As Good As It Gets In Latvia?

For Maurice Pialat, champion of the marginal centre.

"This raises a final question, which, while not central to the issues of this paper, is nevertheless intriguing: How can a country with a low minimum wage, weak unions, limited unemployment insurance and employment protection, have such a high natural rate [of unemployment]?"

"To summarize, the actual unemployment rate is still probably higher than, but close to the natural rate of unemployment. Latvia may well want to take measures to reduce its natural rate, but the recovery from the slump is largely complete."
Boom, Bust, Recovery Forensics of the Latvia Crisis, Olivier Blanchard, Mark Griffiths and Bertrand Gruss

With these words three IMF economists (hereafter BGG) effectively signed off on their study of "what just happened on Latvia" and, they hoped, drew to a close a debate which has been going on now for some 6 years. In fact, far from closing the debate, what they may have done is effectively extend it into new terrain, since these apparently harmlesss words - "the recovery from the slump is largely complete" - have far reaching implications, as does the methodology they use for reaching it. These implications reach well beyond Latvia, and even far beyond the Baltics and the CEE in general, despite the conclusion that everyone seems to be reaching that Latvia was just a "one off". Possibly without intending to do so, they have drawn onto the clinical investigation table issues which have been mounting  up in the theoretical lumber rooms of neoclassical growth theory for some time now, issues which begin to assume a paramount practical importance in the context of our rapidly ageing societies. What, for example, do we understand by the term "convergence" these days? And if "steady state" growth can no longer be understood as implying a constant growth rate (trend growth in developed economies is now systematically falling) should we be considering the possibility that headline GDP growth will at some point turn negative, even if GDP per capita may continue to rise, due to the fact that populations are steadily starting to shrink. And if the answer to the former question is "yes", then what are the implications of this for the financial system, for the system of saving and borrowing, and for the sustainability of legacy debt? Not little questions these, but ones which will need to find answers and responses in countries like Latvia over the next couple of decades.

And again, returning to a question I raise about Ukraine (here), while Latvia's recovery may be complete and thoroughgoing, what satisfaction can we really take  from our knowledge of this when - according to the country's President Andris Berzins - the end state leaves the very survival of the country as an independent entity ten years from now as an open question? The problem - the country's population is falling, along with its workforce, and young educated Latvian's continue to leave looking for a brighter future elsewhere, even if they now do so at a slower rate than they did during the height of the crisis.

This is the first time I have written anything on Latvia in some time. In 2007 and 2008 I argued for Latvian devaluation, but refrained from continuing to do so in 2009 since the will of the Latvian people was so obviously against taking this path. I think policy has to work in the real world and not in the one we - like visitors to Andrei Tarkovsky's "room" - might wish we were in. But more than the going back over the debate  about whether or not it would have been better to devalue - we will never know the answer to this one, although although the viewpoint still seems to me a more defensible view than many imagine - what I would like to stress here are the reasons which lead me to arrive at the conclusion is was a good option, along with the factors which influenced me in getting there. These are set out in my June 2007 monster post: Is The Latvian Economy Running Out Of People?. The post is a long one, extraordinarily so as I say there, even by my standards. But going back over it, and with more than six years of hindsight to benefit from, I can't help feeling there is not a great deal I would change or even add. As I say in the introduction to that post:

"It is generally recognised by most external observers that this malaise has its origins in structural problems in the Latvian labour market, and it will be argued here that these structural problems have their roots in recent characteristics of Latvian demography (namely high out-migration and a sustained low birth rate). As such there is no easy solution. Even in the longer run the position will inevitably be difficult, since demography almost inevitably casts a long shadow. This does not mean, however, that we should be complacent. There are steps which can be taken to address the issues which Latvia faces in the short term, and it is important that such appropriate measures are enacted. These measures clearly include policies to reduce the dramatic overheating which is taking place, but they also should include policies to loosen the labour supply, not only by encouraging increased labour market participation and mobility, but also by actively encourage inward migration. Such policies may be seen as short term measures which are vital to move Latvia away from an unsustainable and towards a sustainable economic path."

Measuring Trend Growth

The facts of the crisis in Latvia are by now more or less well know. As BGG outline it the story runs as follows:

"The basic and striking facts to be explained are given in Figure 1 (see chart reproduced above - EH): An increase in GDP of almost 90 percent from 2000:1 to 2007:4, followed by a decrease of 25% from 2007:4 to 2009:3, and a recovery, as of 2013:1, of 18 percent. A mirror image in terms of unemployment, with a decrease in the unemployment rate from 14% in 2000:1 to 6% in 2007:4, followed by an increase to more than 21% in 2010:1, and a decrease since then, down to 11.4% in 2013:2."

For anyone seeking more background BGG gives an excellent and informative summary. What went on in Latvia was not a fiscal overspending issue (which is not to say the administration should not have been running a higher surplus during the latter part of the boom), but an accelerated credit-driven consumer demand and (housing) investment boom financed by external borrowing. This boom massively structurally distorted the economy, in the process taking output to levels well above those which were sustainable in the longer run. As BGG point out, "the ratio of private consumption to GDP (in constant prices) increased from 62% to 72%, [and] the ratio of investment to GDP (also in constant prices) from 22% to 36%." Now you don't have to be a mathematical genius to spot that 72 and 36 add up to 108, ie consumption and investment total more than 100% of GDP. How can that be, you may ask. The answer to the apparent inconsistency is that the difference is made up by imports (or the trade deficit), ie the Latvians were consuming all their own GDP and part of someone else's, with the difference being made up by external borrowing. BGG put it more elegantly:

"As a matter of arithmetic, the result of increasing consumption and investment ratios was a steady deterioration of the current account balance, with the ratio of the current account deficit to GDP increasing from 5% of GDP in 2000 to peak at a very large 25% in mid-2007."

So it is clear the Latvian economy was running above capacity, but how much above capacity? This is really what the present debate is about, since depending on the answer you give to that question the estimated current trend growth level of the country will be either higher or lower, as will the non-inflationary unemployment rate. Using various vintages of output gap estimates taken from real time EU Commission economic forecasts (12% positive  in 2007 as estimated in  2013) the authors derive a series of cyclically adjusted fiscal balances which show how, at least from the current vantage point, the size of the output gap, and hence the degree of laxity in the fiscal stance, was systematically underestimated. In 2007, for example, the EU Commission only thought the positive  gap (ie degree of overheating) was some 3%. Well its always easier to see things more clearly with hindsight might be the common sense response. Would that things were so simple!

An Interlude Concerning Production Function Metaphysics

What is involved here is a really important and hard to resolve methodological (and even, god help us, epistemological) issue (especially in countries which pass thorough a deep and protracted economic slump) - what is the special privilege of the present as a valid vantage point, when compared with the virtual infinity which time will eventually offer us?

After all, in the "present" which was 2007 things did look very, very different. Perhaps our current evaluation of our own "present" is just as conditioned as earlier perceptions of earlier "presents" were. The problem is we are using our present appreciation of the way things are to reach conclusions about the past which may look very different in some other, future, present. Yes, you're right, there is an element of circularity in the kind of argument that is used by BGG. As the people in the trade put it, potential output is an unobservable latent variable, you know, a bit like the Higgs particle, something you can't see or measure, but which you have to assume to exist for everything else in your theory to make sense.

As one of the IMF authors, Bertrand Gruss, puts it in his paper on the topic, there are "many different methodologies" which can be used "each of them encompassing a different precise definition of potential output and entailing advantages and disadvantages". All of them have, however, one thing in common:  "potential output estimates are subject to substantial uncertainty." As he also notes, in the case of a country like Latvia, emerging from a substantial slump, the degree of uncertainty is especially large. So those who would use the arguments in BGG to argue something simplistic, be chastened, the room for error is large. But then "substantial uncertainty exists over the past and future" doesn't make for good headlines, and, perhaps more importantly, doesn't inspire confidence in the policymakers who admit this.

So does each historical moment have its own special "truth" as far as potential output goes? This point - present moment bias - is described by Paul Krugman like this: "These methods automatically interpret any sustained decline in actual output as a decline in potential, and they cause that re-estimate to propagate backward through time." This approach could be described as "present moment reductionism" in the sense that events in the past are viewed and evaluated from the standpoint of the present, in a way which makes them explicable and comprehensible only in terms of the present they give rise to. The German philosopher Liebniz once put it this way,  we live in "the best of all possible worlds", if not in the best of all imaginable ones (back to Tarkovsky's room).

Basically, it is difficult to avoid the bad performance generated during the slump  "contaminating" the data. What we really need is information on Latvia's future performance, then we could situate the present. We need a time series from the future, then we could see much more clearly what is happening now. Unfortunately for us we can't have access to one. The "set up" (or world) we live in has this characteristic.On some views this is precisely what makes it interesting.

At the same time recognising this reality doesn't make the problem simply go away. As macroeconomists we are constantly forced to make what come near to being ad hoc judgements, and we need to do so time and time again, as we go forward and on the fly. As the Spanish poet Antonio Machado put it, "el camino se hace andando" - we make the path we walk along as we walk. The difficulty is that we are in a bit of a "garden of forking paths" here, since the decisions taken in 2008 and 2009 are the reason we have reached reach the endpoint we are at now, and it is this (momentary) endpoint which conditions our judgement about the initial conditions we set out from. And this is the case even though, had we taken another path  at the outset we would surely have arrived at another "now" from whence the starting point would have been seen differently.

That master of neo-classical growth theory Robert Solow put it thus in his Nobel acceptance speech:  

Growth theory was invented to provide a systematic way to talk about and to compare equilibrium paths for the economy. In that task it succeeded reasonably well. In doing so, however, it failed to come to grips adequately with an equally important and interesting problem: the right way to deal with deviations from equilibrium growth........if one looks at substantial more-than-quarterly departures from equilibrium growth........... it is impossible to believe that the equilibrium growth path itself is unaffected by the short- to medium-run experience.......So a simultaneous analysis of trend and fluctuations really does involve an integration of long-run and short-run, or equilibrium and disequilibrium. 

As he says, it is impossible to believe that the longer term path of the economy is unaffected by the trajectory taken during the deviations from trend - whether upwards or downwards.

(Incidentally, I used the comparison with Liebniz above because it seemed appropriate, because it seemed to me that Liebniz's "rationalisation of the real" was exactly what is going on here. This attitude was famously satirised by Voltaire in his Candide. Curiously when I went back to the Solow speech to dig the above extract out what else did I find - a reference to Candide. Happy to be in good company).

Now in fairness our IMF authors are well aware of this issue, although I'm sure they'd like to put it all very differently. Indeed, while they cite the EU Commission output gap estimates, they also carry out their own calculations (at least one of them Bertrand Gruss (as mentioned above) does, with the results being published in the 2013 edition of IMF Latvia selected issues). As his says in his commentary on the study findings:

"Many different methodologies have been used to estimate potential output, each of them encompassing a different precise definition of potential output and entailing advantages and disadvantages. No specific approach can be taken to be “the” correct one and potential output estimates are subject to substantial uncertainty. This uncertainty is probably even larger for countries like Latvia, a transition economy still going through substantial structural changes and coming out of a severe crisis that has likely rendered obsolete a significant part of the economy’s productive capacity."

For technical reasons which we don't need to go into here, BGG decide to use a production function methodology broadly similar to the one in the diagram above (click on image for better viewing), which is in fact the one they use over at the European Commission (Roeger, 2006) where they got the 12% 2007 output gap result.  In fact the IMF variant isn't identical. Their result (at least as of last January when the study was reported):  "Output was probably about 5–10 percent above potential before the crisis, although the extent of overheating at the pre-crisis boom is particularly uncertain."

[For the wonks, the benchmark PF model they used suggested the output gap peaked at around 5 percent of potential output before the crisis - well below the 12% level suggested by the EU Commission. Then, since they were worried about possible cyclical contamination of the TFP input, they used an alternative potential TFP series (cleaned up by applying an HP filter) and this gave them a gap estimate of about 9.5% much nearer to the EU Commission figure, which ain't that surprising since it is Roeger's preferred technique (see right hand path in diagram).]

Just to give us a feel for the kind of range of certainty involved here, Bertrand Gruss concludes his results by stating the following, "While acknowledging the uncertainty of estimates, staff believes output was significantly above potential before the crisis, but probably in the 5–10 percent range rather than in the 15–20 percent range".

More important than the actual result in my opinion is how they achieved it. A quick inspection of the left hand path in the diagram will reveal that a very significant part of the calculation revolves around labour inputs which ultimately depend on demographic dynamics. Indeed Gruss justified his preference for the production function approach precisely for this reason: "The emphasis on a production function approach reflects both staff view that it represents an adequate framework for Latvia (where, for instance, population dynamics and structural unemployment play an important role in potential labor and potential output estimates)....".

Put simply the only real positive impetus to trend growth we can expect in the future from Latvia will be on the TFP side, since the labour input component will turn negative at some point (if it hasn't already done so). Bertrand Gruss in fact puts it quite bluntly: "Labor is not expected to contribute to potential growth in the coming years."

Demographic Destiny?

Now, quite coincidentally, the IMF is finally getting round to thinking about the demographic side of the European periphery problem (not sure why it took them so long since they've been using the kind of production function methodology described above  for years). Well, at least in the Latvian context it is. I say "finally" because for whatever reason there seems to be some sort of resistance among fund economists to thinking about demographic issues (including migration flows) as part of the core macro picture, yet as can easily be seen above it really is, and Robert Solow wouldn't doubt it for a moment.

Anyway, their current thoughts on the Latvian demographic outlook can be found in the form of an appendix to their 2012 Latvia Article IV consultation report. Coincidentally this report was published at the same time as the second part of their program monitoring reflections, ie the signal being given would seen to be that while demography is important, it is an "issue pending" which can be safely passed over to the post program environment. This is in complete contrast with the methodology being advocated here which is that the program should in part have been designed with this central issue in mind. I have been advocating this since 2007 and I will continue to do so.

Be that as it may, as they inform us in their appendix, Latvia’s population is shrinking rapidly.  

During 2000–11, the population declined by about 14 percent (340 thousand people). Emigration was responsible for about two thirds of this decline while natural change due to low fertility accounted for the remainder: 

Emigration: an estimated 200–215 thousand people, mainly young people—roughly 9 percent of the population—have left Latvia during 2000-11 (Hazans, 20111; and Central Statistics Bureau); and 

Low fertility: the decline of the population for natural reasons was about 125–140 thousand people (5 percent of the population). The number of births has halved since the early 1990s—from around 40,000 annual births to around 20,000—falling below replacement levels.

In fact saying that fertility has fallen below replacement levels is putting it mildly, since the Latvian fertility rate is currently around 1.3 (one of the lowest in the EU) and has been effectively below replacement since the country came into existence. The number of births has been falling more rapidly since the onset of the crisis due in part to the harsh economic conditions but also aided and abetted by the fact that the majority of the women emigrating are of childbearing age.

So Latvia is facing a massive challenge. A combination of low fertility and emigration mean that the population is shrinking rapidly and at the same time ageing. The proportion of over 65s is set to surge between now and 2030 as it is all over Europe. Naturally with the hole in the pyramid left by the "missing births" and the working-age-population migration-loss the country is bound to be an example of one of the worst case scenarios, far worse than Japan, since Japan has only been resisting immigration, it has not lost population through emigration. Fortunately, the country has a possible solution - it belongs to the EU, is about to join the Euro, and the possibility exists that the Euro Area will become a transfer union over the next decade. At least that's the theory, I don't doubt the reality could well be different. But really the creation of this transfer union is Latvia's only hope now, and obviously it would be a substantial net beneficiary, since otherwise it is hard to see how the country will be able to offer its elderly population modern minimum standard welfare services like health and non-poverty-inducing pensions.  

Emigration and the IMF Program

Actually BGG do try and address some of these issues. They do so since, as they say, "an important part of the adjustment has taken the form of emigration". As they also point out Latvian emigration long predates the crisis. The average net emigration rate was 0.5% from 2000-2007. It increased to an average 1.3% from 2008 to 2011, but by 2012, was roughly back to its pre-crisis average. So emigration isn't a product of the crisis, it was simply made worse by it, but still, and going back to Solow  ( it is impossible to believe that the equilibrium growth path itself is unaffected by the short- to medium-run experience.) how far was Latvia's longer term future being put at risk by the form in which the adjustment occurred.

[Just as a side issue it is worth noting that exactly the same question arises in the context of the Greek adjustment. Had the IMF forced the EU to accept debt restructuring and an EFF rather than the initial SBA, the pace of the fiscal adjustment could have been slower, and the loss in output lower. Mein Gott, we might not now be talking about a current estimate of a Greek output gap of plus 10% in 2007 (if you follow the logic of the argument advanced earlier). See my "Second Battle of Thermopylae" post].

In fact BGG do attempt to address this issue:

"The question however is whether this emigration is, in some sense, a failure of the adjustment program. In the United States, migration rather than unemployment is the major margin of adjustment to state specific shocks ..... These adjustments are typically seen as good, indeed as the main reason why the United States functions well as a common currency area: If there are jobs in other states, and if moving costs are low, it is better for workers to move to those jobs than to remain unemployed."

This is an argument that it commonly advanced in the context of Euro Area issues (let's leave aside for the moment the fact that Latvia wasn't in the Euro) - in an optimal common currency area this sort of labour mobility is a good thing. In addition let's leave aside the question that Europe isn't the United States, that it is a continent made up of nations, and that these nations form part of our identity as Europeans in a way which is hard to quantify economically and in a way which can't simply be wished away by waving a magic wand (or paying another visit to Tarkovsky's room), the fact of the matter is that the Euro Area isn't an optimal common currency one. At least institutionally it isn't. To become one of those it would need to have a common treasury and a common unemployment benefit and pension system, etc.

Unfortunately, this is an issue which BGG, like so many before them, simply slide silently past - "the largely permanent departure of the younger and more educated workers may indeed be costly for those who stay" -  like a ship in the night looking for open water while at the same time carefully evading the enemy  minefield.

"Is the answer [to the above question:EH] different for a small country than for a US state? Some economic aspects are different: Some of the costs of running a country are fixed costs, and thus may not be easy to support with a smaller population. In the United States, many of those costs are picked up by the Federal government (although, as we have seen for Detroit, the remaining fixed costs per capita may become too large for a state or a city to function). This is not the case for a country, which must for example finance its defense budget alone."

The reference to Detroit is of course salutory (this is exactly the problem), although it is curious that the example they take for the fixed costs of having a separate state is defence, an area where Latvia obviously benefits from the existence of external institutions like NATO and the EU. Again, the extent would be hard to calculate, but one of the factors which must have influenced Latvian's in their decision not to offend their EU partners by devaluing the Lat must have been a consideration of just this issue.

Still, the question remains, from a demographic point of view could things have been done differently? It's very hard to give a conclusive answer. My argument in favor of devaluation was always based on the potential demographic dynamics  which it might induce. Obviously there would have been a large drop in output, but Latvia had one of those in any event. Would less people have migrated out? That is very doubtful, and indeed, as BGG point out, people were emigrating even at the height of the boom. But then again, would the post crisis potential growth rate have been higher? Would the country still have had to face a non inflationary unemployment rate of 10%, or would the additional international competitiveness achieved have meant it was much lower? Would immigrants be arriving to do some of the lower skilled work?

The thing about this last point is, more than just ending the emigration what Latvia really needs (like Japan, like South Korea) is immigration to shore up the population pyramid, to make the welfare system sustainable in the longer run, especially since although the country's future currently depends on the creation of an EU transfer union there is no guarantee there is actually going to be one.

It is unlikely that the emigration hemorrhage would have been avoided even with devaluation - large numbers of Argentinians, for example, arrived irregularly in Spain in 2002 and 2003 and the two countries weren't in any kind of bilateral Schengen arrangement. But would the natural rate of unemployment have been different following the adjustment? We will now never know.

However,  an argument from two of my Economonitor colleagues - Andris Strazds and Thomas Grennes - should give us some food for thought. According to these authors, when it comes to emigration dynamics "Unemployment Matters Much Less Than Relative Income Levels". Now despite the fact that one might have some reservations about the actual methodology they use (they seem, for example, to confound the migration component in population dynamics and the birthrate one where in fact these are quite distinct channels) they are certainly digging in the right area, as the following chart which comes from a pre crisis IMF report makes clear.

The problem, of course, isn't only relevant to Latvia. Despite the fact that Spain's unemployment rate is currently around 27% immigrants continue to arrive in the country (often risking their lives to do so), a fact which puzzled the Financial Times demography correspondent Norma Cohen when we spoke about this article. "Why on earth," she asked me "would people want to come to Spain with such a high rate of unemployment?" Because salaries are better than in their home countries would be the simple answer, and because they are willing to do work which many Spaniards are reluctant to do, at least at the salaries which are on offer. So economic migrants continue to arrive, an estimated 300,000 of them last year, even though the net migrant flow reversed since more left (both native Spaniards and immigrants) with Spain's population falling for the first time in modern history as a result.

The idea of "centre and periphery" seems like a useful analogy here, since more than simple emigration or immigration what we seem to have is a steady displacement of population with migrants of lower skill entering one side of a country while higher skilled natives exit across the other. In this sense one can truly speak about "population flows". Naturally the net human capital loss involved  is substantial. Italy had some three million immigrants during the first decade of this century, but the overall annual rate of growth was not much above zero.

Beyond implementing the maximalist programme of a completely federal Europe with population moving in one direction and transfers moving in the other  it is hard to see what the solution is here.


Conclusions

"Do these lessons extend beyond Latvia? The evidence from adjustment in Euro periphery countries suggests great caution." - BGG

"I’m not sure I believe this [BGG] story but if you do, what lessons does Latvia hold for other countries, and the euro in general? And the answer, in brief, is none. Latvia’s story as I’ve just told it looks nothing like anything we’ve seen in the past, and probably not like anything we’re likely to see in the future – including, by the way, Latvia’s future." Paul Krugman, Latvian Adventures

The general consensus seems to be that Latvia is an interesting case study, but one where the lessons learned have little application beyond the country's frontiers. I'm not sure I buy this. Let's start at the beginning.

We all know what happened in Latvia - the country's economy massively overheated - but are we so sure why it happened? The answer isn't as obvious as it seems. The quick synthesis explanation offered by BGG runs as follows:

In short, the anticipation of a large scope for catch up growth, together with cheap external financing, led to an initially healthy boom. As time passed, the boom turned unhealthy, with overheating leading to appreciation and large current account deficits, with lower credit quality, and with balance sheet risks associated with FX borrowing.

Yep, but why was there so much external financing available, and why did it continue even after it was obvious to all bar the Latvian government that the accumulating imbalances were putting the country at risk of disaster? Paul Krugman puts my question in a little more elegant fashion:

 First of all, on a conceptual level, how does an economy get to operate far above capacity? We understand operating below capacity: producers may fail to produce as much as they want to if there isn’t enough demand for their products. But how does excess demand induce producers to produce more than they want to?

I think part of the answer here is that we all generally thought that in an epoch of large scale globalisation with extensive migrant and fund flows "open" really did mean open, in the sense that to erect a well functioning economy all you needed was a large strip of land (of which Latvia has plenty), cheap tax rates and flexible labour laws, then the entrepreneurs, the capital and the labour would all flow in. The problem in Latvia's case was they didn't. The capital was there, so were the entrepreneurs, but one of the other factors was in short supply, and indeed instead of flowing in it was flowing out. Then bang!

That's over-simplifying a bit, but it is the bare bones of the situation, a situation which surely has lessons to be learnt for other CEE countries (or far flung places with similar underlying demographics like Vietnam). In particular the word "Ukraine" comes into my head.

But beyond this, why was all that capital flooding in to finance something which to the careful eye was evidently not working? My reply would be, and taking us back to the literature of the time, the operation of the Global Financial Accelerator, a term coined by the Danish economist Carsten Valgreen to describe what was happening in Ireland and Latvia before the crisis actually hit. Essentially, in an environment of ample global liquidity being generated by central banks in countries which don't have the capacity to absorb all the liquidity phenomena like Latvia and Iceland simply happen, as we have been seeing in recent months as the Fed tapering debate lead to a sudden stop in one Emerging Market after another. Fortunately on this occasion the liquidity was being withdrawn before the kind of massive imbalances we saw in both Latvia and Iceland had time to occur. I for one, at least, think it's worth considering what happened in Latvia, and what can be learned, in the context of the current EM debate.

Another issue worthy of note, as I say in the introduction to this post, concerns the issue of convergence. Historically it has been assumed that per capita incomes in countries forming part of the EU would tend to grow at faster rates than those in richer economies with the result that all member state economies should eventually converge to some common living standards band in terms of per capita income. This now seems unlikely to happen, especially given the demographic and growth outlook on the periphery, Latvia included. The economy is growing well right now, but as we can see it is labouring under severe structural problems (the unemployment rate) and the demographic outlook suggests that growth will now steadily weaken. What we have is as good as it gets.

Ironically GDP per capita has been performing well in relative terms since the bust, and in ways the textbooks never envisaged - through a drop in the population numbers. Despite the fact that output is still well below the pre crisis level, as BGG note, Eurostat estimates PPP GDP per capita to now be at 9% above its 2008 peak.

Finally there is the point about how the adjustment took place. As BGG explain, the majority of the internal devaluation took place not through wage and price reductions, but through productivity - the mysterious factor X. But is it that mysterious? What happened was that there was massive labour shedding, as unemployment shot up to 22%. Then, as growth resumed, employment didn't follow (mirroring a pattern which arguably we are seeing in a milder form elsewhere, in other countries which are recovering from sharp housing busts). So while output recovered employment didn't which simple arithmetic tells you results in a strong productivity boost. As BGG explain, there was a strong underlying improvement in TFP taking place due to the "catch up" effect, and this undoubtedly helped Latvia in ways we don't yet fully understand. More study would be useful, since again I do think there are things to be learnt.

As a last word I would say that if you are reading these lines you have probably struggled your way all through this inexcusable indulgence in  verbiage. In which case thank you. You may also have noticed I haven't referred to the issue of fiscal austerity once. Not even a teensy weensy bit. There is a simple explanation for this, the Latvia debate was all about whether or not to devalue, it never was a for or against austerity one. As Paul Krugman puts it: "if we were really looking at an economy with a double-digit inflationary output gap, even the most ultra-Keynesian Keynesian would call for fiscal austerity". For reasons I have outlined above, I don't fully grant the whole inflationary output gap estimate, but still I think the point holds, this was never about for or against fiscal austerity, since among other reasons it was never about public sector debt.

Postscript

The paper published by Blanchard, Griffiths and Gruss relies heavily on the work of the Latvian demographer Mihail Hazans whose groundbreaking studies effectively forced the Latvian authorities to amend their population and migration estimates. I had the pleasure of meeting Mihail when I shared a platform with him in a colloquium organised in 2012 by the American Chamber of Commerce in Riga. The title of the gathering was, not surprisingly, Latvia's Demographic Future (you can find my presentation here).

Basically every country on the EU periphery needs its Mihail Hazans, since we have no accurate or systematic system for measuring these important migrant flows.

In response to what I perceive to be a major lack of knowledge and information I have established a dedicated Facebook page in a vain attempt to campaign for the EU to take the issue of  emigration from countries on Europe's periphery more seriously, in particular by trying to insist member states measure the problem more adequately and having Eurostat incorporate population migrations as an indicator in the Macroeconomic Imbalance Procedure Scoreboard in just the same way current account balances are.

If we don't have the necessary information then how can we hope to formulate the adequate policy responses. If you are willing to agree with me that this is a significant problem that needs to be given more importance then please take the time to click "like" on the page. I realize it is a tiny initiative in the face of what could become a huge problem, but sometimes great things from little seeds to grow.

The Czech Economy That Didn't Bounce?

The Czech republic has been making the news recently. On the one hand the country has been on the receiving end of massive, devastating floods, while on the other the country's government was brought to the brink of collapse (and beyond)  by the resignation  of Prime Minister Petr Necas following the arrest of one of his most trusted aides on corruption charges. After the deluge I suppose.

Curiously both these events serve to highlight one important underlying reality - Czech voters are deeply dissatisfied and in a highly skeptical mood, since following seven quarters without growth the country's economy is evidently stuck in the doldrums. The worst part is things look highly unlikely to improve anytime soon.

Naturally the flood damage has resurected an old and somewhat tiresome debate about whether or not destruction is actually good for an economy. The last time this surfaced in any significant way was in the aftermath of the Japanese tsunami (see my piece of the time here), and as we can now see all that reconstruction spending totally failed to get the economy back on track, although it did leave the ailing country with just a bit more debt.

As I think everyone agrees, flood damage is a form of wealth destruction. If you have a house on one day, and the next you don't then somehow you feel poorer. It isn't really surprising that you feel poorer because in actual fact  you are poorer. Naturally, if your home gets rebuilt, and you find yourself with an even better one as a result, then  you may even feel you have benefited (although what about all those valued personal belongings you lost), but that will be because someone else, either a government or an insurance company, has made good your loss, so they are poorer instead of you. As Reuter's reporter Michael Winfrey puts it: "Governments and insurers from Germany to Romania will have to pick up the costs of helping families and business recover from the floods, which have killed at least a dozen people and driven hundreds of thousands from their homes since the start of June".

Now clearly in the short term GDP may benefit, since spending money will generate economic activity. As the country's Finance Minister Miroslav Kalosuek told Czech Television at the time: "If we take just the normal households, and how many brooms, bleach and rubber gloves they must suddenly buy, that is demand. There will also be demand in construction, demand in renewing roads, higher demand for certain goods and services. And higher demand is pro-growth."

But will the extra demand really generate extra growth in the longer run, rather than simply advancing spending from the future to now (or as the Spanish expression so evocatively puts it "give us bread for today and hunger for tomorrow") ?  The evidence we have seems to suggest that it will if the problem the economy was suffering from was a lack of stimulus - which brings us nicely round in a circle to the stimulus versus austerity debate. But if lack of stimulus wasn't the problem, as we have seen in the Japan case, an extra reconstruction programme won't make a blind bit of difference at the end of the day. It will simply shift demand around a bit in time.

So which is it? Is the Czech Republic suffering from a normal common or garden recession, one in which a bit more stimulus might help, or is something deeper going on?

The Demographic Spanner Stuck In The Works

The Baltics, Hungary, Romania and Bulgaria are all recognized - each in their own way - to have encountered serious economic problems and generated sizable imbalances during the run in to the global financial crisis. These problems - at the time - were seen as placing serious question marks over the underlying soundness of a group of economies which in the pre-2008 world were often lauded for their growth prowess and fiscal abstemience when compared with their West European neighbors. The fact that these countries started, one after another, to go off the rails could be explained by viewing them as examples of  the "weaker economic cases"in the group.

But when, in a way which curiously parallels what is now happening in purportedly "core Europe" countries like Finland and the Netherlands in the West,  what were previously regarded as best-case-scenarios, like the Czech Republic and Slovenia, start to struggle and then continue to flounder, well perhaps we should be raising more than an eyebrow or two - indeed,  maybe we should really be asking ourselves some serious, thought-provoking questions not only about the structural depth of the problems being faced by the whole group of Eastern Accession countries, but also even about the very soundness and adequacy of the received theories the main multilateral policy institutions are working with.

In the current case, the Czech Republic is now in all probability in its eighth quarter of  recession - and the last time the economy actually grew was in the three months up to June 2011. This is quite a preoccupying outcome for a country which was not perceived to be suffering from any special problems - like outsize credit booms, or government fiscal largesse - in the pre-crisis world. The economy is now moving sideways, and, more importantly, substantial question marks hover over what the country's real future growth potential actually is. Certainly, and in any event, it is well below that which was considered a norm pre 2008.

In the past the country was characterised by and renowned for the soundness of its industrial base and  its strong export performance, but the continuing crisis in the Euro Area (the principal source of external demand for the country's products) has meant overseas sales have been largely stagnant for some quarters now. And with countries in Southern Europe striving to make a substantial competitiveness correction and claw back some of their lost ground, it is in the East of Europe where the impact of these efforts is likely to be most acutely felt. It was precisely during the time that the Southern economies were shifting over to credit-driven service ones that their Eastern counterparts were busy building their industrial foothold in the EU. Now those in the East face the risk that a sizeable chunk of this coupling and integration process may simply unwind. A rising tide may lift all boats, but what does a flat sea do?

Czech industrial activity has become virtually stagnant when it isn't actually falling.

And construction is steadily sliding downhill.

In addition to the loss of export leverage household consumption has remained very weak. As the IMF put it in their latest country report, "the export-led recovery observed in 2010-11 subsided as euro area import demand slowed, and growth has noticeably underperformed trade partners and peers since the middle of 2011 mainly because of weaker domestic consumption and investment."

Naturally, both the IMF and EU Commission assume that what is happening to the country does not go far beyond a short term blip, and both institutions take it as a given that "recovery" will set in somtime soon. As the IMF puts it, "The Czech Republic's economic fundamentals are strong." The EU Commission broadly agrees: "Due to a strong downturn in consumer confidence, a drop in public investment and a weaker external environment, real GDP is estimated to have decreased by 1.3% in 2012. As these factors ease off in 2013, economic activity is forecast to bottom out in the middle of the year. The recovery is expected to consolidate in 2014, supported by growth of real household income".

That being said a nuanced but interesting divergence has emerged between the two Troika partners over the immediate outlook for the country. While EU Commission see "domestic risks to the outlook" as "fairly balanced", the IMF feels general risks lie  "mainly to the downside" highlighting the risks of  "further deterioration of euro area growth" and the danger of "permanent scars to potential growth".

The Fund explain their concerns as follows:  "With recent disappointing export performance, the economy is at the risk of being dragged deeper into recession. Also, the current poor growth performance, if protracted, runs the risk of translating itself into a long-term decline in potential growth due to lower investment." I.E. the slowdown could eventually become self perpetuating if the recession becomes an even more dragged out affair. Unfortunately this possibility is far from being excluded.

Given the existence of such risks it is worth asking ourselves whether growth in the Czech economy really will bounce back to an average of around 2.8% a year between 2015 and 2018? What is there in the works which really could make such a growth spurt - from the current near zero level - possible? Or could the IMF forecast numbers not be just another example of what Christine Lagarde once called “wishful thinking” of the kind that has been habitually practiced in, say, the Greek case.

But let's put the question another way. What might impede the country from  reverting to a pattern of strong growth rather than simply continuing to bounce along the flatline?  Well, you've got it - it's the demography stupid!  The Czech Republics population and workforce just turned the historic corner pointing towards long term decline. To some this piece of information may seem surprising, but CEE demographics in general really are quite unique, since while fertility fell and life expectancy started to rise as it did in the West, due to the development delay produced by nearly half a century of communist government most of these countries are now in the process of getting old before they get rich, creating a very special set of economic growth and sustainability issues.

Czech fertility has long been below replacement level, and has been below the 1.5tfr level since the early 1990s.    

The Czech population has been virtually stationary over the last few years, but is now finally starting to contract.

As in many countries on the European periphery the decline is an indirect by-product of the economic crisis. Population levels which were previously precariously balanced around the zero growth line are suddenly being destabilised by the drop in births associated with the recession and the sudden disappearance of the positive net number of migrants arriving which helped keep the balance in the pre-crisis world.

"In the first three months of 2013.... net international migration was equal to minus 4 people – the number of emigrants was 9 998 people and number of immigrants was 9 994 people. The highest net migration was reached with the citizens of Slovakia (1 213 people) and Germany (334 people), followed by United States (290 people) and Romania (213 people). The considerable decrease was registered in the number of citizens of Ukraine (by 2 201 persons), Czech Republic (by 505 persons) and the number of Vietnamese citizens (by 427 persons)".

But even more important (in terms of GDP growth potential) than the overall population decline (which is still tiny) is the fall in working age population (WAP).  Following a pattern seen in country after country along the periphery, the start of the decline in this population group has also  coincided in time with the onset of the European debt crisis.

This means that employment growth will have the wind blowing against it, rather than behind it, and that it will become harder and harder to get GDP growth from adding extra labour (indeed at some point the number of those employed may well become negative) and the only major impetus towards headline GDP growth will have to come from productivity improvements. For an examination of this issue from the Portuguese point of view see this post here.

Is There Deflation Risk?

One of the lesser known details about the Czech economy is that - since it has retained its own currency, the Koruna - it has its own independent monetary policy and the central bank therehave now been holding interest rates about as near zero to zero as you can get  (0.05%) for  the past 8 months. This puts the country's bank in more or less the same situation as most of its better known peers across the globe - namely it is now up against the "zero bound" which makes it difficult to lower nominal interest rates any further.

With inflation weakening the debate at the central bank is now moving towards whether it will be necessary to use exceptional measures of the kind which would elsewhere be called QE. One option which is under consideration is a local version of "Abenomics" whereby the bank actively intervenes in the currency markets to provoke Koruna weakening - not so much to generate more export competitivness (banned by the G20) but rather in order to to try and raise the price level and avoid deflation risk (see these comments from central bank board member Lubomir Lizal). Such interventions, which (as in the Japan case) target the price level and not the currency value are for the time being accepted by the international community.

At the present time the Czech Republic is experiencing strong disinflation rather than outright deflation, but the IMF clearly see a danger if domestic demand remains weak and the economy continues to drift that this could become outright deflation.

The policy interest rate has reached the zero bound, but risks to inflation are to the downside. The Czech National Bank (CNB) was swift to cut its policy rate by 70 basis points to 0.05 percent between June and November 2012. Inflation declined below the 2 percent target level starting from January 2013, as the effects of 2012 VAT hike subsided and contributions from food and fuel fell. Inflation is projected to remain at around 1¾ percent through 2014, but risks are to the downside in line with the risks to the growth outlook.

and:

"If a persistent and large undershooting of the inflation target is in prospect, the CNB should employ additional tools. The CNB’s statement that additional monetary easing within the context of inflation targeting framework would come from foreign exchange (FX) interventions is welcome and has been clearly communicated. The mission agrees that FX interventions would be an effective and appropriate tool to address deflationary risks."

The risk of outright deflation is thus intrinsically linked by the Fund to the downside risks to headline GDP growth. If the economy under-performs, and investment does not bounce back then not only will there be damage to the country's long term growth potential, movements in prices might turn negative.


Japan With A Current Account Deficit And Negative Net External Investment Position?

Few, I suppose, would have thought there would be any good reason to make a comparison between the Czech Republic and Japan. Naturally it is noticeable that both countries have strong industrial bases and are very dependent on exports for growth. But beyond that it would seem the two countries have little in common.

Except, except.....  what about the decline in working age population (WAP)? Isn't that the factor that many feel is behind the ongoing battle that Japan is fighting with deflation? (See, for example, this post). The Bank of Japan has long recognised that there is some sort of correlation between the rate of workforce growth and the rate of inflation (see chart below), with price inflation turning negative at more or less the same time as labour force growth did. The causality behind the correlation would be connected with the rate of rise (or decline) in domestic demand (initially consumption and then investment). Movements in WAP could be considered to be a good proxy for movements in employment and incomes, and hence consumer demand. As a country's WAP enters decline then domestic demand tends to weaken and following this the investment which goes with such demand does not occur. This is why failure to adequately resolve the present malaise into which the Czech Republic has fallen could produce a long term negative consequence for trend growth, as the IMF have highlighted.

Thus it isn't just a coincidence that the Czech Republic is starting to notice a fall in domestic demand and a fall in investment at just the time when the working age population starts to decline. This is a development which needs to be closely watched.

But, beyond any loose similarities, there is one important sense in which the country differs from Japan - the state of its Net External Investment Position. 

The Czech Republic has, as I have repeatedly stressed, a strong export sector. So much so that the goods trade balance tends to be positive and large. What's more, it has been growing rapidly since the crisis. In fact, in Japan as the population has aged this balance has weakened.

But while in Japan the current account balance remains strongly positive, in the CR it is constantly negative.

The reason for this apparent paradox  lieswith the large negative income component in the current account.

This income component is largely made up of interest payments on external loans (for example in the banking sector between West European parent bank and Czech subsidiary) and dividends on equities owned by non residents (for instance non-Czech parent companies which bought into Czech utilities during the privatisation wave).

The income item is large and negative due to the country's strong negative Net International Investment Position. Simply put non Czech nationals have more investments in the Czech Republic than Czech citizens have abroad to the tune of some 50% of GDP. In an ageing society, with a shrinking workforce this situation is simply not sustainable. Czech companies and citizens need to save more, even though this will weaken domestic demand further and make the country even more dependent on exports, and more of these savings then need to be invested abroad to generate an income flow which will help the country support its rapidly ageing population from 2020 onwards. This situation is widespread across Eastern Europe (see Hungary here and Bulgaria here).

Summing up: In recent years Czech exports have performed remarkably well, and the country has a strong goods trade surplus. The problem is that most of the country’s exports have been geared to the European market, and consumption in this area is now stagnant with a tendency to decline. In addition the country is heavily indebted abroad. With each passing day the CR looks more and more like Germany and Japan, without the strong overseas investment stock which gives the economies of those countries some sort of stability. The country cannot gain enough export momentum and as a result the economy languishes in recession.

The thing about elderly economies is that they no longer stand on two pillars, domestic consumption steadily runs out of steam, and the economy becomes export dependent. This is what can be observed in the Czech Republic, and the country’s demographics make it unlikely we will ever see strong growth in private consumption again.

On the other hand the country has a low sovereign debt level – around 45% of GDP – and before the onset of the latest recession it did maintain a reasonably strict fiscal discipline, despite the fact that with an ageing population the costs of health care and pensions continue rising annually.

One of the reasons for the low sovereign debt level is the fact the country privatized a number of its state owned companies at the start of the century - and herein lies the problem on the income side of the current account. Privatising to overseas (rather than domestic) investors means the even though the sovereign itself is less indebted, the level of indebtedness of the country as a whole doesn't change much. Ultimately the sovereign supports the nation, and the nation the sovereign, so apart from the political debate about larger or smaller government the rest is more akin to moving the deckchairs around. This kind of privatisation does not guarantee long run sustainability for the country, and if not backed by a rise in domestic saving it can become "bread for today and hunger for tomorrow" as the Spanish expression goes.

So despite being out of the Euro, and having the ability to devalue, it is not clear to what  extent the Czech government will be able to withstand popular pressure to increase spending in the face of a stagnant economy. Without some plan for handling the ageing population problem calls for continuing austerity will likely fall on increasingly deaf ears as they do in country after country along the EU periphery. Despite talk of a constitutional change limiting public debt to 50% of GDP, as we are now seeing in the Polish case such laws are easier to enact than they are to implement. So it is likely that the current wave of austerity policies will increasingly come into question if, as seems probable, the economy continues to stagnate.  In which case watch out for credit rating downgrades, and future surges in yield spreads on the one hand and growing deficit and debt levels on the other. As Paul Krugman once put it, some countries have low growth because they have high debt, and others accumulate high debt because they have low growth. The latter is in dabger of becoming the Czech case.

What Do Ageing Populations Have To Do With The Sovereign Debt Crisis?

Edward Hugh is a Catalan economist of British extraction who lives near Barcelona. As a macroeconomist, he specializes on demographic processes, migration flows, and growth and productivity theory. Although recently he has done a lot of work on the economic troubles of the eurozone (for obvious reasons), his curiosity has taken him far away from his home continent, and he has written about the economies of India, Eastern Europe, and Japan. Hugh is a regular contributor to a number of economics blogs, including “A Fistful of Euros,” “Global Economy Matters,” and “Demography Matters.”


I spoke with Hugh on March 14 at the Morningstar Investment Conference in Vienna, where he delivered a presentation titled “What Do Ageing Populations Have to Do With the Sovereign Debt Crisis?” We started our conversation with a discussion of the demographic problem of the developed world, but ended up visiting topics as diverse as how the United States’ national identity has helped it through the financial crisis and how Italy might be the greatest threat to the eurozone’s stability. Our conversation has been edited for clarity and length.

Francisco Torralba: You argue that the demographic situation in Western Europe, Japan, and the UK implies that sovereign finances are going to be in a very sticky situation within 10 to 20 years. The populations of these countries are aging rapidly and will need help funding their retirements. But fewer younger people are working and paying into the system. What will be the ramifications of these trends for sovereign finances?

Edward Hugh: What this means for sovereign finances in Europe is that there is increasing pressure on the level of sovereign debt and increasing pressure from markets on sovereign bonds simply because of political risk. It's going to be very difficult, as years go by, for the politicians to keep convincing voters that the necessary sacrifices have to be made to help an aging population. So, we're in a complex situation.


But if I can broaden this a bit, it's not simply a question of the demographic change in Europe, the United States, or Japan. What we're facing at the moment is a paradigm shift in the way markets, investors, economists, and everybody are thinking about economic processes, debts, and sovereign risk. As somebody told me about a recent pensions meeting they were at, a presenter said, “It's the population, stupid.”

This idea is very simple, and it's just surprising that it went out of people's heads for so long. In fact, traditionally, economists were always interested in population dynamics and demographic processes. But there were some famous studies in the 1970s and 1980s by the Nobel Economist Simon Kuznets, who found that size of population was not a factor in economic growth. That was the necessary catalyst that caused people to think, “Well, then, population doesn't matter.” But Kuznets’ research was very specific: the size of a population didn’t matter. Iceland is no different from China in this sense.

Later, as we got into the 21st century, with the growth of emerging markets, people started discovering again that population structure does matter. It's not the size; it's the population structure, stupid.

So from the end of the 20th century, there was increasing interest among development economists in the way in which the drop in fertility rates in the emerging economies could help those economies get up to speed, if they made the necessary institutional reforms to accompany these changes.

The first warning signal came from countries like the Asian Tigers--Singapore, South Korea, Taiwan, and Hong Kong. Then, Goldman Sachs got the idea of BRICs, as China started to come online, and suddenly, we were talking about countries like Brazil, India, Indonesia, and the Philippines.

There’s been a definite before and after to the global crisis, with the emerging markets assuming a far greater importance. The valuation of the outlook for both growth and sovereign risk in the developed economies has shifted into another gear, as has the perception of growth possibilities, and therefore, sovereign risk in the emerging markets.

That's why I call this paradigm shift. Some of these debates which we have between Schumpeter and Keynes about how to handle the current crisis are out of date in the light of that paradigm shift, I would argue.

Torralba: You argue that there's a ratio called the dependency ratio: the number of older, retired people relative to working age people….

Hugh: If I can interrupt, actually, there are two dependency ratios. There's a child dependency ratio and an elderly dependency ratio. The problem with the super-underdeveloped economies is that they have a massive child dependency ratio, which means they have very little in the way of saving, because they have large numbers of children. As my father told me, because he was one of a family of 14 and started work at 12 in the Liverpool of the United Kingdom, which was the richest country on the planet at that time, having lots of children means poverty. Having a lot of old people, if we're not very careful, could also mean poverty, too.

We're making an inversion from having too many children in proportion to the rest of the population to having too many old people. For developing economies, the news that fertility is dropping is good. In developed societies, where the key ratio to watch is the elderly dependency one, then a continuing fall can become a major issue. Having let the developed world population pyramid get to the stage it's now in, trying to address the problem is going to be difficult. Giving more facilities to working mothers who want to have children, for example, or some kind of family support system, or paying to subsidize school textbooks so that having a child is not such a direct economic burden on a family—all these are going to be very, very difficult in a situation where resources are so strained, because of the demands on the pension and health systems, due to the large proportions of elderly people.

Torralba: The problem is that we used to have a demographic dividend, where we always had an adequate ratio of retired people to working people. It's what we call a pay-as-you-go system. Each year's taxes are used to pay the pensions for that year. That model will be inadequate for the next two or three decades. How are we going to transition to a new form of financing retirement?

Hugh: Well, the transition will be turbulent. That's the only clear thing we can say. Our societies just aren't prepared for this transition. People in many countries--and it's not just southern Europe, because I think the United Kingdom could soon be in the same situation--don't understand that you need to make systematic cuts--in health systems, for example. One of the reasons why the proportions of elderly dependents are rising is simply because of advances in medical technology. It's getting easier to extend people's lives, but we achieve this end by using more and more expensive medication and technology for increasingly lower additions to quality of life. It’s a very expensive process, but it's going to be very hard to explain to people that that's the case.

What do I see the future? In the first place, I see a lot of turbulence in the political systems. Second place, I see a process of realignment in the global markets. Every company needs growth. Companies need markets to grow for their products to justify the next generations of investment. For corporations, the expansion in emerging markets is a godsend. Even though the majority of the population can't buy Italian luxury products or expensive German cars, the volume of population is so large that even with only a small percentage of that population being rather rich, you've got quite a big market.

So, at the moment, the corporate sector is reorienting and reinventing itself. This is being reflected in the U.S. equity markets; companies are reorienting production toward these new, growing areas. But it's going to be quite difficult for the populations in the developed countries to come to terms with the fact that their status in the world is changing.

What Can We Learn From Japan?

Torralba: Japan is a little bit further along in the demographic transition than Western Europe. Is there anything we can learn from Japan’s situation that is applicable to Western Europe?

Hugh: The thing that's distinguished Japan the most has been its ongoing deflation. Up to now, no other countries have had this kind of deflation. So, at the moment, this is a unique Japanese feature. We need more time to see whether it's going to typify other countries or not.

What we can say, though, is that Germany, which has a similar aging profile as Japan’s, has had a very strong disinflationary tendency over the past few years. The Germans have patted themselves on the back about this and said how good they've been in comparison with their European peers. But to some extent, this could simply be a product of the internal demand dynamic. Because I think the lesson that we can get from Japan is that with populations aging beyond certain thresholds, the structure of production changes. Investment oriented towards domestic consumption, and domestic consumption itself, tends to become more and more lackluster, while the country comes to depend increasingly on having a super-efficient tradable sector and ramping up the level of export production.

We do see a rather similar pattern in Germany. Why is it the case that domestic demand starts to weaken? Because most of the actual economic growth that we get comes from taking demand from the future in terms of credit. In this sense rather than a credit cycle what we see is a structural shift in the role of credit. Where we do get strong consumer demand growth in countries like Spain, Ireland or the United Kingdom during the first decade of the century the driving force was a very large increase in private domestic credit. Once that comes to an end, you seem to notice that consumer demand doesn't have anything like the same dynamic, because a higher proportion of the population is just buying out of current earnings and current income.

There is a certain age profile associated with patterns of spending and borrowing. Nobel economist Franco Modigliani noticed this in formulating his life cycle model. It was indeed a pattern that had already been identified by the British social philanthropist Joseph Rowntree at the start of the 20th century. There are different stages in life. And these stages are successively either ones of increasing borrowing or ones of increasing saving for the future.

When we extend these stages to a whole population, we can see that the domestic demand dynamic isn't what it was as countries get older. So, that's one of the points that we can get from Japan.

The other point is this increasing dependency on exports and external saving. One way of making the situation easier was always the idea that during the good years, when you are having higher levels of economic growth, savings could be diverted out of the country into overseas investments--and to some extent, the population can live off of these overseas investments.

Indeed, this is what we're seeing in Japan at the moment, because Japan's got a 50% of GDP net national investment position, which helps the current account, but the country can’t live forever off this. Little by little, we can see the surplus weakens as people draw down on their savings. So, there's then a big theoretical argument among economists about how long this will last. But if we look at not only Southern Europe but also Eastern Europe—these are all countries that are about to enter this important aging period, and they've got strong negative external investment positions. This is a great concern. How are they going to manage the aging process? They haven't got the external savings to draw down on, and they have got external debts to pay.

Torralba: Exactly. Not only do they have current account deficits, but on top of that, they owe money to the external sector.

Hugh: Every month, just to cover the current outflows on the equities and on the debt obligations these countries have, they have to do an extra dose of exporting to be able to earn the money to pay it down. That exporting doesn't help compensate for deficient internal demand. So, it's going to become an increasing headache.

Labor Mobility

Torralba: I’d like to discuss the relationship between migration and fiscal policy. In an economic area like the eurozone, where in theory you have a free labor market--people are free to work and live whatever they choose--you have the possibility that people will move from the least-productive, lowest-wage parts of the eurozone to the most-productive, highest-wage areas. That leaves behind retirees, or people with very low earnings, who make small fiscal contributions to the state. What does the free labor market in the eurozone imply for fiscal solidarity in the eurozone?

Hugh: This is a very important point. The euro was set up with major institutional deficiencies. Some of these had to do with the fiscal coordination and product market integration, services integration, or whatever. One of the deficiencies was the absence of widespread labor mobility. For some reason or another, people were not moving from one country to another. Or even within countries. Take the example of Spain, even when the economy was growing at 4% a year and 750,000 migrants were entering the country every year, in the southern parts of Spain there was double-digit unemployment, and there was no movement from these areas towards richer regions like Madrid, Valencia, or Barcelona, where the economies were booming, and there was plenty of opportunity for work.

Spain is quite a nice microcosm of the problems that the euro area has as a whole. If this mobility wasn't evident, or wasn't evident in Italy from the south to the north in the first decade of this century, how much less wasn't it there in the euro area as a whole. I mean, there was a migration from Eastern Europe into the euro area, but not from one Eurozone country to another, except at the most highly qualified level.

What we are seeing now is something new, and something which in principle is very welcome - people are moving from countries which are stuck in deep recession to areas where there is economic growth, where there is demand for labor.

But, as you're suggesting, this basically good news also presents us with a problem as it highlights yet another institutional deficiency in the design of the euro area. Basically, those who are moving have been brought up, educated, and prepared for life by one society but they then go and work in another one. Instead of paying contributions through the pay-go system of their own country, they contribute to the pay-go system of another one, and there's no evident mechanism whereby any of this money gets recycled back to meet the old age needs of the parents who raised them.

Spain itself had this problem internally, with the huge migrations of the 1950s and '60s from the south and the west of Spain into Madrid and to parts of the north. The issue was resolved this by having a common fiscal system for the whole country -- burden-sharing, or solidarity, or however you like to look at it.

The argument in Spain is about how far this should go, about what is reasonable, and what is not reasonable. A similar debate exists in Germany, where again, we've seen these very large migration movements out of the old East Germany into other parts of the country.

The issue then is: is the euro area going to set up some kind of equivalent arrangement to the one that's been set up in the Federal Republic of Germany, or the autonomous communities of Spain, and make some kind of allowance for the sharing of the benefits of this migration. Because if it isn’t, then what you are left with is what the old East Germany would be like, if it wasn't part of the Federal Republic, a country with a very, very large number of old people, quite a high unemployment rate, and insufficient growth to support the basic welfare system.

Torralba: From a political point of view, it's going to be extremely complicated. It creates tensions between regions, and it creates resentment. In Spain, people in Catalonia think they're paying too much to Madrid. How is that going to work in Europe when Germany is told that they're going to have to send checks every month to pay for the Spanish retirees? I don't see that going down very well.

Hugh: No, and I don't think that's going to happen, either. Japan has these problems, not at the regional level, but the problem simply of sustaining the health and pension system, given the lackluster nature of the economy and now the declining workforce and problems of productivity that they're having, associated with its aging. How Japan is handling this is just by boosting debt. Japan's gross sovereign debt last year was around 235% of GDP, and they were running a fiscal deficit of around 10%. The prime minister, Shinzo Abe, is talking about doing even more of the same this year, so we can imagine they could go up through the 250% of GDP, and onwards to upwards to over 300% over the next few years.

These are unheard of proportions in any modern society. We don't know where this leads. But I would suggest that the most likely tendency that we can see in Europe at the moment is a tendency for some kind of mechanism to be devised, yet to be specified, which allows these countries to continue spending without all the weight of this falling on Germany.

Torralba: We've been talking about the implications of demographics for fiscal solidarity. Another implication that we read about is that having a single financial system eventually leads to some sort of burden-shedding in the end, because eventually, the state is the guarantor of the financial system liabilities.

It seems that we are entering a new phase in the eurozone crisis. You wrote recently that what Ireland did may be a peek into the future of the eurozone. First, the Irish Central Bank bought promissory notes that were meant to recapitalize the financial system, and then those promissory notes were actually later swapped for Irish government debt.

In the end, what this means basically is that the Irish Central Bank is financing the deficit, in a way, even though this completely goes against the European Union Treaty—that the Central Banks are not supposed to finance deficits. The ECB is against it, the Bundesbank is against it, and nonetheless, it seems to be happening in Ireland.

What do you see happening in countries that could make use of the same policy, certainly Spain, Italy, Portugal, and even France? Is this where we’re headed in Europe?

Hugh: Something is going to have to happen, isn't it? The market's assuming as well that something is going to happen, because otherwise, you can't make sense of the pricing of European sovereign bonds at the moment, unless you think that's the case.

The premise would be what you said in the earlier question, and that is that it's going to be very, very difficult for the Europeans collectively to agree to have the kind of fiscal arrangement they have in the United States, where there are automatic stabilizers from one state to another, which operate immediately. If there is some kind of economic slowdown in one part, that doesn't affect another. People can go and live in Florida and have pensions paid, just the same as if they were living at home.

It's going to be very difficult to convince German voters to accept that, so some other way has to be found. What's concentrated everybody's mind recently is the outcome of the Italian election, because it's clear in Italy that people are not voting at the moment and are unlikely to vote in the foreseeable future for a government that is strongly committed to the kind of reforms that will be needed in order to apply to Mario Draghi to implement an Outright Monetary Transactions bond-buying program. Yet, the whole current market position is based on the idea that ultimately these countries, Italy and Spain in particular, will, if need be, apply to Mario Draghi.

So, everything is skating on thin ice at the moment. I think that's obvious to everybody, even if they're not talking publicly about it. What happened in Italy could easily happen in Greece in the next elections. You could get another party, which is not favorable to continuing with the Troika programs, with a majority, because Greece has this first-past-of-the-post party system, winner takes nearly all. So, if it was Syriza instead of New Democracy that came first by a short head in the next elections, this would cause all kinds of problems. Portugal is going to have elections one day or another and has another similar situation pending. You don't have to be a genius to see that there's a limited lifespan to the unpopular austerity measures, necessary as many of them may be.

Strength of U.S. Federal System

Torralba: This reminds us that monetary policy and fiscal policy are not independent. They're kind of two sides of the same coin. In Europe, it's difficult within the short time horizons to have responsible fiscal policies, so we're going to resort to monetary policy to finance deficits. In the United States, you don't have that fiscal constraint. Why has the U.S. embarked on this monetary expansion policy that seems to be turning into QE Infinity?

Hugh: I think there are two questions here. One is, why the United States has gone for quantitative easing. And the other one is, why is it possible for the United States to do certain things where they don't mind who's paying--whether it's somebody in Alabama who's paying or somebody in California?

Most people I talk to from the United States say that the United States can have this federal system--where people maybe moan a little bit, but nobody really seriously takes issue with who's paying for what--is that they had a Civil War, and the Civil War settled the question.

Now, that's not an argument for having a civil war in Europe, but we've never settled the question, despite all these wars we’ve had. It's quite interesting that the whole idea of the European Union, the traditional argument for it, is that because we were always at war. But in fact, war didn't settle this issue, because we are still a continent of bigger and smaller nations, where the national identity is something that's important to us.

Yet, the whole idea of a working European Union, and especially the euro, depends on everybody feeling part of the same entity. They obviously don't. Therefore, it's dysfunctional.

That's why the United States can do something that Europe can't, and I don't see any short-term or easy solution to this question.

Why do they keep doing QE even when there's no evidence it works? Again, we can go back to Japan. It's curious that people say that the Bank of Japan hasn't ramped up its balance sheet as much as anybody else. In fact, it did ramp up its balance sheet quite a lot before the crisis started, so the baseline is a bit different there.

But it was quite obvious that in fact QE didn't work the first time it was tried in Japan. There was this critical moment in 2005 when the G20 had decided that everybody was going to go back home and try to start raising interest rates, because the environment was perceived as being excessively risky with people extending too much credit, etc. People were anticipating, a little bit, the crisis.

Japan got as far as putting the rate up a quarter percentage point and then stopped the whole tightening cycle, because it couldn't go any further without imploding the economy.

So, on the one hand, it wasn't working, but on the other hand, they weren't able to apply a more hawkish monetary policy without really putting the economy itself at risk.

This is the whole point. It's working in that it’s boosting the equity markets and boosting carry trades across the planet, but this way may be indirectly creating a little bit of inflation. But it's not working its primary objectives of restarting credit flows and generating a slightly higher inflation rate to aid deleveraging. Fine, but what would?

So, if you haven't got an answer to “what would?” then you stay where you are. I think that's why we are where we are. There are people in the United States who would argue that QE is doing certain things, achieving some of its objectives. That's a huge debate that I don't really want to go into because it isn’t really within the bounds of my expertise.

But we are locked into these kinds of situations because nobody's come up with a better idea. The alternative to this is not to raise interest rates. So, what do we do?

Torralba: Speaking about inflation, a prediction that you hear about sometime is that the monetization of government debt in the long run will imply much higher rates of inflation. In fact, this is one way how governments are going to deal with their fiscal problems, just wipe away the real value of their debt by letting inflation run higher.

Do you think that this is eventually an outcome that we should be worried about?

Hugh: Well, it's not a concern that I have at the moment, because of the reason that I gave you, that there seems to be a structural deficiency in domestic demand in many of the economies where they're applying this technique. So, it's hard to see how you can get domestically driven inflation. How you could get troubling inflation is if you provoke a collapse in the currency. This is a risk Japan is running, as George Soros is pointing out.

So, in the long run, you could have hyperinflation, let's say, in Japan, if the yen really collapsed--not if it went from JPY80 to JPY100 to JPY120, but went from JPY120 to JPY300. If there was a dramatic collapse in the yen, because there was a dramatic flight of funds out of Japan at some moment, because people anticipating continuing falls in the yen started really panicking, then, this could precipitate a very strong inflationary dynamic.

This creates a peculiar situation, then, for the countries in Southern Europe, because the only way you can avoid breakup risk coming back again is to let some economies spend more money. The advantage of doing it through the national central banks is that it doesn't all fall back onto Target2 balances and generate additional liabilities for the Germans. If this is shown to be the case, then maybe the Germans will become more relaxed about the situation.

But the interesting thing is that these countries with large net-negative external investment positions and high levels of sovereign debt normally would experience a big run on their currency. What the euro does is stop the big run on the currency, because they're in a common currency--although it isn't a national level currency.

But what Willem Buiter, the chief Citigroup economist, has spoken about over the past months, and it’s becoming increasingly relevant, is the possible ruble-ization of the euro, making a comparison with the old USSR, when the ruble was retained as a common currency for a number of increasingly independent states. In fact, 5 euros in Germany may already effectivelyhave a different value, even though we’re talking about the same banknote, to 5 euros in Greece.

Torralba: Just to make sure I understand what you're saying. Right now, the value of the euro is in a sense anchored by Germany. Germany is seen as a responsible country with a current account surplus.

Hugh: Yes, and as a result of that perception Germans get all kinds of financial perks, like cheaper interest rates when they want credit. But it's interesting, the Germans and the French are increasingly arguing now about this point that you've drawn attention to. It was interesting to hear Jens Weidmann, the president of the German central bank, recently raising doubts about the French will to implement major structural reforms and to bring the fiscal deficits under control. If the tensions grow on the German/French axis, we're going to be in even more trouble. But, yes, Germany is seen at the moment as the heart.

How the Euro Crisis Could Be Rekindled

Torralba: Is there an event or a series of events that could rekindle the eurozone crisis, causing yields to spike again?

Hugh: Clearly the unsuccessful unwinding of the Abenomics experiment would potentially throw global markets once more into turmoil, with major risks for the euro, but if we stay away from Japan I think there are three possible trigger events that we could talk about briefly. One is the situation of tension inside Spain. Again, the thing that holds the United States together is the feeling that everybody belongs to the same nation. The difficulty we have in Europe is that we don't all feel that we belong to the same nation. Sometimes, these feelings even exist within what are one and the same nation-states, as is the case with Catalonia and Spain.

Torralba: Italy, north and south.

Hugh: Exactly. Belgium and Flanders. One of the embarrassing situations about Flanders is, of course, that Brussels is in South Flanders. So, this creates even more difficulties.

But it's very clear that there's a commitment in Catalonia to having some kind of consultation in 2014. Relations between the central government and the government in Catalonia are deteriorating; the sentiment to vote in favor of separation from Spain is growing rather than diminishing at this point in time. This could become a major difficulty, because, obviously, anything that threatens the unity of Spain would be an immediate event risk on the euro horizon.

The second issue is the situation in Italy. People forget that simply expanding the Central Bank balance sheet doesn't solve all problems. It doesn't necessarily mean the economy goes back to growth. Italy has a serious problem of economic stagnation. The Italian economy has more or less gone back in time to the beginning of the century, because Italy had very little growth in the first eight years, and it's had a lot of shrinkage since 2008.

More shrinkage this year will push Italy’s economy back into the late 1990s, and eventually, people may just simply get sick of the situation. So, it's not beyond the bounds of possibility, even with an expanded central bank balance sheet, that somebody comes along with a petition demanding a referendum on the euro. I think it's much more “doable” for Italy to make the decision to leave than it is for Greece, because Greece is a small country. It's got much more to gain, however hard off the population is, by trying to seek help from the rest of Europe, than by trying to go it alone into the wilderness. Italy's a much bigger country. National pride is a much stronger issue. It also feels quite well insulated from currents of opinion in other parts of Europe.

Lastly, you mentioned France. I think the deteriorating relations between France and Germany, more than simply the unwillingness of the French electorate to support reforms, is where the major event risk lies. This is one of the reasons why I think it's not so controversial, from the German point of view, to allow the national central banks to do things--because the big worry for Germany is if eventually the thing disintegrates, what happens to the Target2 balances? Anything that allows these balances to unwind, and we will notice that the ECB balance sheet is coming down now, is positive for Germany, because it means the cost of breakup is less. So, they can bend on this topic. But an open confrontation between the French and German governments would be a very strong risk for the whole euro process.

Francisco Torralba, Ph.D., is an economist with Morningstar Investment Management.

Pull Quotes:

“We're making an inversion from having too many children in proportion to the rest of the population to having too many old people in proportion to the rest of the population.”

--Edward Hugh “The whole idea of a working European Union, and especially the euro, depends on everybody feeling part of the same entity. They obviously don't. Therefore, it's dysfunctional.” --Edward Hugh

You can download the whole presentation here.