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Monday, May 28, 2007

Macroeconomic Adjustment in the Euro Area: The Irish Case

by Edward Hugh: Barcelona

Following Manuel's last post, and the fact that Ireland is to some extent in the news this week, I thought some consideration of the recent dynamics of the Irish economy might be in order here on GEM. In order to begin to contextualise and address what has been happening in Ireland I have been reading through Chapter Two of the recent European Economic Advisory Group (EEAG) report on the European Economy 2007. The chapter, which is entitled Macroeconomic adjustment in the Euro Area: the Cases of Ireland and Italy, asks a number of important questions and makes for interesting reading.

The starting point for the chapter is a most pertinent question: six years after the introduction of the common currency, why do important differences in response to the application of a common monetary policy continue to exist across the eurozone? Indeed, on some readings, one might ask why these differences seem to be increasing rather than diminishing, or put another why, why do several significant eurozone economies appear to be diverging, rather than converging. To be sure some differential response among countries to the impact of asymmetric shocks was already anticipated at the outset, but it was always imagined that these differences would diminish and not increase with time. In the same way it was always anticipated that some sort of internal price convergence process would take place, but again this was always expected to settle down with time. Most recent evidence however continues to suggest that there are significant differences between zone economies in the way in which they respond to what is effectively one and the same monetary policy (even though its impact in real interest rate terms obviously differs between zone members as a function of differences in the underlying inflation rate, a fact which, in reality, only poses the same question at one remove, why should we see such a large spread in inflation rates continuing across time?) This conundrum is then the context in which the EEAG sets its comparison.

At the outset of the report the EEAG spell out and make explicit an assumption on which most traditional analyses of adjustment processes within a monetary union have been based.

"In a monetary union among countries with fully flexible prices and wages (and efficient financial markets), an asymmetric demand boom in a country would lead to an increase in the price and wage levels there, reflecting the relative scarcity of its domestic output."

Now this assumption, whilst not being exactly false, does at least seem to be inadequate and in need of revision in the new global economic climate in which we live. One of the key reasons why this "old" approach now seems so questionable (at least in its crude formulation) is the fact that it does not seem to have taken into account the way in which the globalisation of labour and capital supplies may have changed things. The key issue here would be the underlying notion of "capacity" on which it is based, and the extent to which such traditional notions of capacity (and thus of "overheating") remain valid today.

Perhaps the first person to raise this question in any systematic way was Richard Fisher of the Dallas Federal Reserve, and this early speech of his still makes interesting reading. As Fisher says:

Globalization is an ecosystem in which economic potential is no longer defined or contained by political and geographic boundaries. Economic activity knows no bounds in a globalized economy. A globalized world is one where goods, services, financial capital,machinery, money, workers and ideas migrate to wherever they are most valued and can work together most efficiently,flexibly and securely.

Now, as Fisher asks, "Where exactly does monetary policy come into play in this world?" Well let's see:

The language of Fedspeak is full of sacrosanct terms such as “output gap” and “capacity constraints” and “the natural rate of unemployment,” known by its successor acronym, “NAIRU,” the non-accelerating inflation rate of unemployment. Central bankers want GDP to run at no more than its theoretical limit, for exceeding that limit for long might stoke the fires of inflation. They do not wish to strain the economy’s capacity to produce. One key capacity factor is the labor pool. There is a shibboleth known as the Phillips curve, which posits that beyond a certain point too much employment ignites demand for greater pay, with eventual inflationary consequences for the entire economy.

I cite Fisher at length here, since he does seem to be directly challenging the kind of assumption - as spelt out by the EEAG - which I am drawing attention to. As he goes on to say: "Until only recently, the econometric calculations of the various capacity constraints and gaps of the U.S. economy were based on assumptions of a world that exists no more". A world that exists no more. Please note. (A good summary of the kind of argumentation that lies behind Fisher's approach can be found in the central chapter of the Dallas Fed 2006 Annual Report - Globalizing the Knowledge Economy).

Now, to qualify what I am saying a little, the issue is not that individual domestic economies are not subject to price and wage rises following surges in domestic demand, but that they are not subject to these to anything like the degree they used to be, and unless allowance for the extent of this change is made in the econometric models used, then traditional notions of "capacity" are likely to lead you well wide of the mark in looking at the impacts of monetary policy changes, since capacity itself has become much more elusive and elastic, and it is this very elasticity - ie the capacity for local economies to draw on large pools of underutilized labour, and over long distances, and avail themselves of the increased (and normally cheaper) supplies of capital which are available through global financial markets (and of course in the eurozone context the European capital markets themselves) - which means they are able to respond to rapid increases in demand without the normal wage and prices pressures coming into play to anything like the extent that they once did.

In this post (which which I hope will be followed by two more, one on Italy, and one attempting to spell out what I think can be learned from making this comparison) I will follow the EEAG lead, and begin the process of looking at two eurozone countries as case studies (Ireland and Italy) of a somewhat more general phenomenon - and in particular to ask the question what exactly "capacity" means and implies in each of these cases, and just how has the application of a single interest rate by the ECB affected the ongoing capacity of each of the economies concerned. So now, and without more ado, let's take a look at Ireland.

Europe's Celtic Tiger?

According to the EEAG report:

"Ireland entered the euro area well into a sustained period of economic expansion marked by profound changes in the structure of the economy and its place in the global economy".

As can be seen from the chart below, Ireland has enjoyed quite high rates of GDP growth in recent years:

This process has seen a rapid rise in per-capita incomes, and a dramatic fall in the level of unemployment. Interestingly this rapid economic development upswing coincided with a process known to economists as the demographic dividend, as I note in this post on "the Celtic tiger".

The process of monetary union produced a strong monetary stimulus in the Irish context, as the report indicates:

The most apparent and controversial source of macroeconomic imbalance for Ireland has instead been the strong monetary stimulus since the end of the 1990s, when European monetary policies became strictly coordinated in the last stage of nominal convergence before the introduction of the euro. (Soon afterwards, the monetary stimulus was compounded by a weakening currency.)

Now as the report goes on to say, this monetary stimulus was required to meet the needs (low growth rates, sluggish internal demand) of other eurozone members (among them Italy, but also importantly Germany), even though it was arguably (at least in classic terms) inappropriate in the Irish context:

A relatively loose monetary stance was motivated by the cyclical conditions in the euro area as a whole, but arguably inappropriate forIreland: It created undue demand pressures in the Irish economy.

Now on the traditional account, the presence of such "undue" demand should have lead the Irish economy to "overheat", producing in its wake a growing inflationary wage price spiral., and indeed on conventional measures this was what was happening. But does this view correspond to the Irish reality?

True the Irish economy has had noticeably higher inflation rates than the EU average in recent years, but this process has hardly spiraled out of control.

Indeed if we look at the chart below, we will see that hourly labour costs in manufacturing in Ireland are still in the lower end of the eurozone range:

So - despite the fact that there has been a substantial rise in wage costs (from a very low level) if we allow for some measure of eurozone price and wage convergence over time, the general impact does not seem to have have been to force up prices and wages to such an extent that the Irish economy became uncompetitive. Curiously, if we look at the official Irish CPI, we will find that this actually trended down during the first years of the century, moving from an annual rate of 4.7% in 2002, to 3.5% in 2003, 2.2% in 2004, 2.4% in 2005, and only turning up again to 3.9% in 2006, a move which seems to have been associated with the fact that mortgage interest payments are included in the Irish CPI calculations. This hardly constitutes strong evidence of an inflation-push process fuelled by overheating, and especially not in view of the very rapid rates of GDP growth which Ireland was experiencing. So what happened?

Well, in a nutshell, Ireland got immigration, bigtime, and the combination of this with a ready supply of cheap capital seems to have maintained Ireland on what might be considered to be a sustainable path. The general trend in migratory flows can be seen in the chart below, but as an indication it could be noted that in 2006, 86,900 people immigrated into Ireland, the equivalent of 2.1 percent of the Irish population and 4.1 percent of the labour force.

As the February 2007 reprt of the Economist Intelligence Unit notes:

Ireland’s labour force totalled 2,178,100 in the third quarter, a year-on-year increase of 4.4% or 92,000. This is extremely high by international standards the most recent EU-wide data relate to the second quarter of 2006 and put Ireland’s rate of labour-force expansion at 4.6%, almost four times the EU average of 1.2%. Immigration has been a crucial factor in this. Demographic change accounted for three-quarters (or 69,100) of the Irish labour force’s growth in the year to the third quarter of 2006, and immigration accounted for 70% of this figure. The remaining, non-demographic increase in the labour force reflects continued increases in the participation rate, which rose from 63.2 to 64.1 between the third quarters of 2005 and 2006.

So in part recent growth in the Irish economy has been facilitated by growth in the domestic availability of labour (whether through the arrival in the labour market of Ireland's still relatively numerous young cohorts - given Ireland's comparatively strong recent fertility levels - and through an increase in participation rates, both of these factors forming part of the underlying demographic dividend process) and via the arrival of migrant labour on a very large (indeed almost unprecedented) scale.

Returning to the EEAG report, they go on to argue:

In principle, a strong demand expansion should have created a severe labour shortage.But the booming economy stimulated a strong migratory inflow, with two major effects: first, the increasing supply of labour contained upward pressures on wages somewhat, especially in low-skill occupations.8 Second, the additional workers in the economy raised aggregate demand, reinforcing the expansionary macroeconomic stance for the economy as a whole. Since the availability of jobs acts as a strong driving force for migratory decisions, a sustained economic boom created incentives for further migration.

So the low interest rate environment created a migratory flow which had an important multiplier effect (in classic Keynesian terms). And indeed the report concedes that while:

"adjustment (to the monetary shock) seems to have worked as predicted by theory.... the....overall expansionary policy mix caused real appreciation, although adjustment through wages and labour costs was arguably contained because the strong migratory inflow reduced excess demand in the labour market.

My feeling is that the whole classic account of monetary shock adjustment is rather more challenged by all of this that the EEAG seem to realise, but still.

On the other hand the capital required to enable domestic output to expand so rapidly was readily available internationally, and at remarkably low rates of interest given the presence of the single size for all euro environment. Some evidence of the extent to which the Irish business sector - and indirectly Irish mortgage borrowers - have had access to global found in the graph below, where it can be seen that there has been a very rapid growth in foreign borrowing by Irish banks to finance domestic lending. Since the end of the last century bank borrowing from abroad to on-lend to Irish residents has soared from 10% to 41% of GDP.

Ok, so what I think is now clear is that if Ireland has had an unprecedented economic boom in recent years, it is in part because the "spare" capacity was available (elsewhere). But what about the growth itself. What were the structural drivers?

Well first and foremost, domestic consumption (and the associated consumer indebtedness) has been a significant component.

Private consumption has been growing strongly in recent years, but beginning in the third quarter of 2006 it has been easing back (showing a year-on-year increase of 4.5%, its lowest level since the final quarter of 2004), a sharp drop from the 7.1% recorded in the second quarter.

Well clearly the boom in the housing sector has been an important part of this process. As the Economist Intelligence Unit note (2007) "Residential property prices in Ireland have risen more rapidly than in any other developed world economy over the past decade". Using conventional terminology they then go on to say:

"However, given that the increase in supply of new housing has been just as phenomenal, such rises appear unjustified by the fundamentals (the number of annual housing completions is almost five times that of the early 1990s. this compares with largely static output in the euro area and the UK)."

Really I feel this type of response simply begs the question, whether or not this housing surge is justified by "fundamentals" is in part a question of determining just what these fundamentals really are, and about how well we are actually measuring them, not to mention how fluid they may have become, and whether they are not now something of a moving goalpost, at least in the Irish context.

Certainly, as the EIU suggests, housing growth has been "phenomenal". One indication of this is the the fact that almost a third of the current housing stock has been built since 1990, so Ireland now has the lowest average age of dwellings in the EU (something which we ought not to find *so* surprising since with a median age of only 34 Ireland is still far and away the youngest society in the EU). Annual completions have been running 3.5 times what they were a decade ago and the country has the highest per capita building rate in the EU. But the real issue is, going forward, just how sustainable is all of this? But first,let's take a look at a chart (below) which identifies the impact on house prices of all this construction activity:

Now one of the most interesting things to note from the chart is that the largest spurt in price increases seems to have taken place in the 1997-99 period (ie before the official introduction of the euro, and before perhaps the more flexible supply of migrant labour and capital became available). A second (smaller) spike seems to have occurred after 2003, but it has not been anything like so dramatic. On the back of the most recent round of interest rate tightening from the ECB housing activity in Ireland has been slowing notably and indeed the average price paid for a house in Ireland in March 2007 was 2,007 euros less than the average price paid in February according to the latest edition of the permanent tsb /ESRI House Price Index. This is equivalent to a decline in national prices of 0.6% month on month. This is the first reduction in national house prices since January 2002, when prices declined by 0.9%. In the first quarter of 2007 (January to March) prices nationally decreased by 0.5% as compared with a growth of 3.5% in the same period of 2006. However on a year-on-year basis the average price pay for a house in Ireland was still 7.4% higher in March 2007 than the average price paid in March 2006. The big question is of course what happens next.

This is not the place to enter a debate as to whether what has been happening in Ireland constitutes a bubble (I have some observations on the Indian property situation which are not without relevance here), or indeed of the extent to which such price growth as has occurred represents a distortion from "fundamentals", since this in large part depends on the extent to which fundamentals have changed, and this is precisely what we are still trying to determine. Evidently, with Irish consumers now the most indebted in the OECD, any sustained decline in property prices would make its presence felt via the well-known "wealth effect".

But just how likely is such a significant "correction". In large part the "sustainability" of recent housing activity depends on the future course of interest rates at the ECB, and this is again beyond the scope of the present post, but suffice it to say that the current raising cycle may well peak (due to its impact on the larger economies like Germany and Italy with different structural characteristics to the Irish one) much sooner than many imagine - in the last quarter of 2007 or early 2008, and we may well then see another round of "easing", if so the associated fall in interest rates may well serve to place a platform under house prices in Ireland, and indeed the show (in perhaps a more modest form than hitherto) may well go on. Certainly there are no good reasons at this point to exclude this possibility.

In addition it should be noted that Irish government finances have enjoyed a strong positive balance in recent years, and that any slowdown in the housing sector can - to some extent - be counteracted by the application of a countercyclical deficit. One indication that such an approach - in the eventuality that it may prove necessary - may not be far from government thinking may be found in the most recent National Development Plan. This is projected to cost 183.7bn euros over a seven-year period (2007-13). The NDP is aimed at tackling what are widely acknowledged to be serious infrastructure deficits. In addition - and for the first time in an Irish NDP - the package of measures includes current spending (86bn euros). This current spending, which will be focused chiefly on social expenditure, is dependent on tax revenue remaining buoyant (the government’s plan is premised on average growth rates of 4%-4.5% over the period). As a percentage of GNP, capital spending will increase from 4.7% in 2006 to an average of 5.4% over the term of the seven-year plan.

Finally, it would not be appropriate to leave this review without at least some comment on Ireland's external balance position. In the first place it should be noted that Ireland's current account is un-typical, in the sense that, while there is a small trade surplus, the current account balance is seriously in the red. This is largely due to the strong presence which FDI has had in Ireland over the last decade or so, and the strong consequent outward funds flow associated with the repatriation of profits (which has the further un-typical consequence that GDP is systematically lower than GNP.

Evidently Ireland’s current-account deficit continues to widen. In the first nine months of 2006 a cumulative deficit of 5bn euros was recorded, a figure which was up sharply from the 3.9bn euros recorded a in the same period one year earlier. The third-quarter deficit totalled 1.2bn euros, an increase in 46% over the deficit in the same period of 2005. The increasing current-account deficit is largely a reflection of changes in the income balance, since the merchandise surplus was almost unchanged year on year at 7.6bn euros, while the services deficit actually decreased. However, this narrowing in the services deficit was more than offset by a widening of the income deficit from 5.4bn euros in the third quarter of 2005 to 6.8bn euros in the same period of 2006.

This situation in part reflects an increase of 15.9% in profit outflows generated by foreign-owned business based in Ireland and of a 41.4% increase in portfolio investment income outflows. As with other deficit countries (Spain, the UK, the US) there is no doubting the existence of such "imbalances", the real issue is their significance. As Claus and I have been repeatedly pointing out (and here), if median ages to some extent govern the dynamics of domestic consumption, and some high median age societies (Germany and Japan, for example) are condemned to running current account surpluses if they wish to maintain growth, then logically others are condemned to run deficits.

So, and summing up, what we seem to have in Ireland is a very interesting test case for the validity of the old versus the new models of capacity. On the face of it I would argue that global capital and labour flows have had a significant - and unexpected - impact on the path of the Irish economy, a development from which there is much to be learned. Let's just hope that over at the ECB they are listening.

NB. As I indicate at the start, this post is the first installment of a much longer review process. More to come. Next stop Italy.

Luck of the Irish: PM Bertie Ahern Set for a Third Term in Office - or is he?

by Manuel Alvarez-Rivera: San Juan, Puerto Rico

Irish Taoiseach (prime minister) Bertie Ahern appears set for a third term in office, following a general election last May 24 in which Fianna Fáil (Soldiers of Destiny), led by Ahern, remained by far the largest party in the Republic of Ireland, with 78 of 166 seats in Dáil Eireann, the House of Representatives. However, Fianna Fáil's coalition partners, the Progressive Democrats, fared badly in the election, losing six of their eight Dáil seats - including that of party leader and Tánaiste (deputy prime minister) Michael McDowell - and the ruling coalition lost its overall parliamentary majority.

Although Fine Gael (Gaelic Nation) - the main opposition party - scored major gains and went from 31 to 51 seats in Dáil Eireann, its "rainbow alliance" partners, Labour and the Green Party failed to improve upon their previous election showing: the Labour Party lost one of its twenty-one seats, while the Greens won six seats, the same number as in 2002. In all, the three parties won 77 seats between themselves, whereas Fianna Fáil and the Progressive Democrats hold a combined total of eighty.

Sinn Féin, which in recent years has become the second largest party in Northern Ireland (which remains part of the U.K.) and the largest party among that province's Catholic community, lost one of its five seats, while the small Socialist Party lost its single deputy. The Republic of Ireland has a long tradition of independent parliamentarians, and this year was no exception with five independents elected as deputies, but their number is considerably lower than in 2002, when thirteen non-party candidates won seats in Dáil Eireann.

Dáil elections are carried out by the Single Transferable Vote (STV) system, reviewed in Parliamentary Elections in Ireland - Elections to Dáil Eireann, where detailed results of last week's election are also available. STV is a proportional representation system, but the small size of the electoral constituencies (which elect from three to five deputies) usually favors the larger parties, especially Fianna Fáil. Moreover, parties that fail to attract a significant number of second preferences tend to do poorly under STV. This was the case with Sinn Féin, which won more votes than the Green Party but elected fewer deputies than the latter. (In addition, Sinn Féin's support tends to be concentrated in constituencies bordering Northern Ireland: many of these only have three seats, and even with a sizable vote transfer it can be fairly difficult to reach the resulting STV seat quota of 25%.)

At this juncture, it appears likely that Prime Minister Ahern will remain in office. According to press reports, Ahern is said to prefer a coalition with the Progressive Democrats and independent deputies; among the latter, two are former Fianna Fáil politicians, another is a former Fine Gael minister, and the remaining two are socialists. However, there has been speculation about a coalition between Fianna Fáil and the Green Party as a second choice. In the meantime, Fine Gael leader Enda Kenny hasn't given up hope on forming a government...


Nearly three weeks after the election, Fianna Fáil reached a coalition agreement with both the Greens and the Progressive Democrats, under which Bertie Ahern was elected by the 30th Dáil as head of government for a historic third term on Thursday, June 14, 2007.

Monday, May 14, 2007

Iceland's Economy: Smeltering Away

by Edward Hugh: Barcelona

Iceland's recent elections have already been covered by Manuel in the accompanying post , so here I will concentrate almost exclusively on the economic side of things. On the face of it Iceland is an unlikely place to have been at the centre of global economic attention. It seems hard to believe that a country of barely 300,000 inhabitants could, at one point, have been thought of as a potential trigger for a new version of the 1998 Asian crisis, or the broken thread which would unwind the ever-tensed carry trade, yet such possibilities were clearly being entertained. And now here we are one year later, the long feared emerging market debt crisis has certainly not materialized, and, of course, the carry trade is still very much alive and kicking.

Furthermore, despite a substantial drop in the currency, a sharp hike in interest rates, and a loud screeching of the brakes from the GDP growth department, it would be unwise to consider prime minister Geir Haarde's claim that Iceland has weathered the storm and that the country would emerge from "this economic boom in a very stable way" (read soft landing) to be mere electoral spin, and indeed the Icelandic voters in increasing their support for his party certainly do not seem to have read it that way.

True Iceland's growth rate has suddenly ground to a near-halt, with growth this year being forecast to be a mere 0.9%, but with a current account-deficit at year's end 2006 running at 26% of GDP, and with a currency slide last year of some 30%, and with central bank interest rates currently running at 14.25% (see interest rate chart below) some sort of slow-down would seem to have been inevitable. The only surprising thing really is that it has not all been more serious.

In fact over the longer haul Iceland's economic growth has been pretty impressive by average EU standards (incidentally, click on the charts if you want to see them in more detail):

The root of the recent trouble has, of course, been a massive investment programme in aluminum smelters (details of the background to the aluminum smelter issue can be found on in this useful wikipedia entry). The smelter-welter was accompanied by a sharp surge in housing activity associated to some extent with reform and deregulation in the housing market and as well as with changes in the banking sector which lead to a more widespread availability of funding for house purchases. This increase was, naturally, then further fueled by the consumption boom which accompanied the "sizzling" growth produced in the general economy by the rise in investment and construction activity.

Obviously the Iceland 2006 story was a matter of imbalances if ever there was one, but as we are learning there are imbalances and "imbalances", some are long term and structural in nature (eg the demographic ones, global capital flows) and others are of a shorter term nature, conjunctural, often the result of bad policy decisions, and thus, for this very reason, capable of redress. Fortunately Iceland's problems were of the latter kind, and although imbalances still evidently remain (and even could be rekindled if the ardour for rapid-order smelter building hasn't been damped by now), perhaps the worst is really over, at least for the time being, and certainly according to the latest report from the ministry of finance (watch out very big PDF) which argues that that the investments in aluminum smelters that skewed the economic numbers in the first place by boosting imports will come to an end this year and that these imports will now steadily be replaced by exports as production from the new plants comes online. Indeed according to the Icelandic government's own projections, total aluminum output in Iceland will rise by 68% this year and by 43% in 2008 (domestic aluminum production totaled 326,090 tonnes in 2006, an increase of 19% compared with 2005, while aluminum accounted for 23% of total goods export value last year, a rise of 5 percentage points on 2005).

Obviously downside risks remain, especially with the smelter-temptation in mind. As the Economist Intelligence Unit notes:

"with the stability of the krona increasingly dependent on the willingness of international investors and creditors to fund the deficit, the risk remains that any downturn in the global financial markets could lead to a sharp depreciation of the currency and a deterioration in the inflation outlook, particularly with a tight labour market posing the risk of a wage-price spiral."

The income balance on Iceland's current account - which measures interest payments and income from crossborder investments - has been fairly volatile in recent years. This is in part a result of overseas investment by Icelandic companies. In fact the deficit on the income balance in 2006 (which represented one-third of the overall current-account deficit), was almost three times the figure for 2005. The bulk of the deterioration was the result of higher net interest payments (on account of rising foreign interest rates), together with an increase in dividends and reinvested earnings out of the country (as a result of foreign ownership of Icelandic corporates).

Net financial inflows in 2006 also almost tripled over the 2005 figure. This was mainly a reflection of increased foreign borrowing by banks and corporates. Thus by the end of 2006 Iceland's international investment position was in deficit to the tune some120% of GDP which compared with a 'mere' 85% of GDP 12 months earlier. As a result total net external debt - which excludes direct and equity investment - was equivalent to 207% of GDP at the end of 2006, up from 154% of GDP in 2005.

These are large numbers, and clearly the whole position needs to be corrected, but as the Economist Intelligence Unit again says:

The increasing internationalisation of the economy and the high level of private-sector external debt imply that the financial sector will continue to be affected by foreign investors shifting risk appetite. However, Iceland's strong public finances and pension system, its high standard of living and a well-capitalised and increasingly diversified banking sector mean that a sovereign default or a banking system crisis are unlikely.

At the end of the day the delicacy of the situation surely hangs on the future of the recent surge in aluminum prices - which have almost doubled since the end of 2003. So in part any assessment of the outlook for Iceland hangs on the view you take of outlook for global demand growth in the coming years. If you take the view - as I do - that growth in developing economies like China, India and Brazil etc will tend to maintain global demand growth at a typical levels in historical terms, then, smoothing out the odd bump here and there, the price of aluminum (like other commodities) should remain within tolerable levels for the Iceland project to be able to work, especially since their "alternative" energy background costs may prove to be more stable than those of producers who depend on more conventional energy sources.

The dependency of the future of the of the Icelandic economy depends surely on future trends in the global economy, as the report from the Finance Minstry (link above) explicitly recognises:

In spite of the recent disquiet in international financial markets, prospects for the world economy are generally favourable. World economic growth continues robust, close to 5 per cent this year and next, although this forecast has been slightly scaled down from earlier forecasts due to the outlook for slower growth in the United States. Growth in Japan and the euro area has been modest but stable, and indications are that it is improving. Growth in emerging market economies, especially China and India, will continue rapid. International trade expanded by 9 per cent last year, providing the engine power for growth in the international economy.

In a nutshell, despite the question mark over the strength of domestic demand in Germany and Japan, as long as world trade expansion continues to chug along at something like the 9% rate recorded last year, then the Icelanders should eventually find themselves able to walk their way out of the woods. So while we may well see a drop in the pace of this expansion at some point as and when the developed economies enter recession, over the mid term horizon there is perhaps no need for alarm.

Moving on to more general structural issues, Iceland, along with the other North European economies, has steadily moved from the traditional occupations of fishing and farming, through industrialization and onto the high road of becoming a services economy, producing in the wake of this process a services sector which today employs some 71% of the labour force. For the rest, 22% of the workforce are employed in industry, 4% in agriculture and 3% in the fishing.

As others have noted, the drive towards a service economy in Iceland needs to be contextualized in terms of the very special value framework that permeates Icelandic social and political discourse, namely the presence of an acute sensitivity towards environmental issues, and towards the protection and conservation of natural resources. Whilst this approach has long been evident in sectors like fisheries and agriculture, such considerations have also played a significant part in the debate about industrialization, and have perhaps been an important impetus in the drive towards a services-based economy, which, at the end of the day, could be a lot less environmentally disruptive than an industrial one. In effect, the industrialization of Iceland has been to some considerable extent synonymous with the harnessing of domestically-based energy resources, like the hydro-electric and, more recently, the geothermal ones, which are energy sources which are seen as providing a more consensual base in political terms as well as being a more sustainable basis for economic development than fossil fuels, in particular due to the renewable nature of such energy sources.

So Iceland is in transition, and the very pace of the change which is taking place there towards a high-tech economy specializing in areas like medical equipment, food processing and fisheries equipment, biotechnology and pharmaceuticals means that Iceland has to draw heavily on human resources, and it is precisely in this area that some longer term structural difficulties are raised.

As is noted in Chapter II of this 2006 OECD document (Economic Policy Reforms: Going for Growth 2006) "while participation in tertiary education is high, the proportion of the working-age population with only lower-secondary education is still significant, even among young people", and this situation acts as a constraint on the transition to high value services.

Despite the fact that Iceland's fertility is comparatively high (see below), the comparatively high rates of economic growth that Iceland has enjoyed have continued to put pressure on the available labour supply, a feature which is reflected in the very low unemployment rate, which was running at 2.9% in 2006 (a factor which undoubtedly help fuel the overheating situation). In fact Iceland continuously has one of the lowest unemployment rates and the highest labour force participation rate in the OECD. So to some extent horizontal economic growth in Iceland depends on immigration (Iceland has a current immigrant population of around 7% according to this source), while vertical growth (or movement up the value chain) would seem to depend on educational reform and improved human capital quality (which is obviously a process which needs time to lock-in).

So clearly, if the competitive position of new, high technology industries and services is to be sustained, and the value added component is to be increased in this rapidly diversifying economy, further investment is required, and in particular so in view of the gap between the existing skills of the labour force and the needs of these new activities - a gap which is often commented on by outside observers (see this OECD document, Thematic Review of Tertiary Education) - Iceland really needs to work hard to try and improve the ratio between those with minimal and those with high skills.

So, summing up, even if Iceland may be considered by some to be merely a "a tiny economy in the middle of the Atlantic", the long term position of this "tiny economy" would seem to be relatively sound, since the population structure - as I point out in this post here - is comparatively stable by OECD country standards (fertility is near to replacement level), and a judicious use of structural reform and immigration policy can maintain Iceland on a more or less stable path despite the comings and goings of smouldering smelters.

Perhaps one last point would be in order here. Iceland's trade balance over the last decade or so has been fairly monotonic, in the sense that it is normally a current account deficit story. If we look at the chart below (prepared by the Iceland Ministry of Finance) we can easily appreciate the general picture:

So is this really so bad as it seems? Well let's revisit an argument Claus advances in his recent French post, which is that if some countries with high median ages are now structurally tied to dependence of exports for growth (and sustainability in their public finance), then logically other countries (with somewhat lower median ages) are going to need to run ongoing trade deficits. Claus was referring to France in its ongoing relationship with Germany, but the argument could easily be extended to Iceland and points further afield. Iceland still has a median age of around 34 years, which makes it a very young country in developed economy terms. So if we can apply Modigliani's Life Cycle Hypothesis to populations in the case of the elderly economies (Japan, Germany, Italy, Finland etc), why shouldn't we apply the same notion to the relatively more juvenile economies, who can with some greater realism accumulate liabilities now which can be paid off later, as the population ages and domestic saving increases? I know this as all somewhat politically incorrect, but I do worry just exactly what would be the impact on overall economic welfare of all the younger median age societies bringing their economies into trade balance, since the level of ongoing global growth would obviously be lower, and I am not really convinced that this would be especially desireable as an end result.

William Poole raises some of these questions in this speech here and he leads Mark Thoma to wonder whether such notions might not lead us to "become complacent about the potential for a sudden rebalancing of global accounts". All I can say in response to this is that I appreciate the concern, complacency is never a good thing, but at the same time I cannot hep feeling that if the weighting which people like Claus, William Poole and I give to demographics in the whole narrative account of the imbalances process is justified, then the kind of sudden correction which Mark so fears is unlikely, since the imbalances themselves correspond to a long term underlying process. Really I cannot help feeling that the biggest danger really lies in trying to conceptualise todays problems in terms of yesterday's theoretical framework, but then maybe that is just a case of me being me.

Thursday, May 10, 2007

Iceland 2007 parliamentary election

by Manuel Alvarez-Rivera

Voters in Iceland go to the polls on Saturday, May 12, 2007 to choose members of the country's unicameral legislature, the Althing. Parliamentary elections in Iceland are carried out by proportional representation, and the electoral system - reviewed in Elections to the Icelandic Althing - bears strong similarities to the systems used in Scandinavian countries for national elections.

Although Iceland has a total population of only 300,000 inhabitants, the country has developed a lively multi-party system, broadly similar to those in place in other Nordic nations, yet distinct in a number of ways. First, unlike in the other Nordic countries, Iceland's party politics have been dominated by the conservative Independence Party, which has been the largest single party in every general election held in Iceland since 1944, when the country broke its union with Denmark and became a republic.

Second, until fairly recent times Iceland's Social Democrats were much weaker than their Nordic counterparts, and usually alternated in third place with the left-socialist People's Alliance. However, in 1999 the Social Democrats, the People's Alliance and a feminist group, the Women's Alliance, joined forces and established a social democratic Alliance, which went on to displace the agrarian-liberal Progressive Party as the country's second largest political force.

Third, right-left coalitions between parties that otherwise would be political adversaries have been a common occurrence in Iceland (but remain fairly rare in the other Nordic countries, with the notable exception of Finland). No party has held an overall parliamentary majority since the proclamation of the republic in 1944, and the country has been ruled by a succession of coalition cabinets. The Independence Party, which has taken part in most governments, has been in office since 1991, in coalition with the Social Democrats until 1995, and since then with the Progressive Party.

While the Alliance was largely successful in bringing together Iceland's diverse left-wing groups and emerged as a major challenger to the Independence Party in the 2003 Althing election, some members of the original parties (mainly from the People's Alliance) did not agree to the merger and established the Left-Green Movement as a leftist alternative to the Alliance. Both the Left-Green Movement and the Liberal Party - an Independence Party breakaway - have been represented in the Althing since 1999, along with the three larger parties.


Iceland newsdaily Morgunblaðið ("The Morning Paper") reports complete results of the May 12, 2007 Althing election were as follows:

Independence Party (D) - 66,749 votes (36.6%), 25 seats
Alliance (S) - 48,742 votes (26.8%), 18 seats
Left-Green Movement (V) - 26,136 votes (14.3%), 9 seats
Progressive Party (B) - 21,349 votes (11.7%), 7 seats
Liberal Party (F) - 13,233 votes (7.3%), 4 seats
Iceland's Movement (I) - 5,953 votes (3.3%), no seats

The election had a voter turnout rate of 83.6%.

Although the opposition parties won an overall majority of the popular vote, the Independence-Progressive coalition government of Prime Minister Geir H. Haarde nonetheless survived by the narrowest of margins, hanging on to a one-seat majority in the Althing. Haarde's Independence Party improved its standing with respect to the 2003 parliamentary election, but the Progressives had their worst general election result ever and slipped to fourth place.

Iceland's main opposition party, the social democratic Alliance also lost ground in the election, but the Left-Green Movement polled strongly, becoming the country's third largest party. Finally, support for the Liberal Party remained stable, while the environmentalist-oriented Iceland's Movement failed to secure parliamentary representation.

Following the close election outcome, the Independence and Progressive parties chose to discontinue their coalition agreement, and the Independence Party subsequently reached an agreement with the Alliance to form a coalition government headed by Prime Minister Haarde.

Tuesday, May 8, 2007

France - Europe's New Sick Man?

As France recovers from the election of Sarkozy as new president this Sunday one of the topics which quite naturally has been high on the agenda throughout the campaign is the French economy and how to move things forward in what, after all, constitutes the Eurozone's second biggest economy. I am of course not the only one who has made the assessment that the French economy may now be on the brink of something of a new era after so many years with Chirac at the helm and scoping around through the economic commentaries the French economy is apparently not in a particularly good shape. Over at Morgan Stanley's GEF, for example, Eric Chaney recently nominated France as the new sick man of Europe invoking four macroeconomic indicators (GDP growth, exports, unemployment and public finances) as being worrying beacons of Europe's new economic laggard. However, as Emmanuel from AFOE has recently tried to argue by taking the BBC fact sheet on the French economy to task, the real position is much less clear than many pretend, and France's long-term growth potential may be being systematically underestimated in the same way that Germany's is being systematically overestimated. Indeed just as one swallow definitely does not make a summer, one year's performance definitely does not constitute a trend.

So, is the French economy really in such bad shape? In this note, which accompanies Manuel's excellent posts on the French Presidential elections, I will try to answer just that question. In fact I will argue that France indeed faces important and non-negligible challenges in the immediate future, among them most notably how to better manager the y-o-y and long term evolution of public finances, as well as the need to reform a rather rigid labour market. However, I will also argue that the invocation of France as the new sick man of Europe represents a fallacy and that such analysis does not adequately take into account the (potential) long term fundamentals of the French economy which look healthier than those in many of France's European peers.

France and the Eurozone – A Laggard?

Much of what recently has been written and said about the relatively poor state of the French economy compared to the other large Eurozone countries comes on the back of 2006 which saw a record year of economic growth in GDP in the Eurozone and indeed the whole of Europe. And clearly looked at in this context France would seem to have fallen somewhat behind Germany, for example, which as well all by now know only too well posted an impressive growth rate of 2.6% compared with France’s rather more modest 2%. Yet, if we take a look at real GDP growth in France over the past 12 years there is nothing to suggest that France is not, in fact, by and large monsieur average in terms of economic growth in the Eurozone.

This overview puts in some kind of perspective the rather hasty conclusions being drawn on the basis of what is, after all, only is one year's relative performace, and, as Emmanuel from AFOE points out, this clearly is far from constituting a trend, at least not the way I have been taught in economics it doesn't. Now none of this means that France does not face important economic challenges, and it certainly does not mean that France could not do with some badly needed reforms. Most notably, France needs to reform its rigid labour market. I will not dwell on the very complicated structure of France’s labour market here but there is no doubt that France needs to fundamentally rethink and re-invent the notion, width and depth of job contracts and on that same note re-invent its social security scheme (la protection sociale) whose two tier employee/employer financing is at the heart of a troubled French labour market.

And the problem is of a somewhat pressing nature. In particular, and despite the fact that I shall talk rather favorably of French demographics below, France, along with other developed economies, is set to age rapidly over the next 20 years as a result of the ongoing demographic transition. This means that the labour market needs to be a well-functioning one so that the supply side of the economy is not constrained as workers become an ever scarcer resource compared to elderly dependents. Especially noteworthy in this context is youth unemployment in France, which is running at rather alarming levels, as is demonstrated by the figure below.

Another aspect where France needs to improve its performance is in terms of the management of public finances. Since 1995 France has been running a structural budget deficit and although many will take comfort in the fact that it is now below the dreaded threshold of 3% set by the growth and stability pact under the EU framework there are still fundamental economic issues to be resolved related to getting France’s books in good financial order.

The first issue to be addressed is, I think, of an institutional nature, since the lingering budget deficit first and foremost tells a tale of a state apparatus where expenses are quite simply badly managed compared to receipts. But in terms of the broader and longer term picture we need to talk about the structural drivers of public debt, and here it is clear France also needs to improve.

More worryingly, as also aptly noted by Eric Chaney (linked above), the window of opportunity for France - as with most other major European countries - is closing fast due to the pace of the evolving demographic transition. Chaney presents estimates which show that liabilities will rise to 120% of French GDP as a result of the ageing process alone. This will of course only be exacerbated if France continues on its current course so there is good reason to think in terms of implementing reforms and changes today rather than tomorrow.

Now taking up the baton on the demographic situation in France, as I noted above I am going to speak rather favorably about this. In this context I am, I am afraid, only going to offer a relative exercise as it were, and simply compare with France its European neighbours Italy and Germany. Now if we look at fertility in France we in fact get a rather different picture to that which is to be found in Italy and Germany.

In France fertility rates have rebounded since the middle of the 1990s and are now close to replacement (a situation which has only really be attained by the US among the developed nations), and if we are all busy criticizing French public policy in many areas we might perhaps do well to recognise that pro-natalist policies in France do seem to have had some effect, and this is one thing which certainly seems to have been done well.

This relatively favourable fertility situation by no means saves France from a structural shock to its population pyramid as the effects of the demographic transition ripples across the age cohorts, but it does mean that compared to Italy and Germany where fertility levels stubbornly continue to lingers close to the 1.3/1.4 range the future does look just a little bit brighter for France, with of course the proviso that future trends in net migration represent an unknown in all cases. The key point on fertility however is that although the picture points to an apparent return to 1980 standards so to speak the figure hides the cumulative effect on the size of future generations. As such the size of the various cohorts currently passing through their reproductive ages is smaller than that of the preceding ones, so the absolute numbers of children being born will be commensurately lower (with pension sustainability implications), and again all of this means that the crude figures need to be treated with some caution.

Lastly before I conclude this note I want to dwell a bit on another aspect highlighted by Chaney as part of France’s misery, namely her exports. In many ways, Chaney’s analysis on France’s exports is airtight and he even includes the following point which I fully endorse although growth rate of populations perhaps should be changed to something like ‘changing structure’ …

By itself, a trade deficit is not a symptom of macro illness (nor is a government budget deficit). Diverging domestic demand growth between countries having similar productivity and cost trends generates temporary surpluses and deficits, with temporary maybe meaning several years. That Germany and Japan have large trade surpluses is largely explained by the slow growth rate of their populations and of their domestic demand. That is why it is more revealing to look at export performances.

Essentially, I think Chaney is spot on in terms of his focus on the structural nature of French export business and most notably the relative lack of innovation when compared with other European countries. Yet there is another subtle point here I think which is ever so important both in a European and global context.

In a world where populations are ageing, and where trade surpluses are ballooning and becoming structurally inbuilt in some of the oldest societies, we logically also need importers to make the global books balance. In fact, as was demonstrated by the figure in my recent piece on global decoupling France constitutes Germany biggest export market in terms of total volume on a country basis. Given that background it is clear that the growth of Germany and France is of somewhat a symbiotic nature (like growth in China and the US?) which is also why this idea of France as the sick man of Europe seems to be rather inappropriate I think or at least why we need to think about eurozone and cross-country dynamics too.


Looking into future of France with a new president at the rudder it is my hope and optimistic belief that Sarkozy will now command the legitimacy to carry out what is sure to be big changes in French society. Hopefully theses changes will be for the better both for the French and for the European economy.

To finish where I started with Eric Chaney's notes over at Morgan Stanley’s GEF (see links above) I do not agree with the overall label of France as the new sick man of Europe. Essentially, Chaney makes a whole lot of sense in his analysis and as I have also noted above France indeed needs reforms in order to combat high unemployment as well as shaky public finances. The only qualifier that I would attach Chaney analysis is on France’s trade deficit which actually is much needed to sustain growth in the Eurozone as a whole and once again I feel as if the account of how demographics affect capital and trade flows is somewhat missing in the general analysis. In terms of Europe I still believe that the scarlet letter of sick man rests firmly on Italy mainly due to its government debt at about 100% of GDP, a problem which poses a fundamental risk to the future of the Italian economy, as well as to its future membership of the Euro and public pay-go benefits system; all this of course especially given the demographic realities. Put another way, I don’t think Chaney’s analysis on France is flawed as such, but his headline is.

Sunday, May 6, 2007

Sarko-Ségo, or the 2007 French presidential runoff race

by Manuel Alvarez-Rivera: San Juan, Puerto Rico

Following a first round of voting last April 22 in which no candidate won an absolute majority, France will hold a runoff presidential election, and the top two vote-getters on the first round - Nicolas Sarkozy of the ruling right-of-center Union for a Popular Movement (UMP) and Ségolène Royal of the left-wing Socialist Party (PS) - will face each other off in a much anticipated Sarko-Ségo showdown.

In some ways, this year's contest resembles the 1981 presidential election, in which a center-right candidate (incumbent President Valéry d'Estaing) topped the poll in the first round, narrowly ahead of a strongly-placed Socialist nominee - François Mitterrand, whose 25.9% share of the vote was matched by Royal twenty-six years later. That year, the other major center-right candidate, then-mayor of Paris (and future president) Jacques Chirac, who had arrived in third place, gave Giscard only a lukewarm endorsement. This time around, centrist François Bayrou, who came in a strong third place with 18.6% of the vote, has refused to endorse either Sarkozy or Royal in the runoff, and subsequently indicated he would not vote for Sarkozy; he has also announced plans to create a new centrist political force, the Democratic Party, ahead of next June's legislative elections. Meanwhile, the candidates to the left of Royal have rallied behind her for the second round of voting - not unlike the French Communist Party (PCF) in 1981, which strongly backed Mitterrand in the runoff vote.

However, the similarities end there. In 1981, the Socialist and Communist presidential candidates polled a combined 40.2% of the vote, and the left won an overall majority of 50.7% in the first round, which along with Chirac's less-than-enthusiastic endorsement of Giscard, propelled Mitterrand to the presidency in the runoff. This year, Royal and the candidates to her left secured only 36.1% of the vote between themselves: this figure is even lower than the 40.6% share polled by the left in the 1995 presidential race, when Socialist candidate Lionel Jospin made a strong showing in the runoff, but was nonetheless defeated by Chirac, 52.6% to 47.4%.

In order to win the election, Royal would have to capture a sizable share of the centrist vote. Earlier opinion polls suggested a majority of Bayrou voters would back her in the runoff, but they now appear to be leaning slightly in favor of Sarkozy, who has remained ahead in every poll taken so far - although sometimes narrowly so, within the polls' margin of error.

At this juncture, Sarkozy's victory in the second round appears likely, even after Jean-Marie Le Pen of the far-right National Front (FN) announced he would not be endorsing either of the two candidates in the runoff election, and asked his followers to abstain from taking part in the poll.

So far, this turn of events appears to have had little impact on the race, and opinion polls have continued to indicate that supporters of Le Pen - who finished fourth in the first round with 10.4% of the vote (his worst showing in almost two decades, but still a respectable figure) - will overwhelmingly vote for Sarkozy in the runoff election. That said, if a sizable number of Le Pen's voters chose to follow his advice after all, France's presidential runoff vote could turn out to be tighter than expected.


The French Interior Ministry reports that at 5:00 PM CEST (15:00 GMT / 11:00 AM EDT), 75.1% of the electorate had voted in the second round of the 2007 presidential election, up from 73.9% at the same time of day in the first round of voting held last April 22.

Polls closed at 8:00 PM CEST (18:00 GMT / 2:00 PM EDT).

Voter turnout in French presidential runoff elections is usually higher than in the first round, and it appears this year will be no exception. The first round of voting of the 2007 presidential race had a final turnout rate of 83.8% - the highest since 1974.

On Thursday, May 10, 2007, the French Constitutional Council announced final results of the 2007 presidential election's second round of voting were as follows:

Nicolas Sarkozy - 18,983,138 votes (53.1%)
Ségolène Royal - 16,790,440 votes (46.9%)

Thus, Nicolas Sarkozy has been elected President of France, winning the runoff election with a substantial majority of 2,192,698 votes (6.1%).

84% of French voters took part in the event, making it the highest second round turnout in nearly two decades. The vote was also characterized by a sizable increase in the number of blank and invalid ballots, which nearly tripled with respect to the first round of voting.

The result of the election was largely in line with opinion poll forecasts, although Sarkozy's margin of victory was somewhat smaller than in some late polls, which had him ahead by as much as ten points. At least one exit poll suggests the centrist vote split evenly between Sarkozy and Royal, which may have closed the gap but was not enough to prevent Sarkozy's runoff victory.

In the end, the outcome of France's 2007 presidential runoff election is almost identical to that of the previous left-versus-right, second round showdown in 1995. Although left-wing candidates (Royal included) held a smaller overall share of the vote in this year's first round of voting than twelve years ago, Royal nearly matched Lionel Jospin's 47.4% of the vote in the 1995 runoff.

The Socialist Party is now attempting to regroup ahead of next June, when French voters return to the polls to choose members of the National Assembly - the lower house of the French legislature - in two rounds of voting: an opposition victory in that contest would force President Sarkozy to "cohabit" with a non-UMP prime minister, and largely reduce him to a figurehead. However, such an outcome would be completely unprecedented, given that in past French parliamentary elections held shortly after a presidential poll (as was the case in 1981, 1988 and 2002), voters have consistently supported the party of the president they had just chosen (the Socialists in 1981 and 1988, the UMP in 2002).