Emerging Market Correction and Pressure on the Forint

Unfortunately Hungary's coming correction seems to be getting very near now. Portfolio Hungary reports this morning on the latest readings on the Calyon Risk Aversion Barometer. Caylon reported on Monday that global equity gyrations continue to dictate the direction of emerging market currencies, with risk aversion remaining high and European equities closing lower again on Monday. Indeed many currencies remained under pressure throughout the trading session yesterday. Budapest Economics also said yesterday that the HUF continued to be the most vulnerable currency in the region, with the currency temporarily hitting 259 against the euro yesterday, although it did finally manage to stabilize at slightly stronger levels by the end of the session.

Mitul Kotecha, head of global FX research at Calyon, confirmed the Budapest economics view, saying Hungary's forint appeared to be highly exposed to rising risk aversion. “Reflecting the vulnerability to risk aversion, correlations between the Calyon Risk Aversion Barometer and some emerging currencies are quite high at present," Kotecha is quoted as saying, adding that Hungary's forint “appears highly exposed to rising risk aversion, with the 1-month correlation between the Barometer and EUR/HUF at a strong 0.85." Of course, the HUF is also suffering from deteriorating domestic fundamentals, an aspect which of course he did not ignore.


Stefan Wagstyl, picks up the theme to some extent, and has another long and relevant piece in the Financial Times this morning, reflecting just how a change in tone is taking place even as I write.

The turmoil in financial markets is turning into a nerve-racking test for the economies of central and eastern Europe and the former Soviet Union. Economists have said the fast-growing region faces a slowdown following the financial shockwaves reverberating around the globe. But the precise impact is uncertain, especially on weaker economies.

The differences are registering in the financial markets. As investors reconsider their strategies, they are becoming more risk averse. Some have turned against emerging markets, including the ex-communistregion. Others are discriminating more between countries.

The spread on five-year credit default swaps (a measure of risk) has widened by 26 basis points for the Czech Republic since last June and by 44 basis points for Poland. But for Serbia and Ukraine the increase is 151 basis points; for Kazakhstan it is 218 basis points.

Given the recent unprecedented credit-fuelled growth surge, this slowdown could be welcome in countries trying to cope with inflationary pressures, including Ukraine, Kazakhstan and Russia, and those facing labour shortages, such as Poland.

The benefits could be even greater in economies facing yawning current account deficits, notably the Baltic states, Romania, Serbia and Bulgaria. As Leszek Balcerowicz, the former Polish central bank governor, told a business conference this month: "We should welcome some amount of a slowdown, especially in the Baltic states, which have been growing the fastest . . . We don't have the information that would make us predict a hard landing. Based on the current information a soft landing in the countries which have been growing fastest is more likely."

I am not as optimistic as Wagstyl is here that we will see soft landings. The existence of virtual currency pegs - which will need to be broken during the correction - virtually guarantees an abrupt change, as does the level of household debt in non local currency .

Wagstyl had an earlier FT piece where he drew attention to the way in which ageing populations and labour shortages were playing their part in this emerging crisis.

Fuelled by strong economic growth and soaring foreign investment, employment is increasing in availability just as emigration has sucked around 5m workers from eastern to western Europe. According to Eurostat, the EU’s statistics agency, labour costs are growing at their fastest rate since the end of Communism – with a 30 per cent increase in nominal costs in Latvia in the year to last September and rises of more than 20 per cent in Romania, Estonia and Lithuania. In Poland, the largest new member, the rise was just under 12 per cent.

In real terms, average gross wages in Poland rose more than 7 per cent in the first nine months of 2007 and in Romania by nearly 16 per cent, according to the Vienna-based Wiiw research institute.

While unemployment levels in western Europe have stayed at around 8 per cent since 2002, in the east they have slid from 14 per cent to under 9 per cent. In the region’s booming capital cities, almost everybody who wants work has a job. Leszek Wronski, head of the central Europe division of KPMG, the accountant and management consultant, says: “We have a job market controlled by employees.”


Even if labour markets ease a little, there will be no return to the super-abundance of workers of five years ago. The region’s populations are ageing even faster than in western Europe and, with the added effects of migration, the number of working-age people is falling in the Baltic states and central Europe. Eurostat predicts that the population of the new member states will decline from 103.6m in 2004 to under 100.6m in 2015, with particularly sharp drops in working-age people.

However, for governments and companies alike, rising labour costs and growing skills shortages raise big questions about the region’s future competitiveness. Everything from decisions on investment location to education, migration and population policies is coming under scrutiny.

So even while he doesn't directly go into how long term fertility may be playing a role in the drama we are watching unfold before our eyes, his mention of "population policy" seems to be a euphemism for this very topic. And if fertility isn't an important determinant in what has been happening, I would be grateful is someone could explain to me why we aren't seeing similar sorts of labour shortages in places like Thailand, Turkey, Chile, Brazil or Argentina, all of whom are growing - or have been, Turkey has slowed recently - very rapidly at the present time.

Back on the 28 August 2007 - just after the financial "turmoil" started - I posted the following, in a piece which still looks extremely good when looked at in the cold light of today, on Global Economy Matters:

"But any looming "credit crunch" is also likely to affect the so called "risk appetite" (that is the willingness to invest in riskier areas or activities) and the place where this is most likely to be felt is in the emerging market area. Those emerging markets which are considered to be most vulnerable will undoubtedly have the hardest time of it, and this brings us directly to Eastern Europe I think and to economies like those in the Baltics, Latvia, Estonia and Lithuania), to Hungary, and then maybe (if there were to be contagion) to the larger economies like Poland and Romania. Alarm driven reports about the dangers of a hard landing in the Baltics have been floating around for some months now (I say alarm driven not because the danger isn't real, but because most of the reports are quite superficial, and don't really appreciate the magnitude of the problem). Whatsmore, as the Bank for International Settlements pointed out in the June edition of its quarterly review , in 2006 Eastern European economies accountedfor a staggering 60% of new emerging market credit:"

At the start of September, and as part of an in depth analysis of Turkey, I posted the extract you will find below. The issue here is foresight, and our ability to see things coming. What is happening now has been obvious for some time, completely obvious, even if many people have had difficulty in seeing it. I completely resist the idea that economics cannot be scientific. I think it has to become much more of a science. But if we are to get from here to there we first need some paradigmatic models which enable us to see things coming rather better than we appear able to do right now.

In a much quoted paper - published back in 2004 by two UCLA economists (Schneider and Tornell) - 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 thefuture.

For a fuller analysis of the specifics of Hungary's present crisis see "Just Why Is Hungary So Different From The Rest of the EU10?", "Hungarian Central Bank Leaves Interest Rates Unchanged" and "The EU Comission Warns Hungary on 2008 Budget Deficit".

For e theoretical exposition on why fertility matters to the EU10, see Claus Vistesen "Catch Up Growth and Demographics - Evidence from Eastern Europe".

Italian Employment, Earnings and Consumption

Italy is currently entering into what offers all the indications of being a major political gridlock. At the same time the Italian economy is slowing visibly, and the Bank of Italy only last week lowered their growth forecast for the Italian economy to a mere 1%. Given what is happening now in global stock markets and Italy's obvious political instability even this may be an optimistic estimate (see my 2008 forecast here). Italy's problem is, however, neither so immediate nor so dramatic, since if we look at the relevant chart what we can see is that Italy is suffering from congenital slow growth in the much longer term.

In what follows I intend to step back from the precipice a bit, and take a rather longer term look at one feature of Italy's economic performance, its labour and employment market. In this sense this post is going to form part of a "tripple whammy" I am working on, where I will attempt to carry out an in depth examination of possible connections and interconnections which may exist between population ageing, rapid job creation and weak internal consumption in three key G7 economies: Italy, Germany (see here) and Japan.

Rising-Employment Falling-Consumption?



Well lets start by looking at the story so far, at least as far as Italy goes. Fortunately we do have a number of key stylised facts at our disposal. First off, unemployment has been steadily - I could say relentlessly - dropping in Italy over the last two or three years:

and new jobs have been created, lots of them:




Yet at the same time domestic demand has not been revived to anything like the extent that might have been expected. Retail sales have been in decline for most of the last year as you can see from this retail-sales purchasing-managers-index for Italy (remember that on the PMI reading, anything below 50 represents a contraction).



Meanwhile private household consumption, despite some early strengthening, could hardly be said to have been booming. We did see a couple of (in Italian terms) comparatively strong quarters in the first half of 2007, but then, surprisingly - as can be seen in the chart below - the rate of increase began to weaken in Q3, while, curiuosly, in the position in the Italian labour market remained, more or less, stable.



So how can we account for this apparent paradox of a steadily tightening labour market and deteriorating internal consumer demand? One explanation for this could, of course, be that labour market performance is a lagged indicator (that is that it only registers economic deterioration after other indicators have been pointing to red for some time, and this is surely true), but could there not be something more going on here? Especially since this kind of pattern is being repeated in Germany and Japan, and these two countries have, along with Italy, the highest global median age, and as a result the highest proportions of potential workers in the older age groups. There is something very different about the labour market tightening we are seeing in Italy, Japan and Germany, for example, and the kind of inflation generating labour market tightening which we are observing in Eastern Europe. So why this difference?

Italy's Age Structure

But first off let's take a look at one of the younger age groups for a minute, the 15 to 24 one. As is well known this group is now in historic decline as a proportion of the total Italian population. The decline has been very rapid, with a drop of around one third (from 15% to 10% of the population) since 1990.

What this means, logically enough, is that there are steadily less and less people in this age group to fill places in the labour market. To this numerical decline we need to add theongoing secular decline in economic activity rates among this group, as more and more of Italy's - now scarce resource - young people delay entry and seek to improve their education, their human capital rating and hence their future earning capacity.



Thus the proportion of this group which is economically active has been declining steadily, as have the absolute numbers of those who are active, and the numbers of those who are actually employed. It is perhaps worth noting that the absolute size of this age group has been virtually stationary over the last 3 or 4 years (a statistical effect), but it is now set to fall steadily.



So if new employees will be hard to come by in this age group as we move forward, where can employment growth come from? Well basically there are two evident potential sources of labour, immigration and older workers. It is hard to envisage any large increase in employment in the 25 to 34 or the 35 to 54 age groups since - as can be seen from the chart below - activity rates among these groups are already fairly high, and even the slight fall-off which can be seen to have taken place recently in the 25 to 34 age group seems to be the result of a decline in female activity rates, and this is almost to be hoped for if Italy is to do one thing which is very important for its long term future, and that is have more children. Squeezing this particular lemon too hard at this point in time is only likely to obtain short term benefit in return for substantial negative long term outcomes.



Turning now to the principle sources of potential long run labour supply, in the first place it is obvious enough that there has been a significant surge in the size of the immigrant workforce in recent years (see chart below, and my other post for more details).


The other main potential source of additional labour in an ageing economy is the over 55 age group (and as we move forward of course increasingly it will become the over 65 one). Now many international agencies (the World Bank, the OECD, the IMF, the EU Commission etc) are pinning their hopes on the idea that the effects of population ageing may be to some extent offset by increasing the participation rates of these older workers, presenting impressive looking projections all the way out to 2050 to back their view that this is a workable solution. Yet since we have, in the here and now, a number of examples of societies who are trying quite hard to follow recommendations here, I do think it is important to examine in detail what is actually happening in these societies and try to really start to estimate the longer term macroeconomic consequences of this shift.

Now the important thing to bear in mind when we speak of older workers is that the important decision they need to take is about whether or not to continue working, and what is very clear in the Italian context is that workers in the 55 to 64 age group are increasingly taking the decision to stay at work, in some form or another.

Not only is the activity rate - which has, it must be said, been ridiculously low for this group, especially given Italy's very high life expectancy level - on the way up, the unemployment rate is on its way down, and the number of those employed is steadily rising.

More Work, Less Pay?

What is also significant about this trend is that it is also associated with a significant growth in part time and temporary work. The question really is who is doing this part-time/temporary work? In Japan it has become clear that many people now leave their "lifelong" job at 55, only to continue working in some way shape or form for another 15 years or so (both the Economist and the Financial Times have recently run articles about this trend in Japan - see here - although they fail to explicitly lock-it-in to the ageing population issue, which I think is where it belongs) . The work ethic in Japan is probably quite different from the one in Italy, but the similarities in the way the labour markets are evolving are really quite striking . In the German context it is also clear that the growth in part time and in non-social-security covered employment has been significant. And of course, in Germany, as I explain at considerable length here, the big increase in employment is in comparatively low skill, low wage work, which very often draws the over 55s into employment in much the same way and for much the same reasons as it does in Italy and Japan.

So what IS observable in the case of all 3 of these economies is that they are experiencing at one and the same time skill-shortages in some key areas of economic activity (due to the growing population crunch among the young - Japan for example is notoriously short of nurses) and generating large volume employment in more tenuous and lower skilled categories of work, since such work meets the skill and performance profile of the workforce they really have available. Thus, even as these labour markets tighten we find NO real evidence of significant wage-squeeze push.

From this point in we are left guessing until someone does some really systematic research, but it isn't a bad guess to suggest that the pressure on wages in the more skilled areas is being offset by a downward movement in wages in those less skilled areas where a mixture of lower skilled migrants, retirees and older workers are offering themselves for work in increasing numbers.

One other conjecture about Italy is that migrants are doing jobs in Italy which retired or semi-retired workers are doing in Germany and Japan, and hence we find that the participation rates in the 55 to 64 age group are still pretty low. At the moment I'm not quite sure what the macro economic consequences of this are going to be.

My feeling is that since people reaching 60 can now expect to live quite a long time, and since nowadays there is no great certainty attached to current levels of retirement benefit as we move forward, then older people, who are normally more prudent, will be protecting their current savings - in whatever form they may hold them - as best they can, and supplementing pensions with bits and pieces of work to maintain living standards so as to not run down their capital.

Another point here is that many retirees in Italy have a lot less in the way of accumulated wealth (and imagine the situation in a country like Hungary, which is the next one coming in this group as far as I can see, even though the median age is somewhat younger, but the male life expectancy is also much lower, and the population is already falling) in comparison with Germany and Japan.

This is why the recent deal Prodi struck with the Italian unions about postponing raising the retirement age was such a negative when viewed from where I am sitting.

So what I am suggesting is that the very weak internal consumption we are seeing in these three countries (and I would drop-in that Hungary is "coupling" here perfectly with the others, in terms of the model I am working on) is not ONLY associated with a higher propensity to save associated with older people, but also to do with the earnings profile associated with the new kinds of low level work older people are doing. In other words you can't just take the large number of new jobs being created and translate this into more consumption (as I think most of the conventional analysts are doing) since more things are happening here.

North-South Regional Stresses and Imbalances


But in any event the data we have is fascinating. The regional disequilibrium in Italy seem to be once more becoming really important (just like East-West one in Germany, and Tokyo vs the rest in Japan). While the national participation rate for the 55 to 64 age group went up from 28.9% in Q1 2004 to 33% in Q3 2007, in the mezzogiorno it has gone up from 31.8 to 35.3 over the samer period, so the South is keeping pace here, but if we look at the 65 plus group, while participation has gone from 3.4% to 4% nationally over the same period, in the mezzogiorno it has gone DOWN from 2.4 to 2.1%. The 15 to 64 participation rate also dropped from 54.1 to 52.5 over the period in the mezzogiorno while in the North it went up from 67.8 to 69.2 %. And this situation is reflected in the relative job creation performance between the North and the South.






Basically, given the very strong fiscal pressure which is about to come in Italy, and the danger IMHO of a sovereign default at some point if nothing is done to correct this very weak growth trajectory, Italy can be almost literally torn apart by this disequilibrium, especially given that it is reinforced by the unequal distribution of migrants. We have an ongoing polarisation of wealth, employment and people, and we really aren't giving sufficient consideration to the longer term political implications of the underlying economo-demographic process.

New Forms of Employment: Temporary and Part-Time Work


I have also found a limited breakdown for part time work by age. The two categories which the Italian statistics office use are "15 to 34" and "35 and over". Now strange as it may seem the number of part-time jobs for the 15 to 34 age group actually went DOWN between Q1 2004 and Q3 2007 - from 1.107 millions to 1.102 million - while among the over 35s it went up from 1.74 to 2.121 million. So Italy's new part-time workers are by-and-large not young, and it is a good bet that the majority of these new workers come from the over 55 group, and that it this kind of work which is responsible for the increase in the participation rates at the higher ages.



Of course, when we come to look at TEMPORARY work the pattern is rather different, there are an increasing number of young people (and since the number of such people is steadily declining, a rising proportion) working on temporary contracts. The number has gone up from 1.035 million in Q1 2004 to 1.368 million in Q3 2007. Over 35s (which we can pretty much imagine as over 55s, since the 35 to 55 age group is normally pretty robust in employment participation terms) goes up from 679,000 to 993,000.

By Way of a Conclusion

Basically the macro economics of all this are hard to assess. Italy's working age population - ex migration - has touched the ceiling, and without immigration it will go down and down. So everything depends on raising the productivity of those employed. But raising productivity today is pretty much synonymous with raising the human capital component and if in volume terms the numbers of older but less qualified people working - and working in more and more fragile and less and less well-paid occupations - swamps the number of new highly educated workers in highly productive jobs (we are talking about aggregates here) then the new value created by the society in question won't compensate for the contraction in the workforce. This is particularly true when it comes to raising participation rates in that oft quoted potential labour supply, female workers over 55. Many of the women in question are excellent wives and mothers, but given their often very low level of formal education, and given their lack of real experience of work out of the home, the economic worth in value added terms of their formal labour market participation may be much lower than many expect, and certainly this is where the evidence to date is leading us.

I also feel that the Italian experience is very similar and comparable with what we have been seeing in Japan and Germany, so it seems to me that there is now strong prima facie evidence that we need a big and really systematic research programme into the details of all of this, and rather less of that "gung-ho", we haven't got a problem approach, which has prevailed up to now, and which - at the end of the day - is based on the idea that raising participation rates will do the trick. As we are seeing, and unfortunately, it may well not do. It will do something, but that something may well not be enough.

Getting Choppy, and the Eurozone Gets the Backwash

Well there I was, quietly working away on a series of studious posts about the German, Italian and Japanese labour markets, trying to justify - following an exchange in comments - why I think creating a lot of additional employment among the over 55s won't offset the shortage of bright young educated people that ageing economies and societies will increasingly encounter, when suddenly the global storm seemed to take a swirl for the worse. So I can't just let sit back and let all this pass without even expressing a word:

The FTSE 100 on Monday suffered its biggest one-day fall since the terrorist attacks on the World Trade Centre more than six years ago as fears about the prospects for the global economy took hold.

In a tumultuous session, the index fell as much as 5.6 per cent as dealers capitulated following sharp falls on Asian markets overnight.

This is just short of the 5.7 per cent fall at the close on September 11 2001. "The acrid smell of fears hangs over the City. I've never seen fear like this," said David Buik at Cantor Index.

It's hard to say at this point how far or how deep this will now go, or where it will end, so I guess it's better to take things one day at a time.

But meanwhile it is perhaps worth noting how things are really heating up now in the eurozone interest rate debate, and in the euro-dollar currency markets. In the middle of last week Luxembourg's Central Bank Governor Yves Mersch set the ball rolling when he warned of "downside risks" to growth in the eurozone, sending in the process the yield on the 10-year German benchmark bond below 4 percent for the first time in seven weeks. Then ECB official Axel Weber said in Cyprus that euro-region inflation would slow toward the bank's 2 percent ceiling later this year, despite the fact that on average eurozone prices grew at an annual 3.1 percent rate in December. This is more or less code language for saying that growth is expected to slow, and that interest rates will thus need to come down. This has some significance since Weber has - up to now - been more or less in the "hawks" camp at the ECB. His expression of opinion was then followed by Portugal's Finance Minister Fernando Teixeira dos Santos in a statement where he indicated that he shared "concerns that the slowdown in European economies could be somewhat stronger than we expected a few months ago" and then of course we had the downward revision in the 2008 Italian forecast from the Bank of Italy, which I have already commented on.

So it seems the economic slowdown is finally being recognised as what it is, a far more general issue than a simple sub-Prime problem in the United States.

The process accelerated further this morning, with the euro falling to a five-month low against the yen after European Central Bank council member Nout Wellink admitted that economic growth may slow more than policy makers had expected. Wellink suggested that eurozone growth will be closer to 1.5 percent than 2.5 percent in the coming year. All of this is causing a good deal of uncertainty in the currency markets with the euro falling 1.8 percent against the dollar in the past five days to a three-week low of $1.4510. This is, of course, still a very high value, but what we need to be aware of is that what causes most damage, economically speaking, are violent swings, and at this point in time there is no guarantee that we may not be in for some of those.

What's interesting about the above linked Bloomberg article is the way these statements are being read. That is, higher than desireable inflation is now no longer the plus it was (we have been living for some months now on top of a discourse where inflation was virtually being seen as a positive by currency traders since it meant that interest rates, and hence yield differentials, would rise). This discourse seems to be coming to a rather abrupt end. We could perhaps notice some first indication in Romania in the middle of last week, where the focus moved from the inflation there driving up yield, to the fact that the central bank effectively needs to maintain rates up to stop capital outflows. Hungary is a very similar case (and here). This is also being reflected in a weakening in the so called carry trade and steady upward pressure on both the Swiss Franc and the Japanese Yen.


So the fact that the ECB may be tardy in dropping rates is no longer being read as a euro positive. Market participants seem to be reaching out further into the future, and are thinking more about the future path of relative currency values. Since the ECB can't cut, economic growth will tank more than it would do otherwise, and then the ECB will cut vigourously, so at that point the euro will fall. This seems to be the reasoning, of course, by having the thought these participants simply bring forward the moment when the decline starts, and as a result it starts to fall now. I think this is a sea change.

Of course, if, as the Bloomberg article suggests, the euro is about to follow the dollar into "swoon", we might like to ask ourselves which currencies are in fact going to rise, since given that currency values are relative, they can't all fall at once. My feeling is that the US administration will resist any strong upward correction in the dollar, since they have their own issues to think about - and not least among them the trade deficit - which mean that weaknesses in domestic consumption need to be compensated for by exports, and as a result dollar competitiveness becomes important. In this context Claus Vistesens latest note this morning is, as ever, interesting.


Update Tuesday

Well today seems to be an even rougher one in the global stock markets, and now the EU finance ministers have, more or less, made it official. The eurozone is slowing faster than expected.

European finance ministers said a global stock-market slump and an economic slowdown in the U.S. threaten to slow growth in Europe more than forecast.

``The economic situation and financial markets are highly volatile and uncertain, a good deal more uncertain than usual,'' Luxembourg Finance Minister Jean-Claude Juncker said yesterday in Brussels after presiding over a meeting of counterparts from the euro region. ``If there is a real slowdown in the U.S., obviously that would be felt in the euro zone.''

A global stock-market rout continued as Asian equities tumbled today by the most since September 2001. The slump has wiped more than $5 trillion from share markets around the world this year on concern global growth is faltering. Juncker said forecasts for European expansion will need to be revised down and that an economic contraction in the U.S. can't be ruled out.

Well, maybe I should qualify the above in a number of ways. First off, I think it is important to stress that the eurozone is slowing more than some expected. I think Claus Vistesen and I have been arguing quite consistently since the credit crunch began on 9th August 2007 that all of this was inexorably coming (see here, and here, and here, for example), and secondly it is ever so important to grasp that what is happening is much more extensive than the discourse Junkers advances seems to recognise. There has been a change in the credit conditions, and this change is now being felt, but what it is serving to do is reveal underlying weaknesses in some key eurozone economies. Weaknesses which would exist regardless of whether or not there had been a "sub-prime bust" in the United States. Each case is different, but Spain, Italy and Germany all now seem set to go into the grinding mill, strangely it would seem to be France - as I argue here, and Claus argues here, which may withstand all this the best.

For what it is worth I think we should all now have our eyes on Eastern Europe (and here), and on the German link in with the region via export dependence. Beyond Europe we should now watch China carefully, and if the slowdown there is more rapid than expected then all eyes should shift to Japan, since with sales to US and Europe now weakening, if the Chinese shoe drops, then the Japanese economy is going to be in all sorts of trouble.

The French Economy Is Back At Number 5 Globally

Well, following the good results for French GDP produced in Q3 2007 (as detailed in this post here) - and the weakening performance of the UK economy as the credit crunch starts to really bite, we have a surprising result:

"The size of the British economy has slipped below that of France for the first time since 1999 thanks to the slide in the value of the pound. Sterling’s rapid fall to 11-year lows against European currencies has also pushed Britain into sixth place in the world. The US, Japan, Germany, China and France all had larger economies than the UK in the third quarter of 2007."

Basically the facts behind the story are that in 2006 French GDP was worth €1,792bn compared with £1,304bn for the UK. With sterling worth €1.47 on average in 2006, this put the UK economy comfortably 6.7 per cent ahead of the French one. But with sterling on the slide - it has fallen by more than 10 per cent against the euro in the past six months (to the current €1.32 to the pound), the UK economy entering 2008 is now 4 per cent smaller than France's.

Now this sea change is very likely to produce all kinds of politically motivated commentary, but in economic terms most of that is beside the point. What we have here are two, distantly connected, phenomena. In the first place there is a major currency realignment taking place as I write, and in the second we have very different changes in population growth rates and relative age structures from one developed economy to another at this point (more on this below). If we examine the currency allignment problem first, then we should note that initially this re-alignment produced a steady decline in the value of the dollar and the yen, and a consequent upward movement in the pound sterling and the euro (amongst other developed economy currencies like the Canadian and Australian dollars). But with the new credit conditions some of these previous valuations are no longer really justified, and sterling has been the first to feel the pressure. Those who are in countries which form part of the eurozone should try to avoid any feeling of glee or excess of mirth at this point though, since in all probability the euro will be the next to head south, as housing related crdit crunch issues take their toll in construction driven economies like Ireland and Spain, while the low trend growth ageing societies (Germany and Italy essentially) begin to feel the pressure on exports which comes from the rise in the euro and the slowdown in the global economy (not to mention difficulties which may arise in the context of any large East European correction).

In all probability will all come to a head as and when the ECB have to change course and start to reduce interest rates (as Claus indicates in this post), and at that stage we should expect round two of the currency adjustment (or transition from Brettton Woods II to Bretton Woods III) to lock-in, as the whole batch of developed economy currencies are realigned with the big new players in the emerging economy scene (the yuan, the rupee, the real, the Turkish Lira etc, as explained in this post here). So, with relative currency values set to change and change again (this is what they call volatility), it is hard to draw any meaningful conclusions from this new comparative readout between France and the UK. Other, of course, than to stress that it is always foolish to make too much out of short term transitional currency dynamics.

Institutional Reforms and Demographics


But there is a bigger picture story here, and that is to do with the fact (as Claus tried to sketch out here) that France is far from being the "sick man of Europe" in economic terms, and this is the result of some very important underlying macroeconomic structural features.

This view must surprise some people, since it is obviously a long way away from a lot of conventional wisdom which is being written on the matter. Basically, if you follow the institutional reforms discourse, then the UK should be streaking ahead of France following the latters failure to grasp the nettle and "reform" itself (something, please note, that the present author considers highly desireable in and of itself). But such reforms only focus on micro level phenomena, and do not take into account certain key macro economic trends, and in particular they seem almost never to take into account important macro level phenomena like comparative demographic shifts. What this means quite simply is that something here isn't being measured as it should be, and the outcome is bad results and bad forecasts.

This use of bad arguments (or at best partial ones) also makes it very difficult to persuade some people - in this case French voters - to do something that they are evidently very reluctant to do, and that is support the reform process. When your key argument is flawed, and you can't point to the benefits you would like to point to. This has also recently been made very clear by those eternal "bette noires" of the international financial institutions - Argentina and Thailand - who only last year complained to the world bank that since the normal "competitiveness" indexes were giving them very bad ratings, while at the same time their economies were putting in strong performances, then there must be something wrong with the indexes. I imagine they are still waiting for a coherent reply.

Basically the whole "institutional reforms" story is wrong, not because such micro level competitiveness-oriented reforms are unnecessary (they normally are), but because they are only part of the picture, and thus offer a very misleading perspective. I couldn't help noticing this whole issue in another context this morning, in the Financial Times's recommendations as to how to solve the economic mess which the Spanish economy is now headed towards.

Spain has been content to enjoy the benefits of cheap credit and strong European demand for its goods and services. Unlike France, it has not embarked on the structural reforms needed for longer lasting prosperity.

Mr Zapatero pretends these are not needed. But, if re-elected, he should rethink. Generous tax cuts should be avoided in order to maintain a mildly restrictive fiscal stance. Measures to foster competitiveness are essential. These should include dismantling barriers to competition in retailing, transport and energy. He should ditch a preference for national champions.

Persistent weakness in productivity growth must be addressed too. Recent steps to expand Spain’s small technology base, promote entrepreneurship and bolster its ossified education system are positive. But universities need more independence. Allowing companies to opt out of collective wage deals would make the labour market more flexible. This is far from a comprehensive manifesto. But it is the least Spain must do if it is to remain one of Europe’s pacesetters

Now I think we could pass quietly over the little detail that France is now being cited as a country which is benefiting from structural reform. What is notable about the kind of "rescue package" being proposed for Spain is that it is almost a political manifesto for the coming elections, and it largely ignores the substantial underlying macro economic questions which are in play - like the health of the banking system, some evaluation of the impact of "financial efficiencies", interest rate policy at the ECB, the value of the euro, the presence of five million immigrants (who have largely arrived over the last 6 or 7 years at just the same time as the current account deficit - which the FT does mention -has balooned), the role of the eurosystem and covered bonds in making cheap interest loans available at what were effectively negative real interest rates, etc, etc, etc.

Evidentaly non of this is directly Mr Zapatero's fault, any more than it was Mr Aznar's fault. This is not the moment to attempt a fuller analysis of Spain's current problems - you can find a first attempt at getting to grips with these here. Rather my objective is to point out that basing yourself on micro economic analysis alone you will never get to the heart of major economic issues which face us. And this is what the current mainstream economic discourse seems to do, spilling in the process and excessive amount of ink about shop opening hours, flexible labour contracts, and privatisation of "national champions" (all of which, please note, may well be a good idea, but I can tell you now, none of these are going to get Spain out of the problem which is about to arrive, nor, for that matter, will they prevent the inflation bonfire from roaring away in Eastern Europe).

The theoretical issues which are involved in trying to understand why France is so apparently robust, while Germany, for example, is so fragile are hard to get to grips with. I have had a first stab at offering and explanation in this post here. Doubtless there is still a lot more to do and a lot more to adequately understand, but for now I would simply to present a couple of "exhibit A" type charts, and cite a piece of standard neo-classical growth theory. The piece in question is not any old piece, it is infact the cornerstone on which most of the present economic micro analyses are based. The problem is it may actually turn out to be wrong.


First the charts. These are based on data prepared by Eurostat, and show the volume index of GDP per capita as expressed in Purchasing Power Standards (PPS) (with the European Union - EU-27 - average set at 100). If the index of a country is higher than 100, then this country's level of GDP per head is higher than the EU average and vice versa. Basic data is expressed in PPS which then effectively becomes a common currency eliminating differences in price levels between countries and thus making possible meaningful volume comparisons of GDP between countries. Please note that the index, since it is calculated from PPS figures and expressed with respect to EU27 = 100, is valid for cross-country comparison purposes rather than for individual country inter-temporal comparisons. Nonetheless these charts are extraordinarily revealing.






I have presented these charts in two separate groups. The first is a high-population-growth (near replacement fertility) group, and the second is a low-to-declining-population growth (lowest-low fertility) group. As we can see, in PER CAPITA income growth terms all three of the former hold their comparative position much better than all (or any) of the latter three. The reason why this is the case is not hard to get at since the first three are all ageing much less rapidly than the latter three. So population median age does seem to matter. Worse, for conventional theory, rising population is not necessarily a negative factor for economic growth. Now this finding is important, since Mankiw, Romer and Weil begin what has become a highly influential paper - A Contribution To the Empirics of Economic Growth (see bibliography below) - in the following way:

This paper takes Robert Solow seriously. In his classic 1956 article Solow proposed that we begin the study of economic growth by assuming a standard neoclassical production function with decreasing returns to capital. Taking the rates of saving and population growth as exogenous, he showed that these two variables determine the steady-state level of income per capita. Because saving and population growth rates vary across countries, different countries reach different steady states. Solow's model gives simple testable predictions about how these variables influence the steady-state level of income. The higher the rate of saving, the richer the country. The higher the rate of population growth, the poorer the country.

That is, Solow offers us two testable predictions, and one of them - in the case of higher median age societies at any rate - seem to turn out to be false. So this isn't simply an issue of longer shop opening hours, or some such. There are bigger fish on the plate to be eaten for dinner here.

As I say, all of this still needs a lot of work, and really the argument is only in its initial stages. But what I would argue is that - and again looking at what is currently happening with inflation in Eastern Europe only gives me more power to my elbow I think - the whole idea that fertility wasn't important in the longer run needs to be reexamined, and quickly.

Lastly, oh what the hell, some more charts, this time showing the comparative rates of population growth between the above mentioned countries.

Of course, the observant eye, and the thoughtful reader (who can still remember the starting point of this post) will note that in actual fact the UK and France are moving up in population terms more or less in tandem (so we should expect their relative GDP values to fluctuat more or less as their currency value does). More to the point both of them are catching up on Germany fast. If present trends continue (and possibly even accelerate) the point is not that far off when France may not only overtake the UK in GDP terms, she may even overtake Germany too!


Bibliography


Mankiw, N. Gregory, David Romer, and David N. Weil, “A Contribution to the Empirics of Economic
Growth”, Quarterly Journal of Economics, 107, May 1992, 407-37.