Stuck in the mud and risking deflation

These charts accompanied an article in the FT of last Friday titled :

Spectre of Japan-style lost decade looms over eurozone.

The only thing wrong with this article is that Japan has lost decades ( plural ), not just one decade, by failing to address deflation appropriately and the Euro-zone is risking a similar fate.

This article was published the same day that Mario Draghi was speaking at the Central Bankers' gathering at Jackson Hole Wyoming in the US where he expressed concern about the risk of deflation and promised that the ECB will, within its mandate, adopt more aggressive non-conventional monetary measures.

These few charts say a long story:

• production in the Eurozone is barely expansionary and is stuck well below its potential - first chart.
• GDP in Eurozone is still below its 2007 peak - whereas in the US it is well past it, in UK and Japan they are practically there.  Obviously there is an even bigger gap between the level of production and the trend line i.e. where GDP would have been if we had no 2008 great recession - second chart
• Eurozone inflation is dangerously dipping close to depression levels - third chart
• Unemployment remains obstinately high in double digits - fourth chart

The message coming clearly from these charts is that the Eurozone is suffering from a problem caused by lack of demand and that there is ample spare capacity leaving great space for demand stimulating measures without risking inflation. 

With such a clear message the ECB has a duty to act.  The problem is that probably the ECB's mandate is not wide enough to permit it to take the necessary measures to really address the problem at its source.

If politicians cannot take fiscal policy measures and other direct restructuring initiatives to create the needed demand to start addressing unemployment and restore confidence, can't they at least do what it takes to extend the mandate of the ECB so that Mario Draghi can really do whatever it takes without the restrictions of the present narrow mandate?

A problem of demand which leaves us stuck in the mud

This article was published in The Malta Independent on Sunday - 24th August 2014

Eurostat has published worrying economic data for the second quarter of 2014.

Economic growth in Q2.2014 was zilch compared to Q1.2014 and only 0.7 per cent compared to same quarter last year. Inflation was down to 0.4 per cent which is a million miles away from the ECB target of close to but below two per cent.

Let’s get inflation out of the way first. Is it a good thing or a bad thing to have low inflation? I had tackled this in a contribution in this series on 4^th May where I had written:

“Low inflation or indeed falling prices could be both a blessing and a curse.

“If low inflation or falling prices result from positive supply shocks then it is a blessing. Following the industrial revolution of the late 19th century, great leaps of productivity led to increased supply of consumer goods at cheaper prices giving consumers better choices and value for their money. That certainly is a blessing which stimulates consumer demand and leads to economic growth and job creation as a welcome bedfellow to falling prices.

“Take the drop in our utility rates. Surely these will eventually work their way to lower readings in our domestic inflation, but equally surely no one should be complaining about it. That is a positive supply shock, leaving purchasing power in consumer’s pockets which will be spent on other consumables, giving a stimulus to demand and leading to economic growth and job creation.

“On the other hand, if low inflation or outright deflation is a result of demand shocks, then that is the curse and if prolonged could be difficult to reverse. The lost decades in Japan following the bursting of the eighties’ speculative boom, clearly demonstrate as much.

“Countries in the euro area periphery, Greece, Ireland, Portugal, Italy, Spain, Cyprus and Slovenia have been forced to address their fiscal stress by crushing internal demand. Higher taxes and harsh expenditure cuts drained purchasing power from consumers’ hands. As a consequence, their economies shrank, unemployment exploded, especially among young people seeking their first job, and prices stagnated or indeed started to fall.”

According to Eurostat, Poland and Italy both registered zero inflation in the year to July 2014. But while Poland’s lack of inflation is virtuous, as it is in a context of real economic growth of 3.2 per cent, Italy’s zero inflation is vicious, set in a record of economic contraction of -0.3 per cent. Italy is in deflation and so are Greece and Cyprus. Spain is registering negative inflation but its economy has started to grow, albeit very moderately at 1.2 per cent.

I had barely switched on my mobile as I entered the airport following a summer holiday that I had a prominent journalist on the line. He was fishing for critical views about three consecutive months of negative inflation registered in our Consumers Price Index. Set in the context of real growth to the order of three per cent, this is virtuous price stability caused by supply shocks as lower utility rates work their way through our pricing mechanisms and an abundant fruit season pushes down food prices.

The problem with inflation is when it results from demand shocks; when it results in the context where the economy is not growing and consumers are keeping their purse strings tight as they are apprehensive about the future.

The shock in the Eurostat statistics is that Germany registered an economic contraction of -0.2 per cent in Q2-2014, and Italy yet again registered a similar negative growth, this being the third negative result in the last four quarters and exposing the Q4.2013 positive 0.1 per cent growth as a fluke rather than a turnaround.

How can we end this never-ending euro area recession or anaemic growth, which is now in its sixth year, if the key driver Germany also starts registering economic contraction? Why should Germany with ample space for fiscal manoeuvring to stimulate demand be registering economic contraction? And if countries in fiscal comfort and balance of payments surplus do not take action to stimulate internal demand to keep the growth momentum, how can Italy, France and Spain reap the benefits of their fiscal austerity programmes if they cannot find external demand for their increased production which cannot be internally consumed?

Mario Draghi, president of the ECB, had promised to do whatever it takes to save the Euro. He qualified the pledge by adding that it has to be within the mandate of the ECB, as conferred to it by the member states in the euro monetary system. That pledge had stabilised the financial markets but in no way has it solved the underlying problem. Indeed, it is doubtful whether monetary policy, even if more aggressive than what the ECB can do within its mandate, can solve the economic problems of the euro area. At most, aggressive monetary policy can gain time for the political forces to do whatever it takes, but it cannot replace the need for the political fiscal adjustments necessary to restore equilibrium in euro area countries.

Which means that it would be useless, indeed harmful, if the countries in distress continue to adopt painful restructuring and adjustment programmes if, simultaneously, the surplus countries fail to take steps to stimulate demand in order to address their structural surpluses and use the fiscal space at their disposal to counter-balance, through demand-led policies, the contraction in demand in countries undergoing fiscal restructuring.

The euro area problems are largely a problem of insufficient demand. It can only be resolved if countries that have been over-consuming and under-investing are assisted to succeed in their austerity programmes (programmes which shift resources from consumption to investments) by surplus countries that need to simultaneously switch from savings to consumption modes in order to fill the demand gap. Germany’s economic contraction shows this is not happening. That is leaving Italy Greece and Cyprus stuck in the mud, registering negative growth in spite of their harsh austerity adjustment programmes.

In Q2.2014, German consumers must have been shocked by the instability of curtailed exports to Russia resulting from trade sanctions imposed due to the Ukraine debacle. This is more reason why Germany must use its fiscal space to stimulate internal demand rather than continue to preach the false virtues of balanced budgeting in all circumstances.

Mid-term assessment

This article was published in The Malta Independent on Sunday- 10 08 2014

Economists and financial analysts are forced to make a mid-term assessment of the economic performance of the first half of the year in the heat of August.   Analysing economic data which starts being released at this time of the year for the second quarter from a deckchair by the pool is not a perfect setting to gain the necessary focus, but I try.

Economic performance is benchmarked by standard criteria primarily consisting of Gross Domestic Product (GDP) figures – which give an overall view of the economy – and by indicators related to particular sectors primarily consisting of employment, inflation, tourism, balance of payments, and government finances.

Let me take them in turns without boring readers with too much number crunching.

So far we only have official figures for GDP for the first quarter of 2014.    Second quarter GDP figures will be available early in September.  Following GDP growth of 2.4% in real terms for the whole 2013, the first quarter of 2014 showed GDP gaining momentum registering annual real growth rate of 3.5%.    This augurs well, given strength we are witnessing in tourism and property market ( sectors which lends themselves better to smell tests than say manufacturing), that for the whole year 2014 real economic growth rate will come with a digit 3 handle.

My forecast is based on second quarter economic data which we now have for particular economic sectors.   Foremost amongst these is the data on employment.   The latest is the data of registered unemployed for June 2014.   This confirms a six month trend of reduction in the number of persons registering as unemployed and shows a reduction of 7.25% from the level of June 2013.    However this is more meaningful if put in the context of a growing labour market as it emphasis that unemployment is falling when the number of people seeking employment is growing. The latest Labour Force Survey for first quarter 2014 shows that the activity rate has grown from 63.7% in March 2013 to 64.8% last March. The activity rate is the labour force (persons working or seeking employment within the age bracket 15-64) expressed as a percentage of the population of working age (15-64).   The higher activity rate shows that persons within working age who were previously not seeking employment (e.g. married women) have now joined the labour force and are working or seeking employment.

Further confirmation of this trend of higher activity rate is the Gainfully Occupied Population which is available up to February 2014.  This shows that the pool of registered employed/unemployed has grown by 3.44% in 12 months to February 2014 compared to a growth rate of 2.36% in the previous 12 months. One should note the discrepancy in the size of the labour supply as measured by the Gainfully Occupied Population report and the Labour Force Survey. The former measures the labour pool at 168,288 in February 2014 and the latter measures is at 186,885 in March 2014.   The reason for this stark difference is that the former measures only those working or seeking employment that are registered with the ETC whereas the Labour Force Survey measures the entire labour force even those working or seeking employment without registering.   The stark difference is indicative of the size of the black economy.

On the inflation front it has become a limbo game of how low can you go. The retail price index for June 2014 shows a 12 month inflation rate of -0.10% and a 12 month moving average of 0.66%.   The Harmonised Index of Consumer Prices (HICP - which is the inflation measure used by the EU) shows a 12 month rate of 0.7% and a 12 month moving average rate of 0.8%.   The main difference between the two is that the latter includes restaurant and hotel prices which are largely excluded in the domestic retail price Index. The higher inflation measure of the HICP shows that the strength of the tourist season is permitting hotel and restaurant operators to punch in higher prices and consequently better profitability.

Is low inflation bad?   It is a virtue if set in the context of a growing economy like ours where the low readings are being driven by seasonally low food prices and lower energy costs as a result of government policy.    It could be a vice if set in the context of a stagnant economy as is the case in Greece, Cyprus, Italy and Spain where low inflation is accompanied by harrowing unemployment, though thankfully even there it would seem that things have started to stabilise and perhaps showing small signs of improvement (however from a very low base).

Turning to tourism, figures for the first half of 2014 show an 8.7% increase in the number of visiting tourists (with most of the growth in the non-EU non packaged holiday sector, including an 18% increase in visitors for business and professional purposes) a 7.2% increase in the tourist nights spent in Malta, and an 8.5% increase in tourist expenditure, with more spent on accommodation and other expenditure and less on flights.   It seems like a too-good-to-be-true story but as I said these figures can be confirmed by smell tests as we walk through the streets of Mdina, Valletta and Sliema.

On the Balance of Payments we have only the figures for the first quarter of 2014 showing a marked improvement in the already satisfactory position of the Current Account from Euro -117 million in March 2013 to  Euro -63 million.  The balance of trade statistics for the months of April and May 2014 continued to show marked improvement.   With the strength of tourism in the 2^nd quarter one should expect a solid surplus in the services sector.  Ingredients are therefore set for a very healthy current account of the balance of payments position for the June 2014 quarter when this is published late in September.

Finally the government finance position up to June 2014 shows a slight deterioration over June last year.   For the whole year the Ministry for Finance projected an improvement so we have to see whether by the end of the year the trend of the first half  will be reversed to meet the full year Budget 2014 targets.  In the first half to June 2014 capital expenditure was running ahead of schedule so one expects some claw back in the second half.   Also revenues from the Investment Registration Scheme will be checked in the second half. All revenue items are running ahead of last year proving the strength of the economy which immediately shows up mostly in VAT receipts.  These were up by a smashing 12%.  

There is only one revenue line falling behind and this is Customs and Excise which is very much dependant on Enemalta finding cash flow to update its dues to government.   Hopefully with new share capital infusion Enemalta will be able to honour its obligations to the public purse in a timely fashion.

But all in all the mid-term assessment of Malta’s economic performance offers scope for optimism.  One hopes that the international scene with so many danger flashpoints (Ukraine, Gaza, Libya, Syria, Iraq amongst others, as well as the risk of spread of Ebola disease which is spreading in West African countries) will not be unkind in the second half we are currently sailing through.

In the absence of something more robust to criticise, government is being criticised for the process rather than judged by the results.   Rather than be satisfied that a Maltese person was liberated and safely returned to his family in Malta we argue whether or not he was abducted.   With the confusion reigning in Libya it may be difficult to distinguish between full scale abduction and a less stark version of it, once no demand for ransom was apparently made.

Rather than be happy about Chinese investment especially in our energy sector we argue whether the Minister’s wife who piloted the process is an ambassador or a trade envoy and whether her appointment followed the right process.  Results are more important than the process, even though the process must remain transparent. 

Countries like   UK, US, Australia, Canada, Denmark, Korea, the Netherlands, Sweden, New Zealand  are experimenting with performance budgeting  which involves moving from an emphasis on inputs, to a focus on performance, outcomes or results. Performance budgeting also tackles fiscal consolidation by ensuring that limited public funds are expended on public services that are of most value to the country.

Our conventional system of conventional line-item budgeting lends itself to performance weaknesses, including the lack of information on how efficiently the allocated funds were used.

I look forward to the day when evaluation is done by results not just by rigid adherence to the process.  And the results for the first half of 2014 look positive and promising.