The "Hot Labour" Phenomenon

Strong growth. Rising real estate prices. Rapid job creation. Surging immigration. This list sums up the Switzerland of 2014 down to a tee. However, it also sounds like a description of what things were like in Spain in 2007 - shortly before the country's economy fell off a cliff. What follows is a conversation between financial journalist Detlef Gürtler and economist and crisis expert Edward Hugh about possible parallels and differences between the two booms, and the role of a new phenomenon which Hugh describes as "Hot Labour".

Hugh argues that this is a new phenomenon, and on the increase as a result of central bank bubble inducing activity. While immigration is a vital tool aiding economies to manage the population ageing process, it is important that economic activities be balanced. Immigration fueling boom/bust cycles is far from innocuous, and harm a country just as much as a sudden stop in capital flows if the immigration is followed by emigration.   

Detlef Gürtler: Well Edward, you personally lived through one of the most important real estate booms in European history - the recent Spanish one. Is the real estate boom we are witnessing in Switzerland in any way comparable?

Edward Hugh: Before I start, I think it's worth pointing out that it goes without saying the Swiss are quite different from the Spaniards; and the Swiss economy is completely different from the Spanish one. In this sense every boom or crisis is in its own way different from anything before. That said, such "trivia" doesn't normally stop economists like me from trying to draw comparisons, even if in this case I have to be extremely careful, since while I know quite a lot about Spain I know much less about Switzerland. So perhaps you will help me.

Detlef Gürtler: Yes, economists do make comparisons, and you were even so bold as to draw one between the German 1990s housing boom and the one which took place in Spain after the start of the century.

Edward Hugh: Well this comparison isn't so strange as it may seem. Many talk today about Spain becoming the new Germany - in the sense of an export powerhouse - and while this idea may have a rather dubious basis in reality the shift from domestic consumption to exports is quite striking.

In both cases the subsequent "regeneration" was preceded by a significant consumer boom, in both cases there was a strong increase in real estate prices including a construction boom, in both cases there was an increase in household indebtedness, in both cases the current account deficit deteriorated. And then in both cases there was a rude awakening. The only real difference was one of scale, and in this case scale is important. Spain had what was at the end of the day the mother of all housing bubbles.

Detlef Gürtler: But in each case there was  a completely different historical background and there were very different underlying motifs.

Edward Hugh: Yes, of course. But does that really make a difference when it comes to economic ambition? East Germany's citizens in 1992 - just like their Spanish equivalents in 2002 - saw how big the distance was between their consumption level and the western (or northern) one, and since they could in each case contract debt on what was for them fairly favorable terms they decided to put history straight and to carry out a rapid catch up in consumption. Really, Europe as a democratic political project has some of the responsibility here, since there was no equalizing mechanism put in place, but at the same time people felt they were entitled to similar living standards.

One of the new MEPs from the newly formed Podemos party put it like this in a recent interview: "they have sold us a system in which they told us we would all be rich and we were all going to live very well, and there was a period like that, but all that’s over now."  

Detlef Gürtler: The Germans, on the other hand didn't find themselves with mortgages well below the actual value of the relevant property, while Spaniards are already facing this problem.

Edward Hugh: No, you're right, but this isn't the whole picture. Weren't there massive tax breaks for builders and developers in East Germany, tax breaks which were rapidly converted into 100% financing whereby the government effectively assumed the cost of write-down?.

Detlef Gürtler: Only in the prospectuses of tax-saving-scheme promoters. In fact, many investors ultimately remained sitting on a mountain of debt, debt which was higher than the long-term obtainable sale price for the property.

Edward Hugh: I see. In Spain, instead, creative valuation techniques were used. The economic end  result is the same: you lose the property but get stuck with a large part of the debt.

Detlef Gürtler: And how does Switzerland fits into this picture?

Edward Hugh: Well lets start with something which at face value seems positive. For many years there was virtually no inflation in Switzerland, sometimes the situation was more like deflation. Now a bubble economy without inflation, surely that would seem to be a novelty.

Unfortunately, when you come to look into things a bit more it isn't quite the novelty it seems to be. In fact Larry Summers, in his secular stagnation speech to the IMF 2013 research conference drew attention to this phenomenon. 

"Many people believe that monetary policy was too easy. Everybody agrees that there was a vast amount of imprudent lending going on. Almost everybody believes that wealth, as it was experienced by households, was in excess of its reality. Too easy money, too much borrowing, too much wealth. Was there a great boom? Capacity utilization wasn't under any great pressure. Unemployment wasn't under any remarkably low level. Inflation was entirely quiescent. So somehow, even a great bubble wasn't enough to produce any excess in aggregate demand."

So it seems bubble economies without inflation are becoming more common. The big question is why.


Detlef Gürtler: But if we look at real estate itself we see a different picture. In many market segments show annual price increases of more than ten percent.

Edward Hugh: Well, that is presumably in no small part due to investors from around the world seeking a safe haven for their money in Switzerland.

Detlef Gürtler: Yes. But especially since the franc was coupled to the euro these investors switched from the Swiss currency into Swiss real estate.

Edward Hugh: And obviously this increase is not (or is only insufficiently) taken into account in the consumer price inflation rate. Here again we find a similarity with Spain where the large rise in house prices was not reflected at all in the official consumer inflation rate. So despite official price stability life feels like it is becoming significantly more expensive, especially for those looking for a new apartment.

Normally when addressing the question of whether a real estate bubble exists or not, it is important to think about leveraging, about  whether the home purchases are financed by credit. If real houses are paid for with real money paid, and this money comes from the outside, the economic effect could be seen as more economically similar to exports: A foreigner buys a piece Switzerland. If the price falls back, it is largely a problem for the external investor, not for the Swiss themselves or the Swiss banks.

On the other hand, if all this "speculative" activity drives up property prices in a deflationary environment where wages are stationary, the affordability problem creates a different issue for Swiss nationals.

Detlef Gürtler: And what about the British market? Would you say this is currently more driven by "irrational exuberance" than Switzerland ?

Edward Hugh: Great Britain has at the present time  the fastest growing economy among all industrialized countries. But why should Britain suddenly have become a stellar economy, an exceptional out-performer? Again all this euphoria in the UK really reminds me of Spain, since Spain in its day was also considered to be an "out-performer", experiencing a major economic miracle.

 London house prices are up 18% year on year, and the current account balance is worsening. At the moment national insurance data indicate that roughly 600,000 economic migrants are arriving in the UK annually. Not as many as in Spain during the boom times - either in absolute terms or proportionally - but still a significant number. Because the immigration is mainly focused on London, it is leading to large distortions which affect the whole economy. The new arrivals need homes, but naturally they start without work and are not looking to buy. They end up renting - in maybe groups of 3 or 4 - and are thus able to collectively pay rental prices which a normal family cannot afford. Hence the buy to rent business become interesting.

Sadly many of the young Spaniards arriving (maybe 60,000 a year) are fleeing the consequences of one bubble only to inadvertently fuel another.

Detlef Gürtler: But isn't this an example of exactly the kind of labour mobility the EU in general and (the euro zone in particular) wanted to see? People move from countries and regions were there is little work to those where there is plenty? This pattern of behavior was legendary in the USA. Isn't it good that it now comes to Europe?

Edward Hugh: Well, yes and no. The key point is that the employment growth needs to be sustainable. Look at Spain, nearly half a million former immigrants left the country last year. And yet one more time it is important to understand that Euro Area countries have a different set of institutional arrangements to the ones which apply to US states. When Detroit went bust, the Federal Government was there to act as backstop.

When such activity is not sustainable there is a self perpetuating component which is highly undesirable. As Londoners feel better off since the value of their home has risen the borrow and spend more. They become more leveraged.  This boost to economic activity in turn attracts new immigrants, which push up rents even further and with them property values, making Londoners feel even richer, and so on. As a result you get what you could call an unbalanced but self-reinforcing economic recovery. Hence the "superstar economy" aspect.

So the point is that while developed economy societies need positive migration flows as they age, they don't need just any old kind of flow, otherwise you could end up with problem bigger than the one you started with.

Detlef Gürtler: Thus, labor mobility has a procyclical effect. Where the economy runs well , the process works through increasing migration with everything getting better and better and better, until that is the day bubble bursts.

Edward Hugh: What we are talking about here is a new phenomenon. When people say our economies are becoming "bubblier"  they normally are thinking in term of financial flows. This is the area first are in which the self-reinforcing dimension of the process was evident. Think of what happened to small countries like Iceland or New Zealand in the run in to the global financial crisis.The Danish economist Carsten Valgreen coined the phrase global financial accelerator to describe what was happening.

Detlef Gürtler: You mean the way in which large speculative inflows produced a boom, which the respective central banks tried to contain by raising interest rates, but somehow these increases in interest rates only served to attract more speculative funds. 

Edward Hugh: Yep this was the the original pattern, but it's different now. This is in fact the most important thing which has changed since the German property boom of the 1990s. Migration flows have started to  play a role which is just as important as the financial flows one. The migrant flows we are seeing today are exceptionally large, and have the characteristic that - just like capital flows - they may reverse rapidly. You could call this the global labour flow accelerator. I am convinced that we are dealing here with something new, with a hitherto hardly recognized phenomenon - namely speculative labour flows, or if you prefer" Hot Labour ".

Detlef Gürtler: "Hot Labour "? Never heard of it .

Edward Hugh: Neither had I, till I saw what was happening in Spain. As we mention above, I started speaking about this in 2006.

Detlef Gürtler: Did you invent the expression yourself?

Edward Hugh: No, I got the idea from someone called Pepe .

Detlef Gürtler: Pepe ? Which Pepe ?

Edward Hugh: Well I don't know him personally, or even his full name . Pepe was a commentator who showed up on my Blog. He used this term to distinguish those immigrants looking for a new home, a new life, and a new society to integrate in, from another group, those just moving for work or adventure without for any clear plan.  Locate work quickly, and if a crisis hits then change country.  Possibly this is not a conscious initial decision, but this is how it works out in practice.

Many young Spaniards working now in London or Berlin seem to fit this category. They don't really plan to emigrate, they just want to survive what they perceive as a "difficult period".  If asked in a survey about how they see their future they will normally say they are working abroad "temporarily" and will eventually return home. In fact they may never return home, emigration is a process which is not the product of a firm initial decision, but they also may be forced to move on quickly if the economic recovery where they have foudn work becomes volatile.

So the distinction between immigrants and Hot Labour could be thought of as following the same pattern as a similar one which describes in capital flows, where people have long distinguished between foreign direct investment and speculative investments , as in the expression " Hot Money ".

Detlef Gürtler: In the case of capital flows it is not so hard to differentiate one from the other : direct investment normally relates to plants and machinery, Hot Money is normally associated with securities such as stocks and bonds. How would you differentiate the various migrant populations?

Edward Hugh: First of all : not at all. The vast majority of immigrants change countries for economic reasons, but this does not tell us  anything about whether and how quickly they will leave the destination country if an economic crisis breaks out.

Detlef Gürtler: What would be " fast " in migration dimensions?

Edward Hugh: Well you could say a "fast " wave of migration today is one which turns around in a  period of say five years. Previously such waves were conceptualized in terms of generations. So now we should really not take for granted that all the immigrants who come in a boom phase will remain in the country in the longer term.

Detlef Gürtler: As were the experiences with the boom and crisis cycles in Germany and Spain?

Edward Hugh: The 1990s German phenomenon largely predates the modern phenomenon. At the end of the nineties immigration stalled but hardly reversed. This was probably largely due to the noticeable influx of people of German descent coming from Eastern Europe - they came because there was an opportunity to do so, but they were more like classical immigrants, they came to stay.

But now we are seeing a different phenomenon in Germany, suddenly we have seen a shift in the direction of migrant flows. During the early years of this century the number of people leaving Germany and the number arriving more or less balanced. In 2008 and 2009 in fact more people left than arrived. But since 2010 the number arriving (and the difference between those arriving and those leaving) has steadily increased. The result has been that the German population, which was expected to start falling, is now rising. And since most of those arriving are in younger age groups the same is true of the working age population.

Provisional estimates from the German Statistics Office,  suggest 1.226 million people emigrated to Germany in 2013, an increase of 146,000, or 13%, from 2012. The last time immigration on this scale was recorded in Germany  was in 1993. On the other hand some 789,000 people left Germany in 2013, 77,000 (+11%) more than in the previous year. The result was net immigration of 437,000 – also the highest figure since 1993.Naturally such a large number of people entering is producing a pressure on property prices in just the same way as in London, especially in Berlin and Bavaria.

Detlef Gürtler:  How does this recent German experience compare with Spain?

Edward Hugh: In Spain, both the growth and the subsequent decline have been very rapid. Between 2000 and 2010 the Spanish population grew by more than fifteen percent, from 40 million to 46 million. The number of non Spanish nationals in the country rose sixfold - from one million to 5.8 million .

Now all of this has completely inverted: in 2013 alone approximately half a million people left, most of them former immigrants. The National Statistics Office estimates that the country's population could fall by 2.5 million between now and 2023. The long term consequences for Spain, and the Spanish economy are hard to foresee at this point, but they are hardly going to be positive.

On the other hand people continue to arrive in Spain, principally from sub-Saharan Africa. This is a more classic immigration trend. People are not simply coming for work, they are also coming in search of a new life. Even though economic conditions are difficult most of these will stay and eventually take their lives forward.

 
Detlef Gürtler: Was the initial intention of most of the migrants who came to Spain during the first decade to stay?

Edward Hugh: I would say for the majority this was not initially the case. Back in 2002 I interviewed a group of Bulgarian immigrants about their intentions. The results were predictable enough. Certain groups who might have felt themselves disadvantaged in their own country - women, gays, religious minorities - wanted to make a long term change, but the majority felt they were in Spain temporarily, to earn some money and go home. This is what most of the literature on the topic explains. But most of the people I interviewed are still in Spain. This is normal. Time passes, you put down roots. Finally you have no real "home" to go back to.

Actually I would say that personally this is my own case here in Catalonia.

A somewhat similar phenomenon can be observed among the large number of female care and domestic workers who arrived from Latin America. This immigration was also a new phenomenon, since the women who arrived had largely been married and had children who were being looked after by grandparents. They sent virtually all their earnings home every month, possibly to buy a home. Some of these women have now left, but since caring for elderly at home is a growing occupation in Spain, and many Spaniards are reluctant to do it, the majority are still here, and increasingly they bring their children to Spain to live with them.

But many of the immigrants from Latin America , Romania and Morocco were employed in the construction industry and services sectors like bars and restaurants are leaving in large numbers. How long can they support themselves in a foreign country without work? So despite the fact they might prefer to stay, many are now leaving.

Detlef Gürtler: And how does all this compare with Switzerland ?

Edward Hugh: Well in  immigration terms Switzerland has a net population growth of about one percent per year (most European countries have very little natural population growth), putting it somewhere between the nineties German value (of about 0.7 percent per year ) and the most recent Spanish one (about 1.5 percent growth per year).

Detlef Gürtler:  Yes, and the immigration trend has recently accelerated. Already it is noticeable that something more than a normal recovery phase upswing is in motion. The older Swiss learned in school that their country had around six million inhabitants. The  younger ones found the number had already risen to seven million . In 2013 we found that for the first time the country had more than eight million inhabitants, and many forecasts now predict that the number can easily reach nine million. This in a country with a total fertility rate of around 1.5.

Edward Hugh: It is interesting to note that the Global Property Guide single out immigration for mention in the context of recent house price movements in Switzerland. "One factor has been an increase in the number of immigrants which has led to higher demand for houses. From 2007 to 2011, net migration into the country reached 365,500 people"

What Spain has shown us is that such trends do not necessarily last forever. Anyone with high rates of immigration and a nicely booming economy should also consider that substantial outward migration can occur when the economy weakens. If we are talking about a boom-bust then naturally things are much worse. Sustainability has to be a key idea we get our heads around in this context.

Detlef Gürtler: Unless, of course, the immigrants had come to stay, as was once the case in Germany , with the German-born migrants from Eastern Europe.

Edward Hugh: Yes, but this doesn't seem to be to be the Swiss case. Switzerland is very open when it comes to labor flows when there is work, but much less open when it comes to the subsequent integration of migrants.

Detlef Gürtler: And with an extremely liberal labour market jobs in Switzerland can not only be created  very fast, they can also be deleted very quickly.

Edward Hugh: Which makes Switzerland quite vulnerable to a Hot - Labour type phenomenon, with the capacity  for a very rapid job creation phase followed by a rapid job destruction one. If that were to happen, then people shouldn't be surprised if an economic downturn transforms itself into a veritable downward spiral. When there is work, the new migrants are made to feel somewhat welcome, but when they are without a job, just how much support is available for them? Very little it seems.

Detlef Gürtler: So it's like a game of Monopoly, where at some point you simply get sent back to "Go", the original starting point.  It looks like in Spain at the end of the recession many economic data  looked more like those of the year 2000.

Edward Hugh: Would that you only got sent back to the starting point! On some indicators - unemployment for example - Spain by 2020 may still be worse off than it was in 2000. The age structure would be another example. Those currently leaving the country in droves  in order to seek employment elsewhere  are predominantly young and well educated. Those who remain are either older,or without either skill or qualification. There is a massive human capital loss, and population ageing is accelerated.

Detlef Gürtler: How do such movements affect things like pension systems?

Edward Hugh: Well the initial inward surge is, of course, very positive. Pensions look much more sustainable, but if things go wrong then suddenly they aren't and pension reforms become urgently necessary. Spain has now had two of these since the crisis started.

Detlef Gürtler: But that is looking at things from the point of view of the receiving country. What about the sending one?

Edward Hugh: Well obviously, migrants moving from countries with very low fertility - like Eastern and Southern Europe - leave a serious hole behind them. One which threatens the future of the pension systems there.

Switzerland, with its island type location and the very Hot - Labour  type context can simply wring its hands over the situation as people who have contributed to the welfare system for years suddenly leave. But in the European Union, with its formal commitment to some sort of a politically shared project, there will inevitably be pressure for another kind of solution, one which involves some sort of common pension system.

People in the UK are want to complain about EU labour mobility, and arrivals from Eastern Europe, but countries like Latvia, for example, are hardly going to be sustainable if something isn't done.  It seems to me to be quite irrational for a country to enjoy a boom as a result of immigration, one which in addition means many urgently necessary structural reforms are pushed aside, while another country suffers only the negative consequences of emigration, getting stuck in a long depression while the entire pension system is pushed towards collapse. And then just a few years later the economic situation and the migratory pattern rotates one more reproducing the twin picture of complacency and collapse .

Detlef Gürtler: The technical term for the EU institutional change you mentioned is "intra-European Compensation", which probably means what the Germans call "Social union ".

Edward Hugh: Right. If the Euro and the EU are to continue then this would seem to be inevitable. Or do you expect the Germans to declare that they, in the future, will maintain their pension level thanks to the contribution of Spanish immigrants? And that this outcome is socially just, just because so many Spaniards have benefited from coming to Germany and are willingly depositing their contributions in the German pension box to show their gratitude?

But wouldn't it be totally economically irrational that a  common currency which is set up with totally inadequate institutional support, which overseas the generation of economic imbalances that cannot be corrected via either currency appreciation or depreciation, simply washes its hands of the search for a just solution. Other mechanisms must be established to allow these countries to recover and restore some sort of balance.

Detlef Gürtler: Balance? But don't many agree with George Soros when he argues that financial markets don't tend towards equilibrium, but fall into boom-bust cycles over and over again. Can it be that the the markets for human capital behaves similarly?
  
Edward Hugh: That could be, and that is the phenomenon I would like to draw attention to. However, the possibility has not been sufficiently explored so far,  so let's just leave this outcome today as an "educated guess". But whether we are talking about booming labor markets, like Germany, Switzerland, Great Britain, or busted ones, like those in Spain and Greece we are producing a lot of data with which it should be possible to either confirm or refute the conjecture.

And one last closing point. I have long favored (and continue to favor) sustainable immigration as one way to manage population aging (see my Message To Central Bankers Target Median Ages!: 2006, or my reply to Marty Feldstein "The Effects of the Ageing European Population on Economic Growth" of the same year). But for such a policy to work as intended we need to stop trying to reflate economies which for demographic reasons are trying to disinflate, and develop policies which are appropriate to the times we live in. The first step along this road is recognising that we have a problem.

The above is an adapted translation from German of an interview which originally appeared in the magazine GDI Impuls.

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.