By Claus Vistesen: Copenhagen
Now this is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning.
Churchill 1942
Summary
- The extent, so far, of the internal devaluation process depends on the time period used for analysis. Using Q3-2007 as the beginning of the economic crisis suggest that Greece and Spain have not corrected relative to Germany as a benchmark. However, if we look entirely at the world in a post-Lehmann context the picture is different with Greece and Spain having observed excess deflation relative to Germany to the tune of -1.7% and -4.5% respectively for unit labour costs and -5.4% and -1.7% respectively for the PPI.
- The correction observed in the context of unit labour costs appears technical as German unit labour costs have increased sharply since Q4-2008 due to a large reduction in working hours and an increase in short time work. In comparison, the relative correction in the PPI looks more solid.
- The internal devaluation has not yet trickled down into the overall price level represented by the CPI. Both using the period Q3-07 to Q3-09 and Q4-08 to Q3-09 as the relevant time horizon reveals that there has been no meaningful internal devaluation in Greece and Spain measured on the CPI.
- While the analysis presented here may go some way to quantify the intra-Eurozone imbalances and the course of the internal devaluation so far it is impossible to say precisely how far (and for how long) Greece and Spain (and indeed Latvia, Hungary etc) have to go here. More importantly, it is impossible to say exactly which measures that must be taken albeit that they have to be severe in the context of reigning in public spending and, ultimately, the public debt and ongoing deficit. Likewise, it is difficult to quantity just how high unemployment should drift and for how long it should stay there in order to grind down past excess.
As 2009 is fast approaching an end it is worth asking whether this also means an end to the financial and economic crisis. Even if 2009 will be a year thoroughly marked by a global recession it could still seem as if the worst is behind us. Most of the advanced world swung into positive growth rates in H02 2009, risky assets have rallied, volatility has declined to pre-crisis levels, and interest rates and fiscal stimulus have been adeptly deployed to avert catastrophe. However and precisely because the last part has been a crucial prerequisite for the first three and as policy makers are now adamant that emergency measures must be scaled back or abandoned either because of necessity or a balanced assessment, it appears as if Churchill's well known paraphrase is an adequate portrait of the situation at hand. In this way, what is really left in the way of global growth once we subtract the boost from fiscal and monetary stimuli and what is the underlying trend growth absent the crutches of extraordinary policy measures?
This question is likely to be a key theme for 2010.
Nowhere is this more relevant than in Greece and Spain who, together with Eastern Europe, have slowly but decisively taken center stage as focal points of the economic crisis. With this change of focus a whole new set of issues have emerged in the context of just how efficiently (or not) the institutional setup of the Eurozone and EU will transmit and indeed endure the crisis.
I won't go into detail on this here mainly because I would simply be playing second fiddle to what Edward has already said again (and again) in the context of his ongoing analysis of the Spanish and Greek economy to which I can subscribe without reservations. It will consequently suffice to reiterate two overall points in the context of Spain and Greece.
Firstly, the main source of these economies' difficulties, while certainly very much present in the here and now, essentially has its roots in population ageing and a period, too long, of below replacement fertility that has now put their respective economic models to the wall. It is interesting here to note that while it is intuitively easy to explain why economic growth and dynamism should decline as economies experience ongoing population ageing, it is through the interaction with public spending and debt that the issue becomes a real problem for the modern market economy. Contributions are plentiful here but Deckle (2002) on Japan and Börsh-Supan and Wilke (2004) on Germany are good examples of how simple forward extrapolation of public debt in light of unchanged social and institutional structures clearly indicate how something, at some point, has to give. Whether Spain and Greece have indeed reached an inflection point is difficult to say for certain. However, as Edward rightfully has pointed out, this situation is first and foremost about a broken economic model than merely a question of staging a correction on the back of a crisis.
Secondly and although it could seem as stating the obvious, Greece and Spain are members of the Eurozone and while this has certainly engendered positive economic (side)effects, it has also allowed them to build up massive external imbalances without no clear mechanism of correction. Thus, as the demographic situation has simply continued to deteriorate so have these two economies reached the end of the road. In this way, being a member of the EU and the Eurozone clearly means that you may expect to enjoy protection if faced with difficulty, but it also means that the measures needed to regain lost competitiveness and economic dynamism can be very tough. Specially and while no-one with but the faintest of economic intuition would disagree that the growth path taken by Greece and Spain during the past decade should have led to intense pressure on their domestic currencies, it is exactly this which the institutional setup of the Eurozone has prevented. I have long been critical of this exact mismatch between the potential to build internal imbalances and the inability to correct them, but we are beyond this discussion I think. Especially, we can safely assume that the economists roaming the corridors in Frankfurt and Brussels are not stupid and that they have known full well what kind of path Greece and Spain (and Italy) invariably were moving towards.
Essentially, what Greece and Spain now face (alongside Ireland, Hungary, Latvia etc) is an internal devaluation which has to serve as the only means of adjustment since, as is evidently clearly, the nominal exchange rate is bound by the gravitional laws of the Eurozone. Now, I am not making an argument about the virtues of devaluation versus a domestic structural correction since it will often be a combination of the two (i.e. as in Hungary). What I am trying to emphasize is simply two things; firstly, the danger of imposing internal devaluations in economies whose demographic structure resemble that of Greece and Spain and secondly, whether it can actually be done within the confines of the current political and economic setup in the Eurozone.
On the last question I personally adamant that it has to since failure would mean the end of the Eurozone as we know it but this is also why I am quite worried, and intrigued as an economist, on the first question. Specifically and as Edward and myself have been at pains to point out (and to test and verify) this medicine while certainly viable in theory has three principal problems. Firstly, it takes time and may thus amount to too little too late in the face of an immediate threat of economic collapse. Secondly, an ageing population spiralling into deflation may have great problems escaping its claws, and thirdly, because of the pains associated with the medicine the patient may be very reluctant to acccept the treatment. Especially, the last point is very important to note from a policy perspective and was made abundantly clear recently in the context of Latvia where The Constitutional Court ruled that the very reforms demanded in the context of the IMF program to reign in costs through cutting pensions would violate the Latvian constitution. And as Edward further points out, the situation is the same in Hungary where voters recently (and quite understandably one could say) decided to reject a set of health charges that were exactly proposed as part of a reform program designed to reign in public spending. We are about to see just how willing Spain and Greece are in the context of accepting the austerity measures that must come, but similar dynamics are not alltogther impossible.
Consequently, and while I agree with Edward as he turns his focus on the inadequacy of the political system in Spain and Greece to realize the severity of the mess; it remains an inbuilt feature of imposition of internal devaluations through sharp expenditure cuts that they are very difficult to sustain given the political dynamics. This is then a question of a careful calibration of the stick and carrot where the former especially in the initial phases of an internal devaluation process is wielded with great force.
Internal Devaluation, What is it All About Then?
If the technical aspects of an internal devaluation have so far escaped you it is actually quite simple Absent, a nominal exchange depreciation to help restore competitiveness the entire burden of adjustment must now fall on the real effective exchange rate and thus the domestic economy. The only way that this can happen is through price deflation and, going back to my point above, the only way this can meaningfully happen is through a sharp correction in public expenditure accompanied with painful reforms to dismantle or change some of the most expensive social security schemes. This is naturally all the more presicient and controversial as both Spain and Greece are stoking large budget deficits to help combat the very crisis from which they must now try to escape. Positive productivity shocks here à la Solow's mana that fall from the sky may indeed help , but in the middle of the worst crisis since the 1930s it is difficult to see where this should come from. Moreover, with a rapidly ageing population it becomes more difficult to foster such productivity shocks through what we could call "endogenous" growth (or so at least I would argue).
With this point in mind, let us look at some empirical evidence for the process of internal devaluation so far.
In order to establish some kind of reference point for analysis I am going to compare Greece and Spain with Germany. This is not because Germany, in any sense of the words, stands out as an example of solid economic performance as the burden of demographics is clearly visible here too. However, for Spain and Greece to recover they must claw back some of the lost ground on competitiveness relative to Germany. This highlights another and very important part of the internal devaluation process. Spain, Greece etc will not only be fighting their own imbalances; they will also fight a moving target since they may not be the only economies who face deflation or near zero inflation as we move forward.
Beginning with the simple overall inflation rate measured by the CPI we see that the level of prices (100=2005) has risen much faster in Greece and Spain than in Germany. Compared to 2005 the price level in Germany stood 7.1% higher in Q3-09 which compares to corresponding figures for Spain and Greece at 11.5% and 10.3% respectively. However, this does not tell the whole story about the build up of imbalances since the inception of the Eurozone. Consequently, since Q1-00 the price index has increased some 15% in Germany whereas it has increased a healthy 29.3% and 27.2% in Greece and Spain respectively.
Turning to the bottom chart which plots the annual quarterly inflation rate a similar picture reveals itself with a high degree of cross-correlation between the yearly CPI prints, but where the German inflation rate has been persistently lower than that of Greece and Spain. The average inflation rate in Germany from Q1-1997 to Q3-2009 was 1.6% and 3.5% and 2.8% for Greece and Spain respectively. It is important to understand the cumulative nature of the consistent divergence in inflation rate since it is exactly this feature that contributes to the build-up of the external debt imbalance. From 2000-2009(Q3) the accumulated annual increases in the CPI was 57% for Germany versus 109.4% and 104% for Greece and Spain respectively. Assuming that Germany remains on its historic path of annual CPI readings (which is highly dubious in fact), this gives a very clear image of the kind of correction Greece and Spain needs to undertake in order to move the net external borrowing back on a sustainable path which in this case means that these two economies are now effectively dependent on exports to grow.
If the divergence in Eurozone CPI represents a general measure of the built-up of external imbalances and the need for an internal devaluation through price deflation two other measures provide more direct proxies. These two are unit labour costs and the producer price index (PPI) which are both key determinants for the competitiveness of domestic companies on international markets. Intuitively one would expect unit labour costs as an important input cost to drive the PPI which measures the price companies receive for their output. Yet this is only going to be the case if the companies in question have market power on the domestic market. Consequently, if you regress the quarterly change of the PPI on the quarterly change on unit labour costs you get a negative coefficient in Germany and a positive coefficient in Greece and Spain (highly significant for Spain and not so for Greece). This is exactly what one would expect since German companies are highly exposed to the external environment (where they enjoy no market power) and thus has to suffer any increase in the cost of labour input through a decline in their output price. Conversely in Spain, the connection between an increase in unit labour costs and the PPI is strongly positive which suggest that Spanish companies has enjoyed considerable market power due to a vibrant domestic economy [1]. It is exactly this that must now change.
If we look at unit labour costs and abstract for a minute from the increase in German unit labour costs from Q2-08 to Q2-09 in Germany [2], both Greece and Spain have seen their labour cost surge relative to Germany since the inception of the Eurozone. Since Q1-00 the accumulated change in the German index has consequently been 15.2% which compares to 97.7% and 105.6% for Greece and Spain respectively. More demonstratively however is the fact that since the second half of 2006 the labour cost index of Spain and Greece have been above the Germany relative to 2005 which is the base year. Consider consequently that the labour cost index in Greece and Spain was 13.3% and 16.4% below the German ditto in Q1-2000 and now (even with the recent surge in German labour costs), the Greek and Spanish labour cost index stands 7.2% and 5.2% above the German index.
Turning finally to producer prices the similarity between the three countries in question are somewhat restored which goes some way to support the notion of persistent lower labour cost growth relative to fellow Eurozone members as the main source of the build-up of Germany's "competitive advantage" and in some way the build-up of intra Eurozone imbalances.
Essentially, and while definitely noticeable the divergence between Greece/Spain and German on the PPI is less wide than in the context of unit labour costs and the CPI. Consequently, and if we look at the index, the divergence which saw Spanish and Greek producer prices increase beyond those of Germany came very late in the end of 2007. Moreover, the correction so far has been quite sharp in both Greece and Spain relative to Germany with the PPI falling 14.8%, 5.7% and 2.8% (yoy) in Q2-09 and Q3-09 in Greece, Spain and Germany. The accumulated increase however, in the PPI, from 2000 to Q3-09 has been 85% in Germany and 136% and 101.7% in the Greece and Spain respectively.
If the numbers above indicates the extent to which intra Eurozone imbalances have manifested themselves in divergent price levels and rates of inflation, the concept of internal devaluation concerns the net effect on the prices in Greece and Spain relative to, in this case, Germany. On this account, and if we put the beginning of the financial crisis as Q3-07 (i.e. when BNP Paribas posted sub-prime related losses) the butcher's bill look as follows.
From Q3-07 to Q3-09 and in relation to the CPI the average quarterly inflation rate in Greece in Spain has been 1% and 0.66% higher than in Germany. The accumulated excess inflation rate over the German inflation has been 8% in Greece and 5.29% in Spain. Only in the context of Spain do we observe some indication of the initial phases of a relative internal devaluation as Spain has seen an accumulated inflation rate lower than that of Germany to the tune of 1.28%.
Turning to unit labour costs the picture changes quite a lot depending on the time horizon. Using the same period as above, the average quarterly excess increase in unit labour costs of Greece and Spain relative to Germany has been 1.75% and 0.3% in Greece and Spain respectively. The accumulated increase in unit labour costs has consequently been a full 14% and 2.8% higher in Greece and Spain relative to Germany. However, if we focus the attention on the period from Q4-08 to Q2-09 and due to the fact that labour hours in Germany have gone down further than in Greece and Spain, labour costs have corrected sharply in Greece and Spain relative to in Germany to the tune of -5.2% and 13.7% (accumulated) and -1.7% and -4.6% respectively. The fact that German producers have so far cut down sharply on labour hours could mean that Germany should claw back some of the lost ground vis-a-vis Greece and Spain if and when these two economies follow suit.
Finally, in relation to producer prices the picture is very much the same as in the context of unit labour costs with the notable qualifier that the relative excess deflation observed in Greece and Spain from Q4-08 and onwards is likely to be less "technical" and thus more "real" than in the case of labour costs. In this way the period Q3-07 to Q3-09 saw the excess rate of produce price inflation reach 14.8% and 6.8% (accumulated) and 1.8% and 0.8% (quarterly average) in Greece and Spain respectively. However, if we focus the attention on Q4-08 to Q3-09 the picture reverses and reveals a substantial degree of excess deflation over the Germany PPI in Greece and Spain to the tune of 16.1% and 5.2% (accumulated) and 5.4% and 1.7% (quarterly average) for Greece and Spain respectively.
The End of the Beginning
As we exit 2009 it is quite unlikely that we will also be able to leave behind the effects of the economic and financial crisis and this is not about me being persistently negative or even a perma-bear. Things have definitely improve and much of this improvement owes itself to rapid, bold, and efficient policy measures. However, some economies are in a tighter spot than others and this most decisively goes for Spain and Greece who now have to correct to the fundamentals of their economies with rapidly ageing populations.
As this correction largely has to come in the form of an internal devaluation the following conclusions are possible going into 2010.
- The extent, so far, of the internal devaluation process depends on the time period used for analysis. Using Q3-2007 as the beginning of the economic crisis suggest that Greece and Spain have not corrected relative to Germany as a benchmark. However, if we look entirely at the worldin a post-Lehmann context the picture is different with Greece and Spain having observed excess deflation relative to Germany to the tune of -1.7% and -4.5% respectively for unit labour costs and -5.4% and -1.7% respectively for the PPI.
- The correction observed in the context of unit labour costs appears technical as German unit labour costs have increased sharply since Q4-2008 due to a large reduction in working hours and an increase in short time work. In comparison, the relative correction in the PPI looks more solid.
- The internal devaluation has not yet trickled down into the overall price level represented by the CPI. Both using the period Q3-07 to Q3-09 and Q4-08 to Q3-09 as the relevant time horizon reveals that there has been no meaningful internal devaluation in Greece and Spain measured on the CPI.
- While the analysis presented here may go some way to quantify the intra-Eurozone imbalances and the course of the internal devaluation so far it is impossible to say precisely how far (and for how long) Greece and Spain (and indeed Latvia, Hungary etc) have to go here. More importantly, it is impossible to say exactly which measures that must be taken albeit that they have to be severe in the context of reigning in public spending and, ultimately, the public debt and ongoing deficit. Likewise, it is difficult to quantity just how high unemployment should drift and for how long it should stay there in order to grind down past excess.
In this sense, 2009 will not go down as the end in any sense of the word, but more likely as the end of the beginning.
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[1] - Naturally, this argument assumes non-sticky prices and thus a 1-to-1 relationship in time between a change in input costs and output prices of companies. Since contractual arrangements are likely to make both sticky in the short run and likely with divergent time paths too, the quantitative results are not robust. The results for Germany are significant at 10% whereas those for Spain are significant at 1%. Mail me for the estimated equations if you really want to see the results.
[2] - The index rose 7.8% over the course of the year ending Q2-2009 which is way above 3 standard deviations of the "normal" annual change in the index from 1997 to 2009. The explanation is really quite simple and relates to the fact that German manufactures (in particular) has sharply cut overtime work and short time work has been rapidly extended (see e.g. this from Q2-09) which is obviously not the case in Greece and Spain. The fact that German producers have so far cut down sharply on labour hours means that Germany should claw back some of the lost ground vis-a-vis Greece and Spain if and when these two economies follow suit.
