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Tuesday, August 31, 2010

On The Shoulders Of Giants - How Spain Is Destined To Follow In Germany's Footsteps

by Edward Hugh: Barcelona

The current generation of policymakers seem to be like Captains of large ocean liners, out there on the high seas, bereft of either compass or adequate charts, trying hard to calm there worried passengers by telling them nothing is amiss. But the charts are there, if only they would look at them, and in the present Spanish case, unlike the old refrain, the future is ours to see, and it has a name: Germany.

For those willing and able to examine our present situation with a reasonably open mind, a comparison of the recent history of the Spanish and German economies can prove illuminating, especially since, as I will argue below, there are strong structural homologues to be observed in the evolution of the two.

This post will contain comparatively few words (what a blessing!) since I will try and let the charts themselves tell their own story, in the hope that concepts which seem to be difficult to convey verbally, may be easier to grasp visually.

Consumer Boom

The first myth I would like to debunk is that it simply is not true that the Germans are a group of "non consumers", and inveterate savers. Back in the 1990s German private consumption enjoyed a huge boom, a boom which ground itself to a halt around the year 2000. It is only since 2000 that German private consumption growth has been lacklustre, and incapable of driving the economy. (I am using a Bloomberg chart here, since I don't have a long enough time series to hand to make my own version).

Now if we look at the same chart for Spain, we can see that private consumption growth enjoyed the same kind of "blossoming" that German consumption did between roughly 1999 and 2007.

Driven By Borrowing

But more than the phenomenon of the consumption boom in and of itself, what is interesting is what was driving it. Unsurprisingly we find the "usual suspect" - rapid increases in credit. Again, the following charts belie the idea that Germans have always been a nation of meticulous savers.

And again, the Spanish charts for mortgage increases tell a very similar (if even more exaggerated) story.

And it wasn't only households, corporates were busy at it too. Interestingly, corporate borrowing seems to have had a brief renaissance in Germany on the back of the current crisis.

Yet again, the only area in which Spain distinguishes itself is in the magnitude of the phenomenon. Spanish corporate indebtedness is a much, much more serious problem than German corporate indebtedness ever was.

When we come to look at the last set of loan charts, I would point of two features. In the first place, total private sector debt is not that different between the two countries, despite the fact that German GDP is around twice as large as Spanish GDP.

And in the second place, look at the long tail on German year-on-year borrowing, this is the point where those with eyes to see should be able to discern something of the future which awaits Spain. Interannual lending in Spain isn't going to climb back up again, and we should expect it to trawl around the zero percent level for many years to come, as Spain's private sector deleverages itself.

From Current Account Deficits To Current Account Surpluses

Which brings us to the next point, the association between lending booms and current account surpluses. As we can see in the chart below, Germany was no exception to the rule here, and all through the duration of the consumption boom the country ran small current account deficits. Deficits which then became surpluses after the huge structural adjustment the country went through in the transition from being a consumer driven to being an export driven economy.

And this is the path that Spain will now surely have to follow, but just note the massive difference in scale between the two. Spain's adjustment will need to be enormous. And how could this have happened we might like to ask ourselves? Were all the relevant drivers fast asleep, lurched over their wheels? How come no one "saw this coming"?

Given the magnitude of the correction, it is not really surprising that the IMF seem to want to hope against hope that it really won't be necessary. As the chart below illustrates, they seem to be hoping markets will sustain the current account deficits all the way through till 2015. As can be seen, Spain is the worst case offender, and the country where the structural transformation will need to be largest. So why do the IMF continue to believe in something which is scarcely credible? It could be that they simply accept the Spanish government's own optimistic idea that private consumption will come back to the 2% growth level again, kick started by a surge in borrowing. But a study of what happened in Germany makes that highly unlikely. Spain's banks are having trouble enough financing themselves as things stand, are people seriously suggesting the markets will now fund another bout of additional leveraging?

And if the private sector isn't going to do the borrowing, then who is? Since simple book-keeping tells us that having a CA deficit on the one hand implies capital flows on the other to fund it. The only conclusion I can come to - and this is what I argue in this post - is that we are assuming the government is going to continue to run a sizeable deficit, or that there will be straight fiscal transfers from other parts of the Euro Area to Spain. Otherwise the numbers simply don't add up.

Worm Into Butterfly?

What I have been arguing so far should be relatively uncontroversial for anyone with a sound grasp of applied macro. What comes next is more of a hypothesis. As we have seen, economies seem to transit from being consumption driven to export driven, so we might like to ask ourselves, is the process merely random, or are their underlying structural dynamics at work. As I am trying to argue in the German case, the shift doesn't seem to be a cultural one, and if Spain follows Germany down the same road then we will certainly know it isn't.

So what could be driving all this. Well, as Claus Vistesen and I have speculated, ageing populations and the demographic transition may well have something to tell us here. Using Modigliani's life cycle saving and borrowing idea, and the Swedish demographer Bo Malmberg's idea of population "ages" (child, young adult, middle aged and elderly), Claus has prepared the following chart in an attempt to illustrate the process.

Of course, all of this at the moment remains at the levl of hypothesis. I tend to use median population ages as a rough and ready measure of ageing, and (even though I wouldn't want to claim any precision here) it is interesting to note that both Germany and Spain have started to transit off towards export dependence at around the 40 median age point.

Still, this is early days yet, and we will know a lot more in this regard when we see how the different countries all along Europe's periphery perfom in the years to come. Will they, as the IMF and the EU Commission seem to assume, go back to being consumption driven, or will they be condemned to follow the German path? Certainly Hungary, to take just one example, seems to look more and more as if its economy which desparately trying - but so far unable - to transform itself into yet another Germany.

Real Devaluation

The worrying thing looking at the above inter-country comparison is how much larger Spain's correction is going to need to be than Germany's was. As Wolfgang Munchau pointed out in the FT yesterday, Germany entered the eurozone at an uncompetitive exchange rate and embarked on a long period of (quite painful) wage moderation and deep structural reform. In fact, Germany entered the Euro with an excahnge rate which was too high, give the new role exports were going to play in economic growth. The German adjustment can be clearly seen in the REER chart below, as can the very large adjustment that Spain will have to make in comparison with the German one.

When macro economists say this will be "painful" they don't do so to be sadists, they say this since they know this is going to be hard, very hard. And doubly so when almost all those responsible for taking policy decisions at all the respective levels seem to deny that it is going to be necessary. I have advanced two suggestings (a systematic reduction of 20% in wages and prices in Spain, or a temporary exit of Germany from the Euro Zone). Since neither of these have gained any traction at all, it is reasonale to assume they are now not going to happen (at least in any orderly way). But the car is still heading full speed towards that brick wall. When it finally does crash, will the Queen of England once more say to Luis Garicano, "but tell me Luis, just why was it no one saw this coming?".

Monday, August 30, 2010

The Baron Münchhausen Effect

by Edward Hugh: Barcelona

Karl Friedrich Hieronymus, Freiherr von Münchhausen was a German baron born in Bodenwerder in the eighteenth century. Made famous by the Hollywood director Terrence Gilliam, the baron first came to public attention for his ability to recount outrageously tall tales about his adventures while fighting abroad in the Russian army. Among the astounding feats which legend attributes to him are riding cannonballs and travelling to the Moon. But perhaps his best known marvel is the story of how he managed to escape from a swamp by pulling himself out by his own hair (or by his bootstraps, depending on who tells the story). Which puts me directly in mind of the way some people are now expecting an export-dependent German economy to drag the rest of Europe - and with it the whole global train - up and out of the ditch in which it is currently sunk, simply by exporting to everbody else. Sounds just like one of those tall tales, doesn't it. A very tall one.

Not to be misunderstood, there is no doubting the magnificent export achievement of the German economy in the second quarter of this year, just as there is no doubting the fact that it was helped considerably in attaining it by the impact of the Greek debt crisis, which as well as pushing the euro to a comparatively low level also helped the Japanese yen on-and-up towards record highs with the US dollar (the flight to safety), while the dollar itself was pushed back up to levels which were evidently not compatible with a smooth and orderly transition of the US economy back to growth, as can now be seen from the revised second quarter data, since the growth rate is down primarily because of an increase in the US trade deficit.

No Mean Feat

In fact Germany's economy grew by a seasonally adjusted 2.2% in the second quarter (or as some point out, at almost a 9% annual rate). Now good news is always good news, but shouldn't the very magnitude of this number in a global economy which is struggling to find its footing as it moves forward worry us just a little bit? What is the secret of this German triumph - demand elsewhere? Then where does this demand come from? Liquidity flows to Emerging Economies fuelled by low interest rates which are meant to stimulate the developed economies in which they originate? Or fiscally supported stimulus programmes in other developed economies?

Is this sustainable? Are Germany's sharp rises and sharp falls in GDP really that desireable? For just as we may now welcome the possibility that Germany's economy is possibly going to grow by some 3% in 2010, we should not forget that it actually fell by 4.7% in 2009, and we have no real idea at all by how much it may rise or fall in 2011, since that in fact depends on decisions which will be taken elsewhere.

The bottom line is that Germany's economy is now totally export dependent, and as a permanent condition that is not a desireable thing, not even for the Germans themselves, since it makes their livelihood incredibly dependent on global demand, and thus on others.

French Growth More Balanced

And here we come to one of the striking features of the present situation in Europe, which is that while we have been witnessing a great deal of attention being lauded on the recent German triumph, the French economy has ever so quietly and unobserved been busily recovering at a reasonably steady rate.

In fact, if you look at the comparative performance of the two economies over the last decade (see chart below), we find something very odd indeed - at least for the current mainstream discourse - and that is that in GDP growth terms the French economy has easily outperformed its German counterpart.

Of course, you cannot make deductions about GDP per capita from looking at crude growth numbers, since the underlying population dynamics also matter. And while Germany's population is now almost stagnant, France's is growing steadily - indeed hypothetically we could postulate that at some distant point on the horizon France will have more inhabitants than Germany. More to the point, France's population will be a lot younger, with important consequences for economic performance. But the key issue at this stage is that France, apart from exporting, also has vibrant domestic demand, and demand is one of the things everyone is short of right now, as we all busily rush to get ourselves out of debt by exporting.

The presence of autonomous domestic demand also has important consequences for long run economic stability. And this can clearly be seen in the present crisis. Thus, while in 2009 both economies slumped, the French one slumped by much less (-2.6%) than the German one (-4.7%). Naturally, in the first half of 2010 the German economy recovered much more rapidly than the French one - since there was far more lost ground" to recoup - and the German export sector is highly efficient (far more efficient than the French one) so as global demand recovered the German economy was one of the main beneficiaries.

Anyway, the net result of all these "ups and downs" is that both economies are now back more or less where they were at the end of 2006. This tells us two things. In the first place we still some have some distance to go before we can really begin to talk about "recovery" in any meaningful sense of the word. To be able to use this word we would at least need to surpass the output level attained in the first quarter of 2008, which was the last time, if you remember, that people were talking about Germany and Japan "decoupling" on the back of a rapid growth surge in Emerging Markets. In fact in that very quarter German growth shot up by 1.6% over the previous one (or 6.4% annualised, an earlier high point in the German trajectory). In fact as I wrote in my original analysis at the time:

So the bottom line is that the of the 1.5% increase in q-o-q GDP, nearly half (0.7% points) was accounted for by a growth in inventories, while 0.4% was accounted for by a growth in construction which was in part the result of better weather in January and February and scheduled work being advanced (although you can't simply add these numbers since some of the construction work may well have accumulated in inventories), while the net impact of external trade slowed, and household consumption only accounted for 0.2% points. So basically it would be far from in order to announce this result as strong evidence for anything about the Germany economy at this point, other than that the economy resisted a strong slowdown in Q1. The data from Q2 should make all of this much clearer, I think, we will see what gets to happen to the inventories, and we will see what happens to construction.

By July the ZEW investor sentiment index (which could be seen as a predictor of economic activity six months forward) had fallen to a 16 year low, and I was forwarning - "what is the recession risk for the German economy?" - at a time when few others were prepared to accept the fact that a serious German recession might be on the agenda. At this point I would not be so categorical. It is evident that Germany might once more enter recession in the fourth quarter of this year, but it is far from clear that it will, since as I keep saying, to forecast what is going to happen in Germany you need to be able to see what is going to happen in the rest of the world, and this is by no means clear at this point. Here I simply want to make the point that the answer to this question is not to be found in Germany, or in anything the Germans themselves may or may not do, but in the rate of growth to be found among their key customers, many of which are now Emerging Economies. This is what export dependence means.

All The Stars In Alignment

Coming back to the present, and Q2 2010, one thing we can say about is that it saw a very interesting confluence of factors.

Effectively, if you look at the above chart, all the dials were on green during the quarter, with each of the key components - household spending, capital investment, net exports and construction - all showing growth. A good constellation of stars in alignment then. But this favourable configuration will not, of course, be permanently maintained. In the first place, if we take private consumption, German private consumption really peaked in the last quarter of 2006 (see chart below) for reasons which have little to do with the recent crisis - the German government raised VAT by 3% in January 2007, and German consumption growth, which was already quite weak, received a final from which it has never really recovered.

Of course, German consumption hasn't always been weak. Between 1990 and 2000 it grew rapidly, but then it suddenly "maxed out" as can be seen from this Bloomberg chart.

And Germany hasn't always run a current account deficit (that is to say, the high saving phenomenon is not simply cultural). During all those years of strong private consumption growth Germany was, in fact, running a (small) current deficit. Indeed, between 1991 and 2000 Germany did not have one single year where she produced a current account surplus.

And just what was the median age of the German population in that fateful year of 2000, when the German economy metamorphosised from being a domestic-consumption-driven current-account-deficit one to an export driven current account surplus one? Well you could have guessed it, 40, exactly the age that my rough-and-ready, back-of-the-envelope, home-made model suggests we should find a transformation, or "tipping point".

Another favourable factor in Q2 2010 was fixed capital formation, part of which is machinery and equipment (where some investment has taken place), and the other part is construction where, just as in 2008, a number of factors associated with the weather have served to produce an exceptional reading (see chart). Very bad weather in the first quarter lead to an exceptionally low reading, while there was then a stronger than normal rebound in the second quarter.

In addition both inventories and net exports were positive. Inventories here are something of the wild card, since the level of inventory building depends on the outlook for sales, so in periods of uncertainty (and none other than Jean Claude Trichet was busy saying in Jackson Hole only last week that we currently living with "a degree of uncertainty in the economic and financial sphere" is "largely unprecedented") these can be quite volatile. I had been expecting a significant increase in German inventories, but this didn't materialise, and we had only a very timid increase. This is hard to interpret, but it could wel be that in Q3 levels will be reduced if the outlook continues to deteriorate and orders don't pick up.

Liquidity To The Right Of Us, Stimulus To The Left Of Us

Exports of goods and services rose by 8.2% during the second quarter (an annual pace of nearly 35% ) - which was of course a very impressive performance, but so impressive that it is clearly not sustainable. The most important customers for German exports in June (when they were up by an annual 28%) were the rest of the European Union (which accounted for half of the export growth - other people's fiscal deficits and stimulus programmes), followed by Asia (which with contributed 6.9 percentage points to that 28% - or one quarter of the total - to the rise), and half of the Asian contribution came from China. The US only added 2.4 percentage points - or around one tenth - to total export growth. So Emerging Markets now clearly outweigh the Euro Area (which contributed 5 percentage points or one fifth of the growth), as Morgan Stanley's Elga Bartsch makes plain in the chart below.

So German export growth at this point in time would seem to depend critically on liquidity flows to emerging markets, and stimulus programmes in developed economies. The liquidity flows depend on the continuation of Quantitative Easing at the Bank of Japan, the Federal Reserve and the ECB, while the stimulus programmes depend on countries not applying the fiscal austerity measures that Angela Merkel herself has been advocating. Thus would our erstwhile Baron drag us all out of that ditch into which we have all so carelessly fallen.

Enthusiasm Unbounded

Curiously, none of this does that much to dampen enthusiasm for the new momentum some feel they can perceive in the German economy. As the Financial Times put it - in an editorial entitled "Euro’s locomotive is puffing again" (strange this fascination with the age of steam engines, and toy trains, now isn't it?):

"Germany’s sudden rediscovery of its old role as Europe’s growth locomotive brings the continent back to the future. The 2.2 per cent growth spurt is unified Germany’s best-ever performance. It was not entirely unexpected: trade figures early in the week led economists to predict good news from Berlin. But the outcome was almost a full percentage point above estimates, and helped lift the euro-wide rate".
But, as is by now well know, what the lord giveth with one hand the lord also taketh just as quickly away with the other:
"Germany’s feat is a one-off: sustained 9 per cent yearly growth rates are unheard of in rich countries. Slowdowns in China or the US may well throw cold water on exporters. Europe’s industrial production is already flatlining. And we must not forget how bad things still are: although the second quarter put German output 4.2 per cent above its low point in the crisis, it is still lower than in 2007".
Valentina Romei, in an article entitled "Economic Outlook: Indices to confirm German ascendancy" (published just before the August Flash PMI report), went rather further in proclaiming the current German "renaissance":
"Germany has outperformed the US, the world’s largest economy, in terms of growth in recent months and the trend is set to be confirmed this week. The German purchasing managers’ indices are expected by HSBC to remain at relatively high levels, while US economic growth is likely to be revised downwards".

"Economists say that the slowdown in the recovery in Asia and in the US, and the difficulties in other parts of Europe, could soon have an impact on German growth, which is largely export-driven. However, signs of improving domestic consumer confidence in Germany, and in Europe generally, portray a stable overall scenario".
Of course, the data releases did confirm the continuing high level of German activity, and the downward revision in US GDP - although as Valentina Romei meticulously fails to point out, the downward revision was due to a deterioration in the country's net trade position, as more imports flowed in (from where, I wonder?). Curiously, the PMI data she referred to showed France's manufacturing industry expanding more rapidly and Germany's slowing slightly, but I still haven't found anyone speaking of that new French ascendancy as the Gallic locomotive steams ahead, nor any similar such drivel.

Why The Obsession With The French Deficit?

But still, as I say, France's economy is more balanced, and France is running a (smallish) trade deficit, which is arguably marginally more supportive of both European and global growth. The day the German economy runs a current account deficit again, the very same day the economy will start to fold in on itself, and that's one robustness test it is sure to fail.

But what is so peculiar is that all we seem to hear about France is how she needs to get her deficit under control. And we are talking here of a deficit which, as I say, is helping to sustain demand for products produced elsewhere, and keep that German locomotive puffing away. And if we come to the general topic of endebtedness, neither France's government nor her private sector are among the most seriously at risk. The French banking sector was much more prudent during the boom years, and neither French households nor French corporates are hopelessly in debt. Yet the French administration seems to be under almost perpetual attack, as the Financial Times reports:

Christine Lagarde, French finance minister, on Sunday hit back at critics of the government’s plans to meet its deficit targets, accusing markets of failing to give Paris credit for two years of reform. Speaking to the Financial Times after the government last week reduced its forecasts for growth next year from 2.5 per cent to 2 per cent, Ms Lagarde denied the new estimate remained overly optimistic.

“It is realistic and prudent,” she said, adding that even if the market consensus of 1.5 per cent growth was revised upwards, it would “not grant much credit to the reforms we have implemented and to the added flexibility in the economy”. France had been criticised by the International Monetary Fund and the European Commission for basing its pledge to cut the deficit from 8 per cent to 6 per cent of gross domestic product next year on unrealistic growth forecasts of 2.5 per cent.

Look, sometimes I have difficulty believing what I am reading here. This "criticism" coming from an IMF and and EU Commission who are more or less swallowing wholesale the most ridiculously optimistic growth forecasts from the Spanish government, who evidently also have a much higher level of deficit, and a much more serious economic situation to contend with is almost beyond belief. Is so little macroeconomics understood out there? To be explicit, I have no interest in defending either of the main French political parties, or the current state of the game in the French labour market, or even the absence of reform in the French pension system.

But why, just now, are we seeing all this pressure on Christine Lagarde, and by implication, of course, on Nicolas Sarkozy. Why is almost everything we here about what is going on in France negative, and why does no one ever value the point that, at least in terms of family friendly economic policy they are streets ahead of most other Euro Area countries. Do people imagine that this doesn't matter, and that you can blithely go forward funding generous pension systems whatever your elderly dependency ratio?

Just one little detail. Dominique Strauss Kahn is head of the IMF, and a potential candidate for the French presidential elections due next year: there couldn't possibly be more than meets the eye going on here, could there? (What a wicked mind I have).

To speak plainly, if we make the sort of assumptions which are being made about recovery in all other Euro Area countries, then I personally don't find a 2.5% growth forecast for France in 2011 particularly exaggerated. Of course, if there is a global double dip, and renewed financial stress, then all bets are off. But this applies to everyone, so why single out France? Why are countries like Spain, Hungary, Latvia etc being cut so much slack in the generosity of their forecasts, and France being castigised so?

I mean, if we look at the chart below, France's long term growth rate is quite stable, and somewhere around the 2% mark. And if we assume that ECB interest rate policy is going to remain accommodative in 2011 (a reasonable assumption when we look at the number of patients in the "intensive care" ward), then 2011 could easily see French growth slightly above par.

On the other hand Germany's long term growth rate has been falling steadily since the early 1990s, and the ten year average in 2010 is something like 0.8% a year, which is more or less Germany's sustainable trend growth rate at this point.

Personally, I can't help reaching the conclusion that there is a huge bout of hypocrisy going the rounds at the moment. For example, as reported in FT Alphaville:

"The bailout of Germany’s banking sector may swell the country’s public debt rate to 90% of gross domestic product, Die Zeit weekly newspaper reported on Wednesday. The weekly based this estimate on a recent decision by Eurostat requiring Germany to include the balance sheets of public-owned bad banks — set up to help financial institutions offload toxic and non-strategic assets — into its overall debt ratio".
This situation is getting surprisingly little coverage. And of course, we could see more situations like that of WestLB and Hypo given the extent of German bank exposure to the Spanish debacle. In fact, the underlying demographic pressure on Germany's very expensive pension and health systems constitutes a serious long term worry about a debt to GDP level which is now creeping dangerously near to the 100% threshold.

Short Memory Spans?

And people have short memories. Back in 2008, in the early days of the current economic crisis, Chancellor Angela Merkel's bi-party cabinet pushed through a 1.1 per cent increase pensions. The increase, which included a further 2 per cent rise for 2009, had an estimated cost of €12bn by 2013 - a cost which will largely be borne by companies and younger people via higher insurance contributions.

Then in 2009, the very same cabinet adopted a permanent ban on pension cuts, effectively shielding the country's 20 million pensioners (who might have faced old-age benefit cuts starting this year) from the effect of the economic crisis. But given the extremely low German long term birth rate, wouldn't it have been better to shield some of those young couples who want to have children from some of the negative effects of the crisis in a way that enabled them to push the up the number of children the country has. Isn't it better to invest in the future, than invest in the past?

Naturally the move shocked German public finance economists, who were worried that Berlin's precipitate partial dismantling of decade-old reforms in the social security system could leave future governments facing painful choices between drastic benefit cuts or further tax and contribution increases to finance the weakened system. "We had almost fixed the pension system. We had made it demography-proof and business-cycle-proof," Bernd Raffelhüschen, professor of economics at Freiburg University, said at the time, "In fact, we had a buffer. The pension system could have gone through the crisis. Now we are back to the drawing board."

"What the government did decouple pensions from wages," according to Karl Brenke, a labour market expert at the DIW economic institute in Berlin. "This is something no government had been irresponsible enough to do for the past 30 years."

Since 2001 the value of benefits that German pensioners receive had been indexed to wages. But last year's move broke the link and means pension payments will only ever go up, removing the mechanism that would have reduced payments if and when contributions to pension funds are reduced. The only way to compensate for this is via tax hikes (not VAT again, please!) or increased contributions, the main burden of which will fall on the countries ever less numerous younger population cohorts. Gerontocracy anyone?

In conclusion then, my intent here is not to mount some sort of "anti German" diatribe. Far from it. It is to mount a diatribe against a discourse which seems to me to be extraordinarily biased, and extraordinarily short sighted. German economy and society is facing long term issues and long term problems which it seems to me need to be addressed now, and not ignored by deflecting attention onto France. That German output levels are far more volatile than French ones, is not opinion, it is fact. Fact which unfortunately is all too likely to find itself confirmed yet one more time as we approach the end of this year.

Friday, August 27, 2010

Estonia's Long Awaited Recovery May Still Be Delayed Yet Awhile

by Edward Hugh: Barcelona

In a recent FT Op-ed, entitled "Estonia’s recovery defies economists and academics", columnist John Dizard argued that "the “internal devaluation” policy, which means cuts in nominal costs such as wages and rents, was very hard on the population, but appears to have worked ahead of even the Estonian government’s schedule".

But as I said to John in a very enjoyable phone conversation I had with him before he wrote the piece (where he was kind enough to descibe me as a "freelance economist", one who doesn't have to answer to a boss before expressing an opinion), perhaps we should just hold on a minute before jumping to too many conclusions, since things are still far from clear. So let's take a look.

As John points out, many macro economists, among them me myself (here, and here, and here) and Paul Krugman (here) have been arguing that if the Baltic countries stick to their policy of having a fixed exchange rate with the euro, they face a long period of low growth and serious internal deflation. At the start of this debate, I pointed out that the impact of price deflation on the bank loan books would be just the same with or without devaluation: not so, said Krugman (and he was right), the impact is worse, since even the Kroon or Lati denominated loans (which in truth are quite few) are affected.

John however, does not agree, since, he tells us, the country is "stubbornly failing to comply with the predictions of what are called the 'third generation models' for currency crises" and "is already seeing a resumption of growth and a fall in its real cost of capital".

Well, as I told John at the time, the Estonian case is a complex one, since in a country with only just over a million people a myriad of special case factors can be at work, confounding results. But still, the idea is abroad that Estonia is a kind of "black swan", a data point which tends to suggest that conventional macro economic wisdom is somehow flawed. So just how valid is this view. Let's take a look at some data.

In the first place, John is undoubtedly right, economic activity has revived (slightly) in Estonia. In Q2 2010 the economy grew by a seasonally adjusted 2%, following an equivalent contraction in Q1 and growth of 2.6% in Q4 2010 (yes these are quarterly, not annual, numbers).

So the first thing to say is that if these numbers are truly well adjusted seasonally (which make be hard given the boom bust background, and the amplitude of the movement in the data) what we have is a lot of volatility out there. And in the second place, we could well ask ourselves to what extent it is valid to use that so-oft maligned expression "recovery" at this point in the Estonian context. If we look at the GDP volume index (which I have put in 4 quarter moving average format), you have to look very hard indeed (go on, squint a bit more) to actually see the uptick.

I tell you what, I'll do you all a favour, and shorten the time series and change the scale.

Well, that's a bit clearer, isn't it. I think what you can say looking at this chart is that the Estonian economy has been stabilised (no mean feat that, with an economy in freefall), but what happens next, well that, it seems to me, you can't discern from looking at the chart. To decide on that, I think, you will probably need to go back to the initial assessment you had of the problem. If, like John, you believed that what the Estonians were trying was doable, then you will probably draw the conclusion that what comes next will (eventually) be a recovery. If, like me, you had severe doubts from the outset that this was doable, then you will probably imagine the Estonians are now in for a long period of slow, "L shaped" semi-recovery, with a lot of pain still to come, further down the road. But as I say, all of these expectations probably depend on your initial theoretical assumptions (more on this later), and in that sense nothing has fundamentally changed.

That being said, there are some things that have improved in recent months. Retail sales for example.

And then there is industrial output, which is up sharply. It even almost looks like the fist leg of one of those proverbial "Vs".

And part of the reason for this improvement in output has been the recent improvement in demand for Estonian exports.

But before we get too excited about all this, we should remember that Estonia still has a goods trade deficit. That is, on balance, the net goods trade is a drag on GDP.

The problem is that the part of Estonian industry which was internationally competitive before the bust still is, but that this part is not large enough to drive the whole economy, now that the economy is export dependent. It just doesn't have a big enough share in GDP to carry the whole economy. As the Estonian statistics office put it: "GDP growth in the 2nd quarter was supported by the industrial sector exports. Due to a small domestic demand, the sales of manufacturing production on the domestic market were in downtrend. In construction, the output of which is mainly targeted at the domestic market, the generated value added showed a continuous decreasing trend".

This is what I had always expected would be the case.

It should be noted that Estonia runs a substantial services surplus, which at the present time easily cancels out the goods trade deficit. As a result, and this IS the good news, Estonia now runs a current account surplus. Which means that each month now, instead of getting more into debt, the country is steadily paying down its international liabilities. And this is important, since as John points out, Estonia is considerably less indebted externally than many other of Europe's peripheral economies, with net external debt according to IMF data only being some 30% of GDP.

But nonetheless, achieving this positive situation still has a price, and that price is that the economy is being forced to operate at well below capacity level, and the clearest indication of this is the very high continuing level of unemployment. In fact, I think John got interested in his story when he read this report, that the registered unemployment rate in Estonia fell to 12% in mid-July. Since he was aware that first quarter unemployment was somewhere around 19%, this seemed to him like a dramatic drop. But there is a confusion here, since we are dealing with two different measures of unemployment, one of them people who sign at labour exchanges to register as unemployed (and may do so because they have entitlement to unemployment benefit), and those assumed to be really unemployed when measured using ILO compatible (and EU harmonised) quarterly labour force surveys, and as this article points out, according to the latest of these surveys (April - June) there were still 128,000 unemployed, or 18.6 percent of the workforce out of work in June.

Of course, interpreting such data presents its own problems, and the issue is a complicated one, since in the first place there seems to be a large shadow economy in Estonia. According to Professor Friedrich Schneider of Austria's Linz University, based on a study that covered 37 countries, Estonia had the second largest proportion of GDP in the informal economy, with some 40% not paying tax. Top of the list was Latvia, with shadow economy accounting for 42% of the country's GDP, then came Estonia, Bulgaria, Turkey and Greece. So of course, not all those who are not signing the registers are necessarily unemployed, or in the country even, but still people are dropping out of the statistical system, according to the Estonian Health Insurance Fund some 20,000 less people are registered for health cover today than there were in March 2008. At the very least we can assume these people are not working in the formal economy or registering for welfare benefits. Whether they are working in the informal one, or working abroad, we really have no idea.

Be that as it may, according to the Estonian Statistics Office, in the 2nd quarter of 2010 the estimated number of unemployed in Estonia was 128,000 and the unemployment rate was a - seasonally not adjusted - 18.6%. So unemployment did decrease in the quarter for the first time in nearly two years, but by 1.2% (from 19.8% in Q1), and not by the rather large amount it might appear from the labour exchange registration data.

And if you go to the details of the stats office report the situation is more complex than it seems at first sight, since while the number of new unemployed has been declining, long-term unemployment continues to grow. In the 2nd quarter, 58,000 unemployed persons had been looking for a job for one year or more (long-term unemployed), of whom 19,000 had been looking for a job for two years or more (very long-term unemployed). The share of long-term unemployed among total unemployed increased to 46%, while the share of very long-term unemployed rose to 15%. The number of persons who had stopped seeking a job or discouraged persons was also larger in the 2nd quarter than in the 1st (9,000 and 7,000 respectively).

On the other hand the estimated number of employed persons was 559,000, which was up by 5,000 (0.9%) over the previous quarter. According to the statistics office, "employment increased due to seasonal and other temporary jobs typical of the 2nd quarter". Nonetheless there was employment growth, so we should be thankful for any mercy, however small. What remains to be seen is whether this improvement in employment is sustainable as Europe's economies slow going into the second half of the year.

A further bone of contention between the parties evidently concerns the so-called “internal devaluation” policy being applied by the Estonian government. As John Dizzard explains such a policy "means cuts in nominal costs such as wages and rents, (and) was very hard on the population, but appears to have worked ahead of even the Estonian government’s schedule".

When we come to scrutinise the actual data however, the fall in hourly wages has hardly been dramatic, and they have now fallen about 7% from their peak at the end of 2008. But it should be remembered in 2008 they were up by around 7%, so they are now at about the same level as they were in January 2008, following increases of 17.5% in 2006 and 20% in 2007 - rates of increase which ultimately lead to the consumption bust which followed them, and clearly not sustainable in the longer term. So, unfortunately it is just not the case that Estonia has had a very harsh policy of wage cost reduction implemented. Living standards have fallen sharply, due to the reduced hours worked, and the rapid rise in unemployment - ie due to the recession - but that is not the same thing at all as recovering lost competitiveness.

The Real Effective Exchange Rate data on all this is very clear. Up to 2005 the rise in living standards was more or less in line with sustainable economic growth. From 2006 onwards things really got out of hand, and to date only a very small part of the competitiveness loss has been clawed back.

This intrepretation is confirmed by an inspection of the CPI data, which after 9 months of registering mild interannual deflation is now back in positive territory, and more or less a full percentage point above the Eurozone average, which for a country which is supposed to be in the throes of a substantial "internal devaluation" is pretty incredible, and could be seen as another example of someone or other falling asleep at the wheel, after passing the finishing line for Eurozone membership perhaps.

John Dizzard argues that the Estonians are in position for a relatively rapid recovery (this part I don't see at all, anywhere in the data) because they started out with much less state and private debt than the others. This latter point is certainly true, but we should not miss the fact that while Estonia's state debt is very, very small, private sector debt (at around 100% of GDP, between households and corporates) is not so small, and indeed will continue to exert a significant downward pressure on credit growth for some time to come.

Now one of the points raised by John which does have a certain validity is that of lower capital costs. Given the existence of significant quantities of land and warehouse and factory accommodation which are now surplus to requirement due to the "downsizing" which has been going on (creative destruction) employers do now have access to cheaper premisses, and this can offer them lower unit costs for a given level of technology and output. The key point to get here is where the demand is going to come from, and then we are still back with the same issue: exports.

More than the internal devaluation itself, Estonia is benefitting from the decision to grant the country Euro membership. As a result the cost of servicing oustanding debt has falling, as have credit default swap spreads. John quotes one large shareholder in several Estonian companies as saying, “At the beginning of 2009, the banks were offering our companies loans at 600 to 700 basis points above six-month euribor [the euro base rate]. That’s if the money was available at all; most of the time they were cutting lines. Now the banks are offering the same companies increased lines at 100 to 300 basis points over euribor.”

But if we come to look at the impact of this cheap credit, we will see that, as in other economies where private demand is highly leveraged (the UK, the US, Spain), the uptake on all this ultra cheap credit has not exactly been massive. In both cases the interannual rates of credit growth are still negative, which is one of the key reasons domestic demand remains so weak.

Although we can see the first timid signs of recovery in the housing market, both in terms of sales volume and in terms of prices, but at this point they are just this, timid signs.

So to go back to where we started, and John Dizzard's claim that "Estonia’s recovery defies economists and academics", I would say that rather than economists and academics (or even academic economists) who Estonia's current situation does really defy is the group of people over at the ECB governing council headed by Jürgen Stark, since, as I reported back in April, consensus thinking at the ECB was that Estonia was not coming into the common currency , due to ongoing concerns about sustainability and competitiveness issues.

But that was April, and then came May, when the ECB was forced to do a "U turn" by the crushing pressure of the European Sovereign Debt Crisis, so all these (valid in my view) concerns where simply brushed aside. And anyway, how could anyone argue for keeping Estonia out on these grounds, when you have countries like Spain and Portugal on the inside. Either internal devaluation works, or....

So maybe it was better for them to stay with the line that internal devaluation works, and whether they are right or not is what we are all about to get to see. As I said at that start the post, in this case as in so many others, beauty is in the eye of the beholder. If you believe in the neo classical (academic) theory of "steady state" growth - and the guy over at Swedbank that John cites who is forecasting that Estonian gross domestic product will grow at a 4.5 per cent rate next year evidently does - then naturally Estonia's economy has only been temporarily knocked off its path by this whole unfortnate incident, and will soon be back in it habitual orbit.

If, however, like me you suspect that neo-classical steady state growth is some sort of metaphysical hocus pocus (or what they call a "necessary assumption to get the argument going") with little empirical support, then you will not be terribly convinced by all those numbers blindly and slavishly churned out by the current generation of models, and will look more to the facts on the ground. In particular, when we come to the neo classical growth theories which normally underpin the sort of optimistic analyses we see of the Estonia situation (yes John, there are academic economists on both sides), I tend to think these are flawed due to some initial erroneous assumtions Solow himself made about the impact of population dynamics on growth (see this extended argument here), and I think it is important to remember here that Estonia, along with Hungary, Latvia and Bulgaria, is one of the countries on Europe's Eastern flank where population as well as ageing is actually falling. So I suggest you treat any analysis which talks about a steady recovery in internal demand but does not explicitly explain how this point has been taken into account....... well I suggest you treat it with more than a pinch of salt.

And then, of course, there is the idea of "export dependence" and ageing, and what this all means for the future trajectory of the Estonian economy. This argument, which Claus Vistesen and I have been advancing for some years now (and is one of the reasons so many of those famous "predictions" turn out to be valid), shot to the financial headlines recently when Dominic Wilson and Swarnali Ahmed of Goldman Sachs drew the obvious to everyone's attention - namely that balance of payments current accounts are significantly driven by life cycle savings. Maybe you can argue about the validity of the age group classifiaction they use (an empirical calibration issue), but the obvious is obvious: the relative proportions of different age groups across different countries goes a long way to explaining the pattern of global savings and capital flows. And as Claus Vistesen illustrated in the chart below, this helps us understand how societies (Germany, Japan...) become increasingly export dependent as they age.

So, as I said earlier, your expectations about the future outlook for the Estonian economy will largely depend on the initial theoretical assumptions you make at the outset. If you assume that neo classical steady state growth really exists, and that all this stuff about ageing, capital flows and export dependence is exaggerated, then you will see the recovery coming in the here and now, and if you don't.........