Friday, September 30, 2011

The Euro, Demography and Italy's Long Term Growth Challenge

The Euro, Demography and Italy's Long Term Growth Challenge

Presentation To The Italian Demographic Party Summer School
Edward Hugh - Cortona, September 2011 (Revised and Updated)

Summary Points

• The most recent crisis was not an arbitrary phenomenon
• It was not simply a question of stupid and irresponsible financial products
• There are underlying macroeconomic and social process we need to understand
• The worst of the first stage of the crisis may be over, but we could now be entering a new and more dangerous phase
• The Euro itself forms part of the backdrop to the crisis • As do long term changes in Europe’s demographic profile
• The greatest challenge facing any future Italian government is how to maintain welfare commitments in the face of population ageing given the level of accumulated debt.

Italy Suffers From Low Growth ………… And An Ongoing Current Account Deficit Italy’s average annual growth rate has fallen steadily in recent decades. The rate for 2001 – 2010 was about 0.6% and it is not excluded that during 2011 – 2020 it will be negative. And the growth rate has dropped as the current account deficit has widened. There is an obvious connection – international competitiveness.

Italy first fell into recession at the end of 2007 – some months before the other Euro Area countries - and didn’t come out of it again till the start of 2010 , so the economy contracted for two full years. GDP fell by 1.2% in 2008, and by 5.5% in 2009. After an 18 month recovery, the economy again fell into a second “double dip” recession in September 2011, after a surge in borrowing costs forced the government to apply stringent austerity cuts in an attempt to recover investor confidence.

Double Dip Recession

Sharp Economic Contraction Thus the Italian economy continues to demonstrate it long term underlying weakness of short recoveries followed by longer than average recessions. It is now widely expected to contract by around 2% in 2012, and then by another 1% in 2013. It could then grow moderately in 2014 – perhaps by 0.5% - but why should we expect the country not to fall back into recession again in 2016?

Living Standards In Long Term Decline After years of being stationary Italy’s population has risen sharply over the last decade – from around 57 to just over 61 million - but GDP hasn’t changed. The result has been a large fall in GDP per capita. This fall has been in absolute terms, but in relative terms the change is also clear. Germany’s relative position fell steadily in the 1990s, then stabilised, and has even improved since the crisis. Italy’s fell slowly in the 1990s, then, since the turn of the century, the rate of decline has accelerated.

The outlook is not appetising As the population ages domestic demand moves into long term secular decline. Retail sales, for example, are now around 94% of the 2005 level. And as public debt is paid down, government consumption will simply get less and less.

Italy Didn’t Have A Housing Boom Pre 2008......... Yet Construction Continues To Decline This trend is not likely to change. The winter 2011 Monti measures involved a substantial rise in property related taxes, implying lower property values in the future. In addition Italy’s demographics are not favourable to housing booms.

So Now It Is All About Exports GDP = Household Consumption + Investment + Government Consumption + Net Trade (Exports – Imports) Now if household and government consumption are falling systematically, the only factor which can give a direct boost to GDP is the relative movement in exports and imports.

Positive movement here can stimulate investment in the export (or tradeable) sector as expectations build for increased demand. Total Investment = Investment for Exports + Investment For Domestic Demand. While Italian exports surged back after the financial crisis recession they never in fact attained their pre- crisis level, and now they are once more declining again. In addition, even though Italy’s goods trade deficit has reduced substantially over the last 12 months, it is still a DEFICIT. Just Not Sufficiently Competitive? As we can see in the chart on the right, the Italian economy was on an unsustainable path from the end of 2009 to mid 2011, as excessive government spending fed an import surge. As government spending was cut this import boom burst, and domestic demand collapsed, taking the country deep into recession.

How To Define Competitiveness?

The REER (or Relative price and cost indicators) aim to assess a country's (or currency area's) price or cost competitiveness relative to its principal competitors in international markets. Changes in cost and price competitiveness depend not only on exchange rate movements but also on cost and price trends. The specific REER for the Sustainable Development Indicators is deflated by nominal unit labour costs (total economy) against a panel of 36 countries (= EU27 + 9 other industrial countries: Australia, Canada, United States, Japan, Norway, New Zealand, Mexico, Switzerland, and Turkey). Double export weights are used to calculate REERs, reflecting not only competition in the home markets of the various competitors, but also competition in export markets elsewhere. A rise in the index means a loss of competitiveness. (Eurostat Definition)

The issue of competitiveness has become one generating more heat than light in debate during the current crisis. The validity of one commonplace measure (REERs) widely used historically has been repeatedly questioned. In my opinion such questioning has been largely motivated by ideological and political motives in contrast to scientific ones. In fact the evidence is clear enough. Output & Productivity High output per worker and high wages are perfectly compatible. The road to achieve this win-win combination is through raising productivity, thus maintaining unit labour costs constant, or even reducing them. As can be seen from the accompanying charts, Germany achieved this combination between 2000 and 2008, while Italy didn’t. In Italy productivity stayed pretty much constant while unit labour costs rose, meaning salaries rose without the accompanying productivity, while in Germany unit labour costs stayed constant while productivity rose. This also gived the lie to the “cheap German wages” argument, since if wages hadn’t risen then ULCs would have fallen, which they only did briefly between 2006 and 2008.

The problem in part is that value added is often a sectorial issue. For example agriculture and construction have historically been low value added and often high unit labour cost sectors, whereas petrochemicals or biotechnology are high value added but also often low ULC sectors, despite the fact that wages are higher. Naturally most societies would like to have a large proportion of high value added activities, and a comparatively small proportion of low value added ones. But this isn’t as straightforward as it seems, since the transition from agriculture to biotechnology doesn’t move along what we could call a smooth production function. Namely you can’t simply transfer workers from one section to the other. It ain’t that easy. The large number of construction workers recently displaced in Spain can’t simply move into machine tool manufacturing, for exemple.

A countries ability to engage in what are high value activities at any moment in time depends on key factors like the skill, education and experience levels of the workforce, and these change only slowly. Critically the distribution of these factors depends to some extent on the age structure of the population.

But in part the level of unit labour costs depends on the level of international competitiveness, which in part depends how much of the economy is in the tradeable sector and how much in the non-tradeable part of the economy. By tradeable we mean in competition with other producers or service providers beyond the national frontier. The key mechanism assumed here is that the tradeable sector, being exposed to external competition, by definition needs to be more competitive to survive. So a measure of a country’s lack of international competitiveness isn’t only that exports are too small, it is also that imports are too big, which is another way of saying that the domestic tradeable sector isn’t big enough. Normally this loss of competitiveness is associated with a growing trade and current account deficit, which means the process of non productivity supported rising living standards can only continue as long as some external agent is willing to finance it. When confidence that the process is sustainable subsides, people cease financing, and a crisis occurs. This is what happened to Italy in the summer of 2011.

Population Ageing – A Unique Historical Challenge

We live in a world of rapidly ageing populations, not just in the economically developed societies, but in many emerging nations too. Due to the one child per family policy China will be one of the fastest ageing societies on the planet in the 2020s. The economic and social implications of such a global ageing process are bound to be profound. Two points stand out: • the process is seemingly irreversible. • No other single force is likely to shape the future of national economic health, public finances, and policymaking over the coming decades. Strangely, this issue receives only a fraction of the attention that has been devoted to global climate change, even though, arguably, ageing is a problem our social and political systems are, in principle, much better equipped to deal with. In particular it would be interesting to discover why so many mainstream economists seem oblivious to the problem despite the fact that the developed world sovereign debt crisis seems so self evidently associated with the phenomenon.

Life Cycle Effects – Franco Modigliani Children are dependents, and hence net dis-savers for their families, which is why so many high fertility societies have such low savings rates. The secret to raising the aggregate saving rate is having less children. In terms of a person’s adult life, those in their twenties and early thirties tend to be net borrowers as they are relatively low earners at the same time as they look to establish a family, buy housing, educate children etc. Societies with many people in this age group tend to see rapid credit growth. At some point around middle-age the person then tends to move from being a net borrowers to becoming a net investor at just the time they enter their economic prime and accumulate financial assets to fund their retirement. After retirement people tend to maintain their living standard by gradually shedding the financial assets they’ve been accumulating to fund their nonworking days. This process is not uniform, and older people generally tend to consume less and conserve their savings. Modigliani’s life cycle hypothesis suggests that a population’s aggregate financial behaviour - just like that of an individual - changes depending on age.

So Could Something As Simple As Movements in Median Population Age Help Us Understand How Economies Evolve?

Ours is an age of rapidly ageing societies, but not all societies are ageing at the same rate. The United States for example is a very young society. And indeed even in 2020 will still be younger than Japan was in 2000. Societies are in some kind of homeostatic “bad” equilibrium when they have fertility levels of five children plus per female. As fertility falls societies develop economically, and start to age through population structure impacts. What is so modern about our current situation is not the ageing itself, which started in Europe with the industrial revolution, but its velocity, and its global extension.

As far as we are able to understand the issue at this point, population ageing will have major economic impacts and these can be categorised under four main headings: i) ageing will affect the size of the working age population, and with this the level of trend economic growth in one country after another ii) ageing will affect patterns of national saving and borrowing, and with these the directions and magnitudes of global capital flows iii) through the saving and borrowing path the process can influence values of key assets like housing and equities iv) through changes in the dependency ratio, ageing will influence pressure on global sovereign debt, producing significant changes in ranking as between developed and emerging economies.

While population ageing is universal the short term impact will be much more localised. The pace of aging varies greatly across countries and regions. The effects of the process are expected to be most pronounced in those countries that remained complacent in the face of ultra-low fertility rates (total fertility rates of 1.5 and under), which in effect means Japan, the German speaking countries and much of Southern and Eastern Europe.

Another way of looking at these demographic changes is in terms of the dependency ratio, which can be defined in a number of different ways depending on the problem being addressed. For present purposes what matters is the old age dependency ratio. In Germany total population is expected to fall from its current level of 82 million reaching anything between 69 and 74 million by 2050, depending on the future course of life expectancy, immigration and fertility. And the proportion of people aged 65 and older is projected to rise from just under 20% today to just over 33% by 2050. At the same time, the number of very elderly (those aged 80 and over) will nearly triple to as much as 15% of the total population.

In Italy population is projected to remain more or less stationary, at around 60 million, at least until the 2030s, but the age structure of the population will be constantly shifting. (Data: UN 2008 forecasts, median estimate)

Key Shift In 1970s, As Each Generation Starts To Get Smaller Than Previous One Another Key Decade In 2020s, As Elderly Dependency Ratio Rises Substantially

Italian Fertility Has Fallen To and Remained Around 2/3 Replacement Level Population Has Recently Grown Rapidly, But Only As A Result Of Immigration

There Was A Significant Increase In The Workforce And – Before The Crisis – In Employment But Due To Loss Of Competitiveness And The Strength Of The Informal Economy This Did Not Translate Into Economic Growth

Eurozone Debt Crisis Total Italian Debt Is Not Excessive In Comparison With Some Other Countries in The Eurozone, But Public Debt Is The Second Highest. Despite Normally Having Had Primary Balances Italy Has Run General Budget Deficits since The 1980s The Problem Is The Weight of the Debt, The Interest Payments

Italy Is Poised On A Knife Edge Key Factors: • Growth • Inflation • Interest Charges Hence The Problem Of Market Pressure, And Interest Rates. Any Slippage On Debt To GDP And Debt Restructuring Becomes Inevitable. Investors Are Worried. This is Not Simple Speculation. Hence ECB Support Is Critical. Deutsche Bank reduced its holdings of Italian sovereign bonds from 8 billion euros in December 2010 to 997 million euros at the end of last June.

The Demographics Of Export Dependency As populations age economies transit from being consumption driven to being export driven. Thus the process is not random or arbitrary. We are not talking about choosing between options or “growth models”. There is not a choice here, since there are deep underlying structural dynamics at work, and these dynamics seems to be intimately associated with the dynamics of the demographic transition Worryingly, Italy Still Runs A Trade Deficit And This Deficit Has Been Getting Worse Since The Financial Crisis.

Dangers of Sovereign Debt Default? According to a recent Standard & Poor's report, the timing of the current debt crisis is not a coincidence since cost of caring for the growing numbers of dependent elderly will both affect growth prospects and dominate public finance policy debates across the globe, and for many years to come. Even if most governments have long been aware of the need to prepare for the looming problem, the rapid build-up of government debt over the past three years has effectively heightened the need to do more to advance reforms aimed at containing the risks to sovereign budgets, especially in countries with high expected future increases in age-related spending.

And The Numbers Are Daunting Assuming no policy change, Standard and Poor’s estimate that developed country deficits could rise from 5.7% of GDP currently to over 7.4% of GDP by the mid-2020s. The interest cost of the growing debt burden may exacerbate the budgetary impact of demographic spending pressure. And if nothing is done deficits would rise inexorably to 10.1% of GDP in 2030 and 24.5% by the middle of the century. This would lead the general government net debt burden to increase to 78% of GDP through to 2020, only to then accelerate thereafter. By 2030, the net debt burden is projected to be at almost 115%, at the same time as being on an explosive path to which would see average developed country sovereigns hitting 329% of GDP by 2050.

A Delicate Balancing Act Reasonable empirical confirmation exists that the recent surge in global imbalances was, in part, an offshoot of slow-moving underlying demographic determinants of global capital flows. The near-term adjustments will mean more emerging market current account deficits and less developed market ones. At a global level, demographic pressures will continue to imply that the increase in desired saving will exceed the increase in desired investment. This has one clear implication: globally interest rates can be expected to remain low.

Longer, Healthier Working Lives In terms of policies to address the pressures of ‘ageing’, the debate in terms of social security and healthcare often focuses on raising retirement ages to reduce dependency rates and alleviate fiscal pressures. Extending working lives relative to the time spent in retirement will not only help address the pension issue, it should also serve to accelerate the tendency towards larger current account surpluses across most developed economies, in particular in those parts of Europe which are in the process of private sector deleveraging as part of their fiscal sustainability programme.

Time To Act – What Can Be Done? Short Term: - Continuing and Continuous Structural Reform • Labour Market Reform • Pension Reform • Heath System Reform • Immigration • Formalise the Informal Economy Longer Term: • Raise Fertility Rates • Global Rebalancing Initiatives • Acceptance that the Modern Growth Era – like modernity itself – doesn’t last forever.

 Thank You For Your Attention

You can download the full presentation here.

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