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Thursday, February 27, 2014

A Simple Chart Illustrating Why Japan Style Deflation Is Now More Or Less Inevitable In Spain

Here's one simple chart which illustrates why I think Japan style deflation is now more or less inevitable in Spain. Curiously it comes from the Ministry of Employment and illustrates the relation between the movement in average wages caused by actual movements in the real wage and those caused by what is known as the "compositional effect". This latter is known by this name because it is the result of movements in the composition of the workforce, whether this be in terms of the average skill level or the average level of experience (or seniority premium, if you prefer). Seniority has historically played a very important part in the Spanish wage structure - ie the longer you have worked the more you are likely to earn.



Now if you look at the data superficially, you find that in the first years of the crisis average real salaries went up sharply (the blue line). This surge in average salaries was not due to salaries actually rising to this extent, rather it was the result of the composition of the workforce having changed (the average skill level went up) as unskilled workers in construction lost their jobs. Hence the 2009 spike in the composition effect.

According to Bank of Spain data in 2008 skilled workers represented 23.55% of the total while by 2012 the proportion had risen to 28.2%. On the other hand, over the same time period unskilled workers fell from 14.8% to 10.2% of the total.This naturally had an impact on average wage levels.

Now, however, the labour market has stabilised, and unskilled workers are no longer losing their jobs (at least not in net terms). According to the Spanish newspaper Expansion the Spanish statistics office estimate average hourly labour costs (not unit labour costs, note) fell in Spain by 2.9% en 2012, 1.9% in 2013 and they are expected to fall another 1.7% this year.

Again, looking at the chart you can see that the green (compositional effect) line which surged in 2009 has now flattened.  It has flattened but the impact is still there and has stabilised at a more or less constant rate. Subsequently it is quite possible that the compositional effect will even turn negative due to the impact of the 2012 labour market reform:  average salaries are no longer falling due to labour shedding producing a changing skill composition but due to AGE CHURN. Older workers with long term contracts and lots of seniority are being steadily replaced by younger ones on less well paid contracts, thus dragging down the average wage. The line is flat and extends out in to the future. This can go on for years now, and indeed the compositional effect can even turn negative.This is exactly what has been happening over the years in Japan, and is the principal reason why Abenomics isn't working.


Incidentally, here I have been talking about average hourly labour costs NOT  those famous unit labour costs. These, as we all know, fell significantly in Spain after the onset of the crisis. What isn't so well understood is that this fall wasn't due to falling hourly wage costs (these didn't really start falling till mid 2010, see blue line in chart) but due to massive labour shedding. Spain's GDP has fallen by something like 7% while employment is down by around 20%.




On the surface this shows a large gain in productivity. Where this gain is actually coming from hasn't been sufficiently analysed yet, but part surely comes from a compositional shift in the labour force. One thing is, however, reasonably clear and that is that it hasn't come from industrial productivity, since industrial output is down by some 30% since the pre-crisis peak, even more than the reduction in employment.(I'm afraid you'll have to stare very hard at the industrial output chart if you want to see signs of the much proclaimed recovery - you'll have to stare very hard since there is so little sign of it).




So why do I think this suggests deflation may become endemic in Spain? Well, with average real wages falling, real pensions falling, and credit still shrinking by around 6% a year it is hard to see where the demand is going to come from, especially with very little happening in the way of new employment - the shortfall is becoming structurally implanted.




For more argument on all this (in Spanish) see my book which is being published by Ediciones Deusto next week. You can find a list of chapter headings here.

Wednesday, February 26, 2014

Could Mario Draghi Implementing QE At The ECB Possibly Help Matteo Renzi Raise the Italian Deficit?

What a convoluted title! Still, the lack of formal elegance might just be compensated for by its communicative efficacy. The aim of the above header is to link two names in people's minds, both of them Italian: Mario Draghi and Matteo Renzi. Naturally the idea is not original, the FT's Peter Spiegel  recently published an entire blog post ( Does Renzi owe his job to Draghi?) trying to establish some sort of  connection between the arrival in office of Italy's Matteo Renzi and the recent German Constitutional Court ruling - in the process casting the central bank President in the role of midwife. Indeed, according to the FT,  Italy itself is currently rife with rumours about what might actually lie behind Renzi's meteoric rise, and  again the role alloted to Mr Draghi seems to be  rather more than an incidental one.

But this post is not about rumour, nor is it about speculation - beyond, that is, speculation about what the ECB might do in its campaign to keep the Eurozone deflation menace at bay. Rather than conspiracies (real or imagined) it is about coincidences and the role they so often play in shaping events and outcomes. In this sense the fact that Mario Renzi took over the helm of government in Italy just a short time after the German Constitutional Court ruled on the ECB's Outright Monetary Transactions (OMT) programme has real potential.

What we could call Spiegel's hypothesis suggests the driving force for the "unholy alliance" which may or may not have been forged between Matteo Renzi and Mario Draghi would be found in the latter's interest in getting prime minister Letta out of  office before pressure from within Germany about maintaining open the offer of a legally questionable  OMT programme to an Italy which was enjoying cheaper bond yields but was manifestly not advancing with its reform programme became too strong to withstand.

"Do last week’s German constitutional court ruling lambasting – but failing to overturn – the ECB’s crisis-fighting bond-buying programme and Matteo Renzi’s ousting of Italy’s prime minister Enrico Letta have anything in common? In the view of many ECB critics, particularly in Berlin, the two are not only related, but one may have caused the other."

"The German government has always had a bit of a love/hate relationship with the bond market throughout the four-year-old eurozone crisis. On the one hand, it regarded sovereign bond holders as greedy opportunists looking for German taxpayers to bail out their bad bets. On the other hand, those same traders were a useful tool to keep pressure on wayward governments – particularly Italy – that were in dire need of economic reforms to spur growth."

"In the view of many German critics, there has been no serious effort by the Italian government – be it in the fading months of Mario Monti’s premiership or during Enrico Letta’s foreshortened tenure – to undertake major economic reforms since ECB boss Mario Draghi first announced he would do “whatever it takes” to save the euro in July 2012."

"The bond-buying progamme that the German constitutional court grumbled about last week – known as Outright Monetary Transactions – was the product of that speech 18 months ago and has kept the crisis at bay ever since, helping keep Italian borrowing costs near pre-crisis levels."

Leaving aside the problem of mechanism - how could Mr Draghi or anyone else have stirred up participants in the Italian Democratic Party's primary election - the potential synergy between the two developments (the Karlsruhe ruling and the new government in Italy) is more than evident.

The key part of the background here, as Wolfgang Munchau has already pointed out, is that the German court ruling effectively left OMT - which only ever had a virtual existence and was increasingly seen as an empty bluff since it was clear no one was going to accept the conditionality side - deader than that infamous dead duck. Karlsruhe's objection to the existing bond buying programme was that it went beyond the ECBs mandate since directly financing government debt is prohibited under Maastricht, and the objective of OMT was to help governments finance at an affordable price. Since break-up risk - which could have offered an alternative justification for OMT - is for the moment off the table, OMT lacks definitive legal justification and in practical terms the emperor visibly has no clothes. It is just a question of how long the markets need to wake up to the fact.


Under these circumstances, as one argument would have it, it is only a matter of time before market sentiment turns and peripheral spreads come back under pressure at which point OMT would be tried tested and severely found wanting. While I think this risk to peripheral spreads in the short run is probably overstated (since at this point market participants are so bullish they are effectively immune to flashing red light warning signals), letting Italy simply drift does involve a high level of potential risk, and certainly a higher level of risk than a prudent central banker might want to run. So that part of it I buy: Mario Draghi would be at least rooting for Renzi even if he wasn't doing anything to actively make his wish come true.


But then, enter the deflation threat. The ECB is - and not without justification (see the above chart showing the movement in 5 year index linked forwards prepared by Commerzbank's Michael Schubert) - concerned about the possibility that longer term inflation expectations could become anchored well below the 2% price stability level the maintenance of which the ECB does consider to be its mandate. Aggregated inflation across the 18 countries who constitute the monetary union has fallen and remained below 1% for an extended period of time now. In several EU countries prices have actually started falling, in others inflation has dropped to very low levels of 0.5% or below. Greek inflation is currently running at an annual rate of minus 1.4% and has been in negative territory for eleven months now (see chart above). Worse still, and again as Wolfgang Munchau points out, there is a real risk that the periphery economies drag the German inflation rate down along with them.
"Germany’s federal statistics office said last week that real wages – after inflation – fell in 2013. This was unexpected because other surveys suggested they had gone up. What seems to have happened is profit-related pay and other hard-to-measure components of wages came down last year. For the eurozone, German deflation is a nightmare. If the periphery wants to become more competitive, it needs lower inflation than Germany. But if Germany, too, is deflating, then either the competitive adjustment will not happen; or the whole of the eurozone goes into deflation; or, more likely, both."

"Insee, the French statistics office, announced that the annual rate of core inflation – without volatile items and tax measures – dropped sharply from 0.6 per cent in December to 0.1 per cent in January. Factory prices are another forward-looking indicator. According to data from Eurostat, the EU’s statistical office, they went down in the eurozone as a whole by a whopping 0.8 per cent annually in December." 
 As he says, deflation in Germany would become a true "worst case scenario" nightmare for Euro Area monetary policy. So, with the risk continuing to rise the bank will need to do something, and  some version of Japan-style bond purchases seems to be the most likely thing it will do. Lowering interest rates or more initiating more LTROs simply wouldn't have a big enough impact (which doesn't mean that both of these might not happen taken as part of a broader package. This time the  FT's David Oakley explains:

"At last, after resisting for so long, the European Central Bank looks closer to implementing its own version of quantitative easing to spark growth across the eurozone.................. Investors and strategists expect about 30 per cent of the bond buying will be in German Bunds in a €400bn programme. The ECB would then likely buy about 20 per cent in French Oats, 18 per cent in Italian BTPs, 12 per cent in Spanish Bonos, with the rest being bought in the other much smaller debt markets......"

"The German constitutional court has asked the European Court of Justice to make a ruling on outright monetary transactions, which Mr Draghi introduced as a backstop to the eurozone in the summer of 2012. Although outright monetary transactions would involve buying government bonds, it is not the same as QE as it would be introduced in the event of a run on one or more of the debt markets. The ECB could successfully argue that QE, which involves buying a range of bonds to lift inflation, was within its remit as it is designed to bring about price stability....."
So the initiation of some kind of bond purchases programme at the ECB is looking increasingly likely. If such a programme is implemented it will differ from OMT in the justification offered (to try to attain the bank's inflation objective), the fact that the bank will buy bonds from ALL countries according to their weight in Euro Area GDP, and by the fact that there will be no conditionality attached. Naturally, the fact that they will initiate such a programme doesn't necessarily mean it will work and achieve its objective. As we can see in Japan, the effectiveness of the policy is questionable, but then a central bank can hardly say, "deflation ahoy, but there's nothing we can do about it".

Whether or not it is possible to reflate economies which have entered some kind of enduring process of secular stagnation - as Larry Summers obviously thinks you can (or see here) -  remains an open question as far as I'm concerned. If part of the problem is demographic - as I explain here and here in the context of Abenomics - then it is hard to see how you can. Possible we need to start to learn to live with deflation and find ways of managing the impact on the financial sector. As the FT's David Pilling so cogently put it recently in the Japanese context: "monetary policy can't print babies", and one day or another as our workforces accelerate their decline it may be hard to sustain positive growth. Maybe there are some realities looming out there that we are just not ready or able to accept yet.


But, going back to Renzi, the initiation of sovereign bond purchasing type QE will surely mark the beginning of a Japanese turn in ECB policy. It may start with just 400 billion, but it could then grow and grow, especially if the structural weakness in domestic demand continues to exert a downward pressure on prices even despite the money printing. So just who might benefit from this? Well, you don't have to be excessively astute to see that Italy would be prime candidate. The country currently has a gross government debt to GDP ratio of around 135%, small when compared to Japan's level of nearly 245% but still it is large and rising, especially if Italy continues to push on its fiscal deficit limits. And they will need to do this since there are no signs that the country's economy - like its Japanese equivalent - can grow any faster than it did before the global crisis without ongoing fiscal stimulus. Pushing the debt upward much beyond the current level without being forced into some kind of debt restructuring would seem to be be virtually impossible, unless........... unless the ECB start to buy the bonds. So could Matteo Renzi, who doesn't seem especially worried by the size of Italy's public debt levels be just the man for the job?



The key to the new win-win strategy would lie in the Renzi's aim getting agreement to increase the country's fiscal deficit (rather than as previously lowering the bond spread) in exchange for structural reforms. Basically any ECB Italian bond purchasing would ease pressure on Renzi in the short term. Mario would "have Renzi's back" provided he complied with the reforms. And if he didn't, well then more than likely he would simply go the way of Enrico Letta.

And to those would argue that all of this goes beyond what the German public have come to expect from Euro Area policy, I would suggest that all of what is about to happen was already evident when Mario Draghi used the famous "whatever it takes" phrase. He meant what he said. As I argued in October 2012, in a post entitled "Taking a Man at his Word":
"The heart of the issue is that Mario Draghi has vowed to do enough, and enough seems to have no limits. So what could the ECB do if we really put our imagination to work on the issue? Well like Ray [Dalio] argues, they could print money, lots of it, even to the point of doing it helicopter style. Those people who think the ECB is already printing money (which they aren’t necessarily doing when they increase their balance sheet) ain’t seen nothing yet. That’s what the “it will be enough” promise means. None of this is in the mandate yet, naturally it isn’t, but it could be, and it would be much easier to put more in the mandate than it would be to keep going to the German Parliament to ask for more money. So it could, and most probably will, happen.When you’re crossing that rope bridge and it starts to creak and sway then you just have no alternative but to continue moving towards the other side. We have all seen far too many movies about what happens to the people who try to turn back."