Friday, 26 December 2014

Hits and misses: Evaluation of last year's predictions

As 2014 is coming to an end, this is a good time to wrap up the year and look back at some of the events that passed us by, but most importantly it's a good time to present a quick overview of the predictions I've made in the beginning of the year and assess how good they were. 

I actually had quite a lot of hits, and only a few misses this year. I won't be modest in saying that I'm getting pretty good at this. Perhaps reading Bueno De Mesquita's "The Predictioneer's Game", and Nate Silver's "The Signal and the Noise" rubbed off some of its magic on me?  

Here goes (the predictions for 2014 were made on January 2nd 2014):

The Hits: 

1. "next year a stronger recovery should finally kick off in most of the Western world. Emerging markets will grow too, however less dynamically than before...In America the energy boom will reignite the recovery momentum...America's stronger growth will rub off on Europe as well, so we can finally expect to see the Eurozone with positive growth rates next year (around 1%)...."

This was spot on. The Eurozone grew at 0.8% (the EU at 1.3%), the US reignited their momentum, while the emerging markets slowed down (their growth dropped from an average 7% to 4.4%, amid rising bond yields). 

2. "Central banks will keep rates low in 2014."

This was kinda obvious.

3. "I often make predictions of the World and Euro Cup winners just before the tournament, and I often come close. This time my call is Germany...
...In the other half-final, I see Germany and Brazil, where Brazil will crumble under pressure and lose..."

Painfully accurate! (painfully for Brazil of course)

4. "In Europe, the EU parliamentary elections in May will give rise to anti-EU parties (both far-left and far-right), mostly thanks to low turnout and discontent with economic recovery from the majority of the population."

Yet another painfully accurate prediction. 

5. "In the UK, growth will be better than last year, probably somewhere around 2%. It will mostly rest upon the housing recovery and an improving global environment."

Not too far off, growth will probably be around 2.6% for this year. 

6. "The Scots will vote no. The majority of the population is Scotland doesn't want independence, but rather more power for their country within the Union... They will get this, but not next year."

Got that one right too, even on the long term issue of constitutional reform in Britain.

7. - 12. A number of predictions for the US came out true:

"An immigration reform is expected sometime next year...
...Obamacare, the hot issue in America, will not be repealed. The individual mandate will be triggered in 2014, but despite this many will still stay uninsured...
...The health spending budget will rise even higher, currently around 18% of GDP. This will most likely hurt the Democrats in the November midterm Congressional elections, ... but the power struggle in Washington will remain as it is...
...The recovery will continue steadily with the country growing at around 3%, led by a housing recovery and an energy boom."

Only one miss here: "the power struggle in Washington will remain as it is"

Republicans got hold over the Senate. However one can say that the power struggle on the line President vs Congress did actually remain as it is.

13. "India expects general elections in 2014, where Narendra Modi is expected to become the next PM. The economy will remain to be weak, suffering from high inflation, a large budget deficit, weak currency, rising debt and loss of international confidence." 

Modi did become the PM (and it was a landslide victory), while India's economy remained structurally weak. It does however have reasons for optimism in 2015 (in part due to declining oil prices), but that will be covered in next week's post, in the predictions for 2015. 

14. "In Brazil ... I don't expect the mass protests that have happened last summer during the Confederations Cup to be repeated this summer."

15. "The recovery is not happening because of the policies enacted by the politicians, it is happening despite them (like the housing and energy booms or the reemergence of international trade). It will be bad if the politicians take this good news lightly and halt the necessary reforms. Unfortunately, it seems that this is exactly what will happen." 

A warning sign that went unnoticed. Particularly in France and Italy, so it seems. 

The Misses:

1. "Japan too will continue with positive results, riding on Abenomics, although it will most likely fail to lift inflation to the targeted 2% next year." 

I predicted correctly that inflation will stay low, but I was way too optimistic on Abenomics. I blame it on the bias of the Economist. I got carried away after reading their optimistic reports on Abe as the Japanese Superman (I'm not kidding, this was even a cover of an issue in 2013).

2. "Latvia will once again be the fastest growing member at around 4% growth...
...the largest negative growth will face Greece or Slovenia (around -1%)..."

Latvia grew (at 2.6%), but it wasn't the fastest growing member. This esteemed title went to Ireland (4.6%). Greece was a miss (kudos to Greece for finally reaching positive growth figures, even if marginal) as was Slovenia. The worst was - Cyprus (-2.8%, according to the EC). Note: these estimates don't take into consideration the final quarter of 2014, but already we can notice the trends and declare "victors". 

3. "Chinese growth will drop down below 7%. Will next year be the year of the bubble burst in China? Possibly." 

Underestimating China again? Oh well, maybe next year.

4. Brazil: "I'm not sure Rousseff will hold onto power." 

She did. A very narrow victory (51.6%), but a victory nonetheless.

5. "World Cup: The wild horse will be Belgium, which could reach the half-finals, where it will probably face Spain or Uruguay. In the other half-final, I see Germany and Brazil, where Brazil will crumble under pressure and lose, but will go on and win the third place playoff." 

Ok, so Spain and Uruguay were misses, as was the Brazilian third place, but Belgium did ok, didn't it?

Under the radar: 

I didn't include anything on the Ukrainian situation, as by the end of last year it merely started unfolding. This set the stage for a whole new, cold-war-reminiscent, foreign policy battle that hardly anyone could have anticipated. For Putin I stated that the Sochi Winter Olympics are "expected to be a combination of extravagance, glamour, waste and corruption. But also it will be a new showcase of Putin's power to the rest of the world."

Well, Putin used something else to showcase his power. Something much more convincing - the Russian army.

And with this image I wish all my readers a Merry Christmas and a Happy New 2015!

Monday, 15 December 2014

Why Germany is right to "hold Europe ransom"

As I've stated in an earlier post, my recent trip to Germany has been full of positive experiences. Most importantly I gained insight into why Germany (i.e. its formal institutions) feels so strongly about the agenda for structural reforms and why it opposes any alternatives, particularly looser monetary policy and the idea that Germany should stimulate its economy to raise European aggregate demand.

A country that was once called the "Sick man of Europe", was the first to undergo painful reforms. Back in 2003 they started with preparation and implementation of the so-called Agenda 2010, which I covered on several occasions in the blog (see here or here). The Agenda carried a series of reforms, but the most notable and important ones were the labor market reforms (i.e. Hartz reforms), because of which Germany was able to cushion the blow of the 2008/09 crisis. Germany had the lowest increase in unemployment (virtually none) of all European countries during the crisis. 

The labor market reforms necessitated a joint approach from all sides, so the negotiations that started in 2003 included the federal government, businesses, unions, parliamentary representatives (i.e. all political parties) and even scientists. The centerpiece of the labor market reform was to curb the power of unions and craft guilds, making it easier for the young to enter the market, while contributing to the labor market flexibilization. The unemployment benefits were cut (a German can draw unemployment benefits only around half as long as an American), tax reliefs were introduced to those hiring, in addition to a whole set of marginal but important measures. The initial reaction was, as always, a shock. Unemployment increased as businesses started optimizing their labor intake (and hence firing more), coupled with dissatisfaction among the unions and guilds which in the end cost Chancellor Schroeder the elections. But the system was reformed. And it was precisely because of these reforms that Germany weathered the crisis much better than any other country in Europe. 

Leading by example: a balanced budget 

And once again Germany is leading the way in showing how to get out of the mess of unsustainable debt and sluggish growth. It is leading by example - next fiscal year Germany will have a balanced budget for the first time in decades. According to the debt projections, labor market trends and most importantly demographic trends (an ageing population), cutting debt is essential. An old population overburdened with debt is no promising future. Which is precisely why the number one priority of the government at this moment is to cut debt. How does one do that? "Easy", start by balancing your budget. The figures below show a strong statement of intent: Germany intends to have a budget surplus until the debt-to-GDP level is cut down to the Maastricht ratio of 60%. According to the existing projections, Germany will achieve this in 2018, so in only four years! Take note Eurozone periphery, this is what proper austerity looks like: 

Source: Federal Ministry of Finance
Source: Federal Ministry of Finance
Will this affect their GDP growth? Most surely. Growth will remain to be low at around 1 to 2% in the next few years, but just like in 2003, the system needs to be changed. And in this case the system needs a debt decrease. The opportunity cost of a temporary slowdown is low enough to justify the austerity approach applied by the Germans.

Criticism from the EU

However this zero deficit approach generates fierce criticism across the EU. Many have stated that Germany should continue to pile up debt to keep aggregate demand in Europe higher. They blame Germany on "holding Europe ransom" by forcing them into austerity without providing any relief. Germany should, according to the critics, provide more fiscal stimuli into Europe (indirectly of course) to help the rest recover as quickly as Germany did. However the German logic makes more sense. Germany is not in a recession (contraction) so it sees no point in applying the classical counter-cyclical solutions such as large spending hikes. Instead they opt for encouraging private investments instead of large public investments. This is best done with measures such as capital gains tax write-offs, lower corporate taxes, lower income taxes and other regulatory and non-regulatory (legal) measures aimed at helping businesses grow (see here a short guide for attracting foreign investments). Attracting private investments is the right approach, everything else in a state of unsustainable debt is wrong. FYI, private investments in Germany consist of 17% of its GDP, whereas public ones consists of only 1.8%. 

Germany has its own problems it needs to take care of. As mentioned, with an ageing population large public debt becomes a big problem. Not now, but in the near future. And Germany wants to address this issue immediately, not wait until it's too late. 

Furthermore the rest of Europe isn't far away from the German problem. They too are overburdened with debt, and Europe in general is ageing. Demanding large stimuli and further indebtedness is self-defeating, particularly in the long run, which isn't so far away. Even in the short run it won't cause the effect it is supposed to. Why? Because the private sector deleveraging in Europe as well. Two IMF economists show why this is a drag on growth particularly if all three major sectors of the economy (government, households and corporates) have high debt levels:

Source: VoxEU
The other reason is lack of lending. Banks are safe (according to the latest ECB stress test), but still unwilling to lend. And then we reach monetary policy. Critics of the ECB (and hence the Bundesbank) call for looser monetary policy, i.e. for a more expansionary approach. According to this argument it would be best to simultaneously apply both expansionary monetary policy and an expansionary fiscal policy to raise European aggregate demand. And then do the reforms, which everyone agrees are necessary. 

Where have I seen this approach fail most recently? Oh, that's right, Abenomics, the policy package of Japanese PM Shinzo Abe aimed at finally pulling Japan out of a 20-year-long stagnation. It's not so wise however to use the same policies that have failed consistently for 20 years and then hoping that suddenly they will make a difference. Even if applied simultaneously

Europe tries to do the same thing. Avoid a painful solution and provide persistent short-term stimuli, hoping that at one point they will make it. Economics doesn't work that way unfortunately. Not when there's so many structural unbalances as they are today in Europe (and Japan). Which is why, in my honest opinion, Germany holds the key to Europe's success. Leading by example in balancing their budget, while forcing structural reforms upon other nations is the only way to go for Europe. Everything else leaves them in a state of Japanese-style decades-long stagnation.


Addendum: One of the most commendable things about Germany's economic policies is the continued increase of investment in education. Despite the crisis and the (brief) recovery period, Germany increased spending on education from 3% to GDP before the crisis to almost 5% to GDP in 2014. This will be increasing even more, as the Germans have recognized where the foundations for long-run growth lie in (see here for greater detail). 
Source: Federal Ministry of Finance

Sunday, 7 December 2014

The German Social market economy

I've spent the entire last week in Germany, as a part of a delegation of Croatian economists and economic experts, organized by the Konrad Adenauer Stiftung (KAS). The idea was to visit the main economic and political institutions in Germany and open a dialogue on the problems facing Croatia, but primarily to learn about the experiences of the German solutions/responses to the crisis through the conceptual framework of their Social market economy (i.e. the German ordoliberalism). We have visited a series of institutions, starting with the Bundesbank and the ECB in Frankfurt, and ending with the Ministries of Finance, Economy and Energy, Labour and Social Affairs, and even the Office of the Chancellor, all in Berlin. In the middle we visited a series of other noteworthy institutions like BaFin (the regulator of financial services), the Council of Economic Experts, DIW institute, the banking association, a few members of parliament and so on. I plan to write a separate post on some of the main outtakes of the trip, with emphasis on how the Germans see their role in Eurozone, opposed to how the rest of Europe sees it. And rightly so. Before I descend into commenting the actual state of the German economy, I would like to extend a few thoughts on their "unique" idea of the so-called Social market economy. 

But first a little bit about the trip initiators and organizers, the Konrad Adenauer Stiftung. KAS is a political foundation (stiftung means foundation), associated with but independent of the German center-right party CDU which currently holds power in Germany. The idea of the Stiftung is to promote the ideas of freedom, liberty, peace and justice, democratic consolidation, and development, mainly through their civic education programs, but also to provide a basis for political action, all around the world. A similar institution to KAS is a foundation called Friedrich Ebert Stiftung (FES) aligned with the social democratic SPD. Both of these political foundations act as a sort of a shadow embassy outside of Germany, that connect their own parties (parties they're aligned with) with the opposition and in-office party of the country they reside in. In addition to this role, they both act to promote the civil society. KAS has offices in more than 120 countries worldwide, and thus serves a foreign policy role as well. For example they had an important role in the reconciliation and partnership between Germany and Israel, a relationship previously rebuilt by the Chancellor whose name the foundation carries - Konrad Adenauer. Rebuilding this relationship was crucial for Germany after WWII, and was the final step towards designing a new German society, one based on strong institutions, competition and democracy. Or in other words - ordoliberalism. 

Social Market Economy

So what is the Social market economy (in German: Soziale Marktwirtschaft)? According to the prevalent German interpretation it represents a type of market capitalism combined with policies promoting social insurance (protection for the poor, unemployed, health benefits, etc.). It is based on the idea that markets must be in the center, coordinating the economy (prices), while market participants must be constrained by strong and enforceable institutional rules. It is a system based on competition, order, and most of all on setting a clear institutional framework in which the market actors must participate.

Germans are proud of this model, introduced by the great Ludwig Erhard (pictured) back in 1949, who was then a Minister of the Economy, under Chancellor Konrad Adenauer. Erhard was the Economy minister for the entire duration of Adenauer's Chancellorship (14 years, from 1949 to 1963), and succeeded him as the next Chancellor from 1963 to 1966. He is widely lauded as the creator of the Social market economy, presented at the time as the compromising "Third way", something between the laissez faire Anglo-Saxon liberal capitalism (which was still, in the mind of the Germans, to blame for the Great Depression of the 1930s), and the communist central planning system (introduced during the Weimar Republic and fully applied during National Socialism). Germany needed something new at the time, an idea that transcends the fallen ideologies of the past. It needed, for the first time in its history, to apply a truly capitalist, market democracy.

That's why the model was so successful. From 1949, Germany, for the first time in its history, has introduced a democratic system with a market economy. The term most usually related to Erhard and this initial period of German democratic consolidation is the German economic miracle, which has in the 1960s and 1970s crated an economic powerhouse that Germany is today. It didn't start without problems however. In the begining, after the destruction of the Second World War, Germany was under occupation and under price controls and rationing. Housing was destroyed, industrial production as well, food production halved, inflation was an open threat yet again, and a lot of male population died in the war. The task seemed impossible, particularly due to the country being split in half and the animosity arising among its occupiers. But Erhard was stubborn enough to push through his reform despite the fact that many opposed it at the time. Even the allies weren't sure of his ideas. But he abolished the price controls and rationing of food, he limited monopoly power by introducing antitrust laws, reduced marginal tax rates (from 95% to 18% marginal rate), introduced a new currency reform to bring back price stability (and eventually turn the German Mark into the strongest currency in Europe). All the reforms came as an initial shocks, particularly the contraction of the money supply, but the stage was set for Germany to take flight. Literary overnight the country came to life. 

One might ask how is this economic model any different from the one applied in most of Europe today? A market economy with a welfare state - that's what Europe basically is. Some are more successful at it (Germany, Scandinavia, even the UK), while some are less (France, Italy, Spain) - relatively speaking. Who is to say the UK isn't based on the very same principles, even during the Thatcher era? A strong market-based economy, which has a notable social category. The difference here is not so much Germany vs rest of Europe, as it is Germany vs the United States. However the difference here is also in the margins. The US has something called cut-throat capitalism which fosters huge innovation and a keen trial and error process, while Germany (as well as the rest of Europe) has cuddly capitalism, which also innovates but to a lesser extent primarily due to a more lenient trial and error process. (These terms are used by Daron Acemoglu in a very interesting paper he co-authored with Robinson and Verdier, and which raised quite a discussion back when it's working paper version was published).  In Germany for example if you start a business and fail once, you don't dare repeating the same mistake again. In the US it is quite common to start over 4 or 5 times before finding the right recipe for success. After all Merkel recently expressed concern that there is no German Google or German Facebook. There is a reason why this is so, and why those kind of companies originate in the US, not in Europe. Which is not to say one system is better than the other. Both have their strengths, but both have weaknesses as well. The US exhibits higher levels of inequality because of this (even if we look at it historically), but due to its entrepreneurial spirit it has a much shorter time span for recovery and a much quicker response time than Europe. 

Overall, the German success is a unique story, but it's not a unique economic system. It is a market democracy with strong institutions. As easy as this sounds, for many countries there's still a long way to achieve it.