Stefan Karlsson
German Chancellor Angela Merkel (R) welcomes Iceland Prime Minister Johanna Sigurdardottir for the 'Council of the Baltic Sea States' leader summit in Stralsund in this May 2012 file photo. Iceland's recent economic growth spurt is too weak to be deemed a true recovery, Karlsson argues, and more objective standards should be put in place for calling growth success. (Tobias Schwarz/Retuers/File)
How should we measure economic recoveries?
After having been mired in a deep slump for years, Iceland have recently started to experience a recovery, albeit only a weak one, causing some inflationists, such as Paul Krugman, to hail Iceland as a role model and proof that devaluation works.
It should be noted however that although growth has recently been positive in Iceland, the absolute level of output remains well below the previous cyclical peak, and that the same inflationists that hail Iceland have dismissed Estonia's much stronger recovery by pointing to how Estonia's output is still below its previous cyclical peak, making their evaluations of recoveries hypocritical and inconsistent.
But leaving the issue of double standards aside, what is the correct standard by which recoveries should be evaluated. Should we compare current GDP to the level at the previous cyclical peak or to the level at the cyclical low or to some other standard?
That depends actually on what the purpose of your evaluation is. Is the purpose to assess whether or not the current state of the economy is satisfactory, or is it to assess the effects of policies implemented during the slump?
If it is the former, then the correct standard is to compare it to the level at the previous cyclical peak. And as long as output is below it, we can clearly say that the current state of the economy is unsatisfactory, which in the cases of Iceland and Estonia means that both economies still aren't good.
If it is the latter, then the correct standard is to compare it to the level before the policies were implemented .
In the case of Estonia and its spending cut programs this means comparing current output to the levels of late 2009, and since they were implemented the economy has grown fast.
In the case of Iceland, we can see that its entire devaluation (or more strictly depreciation) took place throughout 2008, and that its currency has been basically stable and in fact appreciated slightly in value since then. After having fallen dramatically more or less gradually during 2008, with the euro being worth 92 kronor in December 2007 and then falling so that it took 191 kronor to buy a euro in late December 2008, it stabilized after that so that it traded at 188 against the euro in December 2011 Yet in the first year of the devaluation (between Q4 2007 and Q4 2008), it's economy contracted by 2% and then contracted an additional 8.2% in the year to Q4 2009 and it remained in Q4 2011 6% lower than in Q4 2008 and 8% lower than in Q4 2007. We can clearly see that devaluation was followed by a really deep slump and it was only several years later, after its exchange rate had stabilized that a modest recovery started.
To the extent one should use "different standards" for assessing Iceland's and Estonia's recoveries, we can therefore see that it should be made in the opposite way that Krugman and others have done, because Estonia's spending cuts came after almost the entire slump was over and was followed by a strong recovery, while basically the entire slump in Iceland came after its currency started to depreciate and its modest recovery started only a long time later after its currency had stabilized.
A man walks outside an one euro shop in central Athens June 18, 2012. Greece's conservative leader pushed on Monday for a new coalition government after a narrow election victory, pledging to soften the debt-laden country's punishing austerity program despite opposition from Germany. (John Kolesidis/Reuters)
Direct effects of debt crisis can't explain away British deficit
Those who disagree with my contention that the increasing British trade deficit is a sign of an overvalued pound may argue that the increase simply reflects the euro area debt crisis.
However, during the latest year, the total monthly trade deficit in goods rose by £2.7 billion, from £7.4 billion to £10.1 billion, while the deficit with the euro area alone only rose by £1.6 billion, from £1.9 billion to £3.5 billion. The deficit also rose by £400 million with other non-euro area EU countries and by £700 million with countries outside the EU.
By contrast, Germany was able to compensate the drop in its trade surplus with other euro area countries by increasing its surplus with both non-euro area EU countries and with countries outside the EU.
So while the general drop in demand the crisis hit countries explain some of the British export weakness, an overvalued pound has weakened it further while also contributing to increased competitiveness of imported goods in the British market.
People walk and jog past the Bank of England, in London June 15, 2012. The Bank of England announced on Friday it will hold its first emergency liquidity-providing operation for banks next week as part of a package of measures aimed at getting credit flowing through Britain's economy as the euro zone debt crisis deepens. (Paul Hackett/Reuters)
Safe haven? Hardly. Why the pound is overvalued.
One of the more bizarre developments in the recent debt crisis is that government bonds from one of the countries with the most messed up public finances, Britain, has been considered a "safe haven", ignoring that not only have Britain a large debt and deficit, but it has also a central bank that relentlessly tries to lower the value of its currency, something that also means that anyone stupid enough to buy British bonds will see the value of their investments reduced.
However, in recent years, though the Bank of England has been successfull in pushing up domestic price inflation to an average of 3.5% per year (a lot higher than in all other major advanced economies) the foreign exchange rate of the pound has actually increased the latest year, trading recently at 1.25 against the euro, up from the 1.10 to 1.15 range This increase in the pounds exchange rate of course reflects the above mentioned "safe haven" status that causes investors to demand pound denominated assets.
The combination of much higher inflation and a significant nominal exchange rate appreciation is of course that the real exchange rate has soared, making British exports very uncompetitive. We should therefore not be surprised that the British trade deficit rose to a new high in April as exports plunged.
In some other countries with a strong currency, the effects on the trade balance is to a large extent cancelled out by the increase in real interest rates caused by disinflation/deflation, but as British real interest rates have been strongly negative.
With a rapidly increasing trade deficit and negative real interest rates, it seems clear that the British pound is one of the most overvalued currencies around.
Nobel Prize winning economist Paul Krugman speaks during an interview in New York in this May 2012 file photo. Krugman recently said that Latvia's drop in unemployment is due to emigration, an assertion Karlsson strongly disagrees with. (Brendan McDermid/Reuters)
Correcting Krugman: Setting the record straight on Latvia labor
Responding to the recent recovery in Latvia, Paul Krugman tries to dismiss it by saying the recent drop in unemployment is due to emigration, and while he writes that labor mobility isn't bad, it's not a model for all of Europe, because "somehow having all of Europe move to someplace else in Europe doesn’t quite seem like a sustainable proposition".
Well, if you phrase it in the stupid way Krugman did, then it makes no sense. But no one is suggesting that all of Europe should move somewhere else in Europe. What does make sense however is if unemployed workers in for example Greece, Spain or Latvia move to countries where their skills are wanted by employers. This will (except perhaps in the construction sector which is a special case for reasons I explained here) reduce unemployment in the countries of origin of these workers And large parts of Europe, most notably the German-speaking countries Germany, Austria, Liechtenstein, Switzerland and Luxembourg but also Norway and Åland, have low unemployment and are likely having labor shortages in some sectors.
This doesn't mean that increased labor mobility, even outside of the construction sector, will alone come even close of solving all problems in Europe, but while the effect wouldn't be very big it would still be positive.
Finally, it should be noted that Krugman is wrong to assert that the drop in unemployment in Latvia is entirely or even mainly due to emigration. The main cause is an increase in the employment rate by about 7% (4 percentage points) since the low in early 2010, and the drop in population reflects to a large extent the effects of the dramatic drop in Latvia's birth rate in the early 1990s something that for obvious reasons means that there will be a lot fewer youngsters in their late teens by now.
A replica of an ancient Drachma coin is pictured outside the Numismatic Museum, as the main building of the central Bank of Greece is seen in the background in Athens on Tuesday June 5, 2012. Greece's GDP lagged behind Finland's in the first quarter of 2012, despite being twice its size in population. (Dimitri Messinis/AP/File)
What Greece can learn from Finland
Greece and Finland are both in the geographic eastern periphery of the euro area, except that Greece is in the south east and Finland is in the north east. In terms of population, though Greece is almost exactly twice as big as Finland, having 10.8 million people versus 5.4 million for Finland.
However. the most recent quarter, Finland actually surpassed Greece in terms of economic size, despite the fact that Greece has twice as big population. In the first quarter Greece had a GDP of €47.19 billion versus €47.42 billion for Finland. First quarter GDP was for seasonal reasons lower than usual in absolute terms in both Greece and Finland, but since the seasonal effect appears to be basically the same for both countries, this has little or no relevance for their relative position.
So despite being twice as many as the people of Finland, the Greeks can't produce more. To what extent this reflects bad behavior from the Greeks and to what extent it reflects good behavior from the Finlanders can be discussed, I for one think it reflects on both, though mostly the former.
Job seekers fill out application forms as they wait to see recruiters at a job fair sponsored by the New York Department of Labor in New York, June 7, 2012. Karlsson argues that in comparison to the US household survey, the US payroll survey is a more reliable marker of short term economic trends. (Keith Bedford/Reuters)
Are we underestimating the US job market?
Permabulls Brian Wesbury and Robert Stein argue that because the household survey say a much bigger gain (422,000) in jobs than the payroll survey's (69,000), the payroll survey underestimates the strength of the U.S. job market. That might have been plausible if that had been a consistent pattern, but that is not the case as the household survey showed significant drops in employment in March and April even as the payroll survey showed gains. In fact for the last 3 months as a whole, the payroll survey showed a bigger increase (279,000) than the household survey (222,000).
This illustrates that the household survey is more erratic and volatile than the payroll survey and that with regard to short-term economic trends, the payroll survey is more reliable. The household survey number could however be useful if the household survey is consistently either stronger or weaker than the payroll survey than that would be reason to suspect that the payroll survey either underestimates or overestimates strength in the job market. However, when it comes to short-term economic trends, which is what Wesbury's and Stein's comments were about, then the payroll survey is more reliable.
In this file photo taken in December 2010, people pass by an anti-euro currency poster in Tallinn, Estonia. Estonia,did not shirk from bailing out much richer Portugal and Ireland. (Timur Nisametdinov/NIPA/AP/File)
Estonia rising: The little country that could
Jason Rave argues that Estonia isn't an example of successful austerity since supposedly growth has been flat since late 2010 and since GDP is still well below the pre-crisis level.
But regarding the first point we should first of all notice that as Rave himself writes, the budget was balanced in early 2010, meaning that the extremely high 2010 growth numbers of 8-9% provide the best test of the effects of austerity policies. While growth did slow down in 2011 and the first quarter of 2012 from those extraordinarily high levels, it was still 4% in Q1 2012, the third highest in the EU after Latvia and Lithuania.
While Rave is correct to note that the absolute level of GDP is still significantly below its pre-crisis peak levels, that isn't relevant for evaluating policies implemented after the initial slump.
A somewhat better argument for dismissing Estonia as an austerity success story is that they were in part lucky. Strong recoveries in Sweden and to a lesser extent also Finland helped boost Estonia's exports to those countries. Yet even if you adjust for that, Estonia's performance the last two years have been strong.
European Central Bank (ECB) President Mario Draghi (l) participates in the European Parliament economic and monetary affairs committee in Brussels in this May 2012 file photo. Continued worries about the global economy are pushing down bond yields, including in perceived "safe haven" countries. (Yves Herman/Reuters)
'Safe havens' starting to look a lot less secure
Continued worries about Spain and Greece, increasing signs that the weak US recovery is getting even weaker and signs that the British and euro area slumps are deepening are continuing to push bond yields in countries that are perceived "safe havens" to even more absurdly low levels. There are now three countries (Switzerland, Japan and Denmark) with 10-year yields below 1%, another four (Germany, Sweden, Finland and the US) with yields below 1.5% and another three with yields below 2% ( Britain, Holland and Austria).
Switzerland 0.52%
Japan 0.82%
Denmark 0.97%
Germany 1.17%
Sweden 1.18%
Finland 1.44%
USA 1.45%
Britain 1.53%
Holland 1.53%
Austria 1.99%
Note that this "safe haven" status is not based on whether a country deserves it or not. British, American and Japanese government finances are messed up badly and of the above only Switzerland and Sweden have balanced budgets and a low debt level, with the remaining five countries coming in between with regard to the strength of their public finances.
Nor is it a matter of whether a country is inside or outside of the euro area, as Germany, Finland, Holland and Austria have the euro as currency and as Denmark is also a part of the euro bloc as its currency have a fixed exchange rate to the euro.
Nor is this status necessarily permanent. 6 months ago, yields were rising significantly in Finland and Austria due to market distress, to 3% and nearly 4% at most, respectively. Yet now yields have been cut in half for both.
Central bank manipulation is however one factor. The ECB's covert "quantitative easing" through banks have for example helped hold down euro area yields generally. Low yields in the U.S. and Britain may perhaps to a small extent be related to expectations of more "quantitative easing". However, if that had been the most important factor, the dollar and the pound would have depreciated in value. Instead, particularly the dollar has in fact appreciated in value, indicating that investor demand for "safe haven" assets is the most important factor.
Instead it seems clear that self-fulfilling whim from the markets is the most important factor. Investors have decided that these assets should be seen as "safe havens" and that is what makes them that. Ironically though, the only thing that's "safe" with most of them is that the people who buy them will lose some of their money, something that given the irrationality of it isn't undeserved.
President Barack Obama pauses in White House on his way to sign the reauthorization of the Export-Import Bank Act of 2012 on May 30, 2012. Karlsson argues that what many economists heralded as an uptick in economic growth last year was actually a slowing down of US productivity. (Pablo Martinez Monsivais/AP)
Economic growth, or a slowdown in US productivity?
It now appears that there wasn't much of a growth acceleration in the US after all. Terms of trade adjusted GDP rose a mere 1.2% at an annualized rate and national income was only slightly stronger during the first quarter.
This means that the somewhat higher employment growth we saw during late last year and early this year didn't really reflect as most people thought, an acceleration of economic growth from the "so low it feels like a recession" level that the "Obama recovery" of the last three years has been characterized by. Instead it simply reflected a decline in productivity
A Spanish Euro coin is photographed in April of 2010 in Bruchkoebel, Germany. Karlsson asks whether in today's economic climate, can the German surplus be reduced without reducing (and preferably in fact increasing) German incomes? (Ferdinand Ostrop/AP)
The case for a German value added tax
I have repeatedly (for example in this post) criticized the view that a reduction in the external deficits of Greece and other crisis countries necessarily requires a reduction in the external surpluses of Germany and other euro area surplus countries, because it simply isn't true.
However, pointing this out doesn't mean that I don't also think that it would be good if Germany shifted more of its production towards domestic demand instead of net exports. But how is that to be achieved in a way that doesn't hurt the German economy?
Some people have accused Germany of "wanting" a surplus, but I don't believe that, I think it is more correct to say that they want the income and the jobs generated by exports. If the income can be attained by other means then they wouldn't object to it. Quite the contrary, that would probably be perceived as preferable since that would mean that they wouldn't risk losing it through debt default from the foreign borrowers that they've lent their surplus to. So the question arises, how can the German surplus be reduced without reducing (and preferably in fact increasing) German incomes?
There are actually probably several ways to achieve it, but the best way is arguably for Germany to repeal its 2006 VAT increase from 16% to 19%, and preferably cut it all the way down to the EU minimum level (that minimum level should be abolished, but as long as it exists it does limit how much it can be cut) of 15%.
The 2006 VAT increase didn't directly hurt the German economy as much as I and other feared at the time because it was combined with reduced payroll taxes and other supply increasing reforms. However, it contributed indirectly to aggravating European imbalances and therefore also the current crisis.
As I've pointed out before, the effects of a VAT (and other consumption taxes) is basically identical to the effects of income taxes and payroll taxes on economic transactions which involve a domestic seller/producer and a domestic buyer. Both create tax wedges between the cost for the buyer and the net income of the seller.
However, while basically no difference exist with regard to purely domestic transactions, they have different effects on transactions with foreigners. The difference is that a VAT isn't directly applied to most (one exception is tourism services, which is why VAT increases in tourism dependent Spain and Greece have been destructive) exports but it is applied to imports, while by contrast income/payroll taxes aren't applied to imports while it is applied to exports. This means that if you make the kind of tax reform that Germany did in 2006, it will increase exports relative to imports and thus in Germany's case increase its trade surplus, the flip side of which was bigger deficits in countries like for example Ireland, Spain and Greece.
This also means that the most effective way of facilitating the adjustment in the crisis countries while not hurting or even strengthening the German economy would be to repeal the VAT increase and lower it back to 16% or better yet 15%.. This will increase demand for economic activities based in part on imports , strengthening both the German economy and other economies. Preferably in other not to hurt other activities the cut shouldn't be financed by higher income or payroll taxes (though such a reform would still help painlessly lower the German surplus). Instead Germany should to the extent it needs to be compensated cut government spending, though particularly given today's ridiculously low German bond yields (only 0.05% on 2-year bonds, and less than 1.4% on 10-year bonds) it could afford a short term increase in its budget deficit.
Finally, it could be objected that if higher VAT rates have hurted tourism in Spain and Greece, why won't a lower VAT in Germany also hurt tourism in Spain and Greece since it also represents a higher differential? Well, there are two reasons for this. The first is that a lower VAT in one country will expand the aggregate amount of tourism in two countries while a higher VAT in once country will lower the aggregate level of tourism. The second is that the limited amount of tourism that exists in Germany competes only to a limited extent with the kind of "warm weather and nice beaches" tourism that Spain and Greece attracts. By contrast, when Spain and Greece have raised their VAT rates they have put them at a disadvantage to countries that attracts similar tourists, like Turkey and Cyprus.
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