Germany on the Brink.........of Recovery?

There has been some talk recently in Bonobo Land as to whether Wim Duisenberg should, by rights, eat his hat. One thing is clear, if the optimists are right, and the German economy does make a surpringly robust recovery, I will have to think again, and wear sackcloth and ashes for at least six months. Meantime allow me to remain the 'doubting Thomas' of the pack. First a piece from today's FT

Germany's Ifo business climate index, one of the most closely-watched economic indicators of eurozone growth, rose for a third successive month in July, further underpinning hopes for recovery in the country's feeble economy. The rise in the Ifo index followed a dramatic jump in another growth indicator, the ZEW economic institute's monthly expectations indicator earlier this month. Together, the indices provide a much-needed boost to the government, which is in the midst of pushing through an ambitious reform agenda in an effort to revive the stagnant economy. Crucially, the Ifo' s third rise - helped by recovering stock markets, the slightly weaker euro and the reform debate - signals that the real economy can be expected to follow the trend. "Based on previous experience, an improvement in the Ifo business climate three months in succession signals a coming economic upturn," Ifo president Hans-Werner Sinn commented. Unlike the ZEW, which is based on a survey of financial market analysts, the Ifo index, which is based on a survey of 7,000 companies, also provides firmer evidence that the turnaround in sentiment extends to businesses. At the same time, however, Monday's rise in Ifo's key index for western Germany was smaller than expected - to 89.2 from 88.8 in June, less than the 89.8 that had been forecast - highlighting that caution is still needed amid mixed signals from the real economy. Numerous economists, including at the IMF and Bundesbank, have revised down their expectations for German growth to near zero for this year, and 1.5 per cent for 2004, well below the government's official forecasts. With the economy still flirting with recession, and much dependent on whether the euro will again strengthen against the US dollar, the pressure remains firmly in place for chancellor Gerhard Schr?der to rapidly deliver on the "Agenda 2010" reforms he outlined in March.
Source: Financial Times
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Now clearly the expectation is one of a global recovery lifting all boats. For a look at what Keynes would perhaps have called the 'treasury view' let's make a brief visit to Morgan Stanley's Elga Bartsch last Friday:

Six months ago, I published a report entitled Is Germany Doomed? (January 6, 2003), in which I argued that the German economy would be reaching a critical point this year, in terms of both the business cycle and economic policies. As I feared at the time, the economy slipped back into recession in the first half of this year and is unlikely to do anything but stagnate for the year as a whole. Nevertheless, I am now ready to give three cheers to the Chancellor on the progress he is making in pushing through his reform agenda (see German Economics: Schroeder's Masterplan, March 16, 2003).

The first cheer is for the attempt to push through structural reforms, notably on labour market regulation. On my estimates, these reforms could add 0.75% to GDP over the next few years -- a small, but not negligible, effect. The second is for trying to lower (or at least limit further increases in) social security contributions, notably by trying to contain healthcare expenditure, reduce unemployment benefits and freeze pension spending. The third cheer is for pulling forward income tax cuts of about €15 billion that were originally scheduled for 2005, to next year, thereby bringing the total tax relief in 2004 to €20 billion, or 1% of GDP.

In light of these developments, we are revising up our 2004 GDP growth forecasts from 1.7% to 2.1%. If confirmed by official data, 2004 would record the second-strongest growth rate since 1994. Only the exceptional boom year of 2000, when the German economy registered a strikingly high growth rate of 2.9%, would surpass our new 2004 GDP forecast. The upward revision to the growth outlook, which brings our numbers to the upper end of the range of available forecasts, is concentrated in domestic demand, the long-standing Achilles heel of the German economy. In particular, we are raising our forecasts for consumer spending by almost a full percentage point to 2.1%, the highest growth rate since 1999. We are also increasing our forecast for investment spending from 1.3% to 1.8%, as small and medium-sized companies, which do not pay corporate taxes but income taxes, will also benefit from the income tax reduction. To some extent, the stronger domestic demand will also translate into stronger import demand, which comes as good news for Germany's neighbours.

Even though a growth forecast of 2.1%, almost one-third above trend growth, may already seem a little vertiginous, we believe that our forecasts are still on the conservative side. In particular, we have not factored in a reduction in social security contributions implied by efforts to contain spending on healthcare, pensions and unemployment benefits. In our view, January 1, 2004, will be too early to expect a marked reduction in contributions, which are equally shared between employers and employees, because we think that the cyclical upward pressures on contribution rates are likely to prevail in the near term.

With monetary policy remaining overly restrictive for the German economy and with fiscal policy under the scrutiny of the excessive deficit procedure, bold structural reforms really seem to be the best way forward. A recent IMF report estimates that by embracing US labour market regulations, the euro-area unemployment rate could be lowered by some 3.5 percentage points and output boosted by 5.25% in the long run. This simulation assumes that the replacement ratio of unemployment benefits, employment protection legislation and labour taxes are lowered to US levels. Of these three factors, however, it is really the replacement ratio and the employment protection legislation that matter most. Both of them are at the heart of Chancellor Schroeder's reform agenda. If, in addition, euro-area product markets were as deregulated as their US counterparts, this would boost output by roughly the same amount as a change in the labour market regime (see Unemployment and Labour Market Institutions: Why Reforms Pay Off, IMF, April 2003). For an economy that has underperformed the rest of the euro area for almost a decade now, attempting to unleash additional growth potential of 10% would not be a bad move. In fact, it might be the best one.
Source: Morgan Stanley Global Economic Forum
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Now as regular readers will know all too well, I am not in principle opposed to the 'labour market reforms', nor to product market deregulation, nor to pension reform, what I am not sure about is whether these measures when applied will produce the anticipated recovery. Elga convinces me of one thing, when you want to be convinced, it's not too hard to convince yourself - 10% additional growth potential, just like that, and you didn't even see my hands move! As Eddie once said, everything here is timing, timing and a broader view of the problem. Among other quaint details, I fail to see why we have to note that the monetary conditions are overrestrictive and leave matters there. If they are overrestrictive, shouldn't they be loosened? Finally, something Eddie sent in the mailbox this morning seems strangely to the point.

It seems to me that people tend to think one-sided. When they talk about structural problems like rigid labour markets, they think supply side. Remove the disincentives to work and flexibilise labour markets. People forget the demand side effects (which become larger, as they are a function of the demographics?)

And when you talk about determination of monetary aggregates for example, a large part of the reason why central banks are having less of an impact must be they are having less of an influence on the relationship between banks & their clients – the reason being the changing demograhics (non-linearity over the age curve?)

While the underlying causes are different, the deflation we get is always Keynesian - insufficient demand. But because of the differences again, much of which is where we are on the age curve, the cures, I agree, would have to be a lot more creative than standard Keynesian remedies.

My sense is that many people out there (particularly policymakers) think all we need to do is get the costing correct. I guess it’s essentially neo-classical thinking? They think micro and not macro.

The Benefits of Homeschooling?

A piece in the mailbox from Francisco about homeschooling .

I see that a lot of your blog revolves around "can old people adapt" and "young people take longer to (finish college, although you don't say that)" and "people have less children because they are expensive". I think that, for a different view on the subject, you should incorporate into your frame of reference the fact that homeschooling is growing very fast (specially in the US), and that it, combined with what's called attachment parenting makes for a wholly different outlook on children that renders all the first 3 points moot -i.e. children are not that expensive anymore, people who homeschool tend to have more of them, and they (the children) learn adaptability from the get-go, start working much earlier and not necessarily go to college, and are very well positioned to change careers a few times in life-. They way I see it, it's getting to critical mass (in the US at least) and could well offer the "next or different avenue we need to find".

Many thanks to Francisco for introducing me to these two interesting concepts. Where this will lead I do not know, whether such movements will, as Francisco suggests, gain 'critical mass' is hard to see. Whether the family environment needs to be a complete substitute for the social life to be found in the school I also do not know, but that we need to be much more flexible in our approaches, of this I am sure. That school was the great socialiser in the 'mass' industrial age is clear, whether things always need to be this way, as we, and our societies, change, is much less clear. Peer group contact has, as many parents know to their cost, become a double edged sword. Technology and social structures are changing, and we can and should be imaginative. Meantime here is my reply to Francisco:

Just to clarify things a bit, my argument doesn't especially hang on children being expensive. I think I am trying to look at it from the point of view of our (complex) reproductive ecology. There was a form of dynamic equilibrium, with slow growth up to the 18 century, then the system received a (technologically driven) shock which opened another dynamic, where we have population explosion. The system then gradually restabilises - during about 200 years in the european case, much more rapidly now in the case of some third world countries - only, as in the case of many dynamic systems, we have 'overshoot'. ie the population falls below reproduction rate. At some stage we will probably find a new equilibrium, but I suspect that this is an example of a complex adaptive system, and that government policies (whether those of Berlusconi or any other) have limited impact. More technological change, of the 'sci-fi' variety will also clearly impact: artificially aided reproduction, genetic engineering, Kurzweil's 'non-intrusive' implants and the imminent, intimate fushion of artificial and biological intelligence. But I am not a futurologist, and I do not wish to speculate, so I try and stick to what we can actually see happening in the here and now.

There is obviously a lot of work still to do in understanding this process, I am far from clear on many aspects, but from an economic point of view it is important since fertility, in the final analysis, is a major determinant of the labour supply, and of the relative cost of labour and capital, and of the structure of demand, investment and saving, and of many other things.

I am only professionally interested, I suppose, in childhood and ageing as tangential phenomena (although personally, of course, I have a lot of interest in both these processes). The topics which emerge in Bonobo are related to my research interests/obsessions, and as such tend to change with the focus of my interests.

Your point about 'homeschool' is interesting. It is in line with Mokyr's argument about the changing relations between home and work in the information age (the factory, and factory office, as the dominant paradigm seem to be uniquely characteristic of industrial society). The home can become much more the focus for all kinds of activity, and of course, the arrival of the internet always was going to have an impact on the institutional structure of learning. This is especially relevant to the universities. As I have said on a previous occasion , you can probably learn economics better these days downloading at home the material from the best courses of your choice which are normally (at least in the US case) freely available on line.

Mind the Gap, One More Time

I don't know whether I'd go so far as Stephen Roach, who titles his latest MSGEF piece 'long live the output gap', since it's the existence of this gap that gives the strongest indication of the disinflationary pressure facing the US economy (perhaps I prefer the infamous 'mind the gap' of the London Tube). But quibbles aside, this piece from Roach is very timely and to the point:

Macro certainly has its moments in captivating financial markets. I suspect another one of those moments is now at hand. The debate over deflation has been given a new lease on life by Federal Reserve Governor Ben Bernanke. He has now set the risks of deflation squarely in the context of an “output gap” framework -- long a central tenet of macroeconomic analysis (see his July 23, 2003, speech, “An Unwelcome Fall in Inflation?” available on the Fed’s website). Using this macro construct, Bernanke has conclud?ed that even if the US economy now enters a period of solid recovery, the risks of deflation are going to be with us for some time to come. I couldn’t agree more.

Like most concepts in economics, the output gap is a complex restatement of a very simple premise -- the inflationary consequences of disparities between aggregate supply and demand. Alas, what always sounds simple in macro rarely is. Economists attempt to get at the notion of aggregate supply by assessing the growth of “potential” output (GDP) -- defined broadly as the sum of labor force growth and trend productivity. In essence, the output gap is then calculated as the difference between an economy’s growth potential and its actual level of aggregate a?ctivity. When output gaps are at “zero,” it’s the best of all worlds -- supply and demand are in perfect balance and, at least theoretically, the economy is at full employment and able to enjoy the luxury of a stable inflation rate. When demand exceeds potential -- a positive output gap -- inflation can be expected to accelerate. Conversely, shortfalls from potential -- a negative output gap -- are invariably associated with falling inflation; they reflect excess slack that gives rise to a phenomenon referred to as “disinflation.” As such, recessions are generally depicted as disinflationary macro events, while recoveries are thought to be inflationary.

As presented in this fashion, the output gap is all about levels of aggregate activity. This stands in contrast to the growth rates that color most of our impressions about the performance of economies. This is a critical distinction. An economy can be growing at, or even above, its potential growth rate and still have ample margins of slack capacity in labor and product markets; disinflationary pressures would prevail in such instances. Conversely, a fully employed economy growing slower than its potential growth rate would still be biased toward an inflationary outcome. In other words, initial conditions matter. An economy’s growth speed is not enough, in and of itself, to Idetermine the ups and downs of the inflation cycle. The verdict is critically sensitive to the state of resource utilization.

Which takes us to the case in point. In his latest speech, Fed Governor Bernanke has used this framework to make some important inferences about the economic and policy outlook for the United States. His most salient conclusion, in my view, is the premise that America’s output gap is likely to remain wide even in the face of a fairly vigorous recovery in the US economy. Bernanke comes to that conclusion by inserting a few key numbers into the o1995t gap framework. Operating under the premise that America’s potential growth rate is around 3%, he points out that even a 4% growth outcome in 2004 will not close the output gap for an underemployed US economy. In that context, a further deceleration in inflation can be expected. Inasmuch as inflation is already quite low -- averaging 0.9% for the core CPIU in the first six months of 2003 -- it’s that next leg of disinflation that becomes so problematic. While Bernanke celebrates America’s achievement of what he calls “the de facto equivalent of price stability,” that may not be a reason to jump for joy. In fact, it doesn’t take much of an imagination to envision what lurks on the downside of this threshold. On that basis alone, the Fed has good reason to remain vigilant in the fight against deflation -- even if the US economy now moves into a solid recovery mode, as the central bank and most other forecasters expect. And that, of course, is exactly the key conclusion that points to a protracted period of monetary accommodation.

Ben Bernanke is hardly alone in reaching these conclusions. Analysts at the OECD have come to the same realization. In their June 2003 assessment of the global economic outlook, OECD economists estimate that America’s output gap will hit 2.1% of potential GDP in 2003 -- the widest such shortfall in the US economy since 1991, when it rose to an nestimated 2.5%. Moreover, over the four-year period, 2001-04, the OECD estimates that the United States will record a cumulative output gap of 5.9% of potential GDP. That’s two full percentage points larger than the 3.9% widening of slack expected in the euro area and only fractionally below the 6.0% cumulative output gap expected in Japan, the land of deflation. Nor can the OECD be accused of sounding the “output-gap alarm” on the basis of an overly pessimistic growth forecast for the US economy. Their current prognosis calls for a 4.0% increase in real GDP in 2004 -- not unlike the outcome Bernanke has built into his stylized depiction of deflation risks. In other words, among the major economies of the industrial world, America is expected to be right at the top of the charts in feeling the full force of disinflationary pressures through the end of 2004. That’s obviously a new role for the unquestioned engine of the global economy.

Having said all that, it pays to take a deep breath and remember that this is macro -- not nuclear physics. The output gap analysis hardly provides an ironclad guarantee of deflation risk and the policies required to cope with such risks. As has long been noted, it is based on a number of heroic assumptions -- including, but not limited to, assessments of trend productivity, the inflation-stable? unemployment rate, and implied rates of full-employment capacity utilization. Moreover, the output gap construct is largely a “closed” macro model -- driven mainly by domestic considerations. In this era of globalization, macro models must be more “open” -- allowing for the possibility that aggregate supply curves are now global in scope. Not only is that true for tradable goods, in the form of Chinese-based outsourcing platforms, but it is now increasingly true in once non-tradable services, as exemplified by Indian-based IT-enabled service exports. In his latest speech, Bernanke concedes that the output gap could be considerably wider if aggregate supply curves were underestimated; in that case, disinflationary pressures would be even more intense as a result. The ever-increasing pace of globalization of goods and services suggests that is hardly idle conjecture.

Notwithstanding these important caveats, I think it pays to take the output gap seriously in assessing the risks of deflation. While the framework is hardly perfect, it provides a reasonably good assessment of the balance between aggregate supply and demand in the US economy. If anything, globalization tells us that the risks to this macro construct are tilted more toward an understatement of slack rather than the opposite. That points to a potential underestimation of theê intensity of disinflation, suggesting that it will take a lot more than a year or so of vigorous growth in the 4% vicinity in 2004 to end the current deflation scare for a low-inflation US economy. Conversely, it follows that any setback in the pace of recovery from the desired 4% trajectory would only widen the output gap even further -- intensifying the disinflationary pressures already bearing down on the US. Either way, the output gap is not about to disappear into thin air. And the longer it persists, there’s no escaping the bottom line for a low-inflation US economy -- the greater risk of deflation.
Source: Morgan Stanley Global Economic Forum
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On the Difficulties of 'Nation Building'

This article from the FT about the CSIS report seems to make a number of points which are surprisingly obvious, and should have been obvious many months ago, what seems far from obvious is why so little thought appears to have been given to them.

Five US soldiers were killed over the weekend in a spate of attacks by Iraqi militants, as a new study warned that the US may soon find itself in the midst of "a third Gulf war against the Iraqi people". On Saturday, three soldiers were killed in a grenade attack while guarding a children's hospital in the city of Baquba, and a fourth was killed in an attack on a convoy west of Baghdad. On Sunday, the fifth was killed by a grenade attack south of Baghdad near the city of Hilla.

Forty-nine coalition troops have been killed by militants in Iraq since the beginning of May, and attacks average 10 to 20 a day throughout the country. General John Abizaid, the new commander of Centcom, on July 16 became the first senior US official to acknowledge that what the coalition faces in Iraq is a "classical guerrilla campaign". A study on guerrilla warfare in Iraq by the Center for Strategic and International Studies (CSIS), a Washington think-tank, blames bad planning by the US administration and the low priority given to "conflict termination" and nation-building strategies by the Pentagon.

CSIS military specialist Anthony Cordesman says the US has not learned the lessons of past conflicts, that "even the best military victories cannot win the peace". He writes: "Unless this situation changes soon, and radically, the United States may end up fighting a third Gulf war against the Iraqi people . . . It is far from clear that the United States can win this kind of asymmetric war." The study is likely to be a further blow to the US administration, already facing mounting criticism for chaotic reconstruction efforts in the country.

Mr Cordesman offers a grim assessment of the future of the Iraqi conflict: "The most likely case still seems to be a mixed and poorly co-ordinated US nation-building effort that does just enough to put Iraq on a better political and economic path, but does so in a climate of constant low-level security threats and serious Iraqi ethnic and sectarian tensions." The Pentagon's policymakers saw the Clinton administration's focus on nation-building as a waste of resources, the report says.

US policymakers say the Iraq war ended too suddenly for an effective postwar strategy to be launched. Mr Cordesman credits the coalition with avoiding many of the worst-case postwar scenarios, such as massive refugee crisis and wholesale destruction of energy infrastructure. But Mr Cordesman offers a detailed critique of the planning and analysis that went into the war - 26 "avoidable problems" ranging from failure to introduce a police force to assuming that toppling Saddam Hussein would have won "hearts and minds". In confused and angry scenes in the Shia holy city of Kerbala on Sunday US troops opened fire as Iraqis protested over Marines killing a man the day before, Reuters reports from Kerbala.
Source: Financial Times
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And just in case the point needed emphasising, here is the Reuters report the FT refers to. (My impression - and it's only an impression since I have no special expertise here, is that the internal dynamic in Iraq is so complicated that possibly the Kurds are the only group which is really content, and that the Kurds being content is also probably a source of unease for the other groups, both internally, and (in the case of Turkey) externally. Living in Spain, and seeing how live the historic internal conflicts involving Basques and Catalans with the dominant 'Castillan' group actually are, despite all the economic progress, it is difficult to see an easy resolution of Iraq's internal rivalries).

An Iraqi man was killed and three wounded in the Shi'ite holy city of Kerbala on Sunday when protesters clashed with U.S. troops and Iraqi police, witnesses and hospital workers said. Marines said two Kalashnikov rifle shots were fired during the protest and they returned fire. Reuters journalists saw troops fire in the air to try to disperse stone-throwers angry at the killing of another man by U.S. troops on Saturday. Doctors at a hospital in the city, home to one of Shi'ite Islam's holiest shrines, said the man killed in Sunday's protest had been shot and showed the wound to a Reuters correspondent. One of the wounded, Shaer Abbas, said he had been hit with an electric cattle prod. "During the protest, two rounds were fired from a building," a Marine officer told Reuters. "They were fired from an AK-47. We're investigating to make sure the firing has stopped."

Residents said unrest began on Saturday when locals accused U.S. troops of encroaching on the grounds of the revered Imam Hussein mosque. In resulting clashes, they said, an Iraqi died. The Marine officer said the Iraqi killed on Saturday had been shot by troops because he was armed and posed a threat. The death sparked Sunday's protest, with hundreds of men marching from the famed, gold-domed mosque waving banners and shouting anti-American slogans. As gunshots rang out, Marines dived for cover behind walls and many Iraqi police fled.

Soldiers arrested several protesters. At least one of the detained Iraqis was carrying a Kalashnikov AK-47 assault rifle. In angry confrontations, Marines threw several protesters to the ground and pointed their weapons at the crowd. The funeral of the Iraqi killed on Sunday was due to take place at 5 p.m. (9 a.m. EDT) on Sunday afternoon, and was expected to be another potential flashpoint in the tense city.

Violence directed against U.S. troops in Iraq has been concentrated in Sunni Muslim areas, the heartland of support for Saddam Hussein. But recent protests and attacks elsewhere are a sign of anger among the country's majority Shi'ites too. U.S. troops have generally stayed out of mosques in the holy Shi'ite cities of Najaf and Kerbala to avoid offending locals. Last weekend thousands of people protested in Najaf to show their support for a radical Shi'ite leader.
Source: Reuters
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