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Wednesday, September 1, 2010

The Odd Couple

The modern world moves at a breathtaking pace, even when most of us find ourselves on holiday. No sooner do we receive, read and start to digest one set of economic data than we find ourselves pushed to think about what the next set will look like. The clearest recent illustration of this undoubted reality is to be found in peculiar twist of events which meant that just as the news reached us that the German economy had expanded at a record rate in the second quarter, at almost the very same moment Federal Reserve officials meeting in Washington decided to significantly downgrade their economic outlook for the United States, saying the “pace of recovery in output and employment had slowed in recent months” and was likely to be “more modest” than anticipated in the near term. But this followed a month of May when it seemed Europe's economies were on the brink of disaster, while over in the United States some sort of recovery was on the cards.

So what is going on here, does the earth switch it’s magnetic pole every six months, with what went up last time round now going down? Or could it possibly be some kind of common thread here, one common factor which unites the unprecedented expansion we have just seen in Germany, and the fears of renewed recession in the United States. Well, as it happens, indeed there could, and it has a name - the Greek debt crisis.

Structural Problems In The Currency Architecture?

So what is the link? Well, the fact of the matter is that we live in a bi-polar world, at least as far as currencies are concerned. Until our current global financial architecture evolves into something more sophistocated, we have two main currencies which rival one another for pride of place in central bank reserves and investment portfolios: the euro and the dollar, and when one of these goes up, the other must come down, and vice versa. It is as simple, and as complicated, as that.

Prior to February, and the outbreak of the European Sovereign Debt Crisis the US economy was seen as the weaker partner, and the euro was priced at a relatively high level. Then the euro slumped (falling at one point from around 135 to 120 to the US dollar in a matter of weeks) as attention focused on what appeared to be significant weaknesses in the Eurozone infrastructure. As a result of the change German exports boomed, while the US economic recovery steadily started to grind to a halt.

And with the rise of the dollar the global economy started to fall back into dangerous - pre crisis – habits. The US trade deficit started to open up again, and one exporting nation after another started to see yet one more time the US market as the global economy's consumer of last resort. Indeed the US June trade statistics reveal the extent to which American consumers are once more sucking in large quantities of imports as their spending power recovers, while weak demand in the rest of the world coupled with the comparatively high dollar has been keeping a brake on American exports.

As the New York Times put it in an editorial, "China is mopping up demand everywhere you look with its artificially cheap supply of goods, while Germany, the world’s other exporting power, is cutting its budget and relying on foreign demand to drive its economic rebound. This isn’t sustainable".

And the numbers prove the point. The United States trade deficit ballooned to $49.9 billion in June, the biggest since October 2008. In July, one month later, China recorded a $28.7 billion trade surplus, the biggest since January 2009. In the first five months of the year, Germany’s trade surplus, driven in large part by demand for machine tools in recovering Asian economies (many of them busily sending exports to the US), rose 30 percent compared with 2009.

And this impression is only confirmed when we come to look at the latest revision for US GDP in the second quarter. According to the revised data, US GDP increased at an annualised 1.6% rate (as compared with the 9% annual rate in Germany), after registering a 3.7% rate in the first quarter, according to the Bureau of Economic Analysis (BEA) today. The second-quarter growth rate was revised down by 0.8 percentage point from the “advance” estimate (of 2.4%), in part as a result of the new data on imports for June. The US Bureau of Economic Analysis report stated that slower GDP growth primarily reflected a surge in imports compared with the previous quarter and a slowdown in inventory investment. In fact, real exports of goods and services increased at a 9.1% rate in the second quarter, compared with an increase of 11.4% in the first, while real imports of goods and services increased by 32.4%, compared with an increase of 11.2% in Q1.

Effectively the American economy is simply too weak to carry this additional load, and is now showing signs of heading back towards recession, forcing the Federal reserve, which only a few months ago was moving towards a tightening in monetary policy to fend off inflation to now re-assert its policy of quantitative easing to avoid any posssibility of a drift towards deflation.

Meanwhile the German economy turns in a 2.2 per cent quarterly growth spurt, unified Germany’s best-ever performance. The annualised 9 per cent growth rate, is, as the Financial Times noted, virtually unprecedented in developed economy terms. Such dramatic changes, rather than reassuring us that all is well, only lead to even more doubts. Is it really desireable for an economy to shoot forward so dramatically, only to fall back again in the second half, which is what almost everyone (Monsieur Trichet included) expects to happen?

Not only does the German performance seem exaggeratedly large, at the other end, on Europe's periphery, the result was lamentably small. Greece naturally exceeded everyone's expectations, on the downside, with a 1.5 per cent quarterly contraction (a 6 per cent annual rate), but Spain remained at the bottom end of the range, with a 0.2 per cent expansion, as did Portugal. Undoubtedly the Greek contraction will slow as the year advances, but the outlook there continues to be preoccupying. Only today the Greek manufacturing PMI, which showed the contraction in Greece's industrial sector accelerated again in August, has reminded us of just how difficult it is going to be for the country to return to growth, and especially if the external environment now starts to deteriorate.

As the FT's David Oakley said yesterday, in many ways Germany could be said to have had a "good crisis", since the Greek issue pushed the Euro down and German exports up, while the current flight to safety is driving down the yield on German bunds to record lows even as it pushes up the spreads for peripheral Europe sovereigns. Among other imapcts this gives German companies an even greater competitive advantage as their capital costs come down even while those for their competitors go up.

Spreads – which are the additional borrowing premiums countries have to pay over benchmark Bunds – hit a fresh record of 357 basis points in Ireland this week, following problems in Allied Irish bank and a Standard & Poor's downgrade. In Portugal and Spain, spreads have been creeping back up, and are now once more close to their all-time highs. Spain’s 10-year bonds are trading at about 192 basis points above Germany, compared with 57 at the start of the year while Portugal is trading at 333 basis points, compared with 67 on January 1. The following chart shows how peripheral spreads have evolved since the start of the year (they have been indexed to 1st January). As is evident they shot up in May, then came down to lower levels in July, but during August they have once more been climbing.

All three economies are experiencing extremely weak growth and Ireland is even flirting with deflation. Higher government borrowing costs can harm economies in a number of ways, from higher borrowing costs for companies to added pressure on a country’s public finances as more is eaten up in interest charges, leaving less for public services and stimulus. Effectively the presence of a large spread differential means that monetary policy is applied unevenly across the Euro Area, despite the "one size for all" objective of the ECB. And doubly so with a credit crunch which means some banks struggle to finance as a backdrop.

Japan Trapped On The Ropes

And as if all of this wasn't enough, Germany's main competitor in Asia (where German exports have been clocking up large increases) has been effectively KO'd by the flight to safety produced by the Sovereign Debt Crisis. Japan's exchange rate against the USD dollar is now hovering around a 15 year high.

The consequence of this is not hard to predict, while Germany clocks up record exports to China and other parts of the continent, the Japanese "recovery" is gradually grinding to a halt, as the latest manufacturing PMI report only confirms.

We Need To Seriously Address The Imbalances

At the end of the day it is hard to avoid the conclusion that we continue to live in a very unbalanced and essentially economically unstable world, where currency valuations and economic growth rates fluctuate with unnerving rapidity. Not only that, the recent Federal Reserve meeting seems to have constituted some sort of defining moment, the point when everyone finally recognises that the long promised recovery was no longer simply weeks or months away, and that emerging from the trough in which the developed economies find themselves is going to involve a long period of slow and painful effort, one where we will also need time to clean up the mess we have made in cleaning up the original mess, assuming that is that we have the dynamism and energy to do so.

On thing is clear, the old habits won't work any better now than they did before 2007, and external deficits which were not sustainable then will not be sustainable now. So we need a new model, a model in which the emerging markets will have a much larger role to play than ever before. And if we are to move towards a more sustainable future, then we need to move beyond those simplistic headlines stressing the virile nature of Germany's export prowess. There is no doubting the efficacy and competitiveness of many German companies, but for that very reason that country needs to shoulder more of the responsibility for sharing the burden which is involved in finding solutions. Here in Europe we don't only need sacrifices in the South, some of them also need to be made in the north. German industry is enjoying real and tangible benefits (via artificially low interest rates and an undervalued currency) from the mess that the Greeks created for themselves, but in the interest of all European some of those benefits need to be plowed back in again, since if Greece is allowed to fail, no one will be the winner.

Looking beyond Europe we need to think about how to best aid and abet the emerging economies in their quest for growth and better living standards. Earlier in the crisis I asked Nobel Economist Paul Krugman a question which is very much to the point. “At a time when the financial crisis is generalised across all developed economies - whether because those who borrowed the money now have difficulty paying back, or those who leant it now struggle to recover the money owed them - to which new planet are we all going to export?”

My response to him back in January was that maybe we don't need to look so far afield. Many developing economies badly need cheap and responsible credit lines, and access to state-of-the-art technologies, so why not accept the world is changing, and go for some sort of New Marshall Plan, one capable of generating a win-win dynamic which would be in all our interests? At the time the proposal seemed totally unrealistic and unobtainable. Now, with every day which passes it starts to look essential. And who knows, maybe the rise of a number of other major economic powers would help solve that bipolar currency problem which is currently causing our policymakers so many headaches.

Monday, August 30, 2010

One Swallow Doesn't Make A Summer, But....

Well, as we all well know one swallow doesn't make a summer, and one data point doesn't swing an argument one way or another, but the latest retail sales PMI reading for Germany is far from being either uninteresting, or (for my part) surprising. Basically after only two months (in the last twenty seven) of registering growth, the August PMI suggested that German retail sales once more fell back. And the anecdotal explanation for this: Spain's victory in the world cup affected the shoppers appetite! Actually, from a long term aggregate point of view I think (and economic study would be a waste of time if it weren't like this) that rather more factors come into play than football and the weather.

August data signalled a modest decline in month-on-month sales, reversing the solid upward trend registered in both June and July. At 48.4, down sharply from 57.2 in the previous month, the seasonally adjusted Retail PMI was below the 50.0 no-change value for the first time since May. The latest reading was the lowest for four months and slightly below the long-run series average (49.1). Anecdotal evidence suggested that less favourable weather conditions and reduced consumer footfall had negative impacts on like-for-like sales in August. Some retailers also noted that the end of the football World Cup had contributed to a decline in household spending.

Of course, the retail PMIs are not an exact science, and they only give us an indication of the retail environment. But their long term trend is not in disharmony with the actual sales data provided later by the statistics office, since sales in Germany have been generally trending down, and as the writers of the report say, the long-run series average (49.1) does show slight ongoing contraction .

Consumer confidence, on the other hand, has risen slightly in recent months, but it is still well below the pre-crisis level:

While the ZEW investor sentiment index - normally a forward looking indicator - has been dropping steadily for some months now.

So if we combine this with the August flash German PMI reading (which dropped back slightly over earlier months), it would seem that some easing off of German GDP is taking place, and indeed few will be surprised by this, since the very rapid rate of Q2 growth was clearly a one off. The issue really is that these very rapid (Leo Messi in-the-box type) accelerations don't seem to pass through to self-sustaining (via the consumption pillar) expansions, and I do wish more people would start to ask themselves why this is.

Moving on to other parts of the Euro Area, French retail sales seem to have continued to grow in August, although at a rather weaker pace than in July.

But whichever way you look at it French retails sales have a decidedly more positive look about them than their German equivalents.

What really seems striking to me is the difference in outlook being expressed by the retailers in the respective countries. According to the German report:

Although retailers were downbeat about their actual sales in August, latest data pointed to a surge in optimism about the prospects for sales in September. The degree of positive sentiment about the outlook for sales in one month’s time was the most marked since April 2008. Almost one-quarter of survey respondents anticipate sales to beat their initial forecasts. A number of retailers linked their optimism to improving conditions in the domestic economy.

On the other hand, the French report talks of caution among those interviewed:

The value of goods ordered by French retailers for resale decreased for a second straight month in August. Panellists indicated that they preferred to take a cautious approach to stock decisions at the present time. Correspondingly, inventories declined at the fastest rate since January.

One wonders what the basis for such expectations actually are. It couldn't possibly be that they are being influenced by the press and media coverage of the situation, could it, since in neither case do I see the expectations as especially realistic. The French seem to be too pessimistic, and the Germans way too optimistic.

Meanwhile over in Italy it was plus ça change, as retail sales continued their now customary decline (if at a rather weaker pace than in recent months), with the consequence that the Eurozone Retail Sales Index suggested that sales across the Euro Area fell very slightly in August (on aggregate).

Well, all meat for Monsieur Trichet to chew on before Thursday's meeting.

Friday, August 27, 2010

The Baron Münchhausen Effect

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

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

No Mean Feat

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

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

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

French Growth More Balanced

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

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

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

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

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

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

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

All The Stars In Alignment

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

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

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

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

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

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

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

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

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

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

Enthusiasm Unbounded

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

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

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

Why The Obsession With The French Deficit?

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

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

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

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

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

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

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

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

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

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

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

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

Short Memory Spans?

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

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

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

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

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

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

Wednesday, March 10, 2010

German Exports and that Looming Double Dip

I hadn't seen an advance release of the January German export data, when I wrote the following on Tuesday, honest injun I hadn't:
Well, this is only a hypothesis. But if the hypothesis has any validity we should be able to make some predictions on the basis of it. I would make two. Firstly, since East Europe’s economies are often dependent for their growth on exports to the West, and in particular to Germany, then we should be able to see some “shadow” of this German process cast out into the East.

In the second place, we should see the process continue to some extent in Q1 2010. That is, based on what we have seen so far, in Q1 imports should rise, as industrial output in the early parts of the supply chain surges, and net trade should as a consequence be less positive than in Q4 2009. On the other hand, all the imported components awaiting processing should make inventories rise. So that’s a prediction. Now we need to wait and see how good it is.
I think I oulined in the post itself just how much you could see the impact of the long Eastward shadow cast by the German economy in the industrial output performance in Central Europe, but little did I expect, when I wrote those words that further confirmation of the hypothesis would come within a mere 24 hours:
Germany's exports unexpectedly declined in January compared to the previous month, official data showed on Wednesday, highlighting risks of a bumpy recovery in Europe's largest economy.Exports, adjusted for seasonal and calendar effects, dropped 6.3% in January compared to December 2009, the Federal Statistical Office, or Destatis, reported.

Most analysts expected a 0.5% increase in exports, which posted a monthly rise of 3.4% in December. Imports posted a monthly rise of 6% in January after gaining 5% in the previous month..

So we are seeing the imports rising effect, which suggests, since domestic consumption is falling at this point, that those inventories are starting to rise again, given that the expected follow through on exports is nothing like as dynamic as most analysts are suggesting. Oh, I know, I know, we have been having some very bad weather of late...

Axel Weber is forecasting a slight negative performance of the German economy in the first quarter, but in fact things are still not so clear since, as I wrote on Tuesday:
"Given everything I have said above about swings in imports and inventories, I would say German GDP will be very near to stationary again this quarter, with a possible slight upside depending on the inventory swing, but whatever upside we do see will more than likely disappear as quickly as it came when we get to the Q2 2010 data."
In other words, it is all down to inventories again, and these are very difficult to foresee. Nonetheless I would make two more points:

Firstly, the Bundesbank’s forecast for growth of 1.6 percent in 2010 is looking rather optimistic at this point, even though GDP was at a very low level last year, so in theory getting some growth should not be that hard.

And secondly, that German recessionary "double dip" that I mentioned back in November does not look so implausible at all at this point. All that is needed is a very slight downward revision to the Q4 2009 data, and Axel Weber's own prediction for very slight negative growth in this quarter to be confirmed, and there we will be, back in recession. Which would only leave us with the French economy - among the EU majors - showing any sign of a robust recovery.

Of course the implications of all this rather technical argumentation are fairly profound. In the first place, as I noted in this post, any talk of the ECB raising interest rates either this year, or in the first half of 2011, would seem to be way, way too premature. And secondly, it is becoming increasingly obvious that Europe's (theoretically) stronger economies are inexorably yoked together with all those supposedly weaker ones, via the Eurozone (and EU27) current account imbalances.

So solving one problem also implies solving the other. Never has the case for a "united we stand, divided we fall" approach been clearer. So gentlemen, please, let's get a note of reality back into all those deliberations about what to do with the problems being faced in countries like Latvia, Hungary, Greece and Spain. We need common solutions to common problems, and we need solutions that work.

Monday, March 8, 2010

The German Economy Is Essentially "Intact"

According to Bundesbank President Axel Weber, Germany’s economic recovery is “essentially intact”, and is now set to benefit from stronger demand in countries outside the euro region.
“I firmly believe that the recovery process that began in summer 2009 is essentially intact, and that it will continue despite the slower growth dynamic in the winter semester. An additional factor in this context is that the German labor market continues to be in extremely robust shape.”

What exactly it means to say that an economy is intact we will explore below, but it is clear that some confirmation for the view that the German economy is benefiting from increased demand originating outside the Eurozone can be found in the latest press release on manufacturing industry turnover from the Federal Statistics Office, where they note that while January's manufacturing sector turnover surpassed that of January 2009 – by a working day adjusted 2.6% - domestic sales actually fell (by 1.1%), and export turnover rose by 7.3%. Most interestingly, as between destinations, sales to euro area countries only increased by 2.4%, while those to other foreign countries were up 12.0%. This illustrates two points: that the German economy is now more dependent than ever on exports, and that sales to emerging markets are what is really driving export growth at this point. This latter development is hardly surprising given the strong fiscal corrections being applied in many of Germany's former customer countries.

Wednesday, January 13, 2010

German GDP "Probably" Stagnated In The Fourth Quarter of 2009

Whoever said economists are people who don't ever get anything right?
"Economic growth in Germany probably stagnated in the fourth quarter from the previous three months, the Federal Statistics office said. Still, the figure is “surrounded by uncertainty,” Norbert Raeth, an economist at the office, said in a press conference in Wiesbaden today."

So German GDP was probably more or less flat quarter on quarter between October and December. The figure is surrounded by uncertainty, as I pointed out in this post (Is There A Double Dip Risk In Germany? ), quite simply because German growth numbers at the moment are all about net trade and inventories, with domestic consumption in an entirely secondary role, and imports rebounded in the third quarter, which means the trade impact may at best be neutral, while inventories were probably run down (the extent to which this has taken place is what most of the uncertainty is likely to be about). As I started to point out back in mid November:
The question in hand is the Eurozone third quarter growth one, and the story is all about differences (between countries) and these differences in the key cases (France and Germany) are in many ways all about inventories……Now if you look at the chart below, you will see that German growth was in the second quarter was, more than anything, a statistical quirk which resulted from a balancing act between strong swings in inventories and in net trade. In the third quarter, as far as we can see (since we don’t have that ever so important detailed breakdown), this position has quite literally been inverted, as the earlier trade bonus has been eaten away by growth in imports....

That was before we got the detailed breakdown of Q3 growth. On November 28, following the publication of this data, I went on to argue that:
While a positive contribution to growth was made by goods exports, which were up 4.9% on the previous quarter, imports also rose , and by more than exports (up by 6.5%), and the resulting trade balance had a negative effect on growth of –0.5 percentage points. This was more or less the same as the contribution from household consumption (which was also negative by 0.5 percentage points). But what really, really mattered here - see the chart below - was the inventory build-up which added a staggering 1.5 percentage points to growth., while government final consumption expenditure only increased slightly (+0.1%) over the period and effectively had zero impact on the growth number. So, as I said, it is all about inventories in Q3.

Which lead me to conclude that:

In Q4 it is all going to be about trade. Since if German exports hold up, then the run down in inventories need not be that strong, but if exports don’t sustain momentum in December - and what just happened in Dubai is making me very nervous on that front - then German GDP will almost certainly fall back into negative territory in the fourth quarter. On the other hand, if I am jumping the gun slightly here, and German economic activity does manage to eke out some small increase at the end of the year, then I think a return to negative growth in the first quarter of 2010 is almost guaranteed. That is to say, we have a double dip on the horizon. At least, that is my call. Now it is over to you.

Well, my instincts seem to have been more or less good ones, and just to show that my forecast was not simply a fluke (ie that it is backed by some sort of coherent analysis, one that is testable), I would also draw attention to my "twin" post on Japan - Double Dip Alert In Japan, dated 7 December - where I said:

"Despite recent optimism about the apparent renaisance of growth in the Japanese economy, and the heightened sense of enthusiasm which surrounds the surge in economic activity right across the Asian continent there are considerable grounds for caution about the sustainability of the Japanese recovery itself".

Just two days laters Japan's third quarter results were revised down, sharply (and for most analysts unexpectedly sharply).

JAPAN'S economy grew much less in the third quarter than initially reported, revised government data showed today, as a strong yen and deflation weighed on economic activity by prompting firms to hold off on new investments. The new data revealed that July-September's real gross domestic product grew 0.3 per cent compared with the previous quarter, much slower than the 1.2 per cent expansion reported last month, and worse than analysts' consensus forecast of a 0.6 per cent rise.

So what's the point of all this? Well certainly not to say simply "aren't I clever now". The issues is that (for demographic reasons) the German and Japanese economies are totally export dependent, and thus it is unrealistic to expect the global recovery to be lead by an expansion in these economies. The recovery will have to come elsewhere (in France, for a start, but with France alone there is not enough) and the export dependent economies can then "couple" to that dynamic. It is difficult to say whether or not the Japanese economy will show some marginal growth in the fourth quarter, since the Q3 revisions make for a much lower base, industrial output has risen considerably on the quarter, but the important services sector has been contracting.

Essentially, until those heavily indebted economies (the US, the UK, Spain, Ireland, Eastern Europe, etc) who formerly ran current account deficits can find a way back to sustainable growth without the aid of large government stimulus programmes, any general recovery will remain extremely weak. And the German result has, of course, implications for four quarter Eurozone growth. As I said in this earlier summary of the Q3 eurozone performance:

So, going back to my original question, is this a whimper recovery, or are we on the verge of a double dip? I think, basically, it is all down to Germany, and those inventories. If external demand weakens in key customer countries then Germany will fall back into negative growth, and with it the whole "eurozone sixteen economy". Since demand in the South and the East of Europe is hardly going to be strong, given the new found need of countries in those regions to run trade surpluses, my inkling is that just this outcome is now a clear possibilty. So while the consensus at the moment seems to be that France disappoints, my view is that it is the German economy we really should be worrying about.