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Sunday, May 24, 2009

Hungary's Trend Growth And Debt Sustainability

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

They also say:

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

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

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

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

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

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

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

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

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

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

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

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