Discussions of the population problem have always had the capacity to stir up public sentiment much more than most other problems.
- Gunnar Myrdal

Last Thursday the yen broke through the psychological threshold of 100 to the US dollar. On Friday the slide continued (see chart), even dropping very close to 102 to the USD at one point before strengthening slightly on the run in to the G7 finance ministers meeting.

The ostensible source of the sudden shift was a news release from the Japanese Ministry of Finance detailing the fact that Japanese investors bought a net total of 514 billion yen ($5.2 billion) in foreign bonds during the two weeks to May 3. Speculation had been rife that Japanese money funds would start to respond to continuing yen weakness and low Japanese yields by investing abroad. It is still far from clear that this is really going to happen in the short term, but nonetheless the news was sufficient to spark bets on more yen weakness.

Naturally the fall has drawn comment, especially during the run up to last weekend’s G7 meeting. US Treasury Secretary Jack Lew told CNBC that while Japan had “growth issues” that needed to be dealt with its attempts to stimulate its economy needed to stay within the bounds of international agreements to avoid competitive devaluations.”I’m just going to refer back to the ground rules and the fact that we’ve made clear that we’ll keep an eye on that,” he said in a comment that was widely seen as drawing a red line in the sand.

But really, what else do external observers expect? On 4 April Bank of Japan governor Haruhiko Kuroda announced he was going to increase the money base by 1% of GDP per month for the next two years. That is to say Japan’s monetary expansion will be incremental and continuous. Kuroda has even stated he will continue to increase the money base beyond the initial 24 months if the targeted inflation doesn’t come. It was always clear that the country was going to have a difficult time trying to generate inflation and that one of the knock-on consequences would be to continually weaken the yen. So you can’t realistically expect him to turn round and say now, “sorry, we didn’t know it would offend you so,  I’m cancelling the policy”. Anyway, that move would throw financial markets straight into turmoil. Didn’t they understand what they were signing up to when they accepted “Abenomics” at the last meeting?

Obviously there is still a considerable amount of confusion around about what exactly Japan’s problem is, and what the policy is trying to achieve. I have tried to examine the more theoretical background to the problem in my  A-b-e of economics post, but looking through the comments to that piece I realised that I was very tightly focused on one, examining only one aspect of what has come to be known as Abenomics, the inflation targeting component and its theoretical justification. Since ideas about what exactly it is the Japanese government is trying to achieve seem to be many and various, I thought it might be worth coming back and taking a second look at the experiment.

Three Arrows Into The Sunset

The aim of Abenomics is obviously to shake Japan out of its deflationary lethargy and return the country’s economy to a more pronounced growth path. In order to achieve this Japan’s Prime Minister has notoriously identified three policy arrows, or transmission mechanisms:

1) Aggressive monetary easing
2) Strong fiscal stimulus
3) An extensive programme of growth enhancing structural reforms

Achieving the inflation target is effectively the key objective of the first arrow, and weakening the yen is basically the transmission mechanism which achieves the objective. In fact while we have heard a good deal concerning the first two arrows, there is still relatively little on the table regarding the third one, as some commentators have started to wryly note.

Since there are many possible pathways along which these arrows may pass, it is probably worth taking a look at the big picture story in all its glory. To do that the following chart from Ritchie King at Quartz (who adapted it from a piece by Nomura economists) should serve as a very handy visual aid.

Central to the model is naturally the idea that generating inflation expectations can kick-start the economy. To help us think a little more about what that involves let’s take a quick look at a non-Japan-related chart – the Spanish retail sales one.

Notice the sharp spike in August 2012? Just what happened to cause that to happen? Essentially the Spanish government decided to raise consumption tax by 3 percentage points from September, so many consumers decided to advance their purchases to avoid the perfectly foreseeable coming inflation. The tax increase pushed up Spain’s CPI a couple of percentage points, and this effect will stay in the data till September 2013, when – guess what – the country might even fall into (irony of ironies) deflation. The reason the rise in the CPI may be followed by a slump into deflation is because the move was a deficit reduction one in an economy which is in ongoing deep recessionary mode, and evidently failed to restart the economy (no one thought it would) since retail sales then fell back onto their previous downward path. Hey, and guess what, Spain’s population just started to shrink. No possible connection I suppose?

A chart like this could be produced for a whole range of different economies on Europe’s periphery, but the point here is this, generating inflation expectations only advances sales, and doesn’t generate new ones, unless you implant the idea  that the inflation will be permanent and ongoing, and will be followed by more inflation and so on, leading people to the conclusion that it is better to get rid of their money by spending it rather than holding on to it for their old age. Whoops!

The most important arrow to leave Shinzo Abe’s bow to date was fired by the steady hand of his helmsman, Bank of Japan governor Huruhiko Kuroda, and this has been the massive monetary easing one. According to the plan announced following their April 4 meeting the BoJ will conduct monetary market operations which will increase the monetary base on a monthly basis at the rate of about 5 trillion yen a month. In this way the base will be raised from 138 trillion yen at the end of 2012 to 200 trillion yen at end of 2013 and 270 trillion yen by the end of 2014.

This amounts to a massive increase in base money to around 50% of GDP (see chart from Citi analysts below), but what is important is to note the incremental and continuing character of the ramping up – by about 1% of GDP a month. And if this isn’t enough Bank of Japan governor Kuroda has already said he is willing to continue the easing process beyond the initial two years. In effect the policy will continue for as long as it takes. I think this is called a “the sky’s the limit” approach.

Yen Devaluation Means Exports Are Up

Anticipation of the move (which was announced by Abe in the autumn of last year) has been successful in driving down the yen, which has now fallen by around 30% against the euro since last summer (see chart below), and by around 25% against the dollar. Naturally, as we have been seeing at the end of last week, we should expect more of the same to come. Plenty of it. As much as it takes.

This reduction in the value of the yen has evidently helped exports, but not by that much so far. They were up 1.1% over a year earlier in March.

But Deflation Stubbornly Continues

Naturally the sharp rise in the cost of imports this produces is generating cost pressure, but not enough to kick the country off the deflation path so far.

Indeed the Bank of Japan’s favoured index, which includes energy but not the cost of  fresh food, saw deflation accelerate in March to an annual price fall of 0.5%, the fastest rate in two years. And what inflation there is in the pipeline – electricity tariff hikes to cover mounting losses among the producers as energy import costs rise - was described by Bloomberg journalists Tsuyoshi Inajima and Brian Swint as the “wrong kind”, a statement which highlights the amount of confusion there is abroad about just what it is that the BoJ is supposed to be achieving.

To back their point they cite Klaus Baader, chief Asia Pacific economist for Societe Generale in Hong Kong to the effect that “this isn’t the kind of inflation we want in Japan to break the deflation mindset. We’d like inflation that is a reflection of higher wages, whereas this is pure cost inflation that decreases purchasing power.”

Maybe this cost push inflation is the “wrong kind” for some adherents of Abenomics, but it is the only kind they are going to get. Those who have gone through the structural lack of demand argument I advance in other posts will have realised that there is permanent downward pressure on costs in an environment of constant oversupply (this is why there is deflation in the first place)  making inflationary wage increases difficult to envision. Indeed, as reported by another group of Bloomberg journalists (Masaki Kondo, Mariko Ishikawa and Yumi Ikeda), reality itself belies such expectations, since Japan’s wage index hit a post 1992 low in January, even if it has bounced back a little since.

Hardy evidence for looming wage pressure. Indeed the wage-increase-driven inflation argument in Japan curiously resembles a similar one advanced for Germany – in both cases adherents tend to forget that market economies are not centrally planned, even by central bankers, and while you can possibly target equities in a long term deflationary economy caught in a liquidity trap you can’t target wages.
Put another way, it simply isn’t clear what the mechanism which fuels the extra wages that some people are expecting actually is, or why company CEO’s should be influenced by massive liquidity in precisely this way.

The central problem in Japan is constant oversupply, given technical change and a stagnant market, and hence there is permanent price pressure on companies to maintain their share of what market there is. Thus it isn’t surprising to find the following statement in the latest Japan manufacturing PMI report:

“While supporting a rise in exports, a further impact of a weaker currency was to raise the price of imported raw materials. Latest data showed that average input costs rose for the fourth month in succession, and at the sharpest rate in over a year- and-a-half. Margins subsequently remained under pressure as a net fall in output charges was recorded for the twenty-first month in a row.”

So raw material prices rose for the fourth month in succession, while the final product (output) price fell for the twenty fourth successive month. If the demand isn’t there you simply can’t raise prices, or wages. That there isn’t a basic understanding of this reality after so many years of deflation simply astounds me. You could argue that making money cheap and plentiful might encourage people to borrow a bit more and consume more, but borrowing to give some more away in wages, under market economy conditions I simply don’t follow the logic.

In fact Japan’s banking system is awash with deposits, deposits which simply can’t find enough loans to finance, even at interest rates on long term loans which are under 1%. Deposits in the banking system exceeded loans by 186 Trillion yen in March (around 30% of GDP), and the situation is unlikely to change. Much more likely than handing out money to wagearners is that banks who are awash with cash invest in one the country’s private equity funds, for which Bloomberg reports there is growing interest. Those who have been around long enough to remember the Bull-Dog Sauce Co affair may be forgiven if they roll their eyes at this point.

If the idea is to put more money in peoples pockets so that they can spend more, then this is exactly what fiscal policy is there for. But Japan is already running a 10% deficit, and has sizeable deficits running back as far as the eye can see, and that approach hasn’t worked to date, so there is no reason to expect it will start doing so now.

Here Comes My Umpteenth Economic Recovery?

Later this week we will surely open our newspapers (on Thursday to be exact)  to discover that the Japanese economy “bounced back to life” in the first three months of this year. Certainly it would be a huge surprise if it hadn’t. But much as any good news will be welcome we should never forget that Japan has been struggling with its problems since the property bubble burst over 20 years ago. So there has been more than one disappointment along the way.

The sad truth about the Japanese economy is that the demand just isn’t there. Indeed, despite a number of bullish “bravado type” articles (“Japan household spending surges as “Abenomics” gains momentum” -Stanley White and Kaori Kaneko, Reuters, or “Older shoppers lead Japan’s surge in consumer spending” – Ben McLannahan, Financial Times) nothing which has happened of late really changes that assessment.  What consumption indicators we do have are often contradictory. Thus, despite the fact that household spending “soared” 5.2 percent in March from a year earlier in price-adjusted real terms (clearly very good news), in the same month overall  retail sales actually fell 0.3 percent from a year earlier. The key point is that neither of these pieces of data is any way conclusive of anything, and especially since the policy itself didn’t come into operation till April. To be convincing the consumption data would need to improve on a sustainable basis over months and even years.

Looking into the situation a bit further, though, it becomes clear that most of the positive dynamic in consumption is coming from big ticket and  luxury items, and the reason for this isn’t hard to discern – Japan’s Topix stock index is up 65 per cent over the last six months, its strongest rally in decades. But it is important to bear in mind that four-fifths of Japanese households have never held any securities at all and 88 per cent have never invested in a mutual fund, according to a survey carried out last year by the Japan Securities Dealers Association. So while those who do hold shares will benefit from a “wealth effect” (another of the channels in the diagram above, monetary policy puts spending power in the hands of the top 20%) it’s always going to be a fairly minority affair.

But I would stress, since the BoJ measures were only announced on April 4 it is still far too early to be drawing any firm conclusions one way or the other.

It should also be borne in mind that Abe’s second arrow is a boost to fiscal stimulus, and naturally we would expect to see some positive impact on spending coming from that. When you couple this spending with the boost to exports which comes from the weak yen then  it is quite clear the economy should be expected to perform better in 2013 than it did in 2012. But at the end of the day this isn’t really what this experiment is about, since no one doubts extra fiscal spending adds to growth, and Japan isn’t simply trying to emerge from a garden variety recession.

What matters is that the country needs to convincingly demonstrate its ability to “turn the corner” so as to start paying down all the sovereign debt it has been accumulating. Or at the very least it needs to generate sufficient inflation and growth as to reduce the size of the debt as a proportion of GDP. Maybe the economy can get a bit of “bang for the yen” from the various measures, but with the labour force set to decline for decades to come ongoing economic contraction becomes inevitable at some point.  What matters then is the debt and the deflation tandem and how this can be put on a more stable dynamic without resorting to draconian spending cuts which will surely reduce the size of the economy even further. This is what the Abe experiment is about, and this is why the economy needs inflation, but on that front we are still very much in “wait and see” mode.

Domestic Critics Await The Day Of Reckoning

One of the issues facing Abenomics is that while the approach has become highly fashionable abroad (and especially among Hedge Fund managers), back home there are a growing number of critics raising doubts it will actually work. Doubts about the ability to reach the inflation target even start with the current board of the central bank itself. Board members are divided over the outlook for inflation, with some anticipating that consumer prices won’t even be rising at half the targeted rate two years from now. Former investment-bank economists like Takahide Kiuchi and Takehiro Sato, themselves recently appointed to the board, voted against the statement which set down that the bank believes inflation is likely to reach 2 percent in the latter half of the three-year BOJ forecast horizon. Governor Kuroda, however, is more optimistic and thinks the goal will be achieved in the 2015 fiscal year.

If the current board members have their doubts, those from the outgoing one tend to be even more scathing. Masaaki Kanno, now chief Japan economist at JPMorgan Chase in Tokyo put it bluntly to Bloomberg journalists, “It’s unrealistic — they won’t be able to reach their target in two years, or even in five.” Kuroda’s predecessor at the bank, Masaaki Shirakawa, is another who is far from convinced. Shirakawa sees deflation more as a symptom than a cause of Japan’s problems which, he argues, have important demographic roots.

“If there was a single thing that would have cleared the fog and solved all problems, Japan wouldn’t have been in this situation for 15 years,” he said in a speech on March 19, his last day in office. Journalists covering the Japan story might like to bear this in mind.

It is hard to disagree with Shirakawa, even though the former central bank board is being widely trashed. If demography is at the heart of the problem, it’s far from clear how massive monetary easing is going to solve it. In fact even Paul Krugman, intellectual godfather to Abenomics, sometimes seem to have his doubts. At one point he even said: “Here’s the thing, however: the economy won’t always be in a liquidity trap, or at least it might not always be there”. (Monetary Policy in a Liquidity Trap – NYT April 11 2013).

The use of that little word “might” is striking for such a bold experiment.

In fact once you look into it the Nobel economist seems to be hedging his bets all over the place. In the same article he says: “So, at this point America and Japan (and core Europe) are all in liquidity traps: private demand is so weak that even at a zero short-term interest rate spending falls far short of what would be needed for full employment”.
So its not just one problem, it’s at least three. But are all these liquidity traps the result of low fertility, or only some of them?

In an earlier article – The Japan Story (NYT February 5 2013)  –  he threw a bit more light on this, since he commented: “Oh, and what about the US relevance?………… What I think you can argue is that because we don’t share Japan’s demographic challenge, our liquidity trap is probably temporary, the product of an episode of deleveraging”.

Temporary????  Doesn’t that imply Japan’s may be permanent, which it is why he says it only “might” escape. And what about Europe, which is half US half Japan in demographic terms, will Europe’s liquidity trap be “semi-permanent”?

The thing is this, given all the doubt about the real roots of Japan’s problem, and the fact that it may well be permanent – as working age population slides there might be a permanent, structural excess of supply over demand – is it really justified to run such a high risk, all-or-nothing experiment?  What makes people nervous is the thought that if the central bank can’t deliver on its promise then a loss of confidence might ensue, and all those dubious risky asset positions might unwind suddenly, just like an earlier set did in 2008.

Seki Obata, a Keio University business school professor who in January published a book “Reflation is Dangerous,” argues exactly this, that “Abenomics” is exposing Japan to considerable risk without any clear sense of what it can accomplish. Obata also makes the extremely valid point that there is simply no way incomes can rise across the entire economy because the baby boomers are now retiring to be replaced by young workers with only entry-level wages. Japan’s overall consumer spending power will therefore fall, rather than rise as Abe hopes.

“Individual companies may offer wage increases, but because of demographics it is simply impossible to increase the total amount that is paid out in wages,” says Obata. “On the contrary, that amount will shrink.”

Simple logic you would have thought, but logic in the face of irrational exuberance scarcely stops people in their tracks.

As is clear from all I am saying here, the gist of the criticism which is leveled at Abenomics is related to the the idea that the country’s problems have strong demographic roots. With this in view, many members of the central bank “old guard” feel they are being unjustly held responsible for not finding a solution to a problem which it may not be within the capacity of monetary policy to solve. In a 2012 speech – Demographic Changes and Macroeconomic Performance – former BoJ governor Masaaki Shirakawa argues the following:

“Japan’s economic growth gradually slowed during the past two decades mainly for two reasons. In the former half of the period, the Japanese economy was hobbled by the crippling effect of the burst of the bubble. In the latter half, the rapid population aging hampered the Japanese economy through a variety of channels.”

Regarding inflation, he continues:

Seemingly, there would be no linkage between demography and deflation. But it may not be the case. A cross-country comparison among advanced economies reveals intriguing evidence: Over the decade of the 2000s, the population growth rate and inflation correlate positively across 24 advanced economies. That finding shows a sharp contrast with the recently waning correlation between money growth and inflation. How could we square those facts with each other?

Another former board member Takahiro Sekido, now a strategist at the Bank of Tokyo-Mitsubishi UFJ is even more direct:“The BOJ’s bond buying can’t resolve the shrinking population or aging of society. Because Japan’s productivity has only marginal room to rise, it’s necessary to prevent a decrease in population or to encourage more participation of female workers for economic growth.”

A comment which points to one evident conclusion, that Japan needs deep seated cultural changes, especially ones directed to greater female empowerment and more open-ness towards immigration. Hardly matters for central bank initiatives, and indeed ones for which Shizo Abe, who naturally has given his name to this new economic trend, is singularly ill equipped to carry through.

Managed Population Decline

Perhaps the most important thing which the whole Abenomics episode has brought to light is the urgent need to bring the existing corpus of economic theory somehow up to date with our modern realities. Despite all the talk of policies for “growth, growth, growth” a simple look at the population outlook in OECD countries, and especially the potential work force numbers means at some point or another economic growth will turn broadly negative. Valter Martins wrote about this in a post examining the Portuguese case I put up at the weekend, but former Bank of Japan governor Masaaki Shirakawa makes exactly the same point in the speech I mentioned earlier.

“Neoclassical growth theories normally do not distinguish the overall population from the working-age population for reasons of analytical simplicity. However, without taking into account the distinction between the two variables explicitly, the very challenges that Japan is currently faced with will be outside the scope of analysis.”

The key point is that when labour forces are growing, the extra employment adds positively to productivity to generate growth, when they are stationary labour is neutral and economic growth is equivalent to productivity growth, but when they are contracting then you have to subtract the rate of contraction from the rate of productivity growth to get your final GDP growth number.

“The [neo-classical] economic growth model supposes that everyone works at a given intensity. With a labor-augmenting technological change, in the long run steady state, per capita variables grow at the rate of technological change, and aggregate variables grow at the rate equal to the sum of population growth and technological change. In aging economies, including Japan, where the working-age population has started decreasing, the labor force also declines, given the participation rate being held constant. Because the scarce labor force imposes a natural constraint on labor supply, the marginal product of capital declines accordingly. As a result, macroeconomic growth would be impeded. With this idea in mind, the Japanese economic data in the past decade indicates that the workforce declined by 0.3 percent point, labor productivity increased by 0.8 percent point, and they add up to real GDP growth rate increase by 0.6 percent”.

Many of those who want to argue that miracle productivity performances make the demographic issue irrelevant normally simply fail to understand growth accounting dynamics or little about the productivity performance of developed economies over the last 20 years. Getting productivity growth of over 1% per annum  is hard, very hard, and will become even more so with an increasingly elderly workforce. A point which isn’t lost on US growth theory expert Robert Gordon.

So the real point is there is an experiment being conducted in Japan, but the experiment isn’t Abenomics (which I suspect won’t work, and could end very badly). No, the experiment is about learning to grow old with dignity, not as individuals, but as societies. It is about managing debt in a time of deflation, about giving opportunities to the young, even while the force of the ballot box rides with the old, and about finding ways to ease that rate of work force decline to give some additional room to allow productivity to help, which means again helping the young, since they are the ones who start families.

I will close with a quote from Keynes, one which comes from the same talk from which I drew an extract to start this piece. Population decline has been seen coming for decades, there are few things about the future we can know with a higher level of probability, and yet we find the reality and its consequences hard to accept. Rather like our own finitude I suspect. Yet accept we must, since otherwise it will be hard to find the energy to act, and to make the changes we must make if we don’t want a difficult process to become an extraordinarily painful one.

“Perhaps the most outstanding example of a case where we have a considerable power of seeing into the future is the prospective trend of population. We know much more securely than we know almost any other social or economic factor relating to the future that, in the place of steady and indeed steeply rising level of population we have experienced for a great number of decades,we shall be faced in a very short time with a stationary or declining level. The rate of decline is doubtful but it is virtually certain that the changeover, compared to what we have been used to, will be substantial. We have this unusual degree of knowledge concerning the future because of the long but definite time-lag in the effects of vital statistics. Nevertheless the idea of the future being different from the present is so repugnant to our conventional modes of thought and behaviour that we, most of us, offer a great resistance to acting on it in practice”.

Recently I came across a post by Portuguese blogger Valter Martins, where he looks in some depth at what is happening in Portugal. Really, despite the use of some technical details his argument is extraordinarily straightforward, in fact it is as elegant as it is simple. What he points out is that population growth rates serve as some kind of “quick and dirty” proxy for GDP growth rates, and growth in working age population serves equally well as a quick proxy for growth in GDP per capita. Any simple growth accounting process breaks growth down into a labour input component and a productivity component, so if your labour component turns negative, even to get the same growth your productivity component has to be greater. For societies that have considerable difficulty raising productivity in the first place this process of working population decline is going to make an already Herculean task even more difficult.

In addition Valter picks up a point few researchers seem to have noticed up to now, that working age population in Portugal just surprisingly peaked. Natural population dynamics have long been stationary in Portugal, and emigration has long-standing and deep roots. During the first eight years of this century the population loss caused by emigration (nearly all young educated Portuguese) was masked by the steady influx of immigrants looking for work. But now the country is in deep recession the immigrants aren’t coming. Indeed  some are even leaving, while the rate of emigration by Portuguese nationals has accelerated and continues to accelerate, sending working age population (and just as importantly its age distribution) on an increasingly negative path.

During the years of austerity we have become familiar with the phenomenon that as fiscal spending is cut growth falls making the achievement of fiscal targets even more difficult. Well something similar seems to be happening with migration movements, as part of the benefit to long term growth that accrues from making structural reforms disappears on the other side of the ledger as the workforce shrinks.   Again we are in danger of running round and round in ever diminishing circles.

Reading Valter’s post I became impressed with the power of his argument and was struck by the importance of what he had discovered. I therefore took the unusual step of asking him to translate the piece and offering to publish it on my blog. So, without more ado, here is:

Is Portugal Facing A “Shortage Of Japanese”?

Guest Post by Valter Martins

“So, about the slow growth/debt connection: I’ve done a quick and dirty mini-RR for the period 1950-2007 ……focusing only on the G7……and if you look at it, you see that most of the apparent relationship is coming from Italy and Japan……And it’s quite clear from the history that both Italy and (especially) Japan ran up high debts as a consequence of their growth slowdowns, not the other way around.” – Paul Krugman, Reinhart-Rogoff, Continued

Despite so much intense debate about the ailment from which Portugal suffers, and the mountain of sacrifices currently being borne by the Portuguese people one fact has gone virtually unnoticed in amongst all the noise – for the first time, at least in the modern era, Portugal’s working age population has started to shrink. Demography and its possible impact on economic growth is a topic which has been largely ignored by practitioners of economic science in recent decades as population growth has by-and-large been on an upward trend. However, as we enter a new period in human history, one in which the upward trend has shifted towards stagnation or even in some cases towards long run decline, the economic and financial implications of this transformation can no longer be ignored. As Nobel economist Paul Krugman indicates in the above quote, some countries have large debt simply because they have low growth.

So what is the common thread that runs through these low-growth high-debt countries? Could it be decelerating labour force growth and eventual labour force contraction? The cases of Italy and Japan are well known. In the case of Portugal, it will be argued here, demographic trends can not only explain a significant part of the slow economic growth the country experienced during the first decade of this century, they can also help us understand the depth of the current recession. More important still, we need to think about the consequences of this continuing lose-lose dynamic for the country’s future in both the short and much longer term.

Economists didn’t always take the view that population dynamics were irrelevant to economic performance. The 1930s gave birth to a serious debate about the possible problem that would arise if many decades of strong population growth were followed by population stagnation and then decline, a debate which was provoked by the fact that birthrates in a number of countries fell below replacement level for the first time in human history during the economic depression. And among the names of those economists who took the problem seriously enough to think and write about it was none other than John Maynard Keynes.

“There are, indeed, several important social consequences already predictable as a result of a rise in population being changed into a decline. But my object this evening is to deal, in particular, with one outstanding economic consequence of this impending change; if, that is to say, I can, for a moment, persuade you sufficiently to depart from the established conventions of your mind as to accept the idea that the future will differ from the past.” J.M. Keynes, Eugen Rev. 1937 April; 29(1): 13–17.

While the phenomenon has arrived largely unnoticed Portugal’s total population has long been near to stationary.

As can be seen in the above chart, Portugal’s population has been struggling to find growth momentum since the mid 1980’s (the first time numbers actually dipped downwards) but the years 2010/2011 seem to mark a more fundamental turning point, since it was in that time interval that Portugal’s population started on a long, and possibly irreversible, path of decline. Having long had a total fertility rate of below 1.5 this was a more than predictable outcome, and one that should have been expected ever since the total fertility rate fell (and stayed) below the 2.1 replacement level in 1982.

As is well known, population change is comprised of two major components: natural growth and net migration. Natural growth, births minus deaths, became negative in 2007 and thereafter population growth has become exclusively dependent on having sufficient positive net migration. Up to 2010 this condition was satisfied given the continuing influx of immigrants into the country as can be seen in the chart below.

However, since the onset of the 2008 recession, not only have the immigration flows reversed completely, but emigration has started to increase again, thus reanimating a trend that has been constantly present in Portuguese history over decades, even centuries. This is perhaps the most critical factor driving the recent population decline. In fact the decline would have occurred much earlier had it not been for the return of thousands of refugees from the Portuguese colonies in the 1974-1981 period.

According to the European Commission’s 2012 Ageing Report, projections for the Portuguese population during the period 2010 – 2060 anticipated that population would peak in 2034, but as we have seen, the latest data show the population unexpectedly reached its peak in 2010 (total population, previous chart), the year in which the population began to decrease (a similar phenomenon seems to have occurred in Spain in 2012, with again a reversal in migrant flows in an otherwise stagnant population being the trigger). This fact that this turnaround comes as a surprise is clearly the result over optimistic assumptions on the net migration front since the numbers for natural growth are well known and change little (although birth numbers are now dropping in many EU countries under the impact of the long recession). Clearly the unexpected factor here is the severity of the recession from which the country is suffering and the size of the exodus of young people who are leaving.

Just to highlight even more the speed with which all this is happening, in Japan, the interval between the beginning of the decline of the working age population and the beginning of total population decline was a full decade. In Portugal this interval was only two years.

Even more relevant than the decline in total population for the purpose of the present discussion is the decline in the working-age population. While the former gives us a good proxy for domestic consumption, it is the later which is important in terms of potential national output. All other things being equal a reduction in the working-age population means a reduction in output. Therefore, the most important detail to catch from the chart above is that the working-age population, defined as the population with ages ranging from 15-64, declined for the first time in Portugal between 2008 and 2009. As highlighted by both Daniel Gros and Paul Krugman if you want to compare economic growth performance as between countries with growing populations and those with declining ones the best indicator to use is undoubtedly GDP per Working Age Person (GDP/WAP).

In the Portuguese case if we take this ratio and compare it with both Real GDP growth and Working Age Population change (my calculations VM), we can get an impression of how variations in the Working Age Population affect the economic growth of a country. Surprisingly or otherwise, the data for Portugal viewed graphically not only confirms the existence of the “workforce effect” – the relationship seen between Real GDP and GDP/WAP – but also suggests that Portugal has already passed the point where this effect is beginning to have a negative impact on GDP growth.

As can be seen in the above chart, until 2008 the growth rate of Real GDP was always higher than the rate for GDP/WAP offering a strong suggestion that labour force growth was having a positive impact on GDP growth. It is noteworthy, however, that both in the period 1986 – 1991 and in the period 2003 – 2008, the growth rates of Real GDP and GDP/WAP almost overlapped. This phenomenon coincided with very low or zero rates of working age population growth and as such the “workforce effect” was mostly neutral. The first of these periods, 1986 – 1991, the stagnation in the workforce was the direct result of the increase in emigration that followed the entry of Portugal in the European Union. The second one coincides with the arrival of the turning point in long term WAP growth, as the size of the working age population irrevocably turns negative.

Indeed, during this early period of emigration towards the EU Portugal’s total population decreased, as shown in the chart Population by age group (above, blue line), but at the time, since the population in general was much younger, and many more new labour force entrants were arriving at working age, the growth rate of the workforce remained slightly positive. In other words, there were still enough Portuguese entering the labour market to replace those who were leaving it (either to retire or to seek a future abroad). In the second period, 2003 – 2008, the large exit of Portuguese nationals, about 700,000 between 1998 and 2008 according to research by the now Economy and Employment Minister Álvaro Santos Pereira, was to some extent offset by an inflow of immigrants, but these were only sufficient in number to maintain the workforce at a stationary level.

All this calm and stability disappeared, however, after 2008 when the growth rate of Working Age Population turned negative, i.e. the labour force began to decline (see graph below). Where the growth rates of Real GDP and GDP/WAP overlap we can surmise that working age population change is having no effect on real GDP growth. Subsequently, however, the growth rate of GDP/WAP becomes higher than the growth rate of Real GDP and thus the “workforce effect” starts to act as a drag on the economy steadily bringing the potential overall growth rate down. In other words, Portugal is now suffering from a “Shortage of Japanese” as Edward Hugh has called the phenomenon, after Paul Krugman originally coined the term to describe the underlying problem which has been afflicting the Japanese economy since the mid-1990s.

The fact that the three lines in the above chart happen to intersect at zero is perhaps just an unfortunate coincidence but is consequences are disastrous, since the downward trend that was already evident accelerated greatly after the onset of the recession. The resulting rise in unemployment not only caused a collapse in the immigration flow, it also led to a sharp increase in emigration. As a result workforce shrinkage intensified even further, as can be seen in the above chart by looking at the growing distance between the Real GDP and the GDP/WAP lines. That is, if the workforce had remained stationary the economy would be growing at similar rates to the GDP/WAP, i.e. above the current level as indeed happened in the period 2003 – 2008.

Naturally, the argument can be advanced here that the recession is a cyclical phenomenon, and this is surely true, there is an ongoing cycle, but the argument being used refers to long term trends – a reversal in direction (or change of sign) for inputs from the labour force component brings down the overall trend growth rate making booms weaker and recessions deeper, all other things being equal. This would seem to be a simple conclusion which stems from elementary growth accounting theory. Naturally, there are other factors which contribute to growth, like multi factor productivity, but again other things being equal you would need more of this to achieve the same growth rate as before under conditions of weakening in the labour force growth component.

Thus the argument is not that economic growth becomes impossible with a stagnant or slowly declining workforce, but simply that it becomes harder to achieve because it relies more on other factors, such as productivity and raising participation rates, but these change slowly over time, and more so in already developed countries. As such trend growth will surely steadily fall. This can be clearly seen in the following chart: while workforce growth was an important source of growth when Portugal was a developing country, its importance fell back as the workforce started to stagnate even as Portugal was approaching converge with other developed countries in terms of productivity. Other factors took over and increased their importance steadily as the economy started to converge with more advanced ones. Now that this catch up process seems to have come to a standstill as well the economy simply can’t growth, at least at rates considered normal. With a stagnant workforce, low growth or no growth is the new normal.

Following standard growth accounting procedures, during the 1970s workforce growth accounted for more than half of Portuguese economic growth (see chart above, my calculations VM), and this contribution had fallen to only 16% in the first decade of this century. However, since 2008 not only has this contribution reversed sign but also the magnitude of the negative effect has begun to increase rapidly. Such that, by 2011 the “workforce effect” could be considered to explain more than 29% of the GDP decline. This “negative drag” will continue, and the effect possibly become greater, as the working age population shrinks further. Had the workforce remained stationary we could surmise the 2010 recovery would have been more pronounced and the 2011 recession wouldn’t have been so deep. This is the principal reason why official growth forecasts have been being constantly revised to the downside, and this will continue to happen until the models the forecasters use adequately incorporate the effects of population decline on economic growth. Adding insult to injury, ignorance of the existence of such effects recently led Portugal’s Prime Minister Pedro Passos Coelho to suggested young unemployed Portuguese resort to emigration as an escape route from the crisis, advice thousands have now followed thus making a bad situation even worse.

Economic growth in Portugal appears to be on a long downward trend, a trend which will only be made worse by the onset of the decline in its working age population. Economic output is now at 2001 levels and thus we can now conclude that the last decade has been completely lost. More worryingly though, is that after such a bad start to this decade, it might not be unreasonable to conclude that this one is also in the process of being lost too.

At best the economy will stagnate in the years to come but the possibility is there that it will continue to regress – especially if nothing is done to stem the outflow of young educated people – and by 2019 it might even be back somewhere in the 1990’s. This is scenario simply cannot be excluded since, in addition to all the other problems the country faces, a situation that would be in any circumstance challenging is now being aggravated by one more variable whose contribution cannot be easily reversed in the short term – the decrease in the working age population. More than the fact in itself, it is the speed at which this is happening which is alarming, and the fact that policymakers appear unaware of the problem. In analyzing the low Portuguese economic growth issue the decrease in the country’s working age population can no longer be ignored! Or at least it is hoped that this will be one of the outcomes of this short report.

To return to where we started, Keynes concluded in his pioneering presentation that a stationary or slowly declining population could increase its standard of life while preserving the institutions society values most if, and only if, the process was managed with the necessary strength and wisdom. On the contrary, he argued, a rapid decline in population, of the kind that we are seeing in Portugal today, would almost inevitably result in a serious decline in living standards and a breakdown in highly valued social security mechanisms. The distinction Keynes drew some 80 years ago between rapid and managed rates of decline seems plausible, reasonable and highly relevant today. What we now need to see are urgent measures taken – initiated by the EU and the IMF – to counter the exodus which lies behind this dramatic decline which is occurring before our eyes, measures which at least try to decrease its speed, because once a process like this gains full velocity it will be very difficult to stop, and we have already seen it gather considerable traction. Ireland is a pointer and a great example to learn from, since it took that country more than a century to recover the population decline precipitated by the natural disaster which hit the country in the middle of the nineteenth century.

Postscript From Edward

I have established a dedicated Facebook page to campaign for the EU to take the issue of  emigration from countries on Europe’s periphery more seriously, in particular by insisting member states measure the problem more adequately and having Eurostat incorporate population migrations as an indicator in the Macroeconomic Imbalance Procedure Scoreboard in just the same way current account balances are. If you agree with me that this is a significant problem that needs to be given more importance then please take the time to click “like” on the page. I realize it is a tiny initiative in the face of what could become a huge problem, but sometime great things from little seeds to grow.

If the sovereign had shouldered these massive recapitalisation needs, debt would have risen to 145% of GDP. This would have critically endangered public debt sustainability. At the same time, traditional ways of burden sharing by the private sector bank creditors were limited, given little junior debt outstanding in banks.

The Eurozone has an effective* traditional way of burden-sharing with non-depositor creditors?

In particular, it was decided to cover the capital needs of the two largest banks exclusively through the own contributions of uninsured depositors and senior and junior debt holders. The creditors of the two banks would not be made worse-off than they would have been in the case of liquidation, which would have been the alternative to the programme. 

The Eurozone has a criterion that bank debt writedowns can be justified as long as the creditors are not worse off than they would have been under liquidation?

If only Ireland had thought of these things in 2010!

[*i.e. that doesn't endanger debt sustainability]

Naturally such a custom does not exist along Europe’s Southern fringe, which doesn’t mean it couldn’t be invented since the young and educated are increasingly leaving much to the chagrin of those they leave behind.

But the “packing up and leaving” variant has now become the predominant one in another country suffering brain flight, one which has does have significant historical associations with traditional Russian culture: Ukraine. The suitcase mood is alive and well among a growing number of young Ukrainians, as journalist Vitaly Haidukevych discovered when he conducted an online survey on the subject via his facebook page,

“The suitcase mood is there. [...] Young, promising people have it. [...] Since they are young, they are leaving not for the sake of immediate earnings [...], but to grow roots for the future. [...] I assume that these people asked themselves whether it was possible to change the state of things in the country – and the answer was ‘no’. [...] Some are leaving for exactly the same reason others are reluctant to join [the anti-regime] protests – they care about themselves, their families and their future. [...] “what are those rapid movements for, you’ve got kids, think about them” – this is what those who’ve stayed think. And those who are leaving [...] do not want to wait for the tax authorities to come and take away their last pair of underpants. [...]“

Is Ukraine Headed For Imminent Population Meltdown?

Now, as I say, this “want out” phenomenon can now be found in many countries on Europe’s periphery (here, here, here and here), but the Ukranian case is an extreme one. So much so that the Ukrainians themselves have a word for those who have left the country in search of work and fortune elsewhere - zarobitchany. According to a 2011 report issued by the International Organization for Migration six and a half million Ukrainians, or 14.4 percent of the population, are now emigrants who have left their country (or rather they were at that point, since the 2013 number is certainly larger). Countries like Russia, the Czech Republic, Hungary, Poland, Italy, Portugal and Spain are among the most popular destination countries identified in the report.

In all cases of low fertility societies young population exodus is a problem, but in Ukraine’s case it is well nigh lethal. The country has a little over 45.5 million inhabitants and the population is shrinking by 330,000 per year. Besides the birth/death deficit emigration obviously contributes significantly to this sharp downward demographic trend (hat tip to Ukrainian blogger Veronica Khokhlova for most of the above).

Even without emigration the population would be falling, since the birth rate is around 1.3 (well short of the 2.1 replacement level) and far more die each year than are born, but the fact that so many also chose the exit route raises deep and preoccupying questions about the future of such countries.

The latest UN population forecasts put Ukraine’s population at around 30 million by the end of this century, but this number is surely a highly optimistic one, in part because it assumes some sort of fertility rebound, but more importantly because it assumes that emigration won’t melt the country down much more quickly and much sooner than that. In addition to the smaller population the shifting age structures mean that the proportions of Ukrainians over 65 and over 80 will rise continuously. According to latest estimates Ukraine’s population in 2050 will look something like this.

Obviously people aren’t leaving because the population is declining, but rather because the economy is not able to incapable of generating sufficient economic growth and sufficient jobs to encourage people to stay. There is a loss of confidence in the future of the country because the economic decadence becomes associated with degeneration in the political system.

Decadence certainly seems to have set in at the economic level. The economy fell by nearly 15% in 2009, recovered growth of 4-5% a year in 2010/11 and then fell back into recession in the second half of 2012 (in which year overall growth was effectively zero. The IMF forecast a further year of zero growth in 2013 followed by a return to 3% growth thereafter. This subsequent out come may be very optimistic, and the country will possibly suffer from weak growth from hereon in, before eventually turning negative.

In this context the feeling inevitably grows that there is no way to turn the situation round. This feeling feeds on itself, and the big question is whether it produces a kind of circularity whereby the loss of confidence and the loss of people also feeds back into the economic process making the lack of growth and employment even worse.

Low Fertility Trap?

Such seems to be the situation Ukraine finds itself in, and naturally the frustration can be seen everywhere. As one comment on Vitaly Haidukevych’s Facebook thread put it, “It’s futile to expect economic growth in Ukraine. Everyone is trying to escape from it as quickly as possible.” Another said, more ironically, “One has to leave quietly, or else they’ll soon introduce a tax on leaving.” Others are more passionate and apparently even more determined:

“People ran, are running and will run. So many have left [Western Ukraine] for Italy, Portugal and the Czech Republic, and have not returned, and more will leave. It’s just that [mostly people from] the provinces used to be leaving before, and now Kyiv is moving as well. People are taking their kids to study to Poland and some even further! It’s a difficult situation in the EU now, but it’s still livable, while in Yanukovych’s Ukraine it’s 100 times harder! Me, I came to the Czech Republic five days ago, sit here without a job, but I’m not going back home”.

All of this puts me in mind of a fertility model developed by the Austrian demographer Wolfgang Lutz which he called the low fertility trap hypothesis. In developing this hypothesis his starting point was the assessment that “there is no good theory in the social sciences that would tell us whether fertility in low-fertility countries is likely to recover in the future, stay around its current level or continue to fall”. He then goes on to advance ”a clearly defined hypothesis which describes plausible self-reinforcing mechanisms that would result, if unchecked, in a continued decrease of the number of births in the countries affected”. Claus Vistesen wrote up a description of the hypothesis on the Demography Matters blog (back in 2007) and I have some notes here.

Obviously the number of live births fluctuates according to the number of women in a given population who are of childbearing age, which can be more or less depending on the size of the cohorts involved. But in general terms a country with 1.3 or 1.4 fertility will have steadily less and less children as cohort size drops. This is basically population melt-down, and this critical state can be triggered by a number of processes, including social and economic ones. Some country’s, as well as possibly being caught in fertility traps are also caught in liquidity ones, a connection which has not escaped the notice of Nobel economist Paul Krugman. While Krugman is surely not familiar with the fertility trap literature, he sees clearly that the low fertility Japan has experienced over decades has played an important part in the country getting stuck in a liquidity trap.

As he puts it: “Why is Japan in this [liquidity trap – EH) situation? A debt overhang from the 1980s bubble surely started the process; but surely it’s reasonable to suggest that the demography also contributes, since a declining working-age population depresses the demand for investment“.

Lutz already suspected that their might well be an economic feedback mechanism that would work to drive the number of children born in a country ever further downwards towards lower and lower levels, but I think the experience of the crisis has made this pathway a little clearer, in that those low fertility countries whose economic trajectories fall off a stable growth path may find it ever more difficult to get back on one again. In street jargon they could fall into a “lose-lose” dynamic driven by low-living-standards low-growth expectations and high unemployment. Not only do such negative economic conditions discourage young people from forming families and having children (obvious I think), they can also have the effect that young people leave in search of a better future thus reducing the potential number of children who can be born in the future.

The ensuing acceleration in the rate of population ageing and the proportions of older people only makes the problem of sustaining public spending on pensions and health systems worse and worse, causing the fiscal burden on those who stay to grow and grow, a development which makes it more and more attractive  to leave and start up again elsewhere. And with each additional person who leaves there is another turn of the screw, and the costs of staying get higher, as do the advantages of not doing so. This is how melt down can happen.

Naturally there can be a political dimension to the disintegration, as the need to implement ever less popular policies (especially policies unpopular with older people, those who do vote) leads politicians to become more and more demogogic while delivering less and less. Naturally the democratic quality of a country’s institutions starts to deteriorate under these circumstances, which only makes the young feel even more helpless and under-represented.

This outcome is now becoming plain in much of Southern Europe, but it is obviously even more evident in Ukraine, where the former Prime Minister Yulia Tymoshenko is currently imprisoned, a decision which has just been roundly criticised by the European Court of Human Rights.

Can Countries Actually “Die”?

So where does all this lead. Well it leads me personally to ask the question whether it is not possible that some countries will actually die, in the sense of becoming totally unsustainable, and whether or not the international community doesn’t need to start thinking about a country resolution mechanism somewhat along the lines of the one which has been so recently debated in Europe for dealing with failed banks.

That something like this is going to be needed I regard as being what John Locke would have termed a “self evident truth”. As we know, in country after country each generation is getting smaller. While we can argue about exact timing, what this falling population means means is that GDP will eventually start to contract. This should make those ecologists who have long been arguing that the planet was over populated and that zero of even negative economic growth was desirable extremely happy. But what about the debt left behind by earlier generations, will that also contract? The Japan experience so far tends to suggest it won’t, and herein lies the rub.

But this is only part of the problem, since the process of country decline, like most processes in the macro economic world, is non linear. That is to say critical moments or turning points will exist when suddenly things move a lot faster than expected. Hemmingway grasped the essence of this in his much quoted “bankruptcy comes slowly at first but then all of a sudden”. As the economy falls back, and the burden of debt grows on the ever smaller numbers of young people expected to pay, the pressure on those young people to pack their bags and leave simply mounts and mounts, accelerating the process even further.

In fact populations dying out is nothing new in human history if we move beyond the most recent world delineated by nation states. In hunter gatherer times populations occupied increased or reduced proportions of the earth’s surface as climate dictated. In more modern times, islands have been populated or become depopulated according to economic dynamics (think the Scottish coastline). More recently, it is clear the old East Germany would have become a country in need of “resolution” had it not sneaked in under the umbrella of the Federal Republic. Why people should find the idea of country failure so contentious I am not sure, perhaps we have just become accustomed not to have “hard” thoughts.

Applying the argument many apply to banks, unsustainable countries “deserve” to fail, don’t they? Why should the US or German taxpayer have pay to keep them afloat? Naturally, including Spain in this group of countries that can only now salute Cesar as they prepare to die my seem extreme, but just give it time. 

I expect (should I say “predict” in the Popperian sense, since this argument IS empirical, and is surely falsifiable) the first countries to die to be in Eastern Europe, with the most likely candidates to get the ball rolling being Belarus, Ukraine and Serbia. But then gradually this phenomenon will spread along the EU periphery, from East to South. Latvia’s own president said recently that if the net outflow of population was not stopped, within a decade the country’s independence would not be sustainable. I don’t think he was exaggerating.

So, as these countries “die”, we (the rest of the international community) will have to decide what to do about them. A country “resolution” programme should be considered. The scale of the humanitarian tragedy will not be small.

Now, from time to time conventional economists do start to have a glimpse of what is really going on. This happened to Paul Krugman a month or so ago when he came up with the memorable phrase that part of Japan’s economic problem was the result of a growing “shortage of Japanese”. Now, as I am trying to suggest, this shortage is not simply a local, Japan specific, phenomenon, but forms part of a global pattern. Again, exact timing isn’t clear, but sometime in the second half of this century global population will peak, and the shortage will steadily spread to take in all countries. To quote Krugman (in an earlier piece) again, at that point “to which planet will we all export“? Answers on a single piece of paper, in a plain white envelope, please.

But not all countries will experience the shortage (which is already being talked about in China in labour force terms) in the same way. Some countries, with competitive economies, healthier banking systems, younger populations, and better-quality institutions will gain the population which is being lost by the others. That is another of the reasons I say the process will not be linear. This is naked capitalism in the raw, sovereign against sovereign, with a winner take all structure.

So the modern economic system becomes something like the game musical chairs. When the music is playing everyone gets up to dance, but each time it stops there is one less chair (country) to fall back on. And so it goes on and on, through numerous iterations. Now where’s my suitcase.

Postscript

I have established a dedicated Facebook page to campaign for the EU to take the issue of  emigration from countries on Europe’s periphery more seriously, in particular by insisting member states measure the problem more adequately and having Eurostat incorporate population migrations as an indicator in the Macroeconomic Imbalance Procedure Scoreboard in just the same way current account balances are. If you agree with me that this is a significant problem that needs to be given more importance then please take the time to click “like” on the page. I realize it is a tiny initiative in the face of what could become a huge problem, but sometime great things from little seeds to grow.

Consider first the European Commission’s Spring Economic Forecast –

The first quarter of 2013 is likely to have marked the trough of a protracted balance-sheet recession that started at the end of 2011 and is linked to the financial crisis and unsustainable debt levels. The euro area entered its fifth quarter of contraction, while the downturn in the EU was only shortly interrupted in the third quarter of last year. Balance-sheet recessions tend to be characterised by deeper downturns as well as shallower recoveries and are often associated with substantial and permanent output losses.

These sentences refer to Richard Koo for the definitive account of balance sheet recessions. And note also for those of you used to thinking as the global economic crisis as an event unfolding since 2007, the Commission quite clearly dates the recent unpleasantness to 2011.

On now to Mario Draghi at a speech yesterday in Rome

In a second phase [of crisis] beginning in 2011, the lack of credit to the more vulnerable sovereign issuers became the centre point of the crisis.

Finally now to the IMF statement on Greece yesterday –

Looking over the period 2010–2012, the much deeper than expected recession was overwhelmingly due to a progressive loss of confidence, culminating in acute concerns about euro exit, as political uncertainty continued to grow, making it increasingly evident that there was no strong political resolve to stand up to vested interests fiercely opposed to reforms. This led to a dramatic contraction in investments not only through poor sentiment, but directly through deleveraging and an attendant sharp credit contraction.

It should of course be allowed that not all Eurozone crises are like Greece, although the jury is still out on whether Greece is just further along the continuum or contains some unique elements; nevertheless during 2010-11 it was clearly a source of contagion to other peripheral economies funding ability.

So what’s the issue? The European Commission sees a full-on balance sheet recession — public and private deleveraging in the face of debt overhangs. Mario Draghi sees a specific shut-down in credit to sovereigns. And for Greece, the IMF sees all of the above, but fundamentally driven by a paralyzed structural reform process.

Not surprisingly, different interpretations should come with different policies. In classic balance sheet recessions, expansionary fiscal policy is justified, as Richard Koo himself has emphasized. If it’s a dry-up of funding for sovereigns, then the ECB diagnosis and reaction is the most internally consistent: eliminate the extreme risk in sovereign bonds (OMT) and cajole official funders to the table.

But the IMF diagnosis is the most sweeping and potentially radical: the fundamental overhang is not economic or financial, but political. Strictly construed, it suggests that the focus on the pace of fiscal consolidation in program countries is somewhat misplaced. The focus should instead be on the pace of economic reforms, with the more front-loaded the better. Is the EU ready to pursue that logic in the case of the big Eurozone countries currently not in programs but showing similar signs of a stalled structural reform agenda?

“The point is not that I have an uncanny ability to be right; it’s that the other guys have an intense desire to be wrong. And they’ve achieved their goal.” Paul Krugman

A new craze is sweeping the planet. The image I have in mind isn’t exactly that of the community of central bankers all dancing the Harlem Shake in unison, but for all the economic sense it has it might as well be. In fact the craze is called “Abenomics” and it is gathering adepts in financial markets across the globe. A precursor in Japanese history has already been found for the movement, Korekiyo Takahashi, who was the country’s finance minister during the key years of the 1930s depression. Even a book has been written to extol his virtues entitled “From Foot Soldier to FinanceMinister: Takahashi Korekiyo, Japan’s Keynes.” Unsurprisingly it was an immediate hit with Japanese academics when it came out in 2010.

While the creation of the Takahashi lineage may be important for home consumption in order to make the Japanese themselves more comfortable with the adoption of a set of radical and even unprecedented measures – Japan isn’t exactly the country you would expect to be in the vanguard of a major economic experiment with extensive global implications – the resonance of Abenomics outside the country among those with little knowledge of economics and even less of the specificities of the Japan problem is perhaps rather more surprising. Mariano Rajoy, for example, told journalists recently that the recent BoJ decision represented a “very important change in its monetary policies.” The Spanish PM argued in a clear reference to what is going on in Japan that Europe needed to decide which kind of powers its central bank should have, those it has now or “the ones other central banks across the globe have”. “We are in a decisive moment,” he said.

Despite the fact Abe’s move fits comfortably on the austerity vs growth policy axis, at the heart of the new approach lies not a strategy to directly create growth per se, but rather one to try to induce inflation. The idea, which may have some understandably scratching their heads in confusion, is to see whether by this rather circuitous route it is possible to tease the country back on to what advocates of the policy consider would be a more normal growth trajectory of the kind from which it has been exiled for the best part of two decades now. The inflation-inducing monetary injection could be thought of as something like the kind of sharp jolt given to a twisted spine (or a dislocated shoulder) by the firm hand of an experienced osteopath. Once the shock has been administered, so the story goes, the patient should once more be able to walk – and develop – normally.

Naturally, the very existence of the this other, alternative, path for Japan remains at this point a mere theoretical postulate since with so many bouts of fiscal and monetary stimulus having been administered over the years, just exactly what a normal growth pattern would be for the country, or even what exactly “normal” means in this context, is at this point very difficult to discern. The fact that the population and workforce are now both ageing and shrinking in ways for which we have no historical precedent means that you wouldn’t necessarily expect to see that much growth in the economy anyway. Indeed, in order to make allowance for this new phenomenon some have started to claim that Japan is not doing so badly after all (or here), since GDP per capita has been performing tolerably well in comparison with the US or Europe, so in some ways it is hard to see what all the fuss is about, except… except….. except for that nasty, nagging little detail of all the government debt that has been being run up in the meanwhile.

For those who have not been following the Japan saga as it has developed over the last twenty odd years this whole debate may seem like a strange way of thinking about things, after all isn’t inflation supposed to be a bad thing, one central banks are supposed to combat? And how can a country become more competitive by force feeding inflation? The fact of the matter is, however, that during all that time the country and the Bank of Japan have been continually fighting and losing an ongoing battle with falling prices. And it is this battle with falling prices which means that the “tolerably good” economic performance becomes a serious problem, a serious debt problem.

Of course, falling prices are not necessarily in-and-of themselves a bad thing - as any old consumer will tell you -since products get cheaper and cheaper with each passing day. So the run of the mill consumer might find life in Japan quite a pleasing and desirable thing, especially if that particular consumer happens to be retired and living on a fixed income from savings as many contemporary Japanese actually are. Falling prices only really become a problem in a more general macroeconomic sense if they lead people to postpone consumption, and if this postponement becomes self perpetuating in a way which leads prices to continually fall, as the combination of constant productivity increases and stagnant demand produce perpetual oversupply. Falling prices also constitute a nasty headache for policymakers since while prices go down the value of accumulated debt doesn’t, and herein lies the rub. So additional “stimulus” which doesn’t lead to increasing nominal GDP simply pushes the sovereign debt even farther along an unsustainable trajectory.

The problem Japan has is one of a perpetual shortfall in domestic consumer demand and the core issue is whether this shortfall is simply being generated by consumption postponement, or whether there are deeper structural factors at work.

It’s The Demography Stupid!

As everyone now recognizes and accepts Japan has a rapidly ageing population and an ageing and shrinking workforce. This situation, which has really been obvious for years has only lately come to be regarded as a significant component in the “Japan problem”. This neglect has most probably been due to the influence of a deep seated predisposition among adherents of neoclassical growth theory to think that population dynamics don’t fundamentally influence economic performance in the long run.

However, and as I think is now clear to all, one result of the “demographic transition” that is going on in Japan (and which will be replicated in one country after another as the century advances) is that while GDP per working Japanese continues to perform tolerably well, and, as I said, GDP per-capita growth bears comparison with many other countries in the developed world, government debt to GDP levels now bear no such comparison and have started to surge off the known register. Obviously something has to be done.

In 2012 Japan gross government debt stood at 235% of GDP and naturally with falling nominal GDP the burden of the debt would still continue to rise even if there were no further fiscal deficits. But fiscal deficits there are and there will continue to be since without such “stimulus” it is apparent that even real GDP would be perpetually negative. The country has been running a fiscal deficit of close to 10% annually and Shinzo Abe has promised even more fiscal stimulus in 2013 as one of his three key “economic arrows”.

You don’t have to be an economic or mathematical genius to see that this can’t simply go on and on. Japan has now passed some sort of tipping point. GDP per working Japanese may continue to rise nicely, but as the working population steadily shrinks a the 21st century advances then surely total GDP will eventually start to fall. If in addition prices continue to drop then government debt to GDP would start to rise almost asymptotically even without any more government borrowing. And naturally Japan is not a unique case, since during the course of the 20th century one country after another will be faced with the same sort of problems. That is why the country is now so important.

What is going on in Japan is a huge collective experiment on all our behalf’s. And we have also passed a tipping point in another sense, since if what Abe is doing doesn’t work there is now no realistic possibility of turning back. Relative prices and values across the whole global economy are currently being distorted to such an extent that any sudden loss of faith in the experiment would surely have consequences which reached far afield and far from benign. Austerity reins are now being loosened all over Southern Europe (a region where population ageing is not far behind Japan) and debt levels are surging. If Japan can’t pull it off then neither can Southern Europe, meaning all those bond yields which are coming down simply shouldn’t be doing so. Japan is simply the pioneer.

What Went Wrong In Japan?

Basically, in terms of our classical understanding of economic problems there are two straightforward solutions to the Japan debt problem: either the economy achieves more growth (which as we have seen will prove difficult given the shifting demographics) or it generates continuing inflation, since inflation pushes nominal GDP into positive territory and hence eases the scale of the debt burden. But, we need to ask ourselves, what if something important has changed and Japan now faces the worst of both worlds, getting virtually no growth while at the same time remaining stuck in deflation. While few are yet willing to contemplate either the possibility or the consequences of this eventuality this does not mean that it is an outcome which can’t happen.

But before examining that possibility a bit further, let’s dig a little deeper into the intellectual backdrop that lies behind Abenomics.

“Japan: what went wrong?” is the title of a 1998 article by Paul Krugman (you can find it on this site under “Japan”). Krugman’s work at this time has some significance for the current policy approach since in many ways he can rightly claim to be the intellectual father of the Japanese experiment. He was the first economist of note to see that something important was happening in the country, and the first to see that some sort of major initiative was going to be needed to address the emerging problems. In particular the whole idea of trying to correct the Japanese imbalance by targeting inflation can be traced, for good or ill, back to his door.

The “what went wrong” article is useful, since there he tried to set out in simple layman’s terms his version of the Japan story. For a number of reasons it is worth going back to these old arguments since they help make sense of recent events, and offer us the opportunity of glimpsing the initial justification for the Bank of Japan policy initiative that Mariano Rajoy and others find so interesting in all its full glory.

Krugman’s starting point is population ageing. The details could be changed, and the argument fleshed out a lot, but this is basically the picture he paints to explain why the country fell into deflation – the Japanese don’t spend more because, on aggregate, they are trying to hang onto their savings.

Here’s the story: Japan, like the United States only much more so, is an aging society. Thanks to a declining birth rate and negligible immigration, it faces a steady decline in its working-age population for at least the next several decades while retirees increase. Given this prospect, the country should save heavily to make provision for the future–and lacking the kind of pay-as-you-go Social Security system that allows Americans to ignore such realities, it does. But investment opportunities in Japan are limited, so that businesses will not invest all those savings even at a zero interest rate. And as anyone who has read John Maynard Keynes can tell you, when desired savings consistently exceed willing investment, the result is a permanent recession.

Actually more than saving, the problem is really that the Japanese won’t commit to borrowing (again on aggregate). Hence some people locate the problem as a monetary transmission mechanism one – the normal credit cycle simply won’t start because the economy is suffering the after-effects of a “balance sheet recession”.

But another approach to the problem would be to try and understand whether the failure of both Japanese households and corporates to harness themselves to what is considered to be a “normal” credit cycle might not be associated with the age structure of the country’s population. In fact the Japanese household saving rate has been falling steadily over recent years, and it is Japanese corporates who are doing the saving, but the latter won’t invest in the domestic market for the reason Krugman identified – the lack of consumer demand for end products – and indeed perhaps this reluctance is fortunate since with final demand limited more supply would only push prices down even further. The idea that further investment would in and off itself produce enough incremental demand to soak up the capacity expansion sounds very much like the Spanish housing and immigration story – Spain was, on this account, bringing in immigrants to build houses for which they themselves would be the customers. This kind of investment-lead demand simply doesn’t work, as we are also seeing in China.

Investment has to some extent to be driven by autonomous demand, if it isn’t imbalances are inevitably generated, even if, in a well-oiled economic machine the investment generated by that autonomous demand is what drives the business cycle forward. But in Japan this kind of demand-lead investment process isn’t working (outside the export sector) for reasons which have demographic roots and not due to malfunctioning of the monetary transmission mechanism. Thus the key difference between the world of contemporary Japan and the world Keynes contemplated is that the shortage of demand in his model was simply conjunctural (due to the presence of a liquidity trap) and not structural and permanent, as in the case of demographic decline.

Although one of his contemporaries, the Swedish Nobel prize winner Gunar Myrdal, did go into this demographic possibility (fertility in Sweden had already dipped below the 2.1 child per woman replacement level in the 1903s) and Keynes did read Myrdal’s Godkin Lectures where the ensuing process is examined, the author of the General Theory never really contemplated the kind of problem Japan is facing. This is a pity since it only really makes sense to use the expression “liquidity trap” if you are making the kind of assumption Keynes was – that there is some sort of “normality” (the normal credit cycle, for example) to return to, so that the damage that was being caused to the normal functioning of the economy could be put right by some kind of self-correcting mechanism. If what you are faced with is an economy that is becoming extremely dysfunctional following almost four decades of ultra-low fertility then it is not at all clear that this self-correcting solution is available. Hence Japan’s dilemma.

Promising the Unachieveable?

But to return to the Krugman story, after many years of deflation people simply hang on to cash instead of spending it in the expectation of price rises in the future, even if the demand shortage itself is being caused by a lack of investment which results from a shifting population structure.

“If this is the problem, there is in principle a simple, if unsettling, solution: What Japan needs to do is promise borrowers that there will be inflation in the future! If it can do that, then the effective “real” interest rate on borrowing will be negative: Borrowers will expect to repay less in real terms than the amount they borrow. As a result they will be willing to spend more, which is what Japan needs. In short, this explanation suggests that inflation–or more precisely the promise of future inflation–is the medicine that will cure Japan’s ills”.

So the idea is this. According to standard macro theory in order to get an economy stuck in a never ending recession being fueled by the expectation of future price falls back onto a dynamic growth path you need to generate negative real interest rates to push people into saving less and borrowing and spending more – basically you need to make it more expensive for people to hold on to money.

Now given the zero limit associated with the conventional application of interest rates it isn’t easy to generate negative interest in the here and now, so one proposal is to go for second best and give the impression they will exist in the future and thus change behavioral patterns by changing expectations. This you try to do by generating the expectation of significant inflation in the future.

This expectation is hard to achieve due to the credibility attached to the inflation fighting credentials that developed world central bankers have built up in recent decades. Despite the fears being raised by some monetary hawks that all and every kind of central bank balance sheet expansion will lead to out-of-control inflation, the general opinion is that central bankers are responsible people who will be effectively able to pull the plug on any excessive liquidity easing (or “exit”) just as soon as the inflation they are trying to provoke starts to raise its ugly (or should that be beautiful) head. In the liquidity trap situation the result is that you are not able to generate sufficient inflation expectations to be able to achieve even low single digit inflation.

So what you get is a kind of chicken and rooster game between central bankers and the citizen in the street, where the central bankers have to credibly convince the world they have “lost their heads” and become sufficiently frustrated and irresponsible as to be willing to go beyond earlier constraints and really put the pedal once-and-for-all hard down on the metal. Maybe if, instead of limiting themselves exclusively to the verbal registers of communication they broadened out the channels used they would have more success. Instead of wearing suits and ties to their monthly meetings, maybe if they wore swimming costumes or t-shirts and colorfully framed sunglasses that would work.

Now you could say, where’s the problem with generating 2% inflation? It doesn’t sound that reckless since most central banks in the developed world have inflation targets at or around that level. But simply declaring a 2% inflation target in Japan is not sufficient, partly because people are doubtful after so much time that the bank is capable of doing it, and partly because even if that hurdle could be overcome, the expectation of 2% would not be enough to change behavior sufficiently to unleash the required consumption. So in the Japan case what the Bank of Japan is being asked to do is ramp up the policy approach to such an extent they seem to be flirting with the possibility that they may not be able to stop what they start, and that inflation could easily significantly overshoot the 2% mark. If they can’t raise this doubt, so the argument runs, consumers will factor-in the effectiveness of the exit strategy, lower their expectations and adopt behavioral strategies that mean the economy doesn’t achieve the required escape velocity to break out of deflation.

All of this naturally assumes that what actually ails Japan is a run of the mill liquidity trap. Now I don’t doubt the capacity of the Bank of Japan and the Japanese government, in the last resort, to generate enough concerns about whether or not they know what they are doing to lead people to start to anticipate an “out of control” situation (see more below), but what I do doubt is that even assuming this feeling of things being out of control feeds through to a 2% inflation level (and not say a sudden and dramatic run on the yen) that this inflation will be sustainable. More probable, I think, if the economy is in a demographically driven deflation trap is the economy, following a short-sharp-burst of inflation slumps back yet one more time into long run deflation. The reason I think this is that if the deflation is the result of a savings/investment mismatch brought about by long term demographic changes – rather than by say “garden variety” deleveraging (or a “balance sheet recession”) – then I don’t see why the supposed “trap” wouldn’t come into existence again once the bank started to roll back its balance sheet.

To some extent Krugman himself admits the difficulty:

“This theory is offensive to many people. Deep economic problems are supposed to be a punishment for deep economic sins, not an accidental byproduct of swings in the birth rate. Inflation is supposed to be a deadly poison, not a useful medicine. Above all, it seems implausible that the proposed solution to such severe difficulties could involve so little pain. And while I think logic and evidence are on my side–that demography, not crony capitalism, is the villain, and inflation is the answer–it is certainly possible that I am wrong”.

In another article from the same period – “Further Notes On Japan’s Liquidity Trap” – Krugman offers us the following curious, but clarificatory, argument:

Japan – like any liquidity trap economy – in effect needs inflation, because it needs a negative real interest rate. The slightly paradoxical conclusion which I believe to be true is that the deflation we actually see is the economy trying to achieve inflation, by reducing the current price level compared with the future. ……….

So, he says, Japan’s economy is trying unsuccessfully to achieve the inflation it needs. Leaving aside the implicit animism of the argument, I would counter by saying “No! Japan’s economy is in fact desperately trying to deflate, and is only frustrated in doing so by the massive liquidity easing from the central bank and the ongoing fiscal injections it receives”. The difference between this deflation and all previous variants known to economists is that this deflationary process is not a simple deleveraging one, but something without end, a way of life, since the economy is seeking an equilibrium point which no longer exists. That is what the deflation is about, the economy is striving to find an equilibrium without being able to locate one.

The “Further Notes” article (again, see the Japan section on this site) also makes one other fundamental point – that his inflation conclusion is not something born “like Athena from the head of Krugman” but is rather the logical outcome of applying universally accepted models based on standard neoclassical assumptions.

“I think I should make it clear that I did not start with this conclusion, then make up a model to justify it. What I did instead was start with a very orthodox model – the same sort of model that is favored by people who are vociferously anti-Keynesian and pro-price stability – and ask under what conditions it could generate the apparent ineffectuality of monetary policy we see in Japan. And the need for inflation pops out – to my own surprise, by the way. If you refuse to accept this conclusion, either you must offer some alternative model, or you are saying that your opposition to inflation comes not from analysis but from gut feelings”.

He is right. If Japan’s economy is just another planet that has temporarily slipped off its orbit then inflation is what it needs. If something more fundamental is happening then the policy remedy is, to say the least, questionable. Japan’s economy may or may not be striving to achieve inflation, but I would no go so far, as Krugman does with those he disagrees with, as to suggest he has some hidden desire to get things wrong. I simply think he is not following his own argument through to its own logical conclusion, he is hovering half way across the rope bridge without finally and decisively striding forward to the other side. He has seen the problem has been produced by a violent fall in the birth rate, but can’t really get to grips with whether or not monetary policy can handle this problem.

I can understand his caution, since he is also right that what is needed now is an alternative model to the standard neoclassical growth one, and possibly a whole new way of thinking about macroeconomics, even if – collectively speaking – we don’t have either the former or the latter right now. What we do have is an accumulating body of evidence to suggest that Japan, despite all its specificities is not unique, that developed world outcomes are increasingly not in concordance with what conventional theory would lead you to expect, and (at least in my own personal case) a gut feeling that the policy remedy being applied in Japan is a rather dangerous one.

The Black Swan Question

“Since everyone eventually gets through the deleveraging process, the only question is how much pain they endure in the process. Because there have been many deleveragings throughout history to learn from, and because the economic machine is a relatively simple thing, a lot of pain can be avoided if they understand how this process works and how it has played out in past times.” Ray Dalio, An In-depth Look At Deleveragings

Those who do not think about what is happening in Japan in demographic terms (a list which would not include Paul Krugman) normally rely on a theory based on the idea of “balance sheet recessions“. At the heart of this theory (which is often associated with the name of Nomura economist Richard Koo) is the idea that economies like the Japanese one are essentially deleveraging following a bubble related unsustainable expansion of credit and debt. The demand side deficit can thus be thought of as being produced by this deleveraging process on the part of households and corporates. Most financial market participants assume that some such deleveraging process is what ails the economies of the developed world as a community. I think the kinds of demographically related arguments we have gone over above suggested that use of the deleveraging idea may be a significant over simplification of what is happening.

Japanese households are not borrowing more on aggregate due to the fact that they are still deleveraging from earlier excesses, and corporates are not neglecting to invest more in domestic Japanese activities for similar reasons. Rather, consumers are now borrowing less and less as the age profile and size of the entire consuming community steadily shifts while corporates are hoarding cash as investing in capacity without the necessary expansion in demand makes no economic sense. The structural deficiency in demand which produces the deflation is not an “accidental by-product” of “swings in the birth rate” but an absolutely comprehensible and systematic outcome of fertility dropping well beyond replacement levels and staying there over several decades.

This is not the conclusion drawn by legendary Hedge Fund manager Ray Dalio, who concluded after studying a large number of deleveraging processes that “everyone eventually gets through the deleveraging process” the only real difference being in how much pain is inflicted on participants in executing the operation. Which brings us to “rara avis in terris nigroque simillima cygno”, or the phrase from the Latin poet Juvenal recently brought near the headlines by financial affairs writer Nassim Nicholas Taleb which roughly traslated means means “a rare bird in the lands, very much like a black swan”. Such a bird was long thought not to exist, since all known swans were white.

In fact, the issue of black swans is not exclusively associated with the issues made famous in Taleb’s book on the subject (the question of random tail events), but has its origins in a basic flaw in inductive reasoning, long ago highlighted by the philosopher of science Karl Poppper: you simply can’t assume something doesn’t exist because you have never seen one. Ray Dalio falls into this trap in the exert which opens this section when he asserts that everyone eventually gets through the deleveraging process. It would be more correct to say that everyone had gotten through the process, and then Japan came along. Two decades after the bubble burst, according to the balance sheet recession people, the country has still not gotten through the process, and if the arguments I am presenting here are valid it is highly unlikely it ever will do. In which case the existence of a black swan in the first (simply epistemological) sense of the term may serve to bring one into existence in the second sense in the shape of a very nasty unexpected tail event as expectations are forced to verge violently from one direction to another.

The problem is that almost all investors at this point are assuming that the country will eventually overcome its deflation problem, and indeed markets are positioning as if it were inevitable that it would (producing large and systematic price distortions) even if this inevitability is accompanied by the idea that if at first they don’t succeed, then they will try try and try again till they do. Or put another way, that the Bank of Japan will simply keep ramping up its money printing activity until the country obtains escape velocity. In fact Ray Dalio uses his logical fallacy in his inductive argument about deleveragings to justify a change of pricing in European periphery risk assets, as I explain in this post here.

But another possibility exists, one which has already been highlighted by another legendary investor, George Soros. The Japanese currency may be precipitated towards an out of control collapse.

To understand how and why this might happen we need to think about how it could be possible for the Bank of Japan to produce inflation. Since the country’s economy has a known structural weakness on the demand side, demand pull inflation is unlikely to occur however much money printing goes on. So it would have to come from the other, or supply, side in the form of cost push inflation. This is not so difficult to generate, since you only need to introduce the expectation that the central bank will use monetary techniques and the currency will, as we have been seeing, fall. The only question here is how far it has to fall to produce a given level of inflation. As of March 2013 the currency had fallen approximately 30% against the euro in 9 months while deflation still remained at a 0.5% annual price decrease rate on the Bank of Japan’s targetted measure.

So more will need to be done. But just how much more. But let’s imagine for a minute that the yen is devalued such as to produce, say, 1% inflation due to rising import costs. What happens next? Well, as we saw earlier, a lot depends on expectations. If import prices remain unchanged during the following year since the value of the yen remains stable, then the induced inflation simply drops out of the system, as it did in Japan in 2009 following the short price burst produced by the 2008 inflation, or as it does in countries that apply a one off consumer tax hike (Japan itself in 1997, just before deflation really took a tight grip, or many countries on the EU periphery at the present time).

So the issue is, will people anticipate further downward movement in the yen to induce even more inflation? Will the central bank be “responsibly irresponsible” and feed not only those expectations but expectations that the devaluation will continue every year while the 2% target exists? And how will “mum’n pop” Japanese savers react, by spending more, or by moving their money out of the domestic currency to avoid some of the value loss? Soros thinks there is a very real chance that the latter will happen, and I agree with him. What’s more, I think it is much more likely that ordinary Japanese savers reach the expectation that the currency value will fall than they do reach the conclusion that ongoing inflation will be induced.

My conclusion then is that there is little evidence or possibility that this policy will work as advertised, largely because it is based on a misunderstanding. It might work if Japan was in a simple liquidity trap as described by Keynes, or a balance sheet recession deleveraging process of the kind Richard Koo talks about. But once you introduce demography into the picture, as Krugman does, the game gets changed and the water incredibly muddied.

Japan is stuck in a shrinking population trap, and neither monetary nor fiscal policy will adequately solve the problem. Continuing to run fiscal deficits in a deflationary environment will only means that government debt is pushed onward and upwards leading to a variety of possible scenarios as to what the end game will finally be. Reining in the deficit, by raising consumption tax, for example, will probably only make deflation worse with a one year time lag, as happened in 1997, and will almost certainly force the economy into more economic shrinkage which in any event makes the debt issue worse.

On the other hand the current BoJ policy while effectively driving down the yen is producing very little in the way of visible inflation. What it is doing is systematically misallocating financial resources across the planet, as those who are convinced that Ray Dalio is right put their money behind their intuition. Italian ten year government bond yields for example hit 3.94% last week, their lowest level since November 2010 based on the idea that at the end of the day, even if the country’s debt (currently at 127% of GDP) does continue to rise Japan style, it doesn’t matter that much since the ECB will surely one day “go Japanese”. Italy is in fact the EU country most similar to Japan in terms of growth and demographic issues.

But if Japan itself cannot go Japanese in the sense of generating the anticipated inflation then the implication will be that neither can anyone else who gets stuck in a similar quandry. Black swans may indeed be very rare birds, but that doesn’t mean you may not be able to sight one flying past the bottom of your garden at some point in the not too distant future.

“To a herd of rams, the ram the herdsman drives each evening into a special enclosure to feed and that becomes twice as fat as the others must seem to be a genius. And it must appear an astonishing conjunction of genius with a whole series of extraordinary chances that this ram, who instead of getting into the general fold every evening goes into a special enclosure where there are oats- that this very ram, swelling with fat, is killed for meat”. – Tolstoy, ‘War and Peace’.

After so many false dawns, the recent announcement by Spain’s Prime Minister Mariano Rajoy that the government was revising down its 2013 economic forecast hardly caused a blink among a citizenry that is now completely inured to deception and ready to believe the worst about the intentions of any politician willing to come forward with either good or bad news. The long announced recovery has once more been delayed, and will now be noted not in the last three months of this year, but during the first six of 2014. Naturally, a public which is now totally accustomed to such postponements will not be surprised if this one is far from being the last.

In fact, the latest institution to throw a bucket of cold water over the Spanish government’s rose-tinted promises is the IMF. In their latest five-year forecast for Spain they paint a pretty bleak picture of low growth and high unemployment lasting at least all through what is left of the present decade. Mariano Rajoy has already jumped into the fray to take issue with their outlook for 2013, but it is their longer-term forecast which is most interesting and preoccupying. Growth between 2015 and 2018 is now only expected to average around 1.5 percent annually. This would seem to be what the IMF now consider longer-term trend growth to be for Spain, and the most notable thing about the number is that it represents a significant downward revision from their earlier optimism. Even this comparatively low number may still be overly optimistic and may yet come down again – I personally expect NO noticeable recovery as cumulative negative developments more or less cancel out positive ones – but it is certainly much more realistic than anything we have seen from the Fund before. There is no question here of any “V” shaped bounce. That is just a fiction of Finance Minister Cristóbal Montoro’s imagination.

Naturally, the other side of the coin on this is the consequence for unemployment. With growth so low there will be little in the way of job creation (watch out, pension system sustainability) and unemployment will linger over 20 percent for many years to come – indeed the IMF have 2018 unemployment at 22.9 percent, meaning they don’t expect it to fall below 20 percent come 2020.

And there’s another highly interesting detail from the IMF Spain forecast. Even to get that rather low level growth of 1.5 percent a year, the Fund pencil in Spain’s running a fiscal deficit of 5 percent a year all the way through to 2018, with the natural consequence that the debt-to-GDP ratio is expected to reach 110 percent by that point, and that isn’t making allowance for any further bank recapitalisation that will be needed. As I have been arguing since 2008 now, Spain’s sovereign debt simply is not on a sustainable path, and what 1.5-percent growth supported by a 5-percent fiscal deficit means is that there is no structurally adjusted growth going on in the economy at all. As a country you are getting more into debt than any increase in output you generate with the borrowing.

A well-oiled crisis

As I have argued in an earlier post, it may well be that the Spanish contraction machine is now so well-greased that it simply continues winding the economy down and down in such a way that things may never recover, in the classic sense of that term. The only argument which stands in the way of reaching this conclusion is the near religious belief now so often heard in policy circles that, well, “economies always recover, don’t they?”

As it happens, they don’t, as a quick look at what happened in Argentina in the 20th century would confirm. But Argentina is arguably an isolated case, and the current economic malaise (I hesitate to use the word “crisis” due to the duration of what is so evidently an ongoing process) seems to be far more general.
What people seem to find hard is asking themselves one simple question, “but what if this time really is different?” Which is strange, since reasons for thinking that things may well not return to what was previously considered “normal” are not in short supply.

Populations in developed economies are all now ageing rapidly, generating a phenomenon never before seen in the entire history of known human societies – systematically falling numbers of under-15s coupled with an ever growing population in the over-80s group. The sheer novelty of this phenomenon, coupled with the manifest feeling of unsustainability it generates about our current welfare arrangements should at least give policy makers food for thought, yet evidence that it actually is doing so is in very short supply. Plough on regardless seems to be the watchword.

The current round of cuts to health and education spending are described as “painful but necessary” in order to facilitate a return to growth which will make further adjustments in the future unnecessary. Unfortunately nothing could be farther from the truth. The credit ratings agency Standard & Poor’s, which has been one of the global leaders in highlighting the likely impact of “first world” demographic changes, argues in its latest report on the subject that despite some recent progress, without ongoing and continuous changes in provision entitlement, deficits and debt in developed economies will spiral out of control as the century advances.

I think everyone who stops and thinks for five minutes about the situation will recognize the obviousness of this point, yet scarcely a single politician is willing to come out from behind the curtain and explain to voters the longer-term implications of having shrinking and ageing workforces at the same time as the size of retirement age populations explodes.

Ignoring the obvious

By the middle of this century, and without policy changes, average deficits for developed countries will rise to 15.1 percent of GDP as the interest cost of the increasing debt burden exacerbates the budgetary impact of demographic spending. Median general government NET (not gross) debt (as a percentage of GDP) is expected to increase to 71 percent by the mid-2020s (from around 40 percent today) – and would then accelerate to 216 percent of GDP by 2050. Government spending would rise to about 57 percent of GDP in 2050, from some 49 percent today.

Naturally, these numbers are just very rough and ready estimates, and such levels are unlikely to be reached since markets will surely not fund them, and policy changes will happen. The problem is that many policy makers are still stuck in denial about the need to make them, and where they are willing to do so it is largely linen washing conducted in private and not in the public space provided by election manifestos. Spain’s leaders, for example, continue to insist that no major changes in either pension contributions or entitlement are in the offing even though the need for one or the other is evident, as the structural deficit in the system continues to grow.

Worse, the more frequently they say in public that there is nothing to worry about and all is well, the lower their credibility falls, since few people continue to believe them. At the same time they insist and insist that the current level of health provision will be maintained no matter what, when obviously this is something the country simply cannot afford to do.

But more than the simple impact on government spending possibilities, it is the impact of these demographic changes on growth which seems to be the least widely appreciated part of the story. This is not an oversight of which Standard and Poor’s is guilty. According to the agency:

For several sovereigns in the Eurozone (European Economic and Monetary Union), the financial strains caused by shifting demographics are being compounded by the current economic and financial troubles, which are both strangling growth and increasing the need for social safety net spending.
This environment can result in tighter financing conditions amid private-sector deleveraging, plus cuts in public investment leading to a reduction in total investment and consequently the stock of capital. At the same time, the decline in investment activity will likely hurt total factor productivity (a measure of an economy’s technological innovation). Adding to these adverse trends, low employment and net emigration from several sovereigns implies a smaller contribution of labor to future economic growth, a continuing threat if unemployment becomes structurally high.

As can be seen, Standard and Poor’s mention a number of other factors which contribute to what they call the current “strangling” of economic growth in countries like Spain (tighter financial conditions, private sector deleveraging, cutbacks in public sector infrastructure spending, net emigration).

They could also have cited the mere existence of the euro. It is evident that participation in the common currency has had the perfectly foreseeable effect on Spain of making it simple to get into trouble and a lot harder to get out of it. Borrowing was cheap and easy of access during the boom years, now lending to Spain’s banks has all but dried up, and what there is available remains burdensomely expensive.

Divergences in interest rates paid by businesses on bank loans across the Eurozone have recently reached record highs, despite ECB attempts to achieve the opposite result. While the spread between yields on Spanish 10-year bonds and their German equivalent has narrowed significantly the Goldman Sachs interest rate divergence indicator – a measure of cross-border variations in rates charged by Eurozone banks on a selection of business loans – has once more risen and reached 3.7 percentage points in January. This means that companies in southern Europe continue to pay significantly higher interest rates than their northern rivals, leading to the conclusion that while ECB measures may well have been effective in avoiding short term Eurozone break-up, they have still failed to address the problem posed by such inhibitive credit conditions along the southern periphery.

The lessons learned from inaction

So not only does Spain have uncompetitive productivity levels, and a damaged brand image, it also has a high cost of new capital making investment in the country’s economy both unattractive and prohibitively expensive. With unemployment at over 26 percent, non-performing bank loans remain on their upward path, meaning that more companies are facing potential insolvency. The recent bankruptcy of food multi-national Pescanova has renewed rumours in financial circles that the Bank of Spain is preparing another round of provisioning increases – this time for loans to large corporates and small and medium companies – is an indication of how severely the crisis is now hitting the entire business sector. The Spanish problem is now no longer simply one of a construction collapse, since the ensuing impact on overall economic activity has now spread right across the board. A stitch in time saves nine, as the saying goes, but in the Spanish case there was no stitch (since according to policymakers there was no deep-seated issue to address) and the garment simply unravelled. Lesson – it is a lot easier to make things worse by inaction than it is to make them better using the same approach.

But backtracking a bit, the euro makes correcting Spain’s present situation difficult due to the absence of a national central bank able to conduct a full range of monetary policy operations, a limited access to fiscal policy and the fact the country has no currency of its own to devalue. But that does not mean, as Wolfgang Munchau recently suggested, that it is becoming more and more rational to think about euro exit as the cost-of-leaving threshold gets lower and lower. Countries may well one day leave the euro, but if they do it will be because the cost of trying to hold it together has driven them all but mad, not because they have made some back-of-the-envelope calculation showing that the benefits outweigh the costs. Leaving the euro would be a huge leap into the unknown, leaving one side of the calculation sheet simply beyond our ken. As I argued in a post for the CNN blog, the currency bares an uncanny resemblance to Dr Strangelove’s doomsday machine, designed so that one day it would almost inevitably blow up the global financial system, but constructed so that any attempt to dismantle it would also produce the same outcome.

Yet, despite the risks, as Gideon Rachman puts it in the Financial Times, in today’s Spain people are slowly but surely losing their faith in both national and EU institutions, and are slowly being driven towards ever more radical “solutions” which far from being rational bear a pretty strong resemblance to the exact opposite:

The “European dream” that Spaniards embraced promised a middle-class lifestyle for most people. But with little prospect of secure jobs for the young and a threat to the future of the welfare state, the fear now is that the Spain of the future will look more like Argentina than Germany. An Argentine future would involve the constant fear of financial crises – and a widening gap between the social classes, as many continue to enjoy a first-world lifestyle, while a growing underclass becomes detached from prosperity. Above all, Argentine public life is characterised by deep cynicism about national institutions and leaders.

Leaving the euro would be an incredibly costly decision for Spain, and becoming yet another Argentina would surely be no panacea, but that doesn’’t mean it won’t happen.

Following in the Footsteps of Japan?

Meanwhile Mariano Rajoy struggles on. Since it is quite obvious that the current policy mix isn’t working, and with one eye on the growing number of “platforms” out there desperately seeking his scalp (those affected by the mortgage crisis, those affected by the preference share haircut) he is desperately thrashing around for a fig leaf policy to stop the nightmare. Last week he found one – in Japan. “I think in Europe we must all ask ourselves whether the ECB should have the same powers as other central banks around the world,” he told a press conference. In particular he seemed to be thinking about what he described as the “very important” shift in monetary stance that had just been undertaken by the Bank of Japan. Now here is not the place to go into the background to the Japan crisis (see my arguments here if you are really interested), but one thing I am sure about is that neither Rajoy nor his main policy advisers have any real idea about what lies behind Japan’s long lingering deflation problem. What he does know is that Japan is able to run a 10-percent fiscal deficit and a 235-percent government debt-to-GDP level with what Nobel economist Paul Krugman calls “no evident ill-effects”. Sounds good to Rajoy. Will it work in the long run? “No idea”, could be his response. In the long run, as is well known, we are all dead, and “anyway I won’t be in the Moncloa” might easily be his reply.

In fact, as billionaire investor George Soros recently warned, systematically debasing a currency (ie not just conducting a one-off devaluation) is an extraordinarily dangerous move. The Bank of Japan has, in Krugman’s words, committed itself “to credibly promise to be irresponsible”. What this “irresponsibility” means is devaluing the currency sufficiently every year to generate sufficient price rises to comply with the central bank’s recently announced 2 percent annual inflation target. This is one promise it will be hard for the bank to keep since Japan’s deflation is being caused not by a poor adjustment in the economic system by structural demand deficiencies produced by the country’s ageing and shrinking population.

The best case scenario would be that the country’s policy makers realize in time that the experiment won’t work, and come to recognize that they have to learn to live with deflation – in which case the only big headache they will have will be what to do with all that debt (you know, the debt that many thought presented no evident problem). Far worse would be success, since if the Bank of Japan succeed in changing expectations (not in the why, but in the how) and lead people to believe that the currency will be debased every year ad infinitum (even assuming the rest of the G20 could ever agree to this), just to guarantee that 2-percent inflation, then they may well end up forgetting their supposedly innate “home bias” and start converting as many yen as they can get their hands on into dollars or some other convenient monetary unit, in the process creating a run on the currency which will make what happened in Argentina look like child’s play.

Such details are doubtless lost on Mr Rajoy and his advisers, which is just my point. The current crisis – which is arguably no longer a crisis but rather a way of life – has all now gotten so complex that the issues involved are almost certainly, and in principle, “beyond their ken.” Spain’s economy will continue to march boldly forward towards what now seems almost guaranteed to be long term decline, while from within the captain’s tower, far from an acceptance that what is happening really is happening, we will continue to hear yet one more crazy and implausible story after another telling us “if only this”, or “if only that” even as representatives of the Plataforma de afectados por las hipotecas (or equivalents) start to assemble outside the local version of the winter palace looking for their hides.

Postscript

I have recently established a dedicated Facebook page to campaign for the EU to take the issue of the Euro Area accelerating population imbalances more seriously, in particular by insisting member states measure movements of their own national populations more adequately and also by having Eurostat incorporate population migrations as an indicator in the Macroeconomic Imbalance Procedure Scoreboard in just the same way current account balances are. If you agree with me that this is a significant problem that needs to be given more importance then please take the time to click “like” on the page. I realize it is a tiny initiative in the face of what could become a huge problem, but sometimes great things from little seeds to grow.

This is a revised version of an article which originally appeared on the Iberosphere website.

Cahuzac x Sarkozy.

There’s been a major scandal around the budget minister Jérome Cahuzac, spearhead of a campaign against tax-evasion, who turned out to have hidden his own multi-million euro fortune in Switzerland and had to resign. As a result, the president announced a campaign to “moralise politics” and legislation to force politicians to declare their financial interests. Ministers were ordered to go first and set an example.

Cahuzac is a weird character, a cardiologist who turned expert in cosmetic hair transplants to make money, and whose wealth was managed by a veteran of the extreme-right student movement, a long-standing member of Cahuzac’s circle of friends, a group of men with a surprising tilt to the far Right. Marine Le Pen’s spokesman was strangely calm about the whole affair, describing it as “anodyne”. This may suggest that the FN’s tax affairs are not entirely in order. Allegedly, some of his patients paid in cash so he could ship the money straight to Reyl & Cie of Geneva.

This even overshadowed the news that the former president, Nicolas Sarkozy, is under police investigation over his campaign finances. The story goes back to the great Bettencourt affair; at the time, certain daring voices (like this blog) suggested that Liliane Bettencourt’s envelopes of cash had reached the president himself. It’s probably most interesting that the issue has been officially recognised – it’s no longer something for intrepid journalists and radical bloggers. It’s also interesting, though, that the investigators are treating the case as one in which Sarkozy manipulated the old lady into handing over her money, rather than, say, the richest person in France and owner of one of its biggest companies pouring untraceable cash into the political system. Clearly, there is a limit to how far anyone is willing to recognise the issue.

That said, Cahuzac’s bank is going to be the object of more inquiries, and it apparently served many other politicians, so you should certainly look out for more revelations.

Salon de thé

Is that a tea party in French? Here’s an interesting blog post on the French conservatives. You may recall that they couldn’t elect a leader after losing the elections, and fell to fighting among themselves. They eventually agreed to try again in a year’s time, which is coming up fast. Lately, would-be leader Jean-Francois Copé, the man once voted the most annoying politician in France, has been suggesting that perhaps they could forget about the election and it’s all better now. Unsurprisingly, would-be leader 2, Francois Fillon, isn’t having that.

And then the government began passing the gay marriage legislation, and the Right put aside the row in order to mobilise against it. Or, as the link argues, they mobilised against it in order to put off the row until later, in a more-or-less conscious imitation of US Republican tactics. They didn’t have the votes to stop it, and it’s popular, but they could agree on putting down 700 amendments to the text, staging demonstrations, and generally going to the mattresses, and so that’s what they did.

Everyone was surprised about the capacity for mobilisation of the rightist and Catholic network, and the whole thing took on its own momentum, ending up with members of parliament coming to blows and thugs attacking gay bars. Now, the law is on the statute book, and although another demo is planned for the 26th of May, you wonder what the point is…other than putting off the evil day when they have to pick a leader.

Also, if you think Cahuzac is a slightly unlikely figure what with the hair transplants and the fascist mates and the socialism, check out the anti-gay marriage campaign’s leader.

In general…

Bernard G.‘s comment here is recommended.

“Le projet communautaire est aujourd’hui meurtri par une alliance de circonstance entre les accents thatchériens de l’actuel premier ministre britannique – qui ne conçoit l’Europe qu’à la carte et au rabais – et l’intransigeance égoïste de la chancelière Merkel – qui ne songe à rien d’autre qu’à l’épargne des déposants outre-Rhin, à la balance commerciale enregistrée par Berlin et à son avenir électoral”, écrivent également les dirigeants socialistes pour qui “la France possède aujourd’hui le seul gouvernement sincèrement européen parmi les grands pays de l’Union”.

So, they accuse Angela Merkel of thinking of nothing but German creditors, the German trade surplus, and her party’s prospects, and describe this as intransigent egoism. Well, perhaps they have a point. They blame all this on David Cameron for having a “Thatcherite tone” and only thinking of “Europe a la carte and with a rebate”. And apparently, the French government is the only sincerely European one.

Now I had no idea Merkel was such a poor weak insignificant figure that her policy was dictated by Britain. You may be surprised to learn that this diplomatic triumph is insufficiently publicised in the UK. Further, I clearly remember that the reason for austerity in the UK was meant to be that things were bad in the eurozone and we were going to be like Greece. Don’t just ask the prime minister, ask Sir Mervyn King. It’s as if British politicians tend to blame everything on the EU and French politicians tend to blame everything on the Brits, or something.

However, not only are they right on the actual issues, they have a point about Thatcherite Europe.

Margaret Thatcher was underrated as a European politician. As prime minister, she was very much in favour and deeply engaged in the creation of the Single European Act and therefore of the single market. It is a cliche to say that the Brits only think of the European Union as a single market, but this is ahistorical – in the mid-80s, single market completion was the absolute top priority on the European agenda. If Europe is a project under construction, the single market was the phase that was completed in the 80s. The notion of catching up with Europe, competing with Europe, trading across Europe – all of this was ingrained in Thatcherite style, tone, and rhetoric.

British macro-economic policy in the Thatcher years was also driven by European integration. After giving up on monetarism, the UK government decided to establish a fixed exchange rate with the D-Mark, and later formalised this by joining the Exchange Rate Mechanism. In fact, the UK spent as much time under Thatcher tracking the D-Mark as it did targeting the money supply. The notions of “importing credibility” that were used to promote the Euro in the 90s and 00s had an earlier run-out in the UK in the 1980s.

With an open capital account and a currency pegged to the D-Mark at a dramatically high parity, the UK in the late 1980s looks rather like a peripheral European economy of the mid-2000s, with inflows of capital chasing yield, a growing financial sector, a trade deficit, a housing bubble, and a political elite frantically clapping themselves on the back, before the crash.

The UK’s broader foreign and defence policy could have been reduced to the word “NATO”, which is another way of saying that it was focused on Europe. In the early 1980s, UK defence plans were all about the BAOR operational area in Germany and the NATO Northern Flank. In fact, if it hadn’t been for the accident of the Falklands, they would have been much more so, sharply reducing the Navy at the expense of the Army and RAF and the nuclear world. Similarly, Thatcher really didn’t care about the Commonwealth or anything much outside, yes, Europe or the North Atlantic.

I can hear a storm of whataboutery building by now. What about the rebate? What about “give me my money back”?

Well, what about it? A lot of European politicians spent the 1980s ripping into each other over narrowly national interests. (They did in the 70s and 90s and 00s, too.) Were any of the various ferocious defenders of the CAP as it applied to them un-Europeans? Was Helmut Kohl un-European for insisting on reunification, to head right for the reductio ad absurdum? Germany was obviously pretty keen on exporting cars – was Hans-Dietrich Genscher a Eurosceptic, then? This is simply hypocrisy, with a dash of sexism chucked in. (Do we have to quote Mitterrand fancying her again?)

I also think it’s important to distinguish Thatcher, prime minister, from Thatcher, post-prime-ministerial pontificator. Her swing to Euroscepticism was post-1990, post-power, rather like her swing towards the climate-change deniers. It’s worth noting that the Eurosceptics were not passive, either – they deliberately sought to claim the Thatcher myth as a source of legitimacy for their efforts to topple John Major. She also, I think, adopted Euroscepticism as a way of projecting influence in the Tory Party after leaving office. That said, we should surely consider action before 1990 as weightier than words after 1990. And her foundation was very much involved in the Central European transition to a certain idea of democracy – in the EU, in NATO, in the stability pact, eventually in the Euro.

So why isn’t this more obvious? I think the answer is that the European Union has not turned out to be the nice alternative to Thatcherism it was sold as in the 1990s. Ask a Spaniard. No, go ahead.

The policies it delivers – open trade, austeritarian macro-economics, open capital flows, no real redistributive budget, and a permanent war on inflation – are basically nothing Margaret Thatcher would not have welcomed. Even the way she thought tact was something sailing-ships did would fit right in with German newspapers claiming Cyprus is a richer country than Germany. And the EU’s generally sane approach to things like environmental regulation would work for the post-1987, Montreal Protocol and IPCC-championing, “first scientist prime minister” version of Thatcher. It did at the time.

I wonder, in conclusion, if Thatcher can be understood from a European point of view as an ordoliberal politician, rather than a libertarian or just a conservative? Britain has always been more like Germany than it lets on. Thatcher was a European; it’s Europe that’s the problem.

The deficit is forecast to be the highest in Europe in 2013 and gross debt is set to reach 100 percent of GDP in the coming years. The UK also has a large and systemically important financial sector, which the IMF described as a “global public good” in the 2011 UK Spillover Report. A strong and credible consolidation plan is therefore essential for global, as well as domestic, financial stability.

That referenced IMF’s 2011 UK Spillover Report –

The size and interconnectedness of the U.K. financial sector make it a powerful
originator, transmitter, and potential dampener of global shocks. The U.K.
agglomerates core international financial functions making it a key node in “funding”
liquidity and balance sheet hedging, providing buoyancy to global markets and
acting as a key channel transmitting shocks or stabilizing measures.

The stability and efficiency of the U.K. financial sector is therefore a global
public good, requiring the highest quality supervision and regulation. Significant
efforts to strengthen supervision will help contain the risks to global stability posed
by the sector’s size and complexity. Stronger liquidity, capital and leverage rules
should dampen credit cycles and lower systemic risk, as can the U.K.’s
macroprudential policies. 

Thus, the IMF did not say that the UK financial sector was a global public good. It said that it performs various functions (for which, by the way, it is handsomely remunerated) but in doing so it is potentially destabilizing to the global economy. Furthermore, it said that this property motivated various policies regarding regulation and supervision — not contractionary fiscal policy, as Osborne implied.

George Osborne went to a Washington IMF meeting and put on the record a willfully and egregiously misconstrued version of IMF analysis of the UK. But more column inches will be expended tomorrow on Luis Suarez’s teeth than on Osborne’s sleight of hand. Something ain’t right.

Endnote: the use of the term “global public good” specifically in connection with the financial system seems to have gotten its most careful articulation from Alberto Giovannini. It’s clear that not what Osborne meant.

Also, you’d think Osborne might have been wary of complicating his IMF visit given the austerity backdrop to it.