[Update: Brad Setser clarifies, in the comment section, his view on Sender's FT piece referenced below]

THE last week (or was that year?) has certainly been something of a ride hasn't? In fact, I thought it would be apt to reproduce this picture by the brilliant KAL who normally spices up the Economist with his imagery that lay serious claim to the adage that a picture tells more than a thousand words. This particular specimen and the ensuing headline were on the front cover in October 1997 when markets also took investors and observers for a roller-coaster ride. I think it is quite fitting in describing the feeling many a trader and market participant must have at the moment.

Even though it could only seem as a few days ago that the credit turmoil went global with BNP Paribas' announcement that it too would be suffering subprime related write downs it is actually almost a year ago. Actually, if you use the same yardstick as I have tended to apply, the first of August will see the one year anniversary of one of the worst global financial crises (arguably) since the 1930s. The ever readable Martin Wolf (from the FT) expresses a similar sentiment in his most recent column. What is more, Wolf makes the point that we may not even have seen the end of the beginning yet. Adding to the gloom, I tend to agree with this.

Concepts such as bear market, stagflation, bailouts of tarnished financial companies, increased market volatility, and housing market busts have thus all become ingrained in investors', regulators' and not to mention central bankers' vocabulary as of late. Personally I think that we may soon add deflation to the list but more on that below.

Where Art' Thou My Fair Market?

If we begin at the first group it has not been an easy game to play; to say the least. Sure, commodities have been a solid play and in general the tendency has been one of wealth destruction in the context of risky assets as most international equity markets have seen near bear market conditions. I hear that real estate projects have been quite sluggish too. But in the current environment and given the amount of volatility, any leveraged position, in any asset class, firmly in the black one day could have easily been subjected to a margin call the next.

One excellent window into the daily workings of the market place is of course our devoted and popular Macro Man who never tires of sharing his insight with the rest of us. Usually, MM massages several topics but one interesting theme passing on his blog recently has been the difficulty with which investors, even the pros, have had exercising their hand. Consider thus the following point made by Macro Man;

As observed a few times over the last week or so, Macro Mas has found trading conditions evolve from pretty relaxing to downright terrifying at times. He's found it pretty easy to second guess every trading decision he makes, often after only a few minutes. That's an urge that he is trying to fight; in all conditions, but particularly when it gets a touch difficult, it's important to look forward rather than back.

In any event, it doesn't take much digging to confirm that conditions have been tricky, and that Macro Man hasn't dropped 50 points of trading IQ since the 4th of July. Consider that over the past 10 trading days, a period in which the SPX has dropped 5.1%, no less than seven of those days have witnessed an intraday rally of at least 1.5%. Unless one is a brilliant intraday trader- and Macro Man is not- this sort of market naturally lends itself to trades that have a, ahem, "suboptimal P/L impact."

In his examples Macro Man uses the SP500 as the main example of the adage that not only the almighty but also, it seems, the market sometimes moves in mysterious ways. These points and not least this graph fielded incited me to have a look at the intra-day volatility of the SP500. The ensuing results confirm the remarks above.

The first graph shows an implied version of volatility during the entire subprime turmoil period. As can been the past weeks have not, on the face of it, been extraordinary. Yet, if we look at intra-day volatility over the past month one can easily see the message conveyed above. The sample period in question can of course be debated ( for the short term frequency graphs I have opted for the same as Macro Man) but it is long enough the prove the point. As such and even though the trend in SP500 has been inexorably down there has been some significant spurts (or as some would call them sucker rallies) along the way. In fact, if we look at the intra-day volatility we see that a good number of spikes above 2% both with respect to the difference between high and low as well as open and close values.

In a general sense and with the distinctly execrable economic environment in the US one should also have expected more action in currencies. This is especially the case with respect to the EUR/USD that has not, despite a faint inclination, managed to break decisively above 1.60. Not unlike neglecting to change gears as you race towards the rev limiter the EUR/USD has been bouncing off against the 1.60 mark and then down again to 1.585ish. Perhaps this has more to do with the stock market than anything else as the USD moves closely together with equities through its correlation with oil; with an inverse relationship of course. In light of the point made above on the 'on-off' nature of equity markets it may just be that the USD is finding it difficult to choose a direction. One thing is certain then; there does not seem to a magic barrier surrounding the 1.60 mark but as long as the market chooses to believe in various rescue packages and the (final) inclination for the Fed to go for inflation it is unlikely that we will see a violent rally.

The latest earning reports have been a bit mixed with a significant addition to the Butcher's Bill by Merrill Lynch over to the less than expected write-off by Citigroup. I will let the gun-slingers of the world markets discern these reports but I definitely think that momentum in equities is down since the slowdown, at this point, is far from over. Although, one has to wonder whether signs that oil prices may be heading down will also provide support for equities in the immediate future. Sean Maher thinks so for one. The main point as can also be derived from the plight expressed by Macro Man would however be that even though you have the overall trend right, you should not leave you trading screen for more than a whee coffee break less you wanna be pulled down by a quick reversal.

Finally with respect to the markets and on a more general note I do tend to agree with Steen Jakobsen that the next bout of volatility will (or more aptly should) be in currency markets. At least, one has to wonder why there has not been more action on the back of the Fannie/Freddier debacle. As such, one would have expected risk aversion to have hit currency markets to a higher degree than has been seen (more about that here). However, position taking to take advantage of the expected risk reduction has so far been an ill-advised and actually a quite painful play. In this way and while the USD/JPY did have a go at 104ish it ended the week close to 107. Furthermore, the GBP/JPY clocked in at a healthy 213 while the EUR/JPY continued to flirt with 170 as it ended the week at 169.2. Interestingly and once again this may be up to the rather volatile and uneven way in which equities (e.g. SP500) have been moving down and then up again. In fact, equities ended the week with a rather strong showing which suggest that while risk correlations have not dissipated all together the link has grown weaker. In the case of the JPY, it may also be a sign that something else is going on; pressure from outflows perhaps? 

Revisiting Old Arguments?

Now, this is obviously not only a story about market volatility which can thus be seen as a derivative of a much wider issue in financial markets and with respect to the global economy. More specifically it is a story about the global economy, its structure through capital flows, and the sustainability of these. In this light, a couple of important new themes have emerged lately while some old ones have been intensified.

On obvious lingering theme is the continuing weakness of the US economy and financial system which is not only sending ripples through the US society but also the global economy. As you can imagine the econsphere and media in general have been absolutely buzzing with the recent shot across the bov in the form of the debacle of Fannie and Freddie Mae. A good place to start would be Tyler Cowen who provides a good overview of the initial flurry. RGE's Finance and Market monitor which has virtually been turned into a Fannie/Freddie Mae watch this week is also a good place to; I would especially highlight the following two from James Hamilton. Also, Thursday's edition of Morgan Stanley's Global Economics Forum features a fine re-cap by Richard Berner and David Greenlaw. Finally, the Economist's print edition just fresh off of the publisher also devotes a fair amount of pages to the issue at hand.

Obviously, even after churning through the pages linked above you would hardly get that illusive "big picture". It is certain that the Fed, in conjunction with the Treasury, have rolled out the big guns in order to ensure that Freddie and Fannie do not fail. So far it has worked, since even though the shares have plummeted the debt outstanding in the form of agencies have not. This is what was initially the intention I think since a crash of the agency market would have been catastrophic.

One particularly interesting aspect here is obviously the fact that a fair part of the financing of the US external deficit and by derivative its mortgage boom was done through purchasing of agencies by foreign central banks and state investment vehicles. The link to the USD peggers are brilliantly exposed by Brad Setser as he estimates that China alone holds anywhere between $500 and $600 billion in agencies or roughly 10% of the outstanding stock.

The functioning of Bretton Woods II and the collective bet on the US consumer of last resort is well known. As such and since the external deficit in some ways has been fuelled by the financing of the housing boom it would only be natural to expect that as the debitor struggles so does the creditors. Well, unfortunately this does not seem to be the case. I say unfortunately here since the devil in me (and although I know this is not really an option) would have no problem seeing US creditors taking part of the hit from this; i.e let those bonds burn if that is what it takes. Consequently, I had to shake my heads several times when I read some of the initial reactions by foreign holders of agencies as conveyed by one of Michiyo Nakamoto's recent pieces in the FT. Consider example the following tidbits:

The Financial Supervisory Commission (FSC), Taiwan’s regulator, said the market reaction had been driven by fear rather than fact, pointing out that the US lenders’ federal backing made their debt quasi-governmental.

(...)

“We believe that the impact on Japanese banks [of their exposure to the government-sponsored enterprises] is minimal since they do not own equity,” Hironari Nozaki, banking analyst at Nikko Citigroup, said in a report yesterday. The default risk of the GSE bonds that Japanese banks owned was extremely small, he said.

Now, let me be clear that I don't really think that Paulson and Bernanke could have acted otherwise here (well, the banning of "naked" shorts is another matter) but what a royal mess we have on our hands. It is hardly a wonder that some, in the current environment, are musing about the credit worthiness of the US government all together. Obviously, this has a whiff of theatricals about it, not least in a context where one major rating agency recently downgraded India at one and the same time as Japan is upgraded (recently) and Italy maintains its rating. Anyone with a definition of "economic fundamentals" ready at hand?

In a more structural perspective the FT (and here through Reuters) also ran story well in line with current sentiment as it suggested how the big players amongst the sovereign wealth funds and central bank authorities were seriously considering to diversify away for the USD. This is hardly news as these stories have been surfacing in regular intervals since the subprime turmoil hit global markets. Given the y-o-y slide in the buck it is difficult not to put more than a little bit emphasis on this story but to me it is also somewhat of a smoke screen. As such, I wholeheartedly agree with those who believe that the Bretton Woods II is due to a revision. However, so far I can only see one strong impetus for this and that is the obvious need for the US economy to get the house in order and reduce the twin deficits. Recently quarterly reports on export contribution to US growth are good news in this regard. The other part of the equation however is still somewhat missing.

The question we need to ask is thus the extent to which the USD peggers can actually turn the ship around at this point ... you know, with respect to becoming consumption driven and all. More to point and if we accept that the US should be replaced by another economy or a group of economies it is not straight forward, at this point, to see where the candidate(s) are.

With respect to the illusive concept of diversification I rely on the principles of the comparative advantage and thus the work by Brad Setser and Rachel Ziemba. The former massages the above mentioned article posted in Reuters and unlike what you might expect he does not latch on to the fact that Gulf states are reducing their exposures to the USD (he already knows the data by heart I imagine). Rather, Setser points out the growing discontent of reserve asset managers with their investments in Europe and the US.

But perhaps the most interesting part of Sender’s article is the part suggesting that the United States’ creditors are increasingly frustrated by US policy — and no doubt also unhappy that their investments in US (and European) financial firms have performed so poorly.

The fact that this frustration is starting to spill over into the press is news. My guess is that a lot of funds are down significantly so far this year, and in some cases the falling value of their existing portfolio may be a big enough drag to nearly offset all the new oil inflows.

Regarding the prospect of some kind of USD crash I still think we need to keep our heads decidedly cool. My feeling is thus first of all that we need to tackle the extent to which we are past a point of no return. The extent to which we will see significant diversification (or depegging) therefore rests on two important obstacles in my opinion. First of all there is the question of what SAFE et al. should diversify into and whether the 'recipient(s)' would accept this? Surely, the Euro is heading for more than a bit of problems in the years to come which will make it quite clear that it cannot take up the baton for the US. Secondly, many SWFs and central banks WOULD have to incur loses on their remaining USD holdings if they decided to bury the buck. All this does not mean that we won't see diversification at all; to put this as an argument would also be somewhat of a reality defying argument. My only point would simply be that the process will not be a linear one in which the Euro takes over from the Dollar and therefore that old notions of de-coupling and rebalancing need to be taken with more than a pinch of salt.

As a final point on this, the hunger with which the recent Fannie/Freddie offerings was munched suggest, at least initially, that it is all back to business as usual. Note here that 61% of the issue was picked up by investors outside America apparently content with the higher, government backed, yield over treasuries.

To Inflate or Deflate?

If the credit crunch began with a fear of growth and damage control it has since shifted into a focus on the adverse effects from inflation. Especially, the nexus made up by the pressure from headline inflation fuelled by a weakening Dollar over to the ensuing pressure on risky assets have been much under scrutiny. In fact, it would not be a long shot to say that the graph below pretty well sums up the market's response to the credit turmoil.

The focus on inflation is understandable and important not least in the context of indications that inflation expectations have been edging up. Much debate has been devoted to the extent to which global central banks are really serious when it comes to focusing on inflation at the same time as the economic edifice is crumbling. Of course, in emerging economies such as for example in Eastern Europe, key parts of Asia and Latin America inflation is a very serious concern as many of these economies are quite literally burning up. But how much can higher domestic interest rates help here? In a world where capital goes for yield, inflation targeting by one central bank will not work if the rest of gang chooses to go for growth. Moreover, there is the delicate point with which to balance the need for emerging economies to see nominal appreciation of their currencies while avoiding to become to the new global consumer of last resort as the hot money comes flowing in. China is almost a perverse example here since, while there has been no official mutterings about a revaluation money is coming in fast on the expectation that inflation ultimately will bring the USD peg to its knees (see nice discussions here and here). In India and Brazil policy makers are wrestling with the same problem as the attempt to keep the economy balanced conflicts with the need to do something about inflation. There are no easy solutions here it seems.

In an immediate policy context, there is also a lot of sentiment flying around I think. Lowering interest rates to cushion those who should not be cushioned and, in turn, submitting the global economy to a heavy yoke of inflation is thus not popular. Bernanke and Paulson are certainly making themselves distinctly unpopular in some parts of the investment community as they have chosen to respond to the crisis by supplying ever more liquidity. But could they have done anything else?

As I have argued before it is rather funny to see the US being branded the scarlet letter of the global excess liquidity source. The point here would be that it was only 1 and a half year ago that this role was assigned to Japan and since the BOJ has not exactly managed, with great force, to shed itself of the low interest rate policy it is difficult to see whether anything has materially changed? I shall be the first to admit that excess global liquidity is a problem and that this problem to a large extent is at the heart of the current mess. However, I would also wish that more people tried to connect the dots in a slightly more sophisticated way than to blame it all on Greenspan and Bernanke.

Ultimately then, this is first and foremost a debt crisis coupled with a search for assets to match the structurally persistent availability of excess liquidity. Thus, it is also important to understand that as we are about to enter a significant bout of asset destruction and while at the same time providing more liquidity, the global yield game is likely to intensify. The debt problem and the subsequent need for many economies to significantly tighten the belt and ramp up savings is a key trigger effect here. It means that the effects on the real economy may well turn out to be deflationary in the context of some economies who simply do not have the ability to propel internal demand at the same time as turning the ship around towards more focus on saving. If you doubt me on this I suggest you take a look at Spain and quite possibly also Italy, Germany and Portugal; not to mention key economies in Eastern Europe but that may be further into the future. In the end this is also why I have been persisting in my focus on the distinction between core and headline inflation; In for example Japan (top graph) and the Eurozone:

The figures obviously do not indicate that core prices are not rising since in many economies they are; and fast too. The point I would like to emphasise here is simply the asymmetries by which the current crisis may unravel with inflation continuing on a global scale while some countries risk falling into a Japan like deflation trap, out from which it is very difficult to escape. My hypothesis is furthermore that countries with a weak demographic profile will be in the front line as potential candidates to see persistent and ongoing deflation. In a Eurozone context I have been particularly adamant in pointing towards this risk since it is quite clear I think that the ECB would find it very hard indeed, if not impossible, to administer some variant of ZIRP in the context of one country. And then we have not even talked about the effects any provisional liquidity arrangements would have on the Eurozone's countries' relative sovereign debt standing.

So far the market discourse still seems set on inflation even if the recent near collapse of the two US mortgage giants have moved the focal point a slight bit. Moreover, and as is visible in the graphs above oil has recently taken a dip which is prompting many to ask whether the current rally is, if not coming to an end, easing slightly. In-house RGE analyst Rachel Ziemba asks the same question while Paul Krugman and Stefan Karlsson chimes in. I tend to agree with the sentiment expressed by these contributions and while it is true that oil may sell off it is difficult to see a plunge. I think there is a considerable hysteris effect in operation here (in the long run) with respect to commodities in the sense that they are much more elastic to the upside than to the downside. In the short term of course it may be well be the opposite case. 

My main point would simply be however that there is very little central banks can do about this. In fact, as can be seen from the recent Eurozone trade data flogging the Buck has not helped with that distinct problem. I would also add that we should never forget how rising costs of primary goods could ultimately add to the deflation pressure due to the cross price elasticity with core consumer goods. The key for me is the extent to which a given economy is able to muster the sufficient domestic demand to avoid seeing deflation in its domestic market if the going really gets tough. Italy, Spain, and Germany for example may not be able to do this.

Faint mumblings are consequently also beginning to move the focus from inflation to deflation/growth. In the Eurozone where the ECB managed to sneak a last minute raise past the post Trichet is bracing for a recession in the next two quarters which effectively means that the ECB's hands are tied. I also noted that the D-word was mentioned in a Bloomberg headline recently as Société Générale's Albert Edwards, among others, was quoted saying that deflation may be the next story to watch out for. Michael Mandel makes the same observation predicting that the next story on prices will be deflation. I hardly think that this would be a surprise. Personally, I am on record for flagging the deflation flag for quite some time and while it has nothing to do with complacency against inflation or me being an apologist, it is simply a question of adequately balancing the risks.

One Year In ... Still Some to Go

Almost one year into the credit crisis the hard truth remains that we are not near the end of the road. Things are likely to get worse before they get better.

In this note I have dealt with a couple of themes. Firstly, there is the strict market perspective where fundamentals and trading models are being revised by the day. As I noted, I do think that we need to see some volatility in currency markets soon, but in what direction obviously remains the key question.

More specifically, I have also re-visited old arguments and not least in the context of the much tarnished BWII edifice. In many ways, one could argue that it already has crumbled or at least changed significantly. It is consequently quite clear that the US decisively has signalled the unwillingness to act as the future anchor, effectively pushing the decision over to the USD peggers who are finding it more than a bit difficult to contain inflation while at the same time staying pat with their currency policy. Given the extent to which emerging market and BRIC central banks are willing to intervene it is very difficult to envision some kind of rapid move. All this has so far handed the Euro with the dubious honor of taking over from the USD. This is not very likely to be sustained, but when that is said it is also hard to see how the EUR/USD could suddenly move back into the 1.20s. The need to correct a US deficit and rebalance the US economy will mean that Trichet et al. WILL need to pay off their strategy with interests.

In a similar vein, I have emphasised the need for economies such as Brazil, India, and Turkey to accept their potentially new role in the global economy. If they do not, we will simply have too many exporters relative to importers and even if these three do not go mercantilist there will still be too much savings going for too little yield. This is still the ultimate nut to crack in the global economy and the sooner we realize that demographics have something to do with it the better.

Finally, I also noted how the discourse perhaps slowly is beginning to nudge back onto growth and, if core inflation remains subdued, deflation. So far, this is not the case but it is a narrative important to watch I think since it may change quite quickly.

Post Script

Here at the end of my note I would like to feature (or present as it were) two pieces which I enjoyed immensely reading but never really got to comment on; an omission which I am sure my readers will excuse given the sheer amount of pundity being posted on the internet. The author is one Cassandra who, apart from doing Tokyo on a regular basis, recently returned from the soothing calm of Tyrol in Italy to resume services. 

On a side note I would not be going out on a limb, I think, when I say that Cassandra, together with Macro Man and the olive producing Charles Butler make the econsphere a distinctly better place to be. The reason for the grouping of the three might seem odd at first but if you read carefully and stay with them for a while you will see that they manage to combine succint observations and deep financial knowledge with excllent writing; a combination I value greatly.

Anyway and to move things back on track before this turns into a fan letter I thought that the following pieces by Cassandra were very much to the point with respect to (attempting) a lateral cut through this whole mess in which the economy and financial system finds itself.

Liquidity Tug-o-War??

Notes To Self - End Q2 2008

A belated plug I know, but still much worth a closer look.      

There is certainly a lot of commotion at the moment not least surrounding the rescue plan to shore up the two biggest US mortgage lenders Fannie and Freddie Mae, but also, and if we stay in the US we had the collapse of IndyMac, in Spain Martina-Fadesa is in the ropes and in Denmark we have Roskilde Bank.

Especially, the last event prompted me into action as I decided to have a closer look at the Danish economy and where it might be heading. In many ways Denmark is similar to other credit crunch struck economies not least in the context of experiencing a severe unravelling of a housing boom. As we saw last week this is now beginning to have collateral damage. Yet, Denmark is also a bit different not least because the economy is going into this crisis with a positive balance both on the public but also ever so importantly on the external books. 

My note is up on Global Economy Matters and here it is as it is presented over at that space; please click on pictures for better viewing; oh and sorry for not formatting them to Alpha.Sources' template.

--- 

Stagflation, credit crunch, bank bails-outs, and housing market busts are all concepts that are unfortunately now becoming all too familiar to the current Danish economic discourse and indeed even to the Danish public at large as they read their morning paper over breakfast, or listen to the radio on their way to work. And not of course in their United States version, but rather in their homegrown variant. But just how serious is the construction and banking problem in Denmark?

A quick initial glance at the short term data definitely suggests that a serious batch of storm clouds may well be gathering above the economy. Not only did Denmark claim the dubious honor of being the first economy in Europe to exhibit a technical recession but it was also recently handed its very own banking crisis à la Bear Stearns and Freddie/Fannie, since only last Friday the 10th largest bank, Roskilde Bank, had to go hat in hand to the central bank for a provisional liquidity guarantee as the writedowns it was about to announce to the market were judged to be too tough to swallow without risking a bank run.

However, things in Denmark need not be as serious as that initial glance might suggest, and, at this point at any rate, I would most definitely not group Denmark together with other European economies - Spain, the UK, Ireland - who who certainly seem to be facing a very tough time indeed moving forward. On the other hand, I think it is reasonably safe to say that things in Denmark will almost surely get a lot worse before they get better, and really the key question is not how deep will the recession be, but what will be the structural characteristics of the economy which subsequently emerges?


So in the analysis which follows I will attempt to answer this question question through an in-depth look at the Danish economy, where it is, where it has been, and where it is about to go.

If we start at the beginning, with headline GDP growth, it is easy to see the extent of the recent slump of the Danish economy.

In fact, for all the talk about a Danish recession which evidently is measured on a q-o-q basis the y-o-y is more enlightening in terms of what is actually going on, since if we look at y-o-y we can see how the slowdown can be traced back to the first quarter of 2007 , from which point Danish growth has been consistently oscillating between negative and positive, while it is only now that the shoe has finally dropped into recessionary territory. Some economists do question this view it should be noted and are busy cooking up a their own ragoût, offering a what boils down to a technical explanation for the consecutive negative q-o-q GDP reading. This time around, they argue, Easter may be a distoring factor since it fell in Q1. Ironing out the "Easter impact" may positively affect the GDP reading for the second quarter. If Denmark does rebound with a bang in the second quarter, then this would probably be the reason. But will it? The Easter argument is convincing as far as it goes, but it should not distract us from the main message in the sense that activity across the board was down in Q1 and that Denmark may now be entering a longer term correction.

In order to put us on more solid ground here is a break-down of the GDP components. If we start by looking at private consumption, it is clear the Danish consumer seems now to have pretty definitely thrown in the towel, but what a ride it has been on the way to this point.

As I will explain below one of the key drivers of the recent Danish consumption boom has been the upward march of house prices. Now that higher interest rates and rising energy costs are rolling in at the same time as the housing boom gets well past its peak it is only natural that consumers are scaling back. Danske Bank analysts however (the only link is in Danish I am afraid) are fairly sanguine when it comes to their assessment of the Danish consumer. They limit themselves to pointing out that when compared with other "property driven" countries such as the UK, the US, Norway and Sweden the increase in Danish consumption has not been that outstanding. I think such comparisons are - by their very nature - rather spurious. The main point we need to think about is not really the relative strength of the Danish consumer but simply how much in absolute terms we expect consumption to be a drag on growth. In this respect I tend to agree with Danske Bank that it is unlikely that consumption will plummet completely. This is true, at least, in terms of the immediate outlook where an extremely tight labour market will support consumption in the sense that people still have a steady income to spend from. Yet, the credit crunch following the subprime turmoil has not passed the Danish doorstep without paying a visit. The recent quarterly report by the Danish central bank elaborates on this in great detail. Especially chart 11 (p. 20) offers a nice perspective as it shows the year on year trend in lending growth which is inexorably moving down even if the growth rate is still positive. As a final point, Danske Banks points out that real income is still climbing if we deflate the wage bill using core prices only.

Ultimately, my feeling is that it is still too early to call it on the consumption side. The outlook is clearly deteriorating though, and consumer confidence is slumping. Much will depend on the extent to which the labour market softens in the coming quarters (and indeed years). Apart from this, the degree of the unravelling on the housing market boom and the extent to which lending institutions tighten credit standards and lending conditions will obviously also be important. Danske Bank is looking for an increase in consumption at about 1% y-o-y in 2009. Given the outlook on lending and housing I would say that Danske Bank is perhaps rather optimistic.

While it is still a bit too early to say whether consumption will drop down through the floor and descend into the basement, it does seem clear that investment is now heading into a decisive slowdown.

The very impressive recent investment performance by Danish companies - which formed the backdrop to the recent expansion - is by now pretty well known. A tight labour market and low interest rates have consequently provided Danish companies with ample reason to invest. This coupled with residential investment that has been literally booming has meant that investment was a strong driving force in the Danish economy. From 2001 to 2006/07 residential investment increased from 3% of GDP to 7%. All good things must come to and end however and it seems clear from the above graph that the trend is now much more modest and even possibly back stepping in the form of contraction. If Danske Bank are correct in their assessment of fall in residential investment to the tune of about 2% in 2008 this will be a significant drag on aggregate fixed capital formation.

Moving on to the public sector we find one major advantage for Denmark going into the coming downturn, since Denmark has been running a very healthy surplus on the public books to the tune of 4.4% in 2007. Moreover and as can be observed below Denmark is trying to be the proverbial top of the class EU student by bringing down public debt quite dramatically over the past decade.

So far, however, it is far from certain that the coffers will be opened to accommodate the slowdown. Economic advisors to the Treasury and central bank economists seem to have carried the day in the initial skirmish over whether fiscal policy should be used to cushion the economy. In fact, there is an emerging discourse pointing to the fact that the failure to implement fiscal spending contraction measures back in 2006 are what has brought Denmark into its current mess with an overheating and now also stagflating economy. This sentiment will linger until we see a marked deterioration in labour market conditions after which politics may well take over. At this point however the continuing extreme tightness of the labour market will mean that overheating concerns could even lead to a preemptive move to reign in public spending further for the fiscal year 2009.

 

Finally, if we come to look at the external sector we find another of the defining factors that separates Denmark from many other credit crunch struck economies.

The main point would be that even though Denmark has been ramping up consumption to a significant degree this has not lead to a deficit on the external books; even if recent quarters have seen the balance edging slightly into negative. This relatively healthy position, when taken with the situation in the public accounts, is obviously quite important. What we seem to have here is a picture of an economy that has not, on the face of it, been living beyond its means.

One important point to take away from all this I think is the idea that Denmark may be benefiting from being a small open economy situated near the apex of the global value chain. This should then translate into the fact that at any given point in time what goes out adds more value than what goes in, making it "easier" to sustain a positive external balance even if the economy is operating near full capacity. In a cyclical perspective however, there is reason to believe that with the recent surge in the Euro - and by implication the Danish Krona which is effectively locked into it - the positive balance will be more difficult to sustain in the immediate future. This would be certain to bring all kinds of ghosts forth from the past as it was exactly a ballooning external deficit which prompted the Conservative government in the 1980s to instigate the, among Danes now famous, Potatoe Treatment which was a quite harsh bout of fiscal contraction aimed at halting domestic consumption and putting a lid on housing and residential investments.

If the above charts and narrative sketch out the immediate state of play with respect to the Danish economy it could still be argued that I am missing one important aspect of the situation, since Denmark, like the rest of the world, has also caught the stagflation flu which seems to be going the rounds of the global economies right now. And just to prove that it isn't always different, Denmark's inflation is now running close to the 4% mark at one and the same time as the economy is slowing significantly.

As with the general global picture, the increase in prices is coming almost exclusively from headline pressures but many domestic economists would also point towards the fact that the failure to prevent the Danish economy from bumping up against its capacity limit will exacerbate the incoming downturn. However, if we really want to get down to business with respect to the recent performance of the Danish economy, and its immediate outlook, there are two sectors which are absolutely crucial. One is the labour market (and the associated demographic profile of Denmark) and the other is the housing sector.

 

We Don't have Subprime Loans in Denmark, Or ... ?

Among the wide array of economies who have seen a housing boom in the recent years Denmark has been right up there at the top of the list.

For several consecutive installments Denmark thus presided firmly over the pole position in the Economist's house price index and also OECD's 2006 survey of Denmark voiced concerns about the state of the Danish housing market and its potential impact on the real economy should the edifice collapse. In this light, it could seem as if what was back then treated as mere worries now is very much reality. Consequently, the Danish real estate and housing market began its slowdown in some time in 2006 and at the present time there does not seem to be a pick up in sight.

Due to a big reform of the Danish municipal governance system in 2007, statistical work on this topic is quite difficult. Basically, there is a structural break in the statistical series right at its apex in 2006, which makes it rather difficult to obtain a clear picture of what has happened since, and thus put the present situation in some sort of context. Yet, there can be no doubt that the slump is lingering and even intensifying. The price chart above shows us that much.

Moreover, it is very important, in a Danish context, to latch on to the crucial importance of the Copenhagen region in the whole housing discussion. Basically, and while both total turnover and prices are declining on a country-wide basis, the correction in Copenhagen has been particularly severe. This is important because the Copenhagen region naturally commands a crucial position in terms of wealth and income concentration in the Danish economy. Particularly noteworthy has been the extent to which apartments have seen a correction in prices. The situation is now one of a quite serious mismatch between the supply of housing and demand side capacity to absorb it. Obviously, everything has its price and while I have faith in the dynamics of supply and demand the key is the extent to which this price will allow existing owners to actually repay their mortgages. So far, this talk about "technical defaults" is only a fringe discourse but the longer prices fall the more this problem will grow I think.

We also need at this point to consider the relation between house prices and consumption. In overall terms, there are two ways in which we could do this. One is through a traditional academic type discussion about the so-called wealth effect in the context of home price appreciation and whether this link has been strengthened by creative credit products and, as a consequence, the ability to tap mortgage wealth for consumption. The second would be a more subtle point about the link from housing/construction to the banking sector and thus over to tightening credit standards for companies and consumers. This after all is what the lingering credit-crunch mess is all about. Roskilde Bank for example is an important warning shot across the bow in the sense that it was exactly an overly lax lending strategy towards construction/real estate investors that brought the bank to its knees last week.

Regarding the wealth effect from housing a considerable amount of ink has been spilt by academics in recent times over the strength of this link. Normally, the discussion cuts a sharp line between Europe and the US where the wealth effect in general is considered to be stronger; this, by the way, goes for most asset classes. In e.g. a US and UK context, Jirka Slacalek has estimated that that wealth effect from housing is considerably stronger than it is for equities while at the same time confirming that this effect is particularly strong in Anglo-Saxon economies. Turning to Denmark, the rule of thumb, as it has emerged amongst forecasters in the central bank and the Treasury is that 100 dkk increase in housing wealth will translate into a 10 dkk increase in consumption. In general however, this link is not carved in stone and it may then be a question of just what metrics you look at. However, it is reasonable to assume I think that given the appreciation in house prices, and then the subsequent increase in wealth, in Denmark consumers will have had a tendency to increase their propensity to consume. The principal point would really be that the wealth accumulated via the appreciation of household's main asset act has served as a de-facto substitution for saving which would otherwise have been done out of income.

 

At the end of the day the vulnerability of the Danish economy to a housing downturn basically boils down to the extent to which Denmark has been drinking the subprime cool aid in some way or another. Danish bureaucrats would almost certainly frown at such a suggestion, and point to the key institutions in Denmark; the so-called real estate agency institutes who hold the sole right to issue the convertible bonds used to finance homes. However, with amortization free loans, maturities running up 100 years and adjustable rates it merely seems as if Denmark has had its own distinct subprime lingo rather than holding the high ground as many claim. So far though none of these major credit institutions have shown signs of distress while at the same time many analysts expect banks in the mid-size segment (e.g. Roskilde Bank, Amagerbanken, Fionia Bank, and Forstædernes Bank) to be in the frontline of the barrage which may come next. Yet, as house prices continue to drop and as delinquencies steadily rise, it is not certain that old dictums and assertions may not be in a need of some speedy revision.

Needless to say, I believe that the housing sector and the link to the financial sector and then over to the real economy is crucial to watch in a Danish context. At this point, Denmark may very well be able to navigate the skerries which lie ahead but I definitely think that the ingredients for something much more dramatic are there.

Labour Market and Demographics; an Economy at Full Capacity

Having described the housing sector above we turn now to the labour market. Even though many would perhaps, tongue in cheek, call yours truly a bit of a demographics fundamentalist I do not think that it is entirely out of place to say that if you want to understand the Danish economy at the present moment, it is all about demographics.

As can be seen from the unemployment chart above, recent years have steadily ground down Danish spare human capital. But in reality an unemployment rate running at 3.8% in 2007 does not really tell the whole story here, since if we look at the monthly development we can see that unemployment dropped to an almost unbelievable level of 1.7% in May or a mere 47.500 people. These levels adds a whole new perspective to the adage of full employment. Even as the economy contracted in the two last quarters it still created employment, albeit at a slower pace than in recent quarters.

Obviously, the number of new jobs created will steadily decrease as the slowdown grabs hold but there is a silver lining to all this. Given the demographic analysis I field below we may in fact be witnessing an economy at its historical peak in terms of capacity to produce economic growth or more aptly economic trend growth; (migration as always may adjust the path of the process). This conclusion is mainly pinned on the supposition that economic growth at all points in time is driven by people, or more specifically; the right mix between the quality and quantity of human capital.

The formal picture of Danish demographics is shown in the chart below as it plots the Danish population and its growth rate.

The series for natural increase also includes migration which is why there is a spike around 2005-2007 as Denmark received a large batch of workers from Eastern Europe; especially Poland. However, one thing is total population growth and quite another is the proportional change of the population. Thus, if one wants to understand what it means that the economy is at its "peak" one need to accept the tenets of demographic economic analysis which isn't that difficult once you get down to the basics.

Firstly, we need to take a look at two process which combines to form a steady process of ageing of the Danish society; fertility and life expectancy. Starting with the former we actually get a quite interesting picture.

The graph above is very thus very illuminating. Not only does it show that Denmark like most other societies has gone through the demographic transition with a subsequent drop in fertility, it also shows how the decline in fertility during the final (and at this point still ongoing) stages of the demographic transition is driven by two processes. One the one hand you have the tempo effect (also called birth postponement) which covers the process by which women postpone the birth of their first child. This has a knock-on effect on the second process (the so-called quantum effect) which is really synonymous with the fact that women choose to have fewer children in total. The main quibble with measuring the quantum effect is that it can only be done post-hoc through measurement of total-cohort-fertilty, although some "on the fly" proxies such as ideal family size can be used to get an impression of what is happening.

As can be seen Danish women have definitely taken birth postponement to heart, but luckily the quantum effect in Denmark seems to be much less pronounced than in some of the very low fertility European societies. Thus, Denmark is one of the few countries (France would be another example) who have been able to rebound from close-call brush with lowest-low fertility (a TFR of 1.5). On the other hand, on the life expectancy front Denmark is not particularly different in that she is, like most other OECD countries, experiencing a steady, and nearly linear, increase in life expectancy for both sexes.

The decline in fertility and increase in life expectancy taken together serve to produce a steady population ageing process which can be fairly easily tracked through either the rise in the median age of the population, or, more intuitively, via the decline, relative to total population, of the most productive cohort. In this case, I have chosen to label the cohort the proportion of the population aged 25-49.

As can be seen this age group peaked in Denmark around 1997 and is now set to steadily decline. Clearly, and given the fact that Danish fertility seems healthy in comparative terms at about 1.8 child per women, this decline will fairly be slow.

The main point to take away from all this is thus not that Denmark should now be grouped together with the s