Sunday, 1 March 2015

The Greek reform plan: an epilogue of the Greek tragedy?

It's been a rough few weeks, but Europe and Greece have finally reached an agreement. Or to be more precise, the Greeks have caved in to the demands of the financial markets, just as I predicted they would in my last blog post. Again, I hate to blow my own horn (but let's be honest, I need to); I was right once again in predicting the outcome in Greece. This aligns well with my track record of being correct on Greece in 2011, 2012, 2013 and, well, 2015. Just saying. 

So what was in the new deal? In a nutshell here is what the Greek government has pledged to do in return for the extension of the Eurogroup bailout program (much needed to maintain solvency of the Greek government):
  • Combat tax evasion (new tax policies): broadening the definition of tax evasion and fraud, while disbanding tax immunity. This includes reforming the collection of VAT (introducing technology), modernizing the income tax code, and altogether creating a new culture of tax compliance. Keep in mind that the Greek finance ministry fails to collect 30bn euros each year due to tax evasion (that's 10% of their gross public debt! Annually!)
  • Reform public sector wages to avoid further wage cuts, without increasing overall wage bill
  • Improve government efficiency and cut spending this way: more control over all forms of spending in the central and local government, in the health system, and particularly at cutting benefits for non-eligible beneficiaries (i.e. fraudsters)
  • Fight corruption: the government plans to make this a priority. Particularly in its aim to curb money laundering and smuggling of fuel and tobacco products.  
  • Continue with privatization: they've made a commitment not to halt the already introduced privatization schemes and even to review the privatizations not yet implemented with an aim to maximize the government's short term benefit (Wow! How's that for a leftist political platform?)
  • Labour market reform: they plan to introduce a new way of collective bargaining, stopping short of raising the minimum wage immediately, with an approach aimed at balancing flexibility with fairness (now isn't this something you can read in a standard economics textbook?)
  • Tackle Greece's "humanitarian crisis" with housing guarantees and free medical care for the uninsured unemployed (plus things like food stamps for the poor, and even an experimental minimum income scheme), but with no overall public spending increase
  • Pension system modernization: achieving pensions savings by consolidating funds and eliminating incentives for early retirement, however without cutting payments (this is an incomplete measure which should be re-considered since Greek pensions tend to be among the highest in Europe, and in some categories the average pension is higher than the average salary!)
  • Reduce the number of ministries from 16 to 10, cutting special advisers and fringe benefits for officials, in an aim to further cut down government inefficiency, and hence spending. This includes an overhaul of spending across every ministry, with an aim to reorganize non-salary and non-pension spending (which tends to account for 56% of total public spending!)
A more detailed list, with some measures not mentioned above, is available here in a letter from Varoufakis and summed-up here.

All of these sound really good actually. And very, very far from something a left-wing government would propose (which isn't too surprising). Christine Lagarde of the IMF even calls them "too optimistic". Even if this is true and even if it does take a long time for some of these measures to take effect (such as the new culture of tax compliance), there is no doubt this is exactly the reform package Greece needs. Too bad it didn't start doing it back in 2011.

Europe (read Germany) accepted the plan and extended the bailout deal for another four months. How did the Greek voters react? Violently, as usual. At least those voters who felt betrayed. Which is, again, exactly what I predicted would happen: Tsipras will follow the rules of the financial markets, which his voters will interpret as a betrayal and a renege of his campaign promises (at least on the promises he made in the beginning of the campaign). Luckily once you come to power and face the consequences you start realizing reality, even though the same cannot be expected of your voters. 

The tax evasion issue

The most interesting reform proposal is surely the one on clamping down tax evasion. A welcomed policy indeed. But the number I stated earlier (30bn euros) doesn't even begin to describe the extent of this problem.

First off, just take a quick look at the picture below: 

The source is this great paper from Artavanis, Morse and Tsoutsoura on tax evasion in Greece. Their main finding is that contrary to popular belief that only the super-rich are avoiding to pay their taxes, it is actually the middle classes (the upper middle classes to be precise) which are dodging their taxes. This makes a lot of sense, as 30bn euros is too much to link it only to the super rich. The problem must be more widespread. And it is. Basically across the Greek society. In the map above, you can see that tax evasion is even almost evenly distributed geographically (I don't know too much about Greece to comment on the geographical heterogeneity; there must be a reason why the Peloponnese peninsula, the greater Athens area and the island of Crete have the highest number of tax evaders). But the interesting area is the one circled. As the authors note, this is Larissa, "an area...that has the largest number of Porsche Cayennes in Europe". Talk about feeling sorry for the middle classes, huh?

The authors note that the primary tax evaders in Greece are doctors, engineers, private tutors, accountants, financial service agents and lawyers. Not surprising is it? But more problematic is this: "Testing the industry distribution against a number of redistribution and incentive theories, our evidence suggests that industries with low paper trail and industries supported by parliamentarians have more tax evasion." 

It gets better:
"On average, self-employed Greeks spend 82% of their monthly reported income servicing debt. To put this number in perspective, the standard practice in consumer finance (in the United States as well as Greece) is to never lend to borrowers such that loan payments are greater than 30% of monthly income. ...
... Take the examples of lawyers, doctors, financial services, and accountants. In all of these occupations, the self-employed are paying over 100% of their reported income flows to debt servicing on consumer loans."
As you might have figured it out this doesn't mean that the Greeks in all these occupations spend their entire income on servicing debts, but that their incomes are massively underreported.

As I've said countless times before, the Greek problem really is systemic. There is nothing ideological about it. Which is why ideology has to be removed when designing the remedies for Greece. In the current reform plan this seems to be the case, more or less. Let's hope they stick to it. 

Saturday, 14 February 2015

Greek game theory: You can fool the voters but not the financial markets

Back in November 2011 an increase of Italian bond yields for the third time in three months and for the first time above the critical boundary of 7%, resulted in an abrupt and surprising resignation of Italy's controversial PM Silvio Berlusconi. All of his corruption affairs, political blunders, and even the infamous bunga bunga parties could not hurt him. It was the financial markets that punished his reckless behavior of buying time for reforms by playing with the patience of investors.

The financial markets will be crucial once more in the case of the newly elected Syriza government in Greece, led by the radical leftist Alexis Tsipras. After having read his op-ed for the Financial Times published but a few days before the elections, it seems Tsipras realizes the gravity of the situation he and his country are in. Apart from the general anti-austerity rhetoric which won him the elections, Tsipras clearly stated that Syriza will respect the constraints given to them by the Troika (IMF, ECB, EC) and that Greece will, as a fully pledged eurozone member, aim towards reaching a balanced budget and will fulfill all other quantitative goals set by the European Commission. Tsipras emphasizes, however, that austerity imposed upon Greece by the Troika as part of the bailout deal, ruined the country and that such policies aren't the only way to balance the budget.

It's hard not to agree with him. In fact, back in October 2011 I wrote a blog post expressing deepest concerns over the bailout plan designed for Greece. Here's an excerpt from that text:
"...the Greek ‘rescue’ plan. It’s hard to see how this plan can actually help Greece stabilize. Keeping the status quo is not going to make investors ready to invest into the Greece economy. Pushing more money into an insolvent country and keeping it on ‘life support’ will make its economy more and more vulnerable and dependent on foreign aid. The policymakers are turning Greece into a long term problem for Europe. This will have negative implications on all fronts – it will ruin confidence around Greece for a long time, disabling it to achieve any growth whatsoever, it will create massive social instability in the country, and it will give further rise to euro-scepticism around the continent. The country’s future seems to be a lock-down in debt, social turmoil and inability to create growth. Greece at this point doesn't only need a debt restructuring, it needs a restructuring of its entire economy, starting from the labour market, public sector, industrial policy and so on. This is what the policymakers should have focused on, instead they choose to short-fix Greece until 2020. According to all of this, I fail to see how Greece will be able to grow at all until 2020.
But austerity in itself is not the cause of Greek problems. The complete picture of the demise of the Greek economy has to be traced back to decades of unsustainable, populist political concessions which were used to 'buy votes' by increasing pensions and public sector wages, extending public sector jobs to maintain a perception of high employment, and satisfying a plethora of budget-dependent interest groups. They used cheep borrowing on international markets, when Greece could borrow at the same rate Germany did (see here), to fund political concessions which increased their public debt-to-GDP ratio to above 100% (bank bailouts during the crisis coupled with rising budget deficits brought it to the current 175%). A consequence of this is the systemic unsustainability of the Greek public finances.


But it wasn’t all bad. The debt-fuelled growth model led to a rise in living standards as Greek citizens experienced the largest increase of personal income among eurozone countries (particularly the bottom income groups) during the first decade since the introduction of the euro. Due to cheep borrowing, enabled partially by the introduction of the euro, it seemed that the Greeks found a loophole in the system and that there was no ending to this model of debt-led growth. This obvious fallacy reached its painful and bitter end in 2009 when the external shock and the subsequent credit stop brought the domestic instabilities of the Eurozone economies onto the surface and created the final trigger for the sovereign debt crisis, both in Greece and across the euro periphery, which used the same debt-led growth model and political populism. 

There is no doubt that the responsibility for orchestrating such a debt-led growth model lies primarily on the political leadership of the old elites, PASOK and New Democracy. In fact their negligence and misconduct go even further after the discovery that the government’s official financial data has been falsified. The demise of their growth model and corrupt practices was coupled with social turmoil amid an extended crisis for which even Europe’s leaders hold a partial blame. And so the stage was set for Syriza to win the elections and make a genuine attempt to revoke the austerity commitment.  

However, despite high expectations of leftists worldwide, Tsipras and his finance minister Varoufakis, upon taking office have started changing their rhetoric. On their recent European tour they offered policies which the Commission has already asked Greece to do, such as closing down tax evasion (the tax authority fails to collect almost 30bn euros per year), and balancing the budget, but with firm promises that new debts are intolerable. They advocate Greece staying in the eurozone and are asking Europe for more time to implement the reforms which would put an end to the clientelistic and kleptocratic practices of their predecessors.

The main point of disagreement is the negotiation over the debt repayment. In particular, the 240bn euros which the Troika has used to bailout Greece on several occasions during the crisis, imposing strict austerity as a requirement. Varoufakis asks for part of the existing debt to be swapped for new bonds which would be linked to the growth of nominal GDP, achieved with a crackdown on tax evasion and subsequent budget surpluses.

The ECB, however, reacted by forbidding the Greek banks to access ECB credit lines by using Greek government bonds as collateral, thereby exposing the Greek banks to the risk of illiquidity. This created additional pressure for the government to respect the deal imposed in the bailout conditions, which would see them receive another payment rate of 7.2bn euros by the end of February. With deposits fleeing the country and without the help of Europe, Greece could literally find itself insolvent by the beginning of March. The ECB has later allowed the Greek central bank to extend up to 60bn euros to the domestic banks in case of emergency, but this still doesn't make much of a difference for the Greek government.

Greek 10-year government bond yields. Source: Bloomberg
Prime Minister Tsipras therefore has two options; one is to follow the rules of the Troika and respect the realistic constraints of financial markets. This would necessitate entering into various compromises which could be interpreted as a betrayal of his voters. The other option is to use the same populist policies responsible for the crisis in the first place, and descend the country into bankruptcy and subsequently an even bigger recession. This would surely result in a political downfall of Syriza and the ascent of right-wing nationalism, with which Tsipras is already scaring Europe. This seems to be the central strategy of minister Varoufakis, a game theory professor, in his negotiations with the Commission and Germany - a credible threat of national-socialism which should force Europe to cave in. So far the strategy hasn't been too effective; capital is still fleeing the country, liquidity is endangered, risk of bankruptcy is increasing and stock markets are in decline. By the end of February Tsipras will probably choose the first option, coupled with a few benign populist decisions such as rehiring cleaning ladies and firing ministerial advisers, in order to maintain a signal of intransigency towards his voters.

Contrary to ideological illusions, the key to a Greek recovery is the recovery of its private sector. This will not happen by maintaining and even furthering concessions to various budget-dependent interest groups. The budget must be released of such expensive concessions in order to open the scope for tax cuts (particularly on labour) and the removal of various obstacles for businesses. It is of crucial importance for Greece to restore confidence and credibility of its government and its rule of law. Enforcement of contracts is another key area that needs to be strengthened in order to signal greater stability to both domestic and foreign investors. After this, it has to continue with public sector reforms and the crucial labour market reform (both are closely tied since the public sector unions are the ones with the highest level of rigidity). It must show strength in the bargaining process and create favourable incentives for businesses. The banking system will follow upon the positive signs of confidence and stability in the economy, reducing capital flight and slowly but gradually improving their balance sheets and preparing more money to foster economic activity. Restoring national pride can help, but the only solution Greece has are proper reforms, not empty populist promises like Berlusconi's. 

Wednesday, 11 February 2015

'Good hunches': Predictions on Greece

On a few previous occasions I've found myself praising 'good hunches' of certain economists on being right about a number of predictions for the future (see here and here for example). There's also been a few not so good hunches (like when Paul Krugman asked Alan Greenspan to create a housing bubble in 2002 to offset the IT bubble) and a few downright terrible ones (like when Paul Samuelson predicted that the Soviet Union GDP will surpass that of the US by 1984(!), but more realistically by 1997). 

Now it's time to blow my own horn. I've been covering the eurozone sovereign debt crisis and in particular the Greek situation since I started writing this blog. After all, the crisis was a sort of an inspiration.

I was rather content to see how precise I was back in October 2011 to describe the possible outlook for Greece in the next few years, after the policymakers have devised their first draft of the Greek bailout plan. Here is what I wrote back then: 
"First of all is the Greek ‘rescue’ plan. It’s hard to see how this plan can actually help Greece stabilize. Keeping the status quo is not going to make investors ready to invest into the Greece economy. Pushing more money into an insolvent country and keeping it on ‘life support’ will make its economy more and more vulnerable and dependent on foreign aid. The policymakers are turning Greece into a long term problem for Europe. This will have negative implications on all fronts – it will ruin confidence around Greece for a long time, disabling it to achieve any growth whatsoever, it will create massive social instability in the country, and it will give further rise to euro-scepticism around the continent. The country’s future seems to be a lock-down in debt, social turmoil and inability to create growth. Greece at this point doesn’t only need a debt restructuring, it needs a restructuring of its entire economy, starting from the labour market, public sector, industrial policy and so on. This is what the policymakers should have focused on, instead they choose to short-fix Greece until 2020. According to all of this, I fail to see how Greece will be able to grow at all until 2020." (28th October 2011)
 In April of the following year, when Greece made the infamous debt swap the situation was even worse:
"...there is no sign of improvement: consumer confidence is hitting a new low, unemployment is reaching a new high, industrial production is still falling as is the manufacturing PMI, while the growth outlook never looked worse. The only two things showing improvement are government gross debt and the budget deficit, both due to the foreign enforced austerity reforms and as a part of the recovery strategy of the Troika (ECB, IMF, EC). Well, as anticipated it doesn't seem the enforced austerity did much help so far."
"The program of debt restructuring is that Greece needs to do a whole bunch of austere reforms which aren’t likely to jump start the economy or create a sustainable path for growth. They are expected to decrease their debt-to-GDP ratio from 160% to 120% in 2020, which is still a burden far too heavy for Greece, or anybody for that matter. The 120% threshold is too high, and has no economic justification. It’s a politically chosen goal made up to resemble the current Italian debt-to-GDP ratio, which is still deemed to be sustainable." (2nd April 2012)
And in the same month I proposed which reforms in particular Greece should focus on:
"Institutional reform starts with political stability. Greeks have little confidence in their government. In order to address this, the politicians need to restore belief in the system and the rule of law. The government must act as an enforcer of contracts to signal greater stability to both domestic businesses and foreign investors. After this, it has to continue with public sector reforms and liberalisation of the labour market (both are closely tied since the public sector unions are the ones with the highest level of rigidity). It must show strength in the bargaining process and create favourable incentives for businesses. Signals for new specialisation, trade and production should be left to the market - to bring about the necessary restructuring process supported by the new institutional setting. This is the only way to enable an efficient allocation of resources, removed from any distorting signals and able to attract capital. The banking system will benefit from positive signs of confidence and stability in the economy, which will reduce capital flight and slowly but gradually improve balance sheets. A euro exit could threaten this process by making it harder to achieve political stability. It would take Greece much longer to consolidate.  
Greece should turn to pro-market institutional reforms that will reduce distorting signals in the economy and create space for market led specialisation and investment. And these institutional reforms should not be limited to Greece. They are applicable to a series of countries which find themselves constrained by their unsustainable welfare state models of debt accumulation, high current account deficits, fiscal profligacy, corruption and high levels of state intervention." (23rd April 2012)
Pleas such as this one, advocated by many economists at the time, went unnoticed unfortunately.

In January 2013, I discussed why I don't think the euro will perish, despite Greek woes:
"Even though some are still not convinced that Greece will stay much longer in the euro (Roubini has given them a deadline sometimes in the next 5 years - a much careful prediction this time), nor that the euro itself would survive. Some see austerity, some see lack of real reforms as an eventual end to the euro project. It's hard to argue against this, since austerity is done in a completely wrong fashion, without any emphasis on labour market rigidities (sacking public sector workers just won't do it) or the regulatory and bureaucratic burdens. However, investor sentiment is a delicate creature, and an event such as a euro failure may destroy all hopes for recovery for as much as a few decades. In an ageing continent, with a risingly unsustainable welfare state system, this could be a trigger for a great deal of social unrest and new (old) conflicts. Political stability of the Eurozone, a system that became irreversible, is crucial in sustaining it. This is why it will never perish no matter how faulty were its initial foundations." (27th January 2013)
So far so good (in terms of the predictions that is). However the Greek woes continue. In the next few days I'll have a comment on the recent developments. Stay tuned. 

Sunday, 25 January 2015

Being an economist

A few months back The Economist had a great text about economists and how they are, apparently, getting too big for their britches. Here's a few excerpts: 
"...Despite their collective failure to predict the financial crisis ... economists are still very influential. They write newspaper columns, advise politicians and offer expensive consulting services to business-folk far more than other academics. 
 ...economists have come to believe that they are superior. A survey in 1985 found that just 9% of graduate students in economics at Harvard strongly believed that economics was “the most scientific of the social sciences”. But as economics became ever more mathematical, its practitioners grew in self-confidence. By 2003 54% of the graduate economists studying at Harvard strongly agreed with the statement... 
...economists demonstrate their self-belief in subtler ways too. Articles in the American Economic Review cite the top 25 political-science journals one-fifth as often as the articles in the American Political Science Reviewcite the top 25 economics journals. Another study found that American economics professors were less likely than their peers in other subjects to agree with the notion that “interdisciplinary knowledge is better than knowledge obtained by a single discipline.” 
"The odd thing, the authors argue, is that we believe in economists almost as much as they believe in themselves."
The paper the article refers to is available here.

If this is the norm, and if economists are suddenly developing a high opinion of themselves (justifiable to some extent, apart from the quacks), then this could be one of their biggest problems:

HT: Marginal revolution

No more scientific-based debates in the field. This may well lead to complacency and even more dangerously - confirmation bias. It is surprising that even during the current crisis debates in top journals have been absent. This probably has a lot to do with the ascent of economic blogs. The debates have simply moved there. However academic blogs, even very good ones, are not science. They're fun and useful for getting quick information, but they're not science. 

Another reason for the lack of journal-based debates is probably due to the fact that publication in a top economic journal takes a very long time (years even). Much longer than in natural sciences (see The Royal Society for example). So a debate between two opposing ideas is being done much quicker via blogs. Taking the discussion to a journal requires building a model, and/or a lot of empirical testing (which is certainly justified). 

However, if I was to be asked what's the biggest threat to economics as a science (fragile as it is), it would be that its models become an aim in themselves. That's what math is all about, and to some extent economists still tend to get preoccupied with math or game theory as the 'ultimate knowledge'. If one masters math, the saying goes, he/she must be a worthy scientist. Mastering math is only a necessary condition to be a worthy scientist. A sufficient one is to actually apply it. Math is a tool, as is game theory. You use tools to help you get a certain conclusion, a finding. But even more importantly one needs to test this finding using a rigorous scientific method. 

This is what makes me optimistic about the future of economics as a science. I'm seeing more and more academic papers based on applying a scientific method, experiment-based, and less and less focusing on what we can call politically-biased macro (Noah Smith has a lot to say about this, check it our here, here or here).

We all, of course, study economics to understand, influence and possibly (hopefully) design economic policy to make the economy better, more efficient. Even those with "wrong" ideas have only the best intentions. However, too much focus in economics has been placed on designing the "right" macroeconomic (fiscal or monetary) policy. In my opinion, the research direction should go the other way. First we experimentally test and analyze the current policies, find out what's wrong with them and then fix them. No grand scheme, no one-size-fits-all approach. A bottom-up, micro-based approach. This is why I subscribe to institutional economics. It's all about fixing one institution at a time and eventually change the paradigm. Changing informal institutions by changing the formal institutions. And vice versa. It's all self-perpetuating anyway. 

Friday, 2 January 2015

2015: Back to Realpolitik and back to growth

Well, well, well, it seems the Cold War era is back upon us. And I'm not just saying this as a consequence of a holiday season James Bond movie marathon that I watched. No, it's real, or to be more precise it's - Realpolitik! It seems that diplomats are setting the stage once again, and that the debate over Russia vs the West is likely to overtake the debate on the economy next year. Which is good on one hand as it implies that the economy is recovering so it's no longer the main focus of attention, but on the other hand it's bad since foreign policy standoffs only build uncertainty and are not good for economic recoveries. But overall the economy actually is expected to perform quite well next year (well, apart from Russia, but more on that below). Low oil prices will be the key in prompting a stronger recovery. The IMF links a 10% change in oil prices to roughly 0.2% change in global GDP. Prices that have fallen by 50% in the last 6 months are likely to be a significant boost to growth in 2015. The outlook, thus, is a positive one.


Since last year's predictions were quite precise, I am hoping that this year they be even better.

The first big issue is: will the central bankers raise interest rates next year? This is now becoming increasingly likely. The FED will be first to do so amid a stronger recovery in the US. In March last year, the FOMC has announced a rate rise to about 1% in 2015, and slightly below 2% in 2016. The market has had time to adapt to this announcement and has reacted rather well. As I've stated back in March when the rate increase was announced, this won't cause any commotion on the markets, even in the short run. The BoE may follow them in this decision, while the ECB probably won't. The ECB will however go into even stronger quantitative easing next year, still buying time for structural reforms. Draghi has announced this last month, and from what I've heard in my trip to the ECB in the beginning of December, they are convinced they are doing everything they can to help Eurozone via low interest rates and unconventional monetary policies. So obviously the ECB won't directly start the recovery in Europe, this is still left upon Europe's governments. The Bank of Japan also will not increase interest rates next year.

What about the recovery? Is next year the year? Well, yes and no. Yes, as Europe (Eurozone) will continue to grow at around 1% as it did this year, however this won't mean that a robust recovery has started. Unemployment will stay high (particularly in France and Italy), despite some members improving their unemployment situation (Spain, Greece, Ireland, Portugal). Inflation will stay low (the threat of deflation is becoming Europe's serious long run issue), budget deficits will be lower than this year, and we might even see some structural reforms implemented (however their distribution will certainly be skewed and limited to a few countries). So in Europe the year is expected to be a year of positive trends, but they still won't be felt by the majority of its citizens. I stand by what I wrote last year: the recovery is happening despite, not because of the policies enacted by the politicians. It is being led by global growth fundamentals (energy booms, international trade, low oil prices, etc.), not by reforms from within. This still makes Europe fragile and sensitive to any external shocks. Which are plentiful nowadays.

The "it" country in Europe in terms of growth this year will be Ireland (3.5%). The country with the worst performance will be either Cyprus or Croatia (both probably around 0%, perhaps even negative growth).

In the United States I predict around 3% growth for next year, driven by a resurgent Silicon Valley boom, and by low oil prices. It's hard to precisely predict how low oil prices will affect the country, since the US is the world's biggest producer, consumer and importer of oil. However in net terms the US spends much more than it produces (as I've said, it is also the largest importer), so low oil prices will certainly provide a net benefit for the US economy. It might, however, hurt a lot of newly formed shale gas producers and hence contract their exports (along with a stronger dollar). In terms of monetary policy, falling oil prices will certainly push inflation expectations down, but all in all I don't expect the Fed postponing the interest rate increase because of it. The opportunity cost of sending a signal of uncertainty is too high for the Fed to renege on its announcements. 

In political terms, the current standoff remains. The Republicans and the Democrats will start preparing their candidates for the 2016 primaries (due to begin in January), where it seems very likely that the Democrats' strongest nominee will be Hillary Clinton. As for the Republicans many names are being thrown in, so it's hard to predict who might emerge as a likely candidate at this point. By the end of the year we might get a more clear picture.

In Japan, the growth rate will be positive, although less than 1%. It still suffers from many of the same problems as it did in the past 20 years, and Abenomics has clearly failed as the remedy it was hoping to be. The rise in consumption tax has hurt them much more than expected. Japan doesn't have a problem with unemployment as Europe clearly has, but its fiscal balance and gross public debt are still huge issues. Japan is a very puzzling story, a scenario that is very likely to capture Europe in the next 5 to 10 years. It seems that nothing works to prompt Japanese growth. Any short-term macro policies aimed at boosting growth are counterbalanced by a problematic fiscal situation. Japan remains in its limbo state for another year. 

For Germany next year won't be a year with strong economic growth. It will be around the European average of 1%. Introducing the minimum wage should have a neutral net effect on growth (as for many the minimum wage will just replace the benefits they've been receiving so there's no expected increase in consumption). The biggest drag on growth will be a balanced budget. But the Germans are well aware what they are sacrificing for this. For an ageing country overburdened with debt, balancing the budget is a necessity to prevent long term problems. Germany is today preventing the possible collapse of tomorrow. That is the smart way to do it. If (when?) a new structural shock hits Europe, Germany is probably the only country that will be ready for it. Losing a few years of strong growth to see your debt drop down to below 60% of GDP in 3 years, is worth it. Particularly since Germany has strong structural fundamentals that enable its productive capacities to flourish and make sure it can always count on its exports. And finally, low oil prices will certainly help Germany  in the following year. 

In the UK, the general election is coming up. The main prediction is that the Conservatives will stay in power, and that UKIP will become a parliamentary party (they already have two MPs in Parliament, but these were defectors from the Conservatives; UKIP has yet to perform well in a national election - and they will in 2015). On what do I base this prediction? Well, look at the pools, Labour is on a downward trend - its lead over the Conservatives went down from an average 8-9 p.p. in 2013 to about 2-3 p.p. in 2014. Next year it's only going to get worse for Labour as the economy continues to recover and as immigration takes the stage as the main issue in Britain. The problem with the polls is how they translate into actual seats. Having a 15% support for UKIP doesn't imply they get 15% of seats in Parliament. In the first-past-the-post system, it's all about getting wins in constituencies. Although it's hard to imagine a coalition of Conservatives and UKIP, I predict that the Conservatives will enjoy a minority government, with UKIP (and what's left of the LibDems) giving them support to form the government. I don't think there will be a National government of Conservatives and Labour, as some tend to predict. Not in these elections at least.

As for the economy, it will continue on a stable growth trajectory with around 2.5% GDP growth, and more importantly with unemployment declining and the budget deficit decreasing. Housing prices will continue to rise in Britain, although perhaps not as much in London, at least in the super-prime property market.

International relations

In terms of global, foreign policy predictions, many battles wait upon us.

By the end of last year no one saw the annexation of Crimea coming. It was one of those fat tail events that just take everyone by surprise. Another similar event was the rise of ISIS (or ISIL), a radical Islamist rebel group based in Iraq and Syria. Although few could have predicted their ascend last year, the rise of Islamist radicalism was an inevitable consequence of foreign military interventions in Iraq and the Middle East, lasting for more than 10 years by now (after all, they started gaining strength back in 2006).

How will these two major threats to stability be overcome? First off, the fight against ISIS is highly unpredictable. Currently the emphasis is for the Iraqi and Syrian armies to fight them off. So far the US and the NATO are only providing support in terms of training and equipment (US special forces are already there assisting with air strikes). However if things escalate beyond control, I wouldn't be too surprised to see the US putting troops back on the ground and leading the fight against ISIS. In his final two years in office Obama has nothing to lose with such a decision. But again, this will only happen if the conflict escalates beyond control and ISIS starts gaining more power. 

As for Ukraine, in 2015 it is likely to remain in its current status quo. Putin, facing domestic pressure of a declining economy for the first time in his 14-year reign, won't risk new conflicts over Ukraine, but is very likely to increase nationalist and protectionist rhetoric back home, primarily to protect his strong position. It is this rhetoric that will dominate the scene next year. 

The biggest pressure for Putin will be the price of oil. For a very long time (actually for the full duration of Putin's reign) Russia has profited heavily from high energy prices. Not anymore, as next year the price of Brent oil will probably drop below $50 per barrel at one point and will remain low throughout the first half of the year. Putin has failed to use the accumulated wealth from oil and gas earnings to structurally change Russia's economy, and reduce its dependence on energy prices. Even worse Putin has used the accumulated wealth as a typical dictator - to empower his cronies (his winning coalition), thus strengthening his hold on power. That was and still is bad for Russia, as its people are now painfully realizing as the Ruble has plunged about 40% against the dollar.
Oil prices, 1946-2014. Source
The sanctions from the EU aren't helpful either, as the Ruble will continue to decline if things remain the same, pilling up pressure on Putin. This will imply one of the following scenarios: the Russian central bank defends the nominal exchange rate by selling its foreign reserves, which could provide to be extremely costly and can push the country into a real recession (recall the Bank of England trying to protect the pound back in 1992 when Soros imposed a 27bn loss upon them); or having the government defend the exchange rate by engaging into austerity policies, which is also likely to push Russia into a recession. Leaving things as they are and allowing the currency to float with limited sales of reserves (a strategy the Russian central bank is applying) will also hurt the country economically next year. Russia is facing a serious economic crisis, in many ways self-imposed - dependency on oil and gas, cronyism, and foreign policy interventions have finally caught up with Putin. History is repeating itself for Russia, only this time their position of power was short-lived. However Putin won't go down that easily. That's why I expect a resurgence of Realpolitik in foreign relations. 

In China growth will fall below 7%, slightly below expectations. Will next year be the bubble burst for China? Maybe, maybe not. As I've learned from last year's predictions, predicting exactly when will the Chinese bubble burst is an unrewarding task. After all, this too is a fat tail event, so its occurrence will surely be surprising. As for the slight pessimism over China's slowdown, it is due primarily based on reports on weak property sales, a decline in fixed investments and the manufacturing sector, and expected low inflation and lower consumer spending. However let's not forget that low oil prices will significantly benefit China as well. China is the second largest net importer of oil. 

In India after a gloomy year expect the growth rate to accelerate under new leadership of Narendra Modi. There are many reasons for optimism in India; low oil prices will ease the pressure on high inflation and the current account deficit (India imports 70% of its oil consumption). This will enable India's central bank to cut interest rates in order to help the government promote some structural changes to India's economy (the government has already started applying reforms focused on better governance, fiscal prudence and ease of doing business, with the labor reform announced next year, in addition to attracting new investments from China and Japan). All this will help its economy grow above 6% next year. 

As for the rest of the emerging markets? A strong dollar certainly doesn't help, neither does the announced increase in interest rates from the Fed. Low commodity prices and low oil prices will hit the commodity and oil exporters (particularly in Africa and South America). Bond yields are on the rise in most of the emerging markets, so I do expect another growth slowdown next year for the EMs. 

Altogether, it will be a year of positive growth rates, but not everyone will feel it, particularly in Europe. Low oil prices will drive most of the positive growth in the West (and in India and China), but not everyone will be happy because of it. The international stage has been set for muscle flexing, something Putin is very good at (both figuratively and literally). It won't last too long, but in my opinion it will dominate the debates in the following year. I do hope that I'm wrong this time.

Happy new 2015!