One of the reasons that it is been so hard for a lot of analysts, even trained economists, to understand the imbalances that were at the root of the current crisis is that we too easily confuse national savings with household savings. By coincidence there was recently a very interesting debate on the subject involving several economists, and it is pretty clear from the debate that even accounting identities can lead to confusion.

The difference between household and national savings matters because of the impact of national savings on a country’s current account, as I discuss in a recent piece in Foreign Policy. In it I argue that we often and mistakenly think of nations as if they were simply very large households. Because we know that the more a household saves out of current income, the better prepared it is for the future and the more likely to get rich, we assume the same must be true for a country. Or as Mr. Micawber famously insisted:

Annual income twenty pounds, annual expenditure nineteen six, result happiness. Annual income twenty pounds, annual expenditure twenty pound ought and six, result misery. 

But countries are not households. What a country needs to get wealthier is not more savings but rather more productive investment. Domestic savings matter, of course, but only because they are one of the ways, and probably the safest, to fund domestic investment (although perhaps because they are the safest, investment funded by domestic savings can also be misallocated for much longer periods of time than investment funded by external financing).

Saving in itself, however, does not create wealth. It is productive investment that creates wealth. Domestic savings simply represent a postponement of consumption.

In a closed economy, total savings is equal to total investment or, to put it differently, whatever we don’t consume we invest (if we produce something that we neither consume nor invest, we effectively write its value down to zero, so the balance remains). In an open economy, if a country saves more than it invests it must export the excess savings. It must also export the excess production.

Notice that by definition if a country saves more than it invests, total consumption plus total savings must be greater than total consumption plus total investment. The former is the sum of the goods and services it creates, whereas the latter is the sum of goods and services it absorbs. That country, in other words, supplies more goods and services than it absorbs, and so it must export the excess.

What is more, by exporting excess savings, the country is providing the funding to foreigners to purchase its excess production. This is why the current account and the capital account for any country must always add up to zero.

In the late 19^th Century, as I discuss in my most recent book, economists like John Hobson in the UK and Charles Arthur Conant in the US noticed that the rich countries of the west were exporting large amounts of savings abroad – mostly to what were later called by the dependencia theorists of the 1960s the peripheral nations. Hobson and Conant argued that the reason for this excess savings had to do with income inequality. As more and more wealth is concentrated into the hands of fewer people, consumption rises more slowly than production, largely because the wealthier a person gets, the smaller the share he consumes out of his income. Notice that because savings is simply total production of goods and services minus total consumption, this forces up the national savings rate.

This was a very important insight. Excess savings, they pointed out, was not a result of old-fashioned thrift but rather a consequence of structural distortions in the economy. The consequence of this “thrift”, furthermore, was not greater wealth but rather structural imbalances in the global economy.

In a closed economy there are four ways of resolving the imbalances caused by an increase in the savings rate. First, and most obviously, investment can rise by the same amount.

The private sector, however, may be reluctant to increase investment if it believes the consumption share is declining over the long term, in which case the government can sponsor the increase in investment, for example in infrastructure, so that savings and investment balance at a higher rate. This is sustainable only as long as there are productive investments that can be made, but as consumption declines, the reason for investing should decline too. The purpose of investment today after all is to create consumption tomorrow.

The second way to resolve the imbalance is if the government or the labor unions take steps to redistribute income downwards. As middle class and poor households retain a greater share of total GDP, consumption will automatically rise relative to production (the savings rate declines), even if middle class and poor households save a greater share of their higher income. The savings rate declines to the point at which savings and investment are once again balanced domestically and everything a country makes it consumes or invests.

The third way to resolve this in a closed economy – albeit only temporarily – is to fund a consumption boom among the not-so-rich. How would this work? One way might be, as Conant discusses extensively, that as savings grow faster than opportunities for productive investment in infrastructure and production capacity, more and more of the savings of the wealthy go into speculative investments that drive up asset prices – homes, stocks and bonds. As asset prices rise, households feel richer and they begin to take advantage of the abundance of savings to borrow for consumption, and borrowing is just negative savings.

As home prices or the value of investment portfolios rise there is likely to be not just an increase in consumption but also an increase in investment in new housing. As both of these happen, the reduction in consumption caused by rising income inequality is matched by the increase in consumption caused by credit-fueled purchasing and an increase in housing investment, and once again savings and investment can balance domestically. We saw this happen in the US and in the peripheral countries of Europe in the run-up to the 2007-09 crisis.

The fourth way to resolve the savings imbalance in a closed economy is to force up unemployment (this is what Karl Marx said would eventually happen). As income inequality grows, and so consumption grows more slowly than production, companies are forced to cut production and fire workers. Fired workers of course produce nothing, but they still consume, either out of savings, welfare payments, or handouts from friends and families. This causes total savings to drop so that once again it balances investment, but of course in an economy with rising unemployment, profits are likely to drop, and with lower profits comes reduced investment, so more workers need to be fired and the process can become self-reinforcing.

Open economies have another option

In a closed economy there really aren’t many other ways to balance savings and investment if structural factors force up the savings rate. But we do not live in closed economies. Most of us live in open economies (although the world itself is a closed economy), so there is actually a fifth way to resolve domestic savings imbalances, and this is what Hobson and Conant described as the root source of late 19^th Century imperialism.

If domestic savings rates are so high that the country cannot invest it all profitably, it can export those savings, which means automatically that it imports foreign demand for its excess production. Its net export of savings (less net returns on earlier investment) is exactly equal to its net export of goods and services.

In an open economy, in other words, a country’s total savings matters because to the extent that it exceeds investment, it must be exported, and it must result in a current account surplus. Here is where the confusion so many analysts, including economists, have about the difference between national and household savings. Household savings represent the amount out of household income that a household chooses not to consume, and so can be affected by cultural or demographic factors, the existence and credibility of a social safety net, the sophistication of consumer finance, and so on.

The national savings rate, on the other hand, includes not just household savings but also the savings of governments and businesses. It is defined simply as a country’s GDP less its total consumption. While the household savings rate may be determined primarily by the cultural and demographic preferences of ordinary households, the national savings rate is not. Indeed in some cases the household share of all the goods and services a country produces, which is primarily a function of policies and economic institutions, is the main factor affecting the national savings rate.

National savings, in other words, may have very little to do with household preferences and a lot to do with policy distortions. In China, which has by far the highest savings rate in the world, part of the reason for the high national savings rate of course is that Chinese households save a relatively high proportion of their income.

But while China’s savings rate is extraordinarily high, the Chinese household savings rate is merely in line with those of similar countries in the region, and in fact lower than some. Chinese households are not nearly as thrifty as their national savings rate implies. Why, then, is China’s savings rate so extraordinarily high?

The main reason, as I have discussed many times and which now has pretty much become accepted as the consensus among China specialists, is not so much income inequality (although this is certainly a problem in China) but rather the very low household income share of GDP. At roughly 50% of GDP, Chinese households retain a lower share of all the goods and services the country produces than households in any other country in the world.

This is a consequence of policies Beijing put into place many years ago that goose GDP growth by constraining the growth in household income. As a result of these policies, the household share of China’s total production of goods and services has been falling for thirty years, and fell especially sharply in the past decade. It isn’t surprising, consequently, that as households earn a declining share of what China produces, they also consume a declining share. Because savings is simply GDP less total consumption, and most consumption is household consumption, the fall in the household income share of GDP is the obverse of the rise in China’s extraordinarily high savings rate.

Many factors explain this very low household income share in China, including most importantly financial repression, whose characteristics typically include artificially low deposit rates, which, by reducing the amount of money that a saver should earn on his bank deposit, transfers part of his income to borrowers, who are able to borrow very cheaply. In China, this implicit transfer is extremely high, perhaps 5 percent of China’s GDP or more.

Of course the more money that is transferred in this way, the less disposable income the household depositor has, and so he is forced to reduce both his nominal savings and his nominal consumption. We cannot easily predict how this reduced interest rate will affect the household savings rate, but it is pretty easy to figure out how it will affect the national savings rate. If the transfer is substantial, it will reduce the share of GDP retained by households. Unless households reduce their savings rate by more than the reduction in the household share of GDP, it must automatically force up the national savings rate.

Confusing thrift with inequality

China’s extraordinarily high national savings rate, in short, is a function primarily of the extraordinarily low household share of GDP. Even economists who really should know better manage to make some fairly impressive mistakes when they discuss Chinese and other savings imbalances, mostly because their understanding of savings can be hopelessly confused. For a typical example, consider a piece Raman Ahmed and Helen Mees, published last year called, “Why do Chinese households save so much?”

In the article the authors try to address the causes of China’s high savings rate, but they do so by thoroughly confusing national savings with household savings. For example they set out trying to prove that financial repression has no impact on China’s savings rate, but because they fail to understand that financial repression does this by reducing the household share of income, and not necessarily by reducing the household savings rate, they find:

China’s monumental savings rate is a popular topic of for policy discussion.  It has been blamed for the global financial crisis, currency wars, and the ensuing Great Recession. But what explains the high savings rate?

…Although the savings rate varies significantly per income group, with the lowest income group’s savings rate in urban areas in the single digits and the highest income group’s savings rate at almost 40% of disposable income, we do not find evidence that income inequality as such is a motive for households to save a larger portion of their income, as Jin et al. (2010) have suggested. It would have been the Chinese version of ‘keeping up with the Joneses’, albeit that ‘keeping up with the Wangs’ would not have involved conspicuous consumption but rather conspicuous saving. This would have instigated higher savings rates across the board of deciles of savings rates, with the strongest effect on low-income households. However, using urban data on household savings rates and income inequality from 1985-2009, we do not find this effect present.

There is no evidence that the household savings rate in China is high because of low deposit rates, as Michael Pettis (2012) has asserted time and again, which would indicate that the income effect of lower deposit rates trumps the substitution effect of lower deposit rates. The coefficient of the deposit rate has alternating signs, but is insignificant in every single estimate.

The article purports to discuss what they refer to as China’s “monumental savings rate”, which, according to the authors, has been blamed for the global financial crisis, currency wars, and the ensuing Great Recession, but it focuses on the wrong savings rate. Chinese household savings are not by any definition “monumental”, and they most certainly did not cause the global financial crisis, nor does anyone seriously claim that they did. Chinese household savings rates are high, but not exceptionally high, and because household income is such a low share of GDP, Chinese household savings as a share of GDP, which is what really matters, are even lower than the household savings rate would imply. Chinese household savings are not the problem.

It is China’s national savings rate which is “monumental” and which drives China’s current and capital account imbalances, and the national savings rate is monumentally high because the national consumption rate (which consists mostly of the household consumption rate) is extraordinarily low. The authors have either confused national and household savings rates or they have failed to see that what matters is not the household savings rate but rather total savings. Aside from the fact that there is indeed evidence that Chinese savings are negatively correlated with interest rates, for example a 2011 study done by the IMF, the relationship is one of pure logic.

The important lesson from this article, aside from suggesting just how confused many economists are when it comes to understanding the source of global imbalances, is that national savings represent a lot more than the thriftiness of local households, and as such it has a lot less to do with household or cultural preferences than we think. In fact many factors affect the savings rate of a country, including demographics, the extent of wealth inequality, and the sophistication of consumer credit networks, but when a country has an abnormally high savings rate it is usually because of policies or institutions that restrain the household share of GDP.

This has happened not just in China but also in Germany. In the 1990s Germany could be described as saving too little. It often ran current account deficits during the decade, which means that the country imported capital to fund domestic investment. A country’s current account deficit is simply the difference between how much it invests and how much it saves, and Germans in the 1990s did not always save enough to fund local investment.

But this changed in the first years of the last decade. An agreement among labor unions, businesses and the government to restrain wage growth in Germany (which dropped from 3.2 percent in the decade before 2000 to 1.1 percent in the decade after) caused the household income share of GDP to drop and, with it, the household consumption share. Because the relative decline in German household consumption powered a relative decline in overall German consumption, German saving rates automatically rose.

Notice that German savings rate did not rise because German households decided that they should prepare for a difficult future in the eurozone by saving more. German household preferences had almost nothing to do with it. The German savings rate rose because policies aimed at restraining wage growth and generating employment at home reduced household consumption as a share of GDP.

As national saving soared, the German economy shifted from not having enough savings to cover domestic investment needs to having, after 2001, such high savings that not only could it finance all of its domestic investment needs but it had to invest abroad by exporting large and growing amounts of savings. As it did so its current account surplus soared, to 7.5 percent of GDP in 2007. Martin Wolf, in an excellent Financial Times article on Wednesday on the subject, points out that

between 2000 and 2007, Germany’s current account balance moved from a deficit of 1.7 per cent of gross domestic product to a surplus of 7.5 per cent. Meanwhile, offsetting deficits emerged elsewhere in the eurozone. By 2007, the current account deficit was 15 per cent of GDP in Greece, 10 per cent in Portugal and Spain, and 5 per cent in Ireland.

Employment policies and the savings rate

It is tempting to interpret Germany’s actions as the kind of far-sighted and prudent actions that every country should have followed in order to keep growth rates high and workers employed, but it turns out that these policies did not solve unemployment pressures in Europe, and this is implied in the second sentence of Martin Wolf’s piece. Germany merely shifted unemployment from Germany to elsewhere. How? Because Germany’s export of surplus savings was simply the flip side of policies that forced the country into running a current account surplus.

To explain, let us pretend that Europe consists of only two countries, Spain and Germany. As we have already shown, forcing down the growth rate of German wages relative to GDP caused the household income share of GDP to drop. Unless this was matched by a decision among German households to become much less thrifty, or a decision by Berlin to increase government consumption sharply, the inevitable consequence had to be a reduction in the overall consumption share of GDP, which is just another way of saying that the German national savings rate had to rise. During this period, by the way, and perhaps as a consequence of restraining wages, Germany’s Gini coefficient seems to have risen quite markedly, and the resulting increase in income inequality also affected savings adversely.

As German savings rose, eventually exceeding German investment by a wide margin, Germany had to export the difference, which its banks did largely by making loans into the rest of Europe, and especially those countries that were financially “shallower”. Declining consumption left Germany producing more goods and services than it could absorb domestically, and it exported excess production as the automatic corollary to its export of savings.

Of course the rest of the world had to absorb excess German savings and run the current account deficits that corresponded to Germany’s surpluses. This was always likely to be those eurozone countries that joined the monetary union with a history of higher inflation and currency depreciation than Germany – countries which we are here calling “Spain”. As monetary policy across Europe was made to fit German needs, which was looser than that required by Spain, and as German savings were intermediated by German banks into Spain, the result was likely to be higher wage growth, higher inflation, and soaring asset prices in Spain.

In fact this is exactly what happened. Spain and the other peripheral European countries all saw their trade deficits expand dramatically or their surpluses (many were running large surpluses in the 1990s) turn into large deficits shortly after the creation of the single currency as their savings rates shifted to accommodate German exports of its excess savings.

The way in which the German exports of savings were absorbed by Spain is at the heart of the subsequent crisis. As long as Spain could not use interest rates, trade intervention, or currency depreciation to block German exports, it had no choice but to balance the excess of German savings over investment. This meant that either its investment would have to rise or its savings would have to fall (or both).

Both occurred. Spain increased investment in infrastructure and in real estate (and less so in manufacturing, probably because German growth occurred at the expense of the manufacturing sectors in the rest of Europe), but it seems to have done both to excess, perhaps because of the sheer amount of capital inflows. After nearly a decade of inflows larger than any it had ever absorbed before, Spain, like nearly every country in history under similar circumstances, ended up with massive amounts of misallocated investment.

But this was not all. If the savings that Germany exported into Spain could not be fully absorbed by the increase in Spanish investment, the only other way to balance was with a sharp fall in Spanish savings. There are two ways Spanish savings could have fallen. First, as the Spanish tradable goods sector lost out to German competition, Spanish unemployment could rise and so force down the Spanish savings rate (unemployed workers still must consume).

Second, Spain could have reduced household savings voluntarily by increasing consumption relative to income. Higher Spanish consumption would cause enough employment growth in the services and real estate sectors to make up for declining employment in the tradable goods sector.

Raising consumption

Not surprisingly, given the enormous optimism that accompanied the creation of the euro, the latter happened. As German money poured into Spain, helping ignite a stock and real estate boom, ordinary Spaniards began to feel wealthier than they ever had before, especially those who owned their own homes. Thanks to this apparent increase in wealth, they reduced the amount they saved out of current income, as households around the world always do when they feel wealthier. Together the reduction in Spanish savings and the increase in Spanish investment (in infrastructure and real estate) was enough to absorb the full extent of Germany’s export of excess savings.

But at what cost? The imbalance created within Europe by German policies to constrain consumption forced Spain into increasing consumption and boosting investment, much of the latter in wasted real estate projects (as happened in every one of the deficit countries that faced massive capital inflows). There are of course no shortage of moralizers who insist that greed was the driving factor and that Spain wasn’t forced into a consumption boom. “No one put a gun to their heads and forced them to buy flat-screen TVs”, they will say,

But this completely misses the point. Because Germany had to export its excess savings, Spain had no choice except to increase investment or to allow its savings to collapse, with the latter either in the form of a consumption boom or a surge in unemployment. No other option was possible.

To insist that the Spanish crisis is the consequence of venality, stupidity, greed, moral obtuseness and/or political short-sightedness, which has become the preferred explanation of moralizers across Europe begs the question as to why these unflattering qualities only manifested themselves after Spain joined the euro. Were the Spanish people notably more virtuous in the 20^th century than in the 21^st? It also begs the question as to why vice suddenly trumped virtue in every one of the countries that entered the euro with a history of relatively higher inflation, while those eastern European countries with a history of relatively higher inflation that did not join the euro managed to remain virtuous.

The European crisis, in other words, had almost nothing to do with thrifty Germans and spendthrift Spaniards. It had to do with policies aimed at boosting German employment, the secondary impact of which was to force up German national savings rates excessively. These excess savings had to be absorbed within Europe, and the subsequent imbalances were so large (because German’s savings imbalance was so large) that they led almost inevitably to the circumstances in which we are today.

For this reason the European crisis cannot be resolved except by forcing down the German savings rate. And not only must German savings rates drop, they must drop substantially, enough to give Germany a large current account deficit. This is the only way the rest of Europe can unwind the imbalances forced upon the region in a way that is least damaging to Europe as a whole. Only in this way can countries like Spain stay within the euro while bringing down unemployment.

But lower German savings don’t mean that German families should become less thrifty, only that the average German household should be allowed to retain a much larger share of what Germany produces. If Berlin were to cut consumption taxes, or cut income taxes for the lower and middle classes, or force up wages, total German consumption would rise relative to GDP and so national savings would fall – without requiring any change in the prudent behavior of German households.

To ask Spanish households to be more “German” by saving more is not only impractical in an economy with 25 percent unemployment (it is hard for unemployed workers to increase their savings), it is counterproductive. Lower Spanish consumption can only cause even higher Spanish unemployment, until eventually Spain will be forced to abandon the euro and so regain control of its ability to absorb or reject German imbalances. This abandonment of the euro will be driven by the political process, as those in the leadership (of both main parties) who refuse to countenance talk of leaving the euro lose voters to more radical parties until they, too, come around:

The latest opinion polls show the PP has lost 10 percentage points of support since Rajoy’s election in November 2011. Support for the main opposition group, the Socialists remains unchanged, while backing has been growing for smaller, more radical, parties. More than 68 per cent of Spaniards say the government is doing a bad or very bad job, while the latest official forecast shows that a quarter of the workforce will still be out of work three years from now.

An article in this week’s Economist suggests that Spain is indeed becoming more “German” and so that this is reason for hope:

Is Spain the next Germany? It may not feel like that to the 26% of Spaniards who are unemployed. GDP shrank by 0.8% in the fourth quarter of 2012. Yet in some ways, Spain resembles the Germany of a decade ago, when Gerhard Schröder brought in reforms to turn the sick man of Europe into its strongest economy. The efforts by Mariano Rajoy’s government to loosen labour laws and cut public spending are aimed at a German-style miracle.

…Joachim Fels, chief economist at Morgan Stanley, is one of several backers of the Germany theory. “Spain is doing a lot of the things Germany did ten years ago, but in a much shorter time span and tougher global conditions,” he says, pointing to falling labour costs, rising exports and booming Spanish car factories. But, he adds, “Spain becoming Germany is really a two- to four-year story.”

The global constraints

The problem with this argument may be, however, that the global conditions that allowed Germany to grow by exporting savings to Spain cannot be replicated. If Spain were to make its workers more competitive by reducing wage growth relative to GDP growth, it would implicitly be forcing up its savings rate to generate employment. To whom would Spain export those savings? The world is awash in excess savings, and unlike in pre-crisis days, there are no countries with booming stock and real estate markets willing to fund another consumption binge. This means that Spain and Europe are expecting to recover by exporting unemployment, but to whom?

In fact this is the great worry that Martin Wolf expresses n the conclusion to his article:

A big adverse shock risks turning low inflation into deflation. That would aggravate the pressure on countries in crisis. Even if deflation is avoided, the hope that they will grow their way out of their difficulties, via eurozone demand and internal rebalancing, is a fantasy, in the current macroeconomic context.

That leaves external adjustment. According to the IMF, France will be the only large eurozone member country to run a current account deficit this year. It forecasts that, by 2018, every current eurozone member, except Finland, will be a net capital exporter. The eurozone as a whole is forecast to run a current account surplus of 2.5 per cent of GDP. Such reliance on balancing via external demand is what one would expect of a Germanic eurozone.

If one wants to understand how far the folly goes, one must study the European Commission’s work on macroeconomic imbalances. Its features are revealing. Thus, it takes a current account deficit of 4 per cent of GDP as a sign of imbalance. Yet, for surpluses, the criterion is 6 per cent. Is it an accident that this happens to be Germany’s? Above all, no account is taken of a country’s size in assessing its contribution to imbalances. In this way, Germany’s role is brushed out. Yet its surplus savings create huge difficulties when interest rates are close to zero. Its omission makes this analysis of “imbalances” close to indefensible.

The implications of the attempt to force the eurozone to mimic the path to adjustment taken by Germany in the 2000s are profound. For the eurozone it makes prolonged stagnation, particularly in the crisis-hit countries, highly likely. Moreover, if it starts to work, the euro is likely to move upwards, so increasing risks of deflation. Not least, the shift of the eurozone into surplus is a contractionary shock for the world economy. Who will be both able and willing to offset it?

The eurozone is not a small and open economy, but the second-largest in the world. It is too big and the external competitiveness of its weaker countries too frail to make big shifts in the external accounts a workable post-crisis strategy for economic adjustment and growth. The eurozone cannot hope to build a solid recovery on this, as Germany did in the buoyant 2000s. Once this is understood, the internal political pressures for a change in approach will surely become overwhelming.

As long as it is part of the euro Spain has no choice but to respond to changes in German savings rates. There is nothing mysterious about this process. It is simply the way the balance of payments works, and thrift has nothing to do with it. If Germany does not take steps to force down its savings rate by increasing the household share of GDP, then either all of Europe becomes like Germany, in which case growth slows to a crawl and some other country – maybe the US? – will be forced to resolve Europe’s demand deficiency either through higher unemployment or through higher debt, or Europe must break apart to free Spain and the other peripheral countries from German savings imbalances.

I don’t imagine the rest of the world can absorb demand deficiency from a Germanic Europe, and if Europe tries to force it the result will almost certainly be an eventual collapse in trade relations, so either Germany rebalances or Europe breaks apart. It is hard for me to see many other options.

I am writing this in part because of a back and forth between Ryan Avent on Free Exchange and Paul Krugman at the New York Times and Tyler Cowen and Alex Tabarrok at Marginal Revolution where I think some of the assumptions made about German policy views on inflation are incorrect. 

The general consensus about the euro crisis is that it involves three separate adjustments beyond bank and private sector balance sheets. And these are on the wage/labour side, as well as regarding fiscal and monetary policy. Europe is using this three-legged policy stool as the basis for reform in the periphery. However, as I noted last week, although the ECB claims to have loose monetary policy, the Europeans are trying to effect change within a framework that involves contractionary fiscal policy without any currency offset. This is very different from what Japan is doing, which is short-term stimulative in both fiscal and monetary policy as well as via currency depreciation. I believe the policy mix is debt deflationary as it forces a herculean adjustment onto the private sector that weakens balance sheets and leads to defaults that exacerbate financial sector weakness.

In that context, the question is how can the euro zone rebalance economies given the constraints of the euro and the ECB’s limited mandate. A lot of people point to inflation. The theory is that if you get the Germans to inflate their domestic economy and add to aggregate demand, then the periphery would not have to go so heavy on so-called internal devaluation, wage and price cuts, to regain external competitiveness. The theory here is that the Germans are preventing this from happening because their hyperinflation 90 years ago is still such a huge trauma that they are completely irrational about crisis solutions. And so the pain continues.

There are two problems with this. First, as Tyler Cowen points out, wage competitiveness is not enough to restore the periphery to its glory days:

this mechanism solves (at best) only one of the core problems of the eurozone, namely incorrect relative prices between Portugal and Germany.  It helps less with the “Portuguese nominal wages are too high” problem, the “Portuguese banks are not sound” problem, and the “Portugal badly needs structural reform” problem, among other difficulties.  The inflation would be an easier sell to the German public if it really would set the rest of the eurozone right, but that is a difficult case to make.

The second problem here is that for at least a full year, the German government has openly supported a medium-term higher inflation target for the German domestic economy. The FT reported last May that German Finance minister Wolfgang Schäuble was willing to temporarily allow inflation to tick up in Germany in order to aid re-balancing:

Wolfgang Schäuble, German finance minister, has given vital political cover to the Bundesbank, speaking out in support of the idea that Germany could tolerate a rate of inflation above the eurozone average.

Making a rare exception to the rule that Berlin does not comment on central bank policy, Mr Schäuble declared that price rises “in a corridor between 2 and 3 per cent” would be “tolerable” in Germany – slightly above the European Central Bank’s target of keeping average inflation across the eurozone at close to but below 2 per cent.

His statement followed comments before a parliamentary committee on Wednesday by a Bundesbank official, who cautioned that the eurozone’s largest economy might face “an inflation rate somewhat above average” as the likes of Greece and Portugal squeezed prices and wages to regain competitiveness.

There were rumours that the  Bundesbank was also in favour of allowing German domestic inflation to increase but Bundesbank head Weidmann denied this subsequently.

But here’s what we know that has happened since Wolfgang Schäuble formally announced the German government was willing to let inflation in Germany rise:

• Mario Draghi started the OMT program in order to avert crisis in Spain. Under the guidelines of the program, the euro bailout funds could buy euro government sovereign debt at auction with unlimited support in the secondary market from the ECB if the particular government agreed to enter a Troika program of fiscal and structural reforms. This was a dodge on monetary financing of national governments using the Troika program as cover to demonstrate that the ECB was not facilitating fiscal profligacy. Of particular note here is that German ECB member Jörg Asmussen was a vocal supporter of this policy and he was backed by German Chancellor Angela Merkel over Bundesbank head Jens Weidmann.
• Germany acquiesced to demands for above-inflation rates of wage increase for public sector workers in March. That means the German government is officially allowing wage inflation to resume in Germany after a decade in which wage suppression was seen as central to the revitalization of Germany’s export machine. Private sector workers are now agitating for the same.
• Angela Merkel made the unusual step of commenting on monetary policy last month, ahead of an ECB rate cut, specifically noting to German bankers that ECB policy is not just for Germans. While the press made it seem like she was interfering to keep interest rates high, it was clear to anyone who understands German politics that it was just the opposite.

To me, this looks increasingly like an orchestrated campaign on the part of the Merkel-led government in Germany to prepare the German people for higher inflation as a price they should willingly pay for the euro and European cohesion. Moreover, for a year now, official stated German policy is that inflation can move to 3% over the medium-term and that would sit well with the German government. So, it’s a complete myth that the Germans are still trapped in the hyperinflationary mindset of 90 years ago. And anyway, it was always the positive legacy of the strong D-Mark during Germany’s post-World War 2 economic miracle that counted most regarding German views on inflation and monetary policy.

Does all this matter though?

I would argue it doesn’t really. Euro zone inflation is at a 3-year low of 1.2% and falling. Right now deflation and debt deflation are the real concern for Europe, not inflation, irrespective of what Schäuble says about policy. That’s because the euro mandates this. The Maastricht Treaty 3/60 deficit/debt hurdles and the ECB’s no-monetisation clauses are etched in stone. Europe has been quite pragmatic in figuring out ways to flout both of these tenets because of the crisis but policy makers are not willing to completely disregard the rules. And those rules are both deflationary and pro-cyclical during an economic downturn – all the more so, given the severity of this downturn.

Moreover, as I have been arguing for months now, Germany is concerned about its own public finances. So when Angela Merkel says Germany is “too weak for more fiscal stimulus“, that’s what she’s talking about. People seem to forget that it was the capital markets that forced the periphery, as users of currency without an ECB backstop, into the sovereign debt crisis – not the Germans. The Germans too are afraid that they are one sovereign or bank bailout away from meeting the same fate and so they too are constrained fiscally.

Equally, the ECB, despite providing easy money to euro banks – even allowing insolvent Cypriot banks to tap the ELA for months despite their obvious insolvency, has limits imposed by the euro. No-bailout, no-monetisation has meant that the ECB cannot buy up sovereign debt the way the Japanese, British and American central banks are. And they had to jury-rig the OMT into place when it became clear the euro zone faced an existential crisis in Spain. And even there, the German courts might overrule. So, again the euro is a restriction that places downward pressure on inflation and growth in Europe.

I don’t expect any of this to change. Germany is completely willing to make sacrifices for the sake of the euro zone. But those sacrifices are limited by how the euro zone is set up. It’s almost irrelevant whether the Germans are willing to set a higher inflation target when fiscal policy is contractionary and the central bank’s only mandate is to keep inflation low.

The problem is not Germany. The problem is the euro.

Source: Marginal Revolution, The Economist, Marginal Revolution, NYTimes

Moody’s Investors Service has today upgraded Turkey’s government bond ratings by one notch to Baa3 from Ba1, and has assigned a stable outlook.

The key drivers for today’s rating action are:

1. Recent and expected future improvements in key economic and public finance metrics.

2. Progress on structural and institutional reforms that Moody’s expects will reduce existing vulnerabilities to shocks to international capital flows over time.

Moody’s decision to assign a stable outlook on Turkey’s ratings reflects the rating agency’s expectation of continued prudence in the management of public finances and sustained momentum behind current structural and institutional reforms.

RATINGS RATIONALE

The first driver underlying Moody’s decision to upgrade Turkey’s sovereign rating to Baa3 is the improvement in the country’s economic and fiscal metrics. Since the beginning of 2009, Turkey’s debt burden has fallen by 10 percentage points to a manageable 36% of GDP, and Moody’s expects this decline to continue in the coming years. Moreover, Turkey’s ability to finance its outstanding stock of debt is supported by the relatively low and decreasing share of its debt that is denominated in foreign currency (it has fallen from 46.3% in 2003 to 27.4% in 2012). The maturity profile of the central government’s debt stock has also lengthened significantly to 4.6 years (and the maturity of its foreign debt stock is now over 9 years), which reduces its vulnerability to interest-rate increases. Furthermore, the government’s revenue streams have demonstrated resilience in recent years. For example, even in the face of contraction in real GDP growth by 4.8% in 2009, general government revenues increased by over two percentage points in that year and have remained on an upward trajectory since that time. These improvements, when considered in conjunction with the size, wealth, and diversification of the domestic economy, increase the sovereign’s ability to withstand a crystallisation of balance of payment risks over the short to medium term.

The second driver of today’s rating action is the progress that the government has made on a wide-ranging institutional reform programme that Moody’s believes will gradually erode the country’s external vulnerabilities over a longer time horizon. The government’s policy actions are addressing the role that energy plays in driving up the current account deficit, the weak savings rate and the country’s overall competitiveness. Taken as a whole, this reform agenda reflects that the government is taking action to address these vulnerabilities. For example, on 1 January 2013, a new incentive scheme to increase investment in personal pensions came into effect, further to which the number of participants and the amount of contributions increased by 13.5% and 12.1% in the first four months of the year, respectively, thereby significantly outpacing the kind of growth observed over calendar year 2012. The government has also adopted a new commercial code in 2012 that will improve corporate governance standards and overall competitiveness. Moreover, with a view to addressing the structural underpinnings of Turkey’s external vulnerabilities, the government is pursuing a strategy of focusing on energy efficiency and reducing reliance on imported hydrocarbons through nuclear power, domestic energy sources and renewables. Energy imports are a key contributor to the current account deficit (in fact, in 2012, the current account deficit, excluding energy, registered a small surplus), and Moody’s expects that the government’s energy policy will cause those pressures to decline over time.

More generally, Turkey’s rating is appropriately positioned at Baa3 because its key economic and public finance metrics, which are generally stronger than those of Baa3-rated peers, balance out its external vulnerabilities, which are generally greater than those of most other Baa3 issuers. Specifically, Turkey’s economic strengths — its size, wealth, economic diversification and growth prospects — and its public finances are stronger than many other countries in its rating category. However, Turkey has some of the highest external vulnerabilities — as measured by the current account deficit and the external vulnerability indicator (which measures short-term foreign debt obligations in the economy as a proportion of foreign exchange reserves) — within the investment-grade sovereign rating universe. These sources of vulnerability have weighed on the rating and will likely continue to do so for some time. All told, the balance between Turkey’s fundamental strengths and ongoing vulnerabilities has shifted to a stronger overall credit risk profile due to improved competitiveness, structural economic reform, and increasingly robust government financial strength.

WHAT COULD MOVE THE RATING UP/DOWN

According to Moody’s, upward movement in Turkey’s sovereign rating will be constrained by balance-of-payments factors while external imbalances remain large. Upward rating pressure could materialise in the event of structural reductions in these vulnerabilities or further improvements in Turkey’s institutional environment or competitiveness. Reductions in political risk that may emanate from progress on the peace process with the Kurdish insurgency, while credit positive, would not result in upward rating action in the absence of other credit improvements.

Moody’s would consider downgrading Turkey’s sovereign rating if improvements in the public finances were to be materially reversed. A sudden and sustained halt in foreign capital flows would also exert downward pressure on the rating.

COUNTRY CEILINGS

As part of today’s rating actions, Moody’s has adjusted Turkey’s long-term foreign-currency bond ceiling to Baa1 from Baa2, and its long-term foreign-currency deposit ceiling to Baa3 from Ba2. Turkey’s short-term foreign-currency deposit ceiling has risen to P-3 from NP; the country’s short-term foreign-currency bond ceiling remains at P-2. There are no changes to Turkey’s A3 local-currency bond and deposit ceilings.

The principal methodology used in this rating was Sovereign Bond Ratings published in September 2008. Please see the Credit Policy page on www.moodys.com for a copy of this methodology.

You can see from the chart provided by the house price index that there actually was a housing bust in Canada during the global financial crisis with year-on-year declines reaching 6%. What has separated Canada from other markets where there has been talk of a housing bubble is that Canada was able to reverse this trend and bring the year-on-year change to near record highs in 2010. SInce 2011 however, the pace of house price inflation has ebbed and the talk is now about renewed declines.

The talk of a bust is in part due to the soft numbers coming out of two principal bubble markets in Toronto and Vancouver. In Toronto, there has been massive condo overbuilding in the city center and especially along the Lake Ontario coast on Lake Shore Boulevard and Queens Quay where condos are now replacing former docklands. Anyone who has taken the Gardiner Expressway between western Toronto and the city center in the last 5-7 years knows what I am talking about. There is a massive array of cranes building condos everywhere as this is “one of the largest waterfront revitalization projects ever undertaken in the world“. However, now sales of condos are plummeting in Toronto and condo leases are rising as owners are forced to become landlords.  House prices in Toronto are still appreciating.

In Vancouver, house prices have been falling for some time now as are house transactions. According to the House Price Index, the year-on-year decline in prices is only 1.5%, however – though the decline is greater according to other measures. But this April marked the ninth consecutive month of price declines at a time when the Canadian economy is growing. That tells you that this market decline has not been precipitated by a decline in the broader economy as much as a combination of economic and internal market forces. Vancouver looks to have reached a top. Nearby Victoria is the only other major market that has falling prices nationally with prices now down 3.3% in the past year.

The question is what comes next. First, in the residential housing market, because transaction prices are huge compared to incomes,  sales are lumpy because sellers often pull their listings rather than transact at a lower price. That means that consistently lower sales volume is the harbinger of declining prices and we are seeing a large drop in sales volume, particularly in Toronto and Vancouver. Second, the broader Canadian economy is still doing ok but there are troubling signs in the jobs market and in manufacturing data that suggest weakness. For example, the RBC Canadian Manufacturing Purchasing Managers’ Index ticked up in April to 50.1, barely above contraction, after a shock decline in March at 49.3. And the last six months of 2012 were the weakest since the financial crisis, just as they were weak in the US. Third, the Canadian government’s fiscal outlook is going to be a drag on growth and jobs according to the Canadian Parliamentary Budget Office. The PBO estimates that the 2013 budget alone will result in 14,000 job losses by 2016 and have a minor cumulative negative impact of 0.12% on GDP growth. Combining this with cost measures from 2012, gets you to 62,000 job losses by 2016. In sum, the economic and housing market-specific outlook is mixed and not supportive of continued high levels of house price inflation.

Another impediment here is household debt. As of the end of the last quarter, household debt in Canada had risen to a record 165.0% of GDP, with the lion’s share of this debt coming from mortgages. The ratings agency Standard and Poor’s has said that because of the slowing of the jobs market and the modest fiscal drag, the next couple of years will be determined by Canadians’ decision to “spend or to save”. And given the high debt levels, we should expect household spending to be restrained. This is borne out in polls that show Canadian consumer confidence waning.

Could this mean a bust, though? No one in officialdom is talking that way but that is the concern. At a minimum, I believe we should count on monetary policy to be loose, not just to offset the fiscal drag but also as a safeguard against a bust.

To be continued. 

Source: House Price Index

In a number of posts recently I have highlighted the impact of declining workforces on economic growth (here, for example, or here, or here) and the way the policies pursued to address the Euro debt crisis are having the impact of accelerating the movement of young people away from the periphery and towards the core (here, or here) thus accelerating the decline in their working populations and exacerbating their growth problem. This issue has been already highlighted strongly in Japan’s ongoing crisis, and has to some extent come to be known as the “shortage of Japanese” problem following Paul Krugman’s memorable use of this expression to explain  why Japan’s economic performance seemed so poor to so many.

Recently I came across a post by Portuguese blogger Valter Martins, where he looks in some depth at what is happening in Portugal. Really, despite the use of some technical details his argument is extraordinarily straightforward, in fact it is as elegant as it is simple. What he points out is that population growth rates serve as some kind of “quick and dirty” proxy for GDP growth rates, and growth in working age population serves equally well as a quick proxy for growth in GDP per capita. Any simple growth accounting process breaks growth down into a labour input component and a productivity component, so if your labour component turns negative, even to get the same growth your productivity component has to be greater. For societies that have considerable difficulty raising productivity in the first place this process of working population decline is going to make an already Herculean task even more difficult.

In addition Valter picks up a point few researchers seem to have noticed up to now, that working age population in Portugal just surprisingly peaked. Natural population dynamics have long been stationary in Portugal, and emigration has long-standing and deep roots. During the first eight years of this century the population loss caused by emigration (nearly all young educated Portuguese) was masked by the steady influx of immigrants looking for work. But now the country is in deep recession the immigrants aren’t coming. Indeed  some are even leaving, while the rate of emigration by Portuguese nationals has accelerated and continues to accelerate, sending working age population (and just as importantly its age distribution) on an increasingly negative path.

During the years of austerity we have become familiar with the phenomenon that as fiscal spending is cut growth falls making the achievement of fiscal targets even more difficult. Well something similar seems to be happening with migration movements, as part of the benefit to long term growth that accrues from making structural reforms disappears on the other side of the ledger as the workforce shrinks.   Again we are in danger of running round and round in ever diminishing circles.

Reading Valter’s post I became impressed with the power of his argument and was struck by the importance of what he had discovered. I therefore took the unusual step of asking him to translate the piece and offering to publish it on my blog. So, without more ado, here is:

Is Portugal Facing A “Shortage Of Japanese”?

Guest Post by Valter Martins

“So, about the slow growth/debt connection: I’ve done a quick and dirty mini-RR for the period 1950-2007 ……focusing only on the G7……and if you look at it, you see that most of the apparent relationship is coming from Italy and Japan……And it’s quite clear from the history that both Italy and (especially) Japan ran up high debts as a consequence of their growth slowdowns, not the other way around.” – Paul Krugman, Reinhart-Rogoff, Continued

Despite so much intense debate about the ailment from which Portugal suffers, and the mountain of sacrifices currently being borne by the Portuguese people one fact has gone virtually unnoticed in amongst all the noise – for the first time, at least in the modern era, Portugal’s working age population has started to shrink. Demography and its possible impact on economic growth is a topic which has been largely ignored by practitioners of economic science in recent decades as population growth has by-and-large been on an upward trend. However, as we enter a new period in human history, one in which the upward trend has shifted towards stagnation or even in some cases towards long run decline, the economic and financial implications of this transformation can no longer be ignored. As Nobel economist Paul Krugman indicates in the above quote, some countries have large debt simply because they have low growth.

So what is the common thread that runs through these low-growth high-debt countries? Could it be decelerating labour force growth and eventual labour force contraction? The cases of Italy and Japan are well known. In the case of Portugal, it will be argued here, demographic trends can not only explain a significant part of the slow economic growth the country experienced during the first decade of this century, they can also help us understand the depth of the current recession. More important still, we need to think about the consequences of this continuing lose-lose dynamic for the country’s future in both the short and much longer term.

Economists didn’t always take the view that population dynamics were irrelevant to economic performance. The 1930s gave birth to a serious debate about the possible problem that would arise if many decades of strong population growth were followed by population stagnation and then decline, a debate which was provoked by the fact that birthrates in a number of countries fell below replacement level for the first time in human history during the economic depression. And among the names of those economists who took the problem seriously enough to think and write about it was none other than John Maynard Keynes.

“There are, indeed, several important social consequences already predictable as a result of a rise in population being changed into a decline. But my object this evening is to deal, in particular, with one outstanding economic consequence of this impending change; if, that is to say, I can, for a moment, persuade you sufficiently to depart from the established conventions of your mind as to accept the idea that the future will differ from the past.” J.M. Keynes, Eugen Rev. 1937 April; 29(1): 13–17.

While the phenomenon has arrived largely unnoticed Portugal’s total population has long been near to stationary.

As can be seen in the above chart, Portugal’s population has been struggling to find growth momentum since the mid 1980’s (the first time numbers actually dipped downwards) but the years 2010/2011 seem to mark a more fundamental turning point, since it was in that time interval that Portugal’s population started on a long, and possibly irreversible, path of decline. Having long had a total fertility rate of below 1.5 this was a more than predictable outcome, and one that should have been expected ever since the total fertility rate fell (and stayed) below the 2.1 replacement level in 1982.

As is well known, population change is comprised of two major components: natural growth and net migration. Natural growth, births minus deaths, became negative in 2007 and thereafter population growth has become exclusively dependent on having sufficient positive net migration. Up to 2010 this condition was satisfied given the continuing influx of immigrants into the country as can be seen in the chart below.

However, since the onset of the 2008 recession, not only have the immigration flows reversed completely, but emigration has started to increase again, thus reanimating a trend that has been constantly present in Portuguese history over decades, even centuries. This is perhaps the most critical factor driving the recent population decline. In fact the decline would have occurred much earlier had it not been for the return of thousands of refugees from the Portuguese colonies in the 1974-1981 period.

According to the European Commission’s 2012 Ageing Report, projections for the Portuguese population during the period 2010 – 2060 anticipated that population would peak in 2034, but as we have seen, the latest data show the population unexpectedly reached its peak in 2010 (total population, previous chart), the year in which the population began to decrease (a similar phenomenon seems to have occurred in Spain in 2012, with again a reversal in migrant flows in an otherwise stagnant population being the trigger). This fact that this turnaround comes as a surprise is clearly the result over optimistic assumptions on the net migration front since the numbers for natural growth are well known and change little (although birth numbers are now dropping in many EU countries under the impact of the long recession). Clearly the unexpected factor here is the severity of the recession from which the country is suffering and the size of the exodus of young people who are leaving.

Just to highlight even more the speed with which all this is happening, in Japan, the interval between the beginning of the decline of the working age population and the beginning of total population decline was a full decade. In Portugal this interval was only two years.

Even more relevant than the decline in total population for the purpose of the present discussion is the decline in the working-age population. While the former gives us a good proxy for domestic consumption, it is the later which is important in terms of potential national output. All other things being equal a reduction in the working-age population means a reduction in output. Therefore, the most important detail to catch from the chart above is that the working-age population, defined as the population with ages ranging from 15-64, declined for the first time in Portugal between 2008 and 2009. As highlighted by both Daniel Gros and Paul Krugman if you want to compare economic growth performance as between countries with growing populations and those with declining ones the best indicator to use is undoubtedly GDP per Working Age Person (GDP/WAP).

In the Portuguese case if we take this ratio and compare it with both Real GDP growth and Working Age Population change (my calculations VM), we can get an impression of how variations in the Working Age Population affect the economic growth of a country. Surprisingly or otherwise, the data for Portugal viewed graphically not only confirms the existence of the “workforce effect” – the relationship seen between Real GDP and GDP/WAP – but also suggests that Portugal has already passed the point where this effect is beginning to have a negative impact on GDP growth.

As can be seen in the above chart, until 2008 the growth rate of Real GDP was always higher than the rate for GDP/WAP offering a strong suggestion that labour force growth was having a positive impact on GDP growth. It is noteworthy, however, that both in the period 1986 – 1991 and in the period 2003 – 2008, the growth rates of Real GDP and GDP/WAP almost overlapped. This phenomenon coincided with very low or zero rates of working age population growth and as such the “workforce effect” was mostly neutral. The first of these periods, 1986 – 1991, the stagnation in the workforce was the direct result of the increase in emigration that followed the entry of Portugal in the European Union. The second one coincides with the arrival of the turning point in long term WAP growth, as the size of the working age population irrevocably turns negative.

Indeed, during this early period of emigration towards the EU Portugal’s total population decreased, as shown in the chart Population by age group (above, blue line), but at the time, since the population in general was much younger, and many more new labour force entrants were arriving at working age, the growth rate of the workforce remained slightly positive. In other words, there were still enough Portuguese entering the labour market to replace those who were leaving it (either to retire or to seek a future abroad). In the second period, 2003 – 2008, the large exit of Portuguese nationals, about 700,000 between 1998 and 2008 according to research by the now Economy and Employment Minister Álvaro Santos Pereira, was to some extent offset by an inflow of immigrants, but these were only sufficient in number to maintain the workforce at a stationary level.

All this calm and stability disappeared, however, after 2008 when the growth rate of Working Age Population turned negative, i.e. the labour force began to decline (see graph below). Where the growth rates of Real GDP and GDP/WAP overlap we can surmise that working age population change is having no effect on real GDP growth. Subsequently, however, the growth rate of GDP/WAP becomes higher than the growth rate of Real GDP and thus the “workforce effect” starts to act as a drag on the economy steadily bringing the potential overall growth rate down. In other words, Portugal is now suffering from a “Shortage of Japanese” as Edward Hugh has called the phenomenon, after Paul Krugman originally coined the term to describe the underlying problem which has been afflicting the Japanese economy since the mid-1990s.

The fact that the three lines in the above chart happen to intersect at zero is perhaps just an unfortunate coincidence but is consequences are disastrous, since the downward trend that was already evident accelerated greatly after the onset of the recession. The resulting rise in unemployment not only caused a collapse in the immigration flow, it also led to a sharp increase in emigration. As a result workforce shrinkage intensified even further, as can be seen in the above chart by looking at the growing distance between the Real GDP and the GDP/WAP lines. That is, if the workforce had remained stationary the economy would be growing at similar rates to the GDP/WAP, i.e. above the current level as indeed happened in the period 2003 – 2008.

Naturally, the argument can be advanced here that the recession is a cyclical phenomenon, and this is surely true, there is an ongoing cycle, but the argument being used refers to long term trends – a reversal in direction (or change of sign) for inputs from the labour force component brings down the overall trend growth rate making booms weaker and recessions deeper, all other things being equal. This would seem to be a simple conclusion which stems from elementary growth accounting theory. Naturally, there are other factors which contribute to growth, like multi factor productivity, but again other things being equal you would need more of this to achieve the same growth rate as before under conditions of weakening in the labour force growth component.

Thus the argument is not that economic growth becomes impossible with a stagnant or slowly declining workforce, but simply that it becomes harder to achieve because it relies more on other factors, such as productivity and raising participation rates, but these change slowly over time, and more so in already developed countries. As such trend growth will surely steadily fall. This can be clearly seen in the following chart: while workforce growth was an important source of growth when Portugal was a developing country, its importance fell back as the workforce started to stagnate even as Portugal was approaching converge with other developed countries in terms of productivity. Other factors took over and increased their importance steadily as the economy started to converge with more advanced ones. Now that this catch up process seems to have come to a standstill as well the economy simply can’t growth, at least at rates considered normal. With a stagnant workforce, low growth or no growth is the new normal.

Following standard growth accounting procedures, during the 1970s workforce growth accounted for more than half of Portuguese economic growth (see chart above, my calculations VM), and this contribution had fallen to only 16% in the first decade of this century. However, since 2008 not only has this contribution reversed sign but also the magnitude of the negative effect has begun to increase rapidly. Such that, by 2011 the “workforce effect” could be considered to explain more than 29% of the GDP decline. This “negative drag” will continue, and the effect possibly become greater, as the working age population shrinks further. Had the workforce remained stationary we could surmise the 2010 recovery would have been more pronounced and the 2011 recession wouldn’t have been so deep. This is the principal reason why official growth forecasts have been being constantly revised to the downside, and this will continue to happen until the models the forecasters use adequately incorporate the effects of population decline on economic growth. Adding insult to injury, ignorance of the existence of such effects recently led Portugal’s Prime Minister Pedro Passos Coelho to suggested young unemployed Portuguese resort to emigration as an escape route from the crisis, advice thousands have now followed thus making a bad situation even worse.

Economic growth in Portugal appears to be on a long downward trend, a trend which will only be made worse by the onset of the decline in its working age population. Economic output is now at 2001 levels and thus we can now conclude that the last decade has been completely lost. More worryingly though, is that after such a bad start to this decade, it might not be unreasonable to conclude that this one is also in the process of being lost too.

At best the economy will stagnate in the years to come but the possibility is there that it will continue to regress – especially if nothing is done to stem the outflow of young educated people – and by 2019 it might even be back somewhere in the 1990’s. This is scenario simply cannot be excluded since, in addition to all the other problems the country faces, a situation that would be in any circumstance challenging is now being aggravated by one more variable whose contribution cannot be easily reversed in the short term – the decrease in the working age population. More than the fact in itself, it is the speed at which this is happening which is alarming, and the fact that policymakers appear unaware of the problem. In analyzing the low Portuguese economic growth issue the decrease in the country’s working age population can no longer be ignored! Or at least it is hoped that this will be one of the outcomes of this short report.

To return to where we started, Keynes concluded in his pioneering presentation that a stationary or slowly declining population could increase its standard of life while preserving the institutions society values most if, and only if, the process was managed with the necessary strength and wisdom. On the contrary, he argued, a rapid decline in population, of the kind that we are seeing in Portugal today, would almost inevitably result in a serious decline in living standards and a breakdown in highly valued social security mechanisms. The distinction Keynes drew some 80 years ago between rapid and managed rates of decline seems plausible, reasonable and highly relevant today. What we now need to see are urgent measures taken – initiated by the EU and the IMF – to counter the exodus which lies behind this dramatic decline which is occurring before our eyes, measures which at least try to decrease its speed, because once a process like this gains full velocity it will be very difficult to stop, and we have already seen it gather considerable traction. Ireland is a pointer and a great example to learn from, since it took that country more than a century to recover the population decline precipitated by the natural disaster which hit the country in the middle of the nineteenth century.

Postscript From Edward

I have established a dedicated Facebook page to campaign for the EU to take the issue of  emigration from countries on Europe’s periphery more seriously, in particular by insisting member states measure the problem more adequately and having Eurostat incorporate population migrations as an indicator in the Macroeconomic Imbalance Procedure Scoreboard in just the same way current account balances are. If you agree with me that this is a significant problem that needs to be given more importance then please take the time to click “like” on the page. I realize it is a tiny initiative in the face of what could become a huge problem, but sometime great things from little seeds to grow.

Early last month Martin Wolf had another of his very interesting articles, this time on China, which I think suggests some of the concerns we must have about the upcoming adjustment. Wolf argues that it may be useful to think about Japan as a model for understanding the adjustment process in China since the Japanese model shows how risky it is to shift to a slow-growth model. I of course agree.

Over the next decade, China’s growth will slow, probably sharply. That is not the view of malevolent outsiders. It is the view of the Chinese government. The question is whether it will do so smoothly or abruptly. On the answer depends not only China’s own future, but also that of much of the world.

As an aside it is funny to me (and probably no surprise to any Chinese or foreign economist who writes about China) that Wolf had to stress that it is not just “malevolent outsiders” who predict slower Chinese growth. You would think that identifying risks in the Chinese growth model and suggesting ways to minimize or hedge them would be considered a service to China.

But for some reason in China there is a very vocal minority that considers any skepticism about the sustainability of the Chinese growth model to be either an insult to the Chinese people or a malevolent foreign conspiracy. The extent of this rather surprising rage may suggest a level of fragility in China’s social fabric and its self-confidence that could make any slowdown more difficult to manage, but this is a digression. My point in bringing up Wolf’s article is not to play amateur national psychologist but rather to suggest something about the process of shifting to a new growth model. Wolf says:

As the experience of Japan has shown, managing a shift from a high-investment, high-growth economy to a lower-investment, lower-growth economy is very tricky. I can envisage at least three risks. First, if expected growth falls from over 10 to, say, 6 per cent, the needed rate of investment in productive capital will collapse: under a constant incremental capital output ratio the fall would be from 50 per cent to, say, 30 per cent of GDP. If swift, such a decline would cause a depression, all on its own.

Second, a big jump in credit has gone together with reliance on real estate and other investments with falling marginal returns. Partly for this reason, the decline in growth is likely to mean a rise in bad debts, not least on the investments made on the assumption that past growth would continue. The fragility of the financial system could increase very sharply, not least in the rapidly expanding “shadow banking” sector.

Third, since there is little reason to expect a decline in the household savings rate, sustaining the envisaged rise in consumption, relative to investment, demands a matching shift in incomes towards households and away from corporations, including state enterprises. This can happen: the growing labour shortage and a move towards higher interest rates might deliver it smoothly. But, even so, there is also a clear risk that the resulting decline in profits would accelerate a collapse in investment.

The government’s plan is, of course, to make the transition to a better balanced and slower-growing economy smoothly. This is far from impossible. The government has all the levers it needs. Moreover, the economy continues to have much potential. But managing a decline in the growth rate without an investment collapse and financial disruption is far trickier than any general equilibrium model suggests.

In his article Wolf implicitly refers to a process on which he doesn’t actually dwell much, but which I think is very important. A lot of economies, and especially developing economies with distorted balance sheets and one or two major drivers of growth, can have embedded in their economic institutions self-reinforcing mechanisms that can be very powerful.

I discuss this a great deal in my book, The Volatility Machine. As a consequence of these self-reinforcing mechanisms, I argue, movements in any direction can be sharply magnified, so that positive shocks will often result in much faster growth than anyone expected. But this comes at a cost. The reversal of these shocks often can result in much slower growth than anyone expected, or even in a wholly unexpected collapse into crisis.

Wolf mentions in his second point the relationship between slower growth and rising bad debt, for example, and he is absolutely correct, but I would add that rising bad debt itself puts pressure on the financial system in a way that creates at least two additional problems. First, it makes banks reluctant to increase credit further. Second, the rising bad debt increases the hidden transfer from the household sector needed to resolve the debt, which then puts downward pressure on household consumption.

This of course is self-reinforcing. Why? Because slowing growth caused an increase in bad debts, but an increase in bad debts will cause further slowing in growth.

Feedback loops

We speak of the case in which positive shocks are self-reinforcing, as a virtuous circle, and the case in which negative shocks are self-reinforcing as a vicious circle, but the important point is that these processes are part of the same system and are very common. It is usually a pretty safe bet, for example, that when an economy is surging forward at astonishing growth rates – rates which far exceeded anyone’s prior expectations – it has powerful positive feedback loops embedded within its economic institutions.

In my book I focus mostly on balance sheet feedback loops, but they also exist just as powerfully in the underlying economy. Urbanization, for example, can create very strong feedback loops. How does it work? In the early stages of growth, productive jobs are created in the urban areas, for example as factories are built, and workers very quickly leave the countryside to take these jobs. They are also willing to move quickly around the country, so that migration is very sensitive to the perception of demand.

As workers move to the cities, their need for housing and services immediately rises, and their expenditures create additional jobs. What’s more, their remittances create capital accumulation and higher expenditures in their home areas that cause rural growth to increase by more than it otherwise would have. In the end the original investment in the factory is quickly multiplied throughout the economy, so that growth creates urbanization and urbanization creates more growth in a virtuous circle.

This process is reinforced by the impact of the original investment on the financial sector. As workers get jobs, part of their income is consumed, creating more demand and more jobs, and part of it is saved, which allows banks to direct the additional savings into higher investment. Since the growth impact of this process in the early stages of industrialization can be very high, this creates stronger growth expectations, which then justify even higher investment in capacity and infrastructure.

It is probably not a coincidence that in such developing countries that are growing quickly we almost always see credit growth far surpass anything we might have expected. The impact of financial deepening can be extremely strong in a country that starts out with a very weak and underdeveloped financial system, and as growth exceeds expectations year after year, perhaps not surprisingly, credit standards are weakened and money pours into projects that might have otherwise been considered risky

But what happens when these productive jobs dry up and the economy starts to slow, especially if it slows after credit has been too liberally extended? For one thing, either very quickly the workers go home, or they remain in the cities as unemployed workers without savings or social safety nets. In the former case the goods and services they demanded also disappear quickly and unemployment rises by even more than the direct impact of the reduction in jobs. If they remain in the city they create a drag on social expenditure (and perhaps a rise in crime) that transfers spending from more productive to less productive sectors.

As urbanization reverses, or even as it simply slows, it becomes self-reinforcing in the wrong direction. These kinds of feedback loops exist in every economy, but for a variety of reasons they seem much stronger in developing countries with weak institutional structures, in countries that are undergoing rapid social and economic change, and in countries with rigid and unsophisticated financial systems.

This feedback process may explain one of the puzzles typical of developing countries, and especially developing countries undergoing an investment boom. The historical precedents suggest that in the early stages of a growth miracle we are always surprised by the extent of growth – growth far exceeds even our wildest expectations.

Once the economy begins to slow, however, we have also been – in every case that I can identify – shocked by how vicious the slowdown turned out to be. This would not be a surprise if indeed these economies are caught up in very powerful feedback loops. On the contrary, this would be normal.

What does all of this have to do with Martin Wolf’s article? Wolf suggest plausible reasons for expecting a slowdown in Chinese growth, but his idea of a slowdown is relatively moderate and would, in fact, be considered rapid growth in most economies. But if part of the explanation for China’s spectacular – and spectacularly unexpected – growth of the past three decades has to do with the positive feedback loops that are so typical of developing countries with fragile and unsophisticated financial systems, then a moderate slowdown in growth may be an impossible target to achieve. Once growth starts to slow, the self-reinforcing impact on urbanization, on credit growth, on financial distress, and on expectations may force growth rates to drop far more sharply than any “plausible” analysis would suggest.

Back to Europe

Speaking about feedback loops, Europe continues to bounce violently up and down in the markets. In my January newsletter I expressed my surprise that the market was acting as if it thought the bulk of Europe’s problems was behind us, but since then the market has changed its beliefs. The events in Cyprus have reminded us of just how volatile the situation is and just how pro-cyclical it can be.

As I see it however events in Europe are still unfolding just as they are supposed to. Last week I saw a worrying article in the Financial Times.

Spain’s economic crisis and the near-collapse of its banking sector last year have conspired to choke off the flow of bank loans – threatening to dry out the vast and versatile pool that dominates Spain’s private sector.

In the five years since the crisis started, no fewer than 450,000 small and medium-sized enterprises have gone under, says Jesús Terciado, the president of Cepyme, the Spanish SME association. “But it is not just about staying in business – it’s also about growth. There is no way you can grow your business at the moment,” he says.

I have previously discussed the financial distress process – which affects companies as well as countries – as consisting of a highly pro-cyclical change in the behavior of major stakeholders in response to deteriorating credibility, which itself causes credibility to deteriorate further. In other words the more we worry about the government’s ability to repay debt, the more we behave in ways that have the effect of further reducing the government’s ability to repay the debt. We do this by acting in ways that automatically increase the amount of the debt, make the balance sheet more fragile, or reduce debt-servicing capacity.

One of the key modifications in the way stakeholders respond to a crisis is in the behavior of small and medium enterprises. Business owners respond to deteriorating economic conditions by disinvesting and firing workers, while lenders respond to worsening credit risks by tightening credit conditions. Both responses only worsen the underlying debt problem, and cause the economy constantly to underperform expectations, until at some point conditions spiral out of control.

No matter what Madrid does, in other words, the debt crisis will ensure that the Spanish economy continues to deteriorate as stakeholders respond to the deterioration. Without a major positive shock that can permanently reverse the underlying process of financial distress, Spain cannot help but continue its slow slide into crisis, and should any other country leave the euro, the pressures on Spain will automatically intensify as the burden of adjustment is forced onto a smaller group of countries.

Meanwhile in what also shouldn’t be a surprise, Spain’s savings rate continues to drop. Here is an article in El País:

Spain’s household savings rate declined to a new record low last year as rampant unemployment and the loss of spending power due to inflation and wage cuts forced families to dip into their piggy banks to make ends meet. According to figures released Tuesday by the National Statistics Institute (INE), households set aside 8.2 percent of their disposal income last year, the lowest rate since the INE began compiling the series in 2000. The figure was down 2.8 points from a year earlier.

The INE said disposable income in the fourth quarter declined 4.2 percent from the same period a year earlier, a fall of 7.835 billion euros to 176.766 billion. Wages in the period declined 8.5 percent, with was barely offset by slight increases in income from other sources such as interest rates and deposits.

Why are Spanish savings declining?

The article explains the falling savings rate as reflecting rising unemployment (fired workers, after all, still have to consume), but it is perhaps easier to understand the process, and how difficult it is to unwind, by working through the balance of payments. If Germany is still exporting savings (i.e. running a current account surplus), the rest of the world has no choice but to import savings, and because of monetary constraints the rest of the world in this case is peripheral Europe.

Why is Germany exporting savings? This, as I have pointed out many times, has nothing to do with German thrift. It has to do with wage repression. From 1991 to 2000, according to an interesting recent paper by Thomas Palley, nominal compensation per employee in Germany rose by 3.2% a year on average, whereas it rose a little more quickly in Europe overall (3.5% a year). From 2001 to 2010, while European-wide nominal compensation growth dropped to 2.4% annually, however, it dropped to 1.1% in Germany.

The sharp slowdown in German wage growth was a direct consequence of agreements hammered out between the government, large businesses and labor unions to repress wages in order to make German goods more competitive in international markets. It might seem surprising that slower wage growth would create a surge in savings, but since savings is simply total production less total consumption, and wage repression had a secondary consequence of repressing consumption growth, by definition it puts upward pressure on German savings.

In the 1990s Germans saved less than they invested domestically, so they imported foreign capital and ran current account deficits, but after the wage-repressing agreements, German’s savings rate was forced up to the point where it so far exceeded investment that Germany began exporting capital in 2002. The amount of net exported capital surged to 7.5% of GDP by 2007 – or, to put it another way, German’s current account surplus was 7.5% of GDP. Because the structure of the euro ensured that the corresponding deficits to German’s forced surpluses were likely to be the countries of peripheral Europe, German’s net capital exports had to result in net capital imports for the peripheral Europe.

There is only two ways a country like Spain could increase its net imports of foreign savings. Its investment could rise faster than its savings, or its savings could fall faster than its investment. In either case, as savings exceeded investment, Spain would import the difference, and so run a current account deficit equal to its net capital imports.

Of course with the economy in such terrible shape, there is no chance that investment is rising. In fact it is probably falling. This means that Spanish savings must also fall, and there are practically speaking two ways it can do so. First, the Spanish can go on a credit-fueled consumption boom that drives down the savings rate while keeping unemployment low, as they did before 2008-09. Second unemployment can surge, as it has since then.

Because a return to the consumption binge is pretty unlikely any time soon, is it such a big surprise that we are seeing savings adjust through high unemployment? Without a significant reversal of Germany’s too-high savings rate, Spain really doesn’t have much choice. The only ways Spain can reduce unemployment is either with a surge in domestic investment, or with a reversal of the trade deficit, which probably requires that it leave the euro and devalue. This is mostly just arithmetic.

The exorbitant privilege

For one last quick point I want to return to some of the absurdities of the currency war. During the 1980s Japan was fairly certain that its large current account surpluses had nothing to do with monetary policy and everything to do with management and business techniques.

In the past decade China has also argued the same thing. When trade surpluses are extraordinarily high, it cannot possibly be the consequence of distorted monetary policy, it seems. This makes the recent dispute between Japan and China a little surprising. According to an article in the South China Morning Post:

Many of China’s top economists are livid at what they view as an effective currency devaluation by Japan and are calling on the People’s Bank of China to retaliate by weakening the yuan to defend itself in what they see as a new currency war. These economists, including Tsinghua University professor Li Daokui and ANZ Bank’s Liu Ligang, see Japan’s plan to double its monetary base within two years as “blackmail” and have criticised the Japanese central bank’s decision to open the liquidity floodgates to bump up the economy.

Liu said Japan’s unprecedented easing programme, aimed at ending more than two decades of deflation, was “a monetary blackmail” targeted at other export-driven Asian countries such as China and that the central bank should sell more yuan and buy the US dollar to push down the yuan. He also called on authorities to guard against a fresh wave of hot money into China’s fragile financial markets, warning that Japan’s move would reignite the so-called carry trade, under which investors borrow in low-interest yen and invest in high- interest markets.

It is interesting that while Beijing has complained bitterly about the exorbitant privilege that allows the US to exploit foreign purchase of dollars for reserves, when Tokyo acts to push down the yen, many of the same people in Beijing argue that the Chinese response should be to transfer to the US even more of this exorbitant privilege. It seems that none of the world’s economies really want to take any of the exorbitant privilege for themselves.

And why should they? Buying US dollars in order to push down the value of their currencies – and this is all the US exorbitant privilege consists of – allows other countries to increase domestic employment by turbo-charging exports growth at the expense of domestic consumption (and imports). Although countries that do this usually insist that this higher domestic employment does not come at the expense of US employment, no one is eager to carry the current account deficit that comes with the exorbitant privilege.

My guess is that until the US takes steps to prevent foreign accumulation of US government bonds, or, if other countries want to retain the use of an international traded currency, they agree not to game the reserve system, the US will always be faced with the choice either of absorbing demand deficiency from every part of the world that wants more growth or of engaging in its own version of currency war, QE. The very same people who complain about the currency consequences of QE, in other words, are arguing that while it makes sense for them to expand aggressively, it is morally wrong when other countries do it.

That sounds a lot to me like old-fashioned beggar-thy-neighbor politics. And there is no reason we should expect this to end soon.

The future never resembles the past – as we well know. But, generally speaking, our imagination and our knowledge are too weak to tell us what particular changes to expect. We do not know what the future holds. Nevertheless, as living and moving beings, we are forced to act. – John Maynard Keynes

Discussions of the population problem have always had the capacity to stir up public sentiment much more than most other problems.
- Gunnar Myrdal

Last Thursday the yen broke through the psychological threshold of 100 to the US dollar. On Friday the slide continued (see chart), even dropping very close to 102 to the USD at one point before strengthening slightly on the run in to the G7 finance ministers meeting.

The ostensible source of the sudden shift was a news release from the Japanese Ministry of Finance detailing the fact that Japanese investors bought a net total of 514 billion yen ($5.2 billion) in foreign bonds during the two weeks to May 3. Speculation had been rife that Japanese money funds would start to respond to continuing yen weakness and low Japanese yields by investing abroad. It is still far from clear that this is really going to happen in the short term, but nonetheless the news was sufficient to spark bets on more yen weakness.

Naturally the fall has drawn comment, especially during the run up to last weekend’s G7 meeting. US Treasury Secretary Jack Lew told CNBC that while Japan had “growth issues” that needed to be dealt with its attempts to stimulate its economy needed to stay within the bounds of international agreements to avoid competitive devaluations.”I’m just going to refer back to the ground rules and the fact that we’ve made clear that we’ll keep an eye on that,” he said in a comment that was widely seen as drawing a red line in the sand.

But really, what else do external observers expect? On 4 April Bank of Japan governor Haruhiko Kuroda announced he was going to increase the money base by 1% of GDP per month for the next two years. That is to say Japan’s monetary expansion will be incremental and continuous. Kuroda has even stated he will continue to increase the money base beyond the initial 24 months if the targeted inflation doesn’t come. It was always clear that the country was going to have a difficult time trying to generate inflation and that one of the knock-on consequences would be to continually weaken the yen. So you can’t realistically expect him to turn round and say now, “sorry, we didn’t know it would offend you so,  I’m cancelling the policy”. Anyway, that move would throw financial markets straight into turmoil. Didn’t they understand what they were signing up to when they accepted “Abenomics” at the last meeting?

Obviously there is still a considerable amount of confusion around about what exactly Japan’s problem is, and what the policy is trying to achieve. I have tried to examine the more theoretical background to the problem in my  A-b-e of economics post, but looking through the comments to that piece I realised that I was very tightly focused on one, examining only one aspect of what has come to be known as Abenomics, the inflation targeting component and its theoretical justification. Since ideas about what exactly it is the Japanese government is trying to achieve seem to be many and various, I thought it might be worth coming back and taking a second look at the experiment.

Three Arrows Into The Sunset

The aim of Abenomics is obviously to shake Japan out of its deflationary lethargy and return the country’s economy to a more pronounced growth path. In order to achieve this Japan’s Prime Minister has notoriously identified three policy arrows, or transmission mechanisms:

1) Aggressive monetary easing
2) Strong fiscal stimulus
3) An extensive programme of growth enhancing structural reforms

Achieving the inflation target is effectively the key objective of the first arrow, and weakening the yen is basically the transmission mechanism which achieves the objective. In fact while we have heard a good deal concerning the first two arrows, there is still relatively little on the table regarding the third one, as some commentators have started to wryly note.

Since there are many possible pathways along which these arrows may pass, it is probably worth taking a look at the big picture story in all its glory. To do that the following chart from Ritchie King at Quartz (who adapted it from a piece by Nomura economists) should serve as a very handy visual aid.

Central to the model is naturally the idea that generating inflation expectations can kick-start the economy. To help us think a little more about what that involves let’s take a quick look at a non-Japan-related chart – the Spanish retail sales one.

Notice the sharp spike in August 2012? Just what happened to cause that to happen? Essentially the Spanish government decided to raise consumption tax by 3 percentage points from September, so many consumers decided to advance their purchases to avoid the perfectly foreseeable coming inflation. The tax increase pushed up Spain’s CPI a couple of percentage points, and this effect will stay in the data till September 2013, when – guess what – the country might even fall into (irony of ironies) deflation. The reason the rise in the CPI may be followed by a slump into deflation is because the move was a deficit reduction one in an economy which is in ongoing deep recessionary mode, and evidently failed to restart the economy (no one thought it would) since retail sales then fell back onto their previous downward path. Hey, and guess what, Spain’s population just started to shrink. No possible connection I suppose?

A chart like this could be produced for a whole range of different economies on Europe’s periphery, but the point here is this, generating inflation expectations only advances sales, and doesn’t generate new ones, unless you implant the idea  that the inflation will be permanent and ongoing, and will be followed by more inflation and so on, leading people to the conclusion that it is better to get rid of their money by spending it rather than holding on to it for their old age. Whoops!

The most important arrow to leave Shinzo Abe’s bow to date was fired by the steady hand of his helmsman, Bank of Japan governor Huruhiko Kuroda, and this has been the massive monetary easing one. According to the plan announced following their April 4 meeting the BoJ will conduct monetary market operations which will increase the monetary base on a monthly basis at the rate of about 5 trillion yen a month. In this way the base will be raised from 138 trillion yen at the end of 2012 to 200 trillion yen at end of 2013 and 270 trillion yen by the end of 2014.

This amounts to a massive increase in base money to around 50% of GDP (see chart from Citi analysts below), but what is important is to note the incremental and continuing character of the ramping up – by about 1% of GDP a month. And if this isn’t enough Bank of Japan governor Kuroda has already said he is willing to continue the easing process beyond the initial two years. In effect the policy will continue for as long as it takes. I think this is called a “the sky’s the limit” approach.

Yen Devaluation Means Exports Are Up

Anticipation of the move (which was announced by Abe in the autumn of last year) has been successful in driving down the yen, which has now fallen by around 30% against the euro since last summer (see chart below), and by around 25% against the dollar. Naturally, as we have been seeing at the end of last week, we should expect more of the same to come. Plenty of it. As much as it takes.

This reduction in the value of the yen has evidently helped exports, but not by that much so far. They were up 1.1% over a year earlier in March.

But Deflation Stubbornly Continues

Naturally the sharp rise in the cost of imports this produces is generating cost pressure, but not enough to kick the country off the deflation path so far.

Indeed the Bank of Japan’s favoured index, which includes energy but not the cost of  fresh food, saw deflation accelerate in March to an annual price fall of 0.5%, the fastest rate in two years. And what inflation there is in the pipeline – electricity tariff hikes to cover mounting losses among the producers as energy import costs rise – was described by Bloomberg journalists Tsuyoshi Inajima and Brian Swint as the “wrong kind”, a statement which highlights the amount of confusion there is abroad about just what it is that the BoJ is supposed to be achieving.

To back their point they cite Klaus Baader, chief Asia Pacific economist for Societe Generale in Hong Kong to the effect that “this isn’t the kind of inflation we want in Japan to break the deflation mindset. We’d like inflation that is a reflection of higher wages, whereas this is pure cost inflation that decreases purchasing power.”

Maybe this cost push inflation is the “wrong kind” for some adherents of Abenomics, but it is the only kind they are going to get. Those who have gone through the structural lack of demand argument I advance in other posts will have realised that there is permanent downward pressure on costs in an environment of constant oversupply (this is why there is deflation in the first place)  making inflationary wage increases difficult to envision. Indeed, as reported by another group of Bloomberg journalists (Masaki Kondo, Mariko Ishikawa and Yumi Ikeda), reality itself belies such expectations, since Japan’s wage index hit a post 1992 low in January, even if it has bounced back a little since.

Hardy evidence for looming wage pressure. Indeed the wage-increase-driven inflation argument in Japan curiously resembles a similar one advanced for Germany – in both cases adherents tend to forget that market economies are not centrally planned, even by central bankers, and while you can possibly target equities in a long term deflationary economy caught in a liquidity trap you can’t target wages.
Put another way, it simply isn’t clear what the mechanism which fuels the extra wages that some people are expecting actually is, or why company CEO’s should be influenced by massive liquidity in precisely this way.

The central problem in Japan is constant oversupply, given technical change and a stagnant market, and hence there is permanent price pressure on companies to maintain their share of what market there is. Thus it isn’t surprising to find the following statement in the latest Japan manufacturing PMI report:

“While supporting a rise in exports, a further impact of a weaker currency was to raise the price of imported raw materials. Latest data showed that average input costs rose for the fourth month in succession, and at the sharpest rate in over a year- and-a-half. Margins subsequently remained under pressure as a net fall in output charges was recorded for the twenty-first month in a row.”

So raw material prices rose for the fourth month in succession, while the final product (output) price fell for the twenty fourth successive month. If the demand isn’t there you simply can’t raise prices, or wages. That there isn’t a basic understanding of this reality after so many years of deflation simply astounds me. You could argue that making money cheap and plentiful might encourage people to borrow a bit more and consume more, but borrowing to give some more away in wages, under market economy conditions I simply don’t follow the logic.

In fact Japan’s banking system is awash with deposits, deposits which simply can’t find enough loans to finance, even at interest rates on long term loans which are under 1%. Deposits in the banking system exceeded loans by 186 Trillion yen in March (around 30% of GDP), and the situation is unlikely to change. Much more likely than handing out money to wagearners is that banks who are awash with cash invest in one the country’s private equity funds, for which Bloomberg reports there is growing interest. Those who have been around long enough to remember the Bull-Dog Sauce Co affair may be forgiven if they roll their eyes at this point.

If the idea is to put more money in peoples pockets so that they can spend more, then this is exactly what fiscal policy is there for. But Japan is already running a 10% deficit, and has sizeable deficits running back as far as the eye can see, and that approach hasn’t worked to date, so there is no reason to expect it will start doing so now.

Here Comes My Umpteenth Economic Recovery?

Later this week we will surely open our newspapers (on Thursday to be exact)  to discover that the Japanese economy “bounced back to life” in the first three months of this year. Certainly it would be a huge surprise if it hadn’t. But much as any good news will be welcome we should never forget that Japan has been struggling with its problems since the property bubble burst over 20 years ago. So there has been more than one disappointment along the way.

The sad truth about the Japanese economy is that the demand just isn’t there. Indeed, despite a number of bullish “bravado type” articles (“Japan household spending surges as “Abenomics” gains momentum” -Stanley White and Kaori Kaneko, Reuters, or “Older shoppers lead Japan’s surge in consumer spending” – Ben McLannahan, Financial Times) nothing which has happened of late really changes that assessment.  What consumption indicators we do have are often contradictory. Thus, despite the fact thathousehold spending “soared” 5.2 percent in March from a year earlier in price-adjusted real terms (clearly very good news), in the same month overall  retail sales actually fell 0.3 percent from a year earlier. The key point is that neither of these pieces of data is any way conclusive of anything, and especially since the policy itself didn’t come into operation till April. To be convincing the consumption data would need to improve on a sustainable basis over months and even years.

Looking into the situation a bit further, though, it becomes clear that most of the positive dynamic in consumption is coming from big ticket and  luxury items, and the reason for this isn’t hard to discern – Japan’s Topix stock index is up 65 per cent over the last six months, its strongest rally in decades. But it is important to bear in mind that four-fifths of Japanese households have never held any securities at all and 88 per cent have never invested in a mutual fund, according to a survey carried out last year by the Japan Securities Dealers Association. So while those who do hold shares will benefit from a “wealth effect” (another of the channels in the diagram above, monetary policy puts spending power in the hands of the top 20%) it’s always going to be a fairly minority affair.

But I would stress, since the BoJ measures were only announced on April 4 it is still far too early to be drawing any firm conclusions one way or the other.

It should also be borne in mind that Abe’s second arrow is a boost to fiscal stimulus, and naturally we would expect to see some positive impact on spending coming from that. When you couple this spending with the boost to exports which comes from the weak yen then  it is quite clear the economy should be expected to perform better in 2013 than it did in 2012. But at the end of the day this isn’t really what this experiment is about, since no one doubts extra fiscal spending adds to growth, and Japan isn’t simply trying to emerge from a garden variety recession.

What matters is that the country needs to convincingly demonstrate its ability to “turn the corner” so as to start paying down all the sovereign debt it has been accumulating. Or at the very least it needs to generate sufficient inflation and growth as to reduce the size of the debt as a proportion of GDP. Maybe the economy can get a bit of “bang for the yen” from the various measures, but with the labour force set to decline for decades to come ongoing economic contraction becomes inevitable at some point.  What matters then is the debt and the deflation tandem and how this can be put on a more stable dynamic without resorting to draconian spending cuts which will surely reduce the size of the economy even further. This is what the Abe experiment is about, and this is why the economy needs inflation, but on that front we are still very much in “wait and see” mode.

Domestic Critics Await The Day Of Reckoning

One of the issues facing Abenomics is that while the approach has become highly fashionable abroad (and especially among Hedge Fund managers), back home there are a growing number of critics raising doubts it will actually work. Doubts about the ability to reach the inflation target even start with the current board of the central bank itself. Board members are divided over the outlook for inflation, with some anticipating that consumer prices won’t even be rising at half the targeted rate two years from now. Former investment-bank economists like Takahide Kiuchi and Takehiro Sato, themselves recently appointed to the board, voted against the statement which set down that the bank believes inflation is likely to reach 2 percent in the latter half of the three-year BOJ forecast horizon. Governor Kuroda, however, is more optimistic and thinks the goal will be achieved in the 2015 fiscal year.

If the current board members have their doubts, those from the outgoing one tend to be even more scathing. Masaaki Kanno, now chief Japan economist at JPMorgan Chase in Tokyo put it bluntly to Bloomberg journalists, “It’s unrealistic — they won’t be able to reach their target in two years, or even in five.” Kuroda’s predecessor at the bank, Masaaki Shirakawa, is another who is far from convinced. Shirakawa sees deflation more as a symptom than a cause of Japan’s problems which, he argues, have important demographic roots.

“If there was a single thing that would have cleared the fog and solved all problems, Japan wouldn’t have been in this situation for 15 years,” he said in a speech on March 19, his last day in office. Journalists covering the Japan story might like to bear this in mind.

It is hard to disagree with Shirakawa, even though the former central bank board is being widely trashed. If demography is at the heart of the problem, it’s far from clear how massive monetary easing is going to solve it. In fact even Paul Krugman, intellectual godfather to Abenomics, sometimes seem to have his doubts. At one point he even said: “Here’s the thing, however: the economy won’t always be in a liquidity trap, or at least it might not always be there”. (Monetary Policy in a Liquidity Trap – NYT April 11 2013).

The use of that little word “might” is striking for such a bold experiment.

In fact once you look into it the Nobel economist seems to be hedging his bets all over the place. In the same article he says: “So, at this point America and Japan (and core Europe) are all in liquidity traps: private demand is so weak that even at a zero short-term interest rate spending falls far short of what would be needed for full employment”.
So its not just one problem, it’s at least three. But are all these liquidity traps the result of low fertility, or only some of them?

In an earlier article – The Japan Story (NYT February 5 2013)  –  he threw a bit more light on this, since he commented: “Oh, and what about the US relevance?………… What I think you can argue is that because we don’t share Japan’s demographic challenge, our liquidity trap is probably temporary, the product of an episode of deleveraging”.

Temporary????  Doesn’t that imply Japan’s may be permanent, which it is why he says it only “might” escape. And what about Europe, which is half US half Japan in demographic terms, will Europe’s liquidity trap be “semi-permanent”?

The thing is this, given all the doubt about the real roots of Japan’s problem, and the fact that it may well be permanent – as working age population slides there might be a permanent, structural excess of demand over supply – is it really justified to run such a high risk, all-or-nothing experiment?  What makes people nervous is the thought that if the central bank can’t deliver on its promise then a loss of confidence might ensue, and all those dubious risky asset positions might unwind suddenly, just like an earlier set did in 2008.

Seki Obata, a Keio University business school professor who in January published a book “Reflation is Dangerous,” argues exactly this, that “Abenomics” is exposing Japan to considerable risk without any clear sense of what it can accomplish. Obata also makes the extremely valid point that there is simply no way incomes can rise across the entire economy because the baby boomers are now retiring to be replaced by young workers with only entry-level wages. Japan’s overall consumer spending power will therefore fall, rather than rise as Abe hopes.

“Individual companies may offer wage increases, but because of demographics it is simply impossible to increase the total amount that is paid out in wages,” says Obata. “On the contrary, that amount will shrink.”

Simple logic you would have thought, but logic in the face of irrational exuberance scarcely stops people in their tracks.

As is clear from all I am saying here, the gist of the criticism which is leveled at Abenomics is related to the the idea that the country’s problems have strong demographic roots. With this in view, many members of the central bank “old guard” feel they are being unjustly held responsible for not finding a solution to a problem which it may not be within the capacity of monetary policy to solve. In a 2012 speech – Demographic Changes and Macroeconomic Performance
- former BoJ governor Masaaki Shirakawa argues the following:

“Japan’s economic growth gradually slowed during the past two decades mainly for two reasons. In the former half of the period, the Japanese economy was hobbled by the crippling effect of the burst of the bubble. In the latter half, the rapid population aging hampered the Japanese economy through a variety of channels.”

Regarding inflation, he continues:

Seemingly, there would be no linkage between demography and deflation. But it may not be the case. A cross-country comparison among advanced economies reveals intriguing evidence: Over the decade of the 2000s, the population growth rate and inflation correlate positively across 24 advanced economies. That finding shows a sharp contrast with the recently waning correlation between money growth and inflation. How could we square those facts with each other?

Another former board member Takahiro Sekido, now a strategist at the Bank of Tokyo-Mitsubishi UFJ is even more direct: “The BOJ’s bond buying can’t resolve the shrinking population or aging of society. Because Japan’s productivity has only marginal room to rise, it’s necessary to prevent a decrease in population or to encourage more participation of female workers for economic growth.”

A comment which points to one evident conclusion, that Japan needs deep seated cultural changes, especially ones directed to greater female empowerment and more open-ness towards immigration. Hardly matters for central bank initiatives, and indeed ones for which Shizo Abe, who naturally has given his name to this new economic trend, is singularly ill equipped to carry through.

Managed Population Decline

Perhaps the most important thing which the whole Abenomics episode has brought to light is the urgent need to bring the existing corpus of economic theory somehow up to date with our modern realities. Despite all the talk of policies for “growth, growth, growth” a simple look at the population outlook in OECD countries, and especially the potential work force numbers means at some point or another economic growth will turn broadly negative. Valter Martins wrote about this in a post examining the Portuguese case I put up at the weekend, but former Bank of Japan governor Masaaki Shirakawa makes exactly the same point in the speech I mentioned earlier.

“Neoclassical growth theories normally do not distinguish the overall population from the working-age population for reasons of analytical simplicity. However, without taking into account the distinction between the two variables explicitly, the very challenges that Japan is currently faced with will be outside the scope of analysis.”

The key point is that when labour forces are growing, the extra employment adds positively to productivity to generate growth, when they are stationary labour is neutral and economic growth is equivalent to productivity growth, but when they are contracting then you have to subtract the rate of contraction from the rate of productivity growth to get your final GDP growth number.

“The [neo-classical] economic growth model supposes that everyone works at a given intensity. With a labor-augmenting technological change, in the long run steady state, per capita variables grow at the rate of technological change, and aggregate variables grow at the rate equal to the sum of population growth and technological change. In aging economies, including Japan, where the working-age population has started decreasing, the labor force also declines, given the participation rate being held constant. Because the scarce labor force imposes a natural constraint on labor supply, the marginal product of capital declines accordingly. As a result, macroeconomic growth would be impeded. With this idea in mind, the Japanese economic data in the past decade indicates that the workforce declined by 0.3 percent point, labor productivity increased by 0.8 percent point, and they add up to real GDP growth rate increase by 0.6 percent”.

Many of those who want to argue that miracle productivity performances make the demographic issue irrelevant normally simply fail to understand growth accounting dynamics or little about the productivity performance of developed economies over the last 20 years. Getting productivity growth of over 1% per annum  is hard, very hard, and will become even more so with an increasingly elderly workforce. A point which isn’t lost on US growth theory expert Robert Gordon.

So the real point is there is an experiment being conducted in Japan, but the experiment isn’t Abenomics (which I suspect won’t work, and could end very badly). No, the experiment is about learning to grow old with dignity, not as individuals, but as societies. It is about managing debt in a time of deflation, about giving opportunities to the young, even while the force of the ballot box rides with the old, and about finding ways to ease that rate of work force decline to give some additional room to allow productivity to help, which means again helping the young, since they are the ones who start families.

I will close with a quote from Keynes, one which comes from the same talk from which I drew an extract to start this piece. Population decline has been seen coming for decades, there are few things about the future we can know with a higher level of probability, and yet we find the reality and its consequences hard to accept. Rather like our own finitude I suspect. Yet accept we must, since otherwise it will be hard to find the energy to act, and to make the changes we must make if we don’t want a difficult process to become an extraordinarily painful one.

“Perhaps the most outstanding example of a case where we have a considerable power of seeing into the future is the prospective trend of population. We know much more securely than we know almost any other social or economic factor relating to the future that, in the place of steady and indeed steeply rising level of population we have experienced for a great number of decades,we shall be faced in a very short time with a stationary or declining level. The rate of decline is doubtful but it is virtually certain that the changeover, compared to what we have been used to, will be substantial. We have this unusual degree of knowledge concerning the future because of the long but definite time-lag in the effects of vital statistics. Nevertheless the idea of the future being different from the present is so repugnant to our conventional modes of thought and behaviour that we, most of us, offer a great resistance to acting on it in practice”.

Retail savers in the US are abandoning certificates of deposits (CDs). The amount of CDs outstanding that are $100K or smaller has been on a sharp decline since the recession and is now at the lowest level since the Fed began keeping track of these balances.

The question is why? There have been a number of explanations, but few have been completely satisfactory. Here are some of them:

1. Since the financial crisis banks have been less reliant on “wholesale financing”, reducing incentives on term deposits (in some cases under the pressure from the FDIC). Indeed the rate on CDs has collapsed in 2009.

Source: Bankrate.com

The problem with this argument is that CDs still carry better yields than money market funds, most overnight accounts, or treasury bills.

2. After the financial crisis, people want to have access to their money immediately, while banks charge penalties for early withdrawals from CD accounts. This is certainly possible, but at the same time small investors are loading up on short-term bond funds and ETFs (see post). And those products can definitely fluctuate in value enough to cause the equivalent “penalty” from early liquidation.

3. People just don’t have the cash to put into CDs. This explanation would make sense if it wasn’t for the fact that savings account balances have been rising steadily since the recession.

4. Savers don’t trust banks with money they can’t immediately withdraw. Again, it’s a strange argument given the fact that all of these CDs are FDIC insured.

5. Another explanation for this decline in CD balances is that in a number of instances, savings accounts may actually pay more. Some small banks, particularly credit unions, with limited retail presence want to attract customers by offering high savings rates. Non-traditional banks like Ally (GMAC), CIT, American Express Bank, USAA Bank, etc. are also in this game. According to GoBankingRates.com (see story) “short-term CDs often carry half or even less the interest you’ll find on an online savings account, even though savings are more liquid.”

The problem with such savings accounts is that these are often “teaser rates” and banks can and often do lower the rate suddenly vs. a CD that locks the rate for a period. Also in many instances (particularly with credit unions) individuals can’t open these accounts online and have to show up on location in person. But it does seem that “high yielding” savings accounts have been the preferred choice of at least some savers as they walk away from lower yielding certificates of deposits.

6. Probably the most logical explanation is that for many people, getting 25bp in a 3-month CD vs. zero in a Chase overnight account, while massively better on a relative basis, isn’t sufficiently different on an absolute basis (total dollars) to give up liquidity or warrant the paperwork of opening a CD account.

As Merrill’s junk bond index yield crossed the historical low of 5% on Thursday, some senior Fed officials are clearly becoming uneasy. Corporate credit markets are entering bubble territory (see discussion) and up until recently very little has been said on the topic by the US central bank. On Friday Ben Bernanke sent a signal to the markets that the Fed is watching the “reaching for yield” situation “particularly closely”.

Ben Bernanke (May 10, 2013) – … We follow developments in markets for a wide range of assets, including public and private fixed-income instruments, corporate equities, real estate, commodities, and structured credit products, among others. Foreign as well as domestic markets receive close attention, as do global linkages, such as the effects of the ongoing European fiscal and banking problems on U.S. markets. 

Not surprisingly, we try to identify unusual patterns in valuations, such as historically high or low ratios of prices to earnings in equity markets. We use a variety of models and methods; for example, we use empirical models of default risk and risk premiums to analyze credit spreads in corporate bond markets. These assessments are complemented by other information, including measures of volumes, liquidity, and market functioning, as well as intelligence gleaned from market participants and outside analysts. In light of the current low interest rate environment, we are watching particularly closely for instances of “reaching for yield” and other forms of excessive risk-taking, which may affect asset prices and their relationships with fundamentals. It is worth emphasizing that looking for historically unusual patterns or relationships in asset prices can be useful even if you believe that asset markets are generally efficient in setting prices. For the purpose of safeguarding financial stability, we are less concerned about whether a given asset price is justified in some average sense than in the possibility of a sharp move. Asset prices that are far from historically normal levels would seem to be more susceptible to such destabilizing moves.

The chart below must give at least some US central bankers a reason to reflect on the current pace of monetary expansion. What “unusual patterns in valuations” will another $1.5 trillion of securities purchases create? The FOMC is likely to have at least some debate on the topic at the next meeting.

And then he also bolds this accompanying statement from JPMorgan Chase:

It is not surprising that the periphery is exhibiting a rising pattern in terms of NPL ratios. What is worrying is the speed of increase, at 2.5% per year. 

When I see the chart for Euro zone NPLs and look at the numbers, I think debt deflation. And this is exactly the problem with the euro zone’s policy mix. Contractionary fiscal policy only invites more private deleveraging. And that is tipping countries with high private debt into a vicious debt deflationary cycle that vastly inflates NPLs and weakens the financial sector tremendously.

It was interesting for me that just an hour before I saw this chart, I saw via a Twitter link from another FT Alphaville contributor Simon Hinrichsen that Jeroen Dissjelbloem, the new Eurogroup head, came out with a statement this weekend on the policy mix that highlights Europe’s thinking. CNBC quotes Dijsselbloem as saying:

“Monetary policy can really not help us out of the crisis. It can take away the pressure, it can accommodate new growth. But what we really need in all countries is structural reforms in the first place.

“I’d just like to stress the point that in the policy mix of fiscal policy, monetary policy and structural reforms — I’d like the order to be exactly the other way around. Structural reforms in the first place, fiscal policy and viable targets in the mid-term for all regions in second place — and monetary policy can only accommodate domestic economic problems in the short-term.”

Notice that what Dijsselbloem is really saying is that he wants loose monetary policy to partially offset fiscal consolidation while structural reforms are implemented which will enhance medium-term growth. What Dijsselbloem is saying is that Europe wants a fiscal policy that is short-term contractionary but will partially offset this by a looser monetary policy, with structural reforms as the holy grail of longer-term growth – as they were in Germany (and the Netherlands until the crisis killed that growth).

Now contrast this to Japan.

In Japan, it is the same three pillars that define Abenomics: fiscal policy, monetary and structural reform. As I put it in my post on the Widowmaker trade last month, “If you want to use stimulus at all, then you need to have reform policies as well. It’s a three-pronged approach. The supply side matters. And that is the promise of Abenomics, isn’t it: fiscal and monetary stimulus as bridges to sustainable growth due to economic reform. Supposedly, this is what Abenomics is all about.”

In Japan, Abenomics loose monetary policy is used to enhance fiscal expansion while structural reforms are implemented which will allow medium-term growth to continue.  See the difference? Japan’s policy mix is reflationary – with some like Kyle Bass intimating it is even hyper-reflationary. On the other hand, Europe’s policy mix is deflationary – with some like me and the other Edward arguing that it is even debt deflationary. The key difference is fiscal.

On monetary policy, however, just last night I saw the following on from David Beckworth about Abenomics quoting Lars Christensen:

the competitive devaluation arising from Abenomics may be the catalyst to kick start the ECB into more serious efforts if they care about the Eurozone’s external competitiveness. The ECB may ease to keep the Euro from getting too expensive and in the process shore up European domestic demand. How ironic it would be if Abenomics were to accomplish in the Eurozone what  intense human suffering could not: moving the ECB to forcefully act.

We will have to see if that’s actually the case. Jeroen Dijsselbloem is saying just the opposite right now. The Eurogroup head is saying that fiscal policy will remain contractionary and that monetary policy should not be loosened any further to override this. Only structural reform will help in the long run.

If David is to eventually be proved right about the ECB joining the competitive currency devaluation party, it will be because the debt deflation now ongoing in the periphery also hits countries like the Netherlands where private debt is already creating a big problem despite the vaunted structural reforms of the past. As I warned members last year, (Dutch and) German policymakers don’t understand debt deflation. The policy mix will remain debt deflationary until it does engulf the Netherlands (and France). And then we will see what happens.

I have been arguing for several years that once China begins the adjustment process, which I expect to characterize the ten-year period of the current administration, growth rates must slow significantly. My expectation for long-term growth is that it shouldn’t average much above 3-4% annually. This is what it will take for household consumption to rise to roughly 50% of GDP in a decade if consumption growth can be maintained at its historic rates of around 8%.

But I always warn that this is likely to be an upper limit, not a lower limit, to growth  The key is whether or not it is possible to maintain current levels of consumption growth once investment growth is sharply reduced. A recent paper by the IMF on the topic is very interesting and not encouraging.

In the paper(“China’s Path to Consumer-Based Growth: Reorienting Investment and Enhancing Efficiency”) Il Houng Lee, Murtaza Syed, and Liu Xueyan team up again to examine the impact of investment in different regions and sectors of the economy. The abstract of the paper is:

This paper proposes a possible framework for identifying excessive investment. Based on this method, it finds evidence that some types of investment are becoming excessive in China, particularly in inland provinces. In these regions, private consumption has on average become more dependent on investment (rather than vice versa) and the impact is relatively short-lived, necessitating ever higher levels of investment to maintain economic activity. By contrast, private consumption has become more self-sustaining in coastal provinces, in large part because investment here tends to benefit household incomes more than corporates.

If existing trends continue, valuable resources could be wasted at a time when China’s ability to finance investment is facing increasing constraints due to dwindling land, labor, and government resources and becoming more reliant on liquidity expansion, with attendant risks of financial instability and asset bubbles. Thus, investment should not be indiscriminately directed toward urbanization or industrialization of Western regions but shifted toward sectors with greater and more lasting spillovers to household income and consumption. In this context, investment in agriculture and services is found to be superior to that in manufacturing and real estate. Financial reform would facilitate such a reorientation, helping China to enhance capital efficiency and keep growth buoyant even as aggregate investment is lowered to sustainable levels.

Among the interesting findings of the paper, one is not (to me) at all unexpected. The authors find that investment is much less efficient in the poorer inland provinces than in the richer coastal provinces. This shouldn’t be a surprise. The inland provinces have much lower levels of worker productivity and lower social capital. This means that they should be much less capable of absorbing high levels of capital than the coastal regions.

But this argument – so logical, at least to me – flies in the face of the single most widely-used argument that China bulls have made in favor of additional investment. They argue that because capital stock per capita is much lower in China than in the US, the automatic conclusion is that China has a near-infinite ability usefully to expand investment – at least until it begins to approach the frontier of US levels. If this argument is true, investment should be much more productive in the inland provinces than in the coastal provinces because the inland provinces have much lower capital stock per capita than the coastal provinces and so are further from the “frontier”.

But it isn’t, according to the IMF paper. It is even more wasteful. Richer, more productive economies with higher levels of social capital (which include property rights, a clear legal framework, education, minimal regulatory distortions, minimal government intervention, limited corruption, etc.), in other words, are better able to absorb investment than poorer less productive economies. The appropriate level of investment for a country that is much poorer than the US is much lower than the appropriate level in the US. China does not have infinite ability to expand investment productively, and in fact, I would argue, has long ago passed the point where investment in the aggregate is wealth creating.

And this applies within China. It simply isn’t true that the poorer the province, the more investment should be poured into the province. The poorer inland provinces simply are incapable of absorbing investment, and before the authorities pour money into these regions they will need to make the difficult legal and social reforms that improve underlying productivity and social capital. Until then, additional investment is even more likely to result in negative wealth creation in the inland provinces than in the coastal areas.

The other very interesting finding of the IMF paper is that – surprise! surprise! – consumption growth is itself dependent on investment growth, and this is more true in the inland provinces than in the coastal provinces. The more money you pour into investments, no matter how unnecessary, the more local households consume. This shouldn’t have been unexpected because local household income is so dependent on consumption, especially in regions in which government-led infrastructure spending is the only real source of economic activity – such as the poor inland provinces.

The conclusion, I think, is that it is going to be very hard for China to maintain the current level of consumption growth if investment stops growing, and if consumption can only create 4.2 percentage points of GDP growth at current levels, why would we assume China’s long-term growth rate is much above that unless we assume that China can keep investment levels growing for a long time? Another conclusion of the IMF paper – very useful from a policy point of view – is that certain kinds of investment, in agriculture and services, for example, have a much more positive effect on consumption than others (it is probably not a coincidence that these are likely to be the least wasteful investment areas). In that case it suggests that the brunt of the adjustment in investment growth should not occur in the agricultural and service sectors.

Assets and liabilities

On Friday Tom Orlik had an interesting article in the WSJ about Chinese debt, in which he cites analysts who argue that because the government has assets that exceed the liabilities, we should be less concerned about the size of the debt. It’s a short article worth citing in full because, I think, it demonstrates a number of popular misconceptions:

China’s debt is scary, but its assets are reassuring. Taken together with local government borrowing and other obligations, China’s gross government debt could be as much as 60% of gross domestic product, says UBS China economist Wang Tao. Corporate and household debt has also been on a tear, up to 201% of GDP at the end of the first quarter from 138% at the end of 2008 according to Bernstein Research.

Those are alarming trends. But debt is only half of the story. On the other side of China’s balance sheet, there are some significant assets. The net assets of state-owned enterprises reached 27.3 trillion yuan ($4.4 trillion) in 2011 equal to 58% of GDP in that year, says Dragonomics China analyst Andrew Batson. The state is also a major owner of land. China’s public sector is out of the red, even without taking account of massive foreign exchange reserves, which couldn’t easily be used to bail out domestic problems.

For the corporate sector, assets have grown in line with liabilities. Take the firms listed in Shanghai–China’s flagship equity market. The asset to liability ratio for this group has risen to 118% in 2012, up from 113% in 2007, according to Factset. Industrial overcapacity and reckless building by local governments mean some of China’s investment has not been valuable. A bridge to nowhere is not easy to bank. In a crisis, political paralysis and illiquid markets mean selling assets would be tough–Latin American countries discovered as much during debt crises in the 1980s and 1990s.

Still, China’s strong asset base points to a fundamental difference with the build-up of debt in the U.S. Borrowing to fund consumption–the U.S. model–does not create a stream of future income or an asset that can be used for repayment. Borrowing to fund investment–the China model –does.

One of the big problems with analysis of China is that most analysts seem to have little experience with other developing countries, and especially with debt problems in other developing countries. As a result they tend to repeat mistakes in a fairy predictable way. For one thing, they look at current debt levels without factoring in what I call balance sheet inversion in my 2001 book The Volatility Machine.

Basically what this means is that under certain kinds conditions or balance sheet structures, an adverse shock, or slowing growth, causes an explosion in contingent liabilities, most often through the banking system, and it is this explosion in contingent liabilities that creates the debt problem for the country. If growth slows in China, in other words, this should cause a sharp rise in NPLs, especially if borrowers are counting on rising prices to service the debt, which will itself cause slower GDP growth, and so on in a self-reinforcing way. If we want to understand the debt problems facing China we have to consider not just the current debt on the balance sheet but also what the balance sheet is likely to look like after an adverse shock.

In fact there is a regular pattern that we see when debt levels rise in a country to the point at which either we suffer from a debt crisis or from a lost decade of difficult adjustment. First, as sovereign debt levels and contingencies rise, we deny that they are rising. Then we acknowledge that they are rising but we argue that debt levels are very low. Then we acknowledge that they are high, but we point out that the sovereign has more assets than debt. Next we acknowledge that the excess of assets is irrelevant but the country is only suffering from a liquidity crisis. Finally we acknowledge that there is indeed a debt problem.

This seems to be what the WSJ article is describing. It is good that even analysts who used to be much more optimistic are finally recognizing that there is too much debt, but is it true that the Chinese government has more assets than debt? Of course it is. But this was also true in every single country in history that has ever had a debt crisis. Governments always have enough assets, or taxable authority, but since they enjoy sovereign immunity the question is not whether they have enough assets to cover the debt but rather whether they are willing to liquidate assets (and the power that comes with control) to cover debt. They almost never are.

In fact this whole issue is irrelevant. China is not going to default on its debt, and so whether or not lenders can seize government assets doesn’t matter. What matters is whether the returns on the assets are sufficient to pay the true unsubsidized cost of the debt. If they are not, then there must be a transfer from somewhere else to cover the difference, and this somewhere else is usually, and has been in the case of China, the household sector. It is the size of this transfer that causes growth to slow.

This is an abbreviated version of the newsletter that went out three weeks ago.  Academics, journalists, and government and NGO officials who want to subscribe to the newsletter should write to me at chinfinpettis@yahoo.com, stating your affiliation, please.  Investors who want to buy a subscription should write to me, also at that address.

Since the ECB’s decision not to pay interest on reserves, when it brought the deposit rate to zero last July, banks have shifted their funds out of the deposit facility and into current balance.  At the same time, they moved funds out of the ECB altogether.

On May 8th, banks further trimmed their overnight deposits at the ECB and at 120 bln euros is the least amount since November 2011.  Banks increased their current account holdings to 46 bln euro to 347 bln, which is the most since mid-April.  We see rise of the current account holdings as a reflection of banks preparing for their reserve maintenance period.

ECB President Draghi suggested last week that the central bank was taking a fresh look at the deposit rate.   There does not appear to be any economist that thinks it is a good idea.  The reasons vary, but the two main reasons are that it would likely prove ineffective in boosting lending and would be potentially disruptive to the money markets and financial institutions. 

Classic economics teaches a lower price should, all else being equal, increase demand.  It seems that the financial and economic crisis is such that the low price of funds has not increased the demand, for the most part, leaving aside US C&I loans.  Contracting economies, generally high levels of unemployment, and weak aggregate demand have crushed the animal spirits.

The implications of a negative deposit rate go well beyond the 120 bln of overnight deposits at the ECB.  A negative deposit rate would likely downward pressure on other short-term rates and exacerbate the capital preservation efforts.  It would threaten profitability of a range of activities.  No major central bank in the last quarter of century  has done so and after a closer study we expect  the ECB not to be the first.to impose a negative deposit rate. 

Draghi indicated that the ECB was looking for ways to support lending to small and medium sized businesses, which, given the economic structure, is particularly important for Spain and Italy.  Draghi seemed to link this to discussions with national government to reanimate the ABS market, which the US did much earlier in the crisis, with reasonable success. 

That the ECB would buy these, as some news reports suggest is being considered, seems a bit more of a stretch.   Some structures are acceptable as collateral already and adjusting the haircut applied or liberalizing what is acceptable as collateral seems a more likely route for an institution that has been so reluctant to use its balance sheet. 

Some German voices have already expressed concern about the ECB becoming a bad bank (where its balance sheet and collateral is effectively warehousing toxic below investment grade assets).  Similarly, it is inconceivable that the ECB buys the non-performing loans from Spanish or Italian banks as some press reports have suggested.

Meanwhile, rarely has the UK Telegraph or the blogosphere paid so much attention to what former Finance Minister (1998-1999) and leftist opposition leader Oskar Lafontaine says.  However, his recent call for the dissolution of monetary union has dovetailed with the observers’ agenda.  The slippage in recent polls of for Merkel’s CDU has more to do with the recent high profile tax evasion than the rise of the new anti-EMU party, which may not even be represented in parliament after the September elections.