No Sidestepping the Eurozone Implosion?

Originally published on Naked Capitalism

By Jan Kregel, former professor of economics at Università degli Studi di Bologna and Johns Hopkins,m and currently a senior scholar at The Levy Economics Institute and professor at Tallinn University of Technology and Rob Parenteau, CFA, sole proprietor of MacroStrategy Edge, editor of The Richebacher Letter, and a research associate of The Levy Economics Institute

A week ago eurocrats launched their campaign of overwhelming force designed to shock and awe the “wolf pack” of professional speculators and institutional investors (hedge funds and pension fund managers) into a more docile, subservient position. In the currency market, the shock and awe wore off after the first 48 hours, while by the end of the week, it also appeared to be wearing off from the equity markets.

Some of this is undoubtedly just the innate brazenness of the wolf pack being expressed. As a general rule, they do not take kindly to being cowed or constrained in any fashion. It is simply is not in their genetic make up. Consequently, they have no choice but to follow their instincts to call the bluff of the eurocrats, and that is part of the reason we are seeing, for example, the wolf pack dragging the euro exchange rate down to the ground in recent trading sessions.

But this is about more than just testosterone counts. Some wing of the professional investing world is beginning to see the design flaws built into the eurozone from day one. And once the spy these flaws, they begin to realize the nature of the solution is something utterly different than what they are witnessing being rolled out before their very eyes. In the following 11 points, we highlight some of the key aspects of the eurozone predicament using the financial balance approach developed by the late Wynne Godley which we have explored in previous blog submissions, papers, and book chapters. Until more investors and policy makers can understand the true nature of the various predicaments facing the eurozone, and the inherent design flaws exhibited in the European Monetary Union and the (In)Stability and (Lack of) Growth Pact, odds are precious time will simply be wasted trying to make believe the shock and awe fix is already in.

1. Underlying the eurozone predicament is a missing adjustment mechanism. There is neither a price nor a policy mechanism that encourages the current account surplus nations to recycle their surpluses in a win/win, pro-growth fashion. Keynes tried to design such a mechanism into the Bretton Woods agreement, but the American negotiators scotched it. This same pro-growth adjustment mechanism is missing at the global level with regard to China (although they did
report a trade deficit in March).

2. An ostensibly moral stance advocating balanced government budgets is revealing a profound ignorance of the simple accounting of sector financial balances. Those preferring to impose a “fiscally correct” policy on the peripheral nations should best recognize these accounting realities, and soon. If we are correct that domestic income deflation will be the end result of fiscal retrenchment colliding with private sector attempts to net save, then surely more desperate citizens will turn to even more desperate acts. Rather perversely, the combined effects of fiscal retrenchment, private income deflation, and rising private debt distress are likely to make moral considerations a second or third order concern for many eurozone citizens.

3. Ultimately, current account surpluses need to be recycled into chronic deficit nations in a sustainable fashion. Such a mechanism could be set up under the auspices of the European Investment Bank very quickly. Effective incentives to recycle current account surpluses via foreign direct investment or equity flows should be crafted at once.

4. Such an approach is likely to prove superior to funneling financial assistance through the IMF or other multinational arrangements. The IMF will undoubtedly insure that fiscal retrenchment gets imposed across the region. Any fiscal assistance is likely to be imposed with conditionality – a conditionality that fails to recognize sector financial balances are interlinked, both within and between nations. IMF conditionality is bound to set off the twin contagion vectors of falling trade surpluses and rising bank loan losses in the core nations. Surely this is not what Dutch and German policymakers intended, nor is it any way to hold the eurozone together.

5. Rapidly cutting fiscal deficits without considering the impact of such moves on private sector financial balances is a shortsighted, if not dangerous policy direction. Sector financial balances – the difference between saving and investment, or income and expenditures – are interconnected, and cannot be treated in isolation.

6. Hiking taxes and slashing government expenditures will suck cash flow out of the private sectors of the peripheral eurozone nations. These private sectors have been rebuilding their net saving positions in the wake of sharp and prolonged recessions. Companies have been conserving cash by slicing investment spending, inventories, and employment. Households have already drastically reduced home purchases and consumer spending.

7. It is an elementary fact of accounting that the private sector as a whole can only spend less than it earns if some other sector spends more than it earns. That sector has tended to be the government, usually as automatic stabilizers kicked in while recessions deepened. Indeed, most of the dramatic widening of government deficits is due to a collapse in tax revenues, not to discretionary stimulus. Pursuing fiscal retrenchment in order to reduce government debt default risk will merely raise the odds of private sector debt defaults. Cash flow will be taken from households and firms attempting to rebuild their net saving positions, and private debt servicing will falter.

8. The only way to avoid this outcome is if the nations undertaking fiscal retrenchment can swing their trade deficits around in a fully offsetting fashion. Otherwise, domestic income deflation is the likely result, Indeed, this is the madness behind the method of “internal devaluation” so evident in Latvia’s economic implosion. There is no guarantee that trade swings will be large enough to overcome fiscal drag. A return to debt deflation dynamics like those engaged after the Lehman debacle is not out of the question.

9. Furthermore, since the current account surplus of the eurozone has remained between +1 and -1 percent of GDP for quite some time, there is every reason to believe that attempts by the periphery to achieve trade surpluses will undermine the export led growth of Germany and the Netherlands.

10. It would therefore appear that fiscal retrenchment is about to set off two related contagion effects. First, the loans on the books of German, Dutch and French banks are likely to sour as private sector cash flows are squeezed in the periphery. Bank holdings of government debt issued by the periphery may not default, but the mortgages and corporate loans these banks have outstanding to the periphery will experience rising loan losses.

11. Second, the export sales of German and Dutch companies will fade with the falling import demand of the periphery. As their domestic incomes fall, they will import less. In other words, the fiscal retrenchment the core nations are insisting upon is highly likely to boomerang right back on them.

As it stands, investors have started to recognize that bank in the region are at risk. CDS for Spanish and Portuguese debt have started to widen more dramatically over the past two weeks, although investors still appear overly focused on government debt CDS. Policy makers have also begun to realize Greece is unlikely to be the last country requiring a bail out, while they at the same time sign on for rapid fiscal “consolidation” (read retrenchment) in order to ostensibly avoid
becoming the next Greece.

Yet we continue to find many of the points detailed above are not yet recognized by professional investors or policy decision makers. Absent this coherent framework, it will indeed prove very difficult to sidestep an economic and financial implosion in the eurozone, following on the heels of an already historically deep recession, and burst property bubbles in a number of eurozone nations. May wiser heads prevail.

A ticking time-bomb in the Estonian pension formula

By: Ringa Raudla

Based on recent discussions in the media and the political arena, one may get the impression that increasing the retirement age from 63 to 65 was the only shortcoming that needed fixing in the Estonian pension system. In fact, after a closer look, there are other – and perhaps even more urgent – problems that call for solutions, both in the first pillar, which is state-run and PAYG, and in the second pillar, which is pre-funded and run by private pension funds. In this entry, I would like to discuss the problems that may emerge from the existing formula for calculating old-age pension benefits in the first pillar.

According to the State Pension Insurance Act enacted in 2002, the old-age pension from the first pillar is calculated on the basis of three different components: a base component, a working-time component and a contribution-related component. While the base component is paid in equal amounts to all pensioners, the working time component takes into account the number of years worked before 1999 and the contribution-related component is based on the salaries earned after 1999. More detailed technical description of the formula is available at the end of this entry.

In addition to the fact that the formula is rather complex (and putting together the different pieces requires looking into several acts and regulations), there is a ticking time bomb hidden in this formula. Namely, the contribution-related component, if left unchanged, will lead to huge disparities between pension pay-outs in the future. In order to grasp the implications of the contribution-related component, let us have a look at extreme examples. First, how large would be the sum of annual factors for a person who works for 40 years and earns the minimum wage? Making some simplifying assumptions, the formula would grant him an annual factor of 0.3 per year, which adds up to the sum of 12 over 40 years of working. If we were to calculate the value of the contribution-related component in today’s terms, it would be 12 x 68 = 816 EEK. In year 2009, the largest earned annual factor was 100. If this person were to receive the factor of 100 for all 40 years of his working life, it would add up to the sum of 4000, which in today’s terms would mean the benefit of 4000 x 68 = 272 000 EEK. These examples are based on very simplifying assumptions but they clearly demonstrate the inequalities that the current pension formula can lead to, if left unchanged. Of course, there aren’t that many people who earn factors over 10 (see Table 1), but even when we compare those who earn an annual factor of 3 per year over 40 years with those who earn an annual factor of 0.3 per year over 40 years, the resulting differences in the sum of annual factors are stark and would lead to 10-fold differences in the contribution-related component of pension benefits.

Because of the aging of the population (and the ensuing drop in the number of working persons per retiree), the resources available for the Estonian state pension system in 20-30 years are likely to shrink; hence, it is very unlikely that such inequalities in pension benefits would be politically acceptable. Rather, one can imagine, there would be calls for converting the first pillar benefits into flat-rate minimum pension payments for all pensioners. At the same time, the more time passes before this formula is changed, the more difficult it becomes to change the formula without running into constitutional disputes. If people assume that this formula remains in place, they can build up lawful expectations and act accordingly in their decisions concerning retirement savings. For example, if the parliament attempted to the change the formula (and cap the contribution-related component) in 15-20 years, for example, the state could face legal disputes from persons who claim that they decided not to join the second pillar because of the existing pension formula in the first pillar. The more time passes before the formula is changed, the more clout are these arguments, based on lawful expectations, likely to have and the Constitutional Review Chamber of the Estonian Supreme Court would face a very tough dilemma.

One of the motives behind the contribution-related component was to encourage the payment of social tax and constrain incentives for tax evasion. It was conjectured that since individuals perceive a clearer link between their contributions and the future benefits they would be less inclined to collude with the employer by agreeing to receive part of the salary in “an envelope”. However, it is not clear to whether the pension formula of the first pillar should be used for this purpose. On the one hand, the link between the social tax paid and its exact impact on the expected retirement benefits is not easy to calculate and may remain rather uncertain even for those who can compute their annual factors. On the other hand, since the second pillar of the Estonian pension system is defined-contribution, with fund accounts that people can keep track of, the diversion of the part of the paid social tax (4 percentage points out of 20 percent) to the individual accounts already serves the purpose of encouraging the official declaration of salaries paid.

In addition to creating incentives for more extensive tax compliance, the new pension system was intended to stimulate labour supply by creating a better linkage between the contributions paid and pension benefits received as well as providing additional incentives for later retirement. Again, it could be argued that the second pillar is already serving this purpose and using the contribution-related component of the first pillar for that purpose is duplicative. Furthermore, if the sum of the accumulated annual factors during the postponed retirement is low, relative to the minimum pension, they do not yield higher pension than is the level of minimum pension, and the motivation to work for additional years may be undermined. Thus, it is important to recognise that the effects on the labour market also depend on the relative sizes of the minimum pension (or people’s pension), the base part, and the value of one service year. Furthermore, there are specific financial incentives for postponing retirement and disincentives for early retirement built into the State Pension Insurance Act, whereby postponed retirement results in higher and early retirement in lower benefits; these incentives are likely to have a stronger and more direct effect on the retirement decisions.

Alongside the goal of poverty prevention, the designers of pension systems (especially those following the Bismarckian tradition) have pursued the goal of income replacement, which should guarantee that nobody has to face a large drop in the quality of life one is accustomed to. In that light, linking the size of first pillar benefits to life-time contributions seems to serve a legitimate goal. In the case of Estonia, however, one has to keep in mind that the function of income replacement – at least in principle – is already served by the second pillar, where the payouts are directly linked to life-time contributions. Also, those who wish to secure even larger replacement rates for themselves can make use of the third pillar, which is very lucrative in terms of tax deductions (allowing individuals to deduct contributions to the third pillar) and offers very favourable tax treatment of the eventual pay-outs (annuities bought for the third pillar pension savings are not subject to income tax). Altogether, one can say that making the benefits from all three pillars of the Estonian pension system dependent on life-time contributions is overly duplicative with regard to securing income replacement. Furthermore, the disparities created by the different pillars reinforce each other and could give rise to extreme inequalities among future retirees.

Hence, there is a need to change the pension formula of the first pillar as fast as possible. The most obvious way to do it is to add a provision to the State Pension Insurance Act, stating that the maximum annual factor that can be earned in a year is, let’s say 1 or 2. Although an amendment made to the State Pension Insurance Act in 2008 tries to increase the weight of the base component by using a coefficient of 1.1 when the indexation formula is applied to the base amount – and a coefficient of 0.9 when indexing the value of the service year – this change is insufficient to address the disparities. The longer the amendment of the formula is postponed, the louder the ticking of the bomb will become, which could threaten the fiscal and political sustainability of the Estonian pension system.

Technical description of the pension formula

The formula for calculating the pensions in the first pillar of the Estonian pension system can be expressed as following:

B = the base amount

H = the value of a service year

s = number of years worked before 1 January 1999.

Σ α = sum of annual coefficients accumulated after 1 January 1999.

The base amount is paid to all retirees who are eligible for state pension; it was determined in the State Pension Insurance Act in 2002 and has been indexed annually. Until 2008, the indexation was based on equally weighted increase of the consumer price index and increase of the social tax contributions; since 2008, however, the indexation formula attributes the weight of 20% to the increase in consumer price index and 80% to the increase in social tax revenues. In addition to the annual indexing, there have been additional increases, subject to the discretion of the parliament). As of 2010, the base amount is 1793 EEK. The working-time component is calculated as the number of accumulated years of pensionable service attained before 1999 multiplied by the value of one service year. The value of one service year was also determined in the State Pension Insurance Act and is indexed. In 2020, the value of one service year is 68 EEK. The contribution-related component depends on the contributions paid into the first pillar on behalf of the employee after 1 January 1999, and is found by multiplying the sum of a person’s annual factors (or “implicit years”) by the value of one service year. One annual factor or “implicit year” is a person’s pension-earmarked social tax as a fraction of the average pension-earmarked social tax paid by all contributors in the given calendar year. The average part is calculated by adding up the pension earmarked part of the social tax paid by all contributors and dividing it by the sum of accumulated service years earned in that year by all the contributors (if a person has paid social tax on less than minimum wage per month, the “earned” service year is respectively less than 1).

Should Greece follow Estonia’s example?

by Rainer Kattel

(What follows is a write-up of my presentation at the last week’s Hyman Minsky conference at the Ford Foundation in New York. If you want to have a look at the US debate on financial regulation, see Paul Krugman’s talk from the same event.)

As the representatives from the European Union, the IMF and Greek government are trying to flesh out the deal how Greece can use EU’s and IMF’s funding to remedy its fiscal position, the main question hovering above these negotiations is whether Greece can and should follow Estonia’s example in massively cutting public spending. Estonia’s public spending was in 2009 a drastic 12% less than in 2008 and this kept public deficit below 2% of GDP in 2009. Both the European Commission and the IMF have hurried to praise Estonia’s efforts; in credit markets Estonia’s credit default swaps (bets on how likely it is that Estonia defaults on its public debt) valuation has been halved since the beginning of the year (that is, the likelihood of default has halved). While it is odd that Estonia’s debt (one of the lowest in Europe, just over 6% of GDP at the end of 2009; in fact, Estonia has government reserves amounting to almost 9% of GDP) is being valued at all as it is not publicly traded to begin with, it is a sign of a general tendency to see in Estonia an example par excellence of handling the crisis. Indeed, the entire issue of public debt seems to have taken the center stage in the ensuing financial crisis on the both sides of the Atlantic, see for instance IMF’s warning.

It is true that Estonia’s numbers (public debt and expenditure, budget cuts) are sheer magic in the European context. As is the fact that these numbers have been accompanied by no street riots; moreover, the government is now probably even more popular than before the crisis. There’s justifiable cause for envy and this begs the question: should Greece, with 13% of public deficit and 113% of public debt (both as percentage of GDP), follow Estonia, bite the bullet and get down to slashing budget and wages? Similarly to Greece, Estonia has no exchange rate policy option as the kroon is pegged to the euro. (Of course, pegs can always be un-pegged but there seems to be no political will in Estonia or in Europe to do this and by now it is also probably too late as devaluation would now make all the efforts of 2009 futile.) In other words, the question actually is whether the so-called internal devaluation works and if so then precisely how.

The euphoria around Estonia should die rather quickly when one looks at the GDP performance in 2009. It fell nearly 15%; Greece’s GDP contracted just 2%. The figure below shows real GDP growth rates in Estonia, the Baltics taken together (for comparison) and Central Europe (Czech Republic, Hungary, Slovak Republic and Slovenia; simple averages; all data from Eurostat).

The GDP data show one intriguing figure that really begs the question: how come Poland is still growing? Well, not only is Poland growing, its exports haven’t really slowed down at all during the crisis, as is evident from the next figure below.

A look at the real effective exchange rates clarifies the story with a rather amazing picture: Poland’s floating currency seems to have done what it’s supposed to do in the crisis like that – devalue. This has considerably softened the crisis and contrary to the Baltic and other Central European economies, Poland has very quickly regained its export competitiveness. It is clear that at least partially this was deliberate policy as is explained by the Polish Central Bank president in a Financial Times piece published posthumously last week. It remains to be seen whether Poland remains on this course of sanity.

That devaluation works in situations like we are currently experiencing shouldn’t really come as that much of a surprise. There’s an interesting parallel from the Great Depression and its aftermath, depicted in the figure below (the figure comes from Barry Eichengreen and Jeffrey Sachs, “Exchange Rates and Economic Recovery in the 1930s ”, The Journal of Economic History, Vol. 45, No. 4 (Dec., 1985), pp. 925-946, p. 936).

So, what is the price paid by Estonia and the other Baltic states? Again, one would expect that with the heavily overvalued currencies, the main suffering would take place in the labor market and this is indeed what is happening in the Baltics. While the Baltic media is fanfaring that the unemployment figures didn’t not raise last week for the first week since the crisis started, it seems clear that under conditions of weak domestic demand (engendered through anemic borrowing and uncertainty amid wage cuts) and lagging productivity growth (especially if compared to Germany and Scandinavia – Baltic and Central European export industries are largely part of German or Scandinavian production networks) there’s no quick end to the crisis in sight.

While the respective national statistical offices report some price deflation and falling real wages in the Baltic economies, the former are merely cosmetic and the latter in fact contribute to collapsing domestic demand. It has led to positive external balance over the last quarters, but this is not due to exports, but rather because of the breakdown of the capacity to import. Without actual devaluation, in other words, such internal devaluation is bound to last for years in the Baltics and to a lesser extent in the Central European economies generally (other than in Poland, of course). Growth is bound to stay anemic and, because of lagging productivity, exports simply cannot pick up fast and strongly enough to offset the weak domestic demand. Polish companies at the same time could take advantage of their relatively higher export competiveness.

However, without European fiscal transfers, most Baltic and Central European economies would have similar levels in public deficits as Greece, and, accordingly, raising level of debts. See figure below. (Fiscal transfers from the European Union are annual transfers through the so-called structural funds. Here, the EU fiscal transfers include funds from three main sources: Cohesion, Rural Development and Fisheries Fund; calculations by the author.) Continued high unemployment will lead, especially in the Baltics, to increasing public debt – or to even more unemployment until the situation becomes untenable for some who then emigrate.

Thus, one can draw the following conclusions: first, in essence, Estonia and the Baltic economies are simply mirror images to Greece and other PIIGS. In the former, the private sector carries the cost of the crisis, in the latter mostly the public sector (social safety nets); because of the in-built inflexibilities, both are cases of free riding: the former export public deficits, the latter unemployment to the rest of Europe. Second, Central European economies, except Poland, seem to follow Germany (weak domestic demand, high levels of exports) through high level of integration into latter’s production networks and tailwind Germany’s export machine. This assumes recovery in Europe and the world. The danger is that these economies should match Germany’s productivity growth or else their effective exchange rates start to appreciate again. This is precisely the trap the PIIGS fell into. And third, Poland, with floating currency and relatively large domestic market, seems to be faring the best so far among Eastern European economies. Such divergence within Central and Eastern Europe will probably become only more pronounced in the coming years.

It is important to understand that these woes have a common cause: unifying rather unequal countries into an economic union. That this is bound create problems for PIIGS was brilliantly predicted by Jan Kregel already in 1999. Simply put, the eurozone assumed and still tacitly assumes either growing German wages or growing productivity in the rest of Europe. Neither has been the case.

The Baltic economies with pegs, and with insisting on keeping the pegs, have simply tied the noose around their own necks, and trading monetary stability for, first, high financial fragility, and second, now for very probably long-term high unemployment and debt deflation in the private sector. This will probably result in waves of emigration, growing social problems and the like. In other words, the costs have been shifted to the future and they are more than likely to equal Greece troubles in fiscal terms. Estonia is Greece in disguise. It remains to be hoped that the EU and the IMF recognize that and refrain from simplistic fiscal retrenchment that make problems only worse as Greek domestic demand and, accordingly, government fiscal position will only weaken further. This results, as we have seen in Estonia, in real economic depression, that is GDP contraction in double digits.

Addicted to neoliberalism

by Rainer Kattel

Almost two years ago just before the global financial meltdown, some of us predicted the end of neoliberalism, globally and specifically in Estonia (see here and also here). History has proven us wrong. If anything, the lean state ideas are more powerful than ever, at least in Estonia and in the Baltics generally. Many would say that the neoliberal and new public management (NPM) ideas of non-intervening and lean state have never really left the Baltic policy scene. Yet, one would expect that with these economies being hit probably the hardest by the financial and economic crisis that this would lead to some sort of backlash against the established neoliberal ideology. It certainly has not, on the contrary: with the budget cuts in 2009 the lean government ideas seem to have gained even more in currency. Thus, for example, in Lithuania, the new government that took office after parliamentary elections in November 2008 campaigned on the basis of a NPM platform. Similarly the Latvian government adopted in 2009 a public administration reform agenda called the ‘Optimization Plan’ with the main objective to minimize the state. In Estonia, the crisis has re-enforced NPM reform ideas to reduce the civil service, to outsource accounting and similar functions, to widen performance management, and so forth. (The examples are from a forthcoming work by Peters, Pierre and Randma-Liiv, no link available yet.) Also in economic policy sphere all Baltic States have not substantially changed their basic neoliberal policy outlook as main policy focus is turned to cutting back public spending. Ironically, without the European structural funding which embodies precisely the opposite ideas to neoliberal program, the Baltic States would be all but stripped of all funding in labor market, R&D and other key policy areas to counteract the crisis.

This goes certainly against global trend where at least during 2009 there was a lot of talk and policy action about the return of the state in the aftermath of the global financial crisis. One stimulus package or bank nationalization chased the other. There’s also more specific evidence that the state is indeed back, at least in some quarters of the world. Thus, for instance, Ilene Grebel argues that the crisis seems to have opened more economic policy space for developing countries in relation to the IMF. Brazil’s recent bold actions in instating capital controls and using punitive tariffs against US (with WTO authorization) bear witness to very different kind of understanding about the role of the state in economic growth as well.

So, why is the neoliberal slim state back in full force in the Baltics? I would argue there are three key reasons.

First, in particular the Estonian government has been very successful in keeping up the fiscal mythology about the need for balanced budgets. This view is also entrenched in the EU’s Maastricht criteria but has now become much more powerful with the fiscal woes faced by Greece and other EU countries. Ironically, the Baltic States can now serve as examples of prudential fiscal policy within the EU and such powerful wind makes for strong sailing and justifies many a past action.

Second, for the last 20 years Baltic policy makers (as their counterparts in the rest of Central and Eastern Europe) have focused only macro-economic competencies (how to keep inflation low and to discipline public spending and so forth) as these were and still are seen as key ingredients in creating attractive environment for attracting foreign investments. This is how they were socialized almost for a quarter of a century by now. In other words, neoliberalism is all what most policy makers know in the Baltics.

Third, lack of domestic intellectual alternatives: unlike Brazil or India (let alone developed economies) where heterodox economic traditions go back at least half a century, the Baltic economies and policy makers seem to have all but forgotten their own successful industrial policy experiments during the inter-war period. Thus, to many, a state that reacts to economy by intervening with its functioning still equals Soviet style planning.

In sum, the Baltic States seem to seek cure for their current ills in the same medications that caused the crisis in the first place. Baltic policy makers have become addicted to neoliberalism. Yet, fiscal prudence in a deep crisis like the one we are experiencing simply shifts costs either to private sector in form of investments – which are not forthcoming as the private sector deals with debt deflation –, or to future taxpayers in form of social costs (unemployment). Thus, the addiction is paid for by the current European taxpayers (substituting Baltic domestic public and private spending through EU’s structural funding) and the future Baltic taxpayers as key industrial, labor market and other policy reforms are postponed while unemployment grows and wages fall.