Well the eurozone government deficit problem has hit the agenda with a thud again in the last few days. Yesterday the FT ran a story about how the ECB has decided that it will not accept government paper (bonds) in the future from any country which has not maintained at least an A- rating from one or more of the principal debt assesment agencies. (Dave Altig at MacroBlog has also covered the story here, and Nouriel Roubini here). Today the FT has another story about how Trichet has confirmed the policy, and how the Commission too plans to get tough (well they would, wouldn't they, since this may now become a credibility auction).
This topic must appear appaulingly technical and yawn-provoking to the non-economist. In fact nothing could be further from the truth. Let me explain a bit.
Basically the situation we have had to date has been that the ECB has accepted the bonds of any one country as equivalent to the bonds of any other, just like a one euro coin from France is treated as equivalent to a one euro coin from Finland in any shop in the Eurozone. The ECB makes its presence felt on this via the assets it accepts as reserve deposits from eurozone central banks.
Now basically this decision is a vote of only limited confidence in the mechanisms put in place by the EU commission via the Stability and Growth Pact. Italy has been given two years grace to put its house in order. Serious doubts remain as to whether anything will really change significantly during the next two years, but if it doesn't the fiscal credibility of the Commission will be in tatters. The ECB is cleary concerned that its credibility may also go west in the process (a clear case if there was one of 'credibility rot'). So the bank has put up a marker: here and no further. This is always a difficult thing to do, since if you ever say never, and then change your mind, you obviously end up with egg all over your face (the 'moral hazard' issue is all about this).
This decision is an important one (I would even say a landmark one) since it is hard to see how there can be a turning back. Basically the ECB is saying to the Italian government: you may be able to pull the wool over their eyes up in Brussels, now try the same ploy with the rating agencies.
Well, if the Italian government desists from excess deficits there will be no issue, but my fear is that they may not be able to.
Basically, and plagiarising Brad Setser and Nouriel Roubini just a little: 'demographics also matter'. The problem isn't simply that Italy has had a series of governments that have been systematically profligate. It also has possibly the most rapidly ageing population on the planet (it is about to overtake Japan, and then in turn be overtaken by Spain as the oldest country if the UN projections are valid). So this is about sustainable fiscal dynamics and tax wedges vis-a-vis employment generation. The Italian government really is between the proverbial rock and the hard place.
In reality I imagine that what we will see is a steady drift away from central bank willingness to hold Italian paper in reserves (it is important to bear in mind here that the ECB itself has relatively little capitalisation, and each country still has its own central bank, and its own reserves). So the other central banks (and who knows, Asian central banks and anyone else who holds sizeable quantities of eurozone paper) may well slowly move Italian paper out of their reserves. After all, if the ultimate guarantor isn't willing to accept at par, who else is going to risk it.
The consequence of this is that the so-called yield spread - the difference in effective interest rate operating on a 10 year German bund and that on a similar bond from the country in question - should start to widen (at presnt Italian bonds are trading with a differential of a little over 20 base points, or 0.2%, over the German bund). This is very likely now to widen: probably slowly but steadily.
Morgan Stanley economist Joaquim Fels (who I do think is at least listened to over at the ECB these days) has been arguing for some time now that the fact that the ECB treated all euro-govt-bonds at par was one of the principal anchors preventing a thickening in the yield spread. Well now the anchor has been cut (rather than weighed). What can now happen is that each time the Italian deficit fails to comply with promises and forecasts, someone, somewhere can try and test the spread. In the beginning I imagine this will be a non event, but just give it time. A little crack has open up in the wall, and now some will know no rest until it has finally been breached. The ECB decision has opened up the real possibility of speculative attacks against sovereign debt inside the eurozone, and this is obviously a first, in fact *the* first new possibility on the horizon since the euro was launched.
As I say, I think a decision like this is very hard to go back on, so it is difficult to see how the ECB could 'blink' here even if it wanted to. A 'bail out' could be arranged indirectly if the yield spread grew too much, but to keep doing this you need to be convinced that Italian growth and fiscal policy will get back onto a sustainable trajectory. I am not convinced that they will, and thus there may well be a 'high-noon' situation.
Of course, we are only at the begining of a long process here, butas I say I think this decision is a landmark one.
Also, again plagiarising Nouriel Roubini and the late lamented Rudi Dornbusch: politics matter. The backdrop to all this is the recent failure of the EU constitution vote, long standing frustration at Eurostat about blatantly falsified Italian data, and now the Fazio affair, where EU internal market commissioner Charlie McCreevy seems to be so frustrated that he is actually demanding that legal action be taken against the governor of the central bank in a sovereign state. I guess this would also be another euro first.
Many worry these days about the level of tolerance for globalisation and the dangers of protectionism, but my guess is that the danger of a kind of 'internal protectionism' inside the EU, with citizens in one country being reluctant to bail out citizens in another, is a much more real and present danger. Note how Dutch finance minister Gerrit Zalm has taken a ringside seat to applaud the ECB initiative.
Bottom line: we've just pushed the boat out and there may now be no easy way to draw it back in again.
Anybody wanting a more serious academic background explanation to all this could do worse than this paper by Buiter and Sibert: How the Eurosystem’s Open Market Operations Weaken Fiscal Discipline in the Eurozone (and what to do about it) (Hat Tip to Nouriel Roubini).
Germany At A Glance, January 2008
Welcome to the Euro Watch Blog. Below you will find the normal chronological blog posts. But first we would like to present a special feature on the German economy, together with some charts which provide background data and which we hope will help the first time reader better assess and get to grips with the argument being presented here. The big question which arose concerning the Germany economy in 2007 was whether or not the new found dynamism in German economic activity constituted some form of remaissance, and formed part of a global decoupling process whereby a sustainable recovery in domestic demand was taking place. Analysts on this blog never really accepted this view. The key question and central enigma associated with the German economy is really why domestic demand should have remained so congenitally weak over such a considerable period of time. Since this phenomenon is also to be observed in the the two other societes with very high (circa 43) population median ages - Italy and Japan - we postulate that demographics and population ageing processes offer some part of the explanation here. Basically what we can observe as societies move above the 40 median age mark are a number of stylised facts. Weakness in domestic private consumption would be one of these, absence of consumer credit driven property booms would be another, growing pressure on the national debt as the elderly dependence ratio steadily rises would be another, and growing dependence on export growth for sustaining GDP growth would be the central feature of the whole edifice. We hope you will find the background data presented here useful in assessing the argument which we are presenting on this blog, which is basically that a key component in the longer term growth stagnation from which Germany is suffering has its roots in the underlying demographics. Basically and in the long run (possibly with a 30 year lag) fertility does matter. Please click on thumbnails for better viewing.
As can be seen from the chart this crucial age group touched its highpoint in 1997/98. This could be thought of as the moment of maximum capacity for the German economy since it includes the crucial 25 to 40 household-former, first-time-homebuyer group. In terms of credit expansion, it is this group which drives a significant part of internal demand.
The age group also includes another important group, the 35 to 50 years one. This group drives an economy in productive terms, since these are the prime age workers. If you think of a society as a 100 metres sprint athlete, then there is an age when this athlete is at the maximum of his or her running potential, an age after which each time they can only run the 100 metres more slowly.
Well a society is the same in terms of its collective economic potential, without addressing underlying issues either through fertility or immigration, it can only move forward more and more slowly. Consumption becomes flat, and GDP growth - gioven the external dependence - fragile.
Private consumption has hovered pretty close to the 60% mark for many years now, while government consumption - after moving sharply upwards as a total share in the first half of the 1970s has subsequently remained pretty constant, moving around the 19% of GDP mark. The big difference has been in the importance of fixed capital formation (GFCF) which reached from 1975 to 2000hovered around the 22 - 24% of GDP mark.
Prior to 1975 GFCF was at a much higher level, while post 2000 it has dropped substantially And So what we can see is that the year between, say, 1975 and 2000, when GFCF remaind a more or less constant share of GDP, constituted - to use the language of neo-classical economics - the constant growth period of the German domestic economy.The years prior to 1975 were the convergence, or "catch-up" years
And especially the 1960s, after Germany finally broke out of the destruction and devastation of WWII - while the years after 2000 constitute what the neo-classicists would call the "balanced growth period", although as we can see, it isn't very balanced, and there certainly isn't a steady state.
2008 Forecasts: There is a consenus at the present time that the German economy is slowing. Where there is no real consensus is over the rate at which it is slowing and where and when it will settle. It is clear that GDP growth in 2007 will be below the heady 3.1% annual rate achieved in 2006. The OECD last December revised their 2007 German forecast down to 2.6%, and their 2008 one down to 1.8%. The IMF in their October World Economic Outlook forecast growth for 2007 at 2.4%, slowing to 2% in 2008. Morgan Stanley's Elga Bartsch, while optimistic that the German economy will whether the credit crunch better than most (and here she may well be right) is somewhat more sanguine, putting 2008 growth at 1.5%. In general though I rather doubt her overview that "Germany could well be on the way to becoming the new growth locomotive in Europe." and especially her suggestion that "the phase of underperformance in terms of GDP growth, which has plagued Europe’s largest economy for years, is clearly over." Unfortunately, what we are arguing on this blog is that Germany's GDP growth rates since the mid 1990s are not some special kind of "underperformance", but what can be expected from a society with a rapidly rising median age which is increasingly dependent on exports rather than domestic consumption for growth.
The EU commission in it's November 2007 forecast was also convinced that the German economy was now on a "solid growth path", forecasting 2.5% growth for 2007 and 2.1% for 2008. I personally will be very surprised if we see growth in the region of 2% for the German economy in 2008, and I even consider the 1.8% from the OECD and 1.5% from Morgan Stanley still on the high side given the extent of downside risk. Basically the reasonably favourable depreciation rules which currently apply to German investment have been changed as of 1 January 2008, and we might reasonably expect to see some sort of impact on investment comparable with the negative shock which hit private domestic consumption following the VAT rise on 1 Jan 2007. In addition all the indications suggest that German consumption will continue to be weak in 2008. So if consumer consumption is at best flat, governemnt consumption equally so, and investment and construction weakening, we are simply lefy with export growth, and here the outlook is definitely more negative in 2008 than it was in 2007. The Spanish economy (one important German customer) is visibly wilting by the day, as is the UK (another big customer), but it is to Eastern Europe we must look for the biggest impact on German exports of any correction in 2008. Just one data point should suffice, Germany exports roughly the same value of goods to the Czech Republic (and more to Poland) as it does to China. This means that Geramny is proportionately not that exposed to any slowdown in China, but hugely exposed to any sudden shift in growth and demand in the East of Europe.
So I would say, that on current data, 1% growth in Germany in 2008 look a reasonable estimate at this point, but that this needs to be taken to mean with considerable downside risk. Germany is now tremendously dependent on what happens elsewhere, and until what does actually happen elsewhere becomes clearer it is difficult to be more precise on Germany. The only apparent bright spot on the horizon is employment, but I am dubious that in the context of Germany's ageing workforce this will work through as some are hoping, as I expain at some considerable length in this post here. My opinion is that Germany will enter recession at some point during 2008, and that we may well have 2 consecutive quarters of negative growth. The continuing high euro will maintain pressure on German exports, and high oil and food prices will maintain pressure on the inflation front, at least in the first half of 2008. The ECB will probably switch stance towards rate reductions at some point, but since, as Elga Bartsch among many others so eloquently argues German internal consumption and investment are not especially dependent on credit conditions, easing from the ECB may not have as much impact as one would hope for.
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