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Wednesday, September 30, 2009

Germany - The Bitter-Sweet Tears Of Angela von Merkel

by Edward Hugh: Barcelona

German voters gave Chancellor Angela Merkel the green light for a second term on Sunday, along with a clear mandate to form a new government with the liberal Free Democrat Party (FDP). But just what exactly is the new government likely to do? Merlek has been quick to pour cold water on any idea of early tax cuts, “I expect we’ll agree very quickly on tax policy, especially when you look at the leeway we have with the budget," she is quoted as saying.

Angela Merkel's room for maneuver is limited by the fact that Germany has been steadily racking up debt to tackle the crisis. Only today the Federal Statistical Office have said that the deficit in the overall public budget increased to euro 57.2 billion in the first six months of this year from euro 6.9 billion a year earlier as spending rose sharply (8.1%) and revenue declined (1.7%). No figure was given as a proportion of gross domestic product, but it seems to be around 4.89% of the GDP registered in the first six months (unadjusted GDP was reported by the Federal Statistics Office as €1,168 billion over the same period).

So, while the mood in Merkel's Berlin headquarters was naturally jubilant, the euphoria will not last too long, especially since things are not going to be anything like as simple as they may seem at first sight. The problem, of course, is an economic and not a political one. Simply put, Germany’s apparent recovery from recession may have come "just in time" to see Angela re- elected, but the good economic news may not last much longer than today.

Europe's Economies Buoyant But Not Ebullient?

While talk of a Eurozone recovery continues unabated following a recent heavy slew of data, including the business surveys for September and the summer consumer spending numbers from France, which tend to suggest upside momentum. The data continue to support the idea of continuing recovery in the third quarter of 2009 but a more careful examination suggests that the German economy is not building up as much underlying momentum as was prviously hoped, and that sustaining this timid growth into 2010, especially as government stimulus programmes are pulled back, may prove to be hard work.

In France, the latest household consumer data pointed to 1% monthly falls in spending in both July and August as a rebound in inflation and further job losses continued to weigh on consumption. The untick in French inflation while price index numbers remain lodged in negative territory in Spain, Ireland, Finland and even Germany, constitutes just one of the rapidly looming headaches for the ECB.

The weaker French consumption trend was, however, offset by a fairly solid performance in both the industrial and service sectors, with the PMIs powering above the critical 50 level. Similar improvements were not, however, matched in Germany, where both the IFO survey, the Retail PMI and the Manufacruring and Serivices PMIs came in below expectations. So France, far from being a harbinger of things to come, may well turn out to be an exception in a region characterised by stagnation (at best) or continuing sharp contraction (Ireland, Finland, Spain).

Just this cautiousness about the fagility of the recent stabilisation in the Eurozone was underlined by Bundesbank President, Axel Weber in an interview with Market News. Mr Weber was at pains to stress that he still considers the current level of interest rates to be appropriate and that it is still far too early “to exit the currently extremely loose monetary policy.” He also warned that the recovery will be “very sluggish”. Mr Weber placed considerable emphaisis on the behaviour of bank credit, stating he did not expect any turnround in the present decline before mid-2010. Clearly this is likely to be the decisive indicator for the ECB to begin withdrawing liquidity. “As we come out of this crisis and as the economy recovers and as the credit cycle turns, I think we do have an obligation to decisively counter long term inflation risks,” he said.

Germans Get Ready To Tighten Your Seatbelts

If we come to examine the German situation in more detail, then we can see that M. Merkel's room for manoeuvre is going to be extremely limited indeed. Economic growth managed to scrape together a 0.3% increase in the second quarter, but this was driven by exceptional measures of 85 billion euros to lift spending and subsidize jobs, measures which surely helped keep unemployment below levels in many other OECD economies, even while the economy suffered the hammer blows of its worst post-World War II recession. However, the positive feedback impact from so much government spending can't continue like this, and Angela Merkel knows it, and she she also knows that it is either pain now or pain later, then my bet is she will use the political capital accruing from the first post election year to put the German house in order, in the hope of being able to offer some tax-cut based upside in the second half of her mandate.

That is to say, if you are hoping for some more German consumer expansion tow to help pull your own local economy out of the mire, then I suggest you forget about it right now.

Q2 GDP Growth A Statistical Quirk?

First off, the 0.3% growth obtained in the second quarter was actually the outcome of quite a complicated statistical balancing act. As is illustrated in the chart below the small final balance is actually obtained after cancelling out two much larger elements, the inventory run down (which subtracted 1.9 percentage points from the final total) and net exports which (which added 1.6 percentage points, where the positive balance was produced by a much larger drop in imports than the drop in exports).

So while it may not be absolutely correct to talk about a statistical "quirk", and while it is obviously true that there was some real growth, there was so much noise going on in the background that it is hard to know what importance to put on the headline numbers. As should be obvious it is very hard to attach too much importance to the ideat that houshold consumption added 0.4 percentage points when there are such large percentage swings impacting other items, and the fact that the trade impact was achieved by having exports down 1.2% on the quarter while imports were down 5.1% only adds to the lack of conviction which can be attached to the idea that "Germany has now returned to growth", even though this headline perhaps has sold more papers in recent weeks than virtually any other.

In fact as should also be abundantly clear from the two charts below, the sharp fall in exports was largely halted in the second quarter, while the fall in imports continued, but again, it really is stretching the point a bit to call this a solid return to growth.

So with the stimulus programme now steadily set to come off from this point on, and unemployment looking certain to jump and consumer spending to drop as we enter 2010, and with many companies continuing to warn of a credit crunch, while debt remains at very high levels, policy makers would seem to be left with few options to counter any eventual double dip should there be no sharp upturn in world trade. In fact the German economy will never recover on the back of domestic demand, which is weak, and tends to lag behind movements in exports and in GDP. So really a full fledged German recovery must await recovery elsewhere, and in the meantime we are left with simply marking time.

Germany's Economy "Returns To Growth" in the Second Quarter

German second-quarter real gross domestic product rose 0.3% from the first quarter, when it fell back 3.5% from the previous one.

Year on year the economy was down 5.9% in the second quarter. Exceptional stimulus measures amounting to some 85 billion euros have so far helped spending hold up and made it possible to keep people on short time working, but this situation obviously cannot continue much longer and even Germany’s 5 billion-euro “cash-for- clunkers” program has now come to an end. The premium led to a 23 percent increase on spending on vehicles during the first six months of 2009, spending which evidently had a lot to do with the second-quarter rebound. The unemployment rate is set to jump to 10.3 percent in 2010 from 8.1 percent this year, according to the latest IWH institute forecast. The also predict that consumer spending will drop 0.7 percent in 2010 after growing 0.5 percent this year.

And the most recent data results are only likely to add to policymakers’ concerns about the sustainability of Germany’s recovery. The country’s economy is still expected to shrink by about 5 per cent this year, with the under-utilisation of capacity bound to feed through into higher unemployment – which in turn will act as a further constraint on growth.

And as if to offer yet more evidence that the crisis is far over, the VDMA industry group said this week that orders for German machinery and factory equipment were down 43 percent on the year in August.

Export Dependent For Growth

Domestic demand is congenitally weak, and lags behind export and headline GDP gowth. As a result it is not especially surprising to find that retail sales fell for a the third consecutive month in July. Sales, adjusted for inflation and seasonal factors, decreased 0.8 percent from June when they fell 1.8 percent from May. From a year earlier, sales fell 0.7 percent, but this number is not especially significant, since, as can be seen in the chart, German retail sales have now been in decline since 2006.

Spain's retail sales fell again in September, according to the Markit Retail PMI which came in at 47.9, disappointingly weaker that the 49.5 reading registered in August. The index has been below the neutral 50.0 value during every month since June 2008, and the latest reading pointed to the sharpest rate of contraction for three months. Anecdotal evidence attributed the drop in like-for-like sales to weak economic conditions and subdued willingness to spend among consumers. There were also a number of reports in the autos sector that the end of the government’s ‘cash for clunkers’ scheme had contributed to lower sales compared with the previous month.

Despite some slight uptick in houshold consumption, overall domestic demand, which includes both final consumption expenditure and gross capital formation (including changes in inventories), was down by 2.5% in Q2 over the same period in 2008. A large part of this decrease was due to the performance of gross capital formation, which was down by 16.0% year on year. The massive slump in real capital formation in machinery and equipment therefore continued and even accelerated in Q2, with German enterprises reducing their capital formation in machinery, equipment and vehicles by 23.4% compared with the second quarter of 2008. And the trend looks set to continue, if the latest report from the Frankfurt-based VDMA machine makers associationis anything to go by. VDMA said German plant and machinery orders declined 43 percent in August from a year earlier. Export orders slumped 41 percent and domestic orders dropped 45 percent.

Looking into the third quarter German exports rose for a third month in July as global trade picked up generally. German sales abroad, adjusted for working days and seasonal changes, increased 2.3 percent from June, when they jumped 6.1 percent. Exports were still down 18.7 percent from a year earlier.

Imports remained unchanged from June, when they increased 5.9 percent. As a result the trade surplus increased to 13.9 billion euros from 12.1 billion euros in June. The surplus in the current account, the measure of all trade including services, was 11 billion euros, down from 13.5 billion euros in June. But all in all, the balance during the first moth of the third quarter was positive, even if only marginally so.

On the other hand, industrial production output numbers for Junly tempered hopes for a further rebound, since they fell back a seasonally asjusted 0.76 per cent compared with June’s figures, according to Eurostat. According to the German Technology Ministry the strongest performing sectors in recent months have been those producing investment goods and “intermediate” products, shipped for completion elsewhere.

PMIs Suggest Germany Pulled Back In September

Eurozone Flash PMIs generally showed a continued improvement in operating conditions in September, although the rate of improvement slowed somewhat, and indeed the German private sector slipped back even if it continue to maintain a general expansion. France did generally rather better. However, this does start to suggest that the easy part - stopping the slide - may now be over. We have stopped the fall, but restoring growth may well prove to be a very tough nut to crack indeed.

The Markit Flash Eurozone Composite Output Index - based on a sample of around 85% of the normal monthly survey - edged up from 50.4 in August to 50.8 in September, signalling a marginal increase in private sector output for the second successive month. The flash German Composite Output Index stood at 52.2 ( following 54.0 in August), a 2-month low.

Manufacturing new export orders weakened slightly in September, but growth on average in the third was the most pronounced since the first quarter of 2008. Anecdotal evidence suggested that overall demand had improved as a result of more favourable economic conditions and a corresponding rise in confidence among clients. Moreover, a number of investment goods producers pointed to increased exports to emerging markets in Asia.

The German flash Manufacturing PMI came in at 49.6 (49.2 in August), a 13-month high, but still just shy of the critical frontier separating overall expansion from contraction.

Commenting on the Markit Flash Germany PMI survey data, Tim Moore, economist at Markit said:

“The German economy ended the third quarter with output levels still moving in the right direction, supported by the fastest rise in new business since June 2008 and a rebound in business sentiment. PMI data suggest that the economy continued to expand in Q3, but the latest figures point to below-trend growth and only a gradual recovery. Job shedding and cost cutting measures were prevalent in September, while firms were forced to reduce their charges further, suggesting that the outlook for private sector demand remains subdued.”

The German Flash Services Activity Index came in at 52.2 (53.8 in August), again a 2-month low. And the weakening in German activity seems to have been concentrated in the services sector. Service providers were again upbeat about the outlook for the next twelve months. The balance of firms expecting a rise in business activity was the highest since January 2006, largely reflecting optimism that economic conditions will gradually improve in the year ahead.

Nonetheless, private sector companies remained cautious in their staff hiring decisions in September. Overall employment levels fell for the twelfth successive month, largely reflecting a marked decline in the manufacturing sector. Job cuts were linked to output and demand remaining at relatively low levels, with the recent change of direction not yet sufficient to prevent staff restructuring. Furthermore, backlogs of work decreased for the seventeenth month running, suggesting that firms had adequate staffing levels for existing workloads.

Plenty Of Confidence Around Though

German investor confidence jumped again in September,to hit yet another three year high as stocks surged and election day approached. The ZEW Center for European Economic Research said its index of investor and analyst expectations rose to 57.7 from 56.1 in August. The benchmark DAX index has now rebounded 52 percent from its March trough and reached the highest level in almost a year last week. At roughly the same moment the survey result was released the European Commission forecast that the German economy woul barely grow in the fourth quarter after expanding an anticipated 0.7 percent in the third one. My feeling is the Q3 estimate is too high, but the fourth quarter prognosis seems very realistic.

German consumer confidence rose to a 16-month high as the economic recovery boosted households’ income expectations and willingness to spend. GfK AG’s sentiment index for October, based on a survey of about 2,000 people, increased to 4.3 from a revised 3.8 in September, the Nuremberg-based market-research company said in a statement today. That’s the highest reading since June 2008. GfK’s measure of economic expectations turned positive for the first time since June 2008 and jumped to 3.4 from minus 7.5. A gauge of income expectations rose to 16 from 8.8 and an index of consumers’ propensity to spend increased to 36.5 from 31.1.

However it is possible to detect signals thatGermany’s economic recovery is losing momentum to some extent since business confidence rose less than expected in September, and this on the back of the weaker than expected PMI readings certainly serves to highlight the fragility of the growth recovery in Europe’s largest economy.

The Munich-based Ifo institute reported its business climate index rose from 90.5 in August to 91.3 in September. That was the highest reading since September last year, when Lehman Brothers collapsed in the US. But it fell short of many economists’ expectations, suggesting that at least some of the recent optimism about Europe’s largest economy may have been overdone.

The rate of increase in the Ifo index certainly slowed markedly in September. Hans Werner Sinn, Ifo president, pointed out that most companies still regarded current business conditions as poor, and that the rise in the index had been driven largely by the component covering businesses’ expectations for the next six months – which has risen for nine consecutive months to the highest level since May 2008.

Employment Falling As Unemployment Slowly Ticks Up

German unemployment declined in September, but the fall was due to a seasonal upturn and statistical effects rather than any fundamental economic improvement.

The unadjusted jobless rate was 8 percent, down from 8.3 percent in August.

A total of 3.346 million people were registered as unemployed — 125,000 fewer than the previous month but 266,000 more than in September 2008.

In seasonally adjusted terms, the unemployment rate dipped to 8.2 percent from 8.3 percent, with 12,000 fewer people out of work than in August. Economists had forecast an increase of 20,000. The labor agency drew attention to the fact that the number would have risen by 10,000 but for a change made earlier this year under which those being trained by private job agencies were removed from the jobless figures.

At the same time the number of those employed is falling, and there were 40.01 million people in employment in Germany in August 2009. Compared with the previous year, this was a decrease of 216,000, or 0.5%. In fact the German job machine ran out of steam last autumn, and since that time has been adding jobs at an ever slower pace. Now it has turned negative, and less Germans are employed every month than they were a year earlier.

Jobs have been subsidized by the Federal Labor Agency, which pays 60 percent of the net wage that’s lost due to reduced working hours. The program, extended to 24 months in May from 18 months, supported about 1.4 million employees at some 50,000 companies as of June.

As compared with July 2009, there was hardly any change, with the number in employment even rising slightly - by 11,000 (0.0%). But after seasonal adjustment the number in employment dropped by 57,000 (–0.1%) from July to August 2009. In July 2009, the seasonally adjusted number of persons in employment declined by 30,000 (–0.1%) on June.

Given the scale of the current economic crisis, the decline in the employment observed in Germany over the last year has been quite moderate. As the statistics office point out the fact that many employees were placed on short-time working significantly reduced the negative effects of the fall in output on employment.

So far, unemployment has been kept in check because many employers have used government-supported short-time working arrangements - Kurzarbeit - rather than laying off workers. However, this is now widely expected to be gradually wound down and hence the number of unemployed will rise significantly over the next year.

So How Long Can Kurzarbeit Continue To Run?

Well the good news, at least according to analysts at Societe Generale is a good deal longer than many seem to think. The analysts examined the working of the German employment protection programme, and show clearly that while official unemployment in Germany has in fact only risen moderately in the current recession the underlying real effective rate is much higher. The unemployment rate (using the ILO measure) has risen by just 0.6ppt - to 7.7% from its 7.1% low in Q4 2008, while in the euro area as a whole, the rate is up by 2.4ppt to 9.6% from its March 2008 low of 7.2%. As they say, it is also quite clear that this relative stability owes much to the widely-used practice of so called short-time working (Kurzarbeit).

As the SocGen analysts point out, this relatively benign situation could easily turn nasty if company employment intentions deteriorate significantly and growth expectations get revised down. However they are not that convinced by this line of argument, since they think that since German legislation has already extended the period for which companies can run short-time working from 18 to 24 months the programme is pretty firmly supported.

Examining in detail the evolution of the numbers on short-time working they find that the vast majority of companies only resorted to the programme in the spring, so that the 24 month limit will not bite until late-2010. Until the turn of the year 2008/09, the recourse to short-time working was very small indeed. Aside from the seasonal increases in the first quarters of 2007 and 2008, the numbers were small at around 50,000. To put the number in context, they point out that this represents 0.1% of the labour force and is equivalent to the monthly gains in unemployment that were recorded this year. Since then, the numbers resorting to the programme have indeed exploded and by March of this year (the latest available data), there were 1.3 million workers with shortened hours, and this number has probably now risen to around 1.4 million. These are clearly big numbers, amounting to about 3% of the labour force. If they were added to unemployment figures, total unemployment would rise to the previous historic peaks of around 5 million.

Deflationary Winds Blowing?

The German consumer price index declined by 0.4% in September 2009 over september 2008, maintaining pressure on existing deflation concerns. Germany as a whole has never seen such a low inflation rate since German reunification.

The harmonised consumer price index for Germany, which is calculated for European purposes, is expected to decrease by 0.4% in September 2009 on September 2008 (August 2009 on August 2008: –0.1%). Compared with the Augus the index is expected to be down by 0.4% in September.

And producer prices are also falling, with the index of producer prices for industrial products falling by 6.9% in August from August 2008. In July 2009, the annual rate of change was –7.8%. Compared with the preceding month, the index rose by 0.5% (as compared with –1.5% in July 2009).

Meantime the ECB continues to try to offer abundant liquidity to get credit and economic activity moving again, though there seem to be few takers.

The European Central Bank is lending banks less money than economists forecast in its second 12-month auction of unlimited funds, held on September 30, suggesting banks’ need for cash has eased for now.

Banks bid for 75.2 billion euros at the current benchmark interest rate of 1 percent. The ECB loaned a record 442 billion euros at the first auction in June and economists had forecast demand for 137.5 billion euros this month.

The ECB, which will offer banks 12-month loans for a third time on Dec. 15, is trying to flood the system with money in the hope it will be lent on to companies and households. Liquidity, liquidity everywhere, but not a drop of inflation in sight.

In A Tight, And Embarassing Corner?

Angela Merkel did not mince words at last weekends G20, warning fellow world leaders not to make the fight against global imbalances the central issue of the meeting. With Sunday's election looming she came close to accusing the US and Britain of backtracking on the issues of financial market regulation and global limits on bonuses for bankers by shining the spotlight on the export-oriented economic policies of Germany and China.

“We should not start looking for ersatz issues and forget the topic of financial market regulation,” she said in one of her speeches, “We cannot afford to neglect this issue now....Imbalances are an issue, but we must look at all the factors . . . We must talk about imbalances and name the reasons why they came into being.”

“We should also look at imbalances between currency regions and not pick on specific countries within the eurozone,” she added, referring to criticism from the US that Germany is not doing enough to support its domestic demand.”

"In terms of handling the aftermath effects of the financial crisis, the biggest problems and the deepest pitfalls are yet to materialize," according to Munich-based Unicredit economists Alexander Koch and Andreas Rees "It is very likely that typical lagging indicators like the labor market and the public deficit will still deteriorate markedly next year," and "big question marks" remain over the sustainability of the recent upswing.

A fiscal "exit strategy" is needed to avoid ballooning public debt, set to pass 5% of GDP this year, and even more during 2010. At the same time Merkel want to create a growth-friendly environment for consumers and companies by lowering the tax and social security burden. This balancing act is going to be hard, very hard, in a worl dwhich may just not allow Germany to run up the sort of trade surpluses she has been living from.

The German deficit is forecast to rise to 6% of gross domestic product next year, double the amount allowed under normal circumstances under European Union rules. Germany is still expected to see full-year gross domestic product shrink by around 5% in 2009.

One of the main acts of the outgoing government was the introduction of a debt ceiling, under which the German constitution now limits federal government borrowing to 0.35% of GDP by the time we reach 2016. What this means is that the new government will really have its work cut out if it wants to reduce the budget deficit and cut taxes at the same time. The only way will likely be via serious spending cuts. Some of these cuts may well come in the area of social benefits, possibly in health care, where the FDP is proposing a basic private insurance, with subsidies for those who cannot meet the costs. On the other hand, the CDU/CSU is essentially committed to maintaining the status quo, having already abandoned its more radical health care reform ideas. This more or less guarantess that a sizeable chunk in savings will have to come in the area of pension benefits, where the CDU/CSU is committed to the planned gradual increase in the pension age to 67.

Angela Merkel faces no easy task. She has to manage the exit from the massive fiscal stimulus and financial rescue packages,she has to ensure that the post-crisis economy is a more resilient and more balanced one, she has to address the long-standing issue of an ageing German society where generational inequality is on the rise and where younger generations are now burdened with an even higher debt level. And she has to do all this while keeping alive a coalition with a Free Democrat Party whose proposals on pension reform while certainly far reaching, still raise serious doubts about whether they will be sufficient to address the pension time bomb that is ticking away under an elderly export dependent society whose generous entitlements to pension benefits, healthcare and long-term care are becoming harder and harder to square with the long run growth performance of the German economy.

Is Germany Dependent on Exports to Grow?

By Claus Vistesen: Copenhagen

The analysis that follows accompanies Manuel's political overview, over at GEM, of the recent events in Germany as well as Edward's economic survey of the current state of play in the German economy (forthcoming). Essentially we are going to have a look at, arguably, one of the more salient features of the German economy in the recent period, namely that of her dependence on exports to grow. What we are going to ask here is then furthermore whether this presence of export dependency is related to the fact that Germany is one of the oldest economies in the world measured on median age (currently running at approximately 44 years)[1]. This is a bold claim and if it is unlikely that we will be able to provide decisive evidence for our claims that Germany; 1) is dependent on exports to grow and 2) that this can be traced back the economy’s ageing population, we hope that at least we will provide some perspective. As an editorial note, the arguments presented follows closely Vistesen (2010) which is essentially a working paper under preparation at this point in time.

In the first instance, it is worthwhile to point out that while export dependency in the form it will be presented here enjoys very little, if any, backing in the academic literature it remains one of the more popular ways to narrate the German situation in the context of its recent economic performance, not least in a financial crisis context (see e.g. Martin Wolf Martin Wolf (2008) – Global Imbalances Threatens the Survival of Free Trade). The main question which arises is thus how the global economy will, or indeed can, emerge in a situation where hitherto external deficit nations (the US, Spain, etc) now have to live less off of foreign borrowing while those surplus nations supporting these deficits cannot arrive at stimulating domestic demand. This question which ties together a lot of the contemporary discourses on the global economy is important to keep in my as we move along into a more static world of academic theory.

What is Export Dependency?

We define export dependency as a high and increasing connection between the variation of total output and the variation of the external balance, the latter which will be proxied by the trade surplus in the analysis that follows. Consider consequently the following very simple empirical relationship for an open economy;

Where Y(t) is national income modeled as a simple function of its components; consumption expenditures, government spending, investments, and the current account. All partial derivatives are naturally positive and if we focus strictly on the partial derivative for national income with respect to the current account, we get;

In this simple framework, export dependency may arise as function of the increasing importance of this derivative in explaining the variation of total output which simply means that the extent to which we observe the trade surplus as an increasingly strong driver of economic growth we are moving closer to a state of de-facto export dependency.

Now, this still does not answer the question of exactly what export dependency is the present context since while it is certainly one thing to be export oriented or perhaps even export reliant, the term dependency implies a much strong and potentially malignant situation as it translates into a situation where domestic economic activity becomes overtly reliant on matters elsewhere and external to the economy.

In this sense, export dependency arises in the distinction between an economy where external demand may simply be an extra boost to growth beyond a vibrant domestic economy and an economy where domestic activity is not sufficiently able to spur growth to an acceptable degree and where the positive contribution from extra demand become a prerequisite to maintain growth. It is exactly in this context that the demographic perspective becomes interesting since one obvious and intuitive consequence of the prolonged process of ageing as a result of lingering below replacement fertility as seen in Germany is that domestic demand proxied by consumption and investment demand will decline to reflect the decline in the labor force relative to the total population. This would then be a natural consequence of a standard life cycle analysis set in a closed economy where savings have to equal investment in every period.

Of course, the rub which arises as a result of this quite natural and logical process is that the need to keep and maintain economic growth does not dissipate with ageing. If anything, in a society such as the German this need will remain, or even increase, as an ever growing headache in the context of how to maintain (or viably reform) key institutional structures such as pension and health care systems whose continuing existence, whether one likes this or not, is contingent on headline economic growth. In this sense, the open economy opens up a window of opportunity to fight this situation and essentially to make up for an increasingly lackluster domestic economic environment by exporting excess capital and capital goods abroad to earn a return either in the form interest income of a pure addition to growth in the form export revenues.

Demographics and Open Economy Macroeconomics

If the introductory section above should convince you what export dependency is and why it may be related to ageing the fundamental question here is whether and how demographics may ultimately act as a driver of open economy macroeconomics and international capital flows. The empirical and theoretical contributions here are extensive, so we won’t deal with them in detail but merely point out that the idea that demographics may affect capital flows is not an original postulate and has been investigated in seminal contributions such as Summers et al. (1990), Higgins (1998), Feroli (2003), Bryant (2006), Supan et al. (2007) and Ferrero (2007) to mention just a few.

Despite considerable uncertainty surrounding the exact effects, these studies jointly find that demographics indeed do form strong drivers of open economy dynamics and that, by a applying a standard life cycle framework, come reasonably close at providing some interesting results even if for example the hypothesis of rapid dissaving is still highly contested. But what is a standard life cycle framework then in the context of the effect of demographics on the current account? Well, life cycle theory as postulated by Franco Modigliani and Richard Brumberg (see Deaton (2005)) simply states that a consumer’s saving pattern will be hump-shaped to reflect the fact that she will need to spend her working years saving for retirement where she, by definition, will not be receiving labor income. This also indicates that the current account should follow a similar pattern if modeled entirely as a function of the age structure of society

This figure is essentially drawn free hand on the basis of the empirical estimations of Higgins (1998) and comes with an important interpretation. According to Higgins (1998), and in a general life cycle perspective, we need to distinguish between two centers of gravity as economy moves through the demographic transition: One is when the demand for investment is largest as a function of age and thus when, one could argue, the capacity to absorb external investment is largest (e.g. the demographic dividend). Such periods are traditionally thought to be associated with a current account deficit since whereas investment demand may be large, domestic savings are not likely to be adequate to cover this thus implying a current account deficit to the extent that foreign savings stand ready and able to move. The second period occurs later as the total labour force begins to decline relative to the total population. This has the effect of depressing investment demand, but since this is also the period in which savings are maximized (really not counterintuitive when you think about it), it should, all things equal, be associated with a current account surplus.

The green line is a pure hypothecial construct and has no empirical counterpart (yet). It essentially represents a constraint in the form of the economy's need to rely on external demand to provide economic growth. In this sense, the constraint is non-binding up until the economy moves into old age (say a median age of >42 years) after which the expected result from ageing based on the life cycle theory stands in stark contrast with the fundamentals of an ageing economy where external demand becomes one of the only real sources of continuous growth in headline GDP. Remember here, as a rather important point aside, that economies such as Germany need this growth if they want to maintain the continuity of their welfare societies.

Within the typology of Malmberg, Germany would clearly be in the ageing phase, but since the threshold here is very unclear as a general rule, we could say that it is placed somewhere in the maturity phase inching over to the ageing phase and thus the period in which we should hypothetically observe dissaving as the savings supply will decline faster than investment demand. The first thing to observe here is then that the fact that Germany is running a surplus is not surprising given this model framework since, but the crucial and all encompassing question becomes whether this becomes a de-facto state of dependency with respect to economic growth since the decline in domestic demand will continue to depress the potential growth rate of the economy. In the jargon of the typology above, thesis of export dependency attacks the assumption of dissaving and postulates instead that keeping domestic savings above domestic investment demand and thus running an external surplus is one of the only ways in which an economy such as Germany may hope to achieve the desired growth rates as she, inevitably, moves into the unknown with an increasingly skewed old age structure.

An Empirical Perspective

In order to get a hold of the argument in the specific context of Germany it is worthwhile to start out with the following charts which depicts the ratio of consumption to GDP, the ratio of the trade surplus to GDP, the ratio of government spending to GDP as well as the ratio of total savings (including the trade surplus) to GDP. The data is taken from OECD in current prices (seasonally adjusted) and covers the period Q1-1960 to Q3-2008. All manipulations are based on own calculations.

The first thing to notice is that up until the very end of the 1990s the trade surplus did not represent a substantial part of total income in Germany. If we take the large perspective we can say that up until the latter part of the 1980s Germany was running consistent trade deficit, a deficit which narrowed substantially throughout the 1990s and moved into a substantial surplus at the entry to the 21st century. Moving on to consumption it is possible to observe a slight negative trend in the share of consumption to GDP and especially in recent 10 years, the negative trend has been strong and thus we could say that decline in consumption has been substituted for an increase in the trade surplus, at least; it would appear so from just eyeballing the graph. It is also interesting to observe that the point in time where consumption to GDP peaked from somewhere around 1975 to 1985 coincides quite nicely with the peak of the trade deficit in a historical context.

Moving on to the share of government spending to GDP the trend is, contrary to the corresponding figure for consumption and investment, is upwards. However, there is a certain sense of optical deceit here since if you disregard the sharp increase in government spending as a share of GDP from the 1960 to the middle of 1970s, the trend has been very much like the one for consumption with the interesting detail that the share of government spending to GDP has not declined to the same extent as consumption.

If we finally look at the graph which plots the share of investment of GDP in combination with the trade surplus to GDP, it is obvious that while domestic investment has steadily declined as a share of GDP total savings have been more stable thanks to the addition from the trade surplus. In fact, we look at the total savings to GDP in 2008 it resides at the same level seen in 1970. What is crucial here of course is the composition of this saving base in the sense that the external surplus takes up a substantial part (around a quarter).

This last point is interesting with respect to the framework above since while the life cycle framework would definitely predict that Germany would be running a current surplus at the given juncture, it also predicts that, at some point, domestic savings will decline so as to make the external balance a negative contribution to output in GDP. The question we must ask ourselves is whether this is an optimal response to the increase in ageing since this process is also driven by a secular decline in the ability of consumption and domestic investment (not to mention government spending) to spur economic growth.

Specifically, it would be interesting here to check whether Germany may have reached a point in terms of its age structure (proxied by median age) where the contribution from external demand to output growth has been important. To that end, let us have a look at the following graph;

Notwithstanding the fact that this graph can hardly be seen as decisive evidence either way, it is worthwhile just observing the trend of the two series. The first thing we should note is that throughout the median age bracket 33-38 years the external balance has been deficit with a moderate trend towards balance as we move closer to a median age of 38 years. This is an interesting observation in so far as goes the life cycle framework sketched above where we can say that all things equal, this period was when Germany was moving towards its maturity phase in which it now finds itself slowly but surely moving into the horizon where we may only speculate to effects of further ageing. If we relax the typology a bit we can add that if a given economy may have a propensity to run a surplus as a function of its age structure it may only grow to be dependent on the continuing accumulation of this surplus as it enters a later stage of the age transition and it is this point that we are interested in here. Looking at the graph, we can superficially infer that the trade surplus to GDP increased sharply from the point where Germany moved above and beyond a median age of 39 (roughly the beginning of the 2000s).

This point in time is interesting since the sharp increase in the trade surplus’ share of GDP has occurred at the same time as a sharp decline in investment and consumption and thus a substitution in growth derived from internal domestic demand and towards one derived from external demand. The key to which this signifies export dependency is the extent to which this substitution in some sense is involuntary in the sense that it is a natural and necessary (and optimal?) way to compensate for the fact that the ability of domestic demand to generate growth declines as an economy enters the latter part of the age transition.

One issues which is worth stressing here towards the end is that the prediction of an entry into some form or the other of rapid dissaving as a function of age seems very difficult to reconcile with the economic realities of an ageing society such as Germany’s. This is not to say that it won’t ultimately occur, but it is important to emphasize that the extent to which we will see this, it is going to be a very serious issue for the structure of the Germany economy since one would assume that with an external deficit at the same time as an inability to create domestic growth as well as a potentially very large public debt overhang the German economy and indeed society will be in a very difficult position. It then seems a more likely outcome that Germany (and other ageing economies) will fight this and one of the only ways to do this (besides reversing the underlying demographics trends) will be through keeping domestic investment accumulation persistently above the domestic economy’s ability to absorb this and thus rely on the ability to offload this excess investment off to foreign takers.

List of References

Cutler, David M., James M. Poterba, Louise M. Sheiner and Lawrence H. Summers (1990)An Aging Society: Opportunity or Challenge? Brookings Papers on Economic Activity, Vol. 1990, No. 1: 1-56

Deaton, Angus (2005)Franco Modigliani and the Life Cycle Theory of Consumption, Research Program in development studies and Center for Health and Wellbeing, Princeton University; the paper was presented ad the Convego Internazionale Franco Modigliani Feb. 17th-18th March 2005

Ferrero, Andrea (2007)The Long Run Determinants of the US External Imbalance, FRB of New York Staff Report No. 295

Borsch-Supan, Axel H; Alexander, Ludwig; and Krüger Dirk (2007) – Demographic Change, Relative Factor Prices, International Capital Flows and their Differential Effects on the Welfare of Generations, NBER Working Paper No W13185

Bryant, Ralph C (2006) – Asymmetric Demography and Macroeconomic Interactions Across National Borders, Brookings Institute, the paper was presented at a conference hosted by the Reserve Bank of Australia in 2006

Higgins, Matthew (1998)Demography, National Savings, and International Capital Flows, International Economic Review, Volume 39 (1998) Issue (Month): 2 (May) pp 343-69

Vistesen, Claus (2010)Ageing and Export Dependency, Working Paper 2009 (forthcoming)

[1] Japan would be another obvious candidate here and essentially Japan and Germany are very similar on this account.

Tuesday, September 29, 2009

Germany's 2009 Bundestag election: a political realignment in progress?

by Manuel Alvarez-Rivera, Puerto Rico

Voters in Germany gave a substantial plurality to Chancellor Angela Merkel's right-of-center Christian Democratic Union (CDU) and its Bavarian counterpart, the Christian Social Union (CSU), in a general election held last Sunday to choose members of the Bundestag, the lower house of Germany's bicameral legislature. Moreover, Chancellor Merkel - who has ruled for the past four years in a grand coalition with its main adversary, the center-left Social Democratic Party of Germany (SPD), following an inconclusive federal election in 2005 - will be able to form a government with its preferred coalition partner, the liberal Free Democratic Party (FDP), which scored its best election result ever.

The upcoming government will also have a majority in the Bundesrat - the indirectly-elected federal upper chamber - following elections in the Länder (federal states) of Schleswig-Holstein and Brandenburg, which were held concurrently with the Bundestag poll.

Meanwhile, the Social Democrats sustained heavy losses and polled their worst result since the establishment of the Federal Republic of Germany in 1949. However, both the Left Party (an amalgam of leftist SPD dissidents and ex-Communists from the former East Germany) and the environmentalist Alliance '90/The Greens made inroads at the expense of SPD; both parties scored nationwide vote percentages in the double digits for the first time ever.

Members of the Bundestag are elected by a Mixed Member Proportional (MMP) electoral system, under which half the chamber's seats are filled in single-member constituencies by plurality or first-past-the-post voting, while the remaining half come from closed party lists; voters cast a first vote for a constituency candidate, and a second vote for a party list. All Bundestag seats (constituency and party list alike) are distributed by proportional representation among parties that win at least five percent of the nationwide second (that is, list) vote, or secure no fewer than three direct (constituency) mandates. Bundestag seats are subsequently apportioned among state-level lists on a party-by-party basis, and constituency mandates won by a party are subtracted from its corresponding seat total, with the remaining seats coming from the party's list.

However, if a party obtains direct mandates in excess of its assigned seat total in any given state, it is allowed to keep the additional seats - known as overhang mandates - and the Bundestag is expanded accordingly. In Sunday's election, CDU and CSU won a total of 24 overhang mandates - which did not change the election outcome (contrary to what had been feared in the days preceding the vote), but nonetheless will increase the upcoming CDU/CSU-FDP coalition government's Bundestag majority from eighteen to forty-two.

Elections to the German Bundestag has a detailed description of Germany's electoral system, as well as Bundestag election results since 1949, including preliminary 2009 figures.

While the outcome of last Sunday's vote was widely anticipated by opinion polls, it nonetheless constitutes a major departure from previous elections. Although the Union parties were the clear election winners, both CDU and CSU continued to lose ground and scored their lowest shares of the vote since 1949. As a result of their decline and the Social Democrats' sharp drop, Germany's two major groups now command only 56.8% of the party list vote - the lowest figure ever in the history of the Federal Republic, down from 69.4% in 2005 and 77% in 2002. Meanwhile, the gap between the Social Democrats and the liberal FDP is now down to the single digits for the first time ever; in fact, in the southern state of Baden-Württemberg, the liberals came within half a percentage point of displacing SPD as the second largest party.

As such, the results of the 2009 Bundestag election suggest that a realignment of political forces may be underway in Germany. While CDU/CSU will be able to form a coalition government with the Free Democrats for the first time since 1998, the postwar German party system of two large mass parties (Volksparteien in German, literally people's parties) and a smaller centrist party holding the balance of power - is definitively dead. Instead, Germany appears to be shifting towards a more fragmented, Scandinavian-type party system.

In fact, changes in Germany's traditional party system were already underway as early as 1983, when the Greens secured Bundestag representation, mainly by siphoning votes from the Social Democrats. However, the Greens' disastrous 1990 Bundestag election result, brought about by the party's opposition to reunification, as well as its short-sighted refusal to merge with the East German Greens and their allies ahead of the election; and the continuing decline of the post-Communist Party of Democratic Socialism (PDS), which steadily lost ground after a relatively strong start in East Germany's 1990 parliamentary election, appeared to indicate that by the next federal election only CDU/CSU, SPD and FDP would remain as viable political players.

Alas, it was not to be, largely because reunification proved to be far costlier and messier than previously anticipated. Following their 1990 election fiasco, the Greens regrouped and went on to stage a successful Bundestag comeback in 1994, while PDS capitalized on East German discontent with reunification, and managed to bypass the five percent threshold by capturing four constituency seats in East Berlin. Meanwhile, the CDU/CSU-FDP coalition government of then-Chancellor Helmut Kohl barely hung on to office, mainly because overhang seats expanded the ruling alliance's ultra-narrow two-seat majority to ten seats - a pattern that has since become a recurring feature of Bundestag elections.

At any rate, by 1998 Kohl's government had overextended its welcome after sixteen years in office, and German voters were ready for change in the form of SPD leader Gerhard Schröder, who led the party to back-to-back victories in 1998 and 2002, both times in coalition with the Greens, and both times with overhang mandates padding otherwise thin Bundestag majorities. Moreover, Schröder only managed to survive in 2002 by virtue of his government's prompt response to the catastrophic floods that devastated eastern Germany shortly before the election: while the Social Democrats lost ground in western Germany, they scored gains in the east at the expense of PDS, which failed to clear either electoral threshold and lost all but two of its Bundestag seats.

Nevertheless, Chancellor Schröder's final term in office from 2002 to 2005 was characterized by the unpopular labor and welfare reforms his government was forced to enact in order to deal with a severe economic recession. These reforms, which scaled back Germany's generous welfare state, infuriated many Social Democratic left-wing traditionalists, who felt the party had betrayed its socialist roots. Eventually, a number of SPD left-wing dissidents abandoned the party; these subsequently went on to join forces with a reinvigorated PDS to establish the Left Party.

In due course, Chancellor Schröder triggered an early Bundestag election by deliberately losing a parliamentary confidence vote. However, while the Social Democrats put up an unexpectedly strong performance in the election - held one year ahead of schedule in September 2005 - they nonetheless came up a percentage point behind CDU/CSU. At the same time, neither the Union parties nor the Social Democrats could form a majority coalition government with their respective partners of choice, namely FDP and the Greens, and eventually it became clear that the only viable government was a grand coalition of the two major groups. After weeks of negotiations, both sides agreed to a coalition cabinet presided by CDU leader Angela Merkel - Germany's first-ever female head of government - while SPD retained a majority of the ministries.

At the outset, Angela Merkel's CDU/CSU-SPD grand coalition cabinet was widely expected to be a short-lived affair; as it was, Merkel proved to be a popular figure, and her government ran the length of its four-year mandate. Nonetheless, the grand coalition government was very much an alliance of necessity for both CDU/CSU and SPD, and neither group had any desire to continue it beyond 2009; consequently, Chancellor Merkel made it clear that she still regarded the liberal Free Democrats as her party's preferred coalition partner. Meanwhile, the Social Democrats hoped to form a "traffic light" coalition with the Free Democrats and the Greens. However, the liberals made it clear they were not really interested in any such arrangements, even though there was relatively little difference between the Social Democrats and the Union parties during the election campaign.

In fact, that perception may have weighted heavily against SPD: many of the party's traditional voters apparently concluded it had strayed too far from its ideological roots, and shifted their allegiances to the Left Party or the Greens (or stayed at home), which led to the party's disastrous result in Sunday's vote. Moreover, the collapse of the Social Democrats has led to the emergence of two distinct party systems: one in the former West Germany, and a very different one in East Germany.

To be certain, differences in the voting patterns of Germany's western and eastern zones have been a distinctive trait of German electoral politics since reunification in 1990: specifically, over the course of the last two decades PDS and its 2005 successor, the Left Party have retained significant popular support in the erstwhile German Democratic Republic, much to the dismay of politicians in the western part of the country. Nonetheless, until now CDU and SPD remained the two largest parties in the so-called "new Länder," with PDS and subsequently the Left Party in an increasingly stronger third place, but third place all the same.

At the same time, PDS fared poorly in the in the "old Länder" of western Germany, where it was widely reviled as the successor of East Germany's defunct Communist Party; even with the backing of SPD dissidents headed by former Social Democratic leader Oskar Lafontaine, the Left Party had a relatively limited impact outside Lafontaine's home state of Saarland: in the 2005 Bundestag election, the new party polled a quarter of the vote in the east, but less than five percent in the west.

However, while the Union parties are now the dominant force in both German sides of the now-defunct Iron Curtain, after Sunday's election the Left Party has become the second largest in eastern Germany, closely behind CDU; the Social Democrats have fallen to a distant third place. On the other hand, SPD still remains the second largest party in western Germany, where the Left Party has made significant inroads but remains twenty points weaker than in the east, well behind both FDP and the Greens (which like CDU and SPD fared better in the western part of the country). Meanwhile, in the capital city of Berlin, Christian Democrats, Social Democrats, the Left Party and the Greens are now in a very competitive four-way race - none of the parties won as much as a quarter of the list vote - with FDP not very far behind.

Incidentally, the established smaller parties were not the only beneficiaries of the voters' shift away from the major groups: the new Pirate Party, which advocates digital and privacy rights - most notably the legalization of file sharing - polled two percent of the list vote and qualified for state funding; the Pirates, which are now the largest party outside the Bundestag, have set their sights on next year's election in North Rhine-Westphalia, Germany's most populous state.

Nonetheless, a substantial number of voters chose to pass up the event altogether, and turnout dropped to the lowest figure ever for a Bundestag election: just 70.8% of the electorate went to the polls, sharply down from 77.7% four years ago.

While CDU/CSU and FDP have been coalition partners in the past - most recently from 1982 to 1998 - the Free Democrats were previously a much smaller party than CDU, usually with fewer seats in the Bundestag than CSU alone. By contrast, FDP will now have half as many seats as CDU, and over twice as many as CSU, which could introduce a different dynamic from past coalition governments of the three parties. Thus, it's not inconceivable that the liberals may want to throw their weight around on issues such as tax cuts, which were a central plank of the party's successful 2009 election campaign. That said, tax cuts do not appear to be a viable option for at least a couple of years, since Germany is just emerging from the severe recession triggered by last year's global economic crisis, and it remains to be seen how much influence will the liberals ultimately wield in Chancellor Merkel's new government.

Just as important, the future of the much weakened SPD - which returns to the opposition after eleven years in office - remains highly uncertain. The Social Democrats may well lurch to the left in an attempt to neutralize the Left Party and recover its lost support on that flank, but it's far from clear how such a move could be accomplished without losing its more moderate voters - which the party desperately needs as well in order to remain competitive - or for that matter without breaking apart. From that perspective, the changes already underway in Germany's party system may turn out to be a halfway house to yet another political realignment further down the road.

Sunday, September 27, 2009

The G20 and Why Export Dependency And Global Imbalances Matter

by Edward Hugh Barcelona

With the timing of the latest G20 meeting set to coincide with the run-in to the German elections acrimonious debate has not been absent, but even as the passions generated by the arrival of voting day subside, it is clear that just beneath the surface their lie some simmering problems which simply will not go away. Despite the fact that nothing is really on the table that will make that much difference in the short run, I think the structural transformation that they are carrying out at G20 level is going to be very important in the longer term in finding eventual solutions.

According to Bertrand Benoit in the Financial Times the G20: "will endorse a report from the Financial Stability Board that calls for bonuses to be linked to the long-term success of financial companies and not excessive risk taking." Well this of course sounds absolutely fine. I have absolutely no objection, but we need to understand that from a macro economic point of view it is virtually irrelevant, with the added detail that the implications are that a recovery in growth will be slower yet less risky. Evidently the issue of why there has been so much liquidity floating around (and this has been the heart of the problem) has little to do with bank bonuses and salaries.

Having interest rates near zero in a significant part of the developed world for an extended period of time - the inevitable consequence of having such a huge excess in global savings - means the the money will still be there, very cheaply, for people to do just whatever they want with it. They might, for example, like to buy Hungarian forint denominated assets, as Deutsche Bank analysts have been advising them to do, and try to find out just how long it takes them to push the economy of that small country right off the edge of the precipice on which it is presently so perilously perched. Or they might like to do something similar with the Russian Ruble, and see if they can block Bank Rossii from being able to move towards a floating currency. Or, if they are really short of interesting ideas, they might like to buy the South African Rand to see just how far out of line you can push the currency in a country which is suffering its worst recession in a couple of decades. Of course, all of this is not that risky for those who understand the finer arts of Forex trading, and the banks who lend them the money will run little risk. The risk here is for the poor people who live in Hungary's and South Africa's of this world. Risk in these cases is, of course, massive.

The banks are also being pressurised to raise their capital ratios. While this is always well-advised in the boom times, it only makes matters worse in a downturn. The current drive to make banks less leveraged and safer may well have the perverse consequence of reducing money balances in the short term. At least this is what Tim Congdon from International Monetary Research argues. This process simply "strengthens the deflationary forces in the world economy, and that increases the risks of a double-dip recession in 2010," he says.

Meanwhile everyone will continue to drive full speed ahead on open ended stimulus programmes, without being altogether clear what it is they are trying to stimulate (see the Spanish case if you don't believe me). "The G20 will call for extraordinary fiscal and monetary stimulus to be continued until “a durable recovery is secured”". But, and here comes the rub, it will also call on countries to act together to ensure more balanced economic growth in future, with surplus countries – China, Germany, Japan and oil exporters – urged to raise domestic demand and deficit countries asked to reduce budget and trade deficits once the world has secured a recovery.

This is evidently the sensitive point which has had everyone from Peer Steinbrück and Angela Merkel, to the newly elected members of the DJP in Japan and the governing elite in China twitching away furiously in recent days. The leaders of these countries have become nervous, since they feel they are being blamed for something they haven't done, and naturally they are lashing back.

They need not worry so much, these exhortations will also be to no real avail. In order to see why, let's take a quick tour through the real heart of the problem.

Who Runs The Current Account Deficits

According to the current director of the US president’s National Economic Council, Larry Summers, writing in an academic paper published in 1990, the United States economy was set to run current account deficits for a period of 15 years, with the consequence that more than 6 percent of U.S. assets would be owned by foreigners by 2010. However, as he saw it, high saving during the subsequent 15 years would result in the generation of current account surpluses and a reduction in foreign capital ownership to 3.5 percent. After 2025, or so the analysis ran, the rapid increase in the number of elderly, would once again lead the United States to run current account deficits.

Since this forecast seems to come so near to describing a process we are now seeing unfolding before our very eyes – in a world where many hold economists can see nothing at all coming – we might like to ask ourselves how anyone could have known so much so far in advance? The answer to this strange questioin is Larry Summers used a very simple model to arrive at his “predictions”, a model based on the life cycle saving and borrowing mechanism, the description of which was to lead Italian economist Franco Modigliani to win a Nobel in 1995. Summers and his co-authors simply applied the individual Life Cycle model to a whole population, and as it appears came up with a fairly plausible outcome.

Everyone is evidently only too well aware that all developed societies are ageing (some, of course, more rapidly than others), but what many observers do not seem to grasp is that this ageing process has very concrete and forseeable economic consequences, consequences which have now been captured in a whole generation of economic models, and which are described in the accompanying chart prepared by my colleague Claus Vistesen.

As can be seen from the chart, as the demographic transition – identified in age bands following the nomenclature of the Swedish demographer Bo Malmberg - advances median population ages move steadily upwards, producing in their wake a whole series of economic phenomena, phenomena which tend to impact directly on the domestic consumption and the current account balance of a national economy. The thick blue line shows what happens to the current account as a given country moves through the age bands. Initially there is a tendency to sharp deficits and severe economic crises, such as are very characteristic of low income, high fertility, developing economies like Ecuador or Pakistan. Then, as societies develop socially and economically the tendency toward deficit remains, only this time on a more mature, and seemingly more stable, basis as seen most evidently in recent years in countries like the United States, the United Kingdom, Spain and France, who all have population median ages in the 35 to 40 range.

But then something strange happens as population median ages rise past the 40 mark, and especially as they age past 42. The current account suddenly swings into the positive zone, and this can be seen in the real world in countries like Germany, Japan and Sweden, where the ageing population effect means that domestic consumption becomes steadily weaker, and if we look at the second (purple) line in the chart, which illustrates the level of export dependency, we can see that while this is weak at the lower median age ranges (due to the momentum derived from stronger domestic-credit boom dynamics), it steadily grows at the higher median ages.

So, is there any empirical evidence for this phenomenon you may ask? Well just look at Germany, Japan and Sweden, and how the recent collapse in demand for their exports produced by the global crisis sent the economies in these countries spiralling downwards. On the other hand, during periods of economic boom, strong surplus countries need to find an outlet for the savings they accumulate. Hence the large current account deficit countries in the East of Europe, for example, were funded by Austrian, Swedish and German banks. The question we should be asking is not why banks in these countries were so stupid as to lose so much money, rather it is why they had so much money to lose in the first place. That is, why were their populations saving so much, and why were profitable domestic outlets for such savings insufficient? Once we can get hold of this, we can start to see one of the reasons why there have been such large global imbalances in the first place.

One of the problematic aspects of this situation, looking at the chart, is there there is no steady state (or cyclical correction) mechanism at work here, since there is not, to use the jargon, homeostatis, and the need to export (the export dependency purple line) simple heads off exponentially towards infinity, while the level of deficit does the same in the opposite direction. The reason that the need to export moves exponentially upwards is that median age doesn’t just move up from one level to another, and sit there, but keeps climbing steadily upwards, and the more it rises, the less “bang for the buck” in GDP growth you get from any given level of exports. This is the situation we are seeing now in Germany and Japan, and this is why they will struggle mightily to pull themselves out of the present recession, and why the whole situation is evidently not sustainable. So, if the countries in question don’t do something, and do something now, to stop median ages rising too rapidly, more crises like the one we are presently living through are evidently guaranteed.

This way of thinking about things is sure to form, in my opinion, one piece in the new, post-crisis, macro mindset that will emerge. Of this I have no doubt, since the present crisis is all about imbalances, and this is one simple and straightforward model for thinking about and understanding them. Basically one group of people - the current account surplus countries (China, Japan, Germany, Sweden) - were afloat with money, and spent their time rather recklessly lending it to another group of people - the current account deficit crowd ( the United States, Iceland, Ireland, the UK, Spain, Portugal, Greece, Romania, Bulgaria, the Baltics, Hungary and New Zealand etc, etc) - who needed to fund their deficit habit, and who did so by equally recklessly borrowing the money. So if you want to understand the banking crisis, you need, as the US economist Brad Setser would say, to follow the money and find source of all those surpluses and deficits.

And all of this helps us understand not only the crisis, but also the problems we are going to have getting out of it, since as Larry Summers noted over lunch with the FT’s Chrystia Freeland “‘The global imbalances have to add up to zero and so, if the US is going to be less the consumer importer of last resort, then other countries are going to need to be in different positions as well.’

As Freeland highlighted, on this possibility, Summers was absolutely bullish, and understandably so. “The very great enthusiasm for accumulating reserves that one saw globally is likely to be a smaller factor over the next decade than it has been in recent years” he predicts this time. And so too is economic growth (going to be a smaller factor over the next decade), Edward Hugh rapidly adds, since with everyone looking to export their way out of trouble, we have to ask, as Nobel Economist Paul Krugman pointed out, the tricky question about just who the customers with the current account deficits are now going to be to enable all those much needed exports. The current talk of a simple and straightforward recovery for the global economy is misleading, and a long hard road lies ahead for all of us.

And the first evidence of this can be found in the latest quarterly US current account data. The deficit narrowed in the second quarter to $98.8 billion, the lowest level since 2001, reflecting a smaller shortfall in trade of goods as imports and exports both decreased. This is far from being a linear process, and the U.S. trade deficit was up again in July, rising 16.3% over June to hit $32.0 billion, according to Commerce Department data. Despite the fact that imports rose sharply in July on the back of the stimulus programme, total trade activity is still well below last year's level, and the trade deficit with China was $20.42 billion compared with $25.01 billion in July 2008.

In addition US bank loans have been falling fast, and were down at an annual pace of almost 14% in the three months to August (from $7,147bn to $6,886bn). The M3 "broad" money supply, watched as an early warning signal of where the economy will be a year or so later, has been falling at a 5% annual rate. There is absolutely no sign of an imminent sharp rebound in US domestic demand, and little likelihood of a continuing strong current account deficit. The most likely path is for the deficit to steadily close of its own accord as the stimulus programem which is still supporting it is steadily withdrawn. Well, this is what the world wanted, and this is what it is now going to get. So everyone should be happy, I guess.

And while the deficit countries close them down, there is little liklihood of the surplus countries taking their place. It is like telling these countries, you know, you really should have had more children 30 years ago. Do people really think these countries can simply invent policies at the snap of a finger and convince citizens who are worried about the stability of their pension system to spend more now, just because it is in the interest of the global economic system? And what policies exactly. Buy one and get another one for free from the central bank?

But coming back to the G20, as I said at the outset, what I think really matters at this point is that our policymakers have set up a problem for themselves to solve, and they have also set up a structure through which they may solve it. And that is something. Now in all likelihood we will continue to thrash around trying-out false solutions for the next two or three years, but then maybe, just maybe, they will all be ready to talk about what we really might do. And here's the good news, there is another planet out there waiting to be exported to. And the planet has a name - the Emerging Economies. So all we have to do now is work out is a sensible and responsible framework (the so called "supportive environment") through which cheap credit can be channeled into these countries, without that is producing the kind of boom-busts we just saw in the Baltics, Romania and Bulgaria. Not a little task, but not an impossible one either.

(1) An Aging Society: Opportunityor Challenge? - written with David M. Cutler (Massachusetts Institute of Technology), James M. Poterba (Massachusetts Institute of Technology), and Loise M. Sheiner (Harvard University) and published in Brookings Papers On Economic Activity, 1990.

Wednesday, September 23, 2009

The Case of the Disappearing Bid?

By Claus Vistesen: Copenhagen

I should immediately reassure my readers that I am not going to re-account or even continue Macro Man's story of 2007 in which Sherlock Holmes was looking for a vanishing bid in risky assets. Also, I am not sure that we are actually looking at a bid which will vanish but one which will perhaps taper off gradually or so at least is the estimated scenario policy makers would like markets to believe in. Of course, recent messages from the BOJ suggested a very cautious stance towards the economic outlook and although the ECB's chairman Trichet has ardently argued that an exit strategy from extraordinary financing provisions, the statement that, now is not the time to exit, still echoes most of the official messages coming from the ECB.

But perhaps more important than when to exit is the question of how and whether indeed it will be so easy and simple for central banks to simply wind down the supply of medicine. In the context of the ECB for example, I remain rather sceptical.

However, this day is all about the Fed decision and although I only rarely delve into account of US monetary policy decisions (comparative advantage you know!) this one is important since it was always going to be parsed very closely for signs of hawkishness on rates on the one side as well as indications of the future wind down of asset purchases. Now, for those who expected a big bang, I have to side with Macro Man that it seems to be much ado about nothing in the sense that the Fed basically reiterated the general view that although economic activity had been showing positive signs lately and especially in the context of leading indicators pointing to a strong bounce in Q3 and Q4 activity, the fundamentals of very low capacity utilisation and deleveraging across the real economy remain intact. In the context of Fed speak this translates into maintaining the current rate target at the zero bound and the the forward looking statement that rates are to kept low for an extended period;

Conditions in financial markets have improved further, and activity in the housing sector has increased. Household spending seems to be stabilizing, but remains constrained by ongoing job losses, sluggish income growth, lower housing wealth, and tight credit. Businesses are still cutting back on fixed investment and staffing, though at a slower pace; they continue to make progress in bringing inventory stocks into better alignment with sales. Although economic activity is likely to remain weak for a time, the Committee anticipates that policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will support a strengthening of economic growth and a gradual return to higher levels of resource utilization in a context of price stability.

With substantial resource slack likely to continue to dampen cost pressures and with longer-term inflation expectations stable, the Committee expects that inflation will remain subdued for some time.

In these circumstances, the Federal Reserve will continue to employ a wide range of tools to promote economic recovery and to preserve price stability. The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.

So far so good then and this was really all we needed, one would imagine, to extent the rally in risky assets as well as the downward trend in the USD as the new funding currency for carry traders and others of their ilk. So far, there has been no signs of panic anywhere and everything seems to be all engines go.

Meanwhile, the Fed did actually give away some details as to how the future bout of asset purchases are to be conducted. On the matter of treasury purchases the Fed will its total purchase of $300 billion by the end of October. Most of us would naturally like to be able to predict what this will to do yields and prices and really you could spin this two ways. In the context of supply side worries, the Fed's withdrawal from the treasury market should push down yields if we add the, perhaps dubious assumption, that the $300 billion worth of supply of treasury bills has only been there to the extent that the Fed has been the main bidder (Say's law and everything). On the other hand it could also push up yields in a world where one assumes that there has been a decisive need to issue such bills and now that the Fed is stepping aside new buyers must step in and notwithstanding those with a printing press of their own, it should push up yields. Although this may seem quite innocuous and technical (i.e. unimportant) it may turn out to be important in a general context when it comes to the ability of economies (not just the US) to lift themselves out of the mire without the crutches of stimulus to lean on.

In the context of the Fed's outright asset purchases, the statement delivered good news for bulls/doves in so far as goes the fact that although the Fed was invariably going to issue a deadline, it seems to have been pushed somewhat out in the distance; well, at least a quarter. Consequently, the Fed will buy $1.25 trillion of agency mortgage-backed securities and up to $200 billion of agency debt, purchases which are set to be concluded by the end of the first quarter and not by year end which was the final date I had been led to believe judged by the points made in various economics report digested over the last week.

So, it is here perhaps that we may be looking at a disappearing bid in the context of the Fed gradually but surely reducing its presence in the market for MBS turds not to mention the agency market which went belly up as Fannie and Freddie crashed and burned. In the nice soothing light of efficient markets it is difficult to expect the decision to wind down purchases to be a big market mover as long as the incoming bout of data continues to provide plenty of upside and no downside. But if we get a setback just around the time when the Fed had envisioned to stand down its most aggressive measures of QE, one finds it difficult not to expect general sentiment and thus, in a forward looking perspective, real economic activity to take a hit which is exactly what we would all like to avoid; the double dip recession or "WL" recession if you will.

Ultimately, it is of course all still a great big mess, something which was neatly conveyed by the way Bloomberg handled the message carried by the IMF envoy to the G20 summit. On the one hand, the IMF was quoted for urging central banks to map a viable and transparent exit strategy and on the other hand Managing Director Dominique Strauss-Kahn was quoting for urging policy makers to not withdraw fiscal stimulus to quickly. Lost in translation are we?

Well, I am perhaps being unfair here to the editors of Bloomberg not to mention the IMF in particular since ultimately; talking about exit strategies is not the same thing as enforcing them. However, I do feel rather strongly about the need to make the following point that the two are of course intimately connected and withdrawing QE cannot but affect the trajectory of fiscal stimulus. This is a point which I believe for example is absolutely crucial to understand in the context of the Eurozone where the ECB's refinancing operations seem to be implicitly underpinning national governments' efforts to shore up their capsized economies.

In this context and assuming that both the BOJ and the ECB will be trailing the Fed somewhat, it will be most interesting to see whether Bernanke manages withdraw the bid on financial markets currently offered by the Fed's policies and indeed whether others may follow in his footsteps and withdraw theirs.