Ageing and Financial Markets - Going for Yield?

By Claus Vistesen: Copenhagen

Financial markets have evolved with breathtaking pace in the last decade. In what follows I will both attempt to sketch an outline of the bigger picture and I try to pinpoint the effect of ageing on financial markets. This task entails a broad view on many of the major participants in today's rapidly evolving financial markets as well as demanding sensitivity towards the fact that ageing is only one of many factors which affect financial markets in the medium to long run. Consequently, the impact of ageing on financial markets involves musings on longer term dynamics which are essentially, I would say, very difficult to predict even for the most ardent analyst. However, I will argue with some force that before we reach the state of 'rapid dissaving' which many analysts hold to be the end point in terms of ageing, it seems as if the main dictum for global markets, at least for a somewhat prolonged period, could ultimately add up to one thing: too much liquidity chasing too little yield, a reality not entirely caused by, but rather somehow exacerbated by, ageing. My account begins with a brief discussion of a hypothesis recently proposed by Morgan Stanley's Stephen Jen concerning a global asset shortage. The discussion will unfold in the context of equities and sovereign debt* before moving on to a discussion on how households and thus the agers themselves - represented in all this by the so-called retail investors - might act to affect global financial capital markets.

Sovereign Debt - Enough Assets to go Around?

As noted above, Stephen Jen has recently suggested that the world is suffering from a shortage of financial assets relative to evolving demand. Jen especially notes that the recent decade - which has been caharcterised by comparatively high rates of economic growth and 'relatively' modest pressures on governments to resort to heavy-duty counter cyclical fiscal policy (Japan and Italy excluded) - has seen the supply of sovereign debt dwindle. Notional empirical evidence seems to support Jen's hypothesis on sovereign debt as the total world sovereign debt oustanding relative to world GDP stagnated in 1997 at a ratio of about 75%. In short; there is not enough sovereign debt in the world to satisfy demand - a feature which also subsequently lies behind the 'conundrum' of low bond yields. Yet, all this simply begs the question of what drives the supply of sovereign debt in the longer run. According to Jen, one of the drivers of the low supply of sovereign debt relative to demand has been the relative buoyant global growth rate which suggests that if global growth (or growth in key global economies?) begins to falter the supply of sovereign debt should begin to nudge back up. Yet, is this plausible? The first point here of note is that this is somewhat structurally tied to the global macroeconomic imbalances and the subsequent discourse on Bretton Woods II as maintained, for example, by Brad Setser.

It is thus clear that in a world where the large emerging markets (save perhaps India), and the petro exporters, are pegging to the Dollar consquently amassing a fluctuating volume of US sovereign debt and of FX reserves in general these countries are not going to aggressively issue sovereign debt since this would of course entail a de-facto appreciation (re-valuation) of their currencies. Moreover it seems, there is little need at this juncture for big emerging markets to issue debt since they have no substantial deficits to cover. In terms of the imbalances themselves this, of course, means that they have to prop up the currency(ies) to which they are pegging by supporting the external deficit of the countries involved through purchase of debt or equity. This is of course also at the heart of the matter in terms of Bretton Woods II since capital flows are running counter to textbook theory from the point of view of the traditional relationship between developed and developing economies. In short, instead of running current account deficits which would entail issuance of sovereign debt, big emerging markets such as for example Brazil and China represent substantial global net demand, in particular for US sovereign debt but also essentially and more generally for sovereign debt or equity from all countries whose external deficit constitutes the counterpart to their external surpluses.

Another point here is the ageing process itself - which as we know is not only occuring in the developed world but also, and with some force, in many emerging market countries as the final stage of their demographic transition ripples through. In this way ageing will affect the supply of sovereign debt in the long run through two interconnected mechanisms. First of all, as Edward and I have argued before, an ageing economy, such as for example Germany, Japan and perhaps Italy, will have a tendency to revert to a growth path structurally prone to the generation of an external surplus. At least, this seems to be a sound assumption about the general picture before we finally get to a period of 'rapid' dissaving ,whatever this may look like.

Secondly, it seems as if these ageing economies are now embarking on fiscal belt-tightening instead of issuance of new debt, a transition which makes some sense since it is pretty difficult for e.g. Japan or Italy to continue issuing sovereign at debt at this juncture given the rapid ageing they now have on the horizon, and given the sovereign debt to GDP levels which in both cases now constitute over 100% of GDP. This also goes for other large economies in the Eurozone which are in theory bound by the EMU's demand for a maximum limit of debt to GDP at 60%. These countries most likely will not issue new debt in substantial quantities either since ageing and rising dependancy ratios are already pushing heavily on existing debt levels. In fact, it does seem as if the whole idea of sovereign debt rating by the likes of Standard and Poor and Moodys will need to be re-thought as a result of ageing. Take a look for example at the figure below from a paper at the Australian Reserve Bank which plots hypothetical future sovereign debt ratings primarily as a result of ageing. Whether or not this corresponds to a future reality is, of course, a different question, but take a look at Japan which is set to become 'non-investment grade' by 2020, that is a mere 13 years from now!

This suggests then that the future for sovereign debt is set to remain a story of shortage of assets relative to demand. This is, in part, due to ageing on the one side and Bretton Woods II on the other, since the former acts as a de-facto impediment for the already indebted countries to issue new portions of long term sovereign debt, and the latter operates through the lack of meaningful and tradable debt issuance by emerging markets and petro exporters who are pegging to the dollar. Add to this Stephen Jen's point about how growth in the last decade has been extraordinarily strong coupled with a strong growth in liquidity which has, of course, been further exacerbated by the lack of supply of sovereign debt on a global aggregate basis (increased leverage should perhaps also be noted here). My point is just that I do not necessarily think that a sudden turn in the impressive global growth spurt will prompt a resurgence in sovereign debt issuance, at least not from rapidly ageing economies which is of course part of the whole damn problem here since how will Japan and Italy ever be able to repay if the current surge in growth does not continue over a very prolonged period, which, at this point, seems rather unlikely I think. Having said that, a gradual shift in the Bretton Woods II regime could prompt countries such as, for example, Brazil to issue more long term debt, and China might also join in, but such a large change won't happen from one day to the next.

What about Equities then?

Bonds are of course not the only assets around, and equities are also currently offering yield to pension funds, sovereign wealth funds (SWFs), other institutional investors and retail investors. Yet, equities are also included in Stephen Jen's asset shortage hypothesis and the overall theme is the same as with bonds. A decade of impressive corporate profits and growth has reduced the demand for companies to issue shares for financing purposes. Yet, this I feel is not the entire story in terms of stocks and equities. Here we also need to look at the rise of private equity which has hit capital markets like a tornado in the recent years with their buy-out deals (often leveraged, i.e. LBOs). This frenzy has of course pushed prices higher but crucially, since buyout deals often also entail public delisting, this has had the effect of squeezing the supply of equities, at least from the point of view of retail investors, and of index/equity based mutual funds. It is not as if the assets go away just because they become part of a private equity portfolio, but I still think there is an important point here, since private equity for the most part is not available for retail investors. This brings us to the pension funds, and these, of course, and given the rise in saving which ageing involves, are finding it increasingly more difficult to manage their incoming wealth given the pressure to produce yield. This then means that pensions funds are increasingly more actively looking for stakes in private equity, or hedge funds for that matter, in order to produce an adequate return. At this juncture we also need to note the SWFs which increasingly are diversifying into equities, and straying ever farther afield from their traditional and plain reserve management through investing in sovereign debt. A great deal of fuss was made recently about the participation in the IPO of private equity group Blackstone from China via a US 3bn stake.

More generally, as also noted recently by the FT's Alphaville and Morgan Stanley's GEF, the size of SWFs is going to grow substantially as we move towards 2015. Stephen Jen's napkin calculations suggest a whopping amount of about US 12bn in assets. As such, even if equity investments perhaps will continue to be on the margin, such activity is sure to push equity valuations higher, and more generally in terms of sovereign debt the continuing accumulation of reserves are sure to keep those bond yields compressed too. Yet, it is really difficult to make an analytical call on the long term trend here whilst keeping a straight face. On that note, the recent market.view column at the Economist provides an interesting perspective, and one which was also picked up by Brad Setser.

Whether ageing will directly affect the supply of equities is not easy to gauge; most likely it will not do so in any direct sense. The most important driving forces for the de-facto supply of equities seem to be of institutional nature. For example, David Gaffen from the WSJ noted recently how legislation in the US has also decreased the stock of initial public offerings (IPOs). I would also note the continuing, and most likely lingering, trend of private equity buy-outs which is going to nudge up valuations as well as diminishing the supply of assets particularly for those who don't have the financial muscle to directly participate in private equity or hedge funds since these also represent assets beyond the reach of the average retail investor. On this point, I also feel the need to note the recent Buttonwood column which takes on precisely the question of who actually loses out to the emergence private equity and hedge funds; the answer; shareholders (pension funds, insurance funds and retail investors). When all this is said however there is still, presumably, plenty of capital deepening to come in the form of public listings and IPOs in big emerging markets which will act as a long term structural force pushing up the supply of global equities.

Household Behaviour - What Comes Next?

Arguably the most powerful force acting as a proxy for the ageingeffect on financial markets comes from the agers themselves, the households which, in connection with the bird's eye view of financial markets above, could be considered as potential retail investors. This latter point is important, since it is getting increasingly more difficult for the average retail investor to look through an opaque financial market where equities and bonds are spiced up with a myriad of structured and leveraged products. Add to this that retail investors are often exposing themselves to risks they have no idea off. I mean, does John Doe really know the investment strategy of the pension fund in which he is pooling his savings?

However, the real nut to crack in order to gauge the effect of ageing on financial markets relates to the nature and shape of the life cycle path for consumption and saving. It is of course futile to try to identify a global life cycle path but as more and more developed, and in some instances developing, countries enter a stage of rapid ageing and rising dependency ratios important questions are raised. In general, there are two overall narratives. The first one has been widely debated and relates to the concept of rapid dissaving. On this view the fact that ageing occurs more or less across the same time period in many developed countries should lead towards a global movement of rapid dissaving at some point as retired workers begin to spend their savings. It is argued that this will then lead to a steady erosion of the aggregate saving rates and, as a consequence, have a slowing effect on long term growth. Yet, we need to ask ourselves, is this story plausible and, even more crucially, if it happens, when will it happen?

This issue draws attention to an important point about this whole narrative in the sense that what is normally involved is a good deal of speculation about the state of the world in 2040, or 2050, and perhaps further even beyond. Now this entire perspective seems rather imprudent in my opinion mainly because it involves the prediction of things far out in the future which no-one really can claim to adequately make. Moreover it makes the assumption that things which happen between now and then will make no notable impact, and again, and in particular in this regard, the discourse often ignores the fact that even though all the developed countries are ageing, they are not all ageing at the same rate, and thus we need to take into account the possibility that these differences might exert some influence on the final outcome.

Here I think another, rather more interesting, approach would be to start by looking at what may happen during the transition path towards such a hypothetical end point of rapid dissaving, and in particular start from what we can actually see happening right now.

Looked at in this way, the principle of dissaving on an aggregate basis should not be too difficult to understand. As the ratio of retired households to working households rises in an economy there could be a tendency to dissaving on an aggregate basis. But will there be?

I don't have any definitive answers to all this yet, but it is clear that as working households build up expectations about enjoying a period of retirement in relative abundance, as well as taking into account rising life expectancy, we may begin to see that existing savings levels must be stretched and stretched by the increasing demands this will present and this in itself may put pressure on households to begin to save earlier. Moreover, as the governor of the Bank of Finland excellently note recently, theoretical models of dissaving tend to predict that retired households realize their assets far more quickly than is likely going to be the case in reality. Lastly, there will also exogenous pressures on working households to increase their savings in part in order to support a rising dependancy ratio but also because of the general perception that working households will need to ramp up savings to support future economic growth and thereby investment.

All this is of course not imprudent when viewed from a macroeconomic perspective, but as some of the authors here at GEM have pointed out on several occasions, in an ageing society, where working and supporting cohorts will be ever smaller, domestic demand will tend to be depressed over time. Moreover, capital flows will (at least before we get to point zero and rapid dissaving) tend to flow from ageing economies towards higher yielding regions. Examples of this could be Japan and Germany at the current juncture. This also means that in the medium to long term, as more and more countries join the league of countries (potentially!) running external surpluses, there will be even more capital chasing even less yield. And this is perhaps my main point here, in that before we get to a point where ageing will result in rapid dissaving and asset realization by retired households something else will happen. We could think about this something in terms of liquidity, since if an ever-rising median age in a country is a proxy for what is happening in Japanese - ie very low real interest rates in the domestic economy and an external surplus - then ageing economies could be viewed as net suppliers of liquidity to global markets.

In Summary

In this note I have reflected on the effect of ageing on financial markets. Ageing is not, of course, the only determinant of the evolution in financial markets but given the trajectory of the process in the developed world it is likely to have a significant impact. Many commentators have pointed to the transition towards a process of rapid dissavings where households and most notably retiring baby-boomers realize their assets at great pace. I have tried to nuance and qualify that claim.

Firstly, I talked about the supply of and demand for sovereign debt in the light of Stephen Jen's hypothesis of a shortage of assets. Apart from Jen's point that the recent years of extraordinary strong economic growth have deterred, or removed the need as it were, for economies to issue new bulks of sovereign debt (save most notably the US), ageing itself, I think, is already having a strong impact on the issuance of sovereign debt. This is particularly the case in countries where ageing has already entered the prolonged stage where the countries in question will find it very difficult to issue more debt. Also for example under the EMU framework there are very concrete institutional boundaries as to the issuance of debt beyond a long term threshold of 60% of GDP, which of course is a level that could be nudged upwards more or less at will (or perhaps as part of a battle of wills between the EU Commission and the ECB).

Secondly, I noted the situation of Bretton Woods II where some energy exporters and key emerging markets have piled up massive amounts of reserves, a situation which does not make it likely that we will see substantial issuance of sovereign debt from this angle either. Instead, these countries are pushing yields down - most notably on US treasuries - as a result of their dollar (or whatever) peg. On equity markets SWFs are bound to make their presence felt to an even greater extent. More specifically on equity markets it is difficult to see a direct impact on the supply of equities as a result of ageing. However, as with pension funds and ageing, retail investors hungry for yield are moving more aggressively into equities, and thus demand could potentially outstrip supply on a long term basis thus pushing up valuations, especially if the current wave of private equity deals continue along the same path. Another point here are the IPOs and also M&As in emerging markets where there seems plenty of room for increased capital deepening which could push the supply of assets up.

On balance I think that there are reasons to believe that ageing will affect financial markets in the following ways. First of all ageing will most likely increase the demand for assets, and more specifically for yield, and this in turn will mean that ageing also will be a source of global liquidity. Another point which is of note is how ageing might influence financial markets indirectly by prompting governments to intervene. As such, and even though it does not form part of my general analysis, the paper (noted above) by W Todd Groome, Nicolas Blancher, Parmeshwar Ramlogan and Oksana Khadarina from the Australian Reserve Bank offers the proposal that governments act alongside financial markets to insure and essentially hedge against longevity risks associated with ageing. More generally, and in the same tune, the paper speaks of 'financial innovation' as a way to deal with the obvious financial risk associated with ageing. Finally, and very much to the point I think, the financial literacy of households needs to increase, especially in a world where the challenges of ageing to an increasing degree will rest on the individual household.

*In this note I have left out detailed description of the increase in leverage and sophisticated structured products. This is clearly a caveat, but to the extent that these instruments are important (I think that they are) I believe a seperate note should be devoted to them.

Japan - What Now?

The first months of 2007 have certainly seen some wobbling in the Japanese economy, or perhaps it would be more accurate to say in the monetary policy of the Bank of Japan; the economy actually has been muddling along quite nicely as per usual in recent months, driven largely by export growth and of course playing the much allured Japanese specialty of a tightrope game with deflation. So we recently saw the BOJ raise the overnight lending rate to 0.5% in a move which was both odd given the shaky character of some of the economic fundamentals and at the same time perfectly in line with the general perception that global interest rates need to move towards 'normalization' in order to scoop up excess liquidity. However, clearly 0.5% does not constitute normal in any meaningful sense of the word, at least not when it comes to the fundamentals for the carry trade it doesn't. So, what now for Japan? Well, If we look at the economic data we have seen so far for 2007 it is tempting to go for a 'steady as she goes' take and although I do believe that this view would not be too far from the truth I still think it is worth taking a bit closer look at the data we have in front of us.

An Economic Outlook on Japan - Watch that In(de)flation!

The first thing to note I think is that Japan entered 2007 with 0% inflation being registered in January, and this it should be noted was before the hike to 0.5% which was itself justified on the back of comparatively strong Q4 06 GDP figures. However it should be noted that the domestic component in the economy shows continuing signs of weakness and both retail sales and industrial production dipped in January. Retail sales in fact fell by 0.8% on a y-o-y basis, and this of course should not be seen as grave drop yet it does as always bring to the forefront the question of whether or not consumer spending in Japan really does stand before an imminent surge. Industrial production also dropped by 1.5% from December, with this fall being mainly due to de-stocking from the pre-January build-up. Expectations point to further de-stocking in February and perhaps even March although of course the widening export surplus may well provide some much needed relief here. Yet, once again there seems little correction in Japan's overall growth path and this of course raises questions about what actually can be done concerning Japan's growth imbalance, and about just how long we can carry on believing in the likelihood of a spillover effect from buyoant capital spending to the household economy.

In all of this the export sector naturally demands special attention since it is, at the end of the day, what drives the Japanese economy forward at the present time. Indeed the data (see link above) reveals a continuation of the impressive Japanese export performance as epitomized by the February figures which show that the Japanese external surplus widened a whopping 7.7% y-o-y on the back of impressive exports which grew at a rate of 9.7% y-o-y in February. Of course the immediate outlook for export performance (and thus also for capital spending) in Japan is in part clouded by continuing questions about the future of the US economy and just how the current slowdown will play out in Q1 and Q2 of 2007. So what should we expect from Japan going forward?

First of all we have the monetary policy question which is pretty sure to be at a standstill for the immediate and forseeable future (which in the present case means over the course of the coming summer).

Earlier this week the BOJ acted according to expectations and held rates at 0.5% on concerns that consumer prices might drop below zero, and this is a risk I also ascribe some weight to in my economic forecast on Japan. Also the recent announcement by the Fed in the US and the apparent move away from a tightening bias should provide an indication that global rates in the developed economies (save perhaps UK) might be getting close to their upper limit given economic fundamentals, and really I do think the ECB should take note here as well.

Another forthcoming data release from Japan may well point to changing sentiment in the Japanese economy as the Tankan business confidence survey is expected by many to fall back from a 2 year high, although it is worth noting here that there is far from a general consensus on this and, for example, Takehiro Sato from MS sees the Tankan survey in a somewhat different light. Once again the outlook of the US economy is bound to have a significant bearing on this.


The second important point to consider concerns consumer spending and more importantly the future course of inflation. Given the inflation data from January it is now almost certain that Japan will be flirting with deflation in February and March given the inbuilt downward trajectory in energy prices on a y-o-y basis. Whether this evolution in prices will be sustained is of course another story, but I am far from happy about potential developments in Q1 and Q2 and the possible feedback mechanisms with business and consumer sentiment that these may bring into play. On consumer spending, we have of course the recent drop in retail sales in January but on a m-o-m basis we should expect a pickup as the weather gets warmer and spring arrives. None of this will, however, change the underlying growth path of the Japanese economy which driven by capex which is in turn driven by foreign demand or, in other words, by exports. Lastly, and this perhaps is something which could modify the outlook I have sketched above, we have just learnt that land prices in Japan have risen for the first time in 16 years as appreciation in urban areas has finally outweighed depreciation in rural and provincial regions. Of course, this is once more prompting vigilance over at the BOJ where it is being interpreted as a potential forerunner of an asset bubble. Now, I think it is reasonable here to attach some qualifiers.

In the first place there seems to some be indication of speculation here, and especially in the big cities where the appreciation in property values is greatest and as such speculation needs to called what it is, namely speculation on further appreciation. Another interesting aspect is that a lot of the appreciation comes from overseas investors who are investing in Japanese property expecting to wheel-in a gain on future appreciation. Now, the overall property price level development is still substantially negative in Japan as shown here in the latest round up by the Economist on global house prices. I am not attempting here to deny the facts, but merely suggesting that the current speculation which is pushing prices up might be building on the back of expectations and a view of economic fundamentals which perhaps are not present in Japan.

The Yen and Carry Trades - Still Exciting

I cannot of course write any note on Japan without also doing a stop-off in FX-ville and take the latest pulse on the Yen and associated carry trade. The first observation to take away from the carry trade debate of recent months is that it is the volatility displayed by the Yen which has been prompting commentators on an on/off basis to hail the end of the carry trade. Yet, they have of course not been reading or not fully understood what Artim noted recently in his brief on carry trade. Of course I am not trying to say that that we should not be keeping a wary eye on the Yen and on the potential for unwind of the carry trade, but we should also do this whilst remembering that the recent day-to-day volatility has basically been driven by stock market and economic data from the US and elsewhere, and that the fundamentals have not really changed and neither have the expectations, at least not decisively. Of course, the minute expectations begin to solidify towards an appreciation of the Yen Japan will be in hell of a bind since an appreciating currency is associated with deflation which is also why I don't see the BOJ moving much further north on rates in a climate where the Fed is likely to be on hold and perhaps even move down on the back of downside risk of a recession in the US. However, none of this has happened yet which leaves Artim's analysis noted above pretty much right on cue. Now, there is more to a yen carry trade than going short on the Yen and as such what is the most likely long position which we can expect from, for example, your average hedge fund? Well, of course the USD is always an option but as Brad Setser notes in his very recent entry there is much more to this than meets the eye in terms of the choice of high carrying currencies which make the flip side of a carry trade.

In Summary

So, on the economic outlook for Japan going forward I would especially like to stress one thing to watch, and that is the substantial risk of Japan falling back into deflation in March (and perhaps February) on a y-o-y basis. If this happens it will undoubtedly cause some ripples between the MoF and the BOJ where the latter will be accused of acting prematurely on the basis of a backward looking hike in February. The other thing is industrial production which almost inevitably fell in February on a m-o-m basis due to de-stocking on the back of the unsustainably high capex seen in Q4 2006. The evolution of the export surplus from March onwards will determine just how much capex can be ramped up in the months to come, and this again depends on how key economic data coming out of the US (and to some extent also China) evolves. On consumer spending, we should expect to see a small pick-up over the next few months on a m-o-m basis but I am not bullish about the evolution of consumer spending on a y-o-y basis. On the carry trade I see no change in the fundamentals and indeed if the US economy edges further towards a recession and the Fed begins to ease I am not sure that this would cancel out the carry trade in any substantial way. The point is that Japan, at this point, cannot muster an expectations driven appreciation of the Yen as this would feedback into price levels with a deflationary impact. As such, I see a distinct risk for the BOJ heading back into ZIRP if expectations begin to drive the Yen up relative to the USD and the Euro.

Finally, I want to end on an open note in terms of Japanese interest rates and whether the BOJ should normalize or not. My impetus is a recent article in Bloomberg which cites forecasters Christopher Wood and Brian Reading, who are both ardent Japan watchers, as saying that Japanese should interest rates and do so rather sooner than later. Wood for example notes that the BOJ should raise immediately from the current 0.5% to 1.5% in one go. But, we could ask, where might the sanity in such move be located?

Wood and Reading say that higher rates will help banks increase the margin between loans and deposits. Meanwhile, real estate companies should benefit as rising household incomes spur investment in land and deflation's end helps property prices.

``The Bank of Japan should raise short-term interest rates in one go to 1.5 percent now, not incrementally,'' said Wood. ``The normalization of rates in Japan would create a colossal buying opportunity for the stock market.''

So where do I stand here then? Well, first of all I do see the predicament with current monetary policy in Japan since the interest rate pretty much represents a blunt weapon for the BOJ. However, I am not sure I buy the Wood and Reading's chain of arguments. What we need to consider is that any such abrupt move would almost certainly lead to the return of deflation - at least in the short term - and it is hard for me to see how this could push consumer spending higher even if equity markets saw a substantial appreciation. We need to remember Japanese demographics here too (strangely Wood and Reading do not include the marginal propensity to consume vs. saving anywhere in their analysis) and as such deflation coupled with substantially higher interest rates seem to represent a rather strengthened incentive to save relative to consume. Of course, goes the story, property prices would increase as well which together with equity market appreciation would represent enough savings for the domestic economy to put more money into consumption yet once again this is a strange prediction given the fundamentals of the Japanese with a median age of close to 43 and climbing. In the end however I am all for going against the conventional wisdom but even in a best case Wood and Reading's suggestion would represent some gamble not least with the BOJ's credibility and with Japan's ability to service a mounting public debt.

The Global Capex Debate - Odds and Ends

Claus Vistesen: Copenhagen

The global economy today is surrounded by many vexing questions which are subject to much debate amongst economists. These questions include interesting topics such as global macroeconomic imbalances, the existence of a saving glut, and excess liquidity. Of course all these topics are intimately related and my impetus for this entry is a recent note over at MS GEF entitled the global capex debate (link is down right now, but it is the 19th february issue), where a number of MS analysts engage in a discussion on the topic. So in this entry I am going to address yet another derivative of the global economy, namely that of global capex (investment and capital accumulation), what it is, where it is and is there too little, too much, or just about enough of it, and lastly, but by no means leastly, what drives it?

What is Global Capex?

Generally, capex can be thought of as the investment and/or capital accumulation which accrues as a response to increased capacity needs. As such, there is both a supply and a demand dimension here since global capex can be operationalized as the supply side to capacity which then translates itself further downstream into demand. This conceptualization might seem false since it by-passes the tradtional definition of AD which in itself includes investment as a by-product of savings. However, as I move along here I will make it clear why we need to look at it this way.

But why is global capex important then? To answer this question we need to include the concept of the global capital to labour ratio (K/L ratio) and crucially to ask ourselves what has happened to this ratio in the last decade or so. One of the most notable changes in the global economy over the last 10-20 years has been the massive supply shock to the global economy in terms of how big emerging economies such as China, India, and Brazil have come onstream effectively skewing the K/L ratio in favor of the latter. This supply shock, as it were, has most widely been conceptualized as the so-called China effect which is normally thought to have had two overall effects on the global economy. Firstly, this labour supply shock has often been seen as a positive growth shock to developed economies or perhaps more accurately to their domestic labour and product markets. The point, in its most simple form, is that the emergence of cheap labour has enabled central banks to keep interest rates low without fuelling inflation in many domestic economies. The underlying point is that the abundance of cheap labour in, for example, China has lead to the import of deflation in consumer goods. A further consequence of this is also said to be one of excess global liquidity (a saving glut) as a result of low interest rates. Secondly, we have the global labour arbitrage argument which is used to explain why wages or perhaps more specifically labour compensation has been subdued in developed economies especially in certain sectors. In the US this discussion is for example packaged as a discourse about inequality and how to explain the seeming correlation between productivity growth and income inequality.

So what was global capex again? Well, if we follow the definition advanced in the introduction to the MS' debate we can say as the global K/L ratio has become effectively skewed towards labour, and that the global economy is suffering from a shortage of capital investment or more specifically capex. With this in mind, we should also take note of the point made by Stephen Jen in the above-linked debate (as well as elsewhere) that the whole concept of 'excess' global liquidity is itself a result of the low level of investment relative to the volume of capital available. This effectively means that Jen himself turns the traditional argument (as cited above) upside down when he advances the claim that excess liquidity will continue until global capex has sucked up the 'saving glut.' More specifically, Jen refers to the fact that excess liquidity is 'real' and not nominal which in Jen's own words means that;

Many, such as some ‘old paradigmers’, paint the image that we are standing knee-deep in liquidity flooded by the G10 central banks, with emerging economies as the accomplices through their currency interventions. But I believe it is the low level of global investment that has led to excess savings, which, in turn, have artificially depressed the real long bond yields in the world. This investment (I) and savings (S) framework is a real concept, not a monetary or nominal notion.

What we have above then is more or less what you initially need to juggle around in your head as we venture along. Moreover, it serves to brings us a step further as we can now ask where global capex takes place, what drives it and perhaps also my personal favourite question: where is the capacity (i.e. demand) for this capex?

The Anatomy of Global Capex

Let us begin with the first question in terms of who does the global capex? This is of course a tricky question since everybody obviously does some of it, but as we read along in the discussion over at MS two interesting points emerge. Firstly, we have the point made above that capex is conducted generally to rebalance the global K/L ratio which would then mean that for example China and India with their large share in the positive labour supply shock to the global economy should suck up a substantial and growing component of global capex. China and India are of course a little different in this respect in terms of their respective growth paths (and where they are in the development process) but for the purposes of this note I will simply leave that to one side.

The second important point to be found in their debate is the one forwarded by Robert Alan Feldman, who argues that ageing societies also will demand more capex as the only way they can grow is through increasing their investment shares and their underlying productivity. With this idea in mind, we can now begin to approach a framework from which we may be able to explain the current drivers of global capex. There seems to be two; 1), the skewed K/L ratio translates itself into a demand for capex (too much money chasing too little investment?) to meet the situation of excess liquidity and the saving glut and 2) the ageing process in some key developed economies, which in the most affected economies then acts as a driver for increasing capex as these economies enter a growth path where rising investment shares and an increase in TFP (total factor productivity) become the only viable way to sustain economic growth and living standards in the face of increasingly flat domestic consumption.

However, if we accept this explanation, I still think that we are missing a crucial part of the picture and this is also why, although I do sincerely believe that the Morgan Stanley Team and Brad Setser are right on cue with many of the points the make about the current conjuncture in the global economy, I am going to argue that we still need to adequately factor in one last aspect here, and I do not think it should comes as any sort of surprise to many readers, that I am once again going to invoke the importance of demographics.

In fact, as I have also argued before here at GEM, Robert Alan Feldman over at MS has already contributed markedly to the discourse by suggesting that the ageing process, via the consequent structural decline in consumption, will tend to transit economies onto a growth path driven by investment and productivity gains. However, what seems to be missing here is an account of the flipside to all this talk about the need for more capex, or more specifically an account of where the capacity is going to come from? In order to grind down to the core here it might serve us well to re-call the classic identity which makes up the GDP in an economy.

Y = C+I+G-(X-M)

Now, if we lock-in (growth in) Y at a constant nominal value and imagine a given country X with a median age of around 35 years we could imagine a composition of GDP where C (consumption) equals 70% of GDP. Then, and this follows from Feldman's point as well as arguments advanced a number of times by Edward and I, we should expect this figure to gradually decline as the populations steadily age, coming down around 60% of GDP as media age approaches the 45 mark due to the life cycle component of consumption and saving patterns (empirical evidence for this estimate can be currently found in places like Germany, Japan and Switzerland).

Now, if we hold the share of G (government speding) constant, we could begin to think about this transition by arguing that what gradual population ageing means is a relative shift from a consumption-driven growth path to one driven by saving/investment dynamics (i.e. capital accumulation). However, since we are dealing with open economies we can also expect that this transition also is a transition from one where the economy (perhaps) runs a trade deficit (i.e. domestic excess demand) to one where the economy runs a trade surplus (i.e. domestic excess supply). In fact, it is difficult to argue against this argument I think since the decline in consumption is a proxy for a shrinking demand side in the economy and as such the extent to which investment (capex) can propel domestic growth relies on the extent to which this investment is a countpart to foreign demand or capacity.

We need to remember here the argument that capital accumulation or growth through capital deepening runs into decreasing returns over time and this is exactly what would happen in a closed economy where the population ages and consumption declines accordingly; in such a case investment will enjoy ever decreasing returns relative to the decline in domestic capacity to absorb the capex. So all this is simply to say although I agree with Feldman we need to consider that this also means that ageing societies will be structurally prone to running trade surpluses (Germany and Japan are important test cases here).

This, I would argue, is the only way that these countries can, in Feldman's words, 'fight off' the structural effects of ageing'. In general, of course, consumption still constitutes the lion's share of GDP in all countries, but I would argue that there is structural limit as to how far this number can decline without having consequences for absolute real GDP growth and in the meantime this structural push will only increase the economy's reliance on exports. This is also the link to my initial comment on the supply and demand made in the introduction since whereas the demand for capex can be operationalized as a function of the skewed K/L ratio we also need to think about the demand for capex in terms of what the capex is used for, that is to say that an ageing population will (in real terms) demand fewer goods and thus require less domestically-oriented capex. Of course a theoretical end limit point here might entail what some have coined as 'rapid' dissaving process further on down the line, but we need to think about what happens between now and then even if we firmly believe this may well finally happen.

Too Much, Too Little or Just About Enough?

Leaving this theoretical example for a moment and going back to idea of the global K/L ratio it seems to me that although there are a lot indications which point to too little capex relative to an increase in global labour we might end up with too much! Why you ask? Well, let me explain ...

While we have indeed experienced an immense positive supply shock to the global economy in terms of the emergence of China, India, and Brazil (etc) there is another factor pushing in the other direction and that is quite simply ageing and we need I think to consider this a global phenomenon. We then get an inverse effect. As such, if capex needs to rise to accomodate a growing global labour force (or global supply shock) we also need to realize that the global labour supply might begin to fall at some point. This of course is not yet a reality but ageing and the demographic transition are not synchronously occuring on a global scale from the one and the same point of departure. In fact, as I have been arguing, some countries, such as Germany and Japan are now ageing rapidly, while the whole process of population ageing is nowhere near as advanced in many other develped economies. So, I am sketching a rather different scenario here than the one forwarded by the discussion over at MS. Consequently, we might end up having too much global capex and ageing can help us explain why. Consequently, if ageing pushes economies towards growth paths driven by investment and productivity gains we also need to take into account the likelihood that this growth path will be driven by the need to export. As such, if ageing is a global phenomenon, it also means that as countries join the club of 'demographic decliners' as Feldman has aptly put it, we are left with a long reaching situation where too much capex will need to be absorbed by too few importers of capital.

Investment is Bad then?

I would not want to walk away from this one leaving the impression that I am advocating saving/investment dynamics to be a bad and un-wanted thing for the the global economy since this would make me a pretty poor macroeconomist. Indeed, there have been many profound empirical economic studies which show how long term growth to a great extent is correlated with the savings rate. In this regard I also think it is important to note the point made by Stephen Jen (linked above) about saving rates and investments rates in Asia ...

'Exhibit 2 shows that in Asia, one of the fastest-growing regions in the world, while the savings rates for NE and SE Asia have not changed that much in the past 15 years, their investment rates have collapsed, even including the massive investment that has taken place in China in recent years.'

This clearly suggests that, at this point at least, there is indeed a shortage of investment relative to savings. Moreover we also have the US economy which is increasingly driven by consumption rather than capex. This of course conversely to my argument above indicates, at least in theory, that current growth is being traded for future growth. Indeed, some are hard at work predicting a recession in US which of course would have marked consequences for the rest of the world. So we also need to look at the imbalances here and crucially how demographics affect economies' growth paths and thus saving investment dynamics.

However, what I ultimately propose is that ageing and its impact on the economy might turn around the short term/long term view in the sense that we need to think about long term growth driven by for example technology and investment relative to a given level of consumption to GDP. In essence, we need to think about the idea of a balanced growth path and what happens when consumption as a share of GDP decreases to below 60%? Of course offloading your goods abroad might provide a brief asylum, especially if you are good at it, but in the end this is not structurally viable since many countries also have debt to pay and expensive welfare systems which after all depend on growth rates in the absolute level of GDP and not simply on changes in GDP per working member of the population (productivity).

Ending on the remarks made by MS I am not at all at odds with the general analysis that the skewed K/L ratio demands capex from a theoretical point of view. I am also much intrigued by the proposed relationship between this and the concept of excess liquidity and a savings glut. I like the idea that the world might, in fact, be in the 'early stages' of a whole capex cycle. I don't diasgree with much here but I think other structural forces are at play here in the long run which are important to consider when we discuss the global economy, macroeconomic imbalances and other related topics.

4th Quarter to the Rescue?

By Claus Vistesen: Copenhagen

Earlier last week figures for Q4 growth in Japan and the Eurozone came out and by and large the reports make for very comforting reading accentuating the notion of 2006 as a very good year for economic growth in both the Eurozone and Japan. In my initial notes here at GEM I have maintained a rather pessimitic tone towards growth prospects in the Eurozone pointing most notably to long term structural factors, but also looking forward to 2007 I see the potential signals for a marked slowdown in key member states in the Eurozone itself and in Japan. Yet, as the Q4 figures have rolled in this week and the commentaries have appeared, we find ourselves right smack into the same old optimistic discourse. In the Eurozone the commissioner for monetary affairs Joaquin Almunia was quick to up the forecast for 2007 Eurozone growth pointing simultaneously to the robust and Eurozone wide recovery. You could even hear amongst some commentators mention of the illusive concept of a goldilocks recovery resurfacing. In Japan, the optimism amongst market watchers was also almost uncontainable although some still recognise that domestic consumption constitues an ever enduring weak spot for this proclaimed sustainable Japanese recovery.

So what do the numbers say and what should we expect going forward?

Eurozone - Enough Honey in the Pot?

The 4th quarter figures for the Eurozone were an overall comforting read. Relative to the Q3 figures of 2006 where the Eurozone grew 0.5% q-o-q growth rebounded somewhat to 0.9% q-o-q. So what happended? First of all, and quite surprisingly I have to say no one seems to link this rebound in Q4, at least to some extent, to the French economy where, as we might remember, there was a quite surprising 0% q-o-q growth rate in Q3. In Q4 France grew by 0.6% over the previous quarter, which translates into a 2006 growth clip at an annualised rate of 2.2%. Obviously, the 4th quarter is not all about France since Germany and Italy also reported strong growth rates above the earlier consensus forecast. In Germany, growth increased sligthly from Q3 (0.8%) to 0.9%. The reason for this is widely cited to be a pick up in domestic consumption as consumers chose to bring forward purchasing to avoid the three percentage VAT hike which came into effect on the 1st January 2007. I have not had time to consult the figures in terms of composition but generally the commentaries also confirm the picture of a German growth path which remains driven by strong export growth contributing significantly to Q4 growth too. This phenomenon of forward purchasing, especially of durable and capital goods, is also emphasized by MS's Eric Chaney in his note on the Q4 growth figures in the Eurozone. Actually, the German growth rate does not surprise me that much but Italy's does I have to admit. In Q4 the Italian economy raced ahead reporting a 1.1% growth rate q-o-q and here also the break-down of the growth components has not yet been given in the official data. However, intra-trade dynamics within the Eurozone and especially the sustained pace shown by Germany are noted as major contributors. However, as Eric Chaney also notes, external demand cannot be the sole driver for such impressive numbers for the 4th quarter. Lastly, we have Spain where growth also maintained a lively pace reporting 1.1% q-o-q which also translates into a very strong annualized growth rate of 3.8% (annualized quaterly figures) and close to 3.8% in y-o-y terms too.

So, all in all, there should be plenty of grounds for optimism and as such also grounds for the revival of the goldilocks recovery idea. However, the question remains, will there be enough honey to go around as we venture further into 2007? Well, both Eric Chaney's note as well as this analysis by Eurointelligence pretty much beats me to it in terms of calling and essentially maintaining my pessimism. There are at least two things which we all seem to agree on. First of all, as I have also persistantly been arguing since last summer, fiscal tightening is on the menu in 2007 in both Italy and Germany and given the nature of this tightening process which essentially is a proxy for personal savings I am weary for the outlook for consumer spending and ultimately the evolution in aggregate domestic demand in 2007. Secondly, there is the evolution of the US economy to think about, and although recent data continues to point to a 'soft landing' for the US economy on the back of a housing slowdown in Q3 and Q4 of 2006, the US economy is by no means out of the woods yet. Eurointelligence points to a recent note by Brad Setser in which the December Treasury International Capital report is scrutinized. The worrying data point is that private capìtal inflows have turned negative (at least temporarily) which of course brings into question the sustainability of the mounting US current account deficit. Stephen Roach from MS also has more on this in one of his recent notes. Yet, we also, of course, have commentators like Nouriel Roubini who has been busy pointing us to the possibility of impending credit crunch in the US. Lastly, I should also note that Eurointelligence seems to agree with me (or I with them) in terms of the questionability of the continued presence of inflationary pressures and whether or not the ECB really does need to remain so vigilant, at least on inflation grounds.

In this context we need to keep well in mind that liquidity/monetary measures such as, for example, M3 are not necessarily an accurate measure of inflationary pressures especially in the light of carry trading. Secondly, fiscal tightening is key member countries is also likely to have a deflationary effect on Eurozone aggregate inflation rates.

In the end I also need to point to the inability or reluctance of commetators to factor-in the sustained process of ageing in the Eurozone and especially Italy and Germany. As the ECB continues to pursue an ideal Eurozone-wide interest rate I fear that imbalances within the Eurozone itself might very well grow to become even bigger and as such the strutural growth path of key member countries may be pushed even more towards export dependancy. This is why I am so interested in consumer spending figures from especially Italy and Germany which provide an important test case for the hypothesis.

Japan - Expecting a Hike by the BOJ?

Turning over to Japan the Q4 also reported a healthy growth clip. From the third quarter the economy grew 1.2% which translates into an annual growth rate based on annualised quarterly figures of 2.2%. Of course the interesting thing here is consumer spending and here alongside the FT article linked above Takehiro Sato from MS provides the relevant figures in his note on the Q4 figures. The q-o-q figures show an increase in domestic demand in Q4 of 1% after a (-0.3%) decrease in Q3. This translates into an average q-o-q growth in domestic demand of 0.4% (0.35%) in the last two quarters of 2006. Turning to movement on a y-o-y basis, domestic demand grew 4.8% in y-o-y terms in Q4 but declined (-4.2%) in Q3 on a y-o-y basis. This consequently translates into a composite growth rate in the two last quarters of 2006 on y-o-y basis of a 0.3% increase. These figures are of course subject to continous revision and as the main sentiment goes we should perhaps be looking for a downward revision? Sato from MS also notes that consumer spending perhaps declined on a monthly basis in December relative to October and November. Turning to inflation, prices remain subdued and the Q4 did not see any notable move towards sustained inflation; in short, we are still hovering very close to negative price evolution. Sato has the relevant summary:

Among domestic demand deflators, the public and residential investment deflators remained in an upward trajectory, while the capex deflator also bottomed. Above all, the decline in the personal consumption deflator is hurting overall.

So what does this mean for the BOJ and future interest rate expectations? As I have already argued before following one of Takehiro Sato's points, the BOJ should be very careful about raising in March on the back of positive Q4 figures especially when the general trend in consumer spending figures and inflation is still very weak. MS apparently puts the possibility of a March hike at 50% (or marginally at 51%) which is the equivalent, in analyst-speak, of saying ... this could go either way. In the end, I think the BOJ decision should be pretty clear by now and evidently, if the main yardstick is to remain economic fundamentals, I do not see justification for a raise from the BOJ. However, there are other factors in play here, including pressure to unwind the carry trade as well as the perceived need and/or temptation to act on the Q4 figures. In the end I think that inflation will provide the strongest grounds for the BOJ to stay on hold as it is very likely that the first quarter of 2007 will see inflation dropping into negative territory as the headline reading continues to put downward pressure on prices. Finally, Takehiro Sato continued his Japan coverage last week by reporting that MS have recently upped their forecast for the Japanese economy. The above-mentioned reservations do however all remain, and as we stand on the brink of the next BOJ interest rate meeting we have reverted to a 'too close to call' stance by the markets.

4th Quarter to the Rescue?

So then, we should not be doomssayers here. Both in the Eurozone and in Japan 4th quarter economic data points to a solid growth towards the end of 2006, but what we are talking about here really is only data for one quarter and we should be looking at the bigger picture too, and also, crucially, the structural components of growth in the economies in question. As such, the fundamentals have not changed I think and ultimately this is why I remain sceptical on the ability of both these key economic regions to display the same kind of vigorous growth in the future that we have seen in the recent past. In fact, given the rather spectacular growth stint we have just been through, and especially in the Eurozone, we really should expect 2007 to be somewhat different. At the end of the day we need to think about just how to describe all of this and,crucially, we need to consider just what a 'sustainable' recovery actually means in the present context in the key economies? In Japan, 2006 was the year which marked (for the time being at least) the official ending of ZIRP was ended, but even exiting 2006, where it is widely recognised that growth was at an unprecedented rate in comparison to recent performance, interest rates have not been pushed up since the initial move which took Japan out of ZIRP in the summer of 2006. So, will 2007 finally be the year when this, after all, hideously slow normalization process really starts to take root? Perhaps, but perhaps not, and as I have stressed so many times on these issues we need to look at the structural components and what they mean. A 4th quarter rebound is indeed good in and of itself but whether it is a sign of maintained and sustainable strength is an entirely different question.

Ageing in Germany ... an Important Impact

by Claus Vistesen: Copenhagen

Update: My calculations below have been revised slighlty to show average y-o-y figures in stead of the previous figures which showed average quarterly changes on a y-o-y basis.

In a previous post I have already made a big point out of not lumping the Eurozone together as one single economy here at GEM. At least, I argued that for analytical purposes we should be aware of the caveats involved in doing so. The damn thing about this, of course, is that it demands we look at all the Eurozone economies individually which can become a pointless and thankless task in and of itself. So we do indeed need to look at the aggregate state of the Eurozone whilst at the same time being able to grind it down to country level specifics and in terms of doing this we might want to start with Germany, the biggest member of the Eurozone which also accounts for a little under 30% of the Eurozone economy.

So what is it that is so interesting about Germany? Well, I have already highlighted in my previous post (linked above) that I believe demographics to be important in the sense that the course of Germany's growth will provide an important test case for a hypothesis on how demographics affect the macroeconomic environment. But also more generally the German economy is obviously pretty decisive in terms of overall growth in the Eurozone.

Consequently, as with the Eurozone as a whole in 2006, Germany has also come through the last year quite impressively compared to previous years. In fact, this impressive run in 2006 has lead many commentators to hail the return of Germany towards a sustainable recovery from the recent years of sluggish growth ... some have even talked about a 'goldilocks recovery.' However, I have always been rather reluctant to subscribe to this view and although there can be no denying Germany's impressive performance in 2006 I believe the underlying tale of Germany's growth composition is an important indicator of why we should not perhaps be so optimistic after all. As you might have expected I am going to anchor my analysis in demographics and I really want to stress that I don't do this just because of some sort of fundamentalist view that demographics are destiny to economic growth and performance. I do feel, however, that someone has to talk about this topic and quite frankly I am continuously surprised that noone seems to want to factor this aspect into their economic analysis, especially in Germany where the demographic changes and outlook constitute, after all, fundamental shifts in German society. Essentially, I will argue that the persistently sluggish growth in private consumption coupled with a growth path which is driven more and more by exports are, to a somewhat strong degree, symptoms which are endemic to an economy with a sustained process of ageing such as that which is to be found in Germany.

Consumption in Germany - Sluggishness or Outright Decline?

One of the most striking features of the German economy in the last 25 years with exception of the post-reunification boom is the continuing decline in household consumption growth. Let us scrutinize the facts for a moment.

1

The figure above from a paper by Adam S. Posen (summarized here by Wolfgang Munchau) shows this development with the exception of 1990 and the re-unification which is excluded in the figure. However, the time series ends in 2001 and I guess that we should also try to account for the period from 2001 onwards in order to try to get a full picture. Now; I should say here that the number crunching gets a whee bit complicated here but I still think we can get a pretty good estimate of the evolution of things. As such, my rough calculations on price adjusted private consumption expenditure figures from 2002 through 2006(Q1-Q3) show an average increase in private consumption in percentage change of previous year of 0.14%. However, if we exclude the first three quarters of 2006, during the years 2002 through 2005 Germany actually recorded a slight average decline in private consumption of -0.68% y-o-y. This should perhaps indicate that the impressive year in 2006 needs to be explained by other factors, like forward purchasing as a result of the VAT hike perhaps? Only yesterday the 4th quarter figures were released and they point to a strong growth stint in Germany and indeed in the entire Eurozone. However, these figures are still subject to revision, and it is worth bearing in mind that the OECD private consumption index (2000=100) shows for the same period (02-05) a stagnation in private consumption relative to 2000 PPP figures. Essentially, it should be quite clear though that private consumption growth in Germany over the past years has not exactly been rampant and the question of course imposes itself ... why is this? Ageing and demographics surely are not the only explanation but let me put it this way. The hypothesis of a strong life-cycle component of economic growth composition is in this case an 'all things equal argument' and in the broader picture sceptical consumers or not it we should only expect the process of ageing to weigh even heavier on the German consumer's propensity to save relative to consume.

Another related issue to the scrutiny of consumption is the contribution of demand to GDP growth. This has two aspects. First of all we have domestic demand's contribution to real GDP growth and secondly we have the total share of demand (private consumption) in nominal GDP. Looking at the former a recent IMF paper on Germany's exports' share in GDP growth which I will return to later provides a telling figure. Once again the reunification boom stands out as somewhat of an irregularity from the general trend.

2

As we can see in the figure the contribution of demand to real GDP is pretty volatile over the entire time series but if we factor out the reunification boom domestic demand's contribution to real GDP growth has steadily declined since 1994 and especially from 1999 and onwards we see that the emergence of an export driven growth path has become pretty clear. Moreover if we look at the total share of private consumption relative to nominal GDP calculations from the national account figures we can see that private consumption is now just shy of 60%. My concrete calculations show a 59% share of private consumption in nominal GDP between 2002 and 2006 a figure which is relatively stable y-o-y; that is to say, you have to go into decimals in order to track such a slight decline. This figure is of course in striking contrast to younger societies such as India for example where private consumption accounts for about 70% of GDP but also with economies such as the UK and the US where the consumption share of GDP is much higher than in Germany. Why? Well, take a look at the demographic differences between these countries and you should have a pretty good bullseye to go by I would say.

German Exports - Steady as She Goes?

Where Germany's private consumption growth, share of nominal GDP, and contribution to real GDP growth seem on the decline over a more or less extended time series, German exports have, especially since 2000, taken up the baton from domestic consumer demand in contributing to real GDP growth. As I reported in a previous analysis German GDP growth from 1999-2005 averaged 1.2% of which four fifths (0.8%) were due to net exports. By conducting a mirror of the consumption calculations carried out above my calculations show that net exports in Germany averaged a growth rate y-o-y of 1.32% between 2002 and 2006 (Q1-Q3). Between 2004 and 2006 the surplus in trade in goods and services has stood steady at 5-6% of GDP. Another interesting perspective on German exports come from a recent IMF paper (mentioned above) which sets out to explain the rebounding market share of Germany's export sector. The paper is excellently summarised by Wolfgang Munchau over at EuroIntelligence. Essentially, the paper argues that specific ties to fast growing trading partners and the successful exploitation of regionalized production and value chains have been strong contributors to the rebounding market share of Germany's export sector. Interestingly, the paper somewhat goes against the so-called global labour arbitrage theory which argues that wage moderation in developed economies have been necessary in order to compensate for the emergence of especially India and China on the global stage. Indeed, Germany has experienced considerable wage moderation from the mid 1990s and onwards. This is especially evident internally in the Eurozone where the decline in Germany real effective exchange rate has caused many to speak of a beggar-thy-neighbour policy conducted by Germany vis-à-vis its Eurozone colleagues. However, whereas the German exports indeed have been strengthened in an intra-zone perspective the paper dismisses this factor's contribution to the overall increase in Germany's export market share. This is interesting in so far as the general argument on the importance of global labour arbitrage which is also sometimes argued to be the source of exactly sluggish domestic demand in for example Germany and Japan.

Obviously, this remains a very powerful and potent global economic dynamic but we need to look at it alongside another global phenomenon, namely that of ageing and essentially the build-up of demographic imbalances as a result of countries' asymmetric paths through the demographic transition. The thing which stands out in the IMF analysis as the main reason for Germany's growing international export market share are the ties to fast growing trading partners. I don't believe that you need to think long and hard to guess that these trading partners include prominent global players such as India and China, but it is also interesting to note how the petroexporters are singled out by the paper. I find this interesting since some of the very recent news coming out on the Germany tends to suggest that these conditions are changing. As such, exports declined in December 2006 for the second consecutive month but, more importantly, one thing which is highlighted is how, for example, industrial products sold to China are declining as China is moving up the value chain and thus becoming able to produce these goods domestically. Once again, the evidence of another strucutural shift here is just one more reason why we should be very cautious in terms of hailing the sustainable and even goldilocks recovery in Germany.

Conclusion - Once again, strong circumstantial evidence

What I have essentially tried to argue above is once again the attempt to account for a life cycle component of growth in an ageing society. I am duly careful of course and as such the evidence is circumstantial and not conclusive but I do not think it is unreasonable to claim that demographics have somthing to say. In the case of Germany there might indeed be other factors at work holding down consumption but as Germany ages we should only assume that the life cycle consumption component will increase and as such the Germany economy may well become structurally even more biased towards a growth path driven by exports. In the end I am really not a fundamentalist and demographics are not destiny to economic growth but I am pounding away in order to clarify that demographics indeed do matter and that we need to understand how they interact with the macroeconomic environment.

In terms of Germany it is in many ways a good day to address this. The GDP growth figure for 2006 is likely to be upped to 2.7% and as such the proponents of the goldilocks recovery should feel vindicated. However, I am not optimistic about 2007 and the reason is not necessarily that Germany will plunge into recession but rather cautious given that the VAT hike which was in some ways necessary has been coupled with a vigilant ECB whose interest rate hikes may well depress private domestic consumption even more given the already strong structural forces which are in play. In 2006, domestic demand is likely to have contributed strongly to GDP growth but given the very special situation in 2006 where for example consumers have pushed forward purchasing before the VAT hike I just do not expect this rampant pace to be sustainable and I am even a bit pessimistic on the downside too. Also if exports are also set to run into difficulties there is no time for complacency I would say. Generally, the demographic outlook in Germany is of course set to have huge consequences for economic growth going forward and this is epitomized by the figure below taken from a research note from Deutche Bank (linked below). This is of course a model simulation but it should give an idea of what we are talking about.

The last intriguing point I would like to highlight is the angle provided by the paper from Adam S. Posen cited above which actually compares the economic performance of Japan and Germany since the beginning of the 1990s. As Munchau puts it in his summary ...

Japan’s stagnation began with an asset price crash; Germany’s was brought on by unification. In both cases, lousy economic policies made a bad situation worse.

Now, as you will read in the paper or in Munchau's well written summary we should not merely look at demographics and as such the need for structural reforms in both countries and following from Adam S. Posen's main points Munchau makes the following point ...

I have no doubt that Germany will eventually do the right thing, but Japan is currently ahead of Germany in terms of reforms. It is therefore rational to consider Japan’s long-term economic prospects as brighter.

I have no doubt that this is true in the sense that both countries should pursue reforms, but reforms addressing what and why? This is the question I think. In fact, there can many good reasons to compare Japan and Germany and one of them is demographics since these two countries are amongst the oldest societies in the world. This is why I think that if you want to compare Germany and Japan from the beginning of 1990s and onwards you need to incorporate demographics and its impact. Otherwise you won't get the right story ... pure and simple!

References to figures:

1. Adam S. Posen - IS GERMANY TURNING JAPANESE?

2. Stephan Danninger and Fred Joutz - IMF Working Paper, What Explains Germany’s Rebounding Export Market Share?

3. Deutche Bank Research - The demographic challenge Simulations with an overlapping generations model

No such thing as 'healthcare'

By Marcelo Rinesi: Buenos Aires

The fundamental issue with the growing discussion over healthcare costs is that they aren't necessarily costs. After all, health (in its broadest, most inclusive sense) is one of the most interesting goods one might want to buy. And buy it we do -or try to, at least-, with everything from gym machines to diet pills to state-of-the-art interventions. It's a good that, to varying and not always clear degrees, we have decided to subsidize, but it is a good.

But healthcare is also an investment. Even without the disruptive effects of things like plagues, health problems cause all sorts of havoc, like workplace absenteeism and lower productivity (health problems during the first years of life, for example, impact negatively on lifelong overall productivity). And this is only one side of the coin: even nominally "healthy" (i.e., "not sick") people become much more productive -not to mention happy- with regular exercise, caffeine, and other biological interventions.

I've found that replacing the term "healthcare" with "biotechnology" is a very interesting mental exercise. I think it reflects better its economic impact and its technological dynamism (which doesn't preclude tech-free lifestyle interventions - biotechnology isn't always about gadgets). Also, it helps fight a very problematic bias: the idea that there is a nominal "baseline healthy" human, a "main biological sequence" which healthcare should confine itself to keeping us in sync with. First, if Homo Sapiens has a baseline life path, it's rather short, brutal and nasty, involving painful ailments and gruesome deaths that nowadays we (have at least the technical capability to) avoid. Second, our current concept of what "being healthy" means involves a host of cardiovascular, biomolecular and cognitive problems once you reach your seventies, eighties or nineties. Thinking that there isn't nor will be any demand for something better is the biotechnological equivalent of "640K of RAM ought to be enough for everybody." It wasn't and this won't, neither for individuals, their employers or their countries.

This probably universal demand for emerging biotechnology will, I think, make aging societies more economically dynamic than they otherwise would be, with rising demand curves as technology makes new goods available, and as future productivity expectations shift, incentives for saving will decrease. But healthcare/biotechnology markets, highly politicized and subsidized as they are, must work right in order for this to work out and, most importantly, we should stop thinking about "healthcare" and keeping people "baseline healthy", just as we don't think about the automobile industry as giving people their "baseline cars." I do think the state should help people have access to biotechnology -for ethical, societal and economic reasons- but forcing everybody to get "just enough" will hurt what could could become an economic driver -especially for developed, aging nations- as strong as information technologies have proved to be.c

Structural Drivers of Global Macroeconomic Imbalances

by Claus Vistesen : Copenhagen

Here at Global Economy Matters we we are going to emphasize that any analysis at the individual country-economy level needs to incorporate and take into account the global economic context. In this post I will try to outline one important conceptualization of the global economy as it is being widely debated at the moment amongst global economic analysts. I am speaking here of the phenomenon known as global macroeconomic imbalances and in terms of a brief description the visualization offered below from a recent IMF paper on the subject is good starting point.

*

Essentially, the concept of global macroeconomic balances is a proxy for the imbalance in the external balances in-and-between the world's major regions. More specifically, as can be seen from the figure the concept basically juxtaposes the US as an economy running a large current account deficit with other parts of the world running external surpluses or very small deficits. Apart from the actual description of this the most interesting task is to look at the economic dynamics and structural drivers behind these imbalances and it is here, as they say, that the plot thickens.

What are the dynamics and structural drivers of global imbalances?

1. Bretton Woods II

Perhaps the most widely cited explanation for the global imbalances at the moment is the notion of Bretton Woods II. This discourse which is excellently developed by Brad Setser from RGE directs its focus towards the US current account deficit on the one side and the dual dollar peg of Asia (most notably China) and Petro exporters on the other side. The empirical foundation for this analysis is very strong. Consequently, the US current account deficit seems indeed, at least to some degree, to be extensively mirrored in a very large and growing Chinese surplus as well as a joint surpluses being run by the petro exporters. This also brings us to the actual mechanism driving the global imbalances. As such, the main drivers become the surplus nations' fixed exchange rate policy, and the subsequent sterilization of the capital inflows associated with the huge external surpluses. More specifically, this mechanism works through the accumulation of reserves in dollars to keep a de-facto dollar peg by China's and the petro exporter's central banks. Finally, this also brings us to one of the major components in any re-balancing process where a gradual loosening of, for example, the RMB's value against the dollar would help smooth out the imbalances as the bilateral trade relationship of the two biggest economies in the world would correct to the fundamentals in a floating currency regime or as Brad Setser likes to point out: 'relative prices matter.'

2. A Savings Glut

It is of course difficult to seperate the explanations and discourses entirely here. However, where the proponents of Bretton Woods II discourse focus their attention somewhat narrowly on the triangle relationship between the US on one side and China and the Petroexporters on the other, the saving glut thesis attempts to look at global saving dynamics as a driver of global imbalances. The main point of this thesis is an attempt to reconcile the situation of low global real interest rates with the US's ability to continue borrowing ever larger amounts of capital from non-US sources (i.e. the ability to sustain a growing external deficit). Consequently, a growing US current account deficit then becomes a counter-result to the abundance of foreign thrift and as such the main research question becomes the scrutiny of the reasons for the glut in savings and whether this will persist in the future. This clearly also allows for the incorporation of a Bretton Woods II type scenario but crucially it also sets the scene for a broader analysis and conceptualization of the global economy. Another important aspect here involves examining the role of Europe and Japan and asking whether (and to what extent) these two global entities can contribute to global rebalancing, and if so what form (how far and how fast) this will take?

3. Demographics

The idea that demographics should have something to say in terms of explaning and conceptualizing global imbalances follows directly and intuitively from the saving glut thesis referred to above. As such, one of the fundamental pillars in the saving glut thesis is indeed how demographics on a global scale represent a driver of thrift. In fact, a 2005 survey from The Economist on the global economy and more specifically on the savings glut itself (see also the link above) gives a very good initial description of the role of demographics. The survey links the phenomenon of global ageing to the economic theory of life-cycle operationalized specifically in Franco Modigliani's life-cycle hypothesis in order to argue that, at least, one of the factors driving the state of global savings is demographics. I personally think this is a very important point and as such I am also inclined to take the explanation one step further. The main underlying point is that demographics in fact have a lot to do with international capital flows and crucially that this demands we take a very close look at the dynamics of investment and savings in individual domestic economies. A tantalising question then becomes what in fact determines whether a country is running a surplus or deficit on the external balances and crucially whether in fact global macroeconomic imbalances are a proxy for global demographic imbalances? This also brings into question the whole idea and nature of a rebalancing process.

The three points above pretty much sums up the range of views on global macroeconomic imbalances as the debate is packaged today albeit with my own personal gripe that demographics are not often not given sufficient importance at the time of setting up the problem

As can readily be seen seen a lot still remains to be done, as the phenomenon is still hardly a well understood one, and one of the roles of contributors here at GEM will be to follow this issue and debate closely and build on what has already been achieved. My argument here is also based on the important implicit assumption that we cannot and should not seek to present a mono-causal explanation for the phenomenon. The issue and related dynamics are far too complex to be available for encapsulation in one single explanation, but rather we should be trying to weight and and determine the relative importance all the relevant factors which are associated with the hypotheses being advanced. Finally, it is perhaps already clear that I believe demographics represent one of the most important (and normally ill-explored) cornerstones here. As such, I am somewhat driven by my own personal intuitions and as we move along I will among other things dig deeper and explain why I think what I do. However, I can assure you that there are other views present amongst the contributors at GEM which will give mine and others' belief in demographics due challenge and counterbalance. The key point would be that this phenomenon is relatively new, and no-one has all the answers or a monopoly on truth, which is why it is so important that everything is explicitly debated. The need for just this debate is, at the end of the day, the principal reason why this new forum has been created.

* Figure 1 - p. 49. IMF paper on Europe and Global Imbalances, 22/9-2006 - (linked above).