GERMAN FISCAL RETRENCHMENT

Germany has announced a an important package of spending cuts as part it's plans for the next fiscal year. Among these are easures which increase the tax burden on both individuals and companies and are expected to raise €4.2bn in 2003. To this will be added €7.4bn of cuts in Federal subsidies to Germany's unemployment and pensions insurance schemes. These two, plus a €2.6bn increase in net new borrowing are intended to enable the government to meet next year's expected €14.2bn budget shortfall. All in all, and despite the increase in borrowing entailed for next year and 2004, the idea is to try to edge Germany towards complying with their stability pact agreement of a balanced budget by 2006.

Germany's election victors on Monday agreed on large tax rises and spending cuts to address a looming gap in next year's budget because of the severe economic slowdown.The additional tax burden agreed between the governing Social Democrats and their Green junior coalition partners will fall on both companies and private individuals. Companies are now facing limits on their right to carry forward losses, in effect introducing a minimum tax.

For private taxpayers, the biggest change will come with lower benefits for homeowners and extending capital gains tax on share dealings, plus steps to tighten. In the past week, Hans Eichel, finance minister, has come under pressure to loosen his strict debt reduction targets, because of the risks of deflation. His position has been additionally eroded by the willingness of some European Union countries, notably France, to play down the importance of the rules for the euro in favour of stimulating their domestic economies.
Source: Financial Times
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The Financial Times mentions the risk to Germany of deflation. Last week the economist had this to say on the topic, (see blog item below, but the importance of this probably justifies reiteration in full):

Germany probably faces a higher risk of deflation than America. The ECB's interest rate of 3.25% is broadly appropriate for the euro area as a whole, given its inflation rate (2.2%), the size of the output gap, and the bank's chosen inflation target of “less than 2%”. But the ECB seems unlikely to cut interest rates until inflation dips below 2%. And its inflation target is arguably too low. Research by the IMF and the Fed suggests that, if central banks aim for inflation below 2%, the risk of deflation rises markedly. If the ECB had an inflation target with a mid-point (rather than a ceiling) of 2%, it could now trim interest rates.

Even then, however, rates would still be too high for Germany. Since it is the highest-cost producer within the euro area, a fixed exchange rate tends to cause price convergence by forcing inflation to be lower in Germany than in the rest of the euro area. Germany's core rate of inflation (excluding food and energy) has averaged 0.6 percentage points below the euro-area average over the past three years; it is now a full point lower, at 1.1%.

Since interest rates are the same across the whole of the euro area, this implies that real rates will be higher in Germany and growth consequently slower. Germany's output gap, at an estimated 2.5% of GDP, is the second biggest after Japan among the G7 countries, and it is likely to widen. Deutsche Bank recently cut its growth forecast for Germany to only 0.1% for this year and 0.6% in 2003. Back-of-the-envelope calculations suggest that, if the old Bundesbank were setting interest rates to suit Germany alone, they would now be below 2%. Worse still, not only is Germany unable to cut interest rates, but the EU's stability and growth pact also obstructs any fiscal easing. Nor can it devalue its currency. Stripped of all its macroeconomic policy weapons, Germany now runs a serious risk of following Japan into deflation.
Source: The Economist
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So let's get this clear, Germany, according to the Economist (and me too) could well be poised on the brink of following Japan into a protracted cycle of deflation. In this context the recent rapid rise in the Euro can only have made matters worse. But far from taking note of the lesssons drawn from the Japan experience in the recent Federal Reserve paper, real interest rates in the Euro zone remain comparatively high (especially for Germany were inflation is now below 1%) and now fiscal policy is being used to apply the brake. All this seems absurd doesn't it? Well yes, and no. Yes, it is absurd, and no, there is an explanation, even if it's a bad one.

To begin to understand what is going on it is worth going back to a document prepared by the UN on the problems which will be caused by FALLING POPULATION in some European countries, to the associated dramatic rise in population dependency ratios, and to the consequent dangerous public debt dynamics which may arise with the double whammy of rising pension obligations and falling tax income. Put bluntly, the off-balance-sheet liabilities of some EU countries make Enron et al. look childs play. (In fact anyone examining carefully the kinds of creative accounting being employed to meet stability pact obligations by eg Italy, would also come to the same conclusion - that is governments are effectively playing with fire with financial derivatives). The UN proposal - like mine - is for replacement migration as a conscious and explicit policy measure.

Now for the UN. In a series of country specific studies the UN has applied a number of possible birth rate/immigration scenarios. Firstly - in the case of Germany - there is scenario 1: things stay as they are:

Scenario I, the medium variant of the United Nations 1998 Revision, assumes a net total of 11.4 million migrants between 1995 and 2050. For the years 1995-2005 it estimates 240,000 migrants per year and for the period between 2005 and 2050 a net migration of 200,000 persons per annum. For the overall population of Germany the medium variant projects an increase from 81.7 million in 1995 to 82.4 million in 2005. Thereafter, the population would continuously decline to 73.3 million in 2050 (The results of the 1998 United Nations projections are shown in the annex tables). The population aged 15-64 years would slightly increase from 55.8 million in 1995 to 56.0 million in 2000; between 2000 and 2050 it would continuously decrease to 42.7 million. The share of the elderly (65 years and above) would increase from 12.6 million in 1995 (15.5 per cent) to 20.8 million in 2050 (28.4 per cent). Consequently, the potential support ratio would be halved, decreasing from 4.4 in 1995 to 2.1 in 2050.

In the case of scenario four the UN specualte with the dynamics of maintaining a constant size 15-64 age group:

Scenario IV keeps the size of the population aged 15-64 years constant at the 1995 level of 55.8 million until the year 2050. This would require a total of 25.2 million migrants between 1995 and 2050, an average of 458,000 per year. The total population of Germany would increase to 92 million in 2050, of
which 33 million (36 per cent) would be post-1995 migrants and their descendants. The potential support ratio would be 2.4 in 2050.

and, then there is scenario five, keeping the present dependency ration constant:

Scenario V keeps the potential support ratio constant at its 1995 level of 4.4 until 2050. The total of immigrants needed between 1995 and 2050 to keep this ratio constant would be 188.5 million, which is an average of 3.4 million migrants per year. In 2050 the total population would be 299 million, of which 80 per cent would be post-1995 migrants and their descendants.
Source: UN report on Replacement Migration
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As can be seen maintaining the dependency ration constant would involve a Herculean labour, both from the German themselves (in terms of flexibility in the face of a new population) and from the immigrants. The origins of the stability pact lie in the perception realised in the mid-90's that, without an important structural change in the pension and social security systems, the EU countries would effectively eventually go bust. Hence the preoccupation now that it is in part being abandoned. A number of international organisations are attempting to draw attention to the gravity of this situation, among them the Global Aging Initiative: LINK

The growing imbalance between the population of working people and those who are retired threatens to cause a future fiscal crisis in virtually every nation in the industrial world. This crisis will occur because virtually all social security systems, including elderly health and nursing care, operate on a pay-as-you-go basis. That is, they are not prefunded by contributions that are invested in liquid assets that earn a return on those investments. Current workers support current
retirees through the payroll tax (sometimes called a “contribution” in some countries), income tax, and other taxes.

The old-age dependency ratio, then, is the key economic indicator that economists and demographers watch in their forecasts. This ratio
is the number of people over age 65 for each person in the working-age population. Sometimes this figure is expressed as the support ratio, or the number of people of working-age population per person age 65 or older.

Italy faces a daunting increase in its old-age dependency ratio, which is expected to rise from 0.27 in 2000 to 0.42 in 2025 and to 0.66 in 2050. Germany’s old-age dependency ratio will rise from 0.24 in 2000 to 0.37 in 2026 and to 0.49 in 2050. France’s ratio is projected to rise to 0.44 in 2050.

The prospect of these rising dependency ratios got the attention of the World Bank, which, after two years of research, declared in 1994 that pay-as-you-go systems around the globe clearly were unsustainable. “The world is approaching an old age crisis…[and] existing systems of financial security for old people are headed toward collapse,”25 it warned ominously at a time when public awareness of the extent of demographic transformation and the potential fiscal fallout were just emerging. The World Bank also urged careful consideration of how to reform old-age pension systems.

The World Bank report followed on the heels of currency crises in Europe in the early 1990s. These crises resulted partly from the perception by currency traders and speculators that old-age welfare programs in Europe were unsustainable and were most worrisome in countries with high debt levels and sluggish growth. Some European countries, such as Italy and France, have virtually no employer-sponsored pension systems. Although Japan and Germany have such systems, they are greatly underfunded.

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Further to Glenn Hubbard:

In his FT article the Chairman of the US Presidents Council of Economic advisers says:

"Private forecasters expect the overall rate of consumer inflation to rise to about 2.4 per cent in 2003 as the recovery takes hold"

Don't the US government have their own forecasters any more? This, of course, is a silly quibble, but still the argument is a bit unpresentable. Which private forecasters, those who thought the economy would be booming come last March? He also asserts:

"Moreover, the inflation rate for consumer services has stabilised at little more than 3 per cent a year."

This is the really dodgy part of his argument, since this increase in costs comes from a lack of productivity, not from an excess of it. In particular, once we take out housing (which is a case apart in many ways), the majority of this inflation probably comes from education and health (incidentally these belong to Griliches poorly measured sectors - deriving a price index for health when you control for quality has to be a nightmare, what you can clearly say is that the costs per employed worker of providing health for the entire US population is going to rise significantly), ie the immediate consumers are not salary-earners, the consequences of this for GDP per capita, and hence growth, remain unclear. I wish we had a model here.

Stephen Roach tackles this from another angle in this morning's FT, suggesting that global forces will drive down prices in this sector. In part he has a point, but if he's wrong and they don't, then, as I say, these sectors should be a drag on growth, not a plus point. It's all very complicated, and obviously a bit too complicated for poor Glenn Hubbard. He'll be telling US next that strong speeches by George W are good for the economy since they drive up petrol prices and prevent deflation.

I'm trying to work through a model somehow. It started off something like, consider an economy with three sectors. Sector one trades in the international arena, and is subjected to globally falling prices. Sector two produces high tech products and has just had a technology revolution that is producing a continuous fall in prices and systematic excess capacity. Sector three is home directed, inefficient and with low productivity growth, it thus suffers from upward cost push. (This is meant to be fairly serious, but I can't help going back to the begining and starting with imagine an economy with FOUR sectors: the fourth one would manufacture pieces of paper, with I promise to pay written on them, and would be directed to the international market, but this is stealing from Stephen Roach).

OK, this takes care of the supply side. On the demand side the savings ratio has a lot to say, and that's were the demography comes in, Modigliani life-cycle or Ricardian equivalence, or whatever.

NBER BUSINESS CYCLE DATING COMMITTEE SAYS ITS TOO SOON TO SAY ON THE US RECESSION

The problem is that the committe has to try and be sure the recovery is real, and that there is going to be no double-dip, before giving the green light signal. The situation is complicated by the confusing and conflicting signals which are arriving, especially on the employment front, there seems to be a constant 'two steps forward, one step back, one step forward, two steps back' process going on. In the end, as the saying goes, every recession, and every expansion is unique, and it is the absence of mere repetition of the same that makes the calls so damned tricky.

The U.S. economy continues to experience increases in production and income with no significant growth in employment. According to recently revised data, real personal income has generally been growing over the past year. Employment grew slightly from May through August 2002, but declined in September. These and other signs indicate that the decline in activity that began last year may have come to an end. The NBER's Business Cycle Dating Committee will determine the date of a trough in activity when it concludes that a hypothetical subsequent downturn would be a separate recession, not a continuation of the past one. The trough date will mark the end of the recession. The committee will not issue any judgment about whether the economy has reached a trough until it makes its formal decision on this point. The committee waits for many months after an apparent trough to make its decision, because of data revisions and the possibility that the contraction would resume. For example, the committee waited until December 1992 to announce that a trough had occurred in March 1991.

In November 2001, the committee determined that a peak in business activity occurred in the U.S. economy in March 2001. A peak marks the end of an expansion and the beginning of a recession. The determination of a peak date in March is thus a determination that the expansion that began in March 1991 ended in March 2001 and a recession began in March. The expansion lasted exactly 10 years, the longest in the NBER's chronology.

Because a recession influences the economy broadly and is not confined to one sector, the committee emphasizes economy-wide measures of economic activity. The traditional role of the committee is to maintain a monthly chronology, so the committee refers almost exclusively to monthly indicators. The committee gives relatively little weight to real GDP because it is only measured quarterly.

In 2002, indicators measuring output and income generally have been rising, while employment has been essentially constant. The primary factor accounting for the more favorable performance of income and production relative to employment is the continuation of rapid productivity growth resulting in corresponding growth in real wages.

According to data released in September (http://www.bea.doc.gov/bea/newsrel/gdpnews release.htm), real GDP increased at an annual rate of 1.3 percent in the second quarter of 2002, and 5.0 percent in the first quarter. GDP reached a peak in the fourth quarter of 2000, contracted for the first three quarters of 2001, and has expanded since then to a point above its level in the second quarter of 2001. This performance of real GDP is consistent with the other data considered by the committee. Output fell less than employment during the recession and currently is rising faster than employment because of unusual productivity growth.
Source: NBER
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DEFLATION DENIAL

Glenn Hubbard, the chairman of Bush's Council of Economic Advisers makes it official, deflation is greatly over-rated because the US Economy is going just fine:

This modern deflation scenario seems to make a lot of sense - until you get out your calculator. When you do, the basic features of the US economy look quite good and deflation appears unlikely. To start with, analy sis of the productivity data over the past six quarters confirms some of the best news that economists have delivered in a generation - the acceleration in productivity growth that began in 1995 continues unabated. Thanks to this, today's consumers can look forward to real incomes that grow much more quickly than they have during the past 30 years - a good omen for current consumption.

Of course, one can point to the strength of the housing market as a factor keeping consumption strong. House values have risen and low mortgage rates have encouraged homeowners to take out some of the equity in their homes through refinancing. But while this process has been a part of healthy consumption growth, it has been only a part..............The question of why house prices have risen so much in the past few years is interesting. The surge in immigration during the 1990s and the lack of land suitable for new housing in some cities with tight zoning restrictions are probably part of the answer. But fears that the US housing market is in the midst of a bubble are unwarranted. Behind any bubble is the hope that an investor can purchase an asset for one price and sell it quickly for a higher price. This is hard to achieve with houses, because of the high transaction costs in housing markets. And without a rapid and nationwide decline in housing wealth, it is hard to see how deflation can occur.

While in the long run deflation - like inflation - is a monetary phenomenon, low aggregate demand is not likely to push the US toward deflation any time soon. It is a pretty boring story, compared with those told by the deflationists. But it does pretty well when confronted with the facts.
Source: Financial Times
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Now perhaps this article would be eminently forgetable, were it not for the fact that Paul Krugman has seen fit to enter the fray. I post the Krugman piece in full.

JOBS, JOBS, JOBS (10/10/02)
Of all the things to be upset about right now, a silly fallacy in Glenn Hubbard's FT article today doesn't rate very high. But it's a fallacy I hear a lot, so let me take a minute to bash it.

Hubbard, like so many people, asserts that one reason for optimism about economic recovery is our continuing high rate of productivity growth. At first this sounds right: higher productivity growth means, other things equal, faster income growth, which means more spending, which means faster demand growth. So all that is good for recovery, right?

No, not really. What most people mean by recovery is job growth - an economy that is growing, but in which employment grows more slowly than the labor force, may be in recovery by some measures, but it will feel like it's still in recession.

Now what does productivity growth do? It raises incomes and hence demand. But it also raises the growth rate the economy needs to achieve to create jobs, and to a first approximation it does so by exactly the same amount. That is, an economy with 3 percent productivity growth will, other things equal, have 2 percent faster demand growth than an economy with 1 percent productivity growth; but it will also need a growth rate 2 percent higher to keep unemployment from rising.

In fact, the "productivity growth helps jobs" story, if that's what it is, is just the flip side of the lump-of-labor fallacy, which says that productivity growth reduces employment - and equally wrong. (There's a different argument, about how productivity growth reduces the NAIRU - but that's about the supply side, not the demand side).

You might say that I'm being too abstract; what about the lessons of history? But they all confirm this point. Terrific productivity performance in the 1920s didn't protect us against the Depression; all through the 70s and 80s Europe had higher productivity growth than the U.S., but worse job growth; you can multiply the examples.

I'm not surprised that Hubbard would make a silly argument; he is not, after all, a free man. But it's a sign of desperation, I think, that so many people have bought into this fallacy.
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Hubbard clearly has it wrong. Rising productivity can be accompanied by either rising incomes, or falling prices, it depends. And it's this 'depends' that really is at the issue here. Hubbard clearly believes that the current increasing LABOUR productivity will lead to increasing real incomes, increased consumption, and thus, presumably increased investment (although this is my deduced mechanism since it isn't presented explicity), because he says so.

"the acceleration in productivity growth that began in 1995 continues unabated. Thanks to this, today's consumers can look forward to real incomes that grow much more quickly than they have during the past 30 years - a good omen for current consumption."

The deflationist argument is that the other possibility exists, that the increased productivity leads to falling prices as firms compete to sell. This is the role of the output gap argument. This argument is also backed by the idea that current consumption has been maintained by borrowing. It's not the wealth loss caused by the drop in the financial markets that's the problem, but the increased debt encouraged by the false sense of security provided by rising assett, and subsequently rising property, values.


One of the problems here is that productivity is a poorly understood phenomenon - by all of us. The majority of the numbers being bandied-about at the moment seem to be numbers for 'labour productivity' from the BLS. And this is where the argument starts, because the 'jobless recovery' is a product of another process, the relentless drive by corporate America to cut costs, ergo increase output while not contracting new labour, or hiring young workers on short term contracts etc. It's very early to start making conjectures about these numbers because the serious analysis isn't through yet. But it is entirely consistent with the deflation/output-gap argument. US workers are trapped in a kind of modern version of the olive press, and at some stage all that can be will have been squeezed.

"Now what does productivity growth do?" Perhaps this is an unfortunate way to present the story, since maybe productivity growth doesn't 'do' anything. In the present context this productivity growth is an effect of something, and it's understanding this 'something' that is the problem.

Paul Krugman himself in another piece on the related topic of the output gap clarifies what he is saying: "Brad DeLong is quite right that there's no such thing as excess capacity for the economy as a whole. I've been vociferous about that myself in the past. What I meant to say was over-investment in short-lived business capital, mainly tech, relative to other resources...."

However it is in this last point, rather than the conjuctural productivity/output-gap argument, where the real problem lies. You see, I think it's just not credible to say that "over-investment in short-lived business capital" is pushing the global economy into a period of secular deflation (I take it as read that Hubbard just doesn't understand what's going on here). The normal expectation would be that this excess capacity would be worked-off, and on we would go again. But it's all too evident that this just isn't happening.

I've already indicated in this column (ad infinitum) some possible candidates: the continuing fall in ICT and biotech prices, the structure of world trade (especially China, but my guess is India won't be too long making its presence felt), and demographic processes in the G3 countries.

If demography is going to be important in the story then the deflation problem should be more acute in the EU countries (Italy and Spain in particular, but also Germany) than in the US, but obviously with Japan and Europe going downwards the US is bound to be sucked in.

Put this another way: if demography is not important, then why, in Stephen Roach's words is the world lacking an alternative global growth engine right now. Surely using conventional growth theory the 'convergence factor' should be offering plenty of catching-up momentum elsewhere.

Perhaps demography will turn out to be the modern economists 'pons assinorum'.

Incidentally, while the Glen Hubbard piece may be eminently forgetable, the ever-to-be-recommended Economist has a very nice (Krugman influenced?) piece on deflation (see below), and especially the dangers for Germany right now - going 'naked into the conference chamber' - thanks to the voluntary Euro disarmament. (It's hard to remember that it was only 10 months ago that the world was cheering on this single currency 'experiment' - so why, oh why, have all the evangelists suddenly gone silent?).
Now as far as the liklehood of deflation goes, either you believe the deflationist story or you don't. But Hubbard is wrong. There are TWO possible outcomes, and this time next year we'll have a better idea which one of the two it is going to be.

THE ECONOMIST RAISES THE DEFLATION ALERT

An extremely comprehensive and well argued piece in this weeks economist - entitled interestingly enough of debt, deflation and denial - draws attention to the growing unease at a possible global drift towards deflation. In particular it points out the highly preoccupying situation of the German economy and the danger that, lacking any domestic policy instruments of her own - thanks to her Euro membership, she may fall defenceless.

The article also draws attention to the ongoing difference of opinion between the ECB and the Federal Reserve. Greenspan obviously takes the threat more seriously than Duisenberg. Time will show who is right

The world is still awash with excess capacity, in industries from telecoms and cars to airlines and banking. Until this is eliminated, downward pressure on inflation will persist. A good measure is the output gap, the level of actual minus potential GDP. Historically there has been a close relationship in most countries between the size of the output gap and changes in the inflation rate (see chart). When the output gap is negative (ie, actual output is below potential), inflation usually declines. The OECD estimates that America's GDP is about 1% below its potential. If growth remains at or below its trend rate of around 3% over the next two years, the negative output gap will persist into 2004, pushing inflation even lower. It would not take much to tip into deflation.

The Fed is at least aware of the risks. However, not all central banks may be either willing or able to learn from Japan's mistakes. Germany probably faces a higher risk of deflation than America. The ECB's interest rate of 3.25% is broadly appropriate for the euro area as a whole, given its inflation rate (2.2%), the size of the output gap, and the bank's chosen inflation target of “less than 2%”. But the ECB seems unlikely to cut interest rates until inflation dips below 2%. And its inflation target is arguably too low.

Even then, however, rates would still be too high for Germany. Since it is the highest-cost producer within the euro area, a fixed exchange rate tends to cause price convergence by forcing inflation to be lower in Germany than in the rest of the euro area. Germany's core rate of inflation (excluding food and energy) has averaged 0.6 percentage points below the euro-area average over the past three years; it is now a full point lower, at 1.1%.

Since interest rates are the same across the whole of the euro area, this implies that real rates will be higher in Germany and growth consequently slower. Germany's output gap, at an estimated 2.5% of GDP, is the second biggest after Japan among the G7 countries, and it is likely to widen. Deutsche Bank recently cut its growth forecast for Germany to only 0.1% for this year and 0.6% in 2003.

Back-of-the-envelope calculations suggest that, if the old Bundesbank were setting interest rates to suit Germany alone, they would now be below 2%. Worse still, not only is Germany unable to cut interest rates, but the EU's stability and growth pact also obstructs any fiscal easing. Nor can it devalue its currency. Stripped of all its macroeconomic policy weapons, Germany now runs a serious risk of following Japan into deflation.
Source: The Economist
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