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Tuesday, May 26, 2009

The New Orthodoxy Is Upon Us

We seem to be witnessing the arrival of some kind of new financial orthodoxy. The IMF put it like this in the Hungary Standby Loan Report (which by chance I was reading last night):

In emerging market countries with debt overhangs, the “Keynesian” effect of fiscal adjustment is likely to be outweighed by “non-Keynesian” effects related to expectations and credibility. Non- Keynesian effects have to do with the offsetting response of private saving to policy-related changes in public saving. In particular, if fiscal adjustment credibly signals improved public sector solvency, a fiscal contraction could turn out to be expansionary, as private consumption rises based on the view that future tax hikes will be smaller than previously envisaged.
IMF - Hungary, Request for Stand-By Arrangement, November 4, 2008

So from Tallinin, to Riga, to Budapest, to Bucharest, the same sonata on a single note is being played, and the message is cut spending and you will expand. Funny how people are not very convinced about this idea in Berlin, London, or Washington.

Sunday, May 24, 2009

Hungary's Trend Growth And Debt Sustainability

My previous post is very long, pretty technical, and probably over-theoretical for a weblog post, and for this I apologise to readers. However, abstract as it may seem, taking a view - on one side or the other - over the argument which lies at the heart of the post is central at this points for all those discussions which are taking place about the sustainability (or otherwise) of the path the Hungarian economy is set on. For my part, I established this blog in late 2006, since I was pretty sure even back then that all of what we are now seeing (not in the details, of course) was more or less bound to happen. It was bound to happen, since the kind of adjustment process Hungary has been engaged in since mid 2006 simply will not work without addressing the underlying issue, and the underlying issue is the way in which Hungary's population is being allowed to reduce, and the median population age to rise, in far too rapid a fashion. In brief, it is this process, the very low number of annual live births, and the ever growing percentage of the population which is over 60 that this leads to which conditions the proportional weight of the financial obligations which fall on the state AND the growth rate which is attainable with which to shoulder the burden (hence the significance of the previous post).

The basic question which economists need to address I would argue, is not why government debt got out of hand in 2005/06, but why domestic consumption weakened in a way which lead to the sudden growth in government spending to support the economy. If this view is right, the core of the issue is demand side, and not supply side, and thus the supply side recipes being offered, positive as many of them are, simply won't work on their own.

The real question is why Hungarian domestic consumption did not surge in 2004 following the collapse in late 2003. Why did EU membership not produce a large consumer driven boom such as we have seen in many other East European economies, the Baltics for example? The forex lending at cheap interest rates was, after all, available. The thing is, I have seen this sort of pattern before. In Portugal for example - see this entire post if you are interested in understanding a bit better what happened in Portugal.

And my feeling is that the root cause is always the same: structural shifts in demography.

Now this is a bit more than a theoretical game, since it does have a practical endpoint, and that endpoint has a name: national bankruptcy. And really, I am sure we would all like to avoid that if we can. Lajos Deli, who co-authored with Zsuzsa Mosolygó the recent National Debt Agency study I refered to in an earlier post (you can find the whole study - entitled Hungarian Central Government Debt Ratio May Decline After 2009 - here) was kind enough to send in some comments on my argument. In particular:

In addition, I would like to add that it is not the economic growth that determines life and death about debt paths, though it is an important factor. And it is not the best to calculate an average 1.8 per cent economic growth between 2000 and 2010 for Hungary and to derive from this a bad growth outlook for the next decade. In 2008-2010 we are just experiencing a huge world recession not seen long-long ago and there hardly were structural reforms in Hungary in this decade… Economic growth, however, was around 3-4 per cent before authority measures in 2006-2007. In Hungary everyone would argue that this decade was pretty good for us… Just take a look at Slovakia, for example, where Dzurinda-reforms made the economy grow like hell until the crisis.

All in all, debt path is not unsustainable even with 1 per cent growth in the next decade. One should take a look at the USA or UK since it is fiscal deficit that makes debt unsustainable and Hungary performs in the next few years one of the best in Europe and in the world. That is what counts and what should be monitored and enforced. Now IMF terms and conditions helps to carry out a responsible fiscal policy in the following years and this positive fact should be underlined, I think.

In part, the answer one gives to the sort of questions Deli is asking depends on whether or not you think economies are path dependent entities. This is important, since it conditions whether or not you believe there is some variant or other of steady state growth to which to which economies tend to revert in the long run. Deli's argument, at least in some loose informal sense, seems to depend on such a view. If not, it is hard to see the relevance of reference to the US and the UK in comparative terms, since what are we comparing, apples and pears, or two entities which are inherently comparable? In the latter case, economies would not seem to be path dependent.

Since beyond the fact that they are all economies there are such vast differences between the UK and the US economies between themselves, and between the two of them and Hungary that I find it hard to see where we are.

I have serious difficulties with any view that ignores path dependence. I think economies do depend with some degree of sensitivity on their previous time path, and in this sense I find what is happening to the current value of the forint rather disturbing, as it may condition the evolution of several other key variables for some time to come. The presence of all those CHF loan’s is another factor through which recent economic decision making may come back and hit the future with a vengence - indeed I see the resolution of this forex loans issue as the key to progress, since if Hungary is to be an export driven economy then you need an exchange rate well below 280 to the euro, unless of course the decision is to go for drastic wage deflation, but this has many, many attendent difficulties, and to boot there is little recent evidence of this in the earnings data.

Frankly I find the whole idea of convergence to a theoretical steady state to be completely metaphysical, like the Holy Trinity (you know, god is three, and god is one) you either believe in it or you don’t.

However, since I am a great admirer of one well known Hungarian thinker - Imre Lakatos - and his version of Popper’s falsification process, I would simply ask Deli: what would it take for you to change your view that the longer term growth potential of the Hungarian economy is as you believe it to be - other than by waiting till 2020 and checking of course, since by that time the horse will be well gone and bolted (at least if I am right, and economies are path dependent entitities)? In my opinion this is the only way we can get a serious rational debate started.

In the second place I don’t accept that Solow’s original “plausible assumption” that population change was exogenous to economic growth is as plausible as it seemed to him to be, once you start scratching around below the surface and dig into some facts - as I try to illustrate in the previous post.

Now just because the neo-classical version of growth theory seems to be not without problems doesn’t mean we have to thow all the procedures of neo classical economics straight out of the window. The marginal idea seems to me to be a good one, which is why I am not sure how people have become so convinced that drawing marginal labour into the labour force is going to revolutionise Hungarian economic growth.

Don’t get me wrong, I am more or less in sure the measures the Bajnai administration is introducing to reduce the tax wedge are positive, its just that having studied this process in some depth (in relation to ageing population) in Germany, I’m not sure Hungary is going to get the bang per forint everyone is expecting. But the pensions situation, and the implicit obligations to an ever higher proportion of the population make all future calculations very precarious.

Hungary, a nation of 10 million, has three million pensioners. Besides writing checks for regular retirees, the government gives special benefits to accident victims, the disabled, military and police veterans, mayors, widows, farmers, miners and "excellent and recognized" artists. The average Hungarian retires at 58, and just 14% of Hungarians between 60 and 64 are working, compared with more than half of Americans.Hungary's pension obligations are helping to remake the country's politics.
Hungary has run fiscal deficits for years to pay for social programs, and its annual tab for pensions now surpasses 10% of its gross domestic product.
There is no easy answer here. Hungarian's retire much earlier than most of their West European counterparts, but Hungarian men also live on average around ten years less. So making them work as long as say, Germans, do is going to be difficult. Also, while bringing prematurely retired workers back into employment (and off the state payments system) is surely beneficial, it is only one half of the short term solution being offered for ageing and declining workforces (the long term answer is of course to attack those ultra low fertility levels).

The other half of the policy reponse is to promote immigration - as outlined in the World Bank report “From Red To Grey” - and I find the almost complete absence of any plan to stem the rate of inversion in the population pyramid in the whole rescue programme pretty pre-occupying. If the root of Hungarian debt unsustainability is the drop in population, and its relative ageing, then it would seem, to be convincing, that this topic at least needs to be addressed.

The bottom line is that the whole current programme of IMF CEE rescue’s worries me, and I suspect we are going to see a presence from the fund in the region for a long long time to come. Deli says “And it is not the best to calculate an avergae 1.8 per cent economic growth between 2000 and 2010 for Hungary and to derive from this a bad growth outlook for the next decade.” Now I have thought quite carefully about this. Of course we are in the midst of a huge crisis, so you cannot give undue importance to this year and next year's growth rates. But this is precisely why I take ten year moving averages, since to some extent this irons out these ups and down.

What I mean is that as well as the crisis you need to take the excesses which preceded it (everywhere) into account. Prior to 2007, Hungary had an artificially high growth rate, boosted by current account and fiscal deficits. So to some extent the sharp contraction is logical (on the steady state way of looking at things), and it is what it is (on the path dependent approach). In either case it exists, and the ten year average gives us an idea of just how fast Hungary was capable of growing.

Also, look at the long term chart (above) . Before the 1990s there was a clear decline. Of course you can argue this was artificially low (due to state planned economy etc), and I would agree weith you. But what we have between 1990 and 2010 is a lot of “noise” in the data, a huge down and a surge up. I doubt we can extrapolate anything meaningful from that. So I look at other ageing societies, and I find a similar pattern of losing momentum (see the charts in the previous post for Germany, Japan, and Italy).

The tragedy is (from my perspective) that the most societies in the CEE are currently going through a huge metamorphosis (nice Kafkerian expression this one, and more appropriate in this context than the simple expression "transition"), from having consumer driven to export driven economies. The driving force behind this transition is rising population median ages, yet almost no one in Eastern Europe seems to notice (or even care it seems).

Deli also says “it is fiscal deficit that makes debt unsustainable and Hungary performs in the next few years one of the best in Europe and in the world”

I think that he is not taking sufficient account here of the danger of self perpetuating (via deflation) contractions. Obviously he is right in the evident sense that if you don’t run growth plus low enough deficits/primary surpluses, you can’t reduce debt to GDP. But if you apply a very rigid fiscal objective, tight monetary policy and provoke ongoing deflation, then with falling nominal GDP values the tendency is towards higher debt to GDP levels. This is a point that Edgar Savisaar, Mayor of Tallinn, seems to have grasped in the Estonian context:

"The fact is that it is not a miracle cure that removes all our problems. You
can join the euro zone only if you have a strong and sustainable economy,"
Savisaar said."My question is whether transition to euro is realistic or is it
only a pretext to justify budget cuts?" Savisaar asked. "If the budget is cut,
consumption is affected. This in turn will bring less revenue in the budget that
causes a new need to cut the budget. So it's a vicious never-ending circle that
Ansip (Estonia's Prime Minister) is in,"

At the start of their paper,Lajos Deli and Zsuzsa Mosolygó say:

"The path of the government debt ratio can easily be studied considering a simple economic model with variables including real interest rate, primary budget balance ratio and economic growth."

I agree completely, which is why forecasts of future economic growth are so important, especially since, in part, the fiscal stance of the government influences the rate of economic growth. If you run a deficit this boosts growth, and if you run a surplus it constrains it (all other things being equal). The point is - as Hungary has to its pain discovered - if you run a fiscal deficit in order to boost growth which is deficient due to weak domestic demand and weak exports eventually your debt becomes unsustainable. This is why you can't run deficits indefinitely.

They also say:

"One should also note that the macro parameters in the model fully determine the path of the government debt ratio."

"Which is again why GDP growth is so important since it is the key variable. Applying the above equation (the one the authors use) it is easy to understand that if one calculates with persistent high real interest rates and low economic growth, the debt to GDP ratio will necessarily explode unless a favourable primary balance ratio counterbalances the effects of the other two parameters. The task of economic policy is, however, to prevent such a debt spiral. Macro modelling indicates that the room for fiscal policy to stop undesirable processes is rather large."

So this is what the argument is about really. With high real interest rates and low economic growth debt spirals out of control. The issue, quite simply is, does fiscal policy alone - ie running a primary surplus - have the power to reverse the process in the way they assume, or might it not, in the conditions Hungary finds itself in, simply lead to a negative lose-lose dynamic in GDP performance, and hence revenue.

In emerging market countries with debt overhangs, the “Keynesian” effect of
fiscal adjustment is likely to be outweighed by “non-Keynesian” effects related
to expectations and credibility. Non- Keynesian effects have to do with the
offsetting response of private saving to policy-related changes in public
saving. In particular, if fiscal adjustment credibly signals improved public
sector solvency, a fiscal contraction could turn out to be expansionary, as
private consumption rises based on the view that future tax hikes will be
smaller than previously envisaged.
IMF - Hungary, Request for Stand-By Arrangement, November 4, 2008

Hungarian retail sales dropped another 0.6% in March as compared with February, and the slales index (see chart below) is now back down at the 2005 level, and is rapidly falling towards 2004. With a 6.7% GDP contraction forecast by the government for this year (and more downside risk) plus a VAT hike on the horizon it is hard to see this trend reversing, and indeed given the underlying population dynamics you have to ask whether the sales index will ever be up again. Adjusted for calendar effects, sales were down 3.6% year on year in March, following a 3.3% decline in February. On an annual basis sales were down for their 26th consecutive month in March.

As I say, Hungary now will get negative momentum from government spending and negative momentum from domestic consumption. The only possible driver of GDP growth is exports, and investment demand to produce them. But if you want to export, you need to be competitive, so exchange rates matter. And if you want to be competitive you have one benchmark to work against: Germany (and especially since around 30% of all Hungarian exports are destined there). And if we look at the chart below, we will see the extent of the competitveness gap which has opened up between Germany and Hungary post 1999. Now Reel Effective Exchange Rates (REERs) are a nice measure of competitiveness, since REERs attempt to assess a country's price or cost competitiveness relative to its principal competitors in international markets. Since changes in cost and price competitiveness depend not only on exchange rate movements but also on cost and price trends the specific REERs used by Eurostat for its Sustainable Development Indicators have been deflated by nominal unit labour costs (total economy) against a panel of 36 countries (= EU27 + 9 other industrial countries: Australia, Canada, United States, Japan, Norway, New Zealand, Mexico, Switzerland, and Turkey). Double export weights are used to calculate REERs, reflecting not only competition in the home markets of the various competitors, but also competition in export markets elsewhere. A rise in the index means a loss of competitiveness, and as we can see Hungary's index has risen sharply against Germany's in recent years, which is why a value of the forint of 275 to the euro, or thereabouts, is way, way too high.

Unsurprisingly Hungary’s central bank kept its benchmark interest rate unchanged for a fourth month on Monday (25 May). The Magyar Nemzeti Bank left the two-week deposit rate at 9.5 percent today, the European Union’s highest along with Romania. The forint lost 38 percent against the euro between July and March 6, when it fell to 317.22, its weakest ever. The currency has since strengthened 12 percent and was trading around 280 this afternoon.

The rally in emerging markets and accompanying revival of the carry trade can be seen clearly in the Hungarian Forint, which can now claim the distinction of being of the world’s best performing currencies of late.

But why, then, is the Forint rallying? The answer is simple: high interest rates. With the benchmark interest rate stuch up there at 9.5% HUF instruments look pretty attractive. While other Central Banks busy lowering rates to try to boost economic growth the Monetary Council of the central bank keep voting unanimously to keep rates on hold. Given the precarious economic and financial situation, policymakers are forced to sit back and watch the population soak up the pain for fear that a drop in interest rates could precipitate capital flight and a currency crisis, which in turn would produce immediate "distress" among all those who hold non HUF denominated loans. Monetary policy is stuck. It can neither move forward, nor can it move back, unlike fiscal policy, which as Mosolygó and Deli point out can move backwards and backwards. In both cases, the economy winds its way down and down.

As exasperated Julia Kiraly -Deputy Governor at the NBH - recently explained to reporters, “As long as Hungary is considered such a vulnerable country, our interest rates cannot be lower than South Africa’s or Turkey’s; it’s not the Czech Republic, Slovakia or Poland you should compare us to.”

Meantime its "carry on up the Danube" time, with Deutsche Bank analysts earlier this month recommending investors to sell the euro against the forint on bets the rate difference will help the Hungarian currency gain 10 percent to 260 per euro in two to three months "from 286.55 today.” Well, its only gone as far as 280 at the moment, so they had better cross their fingers, just in case the bet turns bad on them. Frankly all of this would be comical, if it weren't so damn serious, and so tragic.

Taking Solow Seriously - Does Neoclassical Steady State Growth Really Exist?

Discussions of the population problem have always had the capacity to stir up public sentiment much more than most other problems....In fact, the discussion of the population problem seems at all times and in all places to be more strongly dominated by the volitional elements of political ideals and interests than any other part of the established body of social and economic thinking. Here, as in perhaps no other branch of social theorizing, the wish is very often father to the thought.
Gunnar Myrdal, The Godkin Lectures, 1939.

All theory depends on assumptions which are not quite true. That is what makes it theory. The art of successful theorizing is to make the inevitable simplifying assumptions in such a way that the final results are not very sensitive.' A "crucial" assumption is one on which the conclusions do depend sensitively, and it is important that crucial assumptions be reasonably realistic. When the results of a theory seem to flow specifically from a special crucial assumption, then if the assumption is dubious, the results are suspect.
Robert Solow, A Contribution To the Theory of Economic Growth, 1956

What is Neo-Classical Growth?

As everyone who has ever thought about economic processes and social development is only too well aware, the last two centuries have been characterised above all by extremely rapid increases in living standards in a number of countries (generally known as the developed, or "advanced" economies), and this phenomenon, which is more or lest unprecedented in the whole of human history has given rise to extensive debate, together with a most voluminous quantity of literature, about what exactly the factors are which lie behind what this modern growth phenomenon. The objective of what follows is not to offer a general evaluation or even an overview of the corpus of work which has come to be collectively known as "growth theory", but rather to attempt go straight to the heart of the issue, and following in the most venerable footsteps of Federal Reserve Chairman Ben Bernanke, try to take Solow seriously, or at least try to take one of his crucial assumptions (one of the ones which intuition suggests might be plausible if "not quite" true) in order to examine just to what extent this assumption still appears "reasonable" in terms of fitting the facts as we now know them (rather than the facts as Solow could, in his day, see them), or if you prefer, to try to see if what may have been nearly "true" at the time Solow wrote his pathbreaking paper still remains so, on any reasonable interpretation of the meaning of the word "true". What we will here investigate is whether or not it is a reasonable starting point for growth theory to postulate ( in order, as it were, to start the ball of analysis rolling) that modern economies may move towards some sort of steady state growth rate (even if only as a theoretical construct), and whether indeed such and idea forms a useful concept with which to try to explore and model the growth process which characterises modern "mature" economies. We will investigate this assumption, in good Popperian fashion by examining the assumption in terms of the validity of what is conventionally considered to be one of the key predictions which may be extracted from its use of this in neoclassical growth models of the Solow type.

Ready, Steady, Go.....

But before going any farther, what exactly is steady-state growth? If we are to decide whether such a crucial assumption is indeed realistic or not, we first need to get a handle on what it is, since reading through the literature which surrounds the topic, you might be forgiven for saying that it wasn't exactly clear. In order to help us ease us into the problem, one useful place to start might be start with an examination some of what Nicolas Kaldor would have termed the "stylised facts" of the situation.

As is well known, on any generally accepted measure the process of wealth creation in the developed world has been a massive and extensive one over the last couple of centuries. According to most estimates GDP per capita in the United states is at least ten times higher today than it was 125 years ago, and if we allow for a growth mismeasurement (underestimate) of only one percentage point per year, the factor in question could easily be more than thirtyfold (Brad DeLong, 1998, see reference at foot of this post). Equally remarkable is the relatively brief time span (when compared with the entirety of human history) during which this rapid growth has occurred. Since we normally assume humans to have been distinguishable from other primates for at least a million years, it is possibly surprising to find that it was not until the agricultural revolution - some 10,000 or so years ago - that the long march to the modern era really beagan, and even more to the point, that it has only been during the last two hundred years or so that we have been able to find that steady and continuous increase in economic growth which so characterises our era and which we so tend to take for granted.

In fact the average GDP per capita growth rate in the United States has been estimated at something in the region of 1.8 percent per year since the start of the 19th century. However such growth has been far from uniform, and it normally used to be thought that (aside from some special periods like the 1930's, or the Solow "computers everywhere except in the productivity numbers" 1970s and 1980s) as the years have passed there has been a general acceleration in growth capacity. Perhaps the most recent, and most famous, exposition of this view is to be found in the 1990's sustainable growth acceleration postulated by Sir Alan Greenspan, and perhaps the most noteworthy questioning of this view has come from Paul Krugman who asks the not entirely unreasonable question about, if what we have had in the United States since the late 1990s has been a "twin" internet and construction bubble, how much of that "accelerated" growth was real, and how much was simply the product of unsustainably bringing forward consumption (Krugman, 2008). Evidently this is an empirical question for later growth accounting researchers, but we might like to note in passing that the present crisis does at least leave open the possibility that the "growth acceleration" which has followed the Solow slowdown may not be quite the acceleration we used to think it was.

However, even allowing for the volatile periods, and the exaggerations, there is considerable evidence to support the existence of some sort of ongoing long term acceleration in US growth, at least during large parts of the twentieth century. Using data taken from Angus Maddison (1995), Charles Jones (2002) estimated that the growth rate of the US economy between 1950 to 1994 was an annual 1.95 percent, which was slightly higher than the rate he derived for 1870 to 1929, which was 1.75 percent. Even these these highly aggregated numbers conceal a considerable degree of variance, since the growth rate registered in the 1950’s and 1960’s - 2.20 percent - was considerably higher than that found during the Solow productivity slowdown of the 1970s and 80s, which was a "mere" 1.74 percent.

Be all this as it may, the existence of such aparent stability in U.S. growth rates over such a long period of time has given considerable support to the "common sense" and conventionally view accepted view that the U.S. economy is, and has been, running at close to what is considered to be some sort of long-run steady-state (or balanced growth) path, as can be seen in the charts below. GDP growth is of course always volatile, but when you strip out some of the volatility the smoothness of the US path really is quite remarkable, making it hardly surprising that many US economists have found the idea of steady state growth a fairly plausible one.

This traditional view of the modern growth phenomenon is often supported by reference to a number of what have come to be termed growth "constants" - one of which would be the absence of trend movement in the U.S. capital-output ratio - constants which were emphasized most notably by Nicholas Kaldor (1961), who proposed a series of stylized facts about economic growth which have, over the years, been fairly influential in casting the debate. Kaldor's " facts" went as follows:

1. Per capita output grows over time, and its growth rate does not tend to diminish.
2. Physical capital per worker grows over time.
3. The rate of return to capital is nearly constant.
4. The ratio of physical capital to output is nearly constant.
5. The shares of labor and physical capital in national income are nearly constant.
6. The growth rate of output per worker differs substantially across countries.

Now it is not my intention here to examine each of the above "facts"in turn, but rather address a much more specific question, one which essentially focuses on the first presumed constant on the list. What I wish to examine is whether it is indeed the case that per capita output grows continuously over time, and further, that its growth rate does not tend to diminish.

To be more explicit, I do not wish in any way to question the view that US economic growth has been not only constant, and even possibly accelerating slightly, rather what I would like to do is ask whether this characteristic is shared by all (or even a majority of) the advanced economies, and if it is not, to move on to ask why it may be that this seeming property of US growth is not a shared one, and indeed what the implication is for a theory whuch takes the existence of such a state as one of its critical assumptions.

In order to carry out this rather straightforward exercise I would like to return to the founding father of modern neoclassical growth theory (Solow) and ask one very simple question: is Solow's "critical" steady state growth assumption "realistic", or put another way, does it appear as realistic today (given what we now know) as it did at the time he made it. And if it isn't, I would like to ask what the implications of coming to realise this are for how we think about modern growth.

The core of the problem here lies in the decision Solow took in setting up his model to consider both rates of saving and population growth as exogenous variables (ones which are determined outside his model). The rate of growth of any economy in the longer run is simply determined by the rates of growth of the labour and capital inputs which are themselves assumed to grow at a constant rate. And once that steady state growth rate is achieved any external perturbation which sends the economy off its growth path will only have a temporary (or transitional) impact before the homeostatic mechanisms which are assumed to be at work send the economy back on course. In more conventional language, once the equilibrium growth rate is achieved, it should be stable, since regardless the initial value of the capital-labor ratio, the system will develop toward a state of balanced growth at the steady state rate. The system can adjust to any given rate of growth of the labor force, and eventually approach a state of steady proportional expansion.

At one point in his paper Solow does examine whether the model could be applied to a case where population movement was endogenous rather than exogenous. His conclusion was that it could, but the explanation he offers is indeed interesting.

Instead of treating the relative rate of population increase as a constant, we can more classically make it an endogenous variable of the system. Suppose, for example, that for very low levels of income per head or the real wage population tends to decrease; for higher levels of income it begins to increase; and that for still higher levels of income the rate of population growth levels off and starts to decline.

What Solow postulates here is a kind of U shaped function, part of which roughly corresponds to what we could call the "Malthusian era" when population levels fluctuated as real wages (or income per head fluctuated), and part of which offers a first approximation to the modern growth era, in the sense that fertility (and hence population levels) tends to decline as income rises. But between these two fertility "regimes" there would seem to be a clear break, since what has not been observed (anywhere) is that as incomes fall back subsequent to the transition from one regime to another then fertility rises. Normally we find (in post Malthusian population environments) that as living standards fall, even in the longer run fertility also itself tends to fall. Eastern Europe following the end of communism would be one clear example of this.

The point here, however, is not to enter into any kind of extended discussion of the factors which influence fertility (and thus population movements), but rather to point out that they do not seem to follow the kind of straightforward function which Solow imagined, and that this difficulty will confront any kind of growth model (whether population is exogenous or endogenous) which postulates the idea of steady state growth, since the kind of homeostatic corrective mechanisms (which would lead an economy back to some kind of equilibrium growth rate) to not appear to be in operation.

Returning however to the substantive issue, what I would like to ask is whether in fact the assumptions of exogenous savings and population growth, and constant steady state growth are as plausible as they seemed to Solow? What if both population growth and saving rates were both more plausibly to be considered as endogenous variables (ones which are influenced by the working of the process itself), what would this do to the foundations of neo-classical growth theory? And indeed if movements in population size and age structure are found to exert a significant and non-stochastic influence on key growth variables (that is are found not to be mere random shocks) then what really is the current serviceability of a model that assumed them to be so? This is a question we should at least be prepared to ask ourselves, and in particular we need to ask it since most our contemporary forecasting models (and indeed even the core of real business cycle theory on which many of them are based) are constructed on at least some sort of loose assumption that neoclassical growth theory is itself a well-grounded and solid edifice.

Of course, and touching for a moment some of my conclusions before I even present them, there could be a number of reasons why Kaldor's first "fact" may not be a fact, and one of these, evidently, could be that the modern growth epoch is just that, modern (rather than post-modern) and an epoch. That is, the period Kaldor was referring to may be a historically bounded one, with a begining and an end, and Kaldor's facts may fit the empirical reality which typified that particular period (when per capita output grew at a constant of even increasing rate), but not the period which it now seems might be the posterior one, the post modern-growth era, when per capita output grows at a declining (and even possibly negative) rate. If this were to be the case it would, of course, fit quite well with the pessimistic mindset of many pre-Solow growth theorists, who although they held assumptions which were in many ways similar to Solow, felt that a process of diminishing returns would eventually grind down output growth (see, for example, Jones, 2001).

What both Solow and his immediate predecessors (Harrod, Domar etc) had in common was the assumption of stable and growing populations, with more or less constant age structures (the demographic transition in age structures being thought to have belonged to the pre modern-growth period), and what we now know (that they didn't) is that such assumptions are unrealistic as we move forward across a century where populations will start to age and decline in one country after another, with radical implications not just for labour force size, but also for age structure and the shape of the population pyramid.

So to put all this another way, what I seek to do here is ask one very simple question, and this is whether there are still sufficiently good empirical reasons for continuing to believe that there is such a thing as a long term steady state trend growth rate for economies whose population size and structure is changing rapidly and constantly. This state of affairs is already a current reality for a number of limit societies (Japan, Germany and Italy would be the obvious "stylised" examples, but many East European countries are already hazardously near the point of entering the group) while for most other advanced economies it still remains only a theoretical possibility, although it is one which, given the demographic data and forecasts we have to hand, we can hardly afford to ignore. So instead of making the kind of assumptions about population change and economic growth which form the basis of the Solow neo classical theory, is it more "reasonable" to assume that growth rates tend to fluctuate over time following a more or less orderly pattern of rise and decline, and - putting the issue even more stridently - should we not be asking ourselves whether it may it not in fact be the case that growth rates fluctuate as the age structure of a population steadily moves across the whole sweep of the demographic transition - from a state of ultra-high to one of ultra-low fertility. Or, if you prefer, could all of this simply be a non-linear process in the classic and most straightforward sense of the term?

Steady State Growth?

In attempting to assess the validity of the "crucial assumptions" which underlie neo-classical growth theory we would do well to keep Kaldor's stylised facts in the forefront of our minds, and in particular ask ourselves how it could possibly be that - in those societies where fertility has now fallen to well below replacement level and labour forces look set to decline and decline - the shares of labour and capital in gross national output could be expected to remain more or less constant. After all, doesn't standard theory tell us that as labour supply comes under greater pressure, wages should rise and technical change should occur? But - and I offer this as simply a throw-away point a this juncture - in the most affected economies like Japan and Germany this does not seem to be what has been happening, since due to recent labour market reforms labour force growth has resumed (after stagnating or falling back) as more and more people in the older age groups have either been reabsorbed or have continued to work, but the value added by the additional work performed does seem to have tended to decline. Put another way, even as employment levels have risen and labour markets tightened in these two countries, the level of real wages has not budged, and on some readings may even have fallen.

Balanced Growth Or Transitional Dynamics?

As Charles Jones points out something funny is evidently going on here, since even in the best case scenario socities growth rates have not performed as Kaldor would have lead us to expect. Even in the case of the US economy some of the core processes we have been observing for some 50 years or more now seem to contradict what we would expect to happen on the conventional account.

For example, time spent accumulating skills through formal education - which we could think of as some form or other of human-capital investment - has increased substantially over the last half century. In 1940, less than 25 percent of adults in the United States had completed high school, while only about 5 percent had completed four or more years of college education. By 1993, more than 80 percent had completed high school, and more than 20 percent had completed at least four years of college.

In the second place, the search for new ideas has intensified, and as a result an increasing fraction of the United States workforce - and indeed of workforces throughout the OECD - is now composed of scientists and engineers engaged in research and development. In 1950 the fraction of the US labour force engaged in such work was in the region of 0.25 percent. By 1993, this fraction had increased threefold to more than 0.75 percent.

Now the point here is, as Jones is only too willing to point out, on the assumptions of virtually any of the standard growth models, both these changes should lead to long-run increases in rates of per capita GDP growth, yet (despite the "acceleration" debate) such anticipated increases have not been observed.

Under standard neoclassical models, changes like the ones Jones mentions should generate what are known transition dynamics in the short run and “level effects” in the long run. Put simply the growth rate of an economy should rise temporarily (during the transition, the "transition" effects) and then return to its original (steady state) value, while the income level of the population should remain permanently higher as a result (the "level effect"). On the other hand, under assumptions which are typical of endogenous (new) growth models, such changes should lead to permanent increases in the growth rate itself. However, as we have noted above, the growth rate of U.S. per capita GDP has been surprisingly stable over the last 125 years with the level of per capita GDP being reasonably well represented by a simple time trend. So what is going on here?

One distinction which may help get address the problem is the one Jones himself makes between a constant and a balanced growth path. Along both such paths, growth rates remain constant over an extended period of time, but in the former case constant growth is simply the (coincidental) by-product of a process which is effectively driven by series of transition dynamics while in the latter what is involved is stable and self correcting since what we have is a steady state.

A balanced growth path is normally defined as a situation in which all variables grow at constant geometric rates (possibly zero). (Jones, 2002 )

Now one possibility (discussed by Jones) is that the apparent steady state growth exhibited by the US economy over so many decades has been associated with a very complex set of transitional dynamics, dynamics which "just happen" to have produced this particular outcome. But if this were the case then one very natural question arises. If a large part of U.S. growth in recent years has been associated with transition dynamics, then why do we not see the traditional signature of a transition path, e.g., a gradual decline in growth rates to their steady-state level? Why is it that U.S. growth rates over the last century or more appear to be so stable?

So we might like to consider one further possibility at this point. Could it be that the "as a matter of empirical fact" transition dynamics associated with the various factors of production in the United States have worked in some strange way to precisely offset one another, and in so doing leave the growth rate of output per worker fairly constant? We will return to this issue below, but since it is an explanation which may not be so easy to discount as many may imagine it to be at first glance, we now need to make a short detour and - in order to examine one of the factors which may be involved - take a more general look at some empirical data concerning the interaction between population dynamics and economic growth.

Demographic Components in Growth

Now obviously national economies differ from one another in a large number of ways, but one of these is the population structure and its underlying dynamic. One reasonably concrete starting point for addressing the issue of population age structure and whether it has an impact on economic performance could be via a comparison of GDP growth rates and population change in a number of the countries most immediately affected by ageing population dynamics. It is interesting to examine the dynamics of more "elderly" societies (in terms of population median ages) since the growth process in "younger" ones (ie those in earlier stages of their demographic transition) have been reasonably well studied under the rubric of what has come to be known as the "demographic dividend" (Bloom et al, 2003).

Simply put the demographic dividend idea suggests that as birth rates decline from previous high levels of fertility, and the age structure of a population changes so that a higher proportion are to be found in the working ages, economies experience a "growth spurt", or a period of what is often termed catch-up growth. This pattern, under the neo-classical view would constitute some form or other of transition dynamic. So the presence of a transition is not in doubt, what is really in question is whether the process settles down in to some form of ultimate steady state.

Now, as we have already noted, it is a key postulate of neo-classical growth theory that each economy has its own long run steady state growth rate. One of the consequences of making this sort of initial assumption (albeit as a purely hypothetical and theoretical one) is not in fact that hard to see, since the steady state assumption would seem to imply that as the demographic transition which produced those earlier "transitional dynamics" is left steadily behind (the demographic transition remember is associated with large fluctuations in levels and growth rates of population) then a steady growth rate in the labour force (achieved in part via institutional efficiencies in the labour market) and a supply of savings regulated by effective monetary and interest rate policy, should mean that any given economy would have its own given balanced growth rate, irrespective of key population variables like fertility rates and life expectancy.

This neo-classical long run steady state growth rate needs, of course, to be understood as a theoretical postulate, a sort of ideal limit case, but nevertheless the concept continues to orient and inform a good deal of conventional economic thinking about economic growth. It also informs the way most people conceptualise and approach the present global economic crisis, since underlying one rescue and stimulus package after another is the idea that there is a long term trend growth rate out there somewhere, just waiting to be "recovered".

So the idea of "trend growth" far deeper roots than are normally taken into account in the simple Solow-derived offshoots of neo-classical theory, and indeed seems to form part of some kind of collective "ideal type" folk wisdom which are deeply embedded in the mindset when it comes to thinking about business cycles and growth prospects (in some form or another such assumptions normally enter the thinking of the Real Business Cycle tradition, to name but one example) . Thus the growth rate which people normally anticipate will be "recovered" following a recession is normally derived from a model based on some version or other of a long run steady state (or constant equilibrium path). The question we are left with though is really, does the idea of convergence to steady state growth constitute one of those suppositions which are assumed - in Solow's words - to be nearly true, and what are the consequences for the theoretical edifice of modern macro economics if the idea turns out to be not quite as "nearly true" as was previously thought to be the case.

Linear Or Non-linear Growth Patterns?

The idea of steady state growth is also often closely associated with the idea of that changes in the long run rate of growth are largely determined exogenously to the economic system, and this idea is typically associated with the Solow model of economic growth, since here long-run economic growth is seen as being determined by such exogenous factors as technical change, aggregate saving rates, schooling rates, and the rate of growth of the labor force. Indeed this is the issue which largely attracted the attention of the new (or endogenous) growth theorists, since it seemed to run against certain basic economic intuitions that this should be the case, although, as Solow argued in his reply to some of the critics, things are by no means as simple as they seem in this context, and most of the newer generation of models have run into what seem to be insoluable difficulties due to certain key, "knife edge" assumptions they need to make (Solow, 1994).

It was in some sense with this kind of issue in mind that Mankiw, Romer and Weil wrote what has since become a highly influential paper - A Contribution To the Empirics of Economic Growth (see bibliography below) - since they clearly felt the need to try to put neo classical theory onto a somewhat more stable footing. In their paper the authors outline what they see as the core of the Solow thesis using following words:

This paper takes Robert Solow seriously. In his classic 1956 article Solow proposed that we begin the study of economic growth by assuming a standard neoclassical production function with decreasing returns to capital. Taking the rates of saving and population growth as exogenous, he showed that these two variables determine the steady-state level of income per capita. Because saving and population growth rates vary across countries, different countries reach different steady states. Solow's model gives simple testable predictions about how these variables influence the steady-state level of income. The higher the rate of saving, the richer the country. The higher the rate of population growth, the poorer the country.

The first thing to notice about the argument is that the Solow model clearly predicts two pretty straightforward and neatly linear relations: more population-less growth, and more saving-more growth. Now, we are immediately presented with an important difficulty here since, as we will see below, there is now a considerable and accumulating body of empirical evidence which seems to suggest that among "mature" developed economies, those who have the fastest rates of population growth are also those who experience the highest rates of per capita income growth (the United States is the most obvious example, but as we will see this is also the case of France and the United Kingdom), while in those countries where population momentum has slowed, even to the point where their populations may now decline (Italy, Japan, Germany, for example) do not seem able to achieve their former high rates of economic growth, and, even worse, seem to be losing ground in per capita income terms with those economies whose populations continue to grow reasonably rapidly. Now I do not seek here to explore this question in all its intricate detail, I simply wish to make one clear and central point, and that is that the relations involved between population growth and per capita income growth do not seem to be simple linear ones, and arguably it is this property which has thrown many previous researchers off track since in running growth correlations they have normally tended to treat them as if they were.

Indeed the whole idea that economies tend to converge towards some sort of balanced growth path is a highly questionable one which, with the notable exception (as I suggest above) of the US, seems to enjoy fairly limited empirical support over the longer term. Economic performance, it seems, tends to fluctuate, but the big question we have in front of us is: do such fluctuations conform to any kind of identifiable pattern?

Arguably they do. To start with one very simple example, let's take a look at the Japanese case. Below you will find a graph of Japanese economic growth from 1955 to the present prepared using statistics made available by the Japanese statistics office.

What is obvious from looking at this profile is that Japanese growth has been far from uniform over the last 50 years or so. And indeed far from converging to a steady state growth rate, Japans growth seems to have peaked in the 50s and 60s, and have been steadily reducing ever since. Arguably, after peaking, there may be a trend there, but this trend would seem to be towards ever lower annual rates of economic growth. And there is no evidence at this point to justify the supposition of a steady state rate - or hypothetical "homeostatic fulcrum" - around which Japanese growth would stabilise and fluctuate. As far as can be seen at present the process of decline is secular and ongoing. To be clear, the argument is not that Japanese GDP growth does not exhibit some sort of trend, arguably it does, the argument is that this trend does not conform to our current conception of a balanced growth path, and indeed is not homeostatic, in the sense that there is no self correcting mechanism, hence the trend may well be one of gradually declining (and eventually negative) growth with no end point in sight. Put like this the prospect is evidently rather alarming, but I can see no other reasonable and responsible way of putting it.

Nor is Japan a unique case, a reasonably similar pattern can be observed if we come to look at long term growth rates for the Italian economy.

Again, Italian growth seems to have peaked, and then entered decline. In Italy's case the peak seems to have been in the 1970s (but it may have been earlier, since I don't at this point have data for the pre 1970 period), and indeed since 1990 Italian GDP growth has only managed an average of something like 1.4% growth per annum, while as far as we can see at the present time, over the decade from 2001 to 2010 it may well turn out (depending on the depth and duration of the present recession) that Italian GDP may well have been nearly stationary.

Age Structure and Productivity

Curiously enough, in this neoclassical speculation on population the factor of age distribution was for a long time not studied, and it was never studied intensively as to its economic implications. It is remarkable, because this factor could to a large extent be taken care of in a stationary model of theory. When a certain trend of the population development is maintained for such a long period that a stable age distribution has been reached, the difference between a progressive, a stationary, and a regressive population -- apart from a different development of population numbers -- is that in the first more than in the second, and in the second more than in the third, the number of children is relatively large and the number of old people relatively small. A corresponding difference rules even within each major age group taken by itself. If we thus compare a regressive population with a stationary one, we find that in the first young children are relatively fewer than older ones and that the center of gravity is also higher in middle age as well as in old age.Now people in different ages are productive in different degrees, and -- within a given standard of living -- their consumptive demands, their cost of living, also differ. Here intensive empirical studies ought to set in...........to ascertain the average productivity and the cost of living in different age groups.
Gunnar Myrdal, Godkin Lectures, Lecture Six, 1939.

So why exactly is it that national growth rates rise to a peak, and then seemingly steadily peter-out again. Well the explanation - while it may prove to be a little disagreeable - should not actually be so surprising if we start to think about economic theory a little. In fact I am far from being the first researcher to have raised this issue, since as early as the 1930s the Swedish Economics Nobel Gunnar Myrdal was raising what are essentially similar issues, and was struggling, just as I am now, to make sense of the neo-classical growth assumptions in just the same way as I am now. What Myrdal argued so cogently (see quote above), in a series of lectures which have unfortunately been long neglected, was that existing neo-classical theory appears to be severely limited when it comes to its capacity either to explain the ongoing changes in age structure which have now become so evident, or to incorporate the impact of such changes into its general theoretical structure.

Essentially, on whichever type of growth model you use, the key to the problem of long term movements in levels of GDP per capita is no great mystery, it is a function of two parameters: a)the proportions of the total population who are working, and; b) the kinds of activities they are engaged in. If we look, for example, at the early section of the above graphs showing GDP for Japan and Italy it is not hard to see that these economies exhibited very high growth rates during their "take off" point (a phenomenon which we can also find today in emerging economies like China and India ). Such "strong" growth rates are basically the result of two factors, a rapid increase in the proportion of the total population who become involved in economically productive activity, and the process of technological 'catching up' which takes place as these economies move ever closer to the "state of the art" technological frontier and thus engage in activities with ever higher components of value added. Since emerging economies start at some considerable distance from this frontier then evidently the growth rates they achieve can be extremely rapid as they close the gap, and this would almost certainly be one form of what is known as "conditional convergence", as techological levels and institutional structures become more uniform.

But there is another dimension to growth, and in this sense societies almost certainly do not converge (except possibly over the very, very long term, where we might postulate that all societies could converge to a similar - and very high - median age, although even this theoretical idea would need to be treated with some caution, since so many features of this situation may ultimately turn out to be "path dependent"). This second dimesion revolves around age structure related productivity and consumption patterns.

The thinking behind the idea I am presenting here would run as follows. In a first moment, emerging economies take off due to a rapid process of input accumulation (Krugman, Asian Tigers), and the resulting growth is simply a result of "more" rather than of "more productivity", as ever higher proportions of the population are economically active in support of total output. I take it as self evident that under such circumstances growth in output per capita has a natural tendency to rise. However, with the passage of time, this intial "input accumulation" driven growth wave starts to slow. Fortunately, under "normal" circumstances this loss of momentum is largely offset as emerging economies move up the value chain (sectoral shifts). These sectoral shifts are also accompanied by a steady upward movement through the median age brackets as the impact of lower fertility and higher life expectancy makes its presence felt. Not only do these movements produce more workers, they also produce more experienced and better educated ones - as the impact of learning by doing and increased investments in education come to be noted.

Also we see a rising proportion of what have come to be known as 'prime age workers' active in the economy. The exact definition of who exactly such prime age workers are may be something of a moveable feast, and in any event the variable needs to be empirically determined for any given society at any moment in time. Essentially prime age workers are those whose productive activity is at its lifetime maximum. Evidently the higher proportion of such workers who are present in any given economy the higher the aggregate output of that society is likely to be, and in this sense there must be a maximum point here. But the essential idea being advanced here is that this maximum is not attained and then sustained, but rather reaches a peak, before the proportion subsequently starts to decline. This phenomenon should be one of the principal reasons why we might consider the idea of "steady state growth" to be, prima facie, a rather implausible one.

The prime age wage/productivity effect can be seen in the chart below which shows how the age related earnings structure has altered in Japan over the years between 1970 and 1997 (the chart was prepared by Wolfgang Lutz, see Lutz et al 2005).

Now one very significant and revealing detail to be noted above, is the fact that while the shape of the hump has changed slightly over the years there has been little noticeable drift to the right, which is what we would expect to see were the extension of life expectancy to be associated with an upward movement in peak performance ages. The absence of such drift should alert us to the possible existence of an age-related productivity problem in high population median age societies and again constitutes some sort of prima facie evidence that there is at least a phenomenon here worthy of investigation, even for those working in the ethereal world of neo-classical tradition where there is no good reason why long term growth rates should be subject to such fluctuations.

Of course, I making here the generally accepted assumption that wage levels bear some statistically significant relation to productive output levels (ie wages can serve us here as a proxy for something, if they can't, and in the longer run, then it would be hard to see why we are talking about neo-classical economics at all). What can be easily seen from the chart is that Japanese wages generally peak somewhere in the 50-54 age range, even though many workers in Japan currently continue to work to 75, while multilateral organisations like the OECD and the World Bank (see "From Red To Grey", for example) continue to rather simplistically offer higher participation rates in the over 55 age groups (and extended working lives generally) as a sufficient condition to offset the inevitable decline in numbers in the traditional working age groups. Far from wishing to claim that such a policy will not help, I merely wish to draw attention to the possibility that things may be more complex than many assume, and also to highlight the theoretical implications of this undoubted empirical reality.

A good deal of the argumentation in this essay is based on the experience of only three countries: Germany, Japan and Italy. This is not simply a coincidence, or a question of random selection, since these three are the highest median age societies on the planet at the present time. In this sense, if we wish to advance conjectures about what the impact of population ageing may be on growth the three of them do offer us a somewhat special opportunity. As we have seen, in both the cases of Japan and Italy, growth has tended to rise to a peak and then steadily decline as the population has aged. Japan has, through very strong export competitiveness maintained some degree of positive economic resilience up to this point - although the 2009 economic collapse has to raise serious issues about the longer term sustainability of such a high level of export dependence. The same cannot be said of Italy, which due to its much weaker competitiveness profile cannot expect the export vibrance that a Japan (or a Germany) can attain.

Turning now to the German case, what we find is that whilst it is significantly better than the Italian one, the growth characteristics are not fundamentally different. According to the Federal Statistics Office:

Measured in terms of gross domestic product changes at 1995 prices, the rates of economic growth in the former territory of the Federal Republic of Germany and - since 1991 - in Germany have continuously declined since 1970. While the average annual change was 2.8% between 1970 and 1980, it amounted to 2.6% between 1980 and 1991 and to 1.5% between 1991 and 2001.

Since 2001 the performance of the German economy has in fact been worse rather than better, much to the consternation of those who hoped that many years of sacrifice in the form of wage deflation and structural reform would lead to a rebirth of the country's former economic prowess. In reality the German economy shrank (0.2%) in 2003, and grew by only around 1% in both 2004 and 2005. And while the German economy picked up notably in 2006 and 2007 (with growth rates of 3.2% and 2.6% respectively) and many talking in terms of such grandiose notions as global uncoupling and "Goldilocks" type sustainable recoveries, the most striking feature of the recent German dynamic has been the way that internal demand failed to respond to the externally driven export stimulus. Of course, all the speculation came to an abrupt end in 2008 when the German economy once more entered recession as world trade expansion slowed and exports collapsed (with GDP only growing by 1% over the year), while 2009 looks set to be a lot worse (with the IMF currently forecasting a contraction somewhere in the region of 5%, and forecasts of up to minus 7% not seeming exaggerated).

So some part of the traditional mechanism of economic transmission seems to have been broken, a phenomenon which has lead Claus Vistesen (using rather traditional Keynesian terminology) to talk about "engine failure" rather than mere magneto problems (Vistesen, 2009). Long term GDP growth rates in the German economy are clearly falling, and the decline looks clearly set to continue.

Population Growth and Economic Growth

But let us return now to our central concern here, which is Solow's critical expectation that as population growth rates decline economic growth rates should increase. And in order to do this let us look at some more charts. This time the charts are based on data prepared by Eurostat, and show the volume index of GDP per capita as expressed in Purchasing Power Standards (PPS) (with the European Union - EU-27 - average set at 100). A reading on the index of a country over 100 implies that the country's level of GDP per head is higher than the EU average and vice versa, and relative movements in the indexes imply that the rates of change in GDP per capita are either improving more or less rapidly than the EU average. The basic data behind the charts is expressed in PPS which effectively become a common currency eliminating differences in price levels between countries making possible meaningful volume comparisons of relative GDP per capita. Since the index is calculated using PPS figures and expressed with respect to EU27 = 100, it is only valid for cross-country comparison purposes and not for individual country inter-temporal comparisons, nonetheless these charts are extraordinarily revealing.

As can be seen in the above chart for the period 1995 to 2006, comparative US PPS per capita GDP, after correcting somewhat post 2000, as the value of the dollar fell vis-a-vis the euro and the pound sterling, maintained a reasonably steady path, while UK comparative per capita GDP rose, and the French dropped (in both cases comparatively slightly). When we come to look at Italy, Germany and Japan, a very different profile is evident.

All three have steadily been losing ground vis a vis the EU 27 average benchmark. Now evidently the classification process I have used here is far from being an arbitrary one. The first chart shows a relatively high-population-growth (near replacement fertility) group of countries, while the second shows a low-to-declining-population growth (lowest-low fertility) group. In each case the economies in question are developed ones, and, as it happens, all are members of the G7. As we can see, in PER CAPITA income growth terms all three of the former hold their comparative position much better than all (or any) of the latter three.

When we come to look at population growth (see the three comparative charts below, which are only classified for visual convenience according to population size), we find that in all three members of the former group of countries (the US, the UK and France) population is rising, and sharply so, while in the latter group (Germany, Japan and Italy) population levels are virtually stationary (with the slight uptick in Italian population in the 2004 - 2006 period being entirely due to the rapid regularisation of a large irregular migrant population). Prime facie then, all of this is in conflict with what Solow would have expected, but then Solow never started to think about movements in age structure, and rising median population ages, which is hardly surprising since he was thinking about the problem as he saw it over half a century ago.

The reason why we should be seeing this difference is not that hard to get at, given all that has been said above, since the UK, France and the US are all ageing much less rapidly than Germany, Japan and Italy. This comparative measure is interesting, I would argue, since while - for the sort of catch-up growth reasons I touched on earlier - it is hardly surprising that developed economies should lose their relative standing vis-a-vis some key emerging ones (conditional convergence), it should raise more than the occassional eyebrow to find that one group of countries among the more established economies should be losing impetus in comparison with another group, and all the more so if we are prepared to entertain the possibility that this difference is reasonably correlated with both population growth and rates of ageing in a way which seems to go right to the heart of some of the most basic predictions of traditional (consensus) neo classical growth theory.

Conclusion - What I Hope (And What I Cannot Hope) To Have Achieved Here

Basically, simple visual inspection of some basic charts hardly counts as strong evidence for anything, especially when we are talking about accepting or rejecting some of the most highly prized (and most generally common sense accepted) core components of our modern economic edifice. But as has so often been found to be the case in the history of scientific thinking, common sense expectation and securely grounded scientific reality are surely not necessarily co-extensive, and when a few easily produced charts can apparently throw so much sand into the highly tuned and greased works of mainstream growth theory, then there should at least be cause for thought, reflection and further research.

On a first pass interpretation I think I would wish to claim to have made some sort of case that population median age does seem to matter, and, even worse for the predictions of standard neo-classical theory, rising population is not necessarily a negative factor for economic growth. As already mentioned, at the present time Germany, Japan and Italy leading the global rising median age charge, but many more countries are soon destined to move up along the trail they are blazing. By median age the next in line are basically Finland (41), Slovenia (41), Sweden (41), Austria (41), Belgium (41), Bulgaria (41) Greece (41), Croatia (41) and Switzerland (40). And the presence of names like Slovenia, Bulgaria and Croatia should really be ringing alarm bells here, since these three belong to a group of countries who have been marked by a very special political and social history, and as such have experienced a very special economic and demographic transition, one which means, if the kind of rising-median-age loss-of-economic-thrust case presented here has any validity, then we may be facing a the first batch of what may becoming a growing band of countries who share the common feature that they grow old before they grow rich.

Now, and going back to where we started, Mankiw, Romer, and Weil (MRW, 1992) carried out an empirical evaluation of a textbook Solow growth model using a multicountry data set for the years 1960-1985 and found support for the Solow model's predictions that, in the long-run steady state, the level of real output per worker by country should be positively correlated with the saving rate and negatively correlated with the rate of labor-force growth. Interestingly Bernanke and Gurkaynak (in their examination of their work) suggest that MRW's basic estimation framework is broadly consistent with almost any growth model that admits a balanced growth path, and adds that this category includes virtually all extant growth models in the literature. In which case, one could argue argue that MRW do not only address the Solow model, in the sense of distinguishing it from possible alternative models of economic growth, but addresses the whole corpus of growth literature, since it almost without exception assumes the potential property of a balanced growth path.

As Bernanke and Gurkaynak say, there are two and only two possibilities here: either the long-run growth rate is the same for all countries (that is, g(i) = g for all i), as maintained (following Solow) by MRW, or it isn't. Even more to the point, "explaining" growth by assuming that growth rates differ exogenously (or for factors which lie outside the model) across countries is not particularly helpful, especially since such changes in the growth rate seem to be systematic and not incidental. Once it is allowed that long-run growth rates not only differ across countries, but that growth processes in individual countries often do not exhibit properties which are normally associated with a balanced growth path ( that all variables do not grow at constant geometric rates, for example) then we are naturally pushed to consider explanations for these differences, and towards a fresh approach in our models. Making evident the need for this consideration is all I can reasonably hope to have achieved in this short essay. As someone once said, at least knowing what it is you don't know is one step beyond knowing nothing.


Bernanke Ben S. and Refet S. Gurkaynak, "Is Growth Exogenous? Taking Mankiw, Romer, and Weil Seriously," NBER Macroeconomics Annual, Vol. 16. (2001), pp. 11-57.

Bloom, David, David Canning and Jaypee Sevilla, "The Demographic Dividend, A New Perspective on the Economic Consequences of Population Change", Rand, 2003.

DeLong, J. Bradford, “Estimating World GDP, One Million B.C. - Present,” December 1998. U.C. Berkeley mimeo.

Jones, Charles I, "Was an Industrial Revolution Inevitable? Economic Growth Over the Very Long Run" Advances in Macroeconomics (2001) Volume 1, Number 2, Article 1.

Jones, Charles I, "Sources of U.S. Economic Growth in a World of Ideas", American Economic Review, March 2002, Vol. 92 (1), pp. 220-239

Kaldor, Nicholas, “Capital Accumulation and Economic Growth,” in F.A. Lutz and D.C. Hague, eds., The Theory of Capital, St. Martins Press, 1961.

Krugman, Paul, "The Return Of Depression Economics And The Crisis Of 2008", W. W. Norton, 2008.

Krugman, Paul, "The Myth Of Asia's Miracle", Foreign Affairs, November 1994

Lutz, Wolfgang, Vegard Skirbekk and Rosa Maria Testa, "The Low fertility trap hypothesis", presentation at the Postponement of Childbearing in Europe Conference, held at the Vienna Institute of Demography, December 2005.

Mankiw, N. Gregory, David Romer, and David N. Weil, “A Contribution to the Empirics of Economic Growth”, Quarterly Journal of Economics, 107, May 1992, 407-37.

Solow, R. M. (1956). A contribution to the theory of economic growth. Quarterly Journal of Economics 70(February):65-94.

Solow, Robert M. (1994). Perspectives on growth theory. Journal of Economic Perspectives, Winter 1994, 45-54.

Vistesen, Claus, Japan - Engine Failure? Japan Economy Watch Blog, March 2009.

World Bank, From Red to Gray - The "Third Transition" of Aging Populations in Eastern Europe and the Former Soviet Union, 2008.

Young, Alwyn, "The Tyranny of Numbers: Confronting the Statistical Realities of the East Asian Growth Experience," Quarterly Journal of Economics, 110, August 1995, 641-80.

Appendix: Some Extracts From Solow's Original Paper

One way to close the system would be to add a demand-for-labor equation: marginal physical productivity of labor equals real wage rate; and a supply-of-labor equation. The latter could take the general form of making labor supply a function of the real wage, or more classically of putting the real wage equal to a conventional subsistence level. In any case there would be three equations in the three unknowns K, L, real wage. Instead we proceed more in the spirit of the Harrod model. As a result of exogenous population growth the labor force increases at a constant relative rate n. In the absence of technological change n is Harrod's natural rate of growth. (Solow, 1956).

Once we know the time path of capital stock and that of the labor force, we can compute from the production function the corresponding time path of real output.

If the capital-labor ratio r* should ever be established, it will be maintained, and capital and labor will grow thenceforward in proportion.......Thus the equilibrium value r* is stable. Whatever the initial value of the capital-labor ratio, the system will develop toward a state of balanced growth at the natural rate.

If the initial capital stock is below the equilibrium ratio, capital and output will grow at a faster pace than the labor force until the equilibrium ratio is approached. If the initial ratio is above the equilibrium value, capital and output will grow more slowly than the labor force. The growth of output is always intermediate between those of labor and capital.

The basic conclusion of this analysis is that, when production takes place under the usual neoclassical conditions of variable proportions and constant returns to scale, no simple opposition between natural and warranted rates of growth is possible. There may not be -in fact in the case of the Cobb-Douglas function there never can be -any knife-edge. The system can adjust to any given rate of growth of the labor force, and eventually approach a state of steady proportional expansion.

In general one would want to make the supply of labor a function of the real wage rate and time (since the labor force is growing). We have made the special assumption that L = Lo, i.e., that the labor-supply curve is completely inelastic with respect to the real wage and shifts to the right with the size of the labor force. We could generalize this somewhat by assuming that whatever the size of the labor force the proportion offered depends on the real wage.

Up to now, whatever else has been happening in the model there has always been growth of both labor force and capital stock. The growth of the labor force was exogenously given, while growth in the capital stock was inevitable because the savings ratio was taken as an absolute constant. As long as real inc.ome was positive, positive net capital formation must result. This rules out the possibility of a Ricardo-Mill stationary state, and suggests the experiment of letting the rate of saving depend on the yield of capital. If savings can fall to zero when income is positive, it becomes possible for net investment to cease and for the capital stock, at least, to become stationary. There will still be growth of the labor force, however; it would take us too far afield to go wholly classical with a theory of popu1:ition growth and a fixed supply of land.

Instead of treating the relative rate of population increase as a constant, we can more classically make it an endogenous variable of the system. Suppose, for example, that for very low levels of income per head or the real wage population tends to decrease; for higher levels of income it begins to increase; and that for still higher levels of income the rate of population growth levels off and starts to decline.

Wednesday, May 20, 2009

Is Hungary Set To Become The New Iceland?

Iceland, why on earth Iceland? Well, the issue I have in mind concerns the independence and viability of central bank monetary policy (especially in a small open economy like Hungary's) and the role interest rates, and investor sentiment, and yield differentials, and oh yes, I almost forgot, that notorious vehicle so beloved by investors the "carry trade" in producing a situation where financial dynamics get really out of hand.

In a visionary paper given at the International Conference of Commercial Bank Economists (held in Madrid, July 2007) - entitled The Global Financial Accelerator and the role of International Credit Agencies - the Danish economist Carsten Valgreen argued the following:
The choice major countries have made in the classical trilemma: ie, Free movements of capital and floating exchange rates – has left room for independent monetary policy. But will it continue to be so? This is not as obvious as it may seem. Legally central banks have monopolies on the issuance of money in a territory. However, as international capital flows are freed, as assets are becoming easier to use as collateral for creating new money and as money is inherently intangible, monetary transactions with important implications for the real economy in a territory can increasingly take place beyond the control of the central bank. This implies that central banks are losing control over monetary conditions in a broad sense. The new thing – this paper will argue – is that we are increasingly starting to see the loss of monetary control in economies with stable non-inflationary monetary policies. This is especially the case in small open advanced – or semi-advanced – economies. And it is happening in fixed exchange rate regimes and floating regimes alike.
Interestingly enough, Valgreen chose as his paradigmatic examples of central bank loss of control over monetary policy the cases of Iceland and Latvia. Equally today we could add the name of Hungary to our list. As Valgreen argued (and this remember, before the sub prime blow-out):
It is no accident that the two examples are small open economies with liberalised financial markets. Being small makes the global financial markets matter more. A country such as Iceland will be the first to notice that the agenda for monetary policy has changed, as the current and capital accounts are naturally very large and important for the economy. However, this is more of a reason to study its experiences carefully, as they might show something of what is in store for larger economies over the next decade.
So the issue really is, does the Hungarian National Bank continue to control monetary policy in any meaningful sense, or is it reduced to responding to events elsewhere? And does the Hungarian government have any effective tool left with which to fight this crisis? But getting ahead of ourselves and going too far into all this, let's step back a bit, and take a longer look at the Hungarian economy, just to set the scene.

The IMF and the EU Agree To A Larger Deficit

The International Monetary Fund and the European Union has now approved Hungary's request for a larger budget deficit this year, thus giving the government marginally more room for manoeuvre in the face of the very severe contraction in GDP. The government is now going to be authorised to aim for a 3.9 percent of gross domestic product shortfall, as compared with the earlier 2.9 percent objective, according to Finance Minister Peter Oszko. The government have also revised their forecasts, and expects the Hungarian economy to shrink by 6.7 percent this year, the most since 1991, a revision from the earlier 6 percent forecast. Hungary was the first EU member to arrange a 20 billion IMF-led bailout last year, lining up 20 billion euros in a bid to avert a default after investment and credit to eastern Europe dried up. The country then pledged to keep its budget deficit under control to qualify for the loan.

The question is, is this good news or bad news? Evidently the decision not to strangle the government budget is welcome (we are in danger of a contraction that feed on itself here, since with external demand at very low levels, applying 9.5% interest rates and fiscal tightening means the economy can simply fall into a downward spiral). But in the braoder context the news is not good. The IMF and the EU have cut Hungary some more slack simply because the ferocity of the slump in output is worse then any previously imagined, and things are now going to get worse, not better. Which made it rather strange to read in Bloomberg this morning that Finance Minister Peter Oszko has announced the government is to consider selling foreign-currency denominated bonds this year in order to take advantage of rising investor confidence. We are on very dangerous gound indeed here gentlemen! I mean, whatever happened to once bitten twice shy. According to Bloomberg:
Foreign-currency borrowing, along with slower growth, a wider budget deficit and higher government debt than elsewhere in eastern Europeraised concern about Hungary’s ability to repay its debt lastyear......IMF and EU officials this week approved Hungary’s plan torun a wider budget deficit this year and next than earlier targeted....
So what exactly has changed? According to the latest data growth is now even slower than before (or rather the contraction is sharper), the budget deficit and gross government debt are both pointing up again, and the only (vaguely) "good" news is that living standards are falling so fast that the trade balance is improving, and with it the current account deficit. But the government debt dynamics are not the same as the external trade one, and things are getting worse, not better, which makes you wonder what all the optimisim is about? In their recent stress testing exercise the Hungarian Government Debt Management Agency suggested the debt path was sustainable (see much more below on this), but in order to offer this assurance they assumed an average growth rate of GDP of 3% 2013 - 2020 even in their worst case scenario! . My estimate is a much more sobre one, and that is, with declining and ageing population to think about - the Hungarian ecenomy will be lucky to average 1% growth over the above time horizon (more justification on this below). So as far as I can see Hungary's public debt dynamics are still set on a clearly unsustainable path.

Then you need to take into account how you have a 9.5% central bank benchmark interest rate going into a 6% percent plus GDPcontraction (with inflation around 3%), so what are people thinking about? This policy mix doesn't work, and it won't. If you lower the interest rates to support the economy, the forint crashes, and with it the balance sheet of all those households still holding CHF denominated mortgages in their portfolio. Hungary is clearly caught between the proverbial rock and the hard place.

And what's more, this policy mix is leading to all sorts of distortions. Hence the reference in the title of this post to Iceland, since Iceland's problems precisely got out of hand, due to the "juiciness" of the trade their domestic interest rate yield differential offered. Viz a recent Deustche Bank report which specifically recommended buying HUF denominated assets, due to the yield differential.
Currency deals that profit from the difference in interest rates globally are returning to favor on speculation the worst of the creditcrisis may be over, spurring investors to buy eastern European assets,Deutsche Bank AG said.The Russian ruble, Hungarian forint and Turkish lira offer investorsthe best returns in the next two to three months thanks to the highestrates in the region, said Angus Halkett, a strategist at Deutsche Bankin London.The so-called carry trade, in which investors borrow in currencieswith low interest rates to buy higher-yielding assets, helped theforint and lira surge to record highs last year before the collapse of Lehman Brothers Holdings Inc. prompted investors to sell riskier assets.
Perhaps people should reflect a little more on the significance of those final few words: "before the collapse of Lehman Brothers Holdings Inc. prompted investors to sell riskier assets".

This is what is known as the "carry" trade, and it works like this. Stimulus plans and near-zero interest rates in developed economies boost investor confidence in emerging markets and commodity-rich nations with interest rates which are often in double figures.Using dollars, euros and yen these investors then buy instruments denominated in currencies from countries like Brazil, Hungary,Indonesia, South Africa, New Zealand and Australia which collectively rosee around 8% from March 20 to April 10, the biggest three-week gain since atleast 1999 for such carry trades, according to data compiled by Bloomberg . A straightforward carry-trade transaction would be to borrow U.S. dollars at the three-month London interbank offered rate of 1.13% and use the proceeds to buy Brazilian real and earn Brazil’s three-month deposit rate of 10.51%. That would net anannualized 9.38% - as long as both currencies remain stable, but the real, of course, is appreciating. Now all of this can present a big problem for a number of CEE economies, because:

Turkey’s key interest rate is 9.25 percent, Hungary’s is 9.5 percent and Russia’s 12 percent. The cost of borrowing in euros overnightbetween banks reached 0.56 percent yesterday from 3.05 percent sixmonths ago as the European Central Bank began cutting interest rates and pledges of international aid allayed concern the global slowdownwould worsen. The London interbank offered rate, or Libor, forovernight loans in dollars fell to 0.22 percent from 0.4 percent inNovember as the U.S. government and the Federal Reserve spent, lentorcommitted $12.8 trillion to stem the longest recession since the1930s.

So basically, "Big Ben's" US bailout is fuelling specualtion on Hungarian debt!

And don't miss this point from the Bloomberg article:
Deutsche Bank recommends investors sell the euro against the forint on bets the rate difference will help the Hungarian currency gain 10 percent to 260 per euro in two to three months from 286.55 today. Investors should also sell the dollar against the lira and buy the ruble against the dollar-euro basket, the bank said.
And it isn't only Deutsche Bank, Goldman Sachs recommended on April 3 that investors use euros, dollars and yen to buy Mexican pesos, real, rupiah, rand and Russia rubles.

We can see some of this impact in the German ZEW investor sentiment index. As can be seen, something interesting is happening somewhere, even if it is not immediately evident where. As Solow would have said, "I can see evidence for improved investor sentiment everywhere, except in the real economies".

So, come on everyone, off you go to Monte Carlo, and place your bets. But meanwhile, remember, in Hungary at least, the most notable phenomena are the growing unemployment and the way the bad loans pile up, even as the Hungarian economy tanks! Basically, the all the evidence now points to the fact that IMF and the EU urgently need a rethink about how they are going about things, but this is beyond the scope of the present post.

"Hungarian lenders face an increase in non-performing loans, which will contribute to “substantially deteriorating” profits for the country’s financial system, central bank Vice President Julia Kiraly said. The whole banking system, which is stable with adequate liquidity, may end up with “negative profit” this year and some lenders need to strengthen their capacity to resist shocks, Kiraly said at a conference in Budapest today."

The Fundamentals, All The Fundamentals, And Only The Fundamentals

Horrid GDP Data

The decision to widen the deficit allowance slightly is not that surprising when you take into account that Hungary's gross domestic product dropped by 5.8% year on year in the first quarter of 2009. The figure was announced by the statistics office last Friday and followed a decline of 2.6% in the last three months of 2008.

Quarter on quarter there was a 2.3% GDP decline, (down from 1.5% contraction in the fourth quarter) which means the economy was shrinking at a 9.2 percent annualised rate, quite sharp, but far from being one of the worst cases in the EU. What makes the Hungarian recession rather different is the way it has been lingering in the air since the initial "correction" in 2006, and is now becoming protracted since this was the fourth consecutive quarter when quarter on quarter growth was negative, and it is hardly likely to be the last.

Household consumption is in continuos decline (see retail sales data below), real wages are falling, and the lack of internal and external demand growth means that investment remains weak. Further, this dynamic is not likely to change rapidly. Exports have plunged - even though since imports have slumped even further we have the ironic detail that net trade is still mildly positive for GDP. However, with interest rates at such a high level and fiscal policy being continually tightened there is little chance of a 'V' shaped recovery in Hungary, and the recession has all the hallmarks of becoming an 'L' shaped" one.

Even the agricultural sector due to the high base effect of last years bumper harvest. So basically, it's back and back in time we go at the moment.

Retail Sales In Continuous Decline

Hungarian retail sales fell for the 25th consecutive month in February as rising unemployment falling wages and a generally deepening recession sapped consumer spending. Retail sales were down an annual 3.2 percent following a 2.8 percent decline in January, according to national statistics office data. Prime Minister Gordon Bajnai, who replaced Ferenc Gyurcsany last month as differences over how to handle the recession boiled over, has indicated he plans to raise the value-added tax as the recession cuts into budget revenue. This will surely push sales down even lower, and household consumption is now expected to decline by as much as 8 percent this year, according to the most recent government estimates.

Consumers started finding themselves with less to spend following the introduction of the government austerity programme in 2006 which raised taxes and utility prices.

Unemployment On the Up and Up

Hungary's jobless rate rose to 9.7% in March, up sharply from the 8% level recorded in December. Hungary's unemployment rate has been howevering continuously in the 7%-8% range for more or les 4 years now, so the current spike (with the prospect of more to come) suggests something important has changed. Between Q4 2008 and Q1 2009, unemployment claims rose by 66,000.

Of the country’s 402,800 registered unemployed, 42.5 percent have been out of work for at least a year, now. The number of Hungarians employed averaged 3.76 million in the first quarter, compared with 3.88 million in the previous three months. It is hard to see a resurgence in the number of Hungarian's employed, even after this recession is past and forgotten, since the working age population is falling steadily, and has been for some time now.

Alongside the increase in unemployment the activity rate has declined even more rapidly. Of the 117,000 laid off during the last quarter some 40,000 chose to remain inactive rather than looking for employment elsewhere. Hungary's already languishing job market received a major blow from the global economic crisis in the form of layoffs and bankruptcies, meanwhile, companies may have been more cautious in hiring new staffers. These job market trends were only to be expected, however downsizing is on a higher scale compared with forecasts. Hungary's economy is in a state of deep recession, with predictable consequences for employment, real wages, and demand.

One consequence of the sharpnesss of the recession has been that Hungarian aggregate wages are falling much more rapidly than anticipated, and this, in turn, has put a major dent in the new government's fiscal adjustment plans. The Finance Ministry had originally anticipated an additional HUF 50 billion in tax revenue. However, the new unemployment figures suggest that the decrease in wage costs may surpass the government's most recent 2% forecast. In a worst-case scenario, the drop in aggregate earnings may be as high as 4%, with a HUF 100 billion-HUF 150 billion negative impact on the budget.

Exports Continue To Fall

Hungary posted a foreign trade surplus of EUR 492.8 million in March, the largest in the past decade, according to the Central Statistics Office (KSH). Still exports were down by nearly 20% year on year, and the improved balance was the result of imports falling even more - by over 23%.

In fact Hungary's exports came in at EUR 5,173 million in March - an 18.2% year on year decline, a considerably slower rate of decline than that registered a month ago (-29.7%). Imports came in at EUR 4,680 million , a staggering 23.4% drop, following a plunge of 32.3% in February.

The gap between export and import growth (5.2 percentage points) has not been as wide as this this wide September 2007 (5.9 percentage points). The March balance shows a record high, a surplus of EUR 492.8 million, which compares with a surplus of EUR 213.9 million in March last year. Exports in the first quarter as a whole amounted to EUR 13,843 million, a decline of 26.3% in annual terms. Imports in Q1 amounted to EUR 13,233 million, down 28.5% year on year. Hungary's Q1 foreign trade balance showed a surplus of EUR 609.3 million, another record, which compares with a surplus of EUR 282.1 million for the same period of 2008.

And Industrial Output Slumps

With exports slumping in this way it is not surprising to find that Hungary's industrial production dropped by 19.6% in March, according to working day adjusted data. Over the first quarter Hungarian industrial output declined by 22.3% year on year, but - although it rose 4.3% month on month, according to data adjusted for calender and working day changes.

And activity in Hungary's manufacturing sector continued to contract in April according to the PMI reading, although the pace of contraction is now down slightly from January's all-time low.

The headline manufacturing PMI stood at a seasonally adjusted 40.4 in April, up slightly from the 39.5 registered in March, according to the release from the Hungarian association of logistics. This was the seventh consecutive month of contraction, following the all-time low of 38.5 hit in January. The Hungarian government currently forecasts that GDP will contract by as much as 6% this year as the German economy, Hungary's chief export market, also faces a similar decline in GDP. Hungarian manufacturing output contracted even more in April than in March, to 37.1 from 37.6. The export index showed a further decline to 35.6 from 36.5 in March. The only positive development came from the new orders index which showed a marginal increase to 37.5 from a reading of 35.0 in March.

Only Inflation Rebounds

Hungary’s inflation rate unexpectedly rose in April for the first time in 11 months, after a weaker forint made imports more expensive, with prices of fuel, medicine, clothing and new cars leading the rise. The annual rate was 3.4 percent, rising from 2.9 percent in March to what is its highest level so far this year. Core inflation, which filters out food and energy prices, was 3.2 percent on the year and 0.5 percent on the month. The annual rate had returned to the central bank’s 3 percent target in February for the first time in more than two years.

The prices of consumer durables, including cars, rose 1.4 percent in a month, while fuel costs climbed 2.9 percent and medicines by 1.9 percent. The price of clothing increased 3.7 percent, the statistics office said. With Hungary’s recession damping demand, consumer prices are set to increase “only moderately,” according to the central bank. Policy makers now expect the inflation rate to average 3.7 percent this year and 2.8 percent next year. The bank raised its estimate from an earlier forecast of between 3.1 percent and 3.4 percent for 2009 and 1.5 to 1.9 percent for 2010.

One factor which will influence future inflation is the new government's decision to raise the main value-added tax rate to 25 percent from 20 percent, as of July 1 in an attempt to offset declines in state revenue and narrow the budget gap. Raising the rate of consumption tax is deeply problematic in the sort of double-bind situation which Hungary faces. Germany raised VAT by 3 percentage points on 1st January 2007, and look what happened to consumption (see chart below) in December 2006, and then subsequently. This is doubly relevant to the Hungarian case since the Hungarian economy is more than likely set on the German path of becoming an export dependent economy. Weakening domestic consumption further could well prove to be a "lethal dose".

Magyar Nemzeti Bank policy makers expect the annual inflation rate to be “near” their 3 percent goal “on the monetary policy horizon” of five to eight months, they said on May 8.

“The NBH would clearly like to cut interest rates, which at 9.5% look far to high for an economy that will contract by 5-6% this year, but this is more dependent on global financial stability and declining risk aversion than the latest CPI release." Nigel Rendell, Royal Bank of Canada

And So The NBH Keeps Rates On Hold

Hungarian monetary policy makers left the benchmark interest rate unchanged at their April meeting for a third month as concern over the forint’s decline outweighed the outlook for slowing inflation and growth. The Magyar Nemzeti Bank kept the two-week deposit rate at 9.5 percent.
Policy makers didn’t consider cutting the interest rate in March based on stability concerns (according to the minutes) and even rejected a proposal, backed by Governor Andreas Simor and his two deputies, to raise the key rate to 10.5 percent. In April the rate-setting Monetary Council considered the recession, the outlook for inflation and economic stability when setting the key rate. The annual inflation rate may be near the bank’s 3 percent target on the 18-month monetary policy horizon, according to the statement.

Much Ado About Debt

Zsuzsa Mosolygó and Lajos Deli, of the Hungarian Government Debt Management Agency recently published what they call " a first a simple model to analyze the impact of the international credit line on debt ratio trends as well as to demonstrate the importance of calibrating reasonable values for decisive macroeconomic parameters".

Read stress tests.

Below you will find the chart showing their basic assumptions, and giving the outcomes for the various scenarios. The whole idea of the process was to show that Hungarian debt to GDP will not necessarily rise in the future as some analysts had been predicting. I don't want to go into all of this in too much, but if you click on the chart and take a look at the assmptions for GDP growth (which is actually the key parameter), you will find that on both the basic and the pessimistic scenarios average growth of 3% is assumed (this is impossible to attain on my view), while the "optimistic" scenario even assumes 4% (incredible). Remember these are average growth rates and over seven years (2013 - 2020). This is like selling Spanish property pre 2007 with a splendid photo of the sun and the beach.

And this comes from two apparently serious analysts, analysts who are supposed to be committed to taking a serious stab at putting the country's longer term finances on a stable footing. All they actually acheive is offering a confirmation of the worst fears of those of us who feel that the debt dynamics in Hungary are totally unstable in the mid term, and illustrate just how out of balance most of Eastern Europe now is as we move forward.

They justify their decision in the following way:

Market analysts tend to assume in their debt models a 2% economic growth for the
Hungarian economy. The National Bank of Hungary estimates currently a 2%
potential GDP growth rate, however, it does not mean necessarily the long-term
economic growth. A few years ago the estimates were higher and it seems to be
possible that adequate reforms to encourage employment would result in a 3-4% or
even higher potential GDP growth rate.

(Please Click On Image For Better Viewing)

In fact the objective of the study was not to seriously stress test Hungarian debt dynamics, but to try to argue that those analysts arguing for unsustainable dynamics have it wrong. The end product isn't very convincing. Not surprsingly the debt to GDP ratio diminishes gradually after 2009 both in the “optimistic" and “basic" version. The authors even underline that debt development does not appear to be unsustainable under very pessimistic macroeconomic conditions, either. In the “pessimistic" scenario debt ratio peaks at about 80% in 2020 and descends slowly afterwards (which is due to the assumed 6% interest rates). Of course, "pessimistic" here means Hungarian GDP rising by 3% a year every year from 2013 to 2020. To put this in perspective, using current Hungarian government forecasts average GDP in the ten years up to 2010 is something like 1.8% per annum. And this has been a pretty good decade by Hungarian standards (see chart for long term growth).

In fact, with a declining and ageing workforce, together with decline domestic consumption (see retail sales chart above), even a 1% per annum growth rate may be optimistic. In any event we won't see 3%, and nothing produced by the Hungarian government to date substantiates the claim that longer term debt is NOT on an unsustainable path. "To sleep, perchance to dream-ay, there's the rub."