveals itself with a high degree of cross-correlation between the yearly CPI prints, but where the German inflation rate has been persistently lower than that of Greece and Spain. The average inflation rate in Germany from Q1-1997 to Q3-2009 was 1.6% and 3.5% and 2.8% for Greece and Spain respectively. It is important to understand the cumulative nature of the consistent divergence in inflation rate since it is exactly this feature that contributes to the build-up of the external debt imbalance. From 2000-2009(Q3) the accumulated annual increases in the CPI was 57% for Germany versus 109.4% and 104% for Greece and Spain respectively. Assuming that Germany remains on its historic path of annual CPI readings (which is highly dubious in fact), this gives a very clear image of the kind of correction Greece and Spain needs to undertake in order to move the net external borrowing back on a sustainable path which in this case means that these two economies are now effectively dependent on exports to grow.
If the divergence in Eurozone CPI represents a general measure of the built-up of external imbalances and the need for an internal devaluation through price deflation two other measures provide more direct proxies. These two are unit labour costs and the producer price index (PPI) which are both key determinants for the competitiveness of domestic companies on international markets. Intuitively one would expect unit labour costs as an important input cost to drive the PPI which measures the price companies receive for their output. Yet this is only going to be the case if the companies in question have market power on the domestic market. Consequently, if you regress the quarterly change of the PPI on the quarterly change on unit labour costs you get a negative coefficient in Germany and a positive coefficient in Greece and Spain (highly significant for Spain and not so for Greece). This is exactly what one would expect since German companies are highly exposed to the external environment (where they enjoy no market power) and thus has to suffer any increase in the cost of labour input through a decline in their output price. Conversely in Spain, the connection between an increase in unit labour costs and the PPI is strongly positive which suggest that Spanish companies has enjoyed considerable market power due to a vibrant domestic economy [1]. It is exactly this that must now change.
 
If we look at unit labour costs and abstract for a minute from the increase in German unit labour costs from Q2-08 to Q2-09 in Germany [2], both Greece and Spain have seen their labour cost surge relative to Germany since the inception of the Eurozone. Since Q1-00 the accumulated change in the German index has consequently been 15.2% which compares to 97.7% and 105.6% for Greece and Spain respectively. More demonstratively however is the fact that since the second half of 2006 the labour cost index of Spain and Greece have been above the Germany relative to 2005 which is the base year. Consider consequently that the labour cost index in Greece and Spain was 13.3% and 16.4% below the German ditto in Q1-2000 and now (even with the recent surge in German labour costs), the Greek and Spanish labour cost index stands 7.2% and 5.2% above the German index.
Turning finally to producer prices the similarity between the three countries in question are somewhat restored which goes some way to support the notion of persistent lower labour cost growth relative to fellow Eurozone members as the main source of the build-up of Germany’s “competitive advantage” and in some way the build-up of intra Eurozone imbalances.
 
Essentially, and while definitely noticeable the divergence between Greece/Spain and Germany on the PPI is less wide than in the context of unit labour costs and the CPI. Consequently, and if we look at the index, the divergence which saw Spanish and Greek producer prices increase beyond those of Germany came very late in the end of 2007. Moreover, the correction so far has been quite sharp in both Greece and Spain relative to Germany with the PPI falling 14.8%, 5.7% and 2.8% (yoy) in Q2-09 and Q3-09 in Greece, Spain and Germany. The accumulated increase however, in the PPI, from 2000 to Q3-09 has been 85% in Germany and 136% and 101.7% in the Greece and Spain respectively.
If the numbers above indicates the extent to which intra Eurozone imbalances have manifested themselves in divergent price levels and rates of inflation, the concept of internal devaluation concerns the net effect on the prices in Greece and Spain relative to, in this case, Germany. On this account, and if we put the beginning of the financial crisis as Q3-07 (i.e. when BNP Paribas posted sub-prime related losses) the butcher’s bill look as follows.
From Q3-07 to Q3-09 and in relation to the CPI the average quarterly inflation rate in Greece in Spain has been 1% and 0.66% higher than in Germany. The accumulated excess inflation rate over the German inflation has been 8% in Greece and 5.29% in Spain. Only in the context of Spain do we observe some indication of the initial phases of a relative internal devaluation as Spain has seen an accumulated inflation rate lower than that of Germany to the tune of 1.28%.
Turning to unit labour costs the picture changes quite a lot depending on the time horizon. Using the same period as above, the average quarterly excess increase in unit labour costs of Greece and Spain relative to Germany has been 1.75% and 0.3% in Greece and Spain respectively. The accumulated increase in unit labour costs has consequently been a full 14% and 2.8% higher in Greece and Spain relative to Germany. However, if we focus the attention on the period from Q4-08 to Q2-09 and due to the fact that labour hours in Germany have gone down further than in Greece and Spain, labour costs have corrected sharply in Greece and Spain relative to in Germany to the tune of -5.2% and 13.7% (accumulated) and -1.7% and -4.6% respectively. The fact that German producers have so far cut down sharply on labour hours could mean that Germany should claw back some of the lost ground vis-a-vis Greece and Spain if and when these two economies follow suit.
Finally, in relation to producer prices the picture is very much the same as in the context of unit labour costs with the notable qualifier that the relative excess deflation observed in Greece and Spain from Q4-08 and onwards is likely to be less “technical” and thus more “real” than in the case of labour costs. In this way the period Q3-07 to Q3-09 saw the excess rate of produce price inflation reach 14.8% and 6.8% (accumulated) and 1.8% and 0.8% (quarterly average) in Greece and Spain respectively. However, if we focus the attention on Q4-08 to Q3-09 the picture reverses and reveals a substantial degree of excess deflation over the Germany PPI in Greece and Spain to the tune of 16.1% and 5.2% (accumulated) and 5.4% and 1.7% (quarterly average) for Greece and Spain respectively.
The End of the Beginning
As we exit 2009 it is quite unlikely that we will also be able to leave behind the effects of the economic and financial crisis and this is not about me being persistently negative or even a perma-bear. Things have definitely improve and much of this improvement owes itself to rapid, bold, and efficient policy measures. However, some economies are in a tighter spot than others and this most decisively goes for Spain and Greece who now have to correct to the fundamentals of their economies with rapidly ageing populations.
As this correction largely has to come in the form of an internal devaluation the following conclusions are possible going into 2010.
- The extent, so far, of the internal devaluation process depends on the time period used for analysis. Using Q3-2007 as the beginning of the economic crisis suggest that Greece and Spain have not corrected relative to Germany as a benchmark. However, if we look entirely at the worldin a post-Lehmann context the picture is different with Greece and Spain having observed excess deflation relative to Germany to the tune of -1.7% and -4.5% respectively for unit labour costs and -5.4% and -1.7% respectively for the PPI.
- The correction observed in the context of unit labour costs appears technical as German unit labour costs have increased sharply since Q4-2008 due to a large reduction in working hours and an increase in short time work. In comparison, the relative correction in the PPI looks more solid.
- The internal devaluation has not yet trickled down into the overall price level represented by the CPI. Both using the period Q3-07 to Q3-09 and Q4-08 to Q3-09 as the relevant time horizon reveals that there has been no meaningful internal devaluation in Greece and Spain measured on the CPI.
- While the analysis presented here may go some way to quantify the intra-Eurozone imbalances and the course of the internal devaluation so far it is impossible to say precisely how far (and for how long) Greece and Spain (and indeed Latvia, Hungary etc) have to go here. More importantly, it is impossible to say exactly which measures that must be taken albeit that they have to be severe in the context of reigning in public spending and, ultimately, the public debt and ongoing deficit. Likewise, it is difficult to quantity just how high unemployment should drift and for how long it should stay there in order to grind down past excess.
In this sense, 2009 will not go down as the end in any sense of the word, but more likely as the end of the beginning.
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[1] – Naturally, this argument assumes non-sticky prices and thus a 1-to-1 relationship in time between a change in input costs and output prices of companies. Since contractual arrangements are likely to make both sticky in the short run and likely with divergent time paths too, the quantitative results are not robust. The results for Germany are significant at 10% whereas those for Spain are significant at 1%. Mail me for the estimated equations if you really want to see the results.
[2] – The index rose 7.8% over the course of the year ending Q2-2009 which is way above 3 standard deviations of the “normal” annual change in the index from 1997 to 2009. The explanation is really quite simple and relates to the fact that German manufactures (in particular) has sharply cut overtime work and short time work has been rapidly extended (see e.g. this from Q2-09) which is obviously not the case in Greece and Spain. The fact that German producers have so far cut down sharply on labour hours means that Germany should claw back some of the lost ground vis-a-vis Greece and Spain if and when these two economies follow suit.
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