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Monday, January 19, 2009

The Long And Difficult Road To Wage Cuts As An Alternative To Devaluation

Well it's pretty clear to me at least that there is now one, and only one, major and outsanding topic towering head and shoulders above all those other pressing and important problems those of us following the EU economies currently find lying in our macro-policy in-trays: the issue of wage cuts. Not since the 1930s has the possibility of such a generalised reduction in wages and living standards loomed out there before policymakers, and doubly so if we now hit - as I fear we may well for reasons to be explained at the end of this post - systematic price deflation in a number of core European economies.

The issue that has suddenly and even violently erupted onto the European macro horizon over the last week (as if we didn't already have sufficient problems to be getting on with) is, quite simply, how, if they either don't want to, or can't, devalue, do politicians successfully go about the business of persuading the people who, at the end of the day, vote them into office (or don't) to swallow a series of large and significant wage cuts? And this is no idle and abstract theoretical problem, since in the space of the last week alone the issue has raised its ugly head in at least four EU member states - Ireland, Greece, Latvia and Hungary.

In the case of the first two of these devaluation simply isn't an option, since there is no a local currency to devalue, while in the case of the latter two the presence of prior large scale foreign currency borrowing means that authorities are nervous about anything that smacks of devaluation (since the providing banks would take large losses following the inevitable defaults, and the cooperation of these providing banks is necessary in the future if the economies in question are ever to recover). This latter view (no devaluation) prevails even though many economists, (including myself), would argue that is a highly questionable one, since wage deflation on a sufficient scale will ultimately produce those very same defaults (with the added schadenfreude, as Paul Krugman points out, that even those who have borrowed in the domestic currency are also pushed into default).

War of the Sicilian Vespers Part II

Now, there is already quite a debate going the rounds on the merits or otherwise of devaluation in the Latvian case (see IMF Central European representative Christoph Rosenberg here or RGE Monitor analyst Mary Stokes here), but what I want to focus on in this post is the acute difficulty faced by any elected politician when it comes to enforcing wage cuts. This has to be one of the most important arguments in favour of devaluation, at least from the practical policy point of view. And this is also why, in my humble opinion, the IMF constantly ends up being the whipping boy, since the easiest way for any local politician to try to side step the responsibility for taking difficult decisions is to throw the country to the mercy of the "dreaded" fund (or at least, as seems to have happened in last weeks Irish case, threaten to do so), and then tell everyone that there simply is no alternative, as "they" will accept nothing less.

All this puts me in mind of the popular urban legend according to which mothers in Naples put the fear of god into their recalcitrant offspring by warning them that they'd better darn well behave since otherwise "the Catalans will come" (in reference to an infamous incident in the aftermath of the War of the Sicilian Vespers in which Catalan Commander Roger de Flor allegedly massacred 3000 Italian soldiers on his arrival in Constantinople - for default on a debt as it happens - simply because his mercenary troops had not been paid). Now mothers all over Europe are apparently telling their children "lock the front daw, Dominique Strauss Kahn is Coming".

The Irish Gaffe, Or Just Another Load Of Old Blarney?

First Up this week was Irish Prime Minister Brian Cowen, whose alleged threat to call in the IMF if the trade unions did not agree there an then to all overall 5% wage cut for public sector workers (a threat which was subsequently denied) made quite a few waves in the press and even got as far as producing an official denial on the part of the Fund.

Prime Minister Brian Cowen, while at an investment conference in Tokyo on Wednesday, was reported to have endorsed the view of an Irish union leader that the parlous state of Ireland's public finances could lead to the IMF ordering mass dismissals of public sector workers. Dan Murphy, the general secretary of the Public Service Executive Union, had previously told his branch members that the Fund could intervene if public spending was not curtailed, according to the Irish Times......As for public sector wages, the prime minister's comments may simply have been an attempt to scare unions into agreeing to public sector wage cuts. That ploy "may have backfired somewhat," for all the attention it has now received, remarked Rossa White, chief economist at Davy stockbrokers.

Around 20.0% of Ireland's 1.2 million-strong workforce get their salaries from the state. While that proportion is not unusual in Europe, wages are unusually high, as are their accompanying pension benefits. The Irish government is now working to scrap a 6.0% pay increase it announced last September--badly timed to have launched around the time of Lehman Brothers Holdings' collapse--and White believes another 10.0% cut is needed.

Lightening Trip To Hungary

Cowen was swiftly followed out of the starters box by IMF Managing Director Dominique Strauss-Kahn who must certainly have been the highest profile vistor to pass through the VIP lounge at Budapest Ferihegy's airport last week as he found himself having to take time out to fly-in and offer a spine-stiffener to a government who were giving every indication of backtracking on the 8% public sector wage cut they had agreed to as one of the conditions for the 20 billion euro IMF-lead rescue loan. Strauss-Kahn arrived amidst a notable weakening in the value of the forint, and all manner of speculation about whether or not the fund was set to withhold the second tranche of the loan.

At the heart of last week's visit were concerns about the size of Hungary's 2009 budget deficit, since while Hungary has been steadily reducing the size of the deficit as part of the austerity programme agreed to in the summer of 2006 and the deficit was down to around 3.3% of GDP last year, according to Finance Minister János Veres last Tuesday, it is not clear what impact the recession will have on the 2009 target number of 2.6%. And we still need to say "about" 3.3% for the 2008 deficit since we evidently don't have a final figure for Hungary's 2008 GDP on which to make a more precise calculation.

The days before Strauss-Kahn's visit were rife with speculation that Hungary might be forced to adopt new austerity measures in order to stay on track with its deficit target, with analysts estimating Hungary could be set to overshoot the target by something in the region of HUF 200 billion-HUF 250 billion, due to the recession being deeper than expected and a sudden drop in inflation. Lower than anticipated GDP growth is important since Hungary currently has an estimated 0.9% contraction pencilled-in for its fiscal calculations, while in reality the final outcome may be anywhere between minus three and minus five percent, depending on the view you take (in fact the EU Commission Hungary 2009 Forecast - out today has -1.9, but this is almost certainly too optimistic). Also the sudden drop in inflation is also taking everyone by surprise, since if prices are lower than expected then VAT returns etc will be down accordingly, too. Hungary's inflation stats will likely undershoot the current forecast, Veres emphasized, confirming analyst expectations for a significantly lower inflation path for Hungary (the current market consensus for annual inflation in December 2009 is 2.6%, but again personally I think this is way too high).

"Currency traders in London took a sentence out of context in last night's media reports (which included Portfolio.hu coverage) which said the International Monetary Fund might cancel October's credit agreement with Hungary. This was the main reason for extreme pressure on the forint this morning," a Budapest-based trader told Portfolio.hu. After this morning's statement by Finance Minister János Veres, who claimed it was “impossible" for Hungary not to meet fiscal targets (or else the government was ready to take further austerity measures), market players began to see that the panic was unsubstantiated. As a result, we have seen an intense correction towards midday, the trader argued.
Portfolio Hungary Report

So Hungary's 2009 budget is in trouble, and this is partly due to exaggerated inflation and growth forecasts, and partly due to some hefty government compensation for state employees who lost their “13th month" bonus at the end of 2008. Arguably it was this latter point which was the main reason for the IMF Managing Director's visit. Strauss-Kahn met with Prime Minister Ferenc Gyurcsány, Finance Minister János Veres and National Bank of Hungary Governor András Simor, President of opposition party Fidesz Viktor Orbán, and a number of MPs, according to the IMF press release.

Apart from putting a stop to any kind of "back door" compensation for wage cuts, the tangible outcome of the meeting was a battery of agreed measures intended to bring the budget deficit back into line with targets.

“In order to partially offset the loss of budget revenues, we do not want to rule out the possibility of tax hikes," Hungary's Finance Minister János Veres told a morning talk show on Hungarian TV channel ATV. Veres did not make direct reference to a VAT hike, but recent press leaks and comments from analysts suggest that this may well be in pipeline.

Naturally Strauss-Kahn explained at his post meeting press conference that the International Monetary Fund was generally satisfied with Hungary's efforts to meet the conditions for the IMF loan (he was, of course, hardly likely to say otherwise in public), and he even dangled out the possibility that the loan might be extended beyond 2010 if economic condititions made it necessary. We will return in the future to this point, since as I personally cannot see the present plan working as anticipated, I cannot help asking myself when it will be (if ever) that Hungary is able to be discharged and certfied as fit to stand on its own by the fund. Or are we about to see the creation of a new set of Fund Economic Protectorates, a possibility which I'm sure was never envisaged by the institution's founders.

How To Dangle Your Government On The End Of A Very Thin Thread Latvian Style

But things were obviously a lot hotter under the collar (despite the snow) in Riga round about the same time, since according to the Financial Times Latvia’s president threatened to call early elections last Wednesday after anti-government protests led to the Baltic country’s worst rioting since independence in 1991.

“It’s going to bring down the Parliament, and through that the government,” said Krisjanis Karins, a member of Parliament and former leader of the opposition New Era party. “It’s already happening, and the pace is such that nobody really understands.”

Such demonstrations - and similar ones in Bulgaria and Lituania (shown in photo) - raise doubts over whether Latvia’s government actually has enough political and social capital to implement the painful austerity plan agreed with the International Monetary Fund last month as an alternative to devaluation.

“Trust in the government and in government officials has collapsed catastrophically,” President Valdis Zatlers told a news conference. “The Saeima [parliament] and the cabinet of ministers have lost links with the voters.”

About 10,000 Latvians demonstrated in Riga’s Dome Square on Tuesday night in a rally called by opposition parties, trade unions and civic organisations. The demonstrators accused the government of corruption and of economic mismanagement and demanded that elections – not due until 2010 – be brought forward. The government now forecasts that the economy will contract 5 per cent this year and unemployment will soar to 10 per cent.

The Latvian government is well aware that strong adjustment will be needed to ensure success. In fact, most of the tough measures—including a nominal wage cut in the public sector of no less than 25 percent—was proposed by the Latvian government itself. This shows that the economy—including the labor market and the wage-setting mechanism—is very flexible, much more flexible than in most other countries, even outside Europe. The IMF is supporting the government's policy package through a $2.4 billion loan, with the EU, the World Bank, and a number of bilateral creditors providing additional financing.
Marek Belka, Current Head of IMF's European Department, quoted in IMF Helping Counter Crisis Fallout in Emerging Europe, IMF Survey Magazine.

What really seems to have angered people are the conditions attached to the €7.5bn stabilisation package agreed last month with the International Monetary Fund and the EU after the nationalisation of the country’s second largest bank shook confidence in the country’s fixed exchange rate. In particular Latvian citizens seem to have been upset by the stringency of the austerity package since in the letter of intent Latvia undertakes to limit budget spending to under 40% of GDP, and this in the context of a sharp contraction in GDP is not an easy thing to do- Clearly not of the envisaged measures are popular - cutting wages in the government sector by about 15%, freezing pensions as well as cutting back government spending on goods and services. And in addition to the cut in provision an increase in VAT is also being contemplated. All this contrasts, however, with the measures envisaged for restructuring the banking sector, including recapitalization of banks, honoring liabilities via the deposit guarantee fund and ensuring the maintenance of confidence in the various liquidity instruments, all of these areas of spending where increases in spending will be permitted. Of course, once you decide to stay on the peg there is no avoiding this, but it is hard for ordinary people to understand that this is not simply favouring Nordic banks at the expensive of Latvia's pensioners and unemployed.

Its All Greek To Me

Greece, as ever, is steering a rather different course. In the Greek case it is not the IMF who is waving the big stick, but the credit rating agencies, in the shape of Standard & Poor's who last week cut its credit ratings on Greece's sovereign debt, already the lowest in the 16-nation euro zone, to A- with a stable outlook from A. Greece was only one of four euro zone countries who have been warned by S&P recently that they may have their ratings cut, and ideed Spain has only today had its rating cut too.

"The ongoing global financial and economic crisis has in our opinion exacerbated an underlying loss of competitiveness in the Greek economy," S&P credit analyst Marko Mrsnik said. "In our opinion, the ongoing slowdown in credit growth will likely lead to a deceleration in domestic demand, thus increasing the risk of a recession and a possibly protracted adjustment."

S&P said Greece was entering the downturn with a fiscal deficit of around 3.5 percent of GDP, after repeated government failures to bring expenditure under control and reduce high debt levels despite years of economic growth averaging four percent. Following the announcement, spreads in Greek 10-year government bonds over benchmark German Bunds widened by about 10 basis points to a session high of 246.9 basis points.

The extra interest Greece must pay to borrow money for 10 years as compared with Germany stands at 246 basis points, while for Ireland the figure hit 180 basis points, also a record, and spreads have widened too for Spain and Portugal.

Wage moderation and enhancing wage flexibility are important challenges. The authorities will continue with the policy of containing increases in basic wages of government employees and are hoping for a favorable signaling effect on private sector wage settlements. However, in recent years, wage increases in the private sector have been relatively large and often exceeded productivity growth.
Greece: 2007 Article IV Consultation - IMF Staff Report On Greece

It should not surprise us then to learn that one of the key areas of controversy behind the recent Greek protests was a law which effectively ended the employees' right to collective wage contracts - a law which won approval in the Greek parliament last August. The government justified the move by saying that it wanted to clean-up debt-ridden state companies and overhaul protective employment laws in an attempt to attract more foreign investment. The now-dismisssed Greek Finance Minister Alogoskoufis recently told parliament the reform should be pushed ahead "for the sake of the Greek economy and society," since higher wages have added to state companies' debts, which ordinary Greeks had to cover with their taxes.

A much fuller review of the Greek problem can be found in my "Why We All Need To Keep A Watchful Eye On What Is Happening In Greece" post.

So What Are The Options?

IMF Survey Online: The IMF appears to be advocating fiscal restraint in all of its loan programs in Europe. Wouldn't these countries recover faster with fiscal stimulus packages?

Marek Belka: The answer is obvious: can a country finance its borrowing requirements or not? If only these countries could afford a larger budget deficit, fiscal stimulus would have been fine. But when a country is already in crisis, the main problem is usually to come up with enough liquidity. In these cases, fiscal restraint is necessary. Choices in a financial crisis are very constrained.

Well really there are no very easy solutions here, and anyone who suggests there are is kidding you. In all the countries we are talking about above (and a good few more) the citizens, and the corporates (and in some, but not all, cases the governments) are very highly leveraged (indebted in relation to their realistic future income expectations) and the debt accumulation process has pushed living standards to a level which is higher than sustainable. Just think of your own household. If you push all the available credit to its limit during the first half of a year, its clear you can't live on the same level in the second half unless you keep borrowing, but when the lenders not only won't allow you to do this, but even have the nerve to ask you to pay some of your borrowings back, well then your standard of living in the second half is bound to drop, and this, of course, is what is happening across all these countries.

There is an additional problem here, however, since all that "over-the-top" borrowing drove these countries forward above their normal "capacity" level, and that is also what all the above four economies have in common. This driving-forward beyond capacity is what is called "overheating", and this overheating is normally reflected in above average inflation, which is again what we have seen in these countries. The end product is that they have not only an indebtedness problem but also a competitiveness one, and that is what the IMF packages are intended to address.

Of course, the problem is if you get your salary cut it becomes harder to pay back the money you owe (loan defaults) and you can't spend as much on consumption (demand slump). And on top of this, as these first two lock-in, government revenue falls (less VAT) while expenditure rises (unemployment payments and bank bailouts), so we get fiscal deficit problems. So not only do you have banks lending less, households spending less, and companies investing less (as demand drops), we also have governments finally forced to cut back (at least in the more vulnerable economies), as the ratings agencies get to work. So you get a downward spiral of falling wages, and falling prices as GDP just comes down and down. And this process can become systematic (deflation) meaning that nominal GDP starts falling even faster than real GDP, making for a car that becomes increasingly "wobbly" and difficult to steer.

In this environment, there really is only one way to halt the spiral, and to jump start the economy, and that is to export, and to try and encourage export directed investment. But to get going with exports you need to recover competitiveness. You can achieve some of this restoration via productivity improvements, but not enough, and not quickly enough, especially if the distortion is large, and has been going on over a number of years (see the real exchange rate chart for Hungary above). So you can either do one of two things, devalue, or cut wages and prices. Neither is easy, but as we are now seeing the second is hardly universally popular either.

Germany IS About To Have Its Worst Recession Since WWII

The German economy is about to suffer its deepest recession since World War II according to economics Minister Michael Glos speaking in an interview with the German newspaper Welt am Sonntag due to be published tomorrow (Sunday). Glos said growth in Europe's largest economy is now expected to drop by as much as 2.5 percent this year (and there is still downside risk here). Earlier government estimates had been for slight positive growth (0.2 percent). This suggests that the miracle export-driven-recovery in German economic performance that so many were enthusing about in 2007 has actually been a short lived, one-off, affair, driven largely by an unsustainable lending boom in the UK, and Southern and Eastern Europe. If we take as good this year's government estimate, it gives us average growth for the German economy over the last 10 years of 1.07%, hardly changed from the supposedly "correctional" pace attained between 1995 and 2005 (see chart below) - or is Germany's lost decade now surreptitiously going to convert itself (like its Japanese equivalent) into the lost decade and a half?

Germany's economy started contracting in the second quarter of 2008, and went officially into recession in third quarter. Further the Federal Statistical Office estimated this week that the economy may have shrunk quarter on quarter by as much as 2 percent in the fourth quarter (ie at an annual contraction rate of 8%), and that annual growth for 2008 may have been as low as 1.3 percent (non calendar adjusted - 1% calendar adjusted) - about half the 2007 level.

Was any of this foreseeable? Well I was predicting annual GDP growth in the 1.3/1.4% range for 2008 back in July last year (see this post on RGE Monitor), and I have attempted to raise an alert about the possibility of Germany falling into deflation (this post here), a risk I now think to be real and immediate with a contraction in GDP of between 2% and 5% (which I think is where we are, and it wouldn't surprise me to see the 2009 number coming in at the steeper end of this range. I mean I think there is more bad news coming in Southern and Eastern Europe that has not been factored-in yet).

Germany’s inflation rate fell to its lowest in more than two years in December, declining to a 1.1 percent annual rate from 1.4 percent in Novembe. That’s the lowest level since October 2006.

“With inflation in Europe’s largest economy dropping at that speed, the ECB has all the legitimacy it needs to cut rates rapidly,” said Jens Kramer, an economist at NordLB in Hannover. “German inflation will actually turn negative by the middle of the year.”

Month on month prices actually rose 0.4 percent, and in fact both the general and the core indices spiked upwards at the end of last year (see chart), but given the extent of the contraction which we can expect, I really don't think that this is going to be very typical.

And The German Labour Market Has Finally Turned

Unemployment in Germany rose last month for the first time since February 2006, thus bringing inauspiciously to an end an unprecedented 34 month labour-market recovery. Figures released by the Federal Labour Agency last week show that the number of those seeking employment in Germany rose by a seasonally-adjusted 18,000 in December. The change is small, but the significance is great, since this is obviously but the first month of many when unemployment will rise in Germany, and this rising unemployment will now, in its turn, feed back into the industrial slowdown which is already underway. The seasonally adjusted unemployment rate remained unchanged (following data revisions for previous months) at 7.6 percent.

This is hardly a surprise, but it is certainly not good news.

In a separate release the Federal Statistical Office reported that the number of persons in employment living in Germany was 40.83 million in November 2008 - up by 500,000 persons on the same month a year earlier. However, the relative increase (+1.2%) was the lowest rate of growth since December 2006. In January 2008, the relative increase compared with a year earlier was 1.7%. So the economic downturn is finally beginning to show up in the labour market, too.

As compared with October 2008, there were 12,000 more people working which compares with an average increase of 53,000 in November 2005, 2006 and 2007.

Exports Drop Sharply In November

The reasons for the uptick in German unemployment are not hard to find, since German exports fell back at a record rate in November - in fact seasonally and working day adjusted current-price sales exports fell back 10.6 percent from October (when they declined 0.6 percent), according to the latest data from the Federal Statistics Office. This is the biggest monthly drop since records for a reunified Germany began. November exports dropped 12 percent year on year, while imports fell 5.6 percent on the month and 0.9 percent from a year earlier. The trade surplus (which is the key consideration when it comes to GDP growth) narrowed to 9.7 billion euros from 16.4 billion euros in October, and almost half the April rate of 18.8 billion euros. The current account surplus was down to 8.6 billion euros.

The immediate future looks even worse, with the latest data from the Technology Ministry showing new orders fell 27.2% (on aggregate) in November (as compared with November 2007) following a 17.5% annual reduction in October, while export orders fell back 30% year on year.

In fact it has been the sharp drop in orderswhich has sent Germany's manufacturing sector into headlong contraction, and the sector shrank at the fastest rate in over 12 years in December, with the Markit Purchasing Managers' Index (PMI) falling to 32.7 - down from 35.7 in November. The reading, which showed the sector contracting for the fifth month running, was the lowest since the series began in April 1996, while the sub-index for new orders also fell to a series record low.

Fiscal Deficit Worries

So what can the German government do? Well quite little at this stage of the game I think. Obviously the ECB can (and should) be taking steps to move into line with the Federal Reserve and the Bank of Japan and start readying up some sort of "European" version of quantitative easing, but as far as the national government goes, then I think we are near to the hang on tight and keep your fingers crossed stage. Chancellor Angela Merkel's governing coalition did agree this week to a further 50 billion euro economic stimulus plan which includes items like investments in infrastructure, and tax relief and payments for families with children. This follows an earlier plan worth 23 billion euro, which was criticized at home and abroad as being too cautious.

But what I think most observers don't appreciate sufficiently is that in an export-driven economy, where population ageing means that domestic consumption is simply not going to take up the slack and drive the economy, then there is simply a limit to what any government can do - without spending money which is going to be badly needed to pay future pension and health care costs, that is. German Finance Minister Peer Steinbrueck admitted in a newspaper interview with Financial Times Deutschland that he now expected Germany's fiscal deficit to exceed 4 percent of gross domestic product in 2010 taking into account the latest stimulus plan. The issue here isn't simply that EU rules require member states to rein in deficits to no more than 3 percent of gross domestic product (and cap national debt at not more than 60 percent of GDP), we are in an emergency and emergency measures are needed.

But EU member states also agreed in April 2007 to balance budgets by 2010, and Germany had been very critical of France for saying they would not be able to meet this target. Germany had already violated the deficit rule for four straight years between 2002 and 2005.

"Of course I would have liked to present you with proof at the end of the legislative period that we would manage to have a budget without new borrowing in 2011. Under normal circumstances, we would have managed that," Steinbrueck said. "But we are dealing with a sharp recession, an enormous financial crisis and a crisis in the auto sector."

The point is that falling back on this target will not come cheaply, in the sense that balancing the books was agreed to for a reason - the need to meet the costs of sustaining a society with a rapidly rising elderly dependency ratio. There is a lot of discussion of widening eurozone bond spreads in the eurozone at this moment, but I find myself asking one simple question: if investors start to get worried about the sustainability of German financing, whose bond will become the benchmark against which the other spreads will rise, France's perhaps?

"A balanced budget remains our target because the demographic changes in Germany will increasingly have an effect from the middle of the coming decade. We must not overburden the younger ones," Merkel said.

Black Hole In The Banking System?

And there aren't only holes in the real economy to try and plug (with cement), the financial sector is also becoming an apparently bottomless pit, with the government being poised on Friday to step in and part-nationalise a second bank. Hypo Real Estate is once more in emergency talks with Germany's bank rescue fund about a deal that looks likely to give the government a stake in the troubled investment bank. These negotiations draw a difficult week for the German banking sector to a close, following the announcement by Deutsche Bank of a 4.8 billion trading loss in the last three months of 2008 (which compares with a profit of about 1 billion euros a year earlier) while landesbank WestLB prepared to warehouse risky investments. WestLB wrote to its owners, local savings banks saying it needed to park troubled assets off its balance sheet in order to stage a recovery - the value of the doubtful assets involved is thought to be about 50 billion euros.

Munich-based Hypo Real Estate on 12 January received an extension until April 15 on a 30 billion-euro framework guarantee provided by Soffin, Germany’s bank-rescue fund. The lender said at the time that talks with Soffin regarding more extensive and longer-term liquidity and capital support measures are continuing. Commerzbank AG, Germany’s second-biggest bank, got a second state bailout on 8 January to strengthen its capital following the acquisition of rival Dresdner Bank from insurer Allianz SE. The German government in return agreed to take a stake of 25 percent plus one share in the combined Commerzbank-Dresdner.

And there is more to come, much more. Der Spiegel is reporting that the major German banks have so far written off only around a quarter of the nearly 300 billion euros in toxic U.S. assets they have on their books. The finance ministry in Berlin estimates that the entire German banking sector is carrying around 1000 billion euros of risky assets on its books, according to Der Spiegel. The government has aset up a 480 billion euro rescue fund to provide fresh capital or lending guarantees to the financial sector, and has already committed 100 billion of the 400 billion set aside for loan guarantees and 18 billion of the 80 billion earmarked for capital injections. However, some see even this as insufficient and there have been mounting calls for the creation of a "bad bank" that would buy up risky bank assets.

Finance Minister Peer Steinbrueck was quoted by the Frankfurt Allgemeine Sonntagszeitung weekly newspaper as saying he could "not imagine (such a step) economically or above all politically". A bad bank would need to be financed with 150 billion to 200 billion euros of taxpayer funds, he said. "How am I supposed to present that to parliament? People would say we are crazy."

China Pushes Germany Into Fourth Place

And to add insult to injury, China this week announced that it had become the world's third-largest economy, surpassing Germany and closing in rapidly on Japan, according to Chinese government and World Bank figures. The Chinese government revised its growth figures for 2007 from 11.9 percent to 13 percent, bringing its estimated gross domestic product to $3.4 trillion, about 3 percent more than Germany's $3.3 trillion, based on World Bank estimates. Even though China's growth is now dropping rapidly - and some estimates suggest it may only be 6% in 2008, Japan's is currently shrinking, and the growth differential is sure to remain, however bad China's performance actually does turn out to be in 2009 and 2010. Hence I don't think it will be that many years before China's GDP manages to overtake Japan's, which is currently estimated to be worth around $4.3 trillion.

Sunday, January 18, 2009

Why VTB Bank's Russia GDP Indicator Is So Useful

This post is partly about Russia, partly about how to follow the present economic crisis on a day to day basis and partly methodological.

So Which Are The Worst Affected Countries In The Present Crisis?

Obviously the simple answer to this question is "all of them", and in particular all those countries who are members of the OECD. Perhaps that is the feature which best defines what is happening this time round (and which separates our present problems from, say, the Asian crisis in 1998) since this is a crisis whose focus has been, and still is, in what are often termed "the advanced industrial" economies, even though some of these are now more services than manufacturing-industry driven. But, come-on, within that ever so long list - which includes each and every member of the OECD (and a goodly number of those who aren't) - who exactly are going to be the worst affected?

Well I don't think I have made any secret on this blog that I think the principal focus of the present crisis is now situated in what Paul Krugman call's Europe's periphery - by which I would mean Central and Eastern Europe, Southern Europe, Ireland and the UK. To that list I would simply add those economies who are largely export driven, and who thus suffer most directly from the sharp contraction in global trade. In particular here Germany, Japan and China. My principal guess is that China is really going to be one of the worst case scenarious, and that consensus thinking still has some way to go in catching up with events here. Hong Kong based UOBKayHian have a Q4 estimate for year on year Chinese GDP growth of 6.3% for China (see here), and I think few people other than professional macro economists and bank analysts (and far from all of these if the truth be told) really realise what this means - it means the quarter on quarter rate of expansion was very low indeed, possibly verging on the negative. I'm guessing but it must have been somewhere in an annualised 0 to 2% range. This means we may well see quarter on quarter negative growth in 2009 in China, and that the possibility of a technical recession of two consecutive quarters of negative growth must be over 50% at this point. It wasn't so long ago that the consensus was saying that annual GDP growth which was as high as 6% would be tantamount to a recession!

Societe Generale economist Albert Edwards is one of those who has been drawing our attention to the rapid decline in China's GDP (although I myself had a go here) and he uses one very interesting "proxy" (an indicator which can serve as a rough and ready substitute for something else, in this case movement in GDP) - electricity output. If you look at the 3 month year-on-year moving average for electricity output in China (see chart below) you will see it is already falling, which means that (in all probability) China's GDP is falling, which is just wow!

The history of using electrical output as a convenient proxy where we simply don't have very adequate data has a long and reputable history - going back to the pioneering work of US growth theorist Edward Dennison in the 1960s - but in case you feel that the correlation may not be a good one, here (see below) is a chart from Edwards which shows China GDP and electricity output compared. The fit is obviously not a perfect one, but that isn't the name of the game here, what should be evident is that a drop in electrical output as large as the one we are seeing in China at this point will be reflected in a very sharp reduction in GDP output.

A very similar situation can be seen in the OECD lead indicator for China, and below I produce a chart which compares this indicator for both Spain and China, and Spain we know is having a very strong contraction at this moment in time, but what we can see is that China post August is slowing much more rapidly, and even, looking at the steepness of the month on month drops, may well have started contracting in November. This is obviously all shell shock stuff.

Which takes me on to my next point, how reliable is Chinese data? Well, perhaps I am going to surprise some of you here, but I would day that for my purposes it doesn't really matter, since what interests me is the rate of contraction (or expansion) in Chinese GDP, and not its absolute level. What matters to the rest of the world is not expecially how rich -or poor - China actually is (from a macro economic analysis point of view that is), but how rapidly it is expanding - or contracting - and what the rate of export and reserves growth is. The rest is interesting, but from a nuts and bolts point of view, it constitutes what Boris Vian used to call froth on the daydream. If the official data is rather inaccurate, then it is not unreasonable to assume that the inbuilt biases are the same from one time period to the next (the same point applies to the existence of the so called "informal economy"), and so my message here is - arrived at on the basis of looking at one economy after another in rapid succession - how much we can learn from how little, if only we know what we are looking for that is (I will come back to this point below).

Is Manufacturing Output A Good Proxy For GDP?

Basically, the economies I am arguing are likely to be the worst affected in what we can at least now call “the long recession” - Japan, China, Russia, Germany, East Europe and Spain - all have quite a significant level of dependence on their manufacturing industry (except Spain, but then Spanish services are now neck and necking it with Spanish manuafcturing industry), and it is manufacturing - and especially consumer durable and machinery and equipment manufacturing - which is worst affected by this stage of the credit crunch. In addition all these economies are now about to see "second round effects" across their manufacturing sectors, and this will then feed back into even stronger contractions as domestic purchasing power weakens even further. So I don’t think that in these cases manufacturing is such a bad proxy for what I want to look at, which really is the size of the hole that has just been blown in the side of the collective ship.

Basically, I am also relying on an old macro economists prejudice about the structural importance of industrial activity when all the froth is stripped away. It’s a hunch. I’m playing it, and the proof of the pudding will be in the eating, although up to now I think I ain’t doing too bad, if I may say so, since the German and Japanese economies did actually fold right on cue as far as my forecasts went, Spain has turned out to be a nightmare, and the focus of the current global financial crisis has moved to the East of Europe, just as I was anticipating in my posts here and on all those Eastern Europe blogs I maintain.

And for those of you who still remain sceptical that this argument has any validity, even for economies with a heavy industrial dependence, here (one more time) is the Manufacturing PMI/GDP comparison chart for Japan - GDP rates to the left, diffusion index PMI readings to the right (click over image if you can't view too well). Not perfect, but not a bad guide I would say, if you like your football live, and want to see what is going on as it happens and not three to six months later.

And Now For the Russian GDP Indicator

The latest survey data from VTB Bank Europe point to an overall contraction in Russian GDP in December. For an economy that was only months ago growing at a 7% annual rate this sharp contraction is astonishing. The VTB GDP Indicator is derived from the bank's Europe’s PMI surveys of business conditions in the manufacturing and service sectors of Russia. By weighting together the output measures from these surveys, an indicator of total output is produced. Regression analysis is then applied to derive an estimate of GDP growth. The bank itself describes the indicator as follows:

The Russian GDP Indicator has been developed for VTB Bank Europe by Markit Economics to provide a tool to help policymakers and investors monitor economic conditions in Russia. Key features of the Russian GDP Indicator are:

It is available several weeks ahead of official first estimates of GDP (for example, Goskomstat did not release their first estimate of 2005 third quarter growth until December 2005);

It is produced monthly, rather than quarterly, allowing quicker identification of changing business conditions and turning points in the economic cycle;

It is internationally comparable with other GDP Indicators that Markit Economics has launched, including the Eurozone GDP Indicator;

On average, Markit Economics’s GDP Indicators have been more accurate at estimating GDP growth rates than official first estimates (the latter tending to be revised significantly after initial publication)
VTB Bank

In December, the Russian GDP Indicator fell below zero for the first time since March 1999, to -1.1%, from 2.1% in November. Over Q4 as a whole, the GDP Indicator has signalled a year on year expansion of 2.0%.

But this is perfectly consistent with a quarter on quarter contraction, as we can see in the monthly diffusion index GDP chart. So there is no doubt about it as far as I am concerned, the Russia economy contracted in Q4 2008, and really, effectively, the Russian recession has now started.

Further evidence for the slowdown can be found in the fact that unemployment rose 400,000 in November and while retail sales grew at the slowest annual rate in five years. Also in November, real disposable income fell on an annual basis while capital investment growth continued to drop back. The rouble ended 2008 20% lower versus the US dollar and 15% weaker against the euro, while the budget for 2009 remains under threat from falling oil prices.

The most recent official GDP figures from the Federal Statistics Service indicated year on year GDP growth of 6.2% in the third quarter of 6.2%, a figure which was itself a three-year low. This result was rather weaker than the advance trend registered by the GDP Indicator, which averaged 6.8% over the same period. The stronger VTB GDP Indicator may well reflect the absence of construction coverage in the PMI surveys – annual growth of construction value added in Q3 almost halved compared to the previous quarter – and probably also did not fully capture the effect of plummeting oil prices and weakening investment growth, on the other hand it the number is not a bad first estimate at all, and I emphasise, we get it at the end of the month in question.

In fact over the past nine years the official statistics office series and the VTB GDP Indicator have had a pretty close relationship, and the correlation is currently 0.88 (see chart below). Moreover, the Indicator has successfully captured the major peaks and troughs in growth throughout the period, thus I think we need to take the latest PMI based data very seriously indeed.

So How Can You Do So Much With So Little?

Now for the methodological part. Basically I am arguing that really it is possible to make reasonably accurate short term forecasts (longer term ones are always - like the weather - much more problematic) on the basis of very little information, the composite PMI is one key reference point here, followed by consumer and business confidence data to give some idea of the immediate outlook, and then employment data to let you know what may happen six months or so down the line. This, and the inflation data (both producer and consumer prices) are all you really need in your home "Chief Economist" amateur toolbox really in order for you to have as good a chance of getting it right as any very highly paid professional.

But there is something else you also need: a framework in which to organise the information you gather. This is the tricky bit really. The good economist should always be testing, or pressing him- or herself in some way or another. Basically a forecast is based on conformity with empirical fact and with a theoretical framework. The late Sir Karl Popper had something to teach us here.

Famously, Popper used to enter the first class of any course and give his students one of those thrilling little "ice-breaker" exercises. "Observe", he would tell them, and then sit down and start to read his newspaper (I doubt it was L'Equipe, or El Mundo Deportivo, but I'm sure you can more or less imagine the picture). Of course, normally not a lot of time would elapse before one of the bemused students would put their hand up and say, "but please, sir, what do we observe?".

"Exactly", would be Popper's response, and so the course would formally begin, since the simple point he wanted to get across was that simple inductive empiricism doesn't work, you always need a theory, or at least a hypothesis, to get the game started. Which is why some people could probably stare at the charts I have presented here today, and still not notice anything special.

And the other point Popper would draw to the attention of any good practicing economist is that you always need to be trying to prove yourself wrong. It turns out we are not, as Bacon thought, playing a game with nature, we are playing it with ourselves. What exactly am I getting at here?

Well, Popper wasn't the first to do this, but he did notice that there was a simple problem with inductive empiricism, in that, no matter how many observations you make you can never actually "prove" a theory, since the next observation may well come along (you know, that black swan in Australia) and knock your whole edifice over. Popper was possibly the first, however, to notice that there is a logical asymmetry lying around in all this, since you can faslify a proposition (or hypothesis, or theory, or law), since the first bit of counter evidence you get should at least start you thinking that something may not be completely aright - although, of course, the first piece of counter evidence should never lead anyone to abandon their theory or hypothesis. But it should set you thinking.

The knack then is, and this is what every worthwhile and halfway serious economist should be trying to do, to try and decide what sort of evidence would make you change your mind, and would lead you to first modify, and then abandon, your theory. And I think if you can't spell out what it is that would lead you to modify and change your framework, that is if you can't spell out a body of facts and events which would lead you to seriously change your mind, then you are probably not doing serious economics at all, but playing round with some variant or other of what Popper would have called ideology.

And just in case anyone out there is asking themselves what the relevance of all this final homily is to what went before, well...

If China doesn't get a level of GDP output well below the consensus in 2009, then I've got something pretty wrong somewhere. If Germany's stimulus programme works by bringing domestic demand back to life before external events enable exports to expand again ditto. If Japan doesn't go shooting straight off back into a serious bout of deflation the same (and if Germany and Spain don't follow suit at least in the short term then there is something here I am not getting right). And of course, if Russia doesn't have a very nasty bout of depression economics in 2009, and if Eastern Europe generally is not the most seriously affected region then I think I really do have something, somewhere upside down (due to the very unusual demographics). Oh, and yes, if Turkey ends up as badly off as the rest of the CEE economies I would not be methodologically happy at all, not at all.

And why do I say this, well here is what I said in a post entitled Turkey, Emerging Markets and the Coming Global Credit Crunch - published on Global Economy Matters on 5 September 2007, that is about three weeks after all that sub-prime "turmoil" broke out.

In a much quoted paper - published back in 2004 by two UCLA economists (Schneider and Tornell, full reference below) - it was argued that:

In the last two decades, many middle-income countries have experienced boom-bust episodes centered around balance-of-payments crises. There is now a well-known set of stylized facts. The typical episode began with a lending boom and an appreciation of the real exchange rate. In the crisis that eventually ended the boom, a real depreciation coincided with widespread defaults by the domestic private sector on unhedged foreign-currency-denominated debt. The typical crisis came as a surprise to financial markets, and with hindsight it is not possible to pinpoint a large “fundamental” shock as an obvious trigger. After the crisis, foreign lenders were often bailed out. However, domestic credit fell dramatically and recovered much more slowly than output.

In starting off with this quote I really want to draw attention to two things.

First off, the way in which the current sub-prime liquidity problem in the banking sector of many developed economies is now steadily extending itself into a credit crunch in several emerging market economies. We are now beginning to see a clear and all too familiar pattern. There has been a lot of talk about the Asian crisis, and evidently there are some similarities with the pre 1998 situation, especially, as I shall be arguing over the coming days, in the emerging economies of Eastern Europe.

Secondly there is the "typical crisis came as a surprise to financial markets" argument, since it puzzles me why exactly this should be, or better put, why it should be assumed as a "stylised fact" about currency crises that such major events are in principle not forseeable. I find this very hard to accept. Are we really so inept we are not able to see trouble coming when it finally does come? Is economic theory really so useless in the face of complex "on the ground" facts. Something inside me resists this view. We ought to be able to see things coming, even if we need to distinguish between the where and the when. What I mean is that it should be possible, if the theories you are working with are worth any sort of candle, to pinpoint the areas of likely vulnerability. On the other hand, given that often seemingly random events precipitate the ultimate unwind, it is pretty well impossible to say in advance which random event will turn out to be the detonator on any given occassion.

The sub prime debt issue in the US is a good case in point here, since only at the start of August the Federal Reserve were assuring everyone that problems associated with the US housing market were well under control, while obviously they weren't and aren't, and equally obviously, now, such problems will be seen from the vantage point of hindsight to have played a key role in the events which are now unfolding before our eyes.

So even with this caveat, and with due regard for the well known problem of human fallibility, lets see if this time any of us are able to do just that bit better than normal, and in attempting to see things coming lets see if we can learn something which may make us better able to handle and foresee macro economic problems in the future.

This post is about Turkey, and it may be surprising in the light of what I have just said if I now go on to suggest that it is precisely the fact that Turkey may not be so badly ensnared in the trouble which is brewing (I mean no one, but no one, will escape completely scott free) as some other emerging economies (and I am talking here about some key members of the EU10 accession countries, and for reasons explained in this post)which may well be of interest.

So summing up, I don't accept that economics is not an empirically grounded science that is incapable of making testable forecasts, not for a moment I don't. And if you do the sort of economics that turns out to be absolutely useless when it comes to making forecasts, then you should be asking yourself what it is about the theoretical framework you are using that leads to this situation, asking yourself what would need to be the case for a part of what you hold dear to be falsified, and get out there having a go at falsifying it.