Thursday, January 29, 2009

Spain's Recession Deepens

Spain's economy is now most evidently, and totally and completely officially, in its first recession since 1993. The final confirmation of this came yesterday when the Bank of Spain released its quarterly report on the Spanish economy. According to the bank, gross domestic product fell by 1.1% in the final quarter of 2008 (over the previous quarter), following a 0.2% decline in the third quarter. GDP fell year on year by 0.8%.

Basically the report confirms my analysis in this post which suggested that while technically speaking the recession started on 1 July 2008, the contraction really started in July/August 2007, and it should have been really obvious to everyone by September of that year that the party was well and truly over.

According to the Bank of Spain the main component driving the contraction in the second half of last year was household consumption, with the contraction in household expenditure accelerating in Q4 when compared with Q3. In particular, household consumption fell at a year-on-year rate of something over 1.5% in 2008 Q4, which meant that - taking the year as a whole - it was private consumption which contributed the most to the slowdown in GDP, to a greater degree even than the decline in residential investment (which was nonethelessdown 10% over the year).

The slide in corporate investment also intensified in Q4, in large part as a result of the worsening economic outlook, the sluggishness of demand and the increasing uncertainty, all of this against a backdrop of financing conditions which were completely unfavourable to new business projects. As a result investment in equipment fell off markedly, by more than 7% year-on-year.

On the other hand the contribution of net external demand to GDP growth was positive in 2008 for the first time since 1997, and added at 0.7 percentage points, which compares with a negative contribution of 0.8 percentage points in 2007. This "improvement" was almost totally the result of a decline in imports, which fell much more sharply than exports.

As a result of the recessionary environment, employment dropped by 0.5% in 2008 (which compares with an increase of 3.1% in 2007) and the unemployment rate climbed to an 11.3% average for the year as a whole (13.9% in Q4), according to the Labour Force Survey figures.

Inflation slowed dramatically inthe last quarter of the year, with the CPI rising at a 4.1% for the year as a whole (up from the 2.8% average in 2007), although in the second half of the year it fell significantly, hitting a years low of 1.4% in December, the lowest figure since 1998. Indeed the HICP differential with the eurozone average ended the year negative on a negative footing (-0.1%) – the first time this has happened since the start of EMU. My guess is that we may well see a spike in inflation in January - due to the foolish increases in administered prices - after which we should steadily head deeper and deeper into price deflation territory.

The drop in household consumption and fixed capital investment was also to some extent offset by a surge in government spending. The government sector sustained aggregated domestic consumption in 2008, with government consumption increasing at a 5% rate over the year a whole. As a result public finances deteriorated rapidly, and moved from a surplus of 2.2% of GDP in 2007, to a deficit of approximately 3.4% of GDP in 2008. The public debt ratio was up by 3.3% in 2008 and reached 39.5% of GDP. For 2009, the government now envisages a further increase in the deficit - at the moment estimated at 6% of GDP - although since this estimate is based on a forecast contraction of only 1.9% of GDP over the year and this is likely to be a strong underestimate (see below), the deficit could be 7% or 8%, even if there are no additional funds which need to be spent on the bank bailout (unlikely to be realistic, since more money than currently budgeted for may well be needed, as we are seeing in one country after another). If we get price deflation to boot, and thus a reduction in nominal GDP, then debt to GDP could easily be up by a full 10 percentage points in 2009.

So what about the rate of contraction? Well at the present time, as I indicate above, the Spanish economy is contracting at an annual rate of 4.4%. Now, if we look at the manufacturing PMI (see below), we can see that this coincides with a monthly average reading of around 30 on the index over the quarter. So we could say that a reading of 30 means a contraction of about 5% a year (to begin to calibrate for the future) but this is probably an underestimate, since we have seen a sharp increase in government spending (which is not sustainable at this pace, or better put, we may sustain the present levels, but we simply can't keep increasing by 5% a year, so the impact of government spending will start to wane) plus we have seen, as mentioned above, a significant positive impact from the trade balance - estimated to have been of the order of 1.7 percentage points in Q4 (in other words without this favourable movement in nthe balance the contraction rate would have been much larger).

So really, without these two factors - the imports slowdown and the increase in government spending - we could easily have been talking about a contraction at an annual rate of 7% plus, which is, well, very, very large. But this is what a 30 manufacturing PMI reading might mean as we go forward, so we had just better hope that the index starts to tick up, hadn't we. The next results (for January) are out next week. Watch this space.

Friday, January 23, 2009

Germany's Economic Woes Continue In January

Germany's economy continued to contract in January, and even more rapidly (slightly) than in December, according to the latest flash estimates for the Markit PMI.

The estimates showed that the composite Markit purchasing managers' index (PMI) fell to 38.0 from December's final 39.5 reading. Any reading below 50 means contraction from one month to the next, so what this means is that the German economy was contracting more rapidly in January. Taken together, the surveys of the manufacturing and service sector showed business activity shrinking at its fastest pace since the composite PMI series began in January 1998. A 38 reading on the monthly PMI is probably equivalent to something in the order of a 10% annual rate of GDP contraction (or a 2.5% quarter on quarter drop), which is, well, massive. Nor does this seem unreasonable, since on initial estimates it seems that German GDP contracted by 2% in Q3 2008 over Q2, which is an 8% annual rate of contraction. Whichever way you look at it, these numbers are very large.

"There are really no signs of any let up in the retrenchment in global markets. So I think the outlook remains very bleak and that Germany will continue to suffer throughout the first half of the year," said Chris Williamson, Markit's chief economist.

The heavy dependence of the German economy on exports means that as demand has fallen back elsewhere so has German economic activity. Exports fell by an unprecedented 10.6 percent month on month in November and according to an Economy Ministry official on Wednesday they fell by another 10-11 percent in December. Again, these are very large numbers in economic activity terms.

The Markit flash manufacturing sector PMI fell in January to its lowest level since that survey began in April 1996, to 32.0 from December's 32.7. The sub-index measuring current manufacturing output also fell to a series low of 27.5, from 29.6.

The services sector flash PMI fell to 45.4 from 46.6 in December.

The government said on Wednesday it expected the German economy, Europe's largest, to contract by 2.25 percent this year, revising down a projection it made last October for growth of 0.2 percent. Since World War Two, the German economy has not contracted by more than 1 percent in a year.

The estimate for the composite PMI for all 16 nations sharing the euro improved very slightly, since the reading ticked up to 38.5 points in January from a record low of 38.2 in December, but again, in GDP terms this means that the whole zone is currently still contracting at an annual rate of somewhere in the region of 10%! So this is very cold comfort stuff I feel, especially when you take into account the margin of error in a flash estimate.

Despite expressing the view that “The year 2009 will be very difficult,” European Central Bank President Jean- Claude Trichet has indicated that the ECB is unlikely to cut interest rates further in February, and the next meeting when they may cut interest rates again will be in March.

Monday, January 19, 2009

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

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

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

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

War of the Sicilian Vespers Part II

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

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

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

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

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

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

Lightening Trip To Hungary

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Its All Greek To Me

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

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

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

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

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

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

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

So What Are The Options?

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

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

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

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

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

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

Saturday, January 17, 2009

Germany IS About To Have Its Worst Recession Since WWII

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

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

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

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

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

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

And The German Labour Market Has Finally Turned

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

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

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

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

Exports Drop Sharply In November

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

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

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

Fiscal Deficit Worries

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

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

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

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

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

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

Black Hole In The Banking System?

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

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

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

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

China Pushes Germany Into Fourth Place

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

Friday, January 16, 2009

Italy Slips Slowly But Steadily Into Its Worst Recession In Over 30 Years

The Italian economy continued to contract sharply in the third quarter of 2008 as exports fell sharply - declining at the fastest rate in three years - under the impact of a global slump which weighed down on foreign demand for Italian products, and pushed the Italian economy into its worst recession since at least 1975. Sales of Italian goods abroad fell 1.6 percent from the previous quarter, their biggest decline since 2005.

Pressure is of course on the government to offer a fiscal reponse to the problem, but given Italy's outstanding debt issues and the fact that a large part of the problem is long term structural and not cyclical it is hard to see much of note happening, and indeed Finance Minister Giulio Tremonti's statement this week that additional stimulus packages were pretty pointless could be read as more of an admission of impotence than anything else. What'smore the Italian government announced this week that its budget deficit for 2008 will be 52.9 billion euros, somewhat above the government’s earlier estimate which forecast a gap of 45.2 billion euros. It is not clear yet how this deficit overrun will actually affect the final % of GDP number for the deficit, since we still do not have an accurate 2008 GDP number for Italy yet. In any event speculation is rife about the future of the Italian bond spread and the danger of a credit rating downgrade. The Italian government went to market this week and sold 6.949 billion euros of five-, 20- and 30-year bonds. The 10-year Italian BTP/Bund spread was trading at around 144 basis points after Thursdays auctions compared with 141 basis points the day before.

Severe Limits On Stimulus Packages and Bank Bailouts

This week the government did approve a further 16.6 billion euros in public works investments to try to boost economic growth, but little of this actually represents new spending. The projects include an additional 7.3 billion euros in public spending, together with 9.3 billion euros in private investment. Among other infrastructural works some of the additional funding will go toward building the “Moses” retractable dams that are designed to protect the city of Venice from flooding.

This infrastructure package is in addition to the 5 billion euro stimulus package to help poor families, small businesses and boost bank capital that was agreed to by the Italian parliament earlier in the week. Under the bill a sum of around 2.4 billion euros will be used to help Italy’s poorest families and pensioners, including some one-off cash payments. Highway tolls will be frozen until April 30 and low-income Italians will benefit from tax breaks on utility bills. Small businesses will get a 10 percent break on a regional tax on condition they are already paying a national corporate income tax.

Following warnings to a number of Eurozone government's over credit downgrades from rating agency Standard and Poor's this week Finance Minister Giulio Trementi said on Thursday that Italy won’t follow up its existing stimulus package with more cash injections . Italy currently has the highest debt level in the European Union, which was running over 105 percent of gross domestic product in 2008, according to a Bank of Italy statement today.

Italy’s bank bailout is likely also to be pretty modest in comparison with what is going on elsewhere. The 20 billion-euro bank recapitalization plan will probably start operating next week, according to the news source Il Sole/24 Ore, but details are not available since the Finance Ministry is still “perfecting” the rules and regulations that go with it.

Bleak GDP Growth Outlook In The Short, Medium and Long Term

Italy's economy is expected to shrink by 2 percent this year, making the present contraction the worst in more than three decades, according to the latest forecast from the Bank of Italy. “Taking into account the government measures .... the economy will shrink by 2 percent and then expand 0.5 percent in 2010". The economy’s last annual contraction on this scale was in 1975.

These central bank predictions are the worst to have come out on Italy to date, and significantly above the 1.3 percent contraction being forecast by employers organisation Confindustria and minus 0.6 percent prediction from retail lobby group Confcommercio. It is also a substantial downward revision since only six months ago the central bank was predicting growth of 0.4 percent. Ominously Confcommercio added that “Should the employment situation worsen, we will have to cut these estimates”. Clearly one of the big dangers with the current contraction in the industrial sector is that it lead to large a scale industrial layoffs, and that this then feed back pushing demand downwards.

The Bank of Italy forecast was described as “realistic” by Finance Minister Giulio Tremonti even though his current government forecasts are for an economic expansion of 0.5 percent in 2009. These differences in forecasts are in fact very important, since the government budget is evidently anticipating far higher revenue levels and far lower social expenditure (on unemployment etc) than is likely to be the case.

Fourth Recession In Seven Years

The last GDP report from Italy's statistics office (ISTAT) confirmed that the euro-region’s third-biggest economy slipped into its fourth recession in seven years in Q3 2008. The economy shrank 0.5 percent in the three months through September after contracting 0.4 percent in the previous three months. Imports in Germany and France, Italy’s largest trading partners, declined in October, and the German import decline of 5.6% in November over October (following a decline of 3.7% in October over September) was the biggest slide in almost four years. As a result Italian year-on-year GDP shrank 0.9 percent in the third quarter.

Italian imports fell 0.5 percent in the third quarter while consumer spending barely grew, increasing 0.1 percent in the quarter. Year on year household spending was down 0.6%.

Gross fixed capital formation was down 1.9% on the year - with the machinery and equipment component down 3.5%. Exports fell 3.1% on the year in price adjusted terms.

Manufacturing Contraction

And as we look forward all the short term data is deteriorating. Industrial production fell yet again in November with output dropping a seasonally adjusted 2.3 percent from October, while production adjusted for working days fell 9.7 percent when compared with November 2007, the biggest drop since 1991.

And if we look at the index, we can see that output has now been trending down since the end of 2006.

And survey data from December suggest the Italian manufacturing sector remained mired in recession as output, new orders, new export orders, backlogs, employment and purchasing activity all contracted. The headline seasonally adjusted Markit/ADACI Purchasing Managers’ Index (PMI) came in at 35.5 in December. Even though this was marginally up from the 34.9 recorded in November, it was the still second-lowest reading recorded in the history of the survey.

And it was the ninth consecutive monthly contraction in production volumes. In their report Markit state that the continued downturn in new business appeared to be the key driver, as firms reduced output in line with falling demand. Steep falls were reported in new business from both domestic and foreign markets. Overall, new order books fell for a 12th successive month, albeit at a slightly weaker rate than November’s series record. And perhaps most worryingly given Italy's need to export, new orders from export markets fell at the fastest pace in the survey history.

Protracted falls in incoming work and production volumes resulted in a further month of job-shedding in December. Moreover, the rate of job losses was the fastest in the history of the series. There was also some evidence from those interviewed that redundancy programs had been implemented over the month and that the non-essential workforce had been reduced.

Commenting on the Italy Manufacturing PMI survey data, Andrew Self, economist at Markit Economics, said: “While December’s fall in output was less pronounced
than November’s series record, the rate at which the manufacturing economy has
contracted throughout Q4 is alarming. Italian manufacturers will hope that the
fiscal packages announced throughout Europe in December will mark the turning
point of the recession. However, with new orders still falling in domestic and
foreign markets the downturn looks set to continue into 2009.”
The Services Sector Also Continues to Contract

Italy's service sector also contracted sharply in December (for the 13th consecutive month), although as with manufacturing the rate was marginally slower rate than the record low hit in November, and the Markit Purchasing Managers Index edged up to 40.3 from 39.5 in November. Again this was still the second lowest level in the survey's 11-year history and well below the 50 divide between growth and contraction.

The index has now not been above the 50 mark that separates growth from contraction since November 2007 and the latest survey, like its companion PMI for the manufacturing sector, offered no evidence whatsoever of recovery.

"December ... painted a gloomy picture of the Italian services economy as,
throughout the final quarter of 2008, activity contracted at rates unprecedented
in the 11-year survey history," said Andrew Self, economist at Markit Economics.

Retail Sales Contract For The 22nd Consecutive Month

Italian retail sales contracted for a 22nd month in December as the Bloomberg retail sales PMI rose slightlly - to 31.9 from 28.5 .The index, based on a survey of 440 executives prepared by Markit Economics, also showed annual sales fell at the fastest pace in the near five-year history of the data.

Declining sales prompted retailers to cut staff for a 12th consecutive month, the report also said, and the rate at which staff numbers were reduced was the fastest since Markit first compiled the data in January 2004. In the third quarter the number of Italians out of work rose and the unemployment rate held at two-year high of 6.7 percent. Joblessness will rise to 6.9 percent in 2008, the highest in three years, from 6.2 percent in 2007, the Organization for Economic Cooperation and Development estimated on Nov. 25.

Falling Consumer and Business Confidence

Italian business confidence fell to a record low in December, and the Isae Institute’s business confidence index dropped to 66.6 from a revised 71.6 in November.

“These figures are consistent with the picture of a deep recession in
manufacturing industry,” said Paolo Mameli, an economist at Intesa Sanpaolo in
Milan. “As there is usually a three-month gap between this data and the
industrial production, we forecast that the economy will contract further next
year and won’t resume growing anyway until the last quarter of 2009.”

About 13 percent of Italian companies trying to get loans don't receive them, either because banks refuse to lend to them or because the costs involved are considered excessive by the company, Isae say in data which accompanies this months report.

Italian consumer confidence also fell in December its level in four months on concern that the recession and the decline in industrial activity would increase unemployment, with the Isae Institute’s consumer confidence index falling to 99.6 from 100.4 in November.

Inflation Falling Back But No Sign Of Deflation Yet

Italy’s inflation rate fell to its lowest level in 14 months in December, as energy costs fell sharply and the recession made it harder for retailers to raise prices. Consumer prices as measured by the EU's HICP rose 2.3 percent from a year earlier, compared with a 2.7 percent rise in November. When compared with November prices were down 0.2 percent.

So Where Does That Leave US - With Very Little (If Any) Growth In the Future, That's Where It Leaves Us!

Unlike many other Eurozone economies, Italy's current contraction in activity is not a simple result of the global economic slowdown. Itay's problems are endemic, and ongoing: hence the four recessions in seven years. Trend growth in Italy has been slowing over the last few decades, and must now be near to zero. Which raises the question as to whether in the coming decade Italy's trend growth could turn negative, with GDP simply contracting from one year to the next.
Obviously this possibility is only a theoretical one at the present time, but it is one which cannot be entirely included, especially when we look at how - despite all the promises that things would change - trend growth has steadily drifted to zero. Ceratinly also there are reasons to imagine that the productive capacity of the Italian population could drop as median population rises. Italy is currently among the three oldest societies on the globe - with median age of 43, and Germany and Japan being the other two - and as we saw at the start of this post, Italy has not been able to raise its export prowess in the way the other two have. And if it hasn't been able to do this over the last 15 years or so, what good reasons are there for thinking that Italy may start now?

S&P and Fitch last reduced Italy's credit rating in October 2006, with S&P reducing the rating to A+ (with negative outlook), the third-lowest of the eurozone countries after Greece and Slovakia, while Fitch dropped it to AA- from AA. Moody’s Investors Service rates Italian debt Aa2, with a “stable” outlook. In November 2005 the ECB announced that would not accept government paper (bonds) in the future from any country which did not maintain at least an A- rating from one or more of the principal debt assesment agencies. Which means of course that Greek sovereign bonds are now very vulnerable to losing acceptable asset status in the longer run, but that Italy is not far behind.

In fact back in October last year, the ECB announced that the Eurosystem would lower the credit threshold for marketable and non-marketable assets from A- to BBB-, with the exception of asset-backed securities (ABS), and impose a haircut add-on of 5% on all assets rated BBB-. But it is important to bear in mind that this expansion of eligible collateral is temporary: “The list of assets eligible as collateral in Eurosystem credit operations will be expanded as set out below, with this expansion remaining into force until the end of 2009.” While it is perfectly possible that the ECB will extend this temporary relaxation of credit thresholds for the duration of the current crisis, the problem of default risk in the most vulnerable economies is likely to outlive the current crisis, and the ECB relaxation is unlikely to last indefinitely.

The gap between the interest rates Spain, Italy, Greece and Portugal must pay investors to borrow for 10 years and the rate charged to Germany has now ballooned to the widest since before they joined the euro. In the graph below you can see ten year bond spreads for Greek, Irish and Spanish government paper as compared with the benchmark German Bund.

The yield on Spain’s 10-year bond averaged 8.5 percent in the six years before it joined the euro and the gap with the equivalent German bond was 246 basis points. In the next eight years, the average yield fell to 4.5 percent and the spread to 13 basis points. That convergence is now being thrown into reverse. In the past week, Standard & Poor’s has downgraded Greece’s credit rating, and those of Portugal and Spain are also under threat. The difference between the Spanish and German 10-year bonds rose to 115 basis points today, the highest since 1997. The spread on Italy’s bond at 144 basis points was the most in 12 years and the Greek spread was the most since 1999.

Different economists take differing views on the implications of this development. The LSE's Willem Buiter argues that the widening of the spreads is a good sign, as it shows that market mechanisms are finally working. In the past the problem had been the way that markets assumed for too long that governments would be bailed out if they defaulted. But RGE Monitor's Nouriel Roubini makes the very valid point that if financial markets get concerned about the risks of exits, a vicious circle of rising rates and poor debt dynamics may force exit regardless of the will to stay in. The effects can be very similar to a currency crisis or a self-fulfilling run on the government debt or the banking system. Basically, countries like Italy and Portugal have quite low trend growth rates as it is, if fiscal support is withdrawn and bond spreads rise this can easily produce a lose-lose dynamic which virtually forces default.

And this is without any reference to the negative feedback effects that can be produced by the health and pension spending required to meet the needs of a rising elderly support ratio, and a lower productivity from a working population with a higher median age. All in all, a very difficult can of worms for everyone to get to work on.

Tuesday, January 13, 2009

S&P's Puts Spanish Sovereign Debt On Ratings Watch Negative

Spain yesterday became the third euro zone country within a week to be warned by rating agency Standard & Poor's that its credit rating (currently the highest - AAA) is under threat from the deterioration in public finances being produced by the government's attempt to support the banking system and put a brake on the dramatic decline in the domestic economy. As in the case of Ireland and Greece last Friday, S&P said Spain faces a painful process of rebalancing of its economy and a consequent marked deterioration in its public finances.

The gap in bond yields between the benchmark German bunds and the sovereign debt of Spain, Greece, Ireland, Italy and Portugal has risen fourfold since July (see charts above to get some idea) to levels not seen since the launch of the euro in January 1999, and this despite the fact that bond yields have fallen for all countries since last year’s peaks in July as interest rates have steadily fallen.

One year ago the financing of Spanish government debt was barely more expensive than it was in Germany, but yesterday the 10-year bond spread between the two reached an unprecedented 92.6 basis points (or nearly a full percentage point) before settling at 92.3 basis points. The spread, or additional interest, between Spanish 10-year bonds and similar German debt rose 9 basis points, or nine hundredths of a percentage point on the day.

Credit-default swaps linked to Spanish government debt also rose 11 basis points to 106, according to CMA Datavision, in the biggest one-day move since 23 October 2008. Credit-default swaps, which are used to hedge against losses or to speculate on the ability of companies to repay debt, typically rise as investor confidence deteriorates and fall as it improves.

The Euro was also affected by the news, and is this morning (Tuesday) still trading at a one-month low of around 1.328 to the dollar, as the negative news from Spain simply added to trader sentiment that the European Central Bank will reduce interest rates, and thus reduce the present yield differential with USD instruments.

“Everyone knew that Spain was in trouble, but this is one of the triggers that investors were waiting for,” said Ivan Comerma, head of treasury and capital markets at Banc Internacional-Banca Mora in Andorra. “This is the worst timing as Spain is about to start with its funding plan for this year and the country’slenders are about to start selling government- backed bonds.”
In a climate where governments across the OECD are preparing to significantly increase their bond issues in 2009 , Spain, Ireland and Greece could find themselves paying significantly more to borrow money if their ratings do in fact fall. Spain is set to increase 2009 debt issuance by around 51 percent to 104.5 billion euros to cover the growing fiscal deficit. This borrowing requirement follows government announcements of something in the region of 90 billion euros in various packages of stimulus measures, in addition to measures to support banks, while at the same time tax revenue is falling due to the contraction in the economy. And we may yet see considerable overshoot on this borrowing estimate, since the government had a one percent GDP expansion (much to the chargin of central bank governor Miguel Fermamdez Ordoñez) incorporated in the original budget, and of course what we are likely to see is a contraction of several percentage points in GDP.

In addition the Spanish government has offered to guarantee 100 billion euros of new bank debt this year as well as promising to buy up to a further 50 billion euros in bank assets intended to boost liquidity as banks are forced to seek news sources of refinance for their steadily expiring existing cedulas hipotecarias. The first financial institution to take advantage of such guarantees may well be savings bank La Caixa, who have indicated they plan to issue a 3-year bond next week, a bond which it seems may well be backed by a government guarantee. La Caixa's decision to move ahead with a government guaranteed bond (and ride out the stigma which could be attached) may well be influenced by the outcome of last Friday's sale by Spain's second-largest bank, BBVA, who placed 1 billion euros in 5-year unsecured senior debt on offer, without a government guarantee - the first such operation by a Spanish bank in over a year and a half. The bank set guidance on the bonds at mid-swaps plus 180 basis points, but it is far from clear that the operation was a spectacular success.

“"The Creditwatch placement reflects our view of the significant challenges facing the Spanish economy as it traverses a period of very weak growth...We expect public finances to deteriorate markedly with the general deficit rising,” Standard & Poor’s analysts led by Trevor Cullinan said. The analysts also said they expected the general government deficit to rise well above 3 percent of gross domestic product until 2011, peaking at more than 6 percent this year.

Spain’s public finances are thus threatened with a marked and sharp deterioration. Debt was equivalent to a mere 36 percent of GDP in 2007, compared with a 66 percent average for the eurozone as a whole, 95 percent for Greece, and 105% for Italy. Worse, S&P's and many others (myself included) are worried not so much by the deterioration itself (in times of crisis fiscal spending is entirely legitimate) but by the level of realism in the government's approach to the problem. What we could thus well see, in my opinion, are two or three years of above expectation annual contractions, accompanied by two or three years of above expectation fiscal deficits, with the national credit rating steadily deteriorating. We could then find ourselves arriving at 2011 with one unholy mess of an economic problem still to be sorted out - a construction sector which is still in need of serious downsizing, and an export sector which is still far from competitive, for example - with all the resources in the national coffers effectively exhausted by a completely useless spending spree. So now it isn't only "Edward" who is saying this, we are getting some objective international responses to the situation too, and we are now likely to see more such moves.

In fact I have been warning about the problem posed by lax fiscal policies and mounting concern from the rating agencies in the Italian case for years (their position will be much more serious in the short term if they do get another downgrade), and I recently commented on Greece. Back in August 2007 I even pointed out what "fools" I felt Sarkozy, the EU Commission and some European MPs were being by pointing the figure directly at the ratings agencies in the wake of the sub prime scandal. As I said at the time (16 August 2007):

The sub prime situation is in fact a good "case in point" example of this process at work. And after the agencies themselves admit the problems were worse than previously anticipated, then the markets, predictably, also over-react. So the question I am asking is, would we all now really like to see this situation replicated in the case of the Italian debt problem, or the Baltic overheating issue? Would we, or the EU Commission, be happy with the outcome?I think in this kind of area it is better not to tempt fate, or call on others to do what you are not prepared to do yourself.

In the event that the Italian government is one day forced to default on its sovereign debt, will we be holding the European Commission itself responsible in the way that they would now try to point the finger at Standard and Poor's or Moody's? The root of the problem here is that the EU itself needs to be able to make accurate and clear assessments of the underlying issues involved on its own account, and to develop the capacity to face up to difficult decisions, take them, and then make them stick, rather than simply fudging everything in an ongoing process of political "deals" and horse trading. Nor is it a solution, when the going gets really tough, to outsource responsibility to agencies which really are neither designed for, or adequate to, the task in hand.

At the present time it isn't clear that there will be an immediate downgrade in Spain's credit rating, and at AAA there is of course quite a long road to travel before we reach the precipice of being awarded the "junk bond" status (BB+) which was attached to Romanian sovereign bonds by S&P's on October 27 last. At the same time, this is a road, however long it may be, that it would have been better never to have gotten started down in the first place. Even the activities of Spain's Instituto de Credito Oficial, a government body which issues bonds in its own right as part of the bailout programme - and which only this week sold a five-year euro-denominated benchmark bond - will see its triple-A rating lowered in the event of a downgrade, since the rating is effectively supported by the Spanish national one. The ICO - in theory - provides backing to small and medium-sized businesses, long-term loans for infrastructure projects and financial support in cases of economic or natural disaster.

The Problems Of Resolving The Credit Crunch

The difficulty I see coming in all of the above refers to the need for a large injection of funds at some point in the not so distant future to decisively unblock the credit crunch. Let's look again at my "exhibit A" from the Japan experience - the chart, prepared by the Japanese economist Richard Koo, which shows the evolution of lending conditions in Japan during the 1990s (those who read my "coffee deflation" post will already have seen this). The thick blue line (please click over chart if you can't see adequately) show large business perceptions of the willingness of banks to lend to them. You will note the line plunges twice, and it is the second plunge, or "credit crunch", which interests us here, since it is my conjecture that we have yet to see this part of the Spanish crunch, but that we will, when push finally comes to shover and the banks throw the towel in on the mounting pile of non-performing loans.

This was the crunch remember, the one that finally drove Japan decisively off into deflation, and produced that now famed "liquidity trap". Basically the first credit crunch was resolved via large scale government contruction spending, the guaranteeing of bank deposits, and the swallowing by the banks of a large number of non-performing loans. Does all this sound familiar? It should. But then Japan reached a point were the financial system could struggle forward no further. So the crunch broke out again, and this time the only way to resolve the problem was with two massive injections of capital into the banking system. These injections served to push the Japan government debt to GDP ratio sharply upwards, and it is this part of the story that I feel we will see repeating itself here in Spain. Maybe in 2010, maybe in 2011. It all depends how far the system can limp forward before it folds in on itself.

And while I am here one further point on all this, since a friend of mine asked me earlier in the week some searching questions about my "back of the envelope" calculation of a 50% to 60% of GDP cash injection requirement. That conversation has lead me to see that I may have been responsible for causing some confusion here. What I want to try and make clear is that I am not saying that the extent of DEFAULT in Spain will reach the order of 50% to 60% of GDP (I mean private sector, household and bank default, we are not talking about government default here, and I hope that in the Spanish case we never will be), but that the size of the government cash injection needed to break the back of the credit crunch will be of this order.

To try to explain the distinction I am trying to make let's look at one of the most publicised recent defaults in Spain - that of Martinsa Fadesa. Now in this case the non-performing loan was something in the order of 6 billion euros. So in a way the press are right to talk about it as a 6 billion euro default. But of course not all the 6 billion euros is lost, since the administration process will recover something from the assets which are still to be disposed of. And so it will be with the rest of them. Ben Sills at Bloomberg recently drew attention to an estimate by R.R. de Acuna & Asociados, a Madrid-based real estate research firm, that there are more than 1.6 million unsold homes (new and second hand I presume) in Spain, while annual demand for housing was down to 220,000 units in 2008 from a peak of 590,000 in 2004. That is we could have an inventory of some 8 to 9 years worth of unsold homes, and the question is who is going to fund holding them while we all sit back and wait.

So even while the fact the Spanish state has to fund in some way or another some 300 billion euros in non performing loans doesn't mean that net government debt needs to rise long term to pay for them (since in the end something can be recovered) some massive "bridging finance" is going to be needed.

The same thing goes for the cedulas. In my opinion the Spanish state will have to buy out all the cedulas which need refinancing over the next 5 years, and they will need to fund this. I estimate there may well be between 250 and 300 billion euros involved here. So someone has to raise this money, and I am saying the Spanish state cannot do this alone, or the yield spread will go through the roof as the credit rating goes down, as we are now starting to see.

One possibility might be the creation of EU bonds which could be used to expand the ECB balance sheet in the way that the US Treasury has done for Bernanke and the US Federal Reserve, but this raises a structural question with important political implications, since non eurozone countries like the UK and Sweden would also be being asked to underwrite eurozone debt. Or are we talking of a "shotgun-fushion of the EU and the eurozone to created that much maligned federal state which some have been arguing we need to make the eurozone a coherent entity, but which others have resisted tooth and nail?

In times of need, you do what you can.

Basically my view is that our EU architecture is in something of a mess here, simply because not enough thought was given to the possibility that something like this might happen when the eurozone was first set up - in the same way little attention was paid to the question of how to avoid the kind of bubble Spain has been subjected to by having a single size for everyone interest rate policy thrust upon it. The problem is there is no eurozone-specific fiscal equivalent of the EU commission which could issue bonds and regulate fiscal policy.

Acknowledging, however, that all this debt doesn't need to go straight onto those widely quoted debt-to-GDP ratios, doesn't amount to saying that all those extra debt obligations don't matter, as we can see in the Japanese case. The true level of Japan debt to GDP is still a hugely controversial issue. The OECD insists on using the gross figure 182% - due to their unwillingness to put a value on assets (like land) still held by the government, and for which no one really knows the mark to market prices. Other agencies quote the much lower net debt to GDP - which is still near 100% - and until someone actually disposes of the assets the Japan government holds post the credit-crunch-bailout no one will really know what the true level of Japan sovereign debt is. In Japan's case this doesn't matter so much, since most of the people buying the debt are themselves Japanese (home bias) and Japan is a current account surplus country. This is not Spain's case, and Spain will need non Spaniards to buy some significant part of this extra debt, hence the problem.

Santander Under Investigation

Well, as we say in English, it never rains but it pours (sempre plou sobre mullat) - and if only to confirm the validity of the old adage I simply can't end this post without mentioning that we have learnt today that Spanish prosecutors are currently investigating Banco Santander's loss of more than 2.3 billion euros of its clients' money by investing with alleged swindler Bernard Madoff. Just what Spain and its badly mauled banking system needed at this moment in time - a crisis of confidence in the professional judgement of Emilio Botin.

According to the Wall Street Journal yesterday Spain's anticorruption prosecutor is set to examine the relationship between Santander, Fairfield Greenwich Group, and the Madoff funds. Fairfield Greenwich Group is an investment fund, whose clients stand to lose $7.5 billion in the alleged $50 billion Ponzi scheme. According to the Journal, investigators are looking into why Santander Chairman Emilio Botin sent his head of risk management operations to visit Madoff weeks before the scheme fell apart. Investigators are also reported to be looking into whether several people who managed money at Santander funds were aware of problems at the Madoff funds.

Monday, January 12, 2009

Portugal Sustains

"Art has a function of teaching about the human condition. We live in hope, hope is fundamental" - Manoel de Oliveira

Manoel de Oliveira (photo and quote above) is a living example for the Potuguese people of how to force their way out of the low growth/low per capita income trap into which they have steadily stuck their neck. Oliveira celebrated his 100th birthday last December - and how did he celebrate it: by starting work on a new film. Traditional productivity theory suggests most people slow down with age, but Oliveira seems to have done just the opposite - and since 1990, he has made at least one film a year. His secret for longevity, work much and rest little (oh yes, and also remember that living in hope is fundamental, it's funny, but my father who lived to be 84 and worked to 80 gave me the same sort of message). Indeed far from implementing a 35 hour week he seems to only stop on Saturdays - "This is the only day of the week that I rest," he told journalists back in December when he interrupted shooting on his latest film to give them a rare press conference. So in a country where the average age of leaving the labour force is currently 63, and where raising employment participation rates is a national priority, what better example of a "local hero" than Manoel. What follows will be an attempt to reveal just what it was he was so meticulously trying to capture with his camera in the photo above. Just call me an inveterate "peeping tom", lookout Portugal all is now going to be revealed!

But Some Reasons Why We Are A Little Short On Hope Right Now

Portugal, it seems lives in perpetual hope, hope for that sustained and substantial recovery which always, somehow and disappointingly, lies waiting for it just around that next corner but never actually appears. Equally Portugal is not in recession, at least not yet it isn't, although if we look at the most recent movements in the EU economic sentiment indicator, the Portuguese economy could hardly be said to be passing through one of its best moments. The thing is, since the turn of the century it has been hard for anyone to identify one of those "better moments" in the Portuguese case, or to offer some empirical justification for that evident existential need we all have to eternally live in hope.

Having said this, Portugal could also hardly be said to be riding the wave of a boom-bust trajectory (like its Iberian counterpart and neighbour), since if you never got the boom in the first place, well you obviously aren't going to get the bust part either. So it should not surprise us to find that after contracting slightly during the first quarter of 2008, the Portuguese economy has continued to move forward, and was even continuing to "sustain" a 0.7% year on year growth in Q3 2008. Hardly spectacular, but then (as we shall see) Portuguese growth has hardly been spectacular in recent years, but equally far from being a "worst case scenario".

But then, as we know, everything that lives was born to die, and so it will be even with Portugal's current (lacklustre) expansion, with the Portuguese economy seemingly set to contract this year for the first time since 2003 as its main export markets weaken and Portuguese consumers rein in their spending. Portugal's central bank now expect the economy to shrink by 0.8 percent in 2009 - a downward revision from its July forecast for a 1.3 percent expansion. Also according to the bank, the country’s economy probably grew 0.3 percent last year, a prognosis which seems reasonably realistic following Prime Minister Jose Socrates recent admission that the economy shrank 0.1 percent in the third quarter. So even while Portugal sustains, resistance, this year at least, would seem to be futile.

The Short Terms Dials All Move Over To Red

All the main short term indicators (industrial output, retail sales, employment etc) showed significant weakening in the second half of 2008 (industrial output, in particular, really went west in the second half - and together with manufacturing industry, construction activity was down, although it is important to note that in Portugal's case construction was never really "up" - or at least in recent years it wasn't as we will see below). Industrial output was down 2.9% in October over October 2007, and contracted on a year on year basis in each of the five previous months (see chart below). Retail sales were down 1.6 % year on year in November and by 1.4% from October (seasonally adjusted).

As just one indicator of the way demand for some Portuguese products is waning at this point, the three European countries most affected by the heavy-truck sales plunge are Spain, Portugal and Germany, with respective declines of 58 percent, 40 percent and 34 percent registered in November. As in other countries the automotive sector is being particularly hard hit, and the government announced a 200 million euro credit line for auto and car parts exporters back in December. The package, agreed between the government and companies including Volkswagen and Peugeot Citroen includes 70 million euros for training courses for some 10,000 employees - the Portuguese association of auto industry producers has estimated that the downturn in car sales will lead to 12,000 job losses during the first half of 2009. Economy Minister Manuel Pinho has stated that, including trade credit insurance of 300 million euros and the potential investments that the incentives should generate, the total value of the government plan is likely to be in the region of 900 million euros - not a lot of money in terms of the sort of programmes being seen in countries like the United States, but for a small, comparatively poor country like Portugal, with a government debt problem to think about, hardly insignificant.

Ever Weakening Trend Growth?

As the big wheel of global events follows its charted course, Portugal can at least be thankful for small mercies, since the country is not suffering under the added burden of a housing crash (it is not an Ireland, or a Spain, or the UK, or even, dare I say it, Denmark), for the very simple and straightforward reason that it never had a housing boom in the first place (or better but, since the late 1990s it hasn't had one, and one of the purposes of this article will be to examine just why that is). Portugal's problems are, unfortunately, more long term and more endemic, strikingly similar in many ways to those of Italy. So we should beware of making a simplistic generalisation and talking about a North-South divide in the eurozone. The economic profile of Portugal (or Italy) is really rather different from that of Spain (or Greece), in much the same way that France's economy is essentially very different from Germany's (of course, Sir Roy Harrod will probably be turning over in his grave at this point, with the thought of what this might imply for the theory of "convergence", but for now we might perhaps leave him in his tomb to timelessly struggle with this rather thankless labour and move on, since before jumping to too many overhasty generalisations it may be worth first examining in detail the actual dynamics of a number of the individual eurozone economies).

The nice thing about empirically grounded sciences is the freedom they give their practitions to follow (or chase after) the "facts", without the pressure of being compelled a-priori to reach premature conclusions, regardless of whether or not it is considered to be politically - or incorrect - so to do (hence Ben Bernanke's multiple references in "The Euro At Five" to the eurozone as a great experiment, a "natural experiment in monetary economics"). We economists have to learn to live with the experimental nature of our science, even if the "rats in the maze" may get somewhat frustrated with our efforts at times.

Now if we look at the chart below we can see that if quarterly growth in Portugal is sluggish, this sluggishness has in fact been operative over quite a long period of time.

In fact since Q1 2000 Portugal has had 2 recessions (when defined as two successive quarters of negative growth): in Q3/Q4 2002, and Q3/Q4 2004. There have also been 7 more quarters where growth has been negative: Q2 2000, Q1 2001, Q2 2003, Q3 2005, Q3 2007, Q1 and Q3 2008. That is out of a total of 30 quarters, the Portuguese economy has contracted in 11, or around 30% and the average GDP growth rate has been 0.37% per quarter or 1.48% per annum. For a country whose per capita income is the lowest in the EU15, and which is badly in need of "catch up" growth this is hardly a happy situation, and beyond the national administration should be giving food for thought for those resposible for economic policy across the Eurozone, and also among those among the EU10 who have recently joined, or are set to join, the common currency area.

Even more worryingly, Portuguese growth seems to have gone through three phases since the early 1980s, with each "wave" being weaker, and indeed during the years since entering the eurozone Portugal seems to have gotten absolutely no "boost" whatsoever.

No Housing Crash Or Pile Of Toxic Debt In Portugal

So what could explain this evidently "sub-par" performance? Well, during the years of ERM participation (the precursor of the euro) Portugal's nominal interest rates dropped from 16% in 1992 to the 4% eurozone entry rate at the start of 2001 - while real interest rates dropped from 6% to zero - so the problem doesn't appear to be - prima facie - what you could call an overly tight monetary regime: post euro-creation ECB interest rate policy has been largely accommodative to Portugal, and in particular interest rates were, by and large, negative during the entire period between the end of 2001 and the end of 2006. Yet, economic activity remained sluggish throughout this period, and even the construction sector showed little sign of life.

In fact the last house price spike Portugal had was in the years 1998/99, and during most of the years since Portugal joined the euro (as can be seen in the chart below) house prices have in fact been falling.

(Please click on image for better viewing)

And if we look at the construction output charts, during all of 2006 and throughout the first half of 2007 the Portuguese construction industry seems to have been in something of a deep slump.

Even more preoccupyingly, Portugal's construction industry seems to have past its historic peak in 2000, with the output index declining steadily ever since.

While the banking system may not be the most splendid of health (remember there is that little issue of the current account deficit to finance), it has not taken any kind of "full frontal" hit from the global financial turmoil - having little exposure to US sub-prime type debt, and no large pile of housing loan defaults set - Spansih style - to arrive and spoil the party. So Portuguese Prime Minister Jose Socrates may well have been right when he reiterated recently his government's view that no major Portuguese banks are likely to fail.

However, since the global financial crisis hit major U.S. and European banks last October, the Portuguese government has reacted by offering state guarantees of up to 20 billion euros on bank loans and 4 billion euros in capital for local banks. Portugal's top banks - Millennium BCP, Banco Espirito Santo and Banco BPI - all seem to weathered the crisis relatively well so far. The government has had to nationalize the small private bank Banco Portugues de Negocios (BCN) while a consortium of larger banks have been invovled in rescuing Banco Privado Portugues (BPP), but the financial problems here preceded the current global financial crisis and seem to have been merely exacerbated by the credit crunch.

The 2009 prospects for Portugal's construction sector seem pretty bleak for 2009 - after the sector probably failed to expand in 2008, following six previous years of decline. Manuel Reis Campos, president of the Portuguese Federation of Construction Industry and Public Works (FEPICOP), expects turnover to be around 20 billion euros in 2008, a similar number to 2007.

"At the start of the year we were saying the sector was going to grow 2.5
percent and what happened is that we have lost another year," Reis Campos told
Reuters. "The overall sector progress is going to stagnate in 2008," he said.
"The situation is so bad and the employment issue so serious that any (2009)
forecasts have to be very cautious."

Campos said the industry has been in decline since 2002 "and it's not a result of the current international situation". He expects the situation to improve in 2009 on the back of government infrastructural project (see below) but his outlook for residential construction is for yet another decline - possibly by between 3 percent and 5 percent. Residential construction has the heaviest weighting in the construction sector (38 percent) and the industry accounts for 5.6 percent of gross domestic product employing 11 percent of the workforce (560,000 jobs).

Real Effective Exchange Rate

One explanation which is often offered when people come to look at Portugal concerns what has been happening to what is called the Real Effective Exchange Rate. Now the Real Effective Exchange Rate (or REER) of a country is an instrument which can be used to assess price or cost competitiveness relative to the position of the country's principal competitors. The REER is an instrument which is widely favoured by economists since competitiveness depend not only on exchange rate movements but also on cost and price trends. Eurostat offers us one such measure of REER, and the REER used in the construction of the Eurostat Indicator has been deflated by nominal unit labour costs (for each economy as a whole) against a panel of 36 countries (EU27 + Australia, Canada, United States, Japan, Norway, New Zealand, Mexico, Switzerland, and Turkey). A rise in the index means a loss of competitiveness (taking into account productivity changes via the movement in comparative unit costs), and as we can see in the chart below, Portugal has substantially lost competitiveness against Germany since 1995. Were a convergence in living standards taking place between Portugal and Germany via a more effective use of a pre-existing labour force, or a boost in productivity achieved through a shift across productive sectors (eg away from agriculture and into knowledge economy products) the we would not expect to see this pattern, since any increase in living standards would be accompanied by a maintenance in the competitive position. (This point, in Portugal's case, is unfortunately highly theoretical, since as we will see below, convergence in living standards is not in fact taking place. That is, Portugal really is stuck).

In fact I have been a little naughty here, since I have also included Spain in the comparison. I have done this since the argument that Portugal has lost competitiveness against Germany is fine as far as it goes, but as an explanation for why Portugal's growth has stagnated post 2000 it is clearly insufficient, since growth in Spain - at least up to 2007 - has been rather stellar, so the question should really not be why is Portugal so different from Germany, but why is Portugal so different from Spain (as I said above, we shouldn't be dividing Europe simply along a north south axis, and that the differences within regions (like also the Germany-Spain one) are also interesting and very, very revealing.

Now basically it seems to me that you can say either one of two things, but not both of them at the same time. Either Portugal should have had the same growth as Spain (all other things being equal), or Spain should have had as little growth as Portugal did. In reality the likelihood is that both countries have had their growth paths rather skewed (in opposite directions) by participation in monetary union, but going further along this path at this point would take us well beyond the matter in hand.

So what we have here is a very strange state of affairs indeed, and it should lead us to ask ourselves just what it is than has been going on in Portugal over all this time? In addition, and as can be seen below, Portugal's relative GDP per capita (vis a vis the EU27) has declined steadily since euro membership, after reaching a high point in 1999.

So What Is The Root Of The Problem?

Just what has been going on all this time in Portugal then? Perhaps the most systematic piece of work to date is a paper written by MIT Professor and Current IMF Research Director Olivier Blanchard - Adjustment within the euro. The difficult case of Portugal. Blanchard's argument, which is certainly the most coherent "mainstream narrative" we have at this point - and I hope I am not simplifying his argument excessively - would seem to run as follows:

In the first place Blanchard divides Portuguese growth into two periods. During the first of these - running roughly from 1995 to 2001 - Portugal experienced reasonably healthy GDP growth, a steady decrease in unemployment, all acompanied by a rapidly growing current account deficit. During the second period, roughly since 2001, there has been continuously weak economic growth, a steady increase in unemployment, while the current account deficit has remained stubbornly high, and even (since his paper was written) increased.

Blanchard argues that the proximate cause of Portugal's mid 1990s boom was participation in the ERM and in the build up to the euro (the longer term cause would, I feel, be some yet to be identified underlying structural transformation that was going on, trying to get to grips with this is the point of this article). This participation combined with expectations that participation in the euro would lead to faster convergence and thus faster growth for Portugal, lead to an increase in both consumption and investment. But, of course, as we have seen, this convergence did not take place, nor does it appear likely to do so.

During this phase Portugal's budget deficit decreased slightly, although discretionary fiscal policy was generally expansionary. Blanchard makes the point that between 1995 and 2001 the cyclically adjusted primary deficit (adjusted for the effects of lower interest rates and output growth) increased by roughly 4%. This choice of dates does seem to me however to be rather tendentious, since - as we can see from the chart below - the main increases in the deficit came after 1999, and in that sense are not really part of the period that should most concern us, which is the one immediately prior to the domestic consumption and construction fixed investment blow out. One possibility here would have be that the budget deficit simply "crowded out" private activity, and placed an excessive burden on an already overstrained capacity. But if we come to look closely at the timing of things, this argument may be harder to sustain than seems at first sight (and indeed government spending as a percentage of GDP only really started to rise sharply after 1999 - see chart further down the post - and thus post dates the contraction in private consumption).

The fiscal deficit was in fact reducing from 1994 to 1999, and only started to rise again after 1999. On the other hand, if we look at private consumption growth, we find a rather different pattern, since private consumption growth peaked in Q1 1999, and then dropped back steadily all the way through to Q2 2001, at just the time the fiscal deficit was increasing.

So the increase in government spending can be thought of as a knock-on consequence of the decline in private consumption growth and not the other way round. It was simply due to the automatic stabilisers coming into action. So the big question is why, in the Portuguese case, the construction and consumption boom came to an end when it did, while it continued and even accelerated in Spain and Greece, rather than why the fiscal deficit started to increase.

The drop in unemployment which accompanied the initial boom lead to significant labour market tightening, and this tightening - coupled with rising EU convergence expectations and talk of Harrod-Balassa effects and suchlike - produced a situation where wages increased rapidly in comparison with other EU countries. Again we should note the similarity between what happened in Portugal and what has been happening over the last two or three years in Eastern Europe, where certainly the comination of sharp decreases in unemployment and strong euro area membership expectations has acted like putting a lighted match to a tinderbox.

To take just one example, when Portugal joined the EU in 1986 workers without college education earned only 50% of corresponding French wages in PPP terms, while college graduates earned 72%. By 1994 unskilled and skilled wages had risen to 67% and 93% of French wages respectively. In addition, nominal wage growth was significantly higher than labour productivity growth, leading unit labor costs to rise at a substantially faster rate than the euro area average. Hence Portugal's competitiveness deteriorated, as did its goods trade deficit.

Blanchard takes the view that unemployment at the start of the first period was above what he terms "the natural rate" - since, he argues, while an unemployment rate of 7.3% (1996) is not especially high by EU standards, it was high in terms of what Portugal had become accustomed to by the early 1990s. Thus he considers that capacity existed for some growth in excess of "normal" was not problematic. By the end of the 1990s - so the argument goes - unemployment had become lower than the "natural rate" and non-inflationary "catch-up" growth started to become problematic - again it would be interesting to make a comparison with what just happened in Eastern Europe in this context.

Blanchard also takes the view (and I thoroughly concur) that some degree of current account deficit was clearly justifed in Portugal in the mid 1990s (since if everyone runs a suplus the whole global system cannot work), given that the arrival of both a lower real interest rate together and expectations for faster "catch-up" growth is likely to stimulate higher private spending, be this from private consumption or be it from investment. The real real issue is that this boom, in theory at least, should lead to a structural transition to higher productivity and higher value added activities, and the issue in Portugal's case is that the needed and anticipated higher labor productivity growth simply did not materialize. Instead, productivity growth nearly vanished, averaging 0.2% per year from 2001 to 2005.

The end result was that the investment boom came to an end as household spending effectively stalled due to the high levels of household debt which were accumulating and the deterioration in future prospects which was taking place (can anyone else smell the Baltics here??). So private consumtion growth stalled and household saving increased.

The end consequence has been that, in an environment where increasing exports to drive GDP growth became very difficult due to the absence of an independent currency and monetary policy and a lack of price competitiveness, the slower rate of consumption growth and the consequent weak investment demand have led to an enduring output slump, while Portugal's unemployment rate has now returned to its former higher level (7.9%) and the current account deficit has steadily increased, reaching 9.4% of GDP in 2007.

Spain, Portugal and...... Hungary

Several commentators have drawn attention to the similarities which may be discovered by scrutinising Portugal in the context of recent events in the East of Europe (see this example from Christoph Rosenberg), and I would like to take this opportunity to draw attention to the remarkable common points I have been finding between what happened in Portugal in the 1990s and what has been happening in Hungary since 2005 (or see this earlier post). In the first place because both countries found themselves faced with a twin deficits crisis, both saw fiscal spending surge sharply upwards as a response to a sudden drop in domestic consumption, both have been unable to sufficiently ramp up exports as a result of excessive downward rigidity is the wage setting process, both have had absolutely stagnant employment growth, and both, and here is the really unusual detail, were experiencing downward movements in their population at the time their problem really got going. Quite what connection one thing has with the other reamins to be established, but I beg to suggest that this correlation is far from incidental.

If we look at the Portuguese case we can see the downtick in overall population numbers quite clearly when we look at the relevant chart (see below), the unusual thing about the Portuguese case this is more the by product of "freedom of EU movement" outmigration (more appropriate to the Baltic and South East Europe connection than the Hungary one) than it was to the impact of lowest-low fertility, since while Portugal's fertility has been below replacement level since 1982, it only really fell below the critical 1.5Tfr rate in 1994.

If we look at the long term migration chart, we can see where the root of the problem was.

And if we also look at the chart below and see how the supply of remittances has dried up (ie all these potential young consumers have now become a net loss to the economy) we can perhaps begin to understand how it was that domestic consumption started to stagnate.

In theoretical terms economists have long spoken about the possibility of having multiple "equilibria", and how economic processes are to a certain degree "path dependent", well in the cases of Spain and Portugal we couldn't have a clearer example I think. If we look at net migration between 2000 and 2008, the difference between the two countries is plain to see. Spain went up and up.

While Portugal went down and down (see below). We couldn't have a clearer example of the contrast between positive and negative feedback processes, illustration of how most contemporary migrant flows are "labour market driven".

And again, if we think about house prices (see earlier Portugal chart) Spain was going through an enormous asset price inflation boom during these very same years.

So Spain and Portugal were receiving one and the same monetary policy, with very different results in each case, since while Spain's inflation accelerated during the highpoint of monetary easing, Portugal's rate even dropped. This should give some food for thought to all those who simplistically talk about the "pernicious" effects of low interest rates.

And again, as can be seen in the next chart, one and the same monetary stimulus lead to very different domestic consumption paths.

Indeed while Spain's unemployment fell during the first years of euro membership, Portugal's unemployment actually went up.

And yet if anything average annual wage cost growth in Portugal has been lower.

In Conclusion - Going Off The Rails In Portugal?

This is where Portugal is today. In the absence of policy changes, the most likely scenario is one of competitive disinflation, a period of sustained high unemployment until competitiveness has been reestablished, the current account deficit and unemployment are reduced............ It is a process fraught with dangers, both economic and political, and one which can easily derail.
Olivier Blanchard - Adjustment within the euro. The di±cult case of Portugal, November 2006.

Well what we most certainly have not seen in the Portuguese case in any sort of credible process of competitive disinflation (which makes me wonder about the extent to which any such process could work in an East European context like Latvia or Hungary, if the prospect of Eurozone membership is dangled out just before them - falling wages never prove popular anywhere, and politicians have a strange habit of not carrying through things which turn out to be unpopular). So has Portugals economic and political development process been thrown off the rails. I fear it has.

Possibly the clearest example of the extent to which Portugal's economy has been "derailed" is to be found in the stagnation of the labour market. After shooting up as the turn of the century (possibly in a process which involved deep "whitening" of the submerged economy, see chart) the number of people employed in Portugal has actually marked time, and now during the present global recession it may even drop back again, to what would effectively be pre 2000 levels.

And now with a global economic crisis breathing down our necks the situation is likely to get worse not better. Indeed Portugal has just announced a 2.2 billion euro package to boost its flagging economy. No harm in that, but when will we really bring the fiscal deficit adjustment to a satisfactory conclusion? The package will focus on investment in schools, boosting technology and alternative energy. The finance minister has said the package is expected to give a 0.7 percentage point boost to GDP in 2009.

In 2008, the general government deficit was forecast at 2.25% of GDP, down from 2.6% of GDP in 2007, but this number now seems to be out of date hardly before the ink was dry.

In fact the government deficit is now projected to rebound to over 3% of GDP in 2009, this is hardly alarming given the global backdrop, but it is also far from being a positive development. On the revenue front, the economic downturn is expected to take a significant toll on tax proceeds, while on the spending side, some acceleration is expected on the back of higher social transfers, which reflect, first, the (partial) indexation of cash transfers to the previous year's inflation rate; second, recent policy measures, and, third, no further decline in unemployment benefits.

Among new spending plans there is a 43 billion euro public-private infrastructure development plan (which is set to run through to 2017), and which includes projects to build a new international airport near Lisbon and a bridge over the Tagus river. The government has also approved an economic stimulus package worth nearly 2.2 billion euros.

For 2010, applying a simple no-policy change assumption, the EU commission currently forecast the government deficit to be around 3.25% of GDP, thus after falling in 2007, the government debt to GDP ratio is projected to resume its upward trend and reach 66.5% of GDP by 2010. And this on a "best case" (no policy change assumption) scenario, when clearly there is abundant downside risk to any present forecast.

Of course another of the problems Portugal will have in 2009 is that of financing and reducing its current account deficit, which is estimated by the IMF to have hit 12% of GDP in 2008. In particualr I would draw attention to the structural damage to the income account (see chart below) which has been caused by the external financing required by so many years of running such large deficits. Thus as we get into 2010/11 the risk of a serious financing problem on the back of a pair of "twin deficits" which simply get worse and worse is hardly to be taken lightly.

Is There A Deflation Risk?

Portugal is currently undergoing something of a strong disinflation process, with the annual CPI falling from a high of 3.4% in June to 1.4% in November. Not only that, the general HICP index has actually declined on a month on month basis for four of the last five months.

And the danger is that demand falls Portugal could be dragged off behind it into deflation territory. And the coming contraction could be a sharp one with both Bank of America and Deutsche Bank predicting that the economy of the 16 nations that share the euro will shrink by 2.5 percent this year.

European Central Bank council member and Bank of Portugal Governor Vitor Constancio is aware of the danger and has indicated that the ECB is prepared to reduce borrowing costs further to prevent inflation slowing “significantly” below its 2 percent ceiling, even going so far, if necessary, as to introduce some variant of quantitative easing. He still thinks it won't happen, but he is well aware of the possibility, as indeed we all should be.

“Any risks of inflation settling well below that level must be preventively contained with interest-rate reductions.........In the middle of the year, we may have some months of negative inflation,” though “not deflation,” Constancio said “the priority” for European governments is “to limit a recession that became inevitable but that has to be contained in order to avoid scenarios of depression and deflation.” If deflation “gains momentum, it’s very dangerous,” Constancio said. “It’s very difficult to escape from a process of deflation.”