Wednesday, October 24, 2007

Catch Up Growth and Demographics - Evidence from Eastern Europe

by Claus Vistesen: Copenhagen

Performing a simple series of adept Googling exercises around various sources on the internet you can easily discover that certain species of the lynx are able to travel at speeds of up to 50 kph (31 mph). Wikipedia informs us that the Eurasian lynx, on average, commands a hunting area of between 20-60 square kilometers in which the lynx is able to walk and run about 20 kilometers in one single night. All in all, a pretty rugged and constitutional little thing this lynx.

In this way, and perhaps because, at that particular point in time, the Eastern European Economies looked as if nothing could come in their way of economic prosperity and growth they were paired, by the Economist, with the region's sturdy feline coining the notion of 'Lynx Economies.' Thus, 'that particular point in time' was sometime back in the spring of 2006 where the Economist's (and my own) coverage of the CEE and Baltic economies came in hot on the heels of publications by the World Bank and and the Vienna Institute of Comparative Economic Studies speaking favorably of the future prospects of economic prosperity and thus 'catch-up' growth in the CEE and Baltic Economics.

Yet, merely 1 year and a tad later things seem to have changed quite significantly with respect to the discourse on the economic situation in Eastern Europe. Many of the contributors to this blog has been pitching on the change in discourse but also some of major institutional actors have been flagging the red banner. Not least the World Bank seems to have changed their attitude somewhat with most notably a recent report on the demographics of Eastern Europe entitled From Red to Gray - The Third Transition of Ageing Populations in Eastern Europe and the former Soviet Union as well as a recent writ with specific focus on the macroeconomic risks prevailing in the region. Yet, also the IMF in their latest World Economic Outlook devotes a chapter to the managing of large capital inflows where Eastern European economies also take center stage of the general tone of warning; in essence this note of warning concerning Eastern Europe seems to be the general talk of the day amongst economic analysts and journalists. As such, perhaps even the lynxes roaming the forests and planes of Eastern Europe are beginning to feel that the otherwise catchy notion conjured by journalists at the Economist is becoming something of a stretch according to the reality of the situation. Sure, things are moving fast now but it is what happens next which might finally serve to make the allegory rather unrealistic. In this entry I set out to explicitly investigate an issue which in fact has been treated several times on this blog and perhaps most often in the context of the CEE and Baltic Economies. Simply put and in the form of one simple question;

  • How do changing demographics and more specifically the final and ongoing stages of the demographic transition affect the notion and principle of economic catch up growth and thus economic convergence as it is stipulated by (neo-classical) economic growth theory?

As I have hinted above in the introduction my main subject of analysis on which the general theoretical argument is based is the current and ongoing situation in the CEE and Baltic economies. A lot has been written about this recently not least from the hands of the contributors to this blog (see also above). As a one-stop overview of the concrete issues at hand this recent note by Edward over at Global.Economy.Matters should provide you with suitable ammunition to get you started. In particular, the following three point overview of the current economic situation in Eastern Europe should always be in the back of your mind as we move forward from this point ...

Basically the principal outstanding issues confronting the EU10 countries are threefold:

  • Labour capacity constraints (which are normally a by product of long-term low fertility and large scale recent migration flows) are producing significant wage inflation and strong overheating.
  • A structural dependence on external financing - which is in part a by-product of the effect of low levels of internal saving, and which is another factor which separates the EU 10 from those like India or China who are benefiting from a typical demographic dividend driven catch up, is leading to large current account deficits, and potentially high levels of financial instability.
  • A loss of control over domestic monetary policy due to eurozone convergence processes which - with or without the presence of formal pegs - make gradual downward adjustment in currency values as a alternative to strong wage deflation virtually impossible. This issue is compounded by the likely private "balance sheet consequences" of any sustained downward movement in the domestic currency given the widespread use of mortgages which are not denominated in the local currency.
Traditionally a rigorous economic analysis in the light of the immediate events would focus a lot on point 2 and 3 but in this note we shall look specifically at number 1 and the issues of labour capacity, its constraints, and what it means of the economic growth of less to medium developed countries. Now, the most obvious caveat in this entry is that I really don't have the time at this point to really lay out the whole theoretical framework of economic growth theory and as such the precise slot in which my argument should be inserted within the wider theoretical framework. This will be the topic of a more rigorous article not suited for the blog format. However, I still need to attach some comments to set the scene where I should also immediately note that my previous note here at DM about catch up growth in Eastern Europe serves as a good state of the game post for what comes next.

Apart from my studies of selected pieces of the economic growth literature one of the best overviews of the concept of economic convergence as a function of the theoretical and practical assumptions vested in the growth models is to be found in an article by Norbert Fiess and Marco Fugazza on economic integration in Europe (PDF). As such it is important to note that convergence of GDP per capita levels is not a holy grail within the fields of economic growth theory. Rather, the process of convergence should be seen as an inbuilt consequence of the fact that as economies mature returns to production inputs decrease; that is to say that this discussion essentially revolves around the concept of increasing v. decreasing returns to scale in our economic model. If we think about decreasing returns to scale and introduce the concept of marginal productivity to production inputs we can then see that less developed countries are likely to exhibit higher rates of growth than their more mature counterparts in the sense that their marginal productivity is higher which then leads to a process of convergence. Now, this argument in its most strict sense is usually applied in the context of capital as a production input and coupled with the properties of an open economy and subsequent free flow of production factors this would lead to a rather rapid process of convergence or absolute convergence as the technical term. As regards to labour as a production input is has also been argued that the universal transition from an agricultural to manufacturing over to service (?) based economy produces a mechanism of convergence in the sense that this process implies a move up the value chain and thus that every unit of labour becomes more productive. Of course and even though we are talking about stylised facts here, this is also where the whole debacle begins in the context of my immediate argument because how certain is this process? Also, we need to take into account the distinction between stocks and flows (of labour) which is a crucial issue to consider when talking about ageing economies.

However and it does not take much of an economist to see that empirical facts do not support the idea of absolute convergence or at least it seems as if the process takes much longer to materialize than predicted by the theory. This has lead, among other factors, to a 'new' strand of economic growth models which allows for persistent growth divergence to exist between countries. The crucial aspect to understand here is the mechanism through which persistent divergences can occur. In this way, one of the widest contributions by economist to this thesis has dealt with the possibility that technological processes and thus accumulation of technological advances exhibits increasing returns to scale. The fundamental brilliancy of this notion is that it allows for a model where there is indeed decreasing returns to labour and capital but where different levels of technological effort leads to internal positive feedback mechanisms and thus explains persistent divergences in growth and 'prosperity' across countries.

Ok, I think that I have already said enough at this point and in order to get us back to track one crucial assumption and conceptual idea needs to be pinned down. As such and if we look at the rudimentary description of the economic growth process above it is not wholly unreasonable to argue that the growth process of an economy is somewhat directly related to the process of the demographic transition. Or as Robert Lucas puts it in a widely cited article ...

That is, the industrial revolution is invariably associated with the reduction in fertility known as the demographic transition.

As such, why don't we take a look at Eastern Europe where the economies have experienced, quite as expected by the conventional theory of economic growth, economic dynamics tantamount to catch-up or convergence. Especially the economic data since the expansion from EU15 to EU25/27 and, for some countries, the subsequent anchoring to the Euro has been very impressive indeed. Yet as Edward and I have been at pains (see link above) to explain again and again these countries are not your average emerging markets. This follows from the fact that their demographic structures have been fundamentally distorted due to a collapse of fertility in the beginning of the 1990s which has been aggravated by a persistent net outflow of migrants serving to further speed up the decline in the working and essentially also most productive cohorts. In order to capture this development and in order to frame the current situation the following point I made in a previous note is worthwhile to repeat.

In short, we are dealing with countries where the demographic transition by far, and indeed worryingly, has out paced the traditional economic process of economic convergence.

This is exactly what we are talking about here and apart from going to the heart of the imminent issues in Eastern Europe it also strikes right smack into the concept of economic growth theory and how to deal with the fact that the demographic transition does not occur the way it was originally anticipated. Most emphatically, we can see in the context of the Eastern European countries that the final stages of the transition have arrived far before and quicker than the twists and turns of history allowed for these economies to really get on with business. Yet, the general argument can just as easily be expanded into a discussion of the ageing part of OECD where it is painfully clear at this point that conventional economic theories are wholly incapable of explaining what is likely to happen next. In fact, we could stretch it so far as to say that modern economic growth theory is not able to explain what happens when fertility drops to a level below replacement level and stays there!

In Summary

Even though that a lot words have been written in this entry I am afraid that only superficial contributions have been made to the final answer of the proposed question. This entry principally had one main task, namely to initiate a line of reasoning which ultimately and hopefully can lead to a better understanding of modern economic growth processes in a context of the current demographic profile of many developed and developing economies. Specifically, this entry revolved around the concept of catch-up growth/convergence where the countries in Eastern Europe were suggested as an example to demonstrate how demographics can fundamentally alter the principles by which the economic growth process is likely to conform. In this way, the message is not that modern economic growth theory and growth accounting methods are rendered obsolete in the face of changing demographics but rather that considerable adjustment needs to be made; especially in the context of catch up growth/convergence but also crucially in the context of the notion of a steady state of economic growth. Returning briefly to the real world before we sign off it could seem as if the branding of the lynx economies never was more than a quick and essentially expensive make-up which is set to quickly wear off as we venture on. Specifically, recent signs coming out of the ECB and the European commission suggest that expectations are aligning towards an outlook where the process of convergence effectively risks grinding to a halt. My advice would then be not to exchange the carrot too swiftly into a stick since this would only serve to kick those who are already on the ground.

Tuesday, October 09, 2007

EU Ministers Criticise Czech Government Deficit

Well, I can't help thinking some people have an obsession with fiscal deficits at the moment, I really can't. EU finance and economy ministers, meeting yesterday in Luxembourg, took it upon themselves to criticise the Czech government for their fiscal policy telling them in the process that they must "take effective steps" to cut their budget deficit to bring it into line with European Union rules, and that they must do this no later than next year. In fact they have given the Czech Cabinet until April 9, 2008 to take measures to ensure that next year's fiscal deficit, adjusted for one-time factors, falls below the EU limit of 3 percent of gross domestic product. At the present time the Czech government government projects a fiscal deficit of 3.6 percent of GDP this year, compared with an initial 4 percent target.

Now in the face of ageing societies I am all for structural reforms and fiscal rigour I really am, but I think there is a time and a place for everything, and a sense of proportion is needed here. The Czech economy is, as I tried to have illustrate yesterday, one of the few real relative success stories to be found among the EU 10, and as such there is a real need for balance and for classifying issues in terms of their importance here. (This stance on the Czech Republic seems to parallel recent exchanges over the level pf the current French deficit between Trichet and Sarkozy, exchanges which seem truly out of proportion when you consider the extent of the accumulated debt problem which exists in say Italy or Greece, and well, I would make a similar point about how the Czech Republic. "Overheating", while still an issue, is far less problematic in Czechia than it is in many members of the EU10, and this "detail" would be my personal initial point of departure for assessing the robustness of the Czech economy, and the margin for manoevre the government may or may not have in terms of fiscal deficits).

The Problem Facing the EU10

Basically the principal outstanding issues confronting the EU10 countries are threefold:

1/. Labour capacity constraints (which are normally a by product of long term low fertility and large scale recent migration flows) producing significant wage inflation and strong overheating.

2/. Structural dependence on external financing leading to current large current account deficits.

3/. Loss of control over domestic monetary policy due to eurozone convergence processes which - with or without the presence of formal pegs - make gradual downward adjustment in currency values as a alternative to strong wage deflation virtually impossible. This issue is compounded by the likely private "balance sheet consequences" of any sustained downward movement in the domestic currency given the widespread use of mortgages which are not denominated in the local currency.

Now the worrying part about all three of these is that they are not simply cyclical in character. As such they are not problems which will "self correct" as a result of a recessionary slowdown, whether this be of the "soft-" or "hard-landing" variety. This problem simply is not being taken into account in many of the current pronouncements on the EU10, and certainly is in no way reflected in the current "deficit obsession" which we can see at EU Commission level.

The Immediate Problem

The current controversy has its roots in a decision by the Czech government last September to push through Parliament a set of tax changes and spending cuts that are intended to narrow the fiscal shortfall to 3.2 percent of GDP next year and 2.8 percent of GDP in 2009, an outcome that the Czech finance ministers consider to be "plausible'' in spite of the "considerable uncertainties'' which are linked to the tax overhaul.

The controversy has of course been well served by a 17 percent jump in welfare spending approved before elections last year, and these have, of course, boosted spending even as a record 6.4 percent pace of economic growth in 2006 brought in more tax revenue than expected. The economy is expected to expand 5.9 percent this year, according to the Finance Ministry forecast in the 2008 draft budget.

``In the absence of measures to address the budgetary impact of aging, the debt ratio is likely to increase significantly over the next decades'' from about 30 percent of GDP now, EU finance ministers said, in their statement. I agree completely, but are we not in danger of confusing two issues here, longer term structural issues, and short term budgetary ones?

Certainly, when compared even with many existing eurozone members, the Czech deficit problems can hardly be said to be of the "basket case" variety:

And as the EU finance ministers accept, the debt to GDP ratio - which is currently around 30% - is hardly huge in comparison with some others I could mention.

So the issue here is the need for longer term structural changes - just like in France - and the best way to achieve this may be by presenting the necessary laws and longer term reforms, and not by focusing on short term deficit issues. As I have indicated, there are far more pressing issues on the table all over the place at the present time.

And even when we come to the external balance position, the Czech position is far from being a chronic one. Trade in goods and services is now in balance:

And even the CA deficit, which does need addressing, is not large in comparison with many of the rest in the EU10.

Finally, and as an example of a more balanced view I would draw attention to the fact that the most recent IMF staff report on the Czech Republic had this to say:

Lingering slack in the labor market has helped contain wage inflation. Despite strengthening demand for labor, suggested by rising vacancies, wage pressures have remained subdued, as rising inflows of immigrant workers have helped offset the impact of population aging on labor supply. Recent employment gains have been concentrated in industry and private services, including real estate, and do not yet appear broad-based. Unemployment has fallen, but remains around 7 percent, as continued geographical and skill mismatches have kept structural unemployment high.

and this:

The main concerns center on the erosion of fiscal discipline in 2006-7 and the medium-term fiscal outlook. The expansionary fiscal stance for 2007 is out of place in view of the expected robust growth. The authorities’ medium-term consolidation plans are appropriate, but supporting measures should be identified without delay. A cutback in high mandatory social spending would improve fiscal flexibility and efficiency. The institutional fiscal framework also needs to be strengthened.

Well exactly. So let's just try and keep things in proportion, shall we?

Monday, October 08, 2007

Czech Inflation September 2007

Czech inflation accelerated to the fastest in 13 months in September, closing in on the central bank's target and suggesting interest rates may rise again as early as this month. Consumer prices rose an annual 2.8 percent, up from a 2.4 percent in August, according to the Czech statistics office.

The central bank has been lifting what are the European Union's lowest interest rates for two years now on concern the consumption-driven expansion will foster price growth. Policy makers target inflation one point either side of 3 percent and have signaled borrowing costs will have to rise further because consumer-price increases are forecast to exceed 4 percent next year. The central bank foresees annual price growth of as high as 4.5 percent next year, driven by higher indirect taxes and wages pressure from a rapidly tightening labour market.

The mid-point peak of the so-called monetary-policy inflation, which excludes the effect of one-time changes in indirect taxes that the central bank omits, is projected to jump to 3.7 percent in 2008 from about 1.8 percent in September. Central bankers raised the key two-week repurchase rate in May, July and August, bringing it to 3.25 percent, a level which still significantly below the European Central Bank's current 4 percent refi rate.

The month on month price change was in fact pushed into negative territory - a drop of 0.3% in the index between August and September - by a seasonal drop of costs of travel packages, which were on average 16.1 percent lower last month than in August.

What is most interesting about the Czech situation is how different it is from many of the other EU10 economies. Despite the fact that GDP growth has been strong in recent quarters:

and a brisk, but not exaggerated, pace of growth in retail sales:

With unemployment coming down quite fast:

Wage costs have not gone through the roof, Baltic style, at least not so far they haven't. There are, however, distinct indications in the chart below that wages inflation has accelerated since the start of 2006:

and this has been reflected by a steady uptick in producer prices, although this has started to ease off a little since June.

Obviously a number of factors are at work here, but could one of them be the fact that the Czech Republic far from losing workers on a net basis to out-migration in recent years, has actually been able to attract inward migrants in significant numbers.

So while Czechs have left to work elsewhere in significant numbers since the turn of the century, the Czech Republic has been more than able to compensate for this by attracting workers from elsewhere. Obviously all of this is not completely problem free, in that wage pressures are building up. But the situation is certainly strikingly better than in many other EU 10 countries. Is there a lesson here for anyone?