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Tuesday, January 30, 2007

Serbia: That Incredible Shrinking Country

This post constitutes a brief economic review and report on Serbia to accompany Manuel's election report (see here on Global Economy Matters). (Also the ever readable Doug Muir has a further breakdown and assesment of the election results over at A Fistful of Euros).

Now only last week GEM blogger Artim was asking the timely and important question as to whether heterodox policies were in fact compatible with the emergence of free market growth-driven economies, and while in the case of Thailand the situation may be debatable,and in Ecuador extremely dubious, in the case of Serbia the answer (which is one which now faces us in the light of the weekend election results) must surely be a resounding: No!

And this for two very simple reasons. In the first place Serbia is a shrinking country (not only in terms of its territorial frontiers but also in terms of its internal demographic dynamic). And in the second place since Serbia is effectively locked out of the European Union - and the recent election results will not help any here - and as such is unable to benefit from a foreseeable surge in inward investment flows of the kind which have so facilitated the growth process for the recent EU accession countries.

Now I will not dwell in too great a detail on the first point here. I have a recent post which gives a general rundown on the Demography Matters weblog, so I will restrict myself here to the basics. Serbia's population is both ageing and declining (most probably, data are not made public by the Serbian government, but it is a reasonable deduction). Fertility at around 1.6TFR, while still above the general norm for East and Central Europe countries - which are normally hovering in the 1.2/1.3 TFR range - is still well below replacement, and, as I argue in the DM post, looks set to fall steadily as the birth postponement process gathers pace. At the same time life expectancy - at 74 - is still comparatively low (in the same range as Tunisia, Mexico and Paraguay), and this is likely now to rise significantly, thanks to the arrival of better medical technologies and medicines. But here is just one part of the problem facing a country like Serbia, since most of this increase in life expectancy will come from improving the outlook for the over 60s, and this will have a significant on-cost with little positive economic (as opposed to human) benefit.

At the same time the median age is fairly high at 40.4, and since fertility at this point is not disastrously low, and life expectancy not especially high it would seem to be a reasonable deduction that there has been a fair amount of outward migration in the 20-40 age range. Again the situation is complicated by the fact that the Serbian government has not made migration figures public since 2000 (if indeed they themselves know, as this paper on migration in the Serbian context makes clear). Indeed the whole issue of Eastern European migration is a complex one, and has been the subject of a recent World Bank report which Claus Vistesen has written a preliminary comment on (and which he will comment in more detail on later in the week). Basically there seems to be a systematic east-west migration process taking place across Europe at the present time, driven mainly by the existence of a substantial wage gradient.

So Serbia has, along with most of the rest of Eastern Europe a substantial problem in retaining its young native-born human capital. Indeed, according to the above cited paper, a staggering 70% of students indicate that they would like to leave the country on completing their studies. But on top of this Serbia - along with a whole swathe of other Eastern European countries (Croatia, Macedonia, Moldova, Ukraine, Georgia, Armenia etc.) - faces the problem of being excluded (at least in the short term) from the European Union. Unfortunately with the current climate towards enlargement inside the EU this situation is unlikely to change much in the near future, and these are likely to be critical years in the demographic history of these countries as the full weight of the second stage of the demographic transition - low fertility and medically driven extensions in life expectancy - comes increasingly to exert an effect.

Now, if we turn to the economic data, we find we have a somewhat complex picture. Many are signaling the recent comparatively high GDP growth rates - which at 6% pa in 2006 is one of the fastest growing in the region - as an indicator of a robustly resurgent economy. Indeed some are even - misguidedly - lead to use the term 'tiger' in the Serbian context. I say misguidedly, since the term tiger was - as is well known - coined to refer to the rapid development of a limited number of SE Asian economies (S. Korea, Taiwan, Singapore, Hong Kong). Use of the term has also been extended more recently by David Bloom and David Canning to the Irish Case (see the Celtic Tiger here). But the whole point about the use of the term 'tiger' in the economic literature is that it is tightly related to an economic process known as the demographic dividend, which is a state of affairs wherein favorable changes in population structure facilitate both increasing labour force participation rates and rising productivity. And it is just this dividend that Serbia (along with most of the rest of Eastern Europe) is not going to be able to leverage, since the key demographic changes associated with the dividend took place without the economic growth spurt (which is why there is nothing automatic about the transmission from demography to economics).

A more sober vision of the spectacular growth rate to be seen in Serbia can be found in this article, where the author - Vesna Peric Zimonjic - is at some pains to point out that the impressive investment figure of 5.2 billion dollars of investment in Serbia in 2006 paraded by Minister for External Economic Relations Milan Parivodic is in fact a rather misleading one, since most of the money involved came through the sale of entities in the telecommunication and banking sectors to foreign companies.

Gross domestic product (GDP) has, of course, risen to 44.7 billion dollars and per capita income now exceeds 5,700 dollars, but it is well worth bearing in mind that Serbia's economic performance is still worse than it was in the benchmark year of 1990, the last pre-war year of former Republic of Yugoslavia. On top of this unemployment currently stands at a level well in excess of 2o% of the working age population, and even more significantly, a recent study by the education ministry revealed that almost half the adult population has only elementary education. And this situation becomes even more serious when you consider that there are comparatively few children being born, and those newly educated people who can are upping and leaving.

Perhaps the final bucket of very cold water is thrown on all this by the most recent authoritative statement on the state of the Serbian economy: the October 2006 IMF selected issues Serbia paper, from which I now freely quote:

Serbia has made significant economic progress since 2000. Output is up 40 percent and the share of the private sector in non-agricultural non-budget employment has almost doubled to around 60 percent. These advances have reversed the decline of the previous two decades. In light of this progress, these notes aim to shed light on the challenges ahead.

Of course it is important to remember here that back in 2000 the Serbian economy was virtually in ruins, so climbing back up was not so difficult, it is what comes next which is important:

With capital formation rates regionally low and employment reportedly falling, much of the economic recovery since 2000 has reflected growth in total factor productivity. In part, this is the dividend of corporate reforms which have increased efficiency. But even with the exceptional steel investment in 2004, Serbia’s investment ratios are well below those in other transition countries. Even allowing for data quality uncertainties, these investment patterns raise questions about the sustainability of Serbia’s recent economic growth. The note infers that these investment patterns indicate that a significant further reform agenda—ranging from improved business and political climates, to bankruptcy and privatization—still lies ahead.


and on employment:

With the unemployment rate at 21 percent and rising, employment reportedly in trend decline, and future restructuring set to result in further layoffs, the issues are challenging. The note is exploratory, suggesting lines of enquiry rather than firm conclusions about the way ahead. It reports that the employment structure has shifted to the private sector, but cautions that data are not yet conclusive as to whether this is re-classification due to privatization or whether private firms are creating new jobs. It suggests that Serbia’s labor institutions could be reassessed in view of the high and rising unemployment, including the complex wage setting mechanisms in the public sector inherited from the Yugoslav era.

Also note the rapid growth of credit, especially to unhedged borrowers (shades of the Hungarian disease):

With rapid credit growth one of the consequences of earlier reform, notably of the banking system, the 2005 FSAP pointed to the need to strengthen banking regulation. Given that the 2005 banking law brought the legal regulatory framework largely in line with Basel Core Principles, this note emphasizes that the key challenge now is implementation. It notes that credit, which is largely fx-indexed lending to unhedged borrowers, requires strengthened regulatory capacity to monitor and manage indirect credit risk arising from foreign exchange exposures.


And note these two points from the Main Findings section:

In Serbia, the large current account deficit has been associated with relatively low investment ratios compared to other CEECs (except Bulgaria)—although data doubts remain.

Given Serbia’s large external debt, financing its large investment needs will require achieving higher national savings and attracting larger non-debt creating flows.


and this:

Given these caveats, Serbia’s data suggests surprisingly high external deficits given lackluster fixed investment ratios. Such delinks are not without precedent—after 2001, the Czech Republic and Hungary both reported continued high external deficits while fixed investment ratios declined, in both cases reflecting weakening domestic savings rates. But overall, Serbia’s performance is unusual in degree—reporting large external deficits alongside low investment ratios.


I think the very last sentence really says it all. So not exactly an appetizing picture, and one which the rather complicated outcome of this weekends elections will doubtless make even less so.

Saturday, January 13, 2007

Stephen Roach Interviews Franco Modigliani

Global: A Conversation with Franco Modigliani

I am reproducing here an interview which Morgan Stanley economist Stephen Roach had with the late Italian Nobel economist Franco Modigliani. The interview was originally published on the MS Global Economic Forum in October 2002, but is unfortunately no longer available online on that site.


Stephen Roach (SR)

There are always great imponderables in the macro outlook. But today the questions seem to loom larger than ever. At the top of my list are two burning issues -- the prognosis for the American consumer and the risk of a US deflation. Nobel laureate Franco Modigliani has long been noted for his path-breaking work on these very issues. He was in town in couple of weeks ago, and we had the chance to sit down for a most engaging discussion. An edited version of our conversation follows.



Let's start out with the burning issue of the day -- the American consumer. Franco, as a pioneer in the macro of consumer behavior, what is your assessment of the outlook for this key sector of the US economy?

Franco Modigliani (FM)

The consumer is at risk. Having said that, I must confess to being surprised about the resilience of consumption after the stock market bubble popped. I would have expected some retrenchment. I would have also expected some related damage in the real estate market and the dollar. I still believe at some point there must be some repercussions.

SR

What gives you such conviction?

FM

The key for the consumer response is not the immediate situation. Too much is made of the day-to-day developments, such as mortgage refinancing. My work shows that consumers frame decisions in the context of their life-cycle considerations. It is an intertemporal theory, whereby decisions in any period have implications for adjustments in the future. That's why the wealth effect can be important. If the popping of the equity bubble results in a reduction of longer-term return expectations on an important asset, that has important implications for life-cycle saving and spending patterns.

SR

But there is more to household wealth than stocks. Hasn't the property market saved the day?

FM

While it may seem that way right now, I have my doubts. I am suspicious of those studies that find the wealth effect is larger from real estate than equities. Theory tells me it should actually be the opposite. That's because the house in part, produces a consumer good -- housing services, which we consume. When the value of the house I inhabit goes up, its implied rental value increases. But that does not significantly improve my spending power, because my imputed rent has gone up as much. Any wealth effect on individually-owned property must net out the consumption of the service we derive from living in our homes. Those adjustments need not be made for stock portfolios. It is possible that new refinancing instruments, such as home equity loans may have temporarily distorted this relationship. But I would view this as a one-time shift, not as a permanent realignment of the link between wealth and consumption.

SR

So how does it all end for the American consumer?

FM

A negative wealth effect tells me it can't go on forever. And that's when I revert to the life-cycle theory. Sadly, the large cohort of aging baby boomers is not adequately prepared for old age. The personal saving rate is too low. It has been depleted by individuals betting on asset markets. Life-cycle theory suggests that the saving rate should have gone up by now. Obviously, it hasn't -- at least, not yet. While that puzzles me, it doesn't dissuade me from the basic view that the balance between consumption and saving will have to adjust. It's just a matter of when. That leads me to conclude that that the American consumer is the most dangerous portion of the picture.

SR

Let's turn to another key issue being debated in financial markets -- deflation. I find myself more worried about deflation than at any point in my professional career. Are you at all concerned about the possibility of deflation?

FM

I was surprised when I first heard of the extent of your concerns. They come across as very strong, very scary. I think you are probably exaggerating.

SR

I have been known to do that.

FM

Does Byron agree with you?

SR

No, nobody does. And that is one of the reasons why I am trying to argue the case -- to give some legitimacy to the deflation debate. These days, when you merely utter the word "deflation," you get strange looks like you're crazy.

FM

Well, let me start by saying one thing at the outset: It really depends on how much deflation we are speaking about. I would say that deflation is something to worry about, only if is going to be large. If it's just a temporary blip down in the price level, it wouldn't worry me. It has to have both depth and duration to be a serious concern. But so far, we really haven't had any deflation at all in the United States. Isn't that right?

SR

So far, you are absolutely right. But the GDP price index is now increasing by just 1.1%. That's the lowest rate of aggregate inflation in the US economy in 48 years. So we're not that far away from the hallowed ground of price stability, to say nothing of the deflation that lurks on the other side of this threshold. But it's not just the data. I worry about deflation for both cyclical and structural reasons.

FM

In other words, you are not just worried about the existence of deflation. You are more worried about it having bad effects.

SR

Yes.

FM

Well, that takes us to a consideration of debt deflation. Essentially you will agree that inflation or deflation has an effect both on creditors and debtors. In that sense it is a zero-sum game -- whatever is gained is lost and vice versa. But the private sector as a whole gains because it is the net creditor of the Great Debtor, namely the government. In practice, firms are also net debtors and creditors are mainly (older) individuals. So from the household's point of view, you might argue that deflation is good. However, I think it is a very important thing to remember is that deflation is bad for the government -- as a net debtor; in effect, it increase the real national debt. On balance, that is good for the current generation that owns the claim on government indebtedness but bad for future generations that will have to pay higher real taxes to finance that claim.

SR

Can I just ask you to clear up one thing: Are you saying that creditors gain because deflation effectively expands their purchasing power?

FM

Yes, it's both the purchasing power with respect to the flow -- debt service -- and the purchasing power of the stock of assets. While retired people lose out from the standpoint of interest earnings in a deflationary period, when they liquidate their capital, they can exchange the proceeds for more goods. In that respect, the stock effect works to their advantage in a deflationary period.

SR

I'm very interested in this differential effect. It seems to unmask some of the tensions that we macro practitioners lose sight of. Can you elaborate on this point?

FM

Yes, your question actually takes me back to a story about a good friend of mine, Harvard economics professor John Kenneth Galbraith. Well, one year, when I was a visiting professor at Harvard, Ken Galbraith invited me for a debate with the students at Lowell House. He decided that we should have a debate about inflation. He made the point that inflation was bad for the poor and good for the rich. And I said, "Ken, you're way off." [Laughter] The poor, I insisted, are more likely to be debtors. And debtors benefit from inflation because of the reduced real burden of the debt. So I concluded that inflation is good for the poor and not for the rich.

SR

And what did he say?

FM

[Laughter] I think it was at that point that Ken said to the students, "Don't believe what he says. He's one of these people who writes textbooks and has to defend what he said in his textbook." But there's a moral to this story: In assessing the macro impacts of inflation, deflation, or fluctuations in interest rates, the distribution of indebtedness matters. For every borrower who gets a boost in purchasing power, there is a lender who loses. They may be different people, but it is the net effect that matters for the macro economy.

SR

Let me go down a slightly different road. Deflation has an impact, as you just described, on the ability to service debt. But deflation has also become a real wake-up call for companies that are coming to realize that they don't have any control over pricing leverage. And they're cutting costs in response. If there comes a point when the cost cutting is aimed at headcount and wage payments, how does an overly indebted society adjust to that?

FM

The answer to that question depends on the causes of the supposed deflation, a subject on which you have not dwelt extensively. I can think of two major causes: The most obvious would be a deep cyclical decline, but this version is most unlikely because of the availability of well known stabilization policies, and because in this century, as a result of wage rigidity, no contraction has ever produced deflation in developed countries, since the Great Depression. The other possibility is dogged foreign competition from countries like China. This type of deflation, within limits, would be good for the consumers and would compensate for any resulting downward pressure on nominal wages.

SR

How might such "good" deflation turn into bad deflation?

FM

The only problem I could see would be the possibility of debtors getting worse off. And even though there may be offset by creditors being better off, that doesn't help if you have wholesale repossession of houses and other levered assets. You also suggest that the price pressure could reach a point where it could lead to a curtailment of domestic production. However, I doubt that even this kind of deflation could get very far because it probably would be offset by a devaluation of the dollar.

SR

So if it's debt deflation that has you most concerned, don't you worry about record levels of household and corporate indebtedness currently existing in the United States?

FM

Macro debt loads have certainly gone up a lot -- it's hard to deny that. But, here again, I want to look beyond the macro and study the composition of debt. And there are some very recent developments on the scene that give me pause -- namely the home equity loan. I think this new instrument has done some very important things. Suddenly, a house has become a liquid asset.

SR

Do you think that's good?

FM

Well, from the standpoint of progress, I think it's good. I have always been in favor of making assets more liquid. In that same vein, I am also in favor of allowing loans on 401(k)s.

SR

But the flip side of that liquidity is debt -- the means by which incremental purchasing power is extracted from these assets. Does this create a new bias toward debt-financed consumption that can only end in tears?

FM

That's obviously a worry, especially if you are right on deflation. What Americans do now is borrow against future asset values. Deflation would bring down the value of the properties themselves and therefore reduce the ability to borrow. This phenomenon can become very important if deflation deepens and lasts.

SR

I have one last question on the deflation issue: Doesn't the endgame hinge on wage rigidities, or the lack thereof? If deflation pushes nominal wages down, won't all bets be off?

FM

As a Keynesian, I believe that macro variables such as employment and prices hinge on wage rigidity. Once you accept that, all the rest follows. Historically the floor for increases in wages is defined by productivity. So as long as productivity growth is maintained, nominal wages are unlikely to fall. It's a very deep question. Employers simply don't like the idea of going to workers and telling them they're going to cut their wages. And because employers rely on the support and loyalty of workers, they can't afford to alienate them. By and large, prices are linked to such "sticky" wages. In short, Steve, your case for deflation is interesting. But I'm not persuaded that that the wage-setting mechanism is flexible enough to turn this into a serious problem here in America.

SR

Thank you very much, Franco. I certainly share your concerns on the consumer. And I will continue to probe the case for deflation.