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Friday, June 01, 2007

Employment In Germany

Ok, well I think the chart below is pretty revealing. It shows quarterly trends in Germany for population, economically active population, employed and unemployed.

Population and labour participation in Germany

Source: Federal Statistics Office

Click on the chart for a better view.

Now the first thing to note is that the German population actually peaked in 2003, and has since been declining. The same also goes for the economically active population. The key point to grasp here is that the unemployed population has a natural tendency to decline in Germany, even with zero economic growth. Now obviously, and in particular during 2006 and the first quarter of 2007 the German economy has been growing at what is - by German standards a pretty high rate.

The second thing to note is that these are unadjusted data, so to get a real idea of what is happening you need to compare the same quarter from one year to another. So if we compare, as an example, data for the first quarter, we can see that between Q1 2005 and Q1 2006, the economically active population dropped by some 425 thousand, while unemployment dropped over the same period by some 440 thousand, so effectively there was a small decline in employment, despite the sharp fall in the unemployment rate. Now if we come to Q1 2007, we can see that - when compared with Q1 2006 - the economically active population dropped by some 120,000 people (less than in the previous year, presumably reflecting the fact that with the improved labour market conditions more people proportionately remained economically active) while unemployment dropped by nearly 700,000, which shows that there was a real and substantial increase in employment in 2006.

So the point I want to make here is that the improvement in employment in Germany in 2006 was real and substantial, but that with those population numbers ticking on downwards, and hence the economically active population trending down, the "natural unemployment rate" outside of substantial recessions will do so too, regardless of real economic conditions.

Which leaves us with the question as to where the labour force will come from to fuel future economic expansions. This becomes doubly important when you take into account - as I explain in this post over on Demography Matters - that migration flows are now more or less neutral, that is, almost as many people leave each year as enter. Presumeably Germany will at some point have to change its immigration policy, but it will be interesting to watch just how and when.

Eurozone Growth

Earlier in the week Claus Vistesen asked whether the eurozone might not actually be losing steam. There is certainly evidence to support this view, but having been bitten once - I certainly think I anticipated a rather stronger slowdown in the Eurozone than we saw in the first quarter - it is now a case of "twice shy" with me, and caution is the watchword.

Clearly I do feel that many have been far too quick off the mark in giving the all-clear on the German VAT rise, since this is a permanent structural change, and we may expect the drag on consumption to last over a lot longer period than the first three months of 2007.

That having been said, momentum has continued to be strong in the Eurozone, and German exports (which to some extent drive the process) have continued to power ahead, with - so far - only one or two "blips", possibly associated with the low growth in the US economy in the first quarter.

But growth in Eastern Europe - for example - which is a key destination for German exports continues to be strong, as it does in many other countries across the globe. So since growth in world trade looks set to continue to be strong throughout 2007, this should remain a very positive stimulus for the German economy. It is internal demand which is the issue.

Well, on the retail sales front, the situation seems to have perked up in April:

Retail sales in Germany, Europe's largest economy, in April marked the highest increase since December, a sign that consumption is recovering from a value-added tax increase in January. Sales, adjusted for inflation and seasonal swings, rose 2.6 percent from March, when they fell 0.3 percent, the Federal Statistics Office in Wiesbaden said today.

Well that this is the largest increase since December should not perhaps surprise us, since sales have been pretty stagnant since the VAT rise. Also the current data is contradictory, since readings from the May purchasing managers index suggests contraction in May:

The Bloomberg purchasing managers index for May fell to a seasonally adjusted 47.3 from 55.6 in April, a survey of 500 purchasing managers showed on May 30. A reading below 50 indicates contraction.

On the other hand, in an economy dominated by the services sector, retail sales may not be the most important indicator of what is actually happening.

True German consumer confidence rose to a five-month high in June, possibly fueled by rising economic outlook and income expectations. In particular this won't have done any harm:

Germany's IG Metall, the country's largest union, on May 4 won a 4.1 percent raise for the 12 months starting June for 800,000 workers in the metals industry.

But this does raise the issue of Germany industry's ability to absorb such an increase, coming, as it does, straight on the back of the VAT hike. Some further indication that these cost increases do have an impact comes from the recent stall in the German unemployment decline:

German seasonally-adjusted unemployment total rose unexpectedly in May, according to the federal statistical office. But rise of 3,000 to 3.855m was slight in comparison with the steep falls reported in previous months, and was almost certainly due to the exceptionally warm April and wet May weather.

Meanwhile the latest Royal Bank of Scotland index of manufacturing shows that the rate of expansion in the eurozone slowed in May:

Royal Bank of Scotland Group Plc's index of manufacturing in the 13 euro nations unexpectedly fell to 55 from 55.4 in April... European growth may cool from the fastest pace in six years as rising interest rates and a U.S. slowdown curb demand for the continent's cars, machinery and appliances.....``The momentum in manufacturing is beginning to ebb,'' Ken Wattret, chief European economist at BNP Paribas in London said. ``If this continues, which we would expect, that does raise some question marks about how far the ECB will go. We're pretty skeptical that they'll go beyond 4.25 percent.''...

There are other signs that the euro-region expansion may be cooling. Export growth slowed to 0.3 percent in the first quarter after 3.5 percent in the last quarter of 2006. Retail sales in the euro area fell for the first month in three in May and French business confidence declined.

In manufacturing, new orders gained at the slowest pace since November 2005, with the index reading 55.4 after 55.8 in April, today's report said. Output growth slipped to 56.1 from 56.9, the least since February 2006. Employment growth maintained the fastest pace of growth in 6 1/2 years, with the index reading 53.3, the report said.

Also evidence from Italy seems to back all of this caution up:

Italian retail sales fell for a third month in May as consumer spending continued to be hampered by rising gasoline prices and tax increases.The pace of the decline slowed in the month with a seasonally adjusted index of retail sales rising to 47.7 from 47.5 in April, according to a survey of 440 retail executives compiled for Bloomberg LP by NTC Economics Ltd. A reading below 50 signals a decrease.

Italian business confidence fell in May from a six-month high on concern that gains in the euro and slowing economic growth in the U.S. will hurt exports. The Isae Institute's confidence index fell to 96.2 from a downwardly revised 97.9 in April, the state-funded research center said today in Rome.

Bottom line: all this now needs careful watching. There are a lot of question marks out there, and especially if the ECB persists with the rate hike process.

Growth In India

Well, the fact that growth in India is accelerating is hardly breaking news, but it is causing a lot of head scratching:

India has recorded its second fastest annual growth rate since gaining independence in 1947, expanding at a pace of 9.4 per cent.....Even though inflation is now coming down, most economists believe that India’s economy is continuing to grow well above its long-term sustainable rate. They predict further tightening of monetary policy and banking reserve ratios lies ahead.

Well, this is just the question, isn't it. What is India's long term growth rate. Back in September 2006 I suggested that in the case of Indian growth we were now entering "uncharted water". This view was also taken by Nandan Desai in a couple of interesting posts (and here). Essentially my argument is that it is impossible to determine whether or not India is running above capacity level, since we really have no accurate measure of what that level is at this point, but there are reasons to think that it may be well above what conventional analysis suggests.

India has grown faster than this only in one year since 1950-51, according to HSBC. In 1998-99, growth surged to 10.5 per cent before falling back in the early years of this decade.

Talk of historic levels of Indian growth is basically misleading I think, since the key issue is whether India has seen a structural change in its growth profile ex-2000, and again there are reasons for thinking it may well have (see Nandan's posts for more argumentation). Essentially India is enjoying the advantage of favourable demographics, and strong capital inflows (both of which tend to raise capacity), as well as comparatively rapid technology transfer and changes in behavioural patterns, both of these facilitated by globalisation processes, processes which were really not operative in India to anything like the extent they are today prior to 1995.

Clearly the possibility exists that India can slow a little over the coming quarters as the Reserve Bank of India continues the interest rate tightening process, but equally the possibility exists that growth may actually continue to accelerate. Again, it would be a daring economist who would risk a call on this.

Everything depends on levels of global liquidity (read risk appetite), and on the strength of momentum in the current wave of growth in the global economy (India is becoming increasingly influenced by all of this as she continues to open her economy).

Certainly the signs are that the wave is continuing. As I was arguing yesterday, the US economy seems to be moving along the soft landing path (which may be more a consequence than a cause of the wave), and growth in places as far apart as the Philippines (and here) and Argentina seems to be holding up very well indeed. So, as far as I can see right now, this show is set to go on.

That being said, the big challenge which faces all of us is to offer a coherent account of just why all this is happening, and why it is happening precisely now.

Thursday, May 31, 2007

Japanese Wages

Well adding more fuel to the fire on my post yesterday, wages data release today say that monthly wages in Japan, including overtime and bonuses, fell (0.7) for the fifth consecutive month in April (as compared with a year earlier):

Japan's wages unexpectedly fell for a fifth month, hampering a recovery in consumer spending that's being fueled by job growth.

Monthly wages, including overtime and bonuses, declined 0.7 percent in April from a year earlier, the Labor Ministry said today in Tokyo. The median estimate of eight economists surveyed by Bloomberg News was for a 0.1 percent increase.

Without higher wages, consumer spending may falter, threatening growth in the world's second-largest economy. Japan's jobless rate fell to nine-year low in April, prompting some economists to say wages will rise later this year.

``The jobless rate is expected to fall close to 3.5 percent, which will start fueling wages and give thrust to inflation,'' said Hiroaki Muto, a senior economist at Sumitomo Mitsui Asset Management Co. in Tokyo.

So here is the puzzle: Japan's unemployment is falling as export driven growth continues and the workforce declines, but why are wages falling?

Two explanations are being offered, both of them relatively plausible, but we definitely need more info and data here:

One reason wages have fallen since December is the replacement of retiring baby boomers with younger, and therefore cheaper, employees, economists say.

Another reason is the increased use of part-time workers, whose pay averages less than half that of regular employees, according to Atsushi Seike, professor of labor economics at Tokyo's Keio University and a member of the government's labor policy council.

This trend in falling (real) wages (remember in a deflationary environment nominal wages are falling, but this isn't the point) is of rather long duration:

Average pay fell about 10 percent between 1997 and 2005, when companies replaced regular workers with part-timers. Part- timers made up more than a third of the workforce in the first quarter, rising almost one percentage point from the previous three months, the statistics bureau said this week.

Household spending has been rising slightly in recent months, but it is not really clear why this is. Certainly household spending will be a data point to watch going forward.

Household spending climbed 1.1 percent in April and has risen every month this year, even as wages slipped.

The US Economy

It is still hard to say exactly where, or at least at what pace, the US is heading, as I argued in this post back in January. The big issue is of course the long run future of the construction sector in the US. Despite the fact that the short term outlook may be for a more protracted slowdown, I am by no means pessimistic in this regard in the mid-term: simply one glance at the US median age (plus my intuition that with so many structural savers out there interest rates are more likely to trawl the bottom than not despite the best efforts of the central bankers) suggests to me that the US housing market will have life, and for many years to come. Demographics seem to guarantee that.

The current housing market situation does not look at all positive:

Builders broke ground on more homes last month, but permits issued for future homes plunged to their lowest level in a decade, in a sign that the housing slump may not yet be over....Building permits, seen as an indication of the housing sector’s future prospects, fell 8.9 per cent to 1.43m, missing expectations of 1.52m and down from a revised level of 1.57m in March. This was the biggest monthly drop in building permits in 17 years.

Bloomberg reports this morning that the extent of the slowdown in the first quarter may have been worse than initially recognised:

First-quarter U.S. economic growth, already reported as the weakest in four years, will be revised even lower as the trade deficit widened and businesses reined in inventories, economists said before a government report today.

The world's largest economy grew at an annual rate of 0.8 percent from January through March, down from the 1.3 percent pace estimated last month, new figures from the Commerce Department may show. The forecast is based on the median of 78 forecasts in a Bloomberg News survey.

Now this is only an estimate, and we need to wait for the Commerce Department report to be published, but again, anecdotal reports like the data for remittances and migrant apprehensions cited yesterday do offer some confirmation that in the short run growth is unlikely to accelerate dramatically.

Really - as always in the US - spending seems to be the key:

A gain in consumer spending last quarter was one of the few things that kept the expansion alive. Spending, which accounts for about 70 percent of the economy, may be revised up to 4.1 percent in today's report, from an initial estimate of 3.8 percent, according to the median forecast in the Bloomberg survey.

and while we may not seen this rate of increase being sustained into the future, I see no good reason to anticipate a dramatic drop at this stage.

Another reason to be cautiously positive is the fact that the economy has been holding *without* the Fed taking recourse to rate reductions. Their ability to keep their hands off the tiller has certainly surprised me, but it should always be borne in mind that this capacity is still there, as and when the need arises. Indeed, at the present time they seem to be just as preoccupied by the US inflation path as they are about the likelihood of an imminent drop into recession:

Federal Reserve Chairman Ben S. Bernanke is pulled in opposite directions by worries over inflation and housing, leaving him little choice other than to keep interest rates unchanged.

Fed officials said they still expect a pickup in the economy this year and view inflation as their main concern, minutes of their May 9 meeting showed yesterday. They listed several caveats, including the risk that the housing recession may ``weigh heavily'' on growth.

Still, officials said the risks of a slowdown have ``diminished slightly.'' Futures trading indicates the chance of a rate cut by the end of December has dropped to 40 percent, the lowest this year. As recently as March, investors saw a half- point reduction as certain.

``If you don't quite understand how the economy's functioning, then there's a temptation to take the view that anything you do to interfere could turn out to be perverse,'' said Neal Soss, chief economist at Credit Suisse in New York, who was an adviser to former Fed Chairman Paul Volcker. ``Therefore, you're better off doing nothing.'

I cerainly like that last point: "If you don't quite understand how the economy's functioning, then there's a temptation to take the view that anything you do to interfere could turn out to be perverse". I think this is where we are, until we get a better measure of just why this present wave of global growth is so strong and so sustained it would, IMHO, be foolish to start jumping to any hasty, and possibly rash, conclusions. Thus - when in doubt "you're probably better off doing nothing". Would that other participants in the economic community could understand the force of this basic but subtle point.


In the end the Commerce Department report showed US first quarter growth to be slightly worse than expected this morning: a 0.6% annual rate.

The U.S. economy grew last quarter at a 0.6 percent annual rate, the weakest in more than four years, as housing slumped, the trade deficit widened and businesses reduced inventories.

In response to a question in comments I did some digging around, and came up with this chart from the Commerce Department.

Now basically this makes the position pretty clear, in the short run the decline in housing has been met by an increase in personal consumption, since the percentage changes in GDP (in opposite directions) more or less cancel out. What has happened is that growth has slowed and consumption maintained its path, so the % of GDP has naturally risen (at least that's my off the cuff reading).

Basically the consumer is hanging in, taking a longer view, and waiting for housing to pick up again. Will it? That is the big question, or better put, when will it? And can the consumer hold out till then?

Wednesday, May 30, 2007

Migrant Flows Into The US

I found this piece in Bloomberg yesterday interesting:

The U.S. housing slump is squeezing Mexican migrant workers from Los Angeles to New York, where permits for new home construction are down 20 percent this year, according to the Census Bureau. That's reducing the pace of money transfers, the second-biggest source of dollars in Mexico after oil exports, and turning the peso into a laggard among Latin American currencies.

I found it interesting since it seems to suggest that movements in the construction sector are a pretty good proxy for rates of flow of migrant workers. This point was in my mind following my recent post on the Irish economy, and the role of migration in reinforcing the Irish boom. This talk of the reduction in the rate of increase lead me to start thinking that remittances flows are probably also a good proxy for the intensity of migrant flows (since the most recent migrants tend to send proportionately more, and then the flow tapers off over the years).

Remittances rose 3.4 percent in the first quarter, the slowest growth in eight years. The peso has strengthened 0.1 percent this year to 10.8137 per dollar, the second-worst performance among the most-traded currencies in the region.

Interestingly the article also mentions that:

The number of people caught trying to enter the U.S. illegally from Mexico dropped almost one-third in the first quarter to 265,000, according to U.S. Border Patrol data.

The article mentions the crackdown on migration as one of the reasons for this reduction in the number of people being "caught in the act", but I am not so sure this is such a good explanation. Clearly increased surveillance can act as a disincentive, but so can the lack of availability of employment, and, ceteribus paribus, you would on the face of it expect increased vigilance to produce more, not less, apprehensions.

Peso Decline

All of this is of course significantly affecting the valuation of the Peso. In fact:

The only Latin American currency to do worse than the Mexican peso this year is the Argentine peso, which has fallen 0.7 percent because of daily dollar purchases by the central bank. The Colombian peso gained the most, up 17 percent, followed by the Brazilian real, up 9.4 percent.

Morgan Stanley and Dresdner Kleinwort predict the Mexican peso will fall for a second straight year because of the slowdown in money transfers, a drop in oil production and weakening demand for the country's exports. New York-based Morgan Stanley forecasts a 5.1 percent drop to 11.4 pesos per dollar by year-end. Dresdner, the investment banking unit of Munich-based Allianz SE, predicts it will slide to 11.19. The peso fell 1.7 percent in 2006.

And, as for the role of construction in all of this:

The decline in illegal immigrants mirrors the U.S. housing market. Residential construction in the U.S. fell by 17 percent in the first quarter, according to the Commerce Department. The construction industry is the biggest source of work for Mexicans in the U.S., accounting for about 20 percent of jobs, data from Mexico's central bank shows.

The pace of money transfers has moved in step with the U.S. construction industry since the late 1990s, said Dawn McLaren, a research economist at Arizona State University in Tempe. The correlation between the two has become so strong that she uses border apprehensions as a ``leading indicator'' for the U.S. housing market.

So border apprehensions could be consider a "leading indicator" for the US housing sector. If this is so, then on recent evidence we should expect the housing market to continue to remain flat. Also, since one of the points I am trying to argue is that migrant flows represent a non-linear feedback mechanism which reinforce the boom, when they slow or stop, this also has non-linear negative feedback consequences in the mid to longer term.

Really I am saying nothing especially new here, since Nobel Economist Simon Kuznets long ago identified what are known as "Kuznets Cycles" which are mini-cycles driven by migrant flows with a 10 to 15 year lag. Obviously with financial markets becoming somewhat more efficient the lead-lag times have probably reduced considerably.

What Kuznets didn't think about, however, was the impact of these flows on age structures and population pyramids. I am now finding myself rethinking just exactly what it was that happened in the US during the 1990s. As we all know there were massive inward migrant flows - 1 million undocumented workers a year from the late 80s I think. And I am being lead to ask myself: did the US median age actually drop during the 1990s? If it did that would explain a lot of things.

Now if you look at this graph (which Ken Gronbach kindly maintains at the top of his Changing Demography Blog) you will see that there have been important structural shifts in the US population over the last 50 years, and in particular the presence of what Gronbach calls the "silent generation" (click over image for a better view).

Now if this idea is right - that migrant flows represent a strong feedback process (or a strong version of what Keynes would have called the multiplier), and that US median age actually fell during the 1990s (which is an idea that needs to be checked and calculated) - then we have another potential explanation (aside that is from productivity and the arrival of the internet) for what Alan Greenspan called the raised cruising speed of the US economy. At this point all of this is largely conjecture, but since the underlying idea seems to fit in so well with what we have been seeing here in Europe - in places like Ireland, the UK, Greece and Spain (and in each of these cases median ages have been going down not up in the last few years) - and indeed if any of this has any validity it does seem to add some force to my old idea that what central bankers should actually be doing is targeting median ages.


Bloomberg today has another piece on roughly the same topic:

The slump in homebuilding, the deepest since 1990, has so far taken only a modest toll on the U.S. job market. Workers like Francisco Leon may be part of the explanation.Two years ago, Leon, an undocumented immigrant from Guatemala, had little trouble finding construction work five days a week in northern Virginia. Nowadays, the 22-year-old mainly does odd jobs, often only two days a week.

As the article notes, the preponderance of undocumented migrant workers in construction may be one of the reasons the brunt of the housing slowdown is not showing in the official employment figures:

Housing-related jobs peaked at about 8 million in April 2006, representing almost 6 percent of the U.S. workforce, according to a tabulation of such jobs compiled from the Labor Department's establishment surveys for a Credit Suisse report that Feldman helped write. Such jobs represented about 18 percent of the growth in payrolls between 2003 and 2006, the report said. In the past year, they've declined about only 2 percent at a time when housing starts were off by about a third. Building permits in April slumped to the lowest in a decade.``Immigrants might be bearing the brunt of the slowdown'' for now, Feldman said.

So a lot of what is happening may not be showing up in the official stats:

Just as government labor statistics don't count many of the estimated 12 million undocumented immigrants, they miss many independent contractors, whether foreign-born or not, according to Daniel Jester, an economist at Moody's Economy.com in West Chester, Pennsylvania. The Labor Department's establishment survey, which covers companies larger than 1,000 employees and a random sampling of smaller firms, fails to capture independent contractors who make up more than 20 percent of all workers in construction, Jester wrote in an April research paper. What's more, those self- employed contractors aren't picked up by the government's weekly figures on filings for unemployment claims.

Now while official agencies lack data, voluntary ones like the Pew Hispanic Center do try to keep some sort of track of what is happening among Latinos - even if they are, at the end of the day, still dependent on the same official data. Back in March they published this data sheet (which relates only to 2006, and what we really need to see are the current numbers) which notes the following:

Hispanic workers landed two out of every three new construction jobs in 2006 benefiting from strong employment growth in the industry even as the housing market endured a year-long slump. The construction industry continues to be a key source of jobs for Hispanics and especially for those who are foreign born. The vast majority of new construction jobs in 2006 were filled by foreign-born Latinos, many of them recently arrived.

As I say, since Pew at the end of the day have to base their estimates on data from the Bureau of Labor Statistics and the Census Bureau, they are still largely missing what is actually happening in the informal sector. Nonetheless the evidence for the strong role of Latino migration in construction is compelling, since while construction employment increased 443,000, or 4.1%, in 2005 and 559,000, or 5%, in 2006, employment for Latino workers in the industry increased 277,000 (12.1%) in 2005 and 372,000 (14.5%) in 2006. Latinos, who accounted for 62.4% of the growth in industry employment in 2005, accounted for 66.5% of the growth in 2006. And "recent arrivals" (defined as arriving post 2000) accounted for 46.4% of new construction employment in 2005, and 45.6% in 2006.

Tuesday, May 29, 2007

Employment in Japan: Theory and Practice

Well unemployment in Japan has fallen yet one more time (and here in Bloomberg). Now there is nothing really surprising about this, since Japan's economic expansion is continuing (albeit driven by exports rather than by domestic consumption) and the population of working age is declining, so there is evidently a "capacity" problem here (although it would perhaps be interesting to ask in the light of my post about the Irish "phenomenon" yesterday, why exactly it is that this expansionary wave is not producing more inward migration). Some background posting on the Japanese labour supply issue can be found here, and here (and incidentally Scott Peterson, Claus Vistesen and I are all now cross-posting on the Japan Economy Watch) blog.

Essentially the position is that Japan's unemployment rate dropped in April to 3.8% from 4% in March. Now, as I say, there is nothing really surprising in this drop, since it is to some extent built into the demographics of the situation. More surprising perhaps is that as unemployment is falling wages have not been rising:

So far higher demand for workers has yet to reverse a decade-long slide in wages or drive up prices. Wages declined for a fourth month in March after rising 0.3 percent in 2006. Consumer prices excluding fresh food fell for a third month in April, declining 0.1 percent after a 0.3 percent drop in March.

As the FT also notes Economy Minister Hiroko Ota is clearly not too impressed with the situation:

Hiroko Ota, Japan’s economy minister, who has been cautious about declaring an end to deflation, said she remained concerned that wages had not responded to tighter labour market conditions. Household disposable income fell 0.4 per cent year on year in April, the first fall in more than six months, suggesting that wages had not picked up as fast as many had hoped.


Bank officials have admitted they are puzzled by the slow rate at which improved corporate performance has influenced other sectors of the economy. However, they say they are confident that they are witnessing merely a lag effect, rather than a breakdown in their central scenario.

Now all of this is interesting, since it will be remembered that standard neo-classical theory would suggest a different impact from a growing shortage in the supply of labour - namely that wages should rise, and that this increase in wages should lead to labour being systematically replaced by capital intensive equipment (and especially in Japan, where capital, as is well known, remains incredibly cheap and widely available). This replacement of labour by capital is also one of the arguments behind the assumption that ageing should lead to a technology driven productivity surge to help offset the impact on the growth rate of fewer workers being employed (Japan has not hit this capacity ceiling yet, but at the present rate, and absent immigration, she soon will). Could we expect the neo-classical idea to kick in as we tank fills, and the water rises steadily towards the ceiling.

Personally I am not sure, which is why I think that this new and very interesting situation (which has large implications for all of us as our societies age) should perhaps be being investigated with rather more intensity than currently seems to be the case.

Sunday, May 27, 2007

Macroeconomic Adjustment in the Euro Area: Ireland and Italy

I am reading through Chapter Two of the recent European Economic Advisory Group (EEAG) report on the European Economy 2007. The chapter, which is entitled Macroeconomic adjustment in the Euro Area: the Cases of Ireland and Italy, asks a number of important questions and makes for interesting reading.

The starting point for the chapter is a most pertinent question: six years after the introduction of the common currency, why do important differences in response to the application of a common monetary policy continue to exist across the eurozone? Indeed, on some readings, one might ask why these differences seem to be increasing rather than diminishing, or put another why, why do several significant eurozone economies appear to be diverging, rather than converging. To be sure some differential response among countries to the impact of asymmetric shocks was already anticipated at the outset, but it was always imagined that these differences would diminish and not increase with time. In the same way it was always anticipated that some sort of internal price convergence process would take place, but again this was always expected to settle down with time. Most recent evidence however continues to suggest that there are significant differences between zone economies in the way in which they respond to what is effectively one and the same monetary policy (even though its impact in real interest rate terms obviously differs between zone members as a function of differences in the underlying inflation rate, a fact which, in reality, only poses the same question at one remove, why should we see such a large spread in inflation rates continuing across time?) This conundrum is then the context in which the EEAG sets its comparison.

At the outset of the report the EEAG spell out and make explicit an assumption on which most traditional analyses of adjustment processes within a monetary union have been based.

"In a monetary union among countries with fully flexible prices and wages (and efficient financial markets), an asymmetric demand boom in a country would lead to an increase in the price and wage levels there, reflecting the relative scarcity of its domestic output."

Now this assumption, whilst not being exactly false, does at least seem to be inadequate and in need of revision in the new global economic climate in which we live. One of the key reasons why this "old" approach now seems so questionable (at least in its crude formulation) is the fact that it does not seem to have taken into account the way in which the globalisation of labour and capital supplies may have changed things. The key issue here would be the underlying notion of "capacity" on which it is based, and the extent to which such traditional notions of capacity (and thus of "overheating") remain valid today.

Perhaps the first person to raise this question in any systematic way was Richard Fisher of the Dallas Federal Reserve, and this early speech of his still makes interesting reading. As Fisher says:

Globalization is an ecosystem in which economic potential is no longer defined or contained by political and geographic boundaries. Economic activity knows no bounds in a globalized economy. A globalized world is one where goods, services, financial capital,machinery, money, workers and ideas migrate to wherever they are most valued and can work together most efficiently,flexibly and securely.

Now, as Fisher asks, "Where exactly does monetary policy come into play in this world?" Well let's see:

The language of Fedspeak is full of sacrosanct terms such as “output gap” and “capacity constraints” and “the natural rate of unemployment,” known by its successor acronym, “NAIRU,” the non-accelerating inflation rate of unemployment. Central bankers want GDP to run at no more than its theoretical limit, for exceeding that limit for long might stoke the fires of inflation. They do not wish to strain the economy’s capacity to produce. One key capacity factor is the labor pool. There is a shibboleth known as the Phillips curve, which posits that beyond a certain point too much employment ignites demand for greater pay, with eventual inflationary consequences for the entire economy.

I cite Fisher at length here, since he does seem to be directly challenging the kind of assumption - as spelt out by the EEAG - which I am drawing attention to. As he goes on to say: "Until only recently, the econometric calculations of the various capacity constraints and gaps of the U.S. economy were based on assumptions of a world that exists no more". A world that exists no more. Please note. (A good summary of the kind of argumentation that lies behind Fisher's approach can be found in the central chapter of the Dallas Fed 2006 Annual Report - Globalizing the Knowledge Economy).

Now, to qualify what I am saying a little, the issue is not that individual domestic economies are not subject to price and wage rises following surges in domestic demand, but that they are not subject to these to anything like the degree they used to be, and unless allowance for the extent of this change is made in the econometric models used, then traditional notions of "capacity" are likely to lead you well wide of the mark in looking at the impacts of monetary policy changes, since capacity itself has become much more elusive and elastic, and it is this very elasticity - ie the capacity for local economies to draw on large pools of underutilized labour, and over long distances, and avail themselves of the increased (and normally cheaper) supplies of capital which are available through global financial markets (and of course in the eurozone context the European capital markets themselves) - which means they are able to respond to rapid increases in demand without the normal wage and prices pressures coming into play to anything like the extent that they once did.

In this post (which will be in three parts) I will follow the EEAG lead, and look at the two countries individually (Ireland and Italy), treating them to some extent as case studies to see what may be learnt (and a reflection on this will constitute the third part of the post). Firstly Ireland.

Europe's Celtic Tiger?

According to the report:

"Ireland entered the euro area well into a sustained period of economic expansion marked by profound changes in the structure of the economy and its place in the global economy".

As can be seen from the chart below, Ireland has enjoyed quite high rates of GDP growth in recent years:

This process has seen a rapid rise in per-capita incomes, and a dramatic fall in the level of unemployment. Interestingly this rapid economic development upswing coincided with a process known to economists as the demographic dividend, as I note in this post on "the Celtic tiger".

The process of monetary union produced a strong monetary stimulus in the Irish context, as the report indicates:

The most apparent and controversial source of macroeconomic imbalance for Ireland has instead been the strong monetary stimulus since the end of the 1990s, when European monetary policies became strictly coordinated in the last stage of nominal convergence before the introduction of the euro. (Soon afterwards, the monetary stimulus was compounded by a weakening currency.)

Now as the report goes on to say, this monetary stimulus was required to meet the needs (low growth rates, sluggish internal demand) of other eurozone members (among them Italy, but also importantly Germany), even though it was arguably (at least in classic terms) inappropriate in the Irish context:

A relatively loose monetary stance was motivated by the cyclical conditions in the euro area as a whole, but arguably inappropriate forIreland: It created undue demand pressures in the Irish economy.

Now on the traditional account, the presence of such "undue" demand should have lead the Irish economy to "overheat", producing in its wake a growing inflationary wage price spiral., and indeed on conventional measures this was what was happening. But does this view correspond to the Irish reality?

True the Irish economy has had noticeably higher inflation rates than the EU average in recent years, but this process has hardly spiraled out of control.

Indeed if we look at the chart below, we will see that hourly labour costs in manufacturing in Ireland are still in the lower end of the eurozone range:

So - despite the fact that there has been a substantial rise in wage costs (from a very low level) if we allow for some measure of eurozone price and wage convergence over time, the general impact does not seem to have have been to force up prices and wages to such an extent that the Irish economy became uncompetitive. Curiously, if we look at the official Irish CPI, we will find that this actually trended down during the first years of the century, moving from an annual rate of 4.7% in 2002, to 3.5% in 2003, 2.2% in 2004, 2.4% in 2005, and only turning up again to 3.9% in 2006, a move which seems to have been associated with the fact that mortgage interest payments are included in the Irish CPI calculations. This hardly constitutes strong evidence of an inflation-push process fuelled by overheating, and especially not in view of the very rapid rates of GDP growth which Ireland was experiencing. So what happened?

Well, in a nutshell, Ireland got immigration, bigtime, and the combination of this with a ready supply of cheap capital seems to have maintained Ireland on what might be considered to be a sustainable path. The general trend in migratory flows can be seen in the chart below, but as an indication it could be noted that in 2006, 86,900 people immigrated into Ireland, the equivalent of 2.1 percent of the Irish population and 4.1 percent of the labour force.

As the February 2007 reprt of the Economist Intelligence Unit notes:

Ireland’s labour force totalled 2,178,100 in the third quarter, a year-on-year increase of 4.4% or 92,000. This is extremely high by international standards the most recent EU-wide data relate to the second quarter of 2006 and put Ireland’s rate of labour-force expansion at 4.6%, almost four times the EU average of 1.2%. Immigration has been a crucial factor in this. Demographic change accounted for three-quarters (or 69,100) of the Irish labour force’s growth in the year to the third quarter of 2006, and immigration accounted for 70% of this figure. The remaining, non-demographic increase in the labour force reflects continued increases in the participation rate, which rose from 63.2 to 64.1 between the third quarters of 2005 and 2006.

So in part recent growth in the Irish economy has been facilitated by growth in the domestic availability of labour (whether through the arrival in the labour market of Ireland's still relatively numerous young cohorts - given Ireland's comparatively strong recent fertility levels - and through an increase in participation rates, both of these factors forming part of the underlying demographic dividend process) and via the arrival of migrant labour on a very large (indeed almost unprecedented) scale.

Returning to the EEAG report, they go on to argue:

In principle, a strong demand expansion should have created a severe labour shortage.But the booming economy stimulated a strong migratory inflow, with two major effects: first, the increasing supply of labour contained upward pressures on wages somewhat, especially in low-skill occupations.8 Second, the additional workers in the economy raised aggregate demand, reinforcing the expansionary macroeconomic stance for the economy as a whole. Since the availability of jobs acts as a strong driving force for migratory decisions, a sustained economic boom created incentives for further migration.

So the low interest rate environment created a migratory flow which had an important multiplier effect (in classic Keynesian terms). And indeed the report concedes that while:

"adjustment (to the monetary shock) seems to have worked as predicted by theory.... the....overall expansionary policy mix caused real appreciation, although adjustment through wages and labour costs was arguably contained because the strong migratory inflow reduced excess demand in the labour market.

My feeling is that the whole classic account of monetary shock adjustment is rather more challenged by all of this that the EEAG seem to realise, but still.

On the other hand the capital required to enable domestic output to expand so rapidly was readily available internationally, and at remarkably low rates of interest given the presence of the single size for all euro environment. Some evidence of the extent to which the Irish business sector - and indirectly Irish mortgage borrowers - have had access to global found in the graph below, where it can be seen that there has been a very rapid growth in foreign borrowing by Irish banks to finance domestic lending. Since the end of the last century bank borrowing from abroad to on-lend to Irish residents has soared from 10% to 41% of GDP.

Ok, so what I think is now clear is that if Ireland has had an unprecedented economic boom in recent years, it is in part because the "spare" capacity was available (elsewhere). But what about the growth itself. What were the structural drivers?

Well first and foremost, domestic consumption (and the associated consumer indebtedness) has been a significant component.

Private consumption has been growing strongly in recent years, but beginning in the third quarter of 2006 it has been easing back (showing a year-on-year increase of 4.5%, its lowest level since the final quarter of 2004), a sharp drop from the 7.1% recorded in the second quarter.

Well clearly the boom in the housing sector has been an important part of this process. As the Economist Intelligence Unit note (2007) "Residential property prices in Ireland have risen more rapidly than in any other developed world economy over the past decade". Using conventional terminology they then go on to say:

"However, given that the increase in supply of new housing has been just as phenomenal, such rises appear unjustified by the fundamentals (the number of annual housing completions is almost five times that of the early 1990s. this compares with largely static output in the euro area and the UK)."

Really I feel this type of response simply begs the question, whether or not this housing surge is justified by "fundamentals" is in part a question of determining just what these fundamentals really are, and about how well we are actually measuring them, not to mention how fluid they may have become, and whether they are not now something of a moving goalpost, at least in the Irish context.

Certainly, as the EIU suggests, housing growth has been "phenomenal". One indication of this is the the fact that almost a third of the current housing stock has been built since 1990, so Ireland now has the lowest average age of dwellings in the EU (something which we ought not to find *so* surprising since with a median age of only 34 Ireland is still far and away the youngest society in the EU). Annual completions have been running 3.5 times what they were a decade ago and the country has the highest per capita building rate in the EU. But the real issue is, going forward, just how sustainable is all of this? But first,let's take a look at a chart (below) which identifies the impact on house prices of all this construction activity:

Now one of the most interesting things to note from the chart is that the largest spurt in price increases seems to have taken place in the 1997-99 period (ie before the official introduction of the euro, and before perhaps the more flexible supply of migrant labour and capital became available). A second (smaller) spike seems to have occurred after 2003, but it has not been anything like so dramatic. On the back of the most recent round of interest rate tightening from the ECB housing activity in Ireland has been slowing notably and indeed the average price paid for a house in Ireland in March 2007 was 2,007 euros less than the average price paid in February according to the latest edition of the permanent tsb /ESRI House Price Index. This is equivalent to a decline in national prices of 0.6% month on month. This is the first reduction in national house prices since January 2002, when prices declined by 0.9%. In the first quarter of 2007 (January to March) prices nationally decreased by 0.5% as compared with a growth of 3.5% in the same period of 2006. However on a year-on-year basis the average price pay for a house in Ireland was still 7.4% higher in March 2007 than the average price paid in March 2006. The big question is of course what happens next.

This is not the place to enter a debate as to whether what has been happening in Ireland constitutes a bubble (I have some observations on the Indian property situation which are not without relevance here), or indeed of the extent to which such price growth as has occurred represents a distortion from "fundamentals", since this in large part depends on the extent to which fundamentals have changed, and this is precisely what we are still trying to determine. Evidently, with Irish consumers now the most indebted in the OECD, any sustained decline in property prices would make its presence felt via the well-known "wealth effect".

But just how likely is such a significant "correction". In large part the "sustainability" of recent housing activity depends on the future course of interest rates at the ECB, and this is again beyond the scope of the present post, but suffice it to say that the current raising cycle may well peak (due to its impact on the larger economies like Germany and Italy with different structural characteristics to the Irish one) much sooner than many imagine - in the last quarter of 2007 or early 2008, and we may well then see another round of "easing", if so the associated fall in interest rates may well serve to place a platform under house prices in Ireland, and indeed the show (in perhaps a more modest form than hitherto) may well go on. Certainly there are no good reasons at this point to exclude this possibility.

In addition it should be noted that Irish government finances have enjoyed a strong positive balance in recent years, and that any slowdown in the housing sector can - to some extent - be counteracted by the application of a countercyclical deficit. One indication that such an approach - in the eventuality that it may prove necessary - may not be far from government thinking may be found in the most recent National Development Plan. This is projected to cost 183.7bn euros over a seven-year period (2007-13). The NDP is aimed at tackling what are widely acknowledged to be serious infrastructure deficits. In addition - and for the first time in an Irish NDP - the package of measures includes current spending (86bn euros). This current spending, which will be focused chiefly on social expenditure, is dependent on tax revenue remaining buoyant (the government’s plan is premised on average growth rates of 4%-4.5% over the period). As a percentage of GNP, capital spending will increase from 4.7% in 2006 to an average of 5.4% over the term of the seven-year plan.

Finally, it would not be appropriate to leave this review without at least some comment on Ireland's external balance position. In the first place it should be noted that Ireland's current account is un-typical, in the sense that, while there is a small trade surplus, the current account balance is seriously in the red. This is largely due to the strong presence which FDI has had in Ireland over the last decade or so, and the strong consequent outward funds flow associated with the repatriation of profits (which has the further un-typical consequence that GDP is systematically lower than GNP.

Evidently Ireland’s current-account deficit continues to widen. In the first nine months of 2006 a cumulative deficit of 5bn euros was recorded, a figure which was up sharply from the 3.9bn euros recorded a in the same period one year earlier. The third-quarter deficit totalled 1.2bn euros, an increase in 46% over the deficit in the same period of 2005. The increasing current-account deficit is largely a reflection of changes in the income balance, since the merchandise surplus was almost unchanged year on year at 7.6bn euros, while the services deficit actually decreased. However, this narrowing in the services deficit was more than offset by a widening of the income deficit from 5.4bn euros in the third quarter of 2005 to 6.8bn euros in the same period of 2006.

This situation in part reflects an increase of 15.9% in profit outflows generated by foreign-owned business based in Ireland and of a 41.4% increase in portfolio investment income outflows. As with other deficit countries (Spain, the UK, the US) there is no doubting the existence of such "imbalances", the real issue is their significance. As Claus and I have been repeatedly pointing out (and here), if median ages to some extent govern the dynamics of domestic consumption, and some high median age societies (Germany and Japan, for example) are condemned to running current account surpluses if they wish to maintain growth, then logically others are condemned to run deficits.

So, and summing up, what we seem to have in Ireland is a very interesting test case for the validity of the old versus the new models of capacity. On the face of it I would argue that global capital and labour flows have had a significant - and unexpected - impact on the path of the Irish economy, a development from which there is much to be learned. Let's just hope that over at the ECB they are listening.

NB. This post is the first installment of a much longer review post. More to come. Next stop Italy.