Facebook Blogging

Edward Hugh is only able to update this blog about once a month at the moment, but he does have a lively and enjoyable Facebook community where he publishes frequent breaking news economics links and short updates. If you would like to receive these updates on a regular basis and join the debate please invite Edward as a friend by clicking the Facebook link at the top of the right sidebar.

Monday, February 16, 2015

Spain's "Good" Deflation?

Spain's domestic economy is booming, or so the story goes, and in no small part this boom comes thanks to the arrival of what is being termed the "good kind of deflation", the sort everyone would like to have, a world where prices fall, real incomes rise, jobs are created, and everyone gets to live happily ever after. Let's not worry that in the process the boom is steadily transforming an export lead recovery into a domestic consumption - or import driven -  one.

"Deflation is like cholesterol", Economy Minister Luis De Guindos told CNBC at the WEF in Davos, "There are two kinds.....The bad one and the good one. In Spain, you know, we have the good kind," So appealing was the story he told I'm surprised many of those in his audience didn't immediately get on a plane to visit the country to try to discover what the secret was. After all, sounds like the next best thing to a free lunch. Wouldn't anyone want some of that?

Or again, we have Bloomberg's Maria Tadeo, who temptingly informed her readers last week that "Madrid is ready to party again". "A strengthening economy and a pickup in consumer spending," she said, "are energizing nightlife in the Spanish capital after a perfect storm of record unemployment, tax increases and a smoking ban put more than 400 venues out of business since 2008."
Madrid is a great place to be,” said Javier Bordas, owner of Opium, which he plans to open seven days a week. “You’ve got the football players, celebrities, and people love to party. We’re optimistic.” 
It makes you wonder why on earth support for the radical Podemos party is surging at the polls. Surely there must be a catch here somewhere?

Of course, Maria is only covering a story, an upside-bullish Spain-recovery one,  and she does point out that Spain's 23.7% unemployment rate is the second highest in Europe after Greece, but still, it couldn't be that all the intense talking-up of Spain's recovery in domestic demand is also helping to sell some of that 3.34 billion Euros worth of retail commercial property that went under the hammer in 2014, now could it?

Certainly the story must be a lot more palatable to the clique of property consultants who are currently doing the selling than it is to one of the 4 million Spaniards currently on the credit blacklist run by credit consulting firm ASNEF, who normally can't get hold of credit under any circumstances and will have a hard time joining in the current consumer "boom" even if they have a job. Spain's Economy minister Luis De Guindos put it even more graphically: "It’s hard not to defer purchases when you’ve got no money for them in the first place. In the case of Spanish unemployed I think they’ve got more worries than waiting for a new sofa suite to drop by €50."

Nor is the "good deflation" argument especially convincing to anyone with sufficient economic common sense to understand that deflation in a heavily indebted economy can NEVER be unequivocally "good". I doubt there are too many mortgage holders out there busily applauding the ongoing fall in house prices.

If there is such a thing as "good deflation" it surely comes from falling prices in the wake of productivity gains rather than from "downward stickiness" in wages and pensions.  But this is not the Spanish case since employment is growing faster than output. Spain's economy grew by 1.4% during 2014, yet employment was up 2.5%, suggesting that labour productivity actually fell during the year. So Spain's drift downward in prices is being fueled more by a demand shortfall than by supply side improvement: it's hard to see what is so "good" about that.

My intention here, however, is not to argue that Spain's economic recovery has been hopelessly one sided, which it has, but rather to try and pick my way through the ideologically-loaded minefield of arguments which are currently being advanced about the significance and meaning of the deflation phenomenon in Spain.

So, Is Deflation A Problem? 

"Deflation is a protracted fall in prices across different commodities, sectors and countries. In other words, it is a generalised protracted fall in prices, with self-fulfilling expectations. Therefore, it has explosive downward dynamics." - Mario Draghi
One of the reasons the arrival of deflation in Spain has generated so much controversy, I think, is that many doubt the country is actually suffering the phenomenon at all (see Bank of Spain Governor Mario Linde, "deflation risk in Spain continues to be low - November 2014 - or Economy Minister Luis De Guindos, "Spain is not at risk of sliding into deflation" - December 2014). Beyond policy makers and those whose job it is to "talk up" the Spanish recovery there is also little perception that it is a real issue, possibly because many have come to doubt so many of the things the administration says that they aren't even sure yet prices are falling. Beyond petrol and house prices the fall is so small it's not easy to perceive, especially when reductions are not shown in the form of like for like changes, but in the form of more complex "offer" and "discounts".

In fact statistics show that consumer prices were down in January by 1.5% over January 2014, while the GDP deflator for the whole of 2014 (the figure that is used to estimate the impact of inflation on overall output) was estimated at minus 0.7%, meaning that the inflation corrected rise in GDP of 1.4% was only half that number, so, statistically speaking at least, it is important.

But beyond those who simply - perhaps for definitional reasons - doubt that Spain is experiencing deflation rather than simple disinflation there are those who doubt falling prices really constitute a problem. This is the so-called "good deflation" argument. The FT's Tobias Buck sums up many of the arguments in his article "Spanish Consumers Defy Deflationary Gloom",and economist/blogger Shaun Richards has a more theoretical version of the argument here.

The gist of the "good deflation" case is pretty simple: on the one hand countries like Spain need falling prices and some kind of "internal devaluation"  in their ongoing attempt to restore international competitiveness, and on the other consumers aren't "so" rational as to engage in long and complex calculations across infinite time just to work out whether it is better to purchase now-or-later  products whose price is falling by only 1% a year.

At this point it is perhaps worth noting what Mario Draghi says deflation is. Deflation, he tells us, "is a generalised protracted fall in prices,  accompanied by self fulfilling expectations which has explosive downward dynamics".

Well in this sense little in the way of conclusions can be drawn from Spain's initial contact with falling prices, since hasn't been that protracted (yet) and certainly has not developed self-fulfilling expectations: most people in Spain regard the situation as transitory. The self fulfilling part of the definition relates to the possibility of a downward wage-price spiral which mirrors the kind of spiral we see under inflationary dynamics but in the opposite direction. As prices fall, then wage reductions can be offered - as we have seen in Japan - to maintain real wages constant and these wage cuts then fuel further drops in prices. None of this is very evident in Spain so far, even if wages have fallen at some points in the crisis, and with this being election year, the process is unlikely to take hold in 2015.

As for the "explosive dynamics", I presume the explosive part refers to the impact of a wage price downward spiral on debt affordability, since debt to income ratios are constantly pushed up.

The idea that economies move into an outright contraction spiral simply because a small fall in prices is repeated over a number of years is a curious one, whose origin isn't clear, and whose reality is to some extent denied -  as FT Alphaville's Matthew Klein points out in a post entitled "Did Japan Actually Lose Any Decades" - by the fact that Japan's economy is widely believed to have performed "tolerably well" all through the deflation years, with weaker consumption growth being more due to declining population (a problem which may also affect Spain in the future) than it is to a supposed phenomenon of  "purchase postponement". It's only when you start to look at Japan's 245% debt to GDP level that you get to see where there might be a problem.

Even in the case of technological products, where price falls are constant and significant, people seem more likely to look for a combination of price and  performance, since improvements are ongoing and unending, yet people do buy.

 So if people are largely agreed that small but constant price falls don't, in and of themselves, produce widespread purchase postponement, and recognize in addition that Spain needs weaker inflation than Germany, then, you might ask yourself, why on earth are policymakers worried by the phenomenon? Yet worried about it they are, since if they weren't why would the German government be acquiescing in sovereign bond purchases at the ECB (which in principle it is opposed to) to try to stop it digging in for the long haul?

Assuming you don't write this institutional concern off as yet another example of things only economists worry about, and go on to ask the question you are likely to encounter three basic explanations: i) not all price falls are small, ii) there is an interest rate impact and iii) those who are burdened by debts become even more burdened as time passes.

Purchase Postponement in Housing

Spanish housing offers us a clear example of something whose price has fallen considerably, around 40% since the 2007 peak, and whose price continues to fall (currently in the 3% to 5% per annum range).

Far from this fall in prices having stimulated demand - the deflation "consumption boom" argument - we are witnessing exactly the opposite effect: demand has collapsed, and is not recovering significantly (see my piece from April 2014, "Firmly Anchored Expectations, No Postponement of Purchases?"). This is not surprising, since housing is a special sort of good (combining both use and investment) and the market is one where price movements tend to be self re-inforcing.

The Spanish housing market is still far from functioning normally - the number of new houses purchased in December was just over 7,000 - the lowest monthly level in more than a decade.

True, the number of second hand houses being purchased is rising, but even the combined total is far from showing a sharp rebound.

Perhaps the most worrying thing about the fact that second hand purchases are improving while new ones aren't is that part of the explanation for this is that properties become reclassified as "used" 2 years after completion (so some of the second hand houses being sold are in fact new), but this makes the situation with new houses deeply preoccupying, since there are more than half a million unsold housing units still classified as "new" (see this article on the Spanish property website Idealista) which means they have been built within the last two years.

The problem with the arrival of deflation in Spain is this is going to create an environment where it becomes even more difficult  for the housing market to really recover. In the meantime, constantly falling prices have had one consequence: Spaniards now prefer renting to buying, they have become more aware of the risk involved in owning a property. So perhaps rather than simple purchase postponement process what we should be looking for are a broader set of behavioral changes over the longer term.

In any event, given the importance of the Spanish housing market to the economy in general - 75% of the country's household wealth is tied up in property - the situation cannot be ignored: ending deflation in Spain would help push house price movements back into positive territory, and in so doing would give a significant boost to the Spanish economy.

Then There Are Borrowing Costs

Moving beyond the issue of the supposed "purchase displacement effect", Mario Draghi has a rather more powerful argument: the interest rate impact. Consumption growth in modern economies is as much about credit as it is about spending from current income. Too many people are still thinking about economic dynamics in terms of confidence and  money stored under the mattress, or as some whit of a Bloomberg journalist put it, burying it beneath bathroom tiles. Credit matters to modern economies, as we have seen during the recent "credit crunch". As consumer credit accelerates, economies grow, and normally when this happens central bankers started raising interest rates to slow credit growth. In general I think it is fair to say that those who think there is "good deflation" in Spain and those who think Spanish deflation is "not so good" agree about this.

Yet credit, curiously, is all about the temporal displacement of purchases. When credit is cheap, and inflation is expected to be present, consumers tend to advance purchases. I don't know whether anyone wants to challenge this, but it is the cornerstone of any kind of interest rate policy. It is what gives the central bank, under normal conditions, the ability to apply counter cyclical policies in the face of recession. If this mechanism doesn't work, then there is a problem in the whole way we have been thinking about things.

Once interest rates reach the zero bound (I think it is impossible to separate discussion of deflation from the issues which arise in the context of a zero bound) then this mechanism hits a limiting factor, since while prices are in negative territory conventional central banking theory makes bankers reluctant to follow by taking interest rates even deeper into negative territory (although, it should be said, we are now increasingly seeing the negative nominal interest rate phenomenon in countries like Sweden, Denmark and Switzerland). As Mario Draghi put it answering questions at the ECBs December 2014 press conference:
 "Now, let me make absolutely clear that we won’t tolerate prolonged deviations from price stability, and the main reason is that if these deviations feed into inflation expectations, they’ll cause a drop on medium to long-term inflation expectations, which by the way still are within a range consistent with medium-term price stability. But if these were to feed into inflation expectations, these lower outcomes of inflation, were to feed into lower inflation expectations, we would have a zero lower-bound nominal interest rate. This would be tantamount to an increase in the real interest rate."
Here we find some key word expressions: prolonged deviations from price stability, lower long-term inflation expectations, increase in real interest rate. This situation is rather different from the one described by the Spanish economist Javier Andrés in the Tobias Buck article I mentioned earlier: “The fall in prices", Andrés argued, " is not strong enough, nor is it perceived to last that long, as to make it worthwhile for consumers to postpone the purchase of goods.” In Spain at the moment the deviations from price stability have not been strong enough or perceived to have lasted long enough to have an impact on consumer expectations.

In fact  deflation has been settling in for a lot longer than people in Spain think it has. Many still believe that the recent negative inflation is simply the result of a negative oil price shock, but if we look at the EU HICP rate excluding energy it is clear that the deflation issue started a lot earlier.

 Another issue which has clouded the Spain deflation issue has been the use of consumption tax increases as a deficit reduction measure.The national statistics office maintain an ex-tax estimated EU HICP inflation rate, rather like the one the Bank of Japan maintains following the consumption tax rise in that country. Obviously if you raise a consumption tax you raise inflation, but this kind of inflation is not thought to be positive (as we are seeing in Japan, the country fell back into recession after the increase) as it weakens consumption (as the various VAT rises have in Spain).  

The ex-tax consumer price index tries to estimate underlying inflation without the tax, and - as the chart below reveals - if we use that measure Spain has been hovering in deflation territory since late 2012. However Spain's citizens seem to have a kind of "inflation bias" after many years of highish inflation, and simply refuse to believe that prices really have started falling.

In fact if we now adjust that earlier HICP excluding energy data and produce a constant tax version, we get a chart which looks like this.

This suggests that Spain has been near to deflation ever since the global financial crisis struck, but that the initial recovery produced an inflation surge as wages and prices across the economy reacted upwards  (price rigidity, things going back to normal in terms of expectations). Now that shock has passed and the underlying trend towards deflation becomes obvious.

Mr Draghi is worried (although NOT Mr Linde, or Mr De Guindos, as we have seen) that if the current trend is not corrected Spain's citizens might eventually begin to believe and expect it, which is why he gives more importance to the issue and is taking measures accordingly. Indeed, such is the importance which EU - as compared to Spanish - policymakers give to the issue they are taking the measures even though their mere announcement has started causing a great deal of difficulty for central banks in countries like Switzerland, Sweden and Denmark. Again, it is noteworthy how by and large these central bankers are accepting such difficulties without protesting too much since they understand why Mario Draghi feels forced to implement them.

Mario Draghi argues that falling inflation expectations raise real interest rates by influencing the perceived cost of credit into the future. If consumers anticipate inflation, then that makes borrowing cheaper and people tend to advance purchases. Conversely expected price falls make the cost of borrowing greater, make the desirability of advancing purchases via credit less, and in this sense constitute monetary tightening. I am aware of an ongoing debate about whether interest rates really are a key factor influencing investment decisions, but I have never seen an argument suggesting that the cost of credit does not influence consumption. And so it is in Spain, since the demand for household borrowing is not surging, even though the country's banks keep telling us they are now "ready to lend".

Deflation Favors Savers Not Debtors

Deflation obviously favors those with money in the bank (unless the banks start charging negative rates on time deposits) since the value of money steadily goes up. It is not so kind on those with debts, since as prices and incomes go down, debts remain unchanged and the burden of paying them increases.

Spain is an endebted country - the net international investment position (NIIP) is negative to the tune of around 100% of GDP - so it isn't the first place that comes to mind when you think of some kind of "good deflation" process. Japan, in comparison, has a positive NIIP of around 50% of GDP, making it a very different case.

The various sectors in Spain's domestic economy are also very highly indebted, and the combined debt of government, households and the business sector comes to about 275% of GDP, not that much less than it was at the start of the crisis. This is because while household and corporate debt has reduced, government debt has increased considerably. All of this means that if deflation sets in it will be a serious problem for Spain.

Spain's external correction still has some way to go in terms of price competitiveness, but having so called "good" competitiveness recovering deflation is not the way to do it at this point, due to the debt impact. This is why ECB policy is directed towards trying to stimulate Euro Area inflation, since obviously if countries like Germany had 2% annual inflation and Spain and others had 0.5% the correction would be a lot less fraught with problems.

Why Is It Likely Deflation Will Continue In Spain?

There are basically two theories why Eurozone countries are suffering from deflation at the moment. One of these is the idea of debt deflation, whereby over-indebtedness creates a consumption drag leading to a shortage of consumer demand while countries deleverage.  This is certainly part of the problem that Spain is experiencing.

But there is second theory going the rounds ever since it was put into circulation by US economist Larry Summers at an IMF research conference in the autumn of 2013. The hypothesis Summers advances is based on ideas developed by Alvin Hansen in the 1930s, and the essential point is that countries like Japan and those in the Euro Area are experiencing some kind of demographically driven secular stagnation. This is not the place to go into this theory in any depth, but basically the idea is that as working age population growth slows, comes to a halt and then turns negative consumer demand starts to weaken and eventually decline. This affects the investment process, and it is the structural "underinvestment" which produces the demand shortfall which means there is constant downward pressure on prices.

Paul Krugman provides a useful summary of the argument in his blog post - "Demography and the Bicycle Effect" - and I offer a summary here.Of course, at this point it is only a hypothesis - the worrying thing is that in Spain the possibility that this might be happening hasn't even been considered, let alone rejected.

So What Is It - Good or Bad Deflation?

At the moment Spain's citizens have mainly seen only the good side of deflation: wages and pensions were up while prices fell. Spanish hourly wages rose an annual 0.6% year on year in October 2014 (last date for which we have available data) according to Eurostat, Spain's pensions were up 0.25% (despite the pension system running a loss of 1.3% of GDP) while consumer prices were down 1.1% year on year in December. In addition 400,000 new jobs were created during the year. It is little surprise then to discover that the statistics office report that price corrected retail sales were up 1% on the year in 2014.

The question is, what happens next? Do workers and pensioners continue to receive above cost-of-living wage and pension increases? This being election year the chances are they do, which means more pressure on profit margins and more withdrawals from the pension reserve fund. And in the longer run, is this sustainable, or will wages and pensions start to fall in line with prices, producing the so called "spiral"?

To get answers to these questions we will need to wait to see in the years to come, but in the meantime important changes may be occurring in consumer behaviour, not only in attitudes towards house purchase, or in terms of any supposed "postponement" activity, but simply in the way people are becoming more sensitive to price movements and bargains. In this context, Justin McCurry's New York Times article on the Japanese experienece - "Spectre of deflation horrifies bankers, but Japan now has a taste for it - makes interesting reading. In particular his conclusion:
"Spending habits honed over 20 years die hard. And if Japan’s experience can teach Europe anything, it is that government attempts to haul consumers out of the deflationary abyss are fraught with difficulty. An entire generation has come to embrace the deflationary devil they know. For the population at large, what started life as a reluctant thrift habit borne of necessity has quietly become the economic version of the Stockholm syndrome."
And here's another piece of evidence from Japan (The Real Housewives of Japan: Shopping for Bargains … Driving Deflation?) highlighting how years of deflation have lead customers to expect price discounts, and have come to leverage online and social media in the search for ever better bargains.
Could 70,000 Japanese housewives tip this Asian giant into a deflationary spiral? As farfetched as that sounds, it's become a major cause for concern in this nation of 128 million, which has been in an economic funk for two decades. These "real housewives" are part of a user-driven, social-networking site called Mainichi Tokubai, which delivers the best prices on specific grocery-store items to the fingertips of Tokyo-region consumers. To hear frustrated Japanese policymakers and retail executives tell it, these bargain-minded consumers and their equally frugal social-networking site are almost-single-handedly undercutting the Japanese economy.
The above article particularly caught my attention since this is a phenomenon which is increasingly to be seen at work in Spain: people shopping around and expecting bargains, and using online media to help them in their search. In deflationary times the evidence suggests the rise of a kind of "consumer power" where people come to expect permanent sales and discounts and virtually force these on retailers, to the great disadvantage of the small, local shop. This kind of behaviour obviously fuels deflation and when entrenched it is hard to change as Stanley White noted in a 2012 Reuters article.
"A bargain-hunting psychology is so entrenched in Japan — after two decades of stop-start economic growth, 15 years of falling wages and nearly 15 years of deflation — that the government will struggle to convince people that their incomes will improve enough for them to buy more expensive goods.
Spanish policymakers take note, and think twice in future before you say Spain is simply suffering from "good deflation".

Saturday, October 18, 2014

Open Letter to the Economist on Catalonia - J'accuse

Those who have interest in neither Catalonia nor the issue of journalistic standards will probably find this posting long, tedious, and not especially interesting. Perhaps you might like to stop at this point. Those of you who are interested in one or other of these, well, I invite you to read on..... 

 To The Editors Of The Economist

I am writing this missive addressed to you as I am outraged, nay scandalized, by the level of your reporting on the Catalan question. The source of my discontent are two recent pieces - both signed by one GT - the first of which appeared on the Charlemagne Blog (Getting to “sí”, 19 September 2014), while the second was published under the rubric The Economist Explains (Catalonia’s independence movement,14 October 2014.)

Of the two, I consider the second much more reproachable since it purports to be an informative document, and not a mere opinion piece. My issue with your journalist is not his opinion - to which any journalist is entitled - but that he attempts to pass off opinion as fact.  My view is the that the level of journalism being demonstrated is  not what you should be seeking in a publication with your high level of international prestige.

At the end of the day, of course, whether this is the case or not is an editorial decision on your part. I fully understand why the Economist originally took the decision to publish non-editorial unsigned articles, but in the modern age I think this be a double edged sword as it leads to confusion about what is an Op-ed and what isn't. Personally I think the practice is now more trouble than it's worth, but again that's for you to decide.

In order to try and demonstrate my case I have gone to the rather tedious lengths of re-reading the two offending articles and identifying what I consider to be factual inaccuracies (see below). 

 In a personal mail addressed to me, GT says he admires President Mas, and even describes the new Catalan "consulta" as a brilliant move. It is a pity he couldn't have brought himself to express such opinions in the articles. My reproach is not related to any one phrase or statement, but to a long history of the same over many years.

My feeling is that in the present context, and with so much for the whole of Europe at stake here in Spain both politically and economically in the coming years, what GT does verges on the irresponsible, especially in an article with the header The Economist Explains. Curiously for an article with such ambitions it is striking that the ANC (Assemblea Nacional Catalana) which is the key civil society organisation promoting the independence drive) doesn't get even a mention.

In his mail GT tells me he is critical of Mr Rajoy, but frankly in his last two pieces this criticism is hardly noticeable. My "j'accuse" is based not on this factual inaccuracy (or superficial assessment) or that one, but on the fact that quantity eventually becomes quality. Despite claiming to admire Artur Mas the sum total of GT's "comedy of errors" makes the Catalan President look more like a character from Hotel Faulty, a sort of mediocre, run of the mill politician who was busying himself "ploughing another furrow" when the indy movement snuck up on him and forced him to try to "regain control". He is seen as a politician who is almost permanently under threat from the "Manuel" (or Sancho Panza) type character (Oriol Junqueras, leader of the openly separatist ERC - "my name is Oriol and I come from Barcelona") who is constantly threatening to wreak havoc with his best laid plans. Funnily enough there is a popular weekly satire programme on TV here which does something similar, but that programme, evidently, is just that, satire.

Getting to “sí

"On Friday Catalonia's parliament passed a so-called “law of consultations”, with a view to allowing Mr Mas to call a referendum on November 9."

This - that what the Catalan Parliament intended to enable under the "law of consultations" was the holding of a referendum - is just plain wrong. The law enables only popular consultations, and this was always its intention. Whether the vote called under the initial decree issued under the law was in fact a referendum is disputed, and vigorously so. The Catalan side argue it was an opinion-sounding vote, with no legal consequences, and have appealed to the Constitutional Court on just these grounds, against the Spanish government submission that it is de facto a referendum. The court has not yet ruled on this issue. When it does it is quite possible that it rule the law as such (possibly with some amendments) falls within the competences assigned to the Catalan Parliament under its charter, but that the question that was to be put is not covered by the law since it may be considered to constitute a referendum. But since the "with a view to"  words constitute an opinion about what was in the heads of the members of the Catalan parliament at the time of voting, all I can say is that there is no evidence to support this view.

Now, there is no harm in putting both sides of the argument, but I do think it is incumbent to put BOTH sides of the case. Also, it would be quite legitimate for GT to take the view it was a referendum by another name, but I do think he should make clear that this is his opinion. If you don't mention that the Catalans considered their attempted vote a "consulta" not a referendum - one without any evident legal consequences - then it's hard to make sense of everything that has taken place subsequent to the suspension, and especially it is difficult to explain how the new vote that has been called for the same day with the same questions differs from the suspended one. Apart from the legal framework in which it is to take place, to all appearances it doesn't.

"If Mr Mas obeys and cancels the referendum, his minority nationalist government, propped up by the separatist Catalan Republican Left (ERC), may fall."

Again, GT refers to "referendum" as if it was clear that this is what it would have been. As can be seen, President Mas cancelled the order authorizing the vote but his government didn't fall. It was never going to, and I think only people in Madrid ever believed this to be a  possibility. In order to understand why this was always going to be a highly improbable outcome maybe you do need to be familiar with some very simple "game theory".

"In the most extreme one, Mr Mas could stage an illegal referendum, with police moving in to remove urns and Madrid suspending the Catalan regional government's right to rule."

Well let's imagine that President Mas was to call an illegal "referendum" (not totally ruled out, but unlikely since he has continually insisted on his desire to work within the existing legal framework, or at least within his legal advisers' interpretation of it). The scenario GT depicts leaves me with one very basic question: where would these police come from? The number of Guardia Civil and Policia Nacional in Catalonia is very, very small. The vast majority of police in Catalonia are either local (municipal) police or belong to the body known as the Mossos de Esquadra, a Catalan police force under orders to the Generalitat de Catalunya. So this was a silly, unrealistic scenario. If the government in Madrid do move against the Catalan government, in my opinion,  it will be through the courts and through cutting-off finances. Maybe even trying to suspend the Statute of Autonomy under which the Catalan Parliament operates.However legal experts here question whether - despite the threats to do so that have on occasion been made - they in fact have the power to do this under the terms of the Spanish constitution. So it is possible that any hypothetical suspension of the "right to rule" may in practical terms need to involve some sort of suspension of the very constitution Mariano Rajoy declares he is determined to defend. That would be ironical, wouldn't it?

"Catalonia cannot negotiate to win more such powers from Madrid, for the simple reason that it already has them."

Well, again this is just an empty silly argument, since it is obvious there will eventually - as in the Scottish case - be third way proposals (maybe even a West Lothian question) as GT admit in his second article. There is no theoretical limit to the amount of devolution that can take place within a federal state. Especially if we start talking here about bi-lateral federalism for Catalonia. Again, he later points out, maybe many Catalans would vote for a new type of arrangement along these lines, and indeed this is why the consultation question is framed in two parts, so people can vote for the option of a (federated) Catalan state within Spain. If GT were to argue that maybe Artur Mas is ambiguous on this point, I would say that view is legitimate. As a democrat I suspect President Mas would go along with what he felt a majority of Catalans wanted. On the other hand I'm not sure I've seen any reference to the fact that there are to be two questions, or any analysis of the significance of this fact in any of his published material.

Catalonia’s independence movement

"The regional government of Catalonia ..... was planning to hold a non-binding referendum on independence on November 9th."

Well again, this is a one side way of putting it (see above) the continual repetition of which brings into question GT's independence on the matter.

"On October 14th the Catalan prime minister, Artur Mas, announced that some form of "consultation", involving "ballots and ballot boxes", would go ahead anyway on November 9th, regardless of the Court's decision."

Well exactly, this is simply the earlier consultation without any decree behind it, since President Mas is gambling that without a decree the Madrid government can't go to the constitutional court to get a decree which doesn't exist suspended. As GT says in his mail to me, it's a brilliant stroke. Since the Catalan Parliament never considered the  9N vote a referendum, neither version could be considered to have legal consequences, the only force they can have is political, in demonstrating people's opinions. At the international level these political effects should not be underestimated, hence, I venture to suggest, Mariano Rajoy's desire that it not take place.

"The two motors of the new wave of separatism are Spain's economic woes and a 2010 Constitutional Court decision to strike out part of a renewed charter of self-government that had been approved at referendum."

This is undoubtedly true, but maybe it would have been helpful to have mentioned WHICH part of the charter was struck down - the declaration that Catalonia is a nation. This is especially relevant since it is at the heart of the current issue, and also in the light of his next comment. The fact that this little word was struck out following an appeal from the Partido Popular to the constitutional court after a "popular participation" protest which involved the collection of a large number of signatures is possibly also relevant. President Mas is simply repeating this performance in reverse.

"Many Catalans, who speak their own language as well as Spanish, believe their taxes pay for poor, lazy southerners to live off government hand-outs."

As well as the fact that they speak that language maybe he could have said a bit more, especially about how the Catalans now feel their language - which was of course banned during the Franco years -  is once more under threat. Recent developments in Valencia, the Balearic Islands, Aragon (where there are significant Catalan speaking communities) are seen as a clear sign of an intention to limit use of and familiarity with the language. The most recent Spanish educational reform which attempts to influence the quantity of teaching in Catalan in Catalan schools is also highly contentious and important in understanding the current strength of feeling.

In addition, the second part of his sentence is little better than an Andy Capp type caricature. The quantifier "many" often hides a multitude of sins. Many Germans think something of the kind about Spaniards in general, but I doubt it is a majority. The same is true of Catalans. What Catalans want is to be able to decide what to do with their own resources.

They also want to be recognized as a nation and not continually told there is only one nation - the Spanish one - of which (under the terms of the constitution) they are all compelled to form part (whether they like it or not).

"Mr Mas has been caught unprepared by this wave of separatist enthusiasm. He responded first by demanding new tax-raising powers from Madrid."

Well, this is one of the issues where I feel GT has things totally back to front. Artur Mas, like the ANC - who he somehow manages to avoid mentioning even once in what is supposed to be a background information article - and everyone else, was as he says surprised by the *size* of the 2012 demonstration, and this undoubtedly encouraged him to move forward more quickly with a project he was already working on - the Catalan "national transition" - and recognise the leaders of ANC and Omnium Cultural as legitimate leaders of Catalan civil society.

No man is an island, and President Mas himself had been evolving as part of this growing separatist feeling since 2006. It was around that time he first started talking about moving towards a "national transition". This transition was already conceptualized as creating the institutions necessary to move towards independence.  A declaration of some kind of statehood was always going to be the end point. So he was himself fanning the flames. He was  not simply a late opportunistic add-on to the developing idea that Catalonia had gone as far as it could within the terms of the 1978 constitution.

On the isssue of the tax proposal GT is just plain wrong: President Mas's tax proposal was not a hasty response to the arrival of a wave of separatism. It was an idea he had been working on all through his years in opposition. Certainly he seems to have been quite happy when Rajoy (perhaps foolishly) greeted this proposal with an outright  "no", since this meant he could then move on to the next stage in the project. I think the size of the separatist movement lead him to accelerate his plans, and shorten the time scale of the "national transition".That is all.

"When they [the tax powers] were refused he called a referendum, knowing it was likely to be banned. It has not been enough to convince voters:"

What is the insinuation behind "knowing it was likely to be banned"? That it was all part of a carefully calculated plan - just another step towards the "elections as a referendum move"? Mas as Machiavelli? Or is GT suggesting that he was simply trying to throw sand in the voters eyes, to stall for time. The general gist of his argument leads towards the latter conclusion, so if he wanted to make the former point may I suggest that there are better ways of doing so. Like saying "this was also brilliant".

"Spain's conservative prime minister, Mariano Rajoy of the Popular Party (PP), has refused to call a referendum, which has only stoked support for one"

Mariano Rajoy, to my knowledge, has not been asked to call a referendum at any point, so he has not refused to call one. The Catalan parliament in the spring of this year asked the Madrid one  to authorize them to hold one - as had happened with the earlier referendum which was held over the new charter in 2006  - but this time the Madrid parliament refused. Once a referendum became impossible the Catalan parliament decided to go for a "popular consultation" - the legal aspects of the two - as I keep saying - are rather different. I suggest that the fact that GT didn't distinguish between referendum and "consulta" in the first instance leads to this kind of confusion. maybe he himself was confused.

"It [the Spanish government] also refuses to countenance the opposition Socialist Party's “third way” approach, which would involve constitutional reform to give Catalonia still more power and make Spain more federal. Polls show such reforms could bring support for independence below 50%."

See my point above, this is the reason more autonomy could clearly be offered, as happened in the Scottish case. And is indeed one of the few occasions on which GT criticizes Mariano Rajoy.

"Mr Mas's pseudo-referendum is still due to go ahead on November 9th, though it will have no legal consequence."

Well, we're back to the same old issue. What would have been the legal consequence of the suspended vote? None. What will be the legal consequence of the new vote? None. What's the real difference? None.

Essentially the two votes are one and the same - same questions, same date, same ballot papers, same ballot boxes -  and serve the same purpose, to find out what those who want to vote think. "No" supporters would not vote in either case, so we are only talking about getting a rough idea of who would vote "yes-yes" in a full referendum.

The use of the expression "pseudo referendum" irks somewhat here, since it sounds remarkably like the Catalan PP leader Alicia Sanchez Camacho's disparaging "refèrendum de costellada" (Sunday afternoon barbeque referendum). Pseudo (unlike say surrogate, or placebo) is normally used very negatively in English.

"The “no” side has either refused to engage or, where it has spoken up, been drowned out."

I dispute this. Both parts. Plenty of people have come to Catalonia from Madrid and other areas of Spain to argue in favour of "no". Both putting the constitutional case for "no" vote (rather than "no" in the vote) and arguing Catalonia is better off inside Spain. What hasn't existed is a "better together" campaign since there has been no third way offer to campaign for, and an assumption that there will be no vote. I also see no evidence of people being "drowned out". Plenty went to the Plaça Catalunya on 12 October (maybe 50,000) to show their support for staying in Spain. If  people think that more than a small minority actively oppose independence, then the best way to find out is to have a real referendum and see. Constant insinuation achieves nothing.

GT also misses the key point about the  elections as referendum proposal: this - in President Mas's opinion - is the only way to get the "no" side to actually campaign and vote - a key point in his international legitimization strategy.

"Mr Mas may now be forced to call early elections."

President Mas is not going to be FORCED to call early elections, as GT obviously knew since he explained to me he watched a video of the relevant press conference. The Catalan president is actively promoting them and sees these as the best way forward. In fact he is struggling with the other parties to get them to accept this idea and join a common list.

"The likely winner would be the radical ERC, which would lead a regional government encouraging civil disobedience, if the party sticks to its current position."

So again no, the likely winner wouldn't be ERC but the "yes-yes" vote. Mas has said he won't call early elections unless a common platform is agreed to.  His mandate extends to November 2016. He doesn't even need the support of any other party to pass the 2015 budget since he can simply extend the validity of this year's in the same way he did this in 2011 with the 2010 ones he inherited when he came to office.

You could, like Oriol Junqueras suggest he has electoral purposes in taking this stance. That is a matter of opinion. Think again about game theory and the prisoner's dilemma. The outcome of those elections wouldn't, in his opinion,  be an immediate UDI, but hey, guess what, Artur Mas's blessed national transition - which it is suggested would last 18 months - during which time an attempt would be made to create the institutional infrastructure necessary for UDI. In fact he has has an advisory body on the national transition at work since the November 2012 elections preparing all the documentation and strategy precisely with this in mind.

Naturally Madrid would probably not stand idly by - see comments above - but that is not what we are talking about here.

Tuesday, September 16, 2014

What Is The Risk The Euro Crisis Will Reignite?

The euro zone crisis is not back -- at least not yet.

Recent movements in global markets following concerns about Portugal’s Banco Espirito Santo really had as much to do with market nerves after a long spell of repressed volatility as it did with the state of the bank’s balance sheet. Despite the current calm, everyone knows that volatility will return one day, and no one wants to be caught on the back foot when it does arrive. So the initial response is to hit the “sell” button and then ask questions.

Beyond this context, there is a lack of certainty in the market about which way bond yields for the so-called “peripheral” euro zone countries are heading in the near term -- and what exactly the risks associated with holding them really are. Riding the yield compression, in the case of the Portuguese 10-year bond from over 7 percent to under 3.5 percent was a one-way-bet no-brainer once the impact of Draghi’s July 2012 speech became crystal clear.

But now yields have started to tick up again, so the advantages of holding in anticipation of further declines become less obvious, while the risks continue to mount. In many ways, the situation is analogous to yen depreciation and the Bank of Japan. The first leg was easy, as the yen fell into the 100 to 105 to USD range. But now it is stuck there, and the debate has become a “will she, won’t she” on further BoJ easing.

It is clear the recent European Central Bank decision to launch Targeted Long-Term Refinancing Operations has disappointed. TLTRO's may do something to help ease access to credit in the south in the mid-term, but they will hardly be effective in combating deflation. In particular, we may need to wait more than six months to see any net liquidity impact, since the September and December allocations coincide with earlier LTRO repayments, leaving what Pantheon Macroeconimcs’ Claus Vistesen calls “a potentially worrying ‘air-pocket’ over the next six months where the central bank’s balance sheet continues to contract, making the verbal commitment to easing increasingly difficult to rely on as a sole back-stop."

Will we really have to wait till 2015 to see any significant step to try to stop the deflation rot?

Digging deeper, and beyond fears about what the coming ECB bank stress tests may turn up, the simple passage of time in itself could complicate things. The recent round of  numbers has had everyone busily revising down their 2014 growth forecasts, and it is obvious that even if outright deflation is avoided inflation will be very, very low. In fact whether or not the Euro Area slumps back into outright recession or not seems to depend more on Vladimir Putin than on the ECB at the moment,

But the key point to take away from all this is that nominal GDP over the next couple of years may barely increase, with the knock on consequence that sovereign debt levels in the most indebted countries will surely be jolted onwards and upwards. This is important since all official sector projections have these levels peaking either this year or next, but now these estimates will surely need to be revisited.

Second quarter GDP data was horribly bad. France's economy stagnated, but more worryingly for policymakers Germany relapsed (minus 0.2 q-o-q), leaving Spain as the only one of the "big four" to put in a positive growth performance (0.6 q-o-q). While the immediate drag on short-term growth may well be the impact on sentiment of a crisis on the frontier between Ukraine and Russia,  the Euro Area  is now clearly stuck in some form of longer term secular stagnation. The daylight just around the next recovery corner argument rings hollower and hollower with each successive loss of momentum.

"Europe is becoming Japanese" is an expression you hear more and more. People saying this normally point to the fact that German 10 year bund yields have now gone under 1% (and hence have started to look like 10 year JGBs).

But behind this argument lies some sort of version of "reverse causality". In Japan JGB yields have been driven to very low levels by central bank intervention, with the BoJ now buying a very large share of all new issue. The ECB isn't buying Euro Area sovereigns, the markets are in anticipation of QE.  So to talk about the Japanification of Euroa Area yields is a little misleading. Bond purchasers and their models are PROVOKING this downward lurch, not weak growth or deflation. To push Mario Draghi into QE markets would need to move back into risk-off mode on periphery assets. As long as the bond markets remain well behaved Draghi will do as little as possible, as I will discuss below.

Another argument used to justify the "Japanisation" of the Euro Area idea carries much more clout, and that is the one being used by Paul Krugman based on working age population dynamics.

"If you’re worried that secular stagnation might be depressing the natural real rate of interest — the rate consistent with full employment — and you think that demography is a big factor, Europe looks really terrible, indeed full-on Japanese."
The basic idea is that working age population dynamics play a big part in determining movements in aggregate demand and hence inflation (see my secular stagnation summary here). This idea received support from a research paper published at the start of August by a group of IMF economists - "Is Japan’s Population Aging Deflationary?" (authors Derek Anderson, Dennis Botman and Ben Hunt). The first part of the abstract runs as follows:
"Japan has the most rapidly aging population in the world. This affects growth and fiscal sustainability, but the potential impact on inflation has been studied less. We use the IMF’s Global Integrated Fiscal and Monetary Model (GIMF) and find substantial deflationary pressures from aging, mainly from declining growth and falling land prices. Dissaving by the elderly makes matters worse as it leads to real exchange rate appreciation from the repatriation of foreign assets. The deflationary effects from aging are magnified by the large fiscal consolidation need."
Bottom line, despite all the denials from Mario Draghi that the Eurozone is not another Japan there are plenty of grounds for thinking that it will be.

So Which Way For The ECB?

Evidently members of the EU Commission, ECB governing council members, and senior political leaders in Berlin, Amsterdam or Paris are neither theoreticians nor intellectuals. The secular stagnation hypothesis is at this point more akin to a theoretical research strategy than a workable template for policy-making, and policymakers are understandably reluctant to take decisions on the basis of what is still largely a hypothesis. As the editors of a recent book on the topic put it in their introduction: "Secular stagnation proved illusory after the Great Depression. It may well prove to be so after the Great Recession – it is still too early to tell. Uncertainty, however, is no excuse for inactivity. Most actions are no-regret policies anyway". As they suggest the risks here are far from evenly balanced. If countries like Japan, Italy and Portugal are suffering from some local variant of one common pathology, then normal solutions are unlikely to work, and matters can deteriorate fast.

Naturally the ECB can go down the Abenomics path, and institute large scale sovereign bond purchases even while the Commission turns an increasingly blind eye to higher deficit spending at the country level. But it is far from clear that Abenomics works (see here) and if it doesn't what happens to all the accumulated debt?

On the other hand time always has a cost. Letting things drift further means letting debt levels rise, and risking testing market patience and this becomes especially important in the cases of Italy and Portugal. The longer time passes the more difficult it is going to be for anyone to convince themselves that the debt of these countries is sustainable.

So there may come a point after which the Germans simply will not allow Draghi to buy Italian bonds without a prior haircut (see my "Italian Runaway Train" here). OK, they've said they won't do more PSI, but they've said a lot of things, and the cost of irritating investors is limited when you have a regional current account surplus and a central bank buying bonds.

Maybe the costs of the Euro "widowmaker" trade will be borne by all those eager bond purchasers who thought nothing could possibly go wrong. I am sure German politicians would decide a loss of credibility on PSI would be less costly to them than getting German taxpayers on the hook for current Italian debt levels. Especially in a country where they are now proudly announcing they have reduced government debt for the first time in more than 50 years. So in this case, maybe the turkeys just did vote for Xmas.

The thing is, despite the meeting between Draghi and Renzi (who may also be a turkey by Xmas) nothing substantial is going to happen in Italy. The government is under no pressure to ask for help (and doesn't even feel it needs it), and Draghi won't act before things change. Gridlock - with rising debt.

Naturally in the short term the “Mario Draghi ultimately has my back” feeling will still prevail, but with markets continuing to finance debt levels that any official study will soon have to recognize as unsustainable lack of proactive policies from the ECB will only fuel concerns that the size of the pill may become just too big for the bank to persuade Germany comfortably swallow, leaving the specter of private sector involvement to once more rear its ugly head. How do you tell people who have just sacrificed hard to get their debt under control that they are now about to help "pardon" 50% of someone else's. It simply doesn't make sense.


These arguments are developed at greater length in my new book "Is The Euro Crisis Really 0ver? - will doing whatever it takes be enough" - on sale in various formats - including Kindle - at Amazon.