Spiral Days

Spiral Days

Miguel Lebre de Freitas

The government announces that, from now on, and for saving purposes, the light at the end of the tunnel will be switched off. 

Intro

A main problem with large cross border capital flows is when they stop. During the up-phase, the excess demand over domestic supply translates into a selective inflation, whereby prices of non-tradable goods increase and workers acquire purchasing power over imported goods. During the down-phase, the reverse has to occur. In the case of Portugal, the fact that it belongs to a monetary union made many people (including me) trust that the down phase would be smooth. But in fact it wasn’t: after a long period of accumulation of external liabilities, private capital stopped flowing in abruptly, in the aftermath of the subprime crisis. True, the replacement of private capital by official lending allowed a smoother transition than otherwise. Still, the shortage of foreign capital broad sense forced the Portuguese economy into external balance in a very short period of time.

Looking behind, the adjustment process so far failed to deliver structural adjustment, in the sense that the labour force released by contracting industries moved to unemployment (and abroad), rather than being absorbed by export-oriented green field investment. Exports did increase, but this was largely achieved through a more intensive use of existing capacity. Some analysts interpreted this failure as a symptom of price and wage stickiness. This view fails however to account for the fact that, during most of the bailout period, external demand remained weak, access to credit was limited and - most important - Portugal faced one of the most serious confidence crises in its recent history. In such a context, lack of green field investment should not be a surprise. 
I take opportunity to argue that the tax hike on food service activities was a poor avenue to raise government revenues. 

The toy story

To make the point on VAT, I need a couple of graphs (don't worry: I just copied and pasted from my class-notes). This is a baby version of the dependent economy model without inter-temporal substitution effects and other complications. Figure 1 plots the country production possibilities frontier, domestic absorption and preferences (as implied by linear income expansion paths), splitting the economy into tradable (T) and non-tradable goods (N). In the Figure, take (P,C) as the situation at the outset of the adjustment process, with domestic absorption (A) exceeding the value of output (Y). In that stage, consumption occurs in C and production in P, and the horizontal distance between P and C measures the external imbalance (for simplicity, we start out with internal balance).

Then, consider the case where a major international portfolio rebalancing causes borrowing constraints to become binding to everyone in this economy, so that the aggregate is forced into external balance (one could discuss the case of a primary surplus, but that would not make much difference). In the figure, this is represented by a contraction of domestic absorption from A to A’.

Figure 1. External adjustment with sticky wages

The well functioning case 

In a well functioning economy, price flexibility would ensure that the relative price of tradable goods (lambda) increased. This would favour the macroeconomic adjustment, by inducing: 
(a) Households to switch consumption away from tradable goods towards non-tradable (the income expansion path would become steeper); 
(b) Firms to reallocate employment towards tradable goods. 
The new equilibrium would be reached at P’=C’, with internal and external balance. 

(Note that, since the value of domestic output in terms of tradable goods declines from Y to Y’, external debt as a percentage of GDP jumps up; in a World with financial market frictions, the implied balance sheet effect should weigh negatively on domestic absorption). 

The case with sticky prices

In the absence of an exchange rate mechanism, a capital flow reversal poses a major policy challenge: how to achieve the downward adjustment of wages and prices. If these fail to respond, economic recovery may become conditional on foreign inflation, implying a slow and painful adjustment process with high unemployment.

The case with nominal stickiness is described in Figure 1 by point S. In this case, nominal wages and non-tradable good prices fail to decline, so the slope of domestic absorption remains unchanged. Thus, production of tradable goods remains stuck in P, consumers remain attached to the original Engel curve and domestic absorption is required to fall much more in order to meet the external balance (A’’). In the new consumption point (S), the demand for non-tradable goods falls short the potential supply (P), so unemployment soars up, proportional to the distance between S and P. Employment fails to be absorbed by tradable good industries, because firms don’t see the relative price of tradable goods increasing. In the non-tradable goods sector, the employment contraction overshoots what is required in the long run.  

Point S illustrates the typical case of a “sudden stop” under fixed exchange rates and sticky prices. A popular example in this category is Chile at the time of the second oil shock, when generalized wage indexation prevented relative prices from changing. In the case of Portugal, there is also a view that the failure of wages and prices to decline is the fundamental explanation for the painful adjustment path along 2010-2013.

An alternative view 

Sticky prices is not the only possible explanation for the failure of export oriented investment and employment to spring up. Another candidate is the theory that entrepreneurs, perceiving an unusually risky environment, low external demand, and high borrowing costs, mostly decided to wait and see. On the financial side, highly leveraged banks with little margin of manoeuvre, found reasons to redirect the scarce loanable funds to the rolling over of debts of large borrowers banished from capital markets (including the government and SOEs), away from new entrepreneurship, which risk is more costly to assess. With low investment demand and low availability of credit, the production structure remained temporarily frozen, as determined by past investments minus current bankruptcies   

This case is described in Figure 2. Figure 2 is similar to Figure 1, except that firms refrain from hiring and investing, so inputs cannot actually move across sectors. Thus, the potential pattern of production remains unchanged, regardless of relative prices (in the figure, this is illustrated by the rotation of producer prices around P). 
The adjustment in this case is observationally similar to that in Figure 1: since employment in tradable goods does not expand, the external balance has to be meet somewhere in the vertical line below P in the direction of S. The actual short term equilibrium will depend on consumption prices: if consumer prices don’t change at all – like in Figure 1 – then external balance will be met at the very same point S; if consumer prices succeed in adjusting in the right direction, external balance will be met somewhere above S, in the direction of P: this will allow unemployment to be reduced, though not eliminated. 

Figure 2. External adjustment with unresponsive supply   

Fiscal revaluation 

In figure 2, I describe by point T the case in which consumer prices move in the wrong direction: from S to T, the relative price of tradable goods declines instead of increasing, causing the income expansion path to rotate further down, and the external balance to be met at a higher unemployment level (TP>SP). 
This case intends to capture the government decision of increasing the value added tax rate on food service activities: as this causes home good prices to increase in consumption, households are induced to switch expenditure further away from domestically produced goods towards foreign goods, causing unemployment to increase even more. Note that this effect also works in the case of Figure 1: irrespectively as to whether the unemployment problem was caused by price stickiness or investment freeze, the tax hike on restaurants acted as a fiscal revaluation on the consumer side, deepening the recession.  

Crowding out

Table 1 shows the IMF estimates of savings and investment as of June 2011, compared with the revised figures at the time of the 8th/9th review. These figures show that the external adjustment was much sharper than initially forecasted: in June 2011, the IMF estimated the current account to reach a deficit of €7.1bn in 2013, but the reality was a  €1.7bn surplus. Along 2011-2013, the cumulative difference amounted to €21.1bn. At the same time, government savings underperformed relative to the initial plan by some €11.4bn, cumulative (this figure does not include SOEs outside the budget perimeter). 
Of course, accounting identities tell us nothing about causality. But the broad idea that a sharper than expected contraction of foreign lending coupled with larger than expected government deficits translated into a huge crowding out of private consumption and investment should not be entirely out of reality.

Table 1: Gross savings and investment, 2011-2013, billion euros  

Source: IMF, Country report, June 2011 and 8th-9th reviews, Oct 2013. 

Spiral fear 

During most of the bailout period, Portuguese citizens shared a sentiment of fear about the future that naturally born out of severe austerity, but which political leaders and opinion-makers actually managed to feed, by discrediting the stabilization strategy. This includes most of the political sphere in Portugal, and - notably - the IMF, which looked like plagued with bipolar disorder. 
As for the general public, the message that the therapy could actually be killing the patient created a sentiment that the sacrifices imposed were useless. In a short period of time, the initial credential, consisting in a large political and social consensus around the MoU was eroded. In the media, the floor was opened for opinion makers and interest groups to show up and toll on discontentment, turning the policy design increasingly more challenging, each time a major initiative was ruled illegal by the Constitutional Court. 
Low social and political support, a narrow legal space and a track record of fiscal slippages amended by one-off measures, helped maintain a sentiment of exposure of taxpayers to the risks of extraordinary taxation, that obviously did not help investment and employment to recover. 

What now?

In the second half of 2013, there was an inflexion in the Portuguese people’ collective mood. This change followed the improvement in global conditions and had been already reflected in high frequency indicators before, but it was really when the media started echoing the first signs of recovery that the spiral word was banished from the opinion makers' lexicon. 
As for the future, the brighter economic environment will come along with renewed exporting opportunities, higher willingness on the part of entrepreneurs to invest and hopefully the easing of credit conditions. Eventually, constraints that were not the most binding in the stage before will show up, slowing down the adjustment process. Whether this will be price stubbornness, low competition, labour market mismatches, energy costs, or the continuing drainage of limited loanable funds by the government deficit,  I don't know. 
What we know is that the challenges ahead on the fiscal side are still immense: at the completion of the adjustment program, the fundamental question - “who is going to pay what?” - is still plenty of blank spots, urging answers of the permanent type. And yet, the prospects of recovery are coming along with a lower willingness on the part of citizens to accept more sacrifices. 

In this context, a political agreement involving the main political parties regarding the drivers and boundaries of the future fiscal strategy would certainly help. 
Until a scenario of fiscal stability becomes credible and perceived to be politically feasible by tax payers and bondholders, economic growth will keep facing strong headwinds. 

Wage productivity gap again

I didn't show the figure below in my earlier post, because I really don't know how to import it and make it readable. But I believe it illustrates quite well the main ideas, so I do it now:

1. Wage-productivity gaps are observed in building construction and agriculture: reality or fiction (decreasing informality...)?

2- In any case, for manufactures, services and the economy as a whole (total), deviations are not significant

3 - Prices/ULC in services increased faster than in manufactures. The later are linked to PPP. The increase in the former explains the RER appreciation: once again, Pn/Pt is the issue , not wage productivity gaps.

To this, I could add a figure showing that on average wages in services are higher than in manufactures.

Thus, the challenge is to convince workers (and unemployed) to accept a lower pay while moving from services to manufactures.

The macroeconomic addjustment will be impaired not only by the economic climate, which is not investment-friendly, but also by any incentives unemployed may have to wait and see, rather than to accept an immediate move to a less friendly production environment.

Wage-productivity gap: where is it?

The problem with exports is not wages being too high in tradables. On the contrary, the evidence is that wages have evolved quite in shape with productivity, especially in manufactures. The problem is about to convince workers and unemployed to move from services, where wages are higher, to manufactures, where wages are lower.

INTRO

Competitiveness is a rather complex concept. In a broad sense, it refers to the extent to which a nation provides economic agents with (socially-aligned) incentives to produce and invest. For a moment, however, let’s focus on a narrow concept of competitiveness, related to wage costs. In particular, let’s stick with a definition proposed by Olivier Blanchard (2007), who refers to competitiveness as the inverse of unit labour cost (ULC) in tradable goods sectors relative to the corresponding world value.
In its influential paper, Blanchard (2007) argues that competitiveness in Portugal deteriorated significantly since the mid-nineties. According to the author, this reflected a misalignment between wages and productivity growth, which caused profitability in tradable goods sectors to shrink. However, Blanchard did not provide evidence supporting the claimed loss of competitiveness. The author showed that economy-wide ULC increased in Portugal faster than in the EU15, but he did not distinguished tradable goods (T) from non-tradable goods (N). The European Commission (2011) goes along with the same argument: “Since the introduction of the euro, Portugal has experienced significant real exchange rate (REER) appreciation vis-à-vis its trading partners, due to wage growth largely outstripping productivity advances (Graph 3)”. However, Graph 3 in the document only displays economy-wide real exchange rate indexes…
In a contrasting view, Campos e Cunha (2008) argues that “there is no room to claim a loss of competitiveness (...)” (p.158). The author points out that, in a small open economy, the real exchange rate and aggregate demand are two sides of the same coin. As it is well known, in a well functioning economy, an aggregate demand expansion translates into higher N-prices, while T-prices are bounded to remain unchanged. This causes a real exchange rate appreciation that has nothing to do with wage-productivity gaps. Fagan and Gaspar (2007) illustrate the argument is in the context of an endowment economy where, by definition, there is no such a thing as competitiveness.
Competitiveness and the real exchange rate do not necessarily go along.

FORMAL

To illustrate this, let’s look at the real exchange rate index based on nominal unit labour costs. By definition, ULC=W/a, where W refers to the compensation per employee (“nominal wage”) and a refers to Gross Value Added at constant prices per worker (“productivity”). Now, assume that the production function is a Cob-Douglas with labour-output elasticity equal to b and let Z be a variable measuring the wage-productivity gap: Z=ba/(W/P)=bP/ULC. When computed in terms of a base year (the constant b disappears) the index 1/Z is labelled Real Unit Labour Cost (RULC) or “real wage gap”. In a frictionless economy, Z=1. In a world with frictions, in face of a wage push, firms may opt to maintain a higher level of employment than that implied by the textbook wage-productivity rule. When this is so, the producer margin shrinks (Z<1).
Using the definitions above, the real exchange rate index based on nominal unit labour costs (RER-ULC) becomes ULC/ULC*=(P/P*)(Z*/Z). This means that RER-ULC accounts for two effects: wage-productivity misalignments (Z*/Z) and the increase in the relative price of non-tradable goods (P/P*). In a well functioning economy there are no wage-productivity misalignments, so Z=Z*=1. Still, unit labour costs may increase relative to abroad, whenever non-tradable good prices increase relative to abroad. This means that we can hardly rely on RER-ULC as an indicator of competitiveness. Competitiveness a la Blanchard is accounted for by the component (Z*/Z) and in the proportion corresponding to tradable goods, only.

EVIDENCE

Returning to Portugal, we now look at the data. In Table 1, se see that between 1995 and 2010 there was a

The Future of the Past

History does not repeat itself, but in Portugal it certainly rhymes. It's easy to say now that the request for foreign aid made yesterday by the Prime Minister was the inevitable outcome of the accumulated stress of the last two years. But during that time the government, the European Commission and even the IMF sought to persuade us that the Portuguese case was different from the Greek and then the Irish. There might be merit in this differentiation, but sometimes it's useful to compare the present with our own past, even if distant. A quarter century of European integration and ten years of Euro membership were enough to convince us that Portugal had 'graduated' in the class of nations, leaving behind a past of financial and currency instability. The dreaded return of the IMF (or EFSF, as the President insists) re-evokes the memories of 1978 and 1984, but in my opinion the past that best rhymes with the present is the late nineteenth century. I speak, of course, of the crisis of 1890-92, which culminated in the last Portuguese bankruptcy. The parallels are striking and instructive.

For the most forgetful among you here's a brief recap. The problems began in April 1890 when the government had trouble placing a loan in Paris. A banking crisis followed in September with a run on the Montepio Geral, which was saved by the Bank of Portugal. Meanwhile, the current account took a wrong turn by the fall in the remittances from emigrants in Brazil. Despite the guarantees (avais) given by the Bank of Portugal and the government to a number of banks and railway companies, heavily indebted abroad, capital started flowing out of the country. Until 1892 the government committed about 12% of total public expenditure to these guarantees to not much avail. In November, the house of Barings, one of the most reputable London bankers, went bankrupt under the weight of its exposure to Argentinean debt (Argentina had defaulted in June). This precipitated a financial crisis worldwide, with capital drying up to peripheral nations such as Portugal. To make matters worse, Barings was the main external agent of the Portuguese government, and its failure cut off the access of Portugal to critical short-term credit. 1891 opened up with a failed republican uprising in Porto and, more importantly, with the bankruptcy of the Banco Lusitano, which the authorities were impotent to prevent. The Bank of Portugal itself had dried up its sources of credit and was in trouble to make up on the debt raised the year before. Under a situation of renewed capital flight (gold), and the threat of a banking collapse the government responded, in May, with a moratorium of 60 days and the suspension of convertibility in gold. By the end of June the currency had lost 6% of its value, adding up to more than a quarter until December. In the second half of 1891 the government negotiated a 'bridge financing' of £6.4 million, in exchange for the 35 year monopoly of the production and sale of tobacco to a group of domestic and foreign investors. Finally, in January 1892, Oliveira Martins (another Northerner at the finance ministry) decreed the suspension of debt payments in gold and began negotiations with foreign creditors. These were quickly interrupted, on 13 June 1892, by a change of government and the imposition of a partial default on the external debt.

Now replace Montepio and Lusitano with BPN and BPP; the railway companies with Refer and the Lisbon and Porto subways; tobacco with the pension funds of PT and the Social Security; and the Barings case with the current fears of exposure of European banks to the 'PIGS' and the story begins to sound like déjà vu. Today, as 120 years ago, the structural imbalance of the current account, particularly in the context of exchange rate stability, brought about an excessive foreign debt under the guarantee (directly or implicit) of the Portuguese state and the inevitable failure to honor the debt service.

There are, to be sure, important differences. Even though the abandonment of the gold standard was perceived to carry severe reputational costs, it was much easier to organize than the putative opting out of the Euro. It also helped that back then the external indebtment was mostly a sovereign affair, compared to today. Although it is hard to reconstitute the magnitudes, my own research suggests that the level of external debt just before the default represented about 40% of GDP, 35% of which government owed. These figures are in strike contrast with the statistics quoted here earlier by Ricardo Cabral. Despite their many design flaws, a network of European and international institutions (EFSF, IMF, ECB) form today a guarantee against an immediate dry up of financing to the Portuguese economy, which would result in a banking meltdown and a painful current account reversal – particularly under the no devaluation option. I agree with everyone who has rejected here the option of leaving the Euro, given the devastating balance sheet effects it would entail, but I also believe that Portugal, Greece, and Ireland should demand a better deal than what has been on offer. Adding up to the high interest charged by the EFSF to Greece and Ireland, the recent reference of Trichet to the peripheral nations as the 'collateral damage' of the fight against inflation in the Eurozone and yesterday's rise of the ECB rate are disturbing. I hope Trichet is playing Janus: indulging the inflation hawks while keeping the floodgates open to the banks.

Sovereign spreads - then versus now

Here is an interesting comparison of the pace of the recent Eurozone sovereign crisis with our own debt crisis of the 1890s. Portuguese troubles started in April 1890 and culminated in January 1892 (21 months). The subprime crisis spread to Europe around October 2008 and by May 2010 Greece had appealed to foreign aid (20 months). There is a also striking similarity between the levels of historical Portuguese spreads up to and after the January 1892 default (green dashed line) and the Greek bailout (blue dashed). By most historical precedent, Greece is clearly bust and will need a debt rescheduling. How about Portugal? Long spreads are still markedly lower than the comparators, although that may be just the time lag from contagion from Greece and Ireland. As we don't have the benefit of the hindsight of the next months this invites speculation. But if Portugal follows the same path of Greece and Ireland, I would bet that we would witness a similar pattern, perhaps more accelerated. Plus ça change?

The state of the Union

Even before it began, Europe's moment as a major world power in the 21st century looks to be over. Richard Haass

The euro is in danger…If the euro fails, then Europe fails. If we succeed, Europe will be stronger. Angela Merkel

I think of the current state of the EMU as the result of three events. The first event is the political decision to adopt a common currency leaving EMU members without automatic mechanisms to adjust to external imbalances beyond self-equilibrating forces. The second event is the global financial crisis with her consequences including the recognition that large shocks are not an historical curiosity. The third event is the sudden comprehension by the financial markets of the first event.

The next figure partially summarizes the state of the EMU. The data are from the ECB and are used to set the stance of monetary policy.

Two sub-periods are evident: the pre-crisis and the post-crisis periods. The first 8 years show the performance of the ECB in controlling inflation ad stabilizing it around 2%: impressive. Equally impressing is the inflation oscillation that started in 2008 and is still unfolding. The EMU public debt to GDP ratio was stable at roughly 70% (10% more than the Maastricht rule) until the global financial crisis. The decline in output and the consequent worsening of public finances have now increased the debt to gdp ratio to almost 80%. Similarly the EMU public deficit has fluctuated around the -3% Maastricht limit until it ballooned during the crisis. Notably the EMU area has always had a fairly balanced current account and her actual net external position is small. The EMU growth has averaged 2.3% from 1999 to 2007 to later collapse and the EMU unemployment rate moved around 8.5%.

I see a picture of a sufficiently solid although static euro area that was hit by a large shock. There could be some concerns regarding the control of inflation (personally I am more worried by the downward trend of the inflation rate that excludes energy). The unemployment performance is unsatisfactory but this is not the picture of a collapsing economy. To observe the large imbalances that are threatening the euro we have to shift to a disaggregated picture.

The next figure depicts the state of the individual members of the EMU.

The heterogeneity within the euro is large in every dimension. Some states have very large debts, some have very large current account deficits, some have both and other have incredible unemployment rates for a modern democracy. The crisis has potentially put some of the weakest states in an unsustainable debt position exacerbated by large external imbalances. The heterogeneity per se is not a sufficient condition for questioning the existence of the euro area (and weights matter). For example the US states are very different in terms of employment, fiscal stance, size, productivity, ratings, etc (see here and here). The EMU has to design and adopt the minimum set of adjustment mechanisms that have to be present within a common currency area. There are many proposals that are discussed such as a common bond market and a larger fiscal integration. For the latter it could be interesting for europeans to know how much of the adjustment to the current shock is achieved in the US through automatic stabilizers such as unemployment benefits and how much is achieved through labor mobility (workers migration).

What is really necessary is for the EMU leaders to decide if they want to continue the integration of Europe (and how: a centralized state or the Europe of regions) or decide to go back to the now obsolete nation-state paradigm. A shadow is rising within Europe and it requires courage to dissipate it.