The Importance of Being Euro

Lady Bracknell. Now to minor matters. Are your parents living?
Jack. I have lost both my parents.
Lady Bracknell. To lose one parent, Mr. Worthing, may be regarded as a misfortune; to lose both looks like carelessness.

Oscar Wilde, The Importance of Being Earnest

In this initial post, I would like to share a recurring thought. In pondering about the current crisis, I am often reminded of the above exchange in Wilde's The Importance of Being Earnest. Yes, I know that the Portuguese situation has its own very particular (perhaps even peculiar) national dimensions - just like the Greek and Irish crises have their own domestic specificities, echoing Tolstoy's oft-quoted dictum about each unhappy family being unhappy in its own way. Yet I find myself invariably returning to Lady Bracknell’s response above. To paraphrase Wilde, if losing one (Greece) could be considered misfortune on the part of the Eurozone, to lose three really does look like carelessness. With another two or three (Italy, Spain, maybe even Belgium further down the road?) edging towards the brink, it seems that Europe has yet to fully realise the political importance of being Euro.

More on wage-productivity gap

Like Miguel Lebre de Freitas in the post below, I have also been exploring the Campos e Cunha hypothesis for Portugal's stagnation. And I am growing increasingly convinced. Miguel gives you some numbers: here is the one plot that makes the point for me, where TOT are terms of trade, RER-ULC is the real exchange rate using unit labor costs against 35 developed economies from the AMECO database, and REC-CPI is the real exchange rate using consumer price indices from the CPI database.

Could bank deposits be used to fund sovereign debt?

Probably yes (available also in my webpage with additional footnote. Sorry, in Portuguese only).

Too much talk about economic growth

It seems to me that this government is going to commit the same mistake of the former one by conveying the message that resuming economic growth is the way out of the crisis. It is not. Economic growth will not resume in the short run and the debt crisis demands very short run domestic solutions. All the talk must be focused on the adjustment of expenditure, private and public. However, passing on that message is very hard for political leaders and for a people that have lived (and were educated) in an age of prosperity and high public spending growth.

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

Openness, internal devaluation and competitiveness

One is entitled to ask if the "internal devaluation" will lead to an improvement in Portuguese's competitiveness given the recent euro-appreciation trend.

First, with respect to the euro-appreciation, given the growing importance of intra-euro are trade for Portugal (> 65% of exports), such phenomenon is not expected to severely damage the trade balance.

Secondly, internal devaluation should be coupled with crucial structural reforms (including the labour market) such that we assist to an emergence of new economic activities. In particular the MoU is highly reliant on opening up the nontradable sector to competition to decrease rent-seeking behaviour and encourage profitability in the tradable sector. The emphasis should then be on export-led-growth rather than specific sectors, which may, at the beginning, naturally favour those with strong(-er) comparative advantages.

Thirdly, internal devaluation can take the form of i) planned fiscal devaluation (as suggested/endorsed by our co-blogger Francesco) which basically adjust relative prices by simulating a currency depreciation; ii) a (further) compression of nominal wages (despite not ideal, may still be necessary); iii) a push for increasing competition (resulting in smaller prices of domestically produced goods).

Regardless of how it is going to be implemented, the timing and correct design of an internal devaluation strategy should take into account its social impact and the existing room for manoeuvre (in terms of available measures) in face of the already large fiscal adjustment in progress...

All in all, the above points together with no increases in the minimum wage (as envisaged by the MoU) should contribute to zero growth in unit labour costs (ULC). This combined with sensible projections for trading partners should imply an important cumulative depreciation by 2016.

Moody's lazy screw up

Moody's has really taken a beating in the last few days in Europe. Their hard to understand, sudden, and dramatic downgrade of Portuguese debt has had people, from the FT and policymakers all the way down to blogs and facebook accounts, calling Moody's analysts names that range from incompetent to dishonest.

I don't agree, since I tend to see Moody's as a serious company that does a good job with often little information in tough circumstances. But the downgrade of Portuguese debt in 4 ratings to junk on Tuesday, is far from its best moments. Actually, it is a moment that the people there should be embarrassed about: it is hard to avoid the conclusion that, at least, they are lazy.

The downgrade decision was justified by Moody's on two accounts. First, the low growth of the Portuguese economy, the high budget deficit, and the political uncertainty on the government's ability to change things. But, these problems are years-old news, and nothing in the past week made them look worse. In fact, with recent elections giving 80% of the vote to parties that are committed to the IMF program, and the announcement of a surprise tax hike, the news has been moderately positive on those concerns. The only backing I can find for this Moody's argument is the revision down of growth forecasts and poor numbers on government spending in the first quarter. But these are week-old news. So, at best, Moody's analysis are right, but lazy, taking weeks to digest simple news.

Second, Moody's points to the new plan to "voluntarily" restructure Greek debt, and the suggestion that this plan could be offered to Portugal's creditors as well. This makes a lot of sense to me, although the Sarkozy plan is very far from likely being adopted. As Alvaro puts it below, it puts the blame of the downgrade squarely on the EU's too-frequent grand announcements and retreats. But if this European shock justifies a 4-level downgrading of Portugal, how can it not involve an even modest change in outlook for Ireland, Spain or Italy? Again, the only explanation that I can come up with is that Moody is being lazy, and will downgrade those ratings too but only in the next few weeks, when it gets around to it.

A downgrade a week or two earlier I could understand; a downgrade later for a group of European countries, including Portugal, would be a gamble, but hey that's forecasting. A downgrade last Tuesday just seems like laziness.

Incomplete information is a fact of life. Poor economic models are a trap for anyone who ventures into forecasting. But laziness is an embarrassing attribute for people monitoring credit.

More on this in Portuguese in today's Expresso.

Domestic extraordinary measures are not a solution for our structural problems

The adoption of extraordinary measures has become an ordinary behavior of Portuguese governments. The most recent example was the extraordinary income tax announced last week. The events of this week have shown that extraordinary measures are not a solution for the structural problems of the Portuguese economy. There are two aspects to this. First, the markets clearly do not believe that these measures are enough to tackle those problems. Second, to the Portuguese people they convey the idea that the problems are, like the measures, temporary and thus the measures fail to put in motion the process of adjustment of expectations (and behavior) that the seriousness of the problems demands – therefore confirming the beliefs of the financial markets.

Structural measures are therefore required. The unsustainable current account deficit is a reflection of the structural problem of the Portuguese economy. It embodies the disconnect that exists between the structures of consumption and production. Devaluation would be the obvious (easy and non-structural) solution outside a common currency area. Absent this possibility, a significant cut in wages has been suggested as a means to restore the competitiveness of Portuguese firms.

A structural measure that would have the same competitiveness effect as a 7% wage cut would be to eliminate, permanently, the 14th wage payment, for both workers and pensioners. Beside the competitiveness effect, this measure would reduce public expenditure permanently. It should also have an impact on expectations, bringing the behavior of Portuguese consumers closer to our economic possibilities and sending a clear message of commitment to the financial markets and to the European Union (i.e., Germany), on top of the commitment to the memorandum of understanding.

Finally, except for legal problems that would have to be dealt with, this is simpler than other measures that would introduce additional complications into our fiscal system, with uncertain effects on the structure of incentives, such as the much discussed reduction in payroll tax. It should also be noticed that other structural measures, such as those in the memorandum, will take a long time to produce effects – if they do.

This kind of measure should be implemented from 2012 onwards. The Portuguese households should be given time to adjust their consumption plans. Obviously, such a measure will deepen our recession. But there is no way out of our problems without a serious recession, except if the Germans accept to pay the bill for our past excesses. Given the events in Greece, this would appear quite extraordinary.

Ich bin ein Grieche!

To fight the North American ones, more and more politicians are suggesting the creation of an European rating agency. It seems that they are not aware of the several dozens of rating agencies that are spread around the world, including Portugal.

Anyway, if there is going to be a new European credit rating agency, I propose that this new rating agency uses the Greek alphabet instead of Latin. Therefore, instead of aaa we would have ααα, or βββ instead of bbb, and so on and so forth.

Misquoting Kennedy, one would say: “Two thousand years ago the proudest boast was civis Romanus sum. Today, in the world of freedom, the proudest boast is 'Ich bin ein Grieche!'... All free men, wherever they may live, are citizens of Greece, and, therefore, as a free man, I take pride in the words 'Ich bin ein Grieche!'”

Moody’s decision was correct…

… if one accepts the ratings agencies’ view that the debt rollover involving private creditors proposed for Greece should be considered “default”. Given that the consensus seems to be that Moody’s decision is absurd, I feel I must explain my previous post and the previous sentence. Considering that:
1. The Portuguese “program entails important risks” (see the IMF’s staff report, page 23, available here), “in particular, refinancing risks”;
2. If the program fails to deliver the results projected, additional official financing will be necessary; i.e. there is an “important” probability that Portugal will need new financing from the European Financial Stability Facility (EFSF), which implies approval from all the Eurogroup governments;
3. It is very likely that France and Germany will apply the principles of the latest Greek program to all future EFSF financing, requiring private creditors to rollover their debts, an event ratings agencies consider to be “default”.
Then, there is “very likely” an “important” probability that an event called “default” will occur, regarding Portuguese debt. That is exactly what a junk rating means, that there is a important probability of default.
This also means that Portugal’s downgrade has nothing to do with Portuguese fundamentals, but it is related to the fact that France and Germany are requiring private creditors to rollover their debts.

Growth and Employment "Trackers"

The growth and employment "trackers" (see footnote for technical details) give a sense of the dramatic decline in economic activity and employment following the last economic crisis and its tepid recovery (particularly in the labour market) in Portugal between 2000-Q1 and 2011-Q1 (from here up to 2015-Q1 the trackers are based on forecasts - grey shade).

The profile of GDP growth forecasts are somewhat in line with what the new Minister of Finance (Vitor Gaspar) has recently said: “Portugal is expected to have 9 terms of consecutive negative growth” (see here).

Source: author’s calculations based on OECD data.

According to these estimates we shall have “contraction at a moderating rate” until around mid 2013 and only then we should begin growing below trend at a moderate rate. Perhaps we won’t go through another “lost decade”, but we are certainly expected to experience at least half a decade of negative, stagnant or moderate growth (at best). More reassuring, might be the case of employment if the “right” structural policies are enacted and put into action such that the “job-destruction” process is reversed and productivity and competitiveness improved. (Note, however, that projections shouldn't be viewed as an exact science but solely as an indication as to where the economy is expected to move based on a number of mathematical and statistical assumptions.)

Footnote: The trackers are constructed using a univariate fitted Structural Time Series Model with unobserved components over the period 1970Q1:2011Q1 allowing for a stochastic trend, cycle and seasonal and estimated by maximum-likelihood via the Kalman filter. Forecasts are then obtained up to 16 periods ahead and the classifications represented in the figure are based on the behavior of a centered 4-quarter moving average.

Time-inconsistency in European policy

We must thank Mr. Sarkozy and Mrs. Merkel for today’s downgrade of Portugal’s debt rating by Moody’s. The main driver of Moody’s decision was “the growing risk that Portugal will require a second round of official financing before it can return to the private market, and the increasing possibility that private sector creditor participation will be required as a pre-condition”. Why? Because Moody’s believes that the EU’s decision to require private sector creditors to participate in the new financing package for Greece is the new official EU policy on financing programs. As such, private sector creditors will not be willing to provide financing to any country that may require official financing in the future, and Portugal will not be able to return to the markets when expected. Mr. Sarkozy and Mrs. Merkel have managed to transform the availability of official financing from a market confidence booster to a sign of future default. Someone needs to teach European politicians about time-inconsistent economic policy, before they completely destroy the euro and a few small countries with it…

Should a struggling country predict too much?

So we have a new centre-right government and, despite previous promises, a new extraordinary income tax, on the 14th monthly pay check (I guess a southern oddity but already factored in by international wage comparisons). The tax is biased against the lower strata of the population, as it is almost flat above 3,000 euro monthly wage or so, and dividends and profits are exempt. Not a very well designed tax, one should say.

The EU/IMF/ECB troika didn't ask for it, at least until now. So, the key question is: should the government of a distressed country, such as Portugal, going through an already massive restructuring program, compress further the economy before it is necessary? Or should it have waited and see whether it would be necessary? The more I think about it, the more I get close to the conclusion that the move was in the wrong direction.

I think I still prefer to be ruled by policies set in Brussels then by too imaginative local officials. At least in Brussels they do not follow so closely the electoral cycle, which may be one of the reasons why the Portuguese government acted as it did on this matter. In fact, it looks as if they were following the same old rule of doing the hard stuff at the beginning of the electoral cycle to ease up later one. Unfortunately, in this juncture, that may have considerable negative macroeconomic effects.

Can the public sector monster be tamed?

On this initial post, I will refer to my experience at the IMF to speculate about economic policy in Portugal in the next few months. It is usually claimed that economic policy will be limited to the application of the vast program agreed with the international institutions, but this is not necessarily true. Every IMF program has quarterly reviews when staff assess whether the program is on track, a necessary condition for the IMF’s Executive Board to approve the corresponding disbursement. The approval of Portugal’s first review, to be completed by September 15th, will release €3,8 billion from the IMF and twice as much from the European financing facilities. In preparation for that review, a troika mission will be in Lisbon for much of August, to analyze June data and the conditionality for end-July.
It is very common that the details of an IMF program change during the quarterly reviews. As long as the main objectives of the program are not at risk, the IMF tends to accept any changes of one measure for another that the local government proposes. It is possible that review dynamics are different in the case of euro-zone countries, making changes less likely since many institutions are involved. However, yesterday’s Eurogroup decision to approve the latest review of the Greek program, has proved that even for euro-zone countries the program that is implemented can be quite different from the program initially approved.
Less than two months ago, international experts made a thorough review of Portugal’s budget, and concluded that the 2011 targets could be achieved with implementation of the 2011 budget and a few extra expenditure measures. Nevertheless, the first real decision of the new Portuguese government was the creation of an extraordinary income tax to raise an additional €800 million. Why? My guess is that the government realized that the expenditure cuts incorporated in the 2011 budget will not materialize, and went for the easy option: a tax increase. Given that programs can be adjusted during reviews, I am afraid that this will happen often: having failed to achieve the proposed expenditure cuts, the government will replace them with tax increases. In the end, instead of a program with a reasonable expenditure / revenue mix of measures (two thirds / one third), we may end with a growth crippling one third / two thirds mix.

The “New Normal” in Portuguese’s Labour Market?

This is my first post.

Eurostat has just released a new report (click here) with new unemployment figures and Portugal keeps its place in the “pole-position”, with 12,4% of unemployed people registered in May. More striking are the numbers for youth unemployment which have been rising at a faster rate and reaching now 28,1% of youngsters (up to 25 years-old). Only Spain, Slovakia and Italy get ahead by presenting even higher statistics.

It is known that employment has taken a deep hit in this last recession, and has been much slower to recover than output (McKinsey Report on jobless recoveries).

This is related to the ongoing debate as to whether the crisis has permanently shifted the level of potential output or whether output will eventually meet the pre-recession trend level. Are we facing structural or cyclical shifts in the labour market? Structural and statistical estimates tend to produce disparate results depending on the country under scrutiny.

If we plot Portugal’s GDP trend growth (see footnote) and corresponding output gap using quarterly data between 1970-Q1 and 2011-Q1 we obtain the figure below.

It is clear that the “golden” days are over and that the so-called “lost decade” seems to have arrived to stay… Not only do we have negative trend growth, despite some mild signs of moderation/reversion(?), but also negative output gap.

Output can be decomposed into a product of population (p), the labor force participation rate (lfpr), the unemployment rate (u), hours per worker (h) and labor productivity (lp): Y=pop*lfpr*(1-u)*h*lp. Let’s just (briefly) analyse some of these components.

Plotting the trend growth of employment, labour force and unemployment we get the following:

One does see a downward evolution of the employment trend growth up to a point where around 2006 it became negative. Evidence seems to suggest than the trend may be reverting and the inflection point reached. A similar, but lagged behaviour, can also be seen in the case of labour force. Simultaneously, unemployment trend growth has been positive (since the early 2000s) having reached a peak in 2009-Q1 and signaling a downward movement. In any case, it seems a “New Normal” has arrived, characterized by higher unemployment and lower employment across all economic sectors and age-ranges which, most likely, won’t go back to pre-crisis levels.

One certainly needs to revert these variables’ behaviour in the short to medium-run for which a sine qua non condition is getting the Portuguese economy back on the growth track, increasing its potential output and closing the gap. All in all, some of these stylized facts should encourage policy-makers and the new government to "do something".

Footnote: For the interested reader, trends were computed by means of a univariate fitted Structural Time Series Model with unobserved components allowing for a stochastic trend, cycle and seasonal and estimated by maximum-likelihood via the Kalman filter. Source: OECD data; author's calculations.