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"Being a Keynesian means being a Keynesian in both the good and bad times."

Andres Velasco (Finance Minister in Chile) [1]

It has been a while since I last had a thorough look at Chile (here and here); more specifically, the last time I had Chile under the loop was in October 2008 and thus around the time when the global economy was about to enter two quarters (Q4-08 and Q1-09) of absolute horror. Whether we are past the worst at this point in time is debatable and I am, personally, skeptical with regards the narrative of second derivatives and green shoots, but it is hard to deny that it does represent a narrative and a fairly strong one too. In this context I thought it would be interesting to have a look at Chile, how it has faired and how we can expect it to fair in the immediate future.

It will immediately become clear as we move forward through the data that Chile is a bit unique both in a global and most definitely so in a Latin American context. In this sense, and if not for any other reason, the following should confirm that although the global economy is in the midst of the worst crisis since the 1930s, there are some economies who are better positioned than others. In order to pin down some fix points from which to begin this analysis, it is interesting to go back to Q4-2008 and the note by Morgan Stanley analyst Luis Arcantales who pointed out that as the global economy was about to slide, it was Chile's time to shine. This analysis was echoed in the Economist's small article about Chile in which it is argued that Chile is cashing in the fruits of rigour.

The question is then; is this true?The analysis which follows supports this positive view on Chile and I thought it would be fair, at the offset, to identify the two underlying mechanisms for this position.

First of all, Chile has been saving for a rainy day and especially in the context of the copper windfall enjoyed in the past years, Chile have been acting with utmost prudence. Coupled with a big pool of sovereign assets/wealth tucked away in main state investment vehicles (SWF) this provides Chile with an enviable and essentially remarkably positive fiscal profile going into the crisis. The most important aspect of this strategy of prudence has been the joint commitment across political leaderships to maintain a structural fiscal surplus of 0.5% of GDP in order avoid the copper windfall from pushing Chile into a variant of the Dutch disease as well as of course as to lock in savings for rainy day. Between 1996 and 2006, Chile’s public balance averaged 1.5% of GDP and coupled with a substantial amount of the copper windfall parked in the SWF Economic & Social Stabilization Fund (FEES) it has granted Chile with a net debt position of -11% (i.e. a net credit position of 11%).

In addition to the story about the timely management of the Copper windfall, I have also emphasised the demographics of Chileand in particular the fact that the key working age brackets are still growing as a percentage of total population. In many ways, Chile is now moving on the outskirts of the so-called demographic dividend with the age group 25-64 still growing as a percentage of total population whereas the age group 25-44 is declining. It is an empirical fact that such favorable demographic momentum has a strong effect on macroeconomic performance; see e.g. Bloom et. al 2007 and Bloom and Williamson 1998.

However, with fertility coming in at replacement levels in these very years Chile now stands on the boundaries of the much debated second demographic transition (SDT) and it will be interesting to see just how Chile enters this second leg of the demographic transition (if at all). It is important to point out that the SDT is far from an inevitable process, but in it the light of the regularity with which life expectancy has continued to increased at the same time as fertility has steadily moved below replacement levels in one country after another, it is difficult to imagine that Chile won't also enter a new stage in its demographic transition. However, and whatever happens in Chile as we move forward it does not change the fact that Chile has the demographic winds blowing firmly in the back at the moment even if the direction is changing. The key will naturally be the extent to which Chile manages what comes next in terms of demographic evolutions.

Touched, but not Harmed?

Even with this set of formidable fundamentals the global economic crisis has not left Chile untouched. On a quarterly basis the third quarter of 2008 marks the last quarter in which Chile grew at the rates its citizens and policy makers have been used to over the course of the years of abundance leading up to the crisis. Since Q3-2005 the average growth rate of Chile's output measured by GDP was a remarkable 4.5% q-o-q, a figure which clocked in at a puny 0.2% in Q4-2008 and then on to a full blown contraction of 2.1% q-o-q in Q1-2009. In fact on an annual basis, Chile has observed negative growth rates since Q3-2003.

The central bank expects GDP for 2009 to hover around the 0% mark with -0.75% as a low point and the 0.25% as the corresponding best case scenario. This relatively bleak figure is produced by the expectations that domestic demand will contract at a rate of 4.7% of which the expected decline in gross capital formation of of -14.3% which contrasts with a 19.5% expansion in 2008.

This headline forecast naturally calls for all kinds questions not least the impending question, as it is being asked around the world, about the extent to which Chile will ever recover to observe growth rates it did before the global crisis. Personally, I believe that most analysts would agree that the script on 2009 as a horrible year is already written and the question now becomes; will 2010 be the year of recovery or will it be the year of disappointment as the boost from 2009's stimulus packages wane and it becomes clear that any kind of second leg with respect to a sustained pickup in global growth will be very tepid. I tend to lean towards the latter account, but it is also clear that the extent to which the global economy is able to limp forward, it will be economies such as Chile who will be doing a lot of the heavy lifting.

This particular view motivates a lot of what follows.

A Closer Look at Trends in Output and Activity

One way in which to differentiate the GDP measures fielded above is to have a look at GDP divided onto sectors to see how ouput in Chile has evolved over a wide array of activities as well as to compare this to some form of base value. As can be seen from the graphs to the right; I have chosen to focus the attention on cobber, manufacturing, construction, housing property, and financial services.

In the graph to the right the base value 100 is equal to the mean value of output over 4 quarters in 2003 measured at constant 2003 prices. For an economist with an inclination to base his analysis on underlying demographic parameters one thing immediately stands out. Indices for construction and housing property have hardly budged. This is interesting since the main driving force across of the real economic collapse across the globe is, in the case of many other economies, precisely driven by a collapse in these sectors. Now, whether this is because Chile did not entertain the same kind of bubble-like environment as elsewhere or whether it represents the fact that Chile's demographic profile would exactly lead us to the point that these precise sectors should be well supported by the underlying fundamentals I will remain silent. Clearly, it will be a bit of both, but it is a point worth remembering when talking about construction booms and bubbles; there is always an underlying capacity story underneath. This discussion is readily available in an Indian version concerning the risk of overheating which was debated furiously a while back.

Meanwhile, the general trend indicates that although there has been a notable drop in the constant price value (in mill pesos, 2003 prices) activity has not collapsed in any sense of the word and remain well above its base value. Now, there has of course been a decline and the jury is still out with respect to the extent that the decline will continue, stabilise or turn into growth. Most likely growth will resume its due course over the course of h02-2009, but as in all other places in the world it is the level of this growth which may ultimately surprise on the downside. One area where activity has markedly declined since the middle of 2008 is in the context of manufacturing and in this sense it is worth while having a closer look at the underlying pattern here.

If we start by looking at the manufacturing indices in the first difference (change) and represented through a 6-month moving average to try to smooth out the trend for the naked eye we observe the negative trend as it has grapped hold in the latter parts of 2008 and into 2009. However, we also observe that this does not like the horrible charts that we have seen e.g. in the context of the US, Europe and Japan. The average monthly rate of change in the general index through the 12 months ending April 2009 was -0.2% which is not exactly cataclysmic; in terms of the subcomponent the production of durables on the other hand decline at an average rate of a full 2% (mom) whereas the average change in the value of capital goods was 1%.

During the time measured in the graph to the right the general index peaked in March 2008 at 139.7 and bottomed in February at 112.8 after which it has recovered to 123.1 at the end of April. As noted, a large part of the drop in the latter part of 2008 and into 2009 was a sharp decline in the value of production of durables which fell (on an index basis) to a low of 65.9 in February 09. At this point in time the production of durables furthermore remain depressed relative its long term trend. Conversely, the value of production of consumer goods and capital goods have pretty much shadowed the trend in the general index; or more aptly, it is the relative stability of these two indices which have helped the general index to skirt what has been a sharp decline in the production of durables.

Finally and perhaps to end where I should have started it is worthwhile to have a look at the main index for economic activity in Chile (the IMACEC).

Looking at this index it is difficult not to conclude that Chile appears to have managed the initial stages of the economic crisis quite well. Surely, the index is down as one would expect but at this point at least, it does not appear to be a decline which will buck the general trend. The index peaked in June 2008 and has since fallen back 5% at the end of April. The most recent data however confirm that the slowdown is lingering as we approached the second half of 2009 with industrial production dropping 10.5% yoy in May prompting comments from central bank president Jose De Gregorio to note that nominal interest rates could be lowered further from its already low level at 0.75%. Moreover, the monthly GDP indicator showed that Chile continued to contract as we entered Q2 posting yoy 4.6% decline and with monthly inflation rates beginning to post negative readings policy makers and analysts close to Chile remain alert. As we have just rapped up Q2 in real time it appears that Chile is poised to surprise somewhat on the downside in terms of prior expectations.

The External Sector

The analysis of Chile's external balance and the country's currency is of course closely tied to the evolution of international copper prices as Chile is, by far, the world's biggest producer and exporter of copper.

Although copper prices have fallen back somewhat in the midst of the global recession relative to the average values through 2006-2008 they are still higher than they were at the turn of the century when the price of copper were below 1 USD/lb. In fact, the graph should make any trader look more than once since with the recent increase the price of Copper is very close to breaching the its 12 month moving average price although of course the strength of the global momentum in general will decide whether commodities, and thus Copper, will fly again. As an aside, it would be very interesting to run an analysis on the extent to which the recent move upwards in Copper prices has anything to do with the reports that China is stocking up on commodities(it does of course, but how much?)

The positive effect from copper on Chile's external balance has, at times, been coined as the copper bonanza and Chile's ability to manage this bonanza in a prudent manner is one of the reasons that the country stand out in the current environment. In general however, the composition of Chile's external balance look very much like one would expect of course that the current account has been in surplus since 2004 due to the positive impact from the trade balance and thus net exports of copper. Thus, up until the advent of the financial crisis Chile's current account was characterised by a positive trade balance which outweighed a negative income balance to produce a consistent current account surplus. This changed in the latter part of 2008 where Chile posted a current account deficit in Q3 and Q4 as copper prices plummeted and exports in general fell. Basically, the trade balance withered away into a small deficit and with a continuing negative income balance, Chile found itself in need of external financing for the first time in 5 years. It also pushed the current account deficit into deficit for the full year 08 and the central bank, rather surprisingly, expects 2009 to see another CA deficit. I say surprisingly here since Q1-09 has so far posted an overall CA surplus worth 639 billion USD driven by a strong trade balance (mainly due to a plunge in imports and higher Copper prices). In any case, it is difficult to imagine that Chile will any problem financing a current account deficit of the magnitude the central bank is forecasting at 1.8% of GDP in 2009.

Turning the analysis to the currency it is interesting to observe that last time I looked at Chile inflation was running close to 10% and with nominal interest rates below the inflation rate the Chilean economy was experiencing negative real interest rates. In the context of the currency this meant that just as we were rounding up Q3 2008 the Chilean central bank decided to hold back on its frequent endeavors into the market to stem the rate of appreciation of the Peso against the USD. Endeavors, which by the way, have been unable to buck the overall trend in appreciation of the CLP ever since 2003 against the USD.

Of course, events had it in Q4 2008 that markets were to experience a significant amount of stress and rising volatility which sent the Peso down against the G3 currencies where it is only now recovering. In the context of the stress encountered in the market and seeing that the spread on Chile's sovereign debt increased less than the average in Latin America (and Asia) I argued that perhaps this was a sign that Chile's currency would not be hit as hard, in the context of increasing volatility, as its emerging market peers. My argument in a nutshell was that since the Peso was amongst one of the best performing emerging market currencies against the USD (back in April) this was perhaps due to the relatively high standing Chile had with international investors. Stefan Karlsson would have none of this however arguing in stead that the relative strength in the context of Chile's Peso was to be found in relation to the increase in the price of Copper. I conceded that Stefan was right in so far as goes the obvious fact that Copper is a very important driving force for the Chilean Peso regardless of whether investors were also targeting Chile as a relative safe haven amongst emerging markets.

However, in the spirit of good argument I decided to let me and Stefan's arguments suffer the, not always flattering, test of empirical validity. To that end I cooked up the following small model;

Y = a + b1X1+b2X2

Where Y is the exchange between the Peso and the USD (quoted directly), X1 is the price of Copper, and X2 is the sovereign spread. I use monthly data from Jan-00 to May-09 for a total of 112 observations and as per convention I am estimating this model in the first difference to avoid issues of stationarity [2]. Given the hypothesis one would expect a negative sign for X1 (i.e. an increase in the price of Copper is associated with an appreciation of the Peso) and a positive sign for X2 (i.e. an increase in sovereign spread is associated with a depreciation of the Peso). The estimation (with OLS) returns the following result;

Y = 0.0016 - 0.16X1 + 0.09X2 + ut [F = 33.25, R-sq = 0.38]

Now, both variables (X1 and X2) are significant at 1% [3] and thus I am inclined to stick my neck out a little bit more vis à vis Mr. Karlsson and conclude that the extent to which investors see Chile as a relative safe haven amongst emerging markets will in turn make Chile's sovereign debt spread increase less relative to its peers in relation to market turmoil which, in turn, has a measurable effect on the exchange rate.

Don't worry, this will be the first and last regression analysis you see in this note and just to sum up; Copper does matter for Chile and with net revenue expected to drop 69 percent this year to $1 billion from $3.2 billion in 2008, it will have a noticeable impact on Chile's economic performance although I need to emphasise that, to my mind, Chile posseses sound fundamentals which move far beyond the benevolence of its Copper ressources.

Employment

In terms of the labour market Chile cannot escape the fact that the crisis has taken its toll. The latest figure for April has the unemployment rate running at 9.6% which makes it almost certain that it is above 10% in the time of writing. 10% hardly constitute a dramatic number in a relative context (although of course it is big in an absolute sense), but given the fact that Chile entered the crisis running at 7-8% the lagged effect of the recession on the labour market may push the unemployment rate to uncomfortable levels which is sure to become a big topic for the elections later this year.

The number of persons employed peaked in August 2008 at 6.693.400 persons and has since declined to 6.574.500 persons for a total loss of employment of 118.900 people in April 2009. At the same time the registered number of persons in the labour force increased by 120.140 people from 7.196.110 to 7.316.250. These figures highlight one of the challenge with having a large and growing labour force in the sense that you need to maintain momentum in order to be able offer the jobs which the people rightfully demand.

Of course, a growing labour force is a good thing in itself, but in the current environment we should not rule out the case that it can become a source of "unrest" and fierce political debate. Should the employment situation continue to deteriorate on the margin (that is unemployment reaching some 15%) it will be very interesting to see how this drives the discourse in the upcoming elections.

Policy and Inflation

As noted, the last time I had Chile under the loop the central bank perceived the risks to economic stability in a wholly different light than it does now. At the time, inflation was running at some 10% on an annual basis and the central bank was busy moving up nominal interest rates. That has changed now.

Chile's central bank is formally targeting an inflation rate of 3% and just as it was running way above this target in the period leading up to the crisis, so has it plummeted accordingly and is currently running at negative values on a monthly basis. This has prompted the central bank to lower rates to an unprecedented level of 0.75% in June and most analysts expect another nudge downward come the July session (the graph to the right plots the interbank rate). If this turns out to be the case, the central bank will have lowered interest rates by 7.75 % over the course of the last 6 meetings. Just as it has been the case with other more prominent central banks, the Chilean derivative is trying to steer expectations in an environment where long term yields have begun to inch upwards to reflect the solidification of the second derivative discourse. In general, the central bank is tracking inflation closely with its target interest rate as can been in the graph to the right.

On the fiscal front Chile is in a much better position than most. Alongside the measures taken on the monetary front the government has, so far, initiated US $4 billion package of government spending and tax cuts. According to the budget office the budget deficit will amount to 4.1% of GDP this year, a position one finds it difficult to believe that Chile will have trouble financing. On June the 15th Chile's fiscal authorities announced a bond issuance worth $ 1.7 bn as well as its intent to use $4 bnfrom its offshore savings to fund spending.

Not too Shappy

All in all this does not look too bad now does it? In many ways I agree with CitiGroup's research department as they wrote in their latest overview of the Latin American economies;

We believe that the Chilean economy is one of the best positioned to capitalizefrom a global recovery. The openness of the Chilean economy made it one ofthe most vulnerable to the global slowdown, certainly after Mexico. But thestrength of its domestic fundamentals helped the economy withstand the globalshock.

Clearly, there are downside risks here and these come mainly from any adverse shocks Chile might suffer from another global fallout or simply the risk that global growth won't recover to the extent many are currently expecting. Yet, it is important to point out here that Chile's relative strength has two sides. On the one hand there is no doubt that the presence of Copper and the important of this commodity in the global value chain as well as the sound management of the windfall from this is very significant. On the other hand I have also, as per usual, emphasised demographics as a key variable and specifically that Chile is still riding the waves of the demographic dividend, or more aptly the afterburner of this process. In fact, what is important for Chile at this point is to lock in the favorable path by avoiding that fertility falls too much below replacement level. If Chile succeds in this, it may truly turn out to be an example to follow on more than one front. 

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[1] - I distinctly remember that he has been quoted for something like this, but I don't remember the exact wording. 

[2] - I use the following formula ln(t0/t-1).

[3] - If you run regressions as single linear models in turn with X1 and X2 respective as explanatory variables this pattern is repeated with almost identical R-sq values albeit somewhat higher for Copper prices.

Japan’s consumer prices fell at a record pace in May, adding to the risk that deflation will become entrenched and hamper a rebound from the nation’s worst postwar recession. Prices excluding fresh food slid 1.1 percent from a year earlier after dropping 0.1 percent in the preceding two months, the statistics bureau said today in Tokyo. It was the sharpest decrease since comparable figures were first compiled in 1971.

Bank of Japan Governor Masaaki Shirakawa said last week that price declines will accelerate through the middle of the fiscal year as demand slackens and crude oil continues to trade lower than last year’s record. Retailers including Aeon Co. are cutting prices to attract customers as falling wages and the worsening job outlook damp spending. “Profits fall, then wages come down, then consumers stop shopping,” said Junko Nishioka, chief Japan economist at RBS Securities Japan Ltd. in Tokyo. “And because people aren’t shopping, companies lower prices. That’s the process that we’re starting to see. It isn’t easy to break out of.”

Now, you might think that this sharp decline has fuel/energy prices written all over it. In some sense this is true. In May, fuel prices registered its first annual drop in several months (-3.0% yoy) which clearly adds to the headline grapping number. Yet, the decline in prices in Japan is broadbased and although the -1.1% is clearly pushed down by a high base effect as we enter a period in which 2008 energy prices were comparatively large, the core of core index slid -0.5% which marks a change of -0.4% from the previous month. In short; the recession in Japan is beginning to push the economy into the dark hole it has spent nearly two decades trying to escape (and never really managed). The point here is not to harp about headline inflation and whether it will go up or down since we are clearly going to be in situation over the next couple of months in which headline deflation on an annual basis will skew the overall index downwards. But this is hardly the point since, as we can see, the core or core index is declining fast too which tells us that domestic demand pressures in Japan are clearly negative at this point in time and may remain so for as far as the eye of a trained economist should be willing to see.

Japan may be sinking into deflation that will undermine the nation’s rebound from its worst postwar recession, the Cabinet Office’s chief economist said. Deflation “will exert a significant amount of downward pressure on the recovery,” Jun Saito, an adviser to Economic and Fiscal Policy Minister Kaoru Yosano, said in an interview yesterday in Tokyo. “An increase in deflationary expectations will raise real interest rates and that will restrain business investment.”

Consumer prices excluding fresh food dropped a record 1.1 percent in May from a year earlier, the statistics bureau said today, spurring concern that the economy is slipping back into the deflation that plagued the nation for a decade until 2005. “Declining prices will mean lower profits, less investment and wage cuts that will weaken consumer spending further,” said Hiroshi Miyazaki, chief economist at Shinkin Asset Management Co.

So, where do we go from here you might ask. Well, this is exactly the issue; there isn't a whole Japan can do at this point but to try to position itself in the best possible ways for exploiting the global green shoots through exports. However, when it comes to the domestic economy deflation is an inbuilt part of the edifice.

So sitting here on a Thursday evening thinking about whether I could wring out something interesting about this week's events it suddenly dawned on me. I don't have to, the Economist has already done it for me by fielding a survey on ageing populations in their latest print edition.

Here are the articles;

A slow-burning fuse

Suffer the little children

A world of Methuselahs

The silver dollar

Scrimp and save

Work till you drop

China’s predicament

Into the unknown

As ususal, such special reports (which were called surveys, I'd have you know!) come with a leader which I reproduce below.

WHEN Otto von Bismarck introduced the first pension for workers over 70 in 1889, the life expectancy of a Prussian was 45. In 1908, when Lloyd George bullied through a payment of five shillings a week for poor men who had reached 70, Britons, especially poor ones, were lucky to survive much past 50. By 1935, when America set up its Social Security system, the official pension age was 65—three years beyond the lifespan of the typical American. State-sponsored retirement was designed to be a brief sunset to life, for a few hardy souls.

Now retirement is for everyone, and often as long as whole lives once were. In some European countries the average retirement lasts more than a quarter of a century. In America the official pension age is 66, but the average American retires at 64 and can then expect to live for another 16 years. Average spending on public pensions across the OECD is now the equivalent of more than 7% of GDP (they cost America just 0.2% back in 1935). In some countries the current figure could double by 2050, to say nothing of the cost of private pensions and extra spending on health and long-term care.

Grey and proud of it

Although the idea that “we are all getting older” is a truism, few governments, employers or individuals have yet come to terms with where longer retirement is heading: the end of the whole concept (see special report). Whether we like it or not, we are going back to the pre-Bismarckian world, where work had no formal stopping point. That reversion will not happen overnight, but preparations should start now—to ensure that when the inevitable happens it is a change for the better.

It should be for the better because it is being partly driven by a wonderful thing: people are living ever longer. Life expectancy has been rising by two or three years for every ten that pass, despite repeated forecasts that it was about to reach its limit. Centenarians used to be rarer than hens’ teeth; now America alone has 100,000 of them. By the end of this century the age of 100 may have become the new three score and ten.

This imminent greying of society is compounded by two other demographic shifts. First, in most rich countries women no longer have enough babies to keep up the numbers (a prospect that may please a lot of greens but not many governments); and the huge baby-boom generation, born after the second world war, has begun to retire. In 1950 the OECD countries had seven people aged 20-64 for every one of 65 and over. Now it is four to one—and on course to be two to one by 2050. That will ruin the pay-as-you-go state pension schemes that provide the bulk of retirement income in rich countries.

It is tempting to think that some of the gaps in the rich countries’ labour forces could be filled by immigrants from poorer countries. They already account for much of what little population growth there is in the developed world. But once ageing gets properly under way, the shortfalls will become so large that the flow of immigrants would have to increase to many times what it is now. Given the political resistance to even today’s levels of immigration (as shown up in the recent elections to the European Parliament), that, alas, looks unlikely.

So individuals, companies and governments in rich countries will have to adapt. There are some signs the first two are beginning to do that. Many employers remain prejudiced against older workers, and not always without reason: performance in manual jobs does drop off in middle age, and older people are often slower on the uptake and less comfortable with new technology. But people past retirement age would not necessarily carry on in the same jobs as before. In Japan, where pensions are Spartan and lots of people are still working in their later 60s and even 70s, big companies like Hitachi have found ways of re-employing staff after retirement—but in a different capacity and, significantly, at lower pay.

Elsewhere employers have been less inventive. But retailers such as Wal-Mart or Britain’s B&Q, and caterers such as McDonald’s, have started hiring pensioners because their customers find them friendlier and more helpful. And skills shortages are already creating opportunities: in the past year or two a dearth of German engineers has caused companies to bring back older workers. Once labour forces start declining, from about 2020, employers will no longer have much choice.

As for the older workers themselves, many of them seem keen enough to carry on beyond retirement. A recent Financial Times/Harris poll showed most Americans, Britons and Italians would work for longer in return for a larger pension (though Germans were much less enthusiastic). This surely makes sense: as long as the job is not too onerous, many people benefit in mind and body from having something to get them out of the house. Many baby-boomers say they never want to bow out altogether, though they would often prefer to put in shorter hours. If they want to go on working, they will have to accept that pay can go down as well as up.

It will all work out, sort of

Can governments make sure this inevitable adjustment goes smoothly? In the recent past some policies have bordered on the demographically insane—for instance “job-creation” schemes that encourage older workers to take early retirement. Many things that make sense anyway, such as making benefits more portable, encouraging immigration, promoting private saving or reforming health care (see article), make even more sense now. Banning mandatory retirement ages in the private sector (as America has done) looks sensible, as does creating conditions in which people can retire more gradually. Above all, the retirement ages for state pensions need to be put back. Recent increases to 67 or 68 are doing no more than compensate for the likely rise in life expectancy: 70 would be a better figure. So far only Denmark has taken the radical step of indexing the pensionable age to life expectancy.

Some of this will be unpopular. Private pensions, which might make up for some of this, last year lost nearly a quarter of their value, a terrifying $5.4 trillion. But as Herb Stein, an economist, pointed out, “if something cannot go on forever, it will stop.” Better to try to enjoy the consequences.

Now, I will of course have much more to say about this. Actually, for a demographic wonk such as me I don't expect to be dramatically surprised, but I for one believe the Economist still got it and thus drives the discoure.  I will be interested to see where it (the discourse) is at the moment. I notice that they focus much on extending retirement age which is of course all well and good; yet, why don't just say it ... we need women to have more children and we need to think long and hard how to make this fact reconcilable with modern society's structures and increasingly integrated labour market. Ok, it is printing as I type, see you later.

In this, the 20th year since the fall of the Berlin Wall, Chancellor Angela Merkel’s government is preparing for a host of celebrations and commemorations leading to the November anniversary. The official story of an eastern revival was reinforced by President Obama’s recent visit to Dresden in all its reconstructed glory.  But outside big cities like Dresden, Leipzig or Berlin, in places like this former industrial mining town, the story of decline and departure has changed little in the former East Germany. Not far beyond the few thriving urban centers, traffic is often spare on the freshly paved highways, and at night in parts of Mecklenburg-West Pomerania in the northern part of the country, there is hardly a light to be seen to either side of the autobahns.

In a popular song a few years back, the performer Rainald Grebe described a feeling of solitude by singing, “I feel so empty today, I feel Brandenburg,” referring to the former East German state that surrounds Berlin. Newspapers track the return of wolf packs to Saxony along the Polish border on the one hand, and the continued migration of the young and the educated to the greater opportunities in the west on the other.

When German government officials last week presented their annual report on the state of unification and the attempts of the former East Germany to catch up to the west, the picture they painted was overwhelmingly positive, but not exactly complete. The government accurately reported that it had spent more than $60 billion supporting businesses and building infrastructure from 2006 to 2008 alone. And economic activity per person has risen to 71 percent of the former western sector’s from 67 percent over the course of this decade.

“Thanks to positive economic development, the east is on the best track to converge with the west,” said Wolfgang Tiefensee, the minister responsible for the development of the former East German states. “The gap is closing.”

It is closing partly because the export leaders taking the hardest hits in the economic downturn are in the west, a leveling down rather than up. Unemployment in the former East Germany remains double what it is in the west, and in some regions the number of women between the ages of 20 and 30 has dropped by more than 30 percent. In all, roughly 1.7 million people have left the former East Germany since the fall of the Berlin Wall, around 12 percent of the population, a continuing process even in the few years before the economic crisis began to bite.

And the population decline is about to get much worse, as a result of a demographic time bomb known by the innocuous-sounding name “the kink,” which followed the end of Communism. The birth rate collapsed in the former East Germany in those early, uncertain years so completely that the drop is comparable only to times of war, according to Reiner Klingholz, director of the Berlin Institute for Population and Development. “For a number of years East Germans just stopped having children,” Dr. Klingholz said.

Now, the issue of Eastern and Western Germany is of course not a new one and essentially traces right back to the reunification and the fact, as many scholars have pointed out, that Germany basically provided the world with a great social experiment. One of the effects from this experiment, as Dr. Klingholz points out, was that women in East Germany essentially stopped having children all together. In a paper from 1994 detailing the immediate evolution of East German fertility in the context of the reunification process, Nicholas Eberstadt shows how births in East Germany indeed did fall dramatically. From 1988 to 1992 the total number of live births fell from 215700 to 88300 which translates into a drop in the crude birth rate from 12.1 to 5.6.

While the relative decline in Eastern Germany since the end of Communism can be fitted to historical parallels, albeit not without difficult, the absolute level of fertility now being recorded [1993] in that territory appears to be a completely new phenomenon - at least, for sizable naturally constituted populations. Eastern Germany's adults appear to have as close to a temporary suspension of childbearing as any such population in the human experience.

According to Eberstadt and given the information available at the time, the drop was especially severe because fertility dropped sharply among women aged 25-34 and thus among those women in their prime age with respect to childbearing. Furthermore, Eberstadt also shows how marriage rates declined sharply during the transition from communism. Marina A. Adler notes that the highly insecure environment following communism made women reluctant to engage in the kind of long term commitments which marriage and child rearing constitutes. In fact, the almost effective halt in childrearing occuring in East Germany is not so unique in the general sense since the fall of communism also marked a decisive structural break in the context of the fertility behavior of an entire generation of women all across the Eastern European edifice. In this sense, Sobotka offers a comprehensive view of the drivers of the fertility transition in the context Eastern Europe.

The ultimate effect of the shift in an Eastern Germany context was remarkable; Eberstadt estimates that the TFR had fallen to an astonishing 0.98 in East Germany by 1991.

Of course, in a bigger perspective this extraordinary squeeze on births in East Germany only served to accelerate an already rapid demographic transition which saw fertility rates in Germany collapse to a TFR of 1.28 in 1994 from where they have since recovered ever so tepidly to the current 1.41 (2008 estimate). Together with a steady increase in life expectancy, this has produced a process og ageing in Germany only, at this point, rivaled by that of Japan.

The issue in the context of East Germany is a well known one in the sense that all those ideas about East Germany rapidly catching up the standards of West never really bore out; at least not in a general sense. According to the Berlin Institute for Population and Development, East Germany harbour three out of the ten most rapidly shrinking regions in Europe and in a world where mobility among the young is high, this has initiated a cycle by which the young people leave as fast as they can further aggravating the dearth of young productive people as well as the simple fact that the number of potential mothers are dropping fast. Yet, the fertility picture in Germany is quite complex since for example there are more childless women in the West than in the East;

As reported by the Federal Statistical Office, in March 2004, 30% of German women aged 37 to 40 years (birth cohorts of 1964 to 1967) in the former territory of the Federal Republic were childless, that means, there were no minor children in the household. Childlessness was markedly lower among German women of the same age in the new Länder and Berlin-East (22%) and among foreign women in Germany (21%).

In fact, in a paper from 2000, Jennifer Hunt from McGill University asks the simple question of why anyone would want to live in East Germany at all given the income and unemployment divergences which highly favor a life to the west. Moreover, the study also indicates that whereas east-west emigration was substantial in the years following the fall of the Berlin wall it decreased (in the 1990s) and became highly centered on emigration of young and highly skilled labor. In 2004, the German statistical office reported that net income for households in the East had reached 77% of net income of households in the West. In this sense there is some convergence. The same year (2004) also saw net East-West migration dwindle to about 49.000 of which one have to assume that the majority are young income earners or other "mobile" parts of the labour force.

Who is Actually Converging Here?

Eastern Germany have, in some sense, come along way in terms of attaining the same standard of living as West Germany. That much is certain and this also shows itself in the context of intra-German migration patterns where the number of people moving from East to West seem to have fallen steadily. However, there is also a composition effect here to think about and thus the fact that one can expect the highly mobile parts of the labour force to move. Also, as the most recent pieces note, especially the small villages and mid sized towns risk effective depopulation. Finally, what is being narrated as a phenomenon exclusively confined to East Germany in the form of a lack of young mothers and young people in general is fast becoming a common German preoccupation.

Thus, Germany is ageing and fast too. Germany's median age is estimated to hit 45 years by 2010 and the process won't stop here. She will continue ageing and it will pose a great challenge moving forward.

Consequently, and while the demise of many small villages in the East and the subsequent return of the wolf packs are evidence of this, the fact of the matter is that this represents an issue for the entire Germany society to deal with even if the specific social issues in Eastern Germany are significant in their own right.

Consequently, let us review briefly what it is that Hutchinson is proposing here:

Many commentators have picked the East Asian economies of China, Korea and Taiwan to emerge the most vigorously from the ongoing global financial crisis. And with some justification, for China and the two Asian “tigers” share some alluring characteristics like:

• A highly competitive and innovative manufacturing industry.
• Excellent government and workforce discipline.
• Modest fiscal and monetary stimulus (or, like China, they started from a position of budget surplus).
• And an export orientation that seems likely to benefit quickly as order is restored in the global trading economy.

But there’s another country that shares those characteristics. It’s nowhere near East Asia. But investors can expect this particular economy to also bounce back from this recession with considerable vigor.

I’m talking about the center of supposedly sclerotic Old Europe itself: Germany.

If you add, to this, the headline suggesting how Germany may be the source of emerging market returns with developed world risk you get an exceedingly bullish story on Germany from a macroeconomic point of view. Indeed, all this makes me wonder whether more than a few financial analysts have been spending time in Pamplona as of late. Obviously, Hutchinson writes in the capacity of an investor or specifically one who is passing on investment advice. In this way, my critique runs right up to the point where Hutchinson asks the perennial question of what exactly to buy. I mean, I really have no idea whether the stock picks suggested are worth much at all, but I can tell you one thing. If they are, it won't be because of the underlying healthy fundamentals of Germany's macroeconomic edifice.

For starters, it does not appear as if the recent stream of data support the underlying optimism on Germany. Sure, we had the ZEW which did indeed post a multi month high, but faced with the general data picture and the outlook. Clearly, Q2 will be better than Q1 across the board and not only in Germany but the central point is the level of stabilisation we will land at. For a reasonable look at the current état du jour in Germany's economy, this piece by Edward is much closer to the point I think.

However, and since I am the one fisking I would be wrong not to deal with Hutchinson's argument specifically.

If we start from the bottom, Hutchinson mentions the export orientation of Germany as a virtue in the context of the current crisis as well as he notes how Germany did not participate in the froth and excess through a highly leveraged financial sector. Evidently, these two arguments are grossly simplifying the situation if not outright wrong. First off, Germany is not export oriented, Germany is export dependent and there is a huge difference between the two. In the context of the latter it basically means the Germany needs the extra boost from exports (and foreign asset income) in order to get the growth it so badly needs and it also means that in a crisis when the initial fault line runs across all major external deficit nations Germany suffers immensely. And why is this then?

As readers of Alpha.Source know only too well Germany is dependent on exports because of its demographic profile and because when external demand falters there is no "second leg" to take over and thus growth crumbles as it has. In terms of the underlying point that Germany would stand ready in the event of a sudden pickup in global activity I have to agree in some sense (otherwise my own argument is not consistent). There are however a couple of important qualifiers. First of all, the regions with which Germany in most recent years has exploited the most for its exports (the CEE) are seriously faltering and secondly; the margins in terms of export dependency and the need to run an external surplus achieve growth is getting thinner by the month.

On the point about the financial sector, I really do not know what to say. Recently the ECB published its financial stability report which estimates that Eurozone banks are likely to be forced into further writedowns at an amount equivalent to $283bn. Now, even if you account for the fact that most of these writedowns are pencilled in to occur in Southern Europe this will surely affect Germany too. After all, Germany needs someone to exports to for the underlying argument to hold.

Then there is the modest fiscal stance by the German government and the alleged discipline from the same entity. I am not sure what is really going on here. Perhaps, Mr. Hutchinson is really buying the fairytale German finance minister Peer Steinbrueck tried to sell markets recently when he assured us that the biggest worry he had was that other Eurozone economies would loose the benign conditions raining in Germany when it comes to sovereign debt and thus the fiscal situation. It is true that Germany has entered this crisis on a relatively better footing than most, but this conclusion only holds in an extremely short term prospective.  In the long run and given the structural drivers, the outlook on the fiscal situation in Germany looks decidedly difficult. The main point is that Germany is the second oldest country on earth and we have now entered a state in which Germany's particular growth strategy doesn't work. This means next to little growth which is not exactly accommodative to public finances in a country such as Germany.

Basically, the point is quite simply the following. Governments all over world are currently ramping up borrowing extensively to counter the crisis and by 2014 the gross debt/gdp ratio in Germany is expected to reach 91.4%. As a comparison the corresponding figure in the US is projected to be 106.7%. [1] Now, you might say that since Germany started at some 66% and the US at some 63% (in 2008) Germany takes the high road relative to the US. Well you might say this, but you would be wrong. I am not saying that the US situation is not problematic, but the German situation (and in extreme case Japan's) is more than problematic, it is outright unsustainable given the future trajectory of demographic developments.

Finally, there is the point on an excellent workforce and manufacturing industry. Certainly in a global context, Germany is one of the most modern economies but it is very difficult for me to see where big macroeconomic story is here. German manufacturing is largely dependent on exports to achieve growth and as for that workforce; well, not only is shrinking but it is also ageing so once again, I don't see the impetus for the big fanfare here.

The fact of the matter is that the German consumer is ageing and while there is certainly not anything inherent better about the age group "20-40" than the age group "40-60" they behave differently. Moreover, the fact that the latter steadily increases as a proportion of overall income earners, the economy's consumption profile changes and in the context of Germany where you also now have a substantial and rapidly growing proportion of the population in the +60 region it will also exert an important effect on the "quality" of the German workforce even if, and this I have difficulty arguing against, one the world's best educated.

Getting it Wrong?

Let me once again make clear that in terms of the concrete investment advice forwarded by Mr. Hutchinson, I remain silent. I am sure that money can be made in the context of the German equity market and indeed I would argue that for the adept stock picker or, if you will, alpha trader there is always a potential for making money. You could even say, that in the event that we stand before a "VL" shaped recovery Germany may shine, but it is important to point out that this shine is going to temporary, at best.

Consequently, my main beef here is with the underlying macroeconomic analysis of Germany which seems to be me to be very superficial if not outright misplaced. Germany's export orientation (dependence) is not a virtue in the current environment, and Germany's fiscal position, while certainly better at the offset, is not in any ways solid, stable or anything of the like. As I have argued recently, the key here is what happens when investors wake up to the fact that the underlying weaknesses in the Eurozone stretches all the way into that alleged anchor and rock in the form of Germany herself?

Ultimately, I may be harboring a fool's hope here, like Niall Ferguson, that I too will have the opportunity to look at a king and live to tell about it. I would let my readers and others in general to make that judgement. However, I still believe that when it comes to the macroeconomic fundamentals of Germany, Mr. Hutchinson gets it wrong; nay ... he gets it wrong, Big time!

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[1]: These numbers come from the Economist (via Financial Armageddon).

Consequently, it seems as if the defences will hold in Latvia, but the apparent vote of confidence from the IMF and the EU commission and thus promises that the external loan financing will continue will not come for free. In order to make due on the loans the Latvian government is planning an unprecented range of spending cuts amounting to an astonishing 10% of the entire fiscal budget according to Bloomberg reporter Aaron Eglitis. These massive cuts include, among other things, a 10% pension reductions and a full fat 20% wage reductions for state employees. As prime minister Dombrovskis is quoted; these cuts should be more than enough to please the debtors in the form of the EU and, most notably, the IMF to whose mercy Latvia finds itself. One would surely hope for Dombrovskis that he is right.

And by all means, it does seem as if markets have been calmed so far [click on picture for better viewing].

As we can see overnight rates have fallen to much more comfortable levels the past few days and we have even had the news that the central bank were actually selling Lats in the open market in stead of its hitherto valiant efforts to maintain the peg, by sucking up domestic Lat liquidity pushing overnight rates up to a massive 100-200% according to a number of, I should say, unofficial reports. Medium term financing in the form of the 3 month and 6 month RIGIBOR remain elevated compared to last month, but so far the massive squeeze in short term financing seems to have abated. Overnight rates consequently fell from an officially reported high of 24.60% to 8% on the 15th of June and further down to a soothing 5% here on Tuesday.

Does it end here then? This seems to be the inevitable question we must ask ourselves.

I have my doubts. First of all, it is difficult to see the big difference here. The fundamentals still look anything but solid and the underlying weaknesses remain. As Edward noted recently in a thorough analysis of Latvia's long term economic potential, the crisis has long and deep roots which go beyond the question of default now or default later. More importantly however, Latvia has now effectively begun a great experiment to see whether it pays off to literally dismantle one's society with the aim to fulfill a distinctly narrow economic objective in the form of a fixed exchange rate. To add insult to injury, the peg itself is not the main goal. Eurozone membership is, and apart from the obvious question of whether such a membership would be a desirable outcome for Latvia at all, I have my serious doubt that we will ever get there. 

But that is somwhat for the long term. In the short term, the horizon is still littered with uncertainty and I tend to agree with Danske Bank's Lars Christenses as he dryly notes:

“There really hasn’t been any fundamental change,” said Lars Christensen, head of emerging markets at Danske Bank A/S in Copenhagen. “The only thing that has changed is how long they can postpone a devaluation. The issues are still there, and what will happen when they need the next loan installment?”

This sounds about right to me and although it distinctly seems as if Latvian policy makers are determined to do whatever it takes, the costs will be immense and one has to wonder whether the fort will hold forever? I don't think it will.

Perhaps the most amusing comment from the weekend came from German FinMin peer Steinbrueck, who warned of further credit dislocations in Europe, putting his marker down to cover his ass in case it all goes wrong. Evidently, winning "European Plonker of The Year 2008" for his powerful mix of forecasting ineptitude and hubristic scahdenfreude deeply affected him, as it seems he wants to avoid a repeat victory.

Amen.

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Your author is feeling smug this late Sunday afternoon. He is typing the first post on Alpha.Sources from his new laptop which is a sorely needed addition to his blogging arsenal as he has, nearly, punched the life out of his old Dell 510m Inspiron. After having endured the sub par, albeit solid, performance from his Dell for quite some time he is happy to now be in a possession of a dual core AMD processor and a nice graphics chip which makes him able to play the latest video game with max settings. So, yes a bit smug indeed.

Anyways, I shall not belabor you with the hardware details of my new rig, but rather point your attention to some recent comments made by the German finance minister Peer Steinbrueck in the context of the increasing risk of further downgrades of European sovereigns following the decision by Standard and Poor to downgrade Ireland's debt rating for the second time in 2009. As I think a bit about what it actually is Mr. Steinbrueck is saying I cannot help but feel that our good Finance minister is perhaps feeling a bit too smug here. Now, as Mr. Steinbrueck points out and as has been the source of wide debate, this is an issue which reflects itself in the widening of sovereign yield spreads among economies in the Eurozone (picture coutersy of Ibex Salad).

Now I am not sure that Mr. Steinbrueck really intended to come off as smug. In truth he may just be concerned, and rightfully so, about Germany fellow Eurozone members and perhaps even the ability of the Eurozone to weather the incoming crisis as one entity. However, I do think the following is rather complacent when you think that it comes from the finance minister of an economy with more than a few problems, not least on the fiscal front.

“What’s going to happen to our friends in the European Union that are not getting the same conditions” as Germany when borrowing money from capital markets, Steinbrueck said in Lecce, Italy, where he’s meeting counterparts from the Group of Eight nations. “I’m hinting at this now so that nobody asks in half a year or so whether I was blind and whether that wasn’t an issue in international discussions.”

Ok, fair enough Mr. Steinbrueck. I for one will not accuse you of being blind further down the road, but I do think a bit of humble pie is in order here. Consequently, there are two risks here. On the one hand there is the narrative Steinbrueck is latching on to in the form of the periphery acting in such a reckless way that they risk pushing themselves so far into the mire that it risks the future of the Eurozone or, if we move the predictions down a nudge, their own economic prosperity. The other risk however is a much more sinister one. Consider then the idea that the threat towards economic stability in the Eurozone comes not from the periphery but from the very core of the edifice in the form of a German economy whose growth model is extremely vulnerable to the current conditions and which has no meaningful defense. The idea here is simple enough. As bad as the crisis in the periphery is, bad indeed it is, what happens when markets wake up to the fact that the weakness and dysfunctional economic edifice stretches into the very heart of the Eurozone? Specifically, what happens to those much hailed better conditions in the context of Germany Steinbrueck points towards?

Clearly, there is ground for more than a little food for thought here and especially so in the context of Germany who has now definitive lost the source of its hitherto export driven growth in the form of a faltering CEE as well as a severe crisis in its main Eurozone trading partners.

But, by no means does Mr. Steinbrueck stop here.

Steinbrueck signaled disappointment that the G-8 failed to choose stronger language today on “exit strategies” to the financial and economic crisis, such as scaling back government borrowing and withdrawing monetary policy stimulus.

“More was not to be expected” on exit strategies, Steinbrueck told reporters after the meeting when asked whether he was happy with the outcome. “At the moment we’re still occupying ourselves with crisis management, but the question of fighting inflationary developments in a timely fashion plays an important role.”

Now, if I feel that Mr. Steinbrueck was coming off as a bit too complacent on the first account I seriously think he is moving ahead of himself on this one. I don't know where this comes from, I really don't. Perhaps it is all the talk about rising yields on the long end of the yield curve in the US and the subsequent prediction that the Fed will soon head north to reflect better than expected conditions (and thus inflation). Consequently, I can't for the life of me understand why a German finance minister would be talking about exit strategies at this point in time. Surely, I respect being ahead of the curve as much as the next guy, but not to the extent that you start making assumptions about a recovery which is clearly not in the offering. Put differently, yes James, I do see what you see but not everybody does it seems. Sorry, but I cannot stress hard enough that talks about exit strategies and inflation fighting seem to me to be rather counter productive at this point in time; especially in the context of the Eurozone and Germany.

Too Smug for His Own Good?

Well, perhaps I am being a bit unfair here. I mean, here I am trying to find something to blog about a late Sunday afternoon and my gaze falls upon Mr. Steibrueck's latest escapades. The biggest issue here I think is really that Germany may not be as "safe" as everyone beliefs. The idea of Germany as the Eurozone anchor is about to be tested now and I have my doubts that the narrative will hold up for scrutiny. Of course, a couple of quotes ripped from Bloomberg are not exactly a solid foundation but, in this context, I would still venture the claim that Mr. Steinbrueck is being a bit too smug here.

I am passing on the mic to FT's columnist Wolfgang Munchau this afternoon. Consquently, I think this is a very well argued piece which gets to the heart of the matter on the global economy as well as, in this case, the German economy. The points emphasised by Munchau are very close to the the ones emphasised my Martin Wolf and Paul Krugman; both of whose points I have dissected before; e.g. here. Especially, I think Munchau gets to the crux of things when he speaks of the implied symbiotic relationship between exporters and importers and how it is the former(!) group which may in fact suffer the most as we venture onwards in this mess of a financial crisis. Germany of course provides an ominous example here.

I have added the piece below (with my emphasis) ...

Let me attempt, perhaps foolhardily, to map out a scenario of how the global economic crisis could evolve in continental Europe.

Even if we assume a recovery elsewhere, Europe’s economy may be stuck at low growth for some time. To understand why, it is perhaps best to look at sectoral balances for households, companies and the public sector.

The current account can be expressed as the difference between national savings and investments. Of the world’s 10 largest economies, the US, the UK and Spain used to run the largest current account deficits before the crisis. The US household sector has been shifting from a negative savings rate before the crisis to a positive rate of 4 per cent of disposable income now. The US corporate sector used to have a large negative savings rate, but this has almost disappeared. So far, the increase in net savings in the US private sector has been balanced by increased borrowing from the US government.

I am making three assumptions: the first is that the return to a positive US household savings rate is permanent – even under a scenario of a strong economic recovery. US households will take time to repair their balance sheets after the housing and credit disaster. Second, I also expect US companies not to return to the high level of borrowings that prevailed before the crisis. Third, I expect the US government to reduce its deficit after 2010. The recent rise in long-term bond yields should serve as a reminder that deficits cannot go on rising forever.

Taking all three factors together, the US will shift from a strongly negative current account balance towards neutrality, perhaps even a small surplus for a short period. I expect similar shifts in the UK and Spain at different magnitudes.

Among countries with large current account surpluses, the three biggest are China, Japan and Germany. I am focusing on Germany here. The German household sector will maintain its high savings rate. The German government increased its deficit during the crisis, but is now looking for a quick fiscal exit strategy. The Bundestag has recently voted through a constitutional balanced-budget clause, which requires cuts in the deficit almost right away. Japan will probably maintain its larger fiscal deficit for longer, but if we take Germany, China and Japan together, we will not see a sufficient and sustained fiscal expansion to compensate for the sectoral shifts elsewhere.

Global current account surpluses and deficits add up to zero. So if everybody is saving more, who will be dissaving? It will have to be the corporate sector in the countries with large net exports. So if the US, the UK and Spain are heading for a more balanced current account in the future, so will the surplus countries.

The current account balance can also be expressed as the sum of the trade balance, net earnings on foreign assets, and unilateral financial transfers. In several countries, including the US and Germany, the gap between exports and imports serves as a good proxy for the current account. A fall in the trade deficit in the US, UK and Spain implies a fall in the combined trade surplus elsewhere. And as some of the shifts in the US and the UK are likely to be structural, this will have long-term effects on others. In particular, it means the export model on which Germany, China and Japan rely, could suffer a cardiac arrest.

What about the argument that a large part of German exports goes to the rest of the eurozone? This is true, but there are imbalances within the eurozone too. Spain has been running a current account deficit of close to 10 per cent of gross domestic product. As that comes down, so will Germany’s equally unsustainable intra-eurozone surplus.

Through what mechanism will this export-sector meltdown come about? My guess is that in Europe it will happen through a violent increase in the euro’s exchange rate against the US dollar, and possibly the pound and other free-floating currencies.

Exchange rate devaluation would greatly help the US and others to reduce their current account deficits, but it will impair the economic recovery in countries with large trade surpluses and free-floating exchange rates. Last week’s remarks by Angela Merkel, who criticised the Federal Reserve and other central banks for running inflationary policies, sharpened investor perceptions of transatlantic policy divergence and decoupling. Many investors are now starting to bet on a strong appreciation of the euro – the last thing Ms Merkel wants.

Neither Germany nor Japan is politically equipped to deal with an exchange rate shock. China may continue to manage its exchange rate, but the Europeans are much less likely to intervene in foreign exchange markets. For the time being, the governments of the classic export nations cling on to their export-based economic model, the model they know best. Their only strategy, if you call it that, is to hope for a miraculous bail-out from the US consumer – which is not going to happen this time.

If my predictions prove correct, Germany will be down and out for a long time with a huge and still unresolved banking crisis, an overshooting exchange rate and lower net exports, presided over by politicians who panic about domestic inflation. This will not end well.

Really, what people need to think about here is the important of deleveraging on a macroeconomic level and what this will mean for aggregate global demand. As I have pointed out before, emerging markets such as Brazil, Turkey, India, Chile, etc are coming (and fast too), but will they be able to provide enough capacity of to suck up the massive increase in desired savings we are going to observe? Well, this is of course only one of the questions here and what we really need is a sound theoretical framework to explain all this and as you might have guessed by now it is crucial that we allow demographics to enter the equation as a driving force for the propensity (desire) to run an external surplus and thus to maintain excess savings vis-à-vis the rest of the world.

If you add the effects of the continuing demographic shifts to the obvious need for economies such as the UK, the US, etc to correct (regardless of underlying demographis) you end up with a problem and specifically a problem of excess saving relative to the willingness and ability to absorb these savings through aggregate demand or if you will productive investment. In terms of (wonkish) economic theory we can think about ageing on a macroeconomic level as the crowding towards one end of the intertemporal spectrum of consumption and saving. Consequently, one can expect (and show) why ageing economies, in stead of simply accepting the inevitable decline through dissaving, will have an intertemporal preference to push forward dissaving (consumption) relative to maintaining a surplus on their external accounts as a cushion againts dissaving. 

I will have much more on the theoretical front here as we move forward.

Like everyone else, I am curious to see what China’s May trade data tells us. If China truly is going to lead the global recovery, China needs to import more – and not just import more commodities for its (growing) strategic stockpiles.

I completely agree here. Another interesting question which the data may help shed light on for us may be the extent of the "recovery" itself and thus the evolution in Chinese exports and particularly imports as a proxy for global trade volume. 

Meanwhile and if this was Asia's contribution, via trade data, to the ongoing discussion of whether the bottom has been reached and indeed whether the bloodbath in the US treasury market should make us worry about inflation, Germany's trade data did its part to calm down the bulls even if of course we are trailing the speedy Korean data release by one month here. According to the German stats office the total German export volume, in April, was 63.8 billion Euros to match an import volume of 54.4 billion Euros for a positive balance of 9.4 million. To match these numbers a couple of interesting points stand out.

If we look at the annual figures exports were down significantly more (28.7%) than imports (22.9%) which means a narrowing surplus and thus, especially in the case of export dependent Germany, a significant dent in the hopes of recovery. More importantly however from the point of view of the general recovery discourse both exports and imports were down from a the previous month (March) by 4.8% and 5.9% respectively. Together with the message from the Korean trade release, this suggests, as Edward notes, how we have not hit the bottom yet in terms of global trade if of course you see the German data as some kind of proxy here. Indeed, if we look at the figures since Q3/Q4 2008 it is difficult to spot much a second derivative at all. (click pictures for better viewing).

If we look at the evolution of German exports, imports, as well as the balance on quarterly basis the trend is inexorably down. Especially, the plot of the first difference of the trade balance (one year moving average) shows the brick wall Germany has hit with this crisis. Actually, and to put things in perspectives; since Q2-2008 the volume of exports have dropped 4.7% on average each quarter (qoq) compared to a corresponding in imports of 1.9%. In terms of monthly figures the data shows how exports, on average, have dropped by 18.2% each month (yoy) since November 2008. The corresponding number for imports is 11.9%. These two numbers need to be taken with a pinch of salt though since they are neither working day nor seasonally adjusted. The data which tracks changed month-on-month however is. In the same period exports have dropped an average of 4.7% each month compared to with a corresponding number of 3.8% for imports.

All this number salad is then merely to suggest how, when it comes Germany, it seems that we have not yet reached the bottom. This point is hammered down with the recent piece of news from the corporate sector which shows how industrial output declined 1.9 % from the previous month (March). 

Germany’s economy may be slow to recover from a record contraction in the first quarter as companies trim jobs and the global slump curbs foreign sales. German exports fell more than economists expected in April and European Central Bank Governing Council member Erkki Liikanen said today that there is “no quick recovery is in sight” for the world economy.

“Today’s numbers are a clear warning against any overhasty optimism,” said Carsten Brzeski, an economist at ING Groep NV in Brussels. “At best, the German economy seems to have entered a period of sideways motion.” Output of investment goods such as machines slumped 6.4 percent in April from the previous month, today’s report showed. Production of intermediate goods fell 1 percent and manufacturing output slipped 2.9 percent from March.

Coupled with the first piece of trade data from Q2 suggesting a continuing slide one has to wonder where people are getting all this recovery hype about. Oh wait a minute, I know; it's the US treasury yields stupid!

Well, be it as it may, I am in less of a disagreement than it seems with the bulls. As I have articulated at length recently, there are green shoots to be found and this may have real economic implications. You just need to know where to look. 

Surely, the pressure has only piled on since I last wrote about this only a few days ago (see links above). The Financial Times' blog Alphaville in this case personified by Izabella Kaminska has steadily been supplying us with the latest on the unravelling in Latvia. A particularly good piece hammers down the point that it is not only freelance bloggers such as yours truly who are questioning the Baltic (Latvian) currency peg but also, now, most professional analysts close to the situation. This is a called a market discourse and although the commitment to maintain status quo may be there one cannot make the waters go back.

However and to be fair to all parties it does seem as if the Latvian authorities got the best of the discourse this week if, that is, being the last one to shout constitutes an upper hand in this case. Consequently, both the central bank and the premier minister Valdis Dombrovkis issued strong statements to suggest that the peg will hold simply because Latvia is committed to seeing this correction through.

Latvian Prime Minister Valdis Dombrovkis pledged to push through budget cuts and ensure the inflow of international loan payments as speculation grows the Baltic state may devalue, threatening the economy of Sweden. “These rumors and speculations should finally be stopped” about the devaluation of the lats, Dombrovskis, 37, said in an interview with Latvian Independent Television today. The currency will not be devalued, he said, and the country will pass budget cuts needed to get the next tranche of money.

This is of course all well and good, but one has the distinct feeling that all this merely constitutes the inevitable last launches before the opponent finally lands the kidney blow to send you crushing into the canvas.

In terms of a more thorough look at the Latvian situation which goes beyond the immediate plethora of market jitter you could do a lot worse than visit Edward's latest post on this issue. As he sets out pointing towards, overnight interbank rates rose to a record of 20% this week and it suggest more than anything the stress being levied on the system.

Another particular issue Edward deals with is the risk of contagion and essentially fallout from a devaluation in Latvia. Certainly, this is an important question in itself but I also agree with Edward [1] in the sense that the immediate plunge in other CEE currencies not to mention the Swedish Krona following a Latvian devaluation is not really the main issue here.

For the record, I see no decoupling and a Latvian devaluation would clearly force others to do the same, most notably I would think Lithuania and Estonia. As for the ripple effects towards the entire CEE edifice, they are likely to be substantial although not necessarily catastrophic. The real issue we need to understand I think is that that IMF program has problems and that this will become clearer and clearer as we move forward. Edward points to one very important data point in the form of a real effective exchange rate where numbers have just been published in 2008 format.

This gives a very clear image of the amount of down scaling the Baltics, and indeed many of the Eastern European Economies, need. It is important to understand that there is a level effect and relative effect here in the sense that one thing is to correct relative to one's own past level, and quite another to correct relative to others. Consequently, this is a chronic problem all across Eastern Europe and thus everybody has to correct. In this sense, the IMF are submitting those with pegged exchange rates to a dose of "medicine" which is simply too strong and which the domestic "system" cannot muster.

So, my feeling is that all this goes beyond whatever effect currency speculation would have in the wake of a Latvian devaluation/default. There are clear signs that the "exit strategy" from this crisis is not working and it is next to scandalous that the IMF/EU do not realize that while these countries certainly need a strong dose of "stick" to get themselves on the right track we need to ensure that they are not obliterated over the course of the next year. I mean, this talk about Euro adoption in 2012 is just so silly and counterproductive since who the heck knows where we are in 2012. Who knows, for example, where the Eurozone itself is in 2012. Really, I cannot stress enough how these road maps of convergence need to be rethought since there has been a structural break. We need a new plan and one which factors in the change in environment.

Moreover, I think we have established by now that the Eurozone is no magic potion and in fact faces a series of very severe tests on Spain, Italy not to mention the mental crush it will be when Germany does not recover because I can tell you; in terms of domestic demand she won't.  Basically as I see it, the option has always been to "let the CEE in", but that would also take a much stronger coordination on the fiscal side and essentially joint European financing through Euro bonds. At the moment, this is far to big a step for the gents in Frankfurt and Brussels to consider.

So, no decoupling in an immediate devaluation context, but more importantly, I tend to look at this more structurally than a simple question of how much the e.g. Forint and Leu will fall in the context of a Latvian devaluation.

At the end of day, this is a question of swallowing those camels and accepting the idea that the current solution being applied is out of touch with reality. Essentially, I don't think the parties involved quite understand the structural damage many of the CEE, and Latvia in particular, have suffered. As per usual I am implicitly referring to the importance of factoring in demographics but then again; it is absolutely amazing that none of the presumed experts here have not added this variable to the equation yet. As Edward says towards the end in his entry ...

That is, the simple fact of the matter is that there is no exit strategy. The programme simply doesn't work. It is "over determined", since whichever way you look at it, there is always one more problem than there is solution. Gentlemen. I think its time to give up. Honourably, but to give up. Come on out of the bunker, white flags and hands in the air will not be called for. There's a world out here waiting for you, it's on your side, and there will be a tomorrow.

I couldn't have put it much better myself, I really couldn't.

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[1] - There is a surprise :)