Sunday, 4 December 2011

Gross fixed capital formation: The Greek paradox and its implications for the Greek tradable sector

I want to share with you a couple of charts concerning gross fixed capital formation in Greece. The first one’s about construction.

source: AMECO, own calculations

And the next one’s about equipment.

source: AMECO, own calculations

The charts highlight some facts. The first one is that in Greece, construction accounts for an abnormally high chunk of gross fixed capital formation (especially in the 1960-1990 timespan) while equipment for an abnormally low one. 

It is crystal clear that this consitutes a monstrous distortion in resources allocation, with rather large negative effects on labour productivity, hence on Greek potential and actual GDP growth.

A good question is why did that happen? This wasn’t the case in none of the other Euro Area countries shown in the graphs.

First I want to try to decipher why gross fixed capital formation in construction is that high. I can think of a couple of reasons that could go some way into explaining this.

The time when investment in the said sector was at its highest was during the 1960s – 1980s period.

One factor that must have contributed its fair share in the construction boom is the rampant urbanization happening in Greece during that particular period. I plotted urban population as a % of total.

source: World Bank

Urban population in Greece exploded upwards back then, but the same phenomenon in an even more extreme form occurred in Finland. Of course, gross fixed capital formation for the construction sector was significantly higher in Greece. That can only mean that the on-going urbanization isn’t the whole story here. (I used urban population since its increase implies an instant need for housing, while overall population growth affects housing demand dynamics with a lag).

Another positive catalyst could have been that the housing stock of Greece should have been extremely dated and run-down back then. Of course I can’t back that claim quantitatively. 

One more factor that we cannot overlook is inflation. The 1970s was the decade that the two oil-crises took place. Furthermore, inflation in Greece was more than persistent back then, invigorated by expansionary fiscal policies during the 1980s. The notion that housing is a good hedge against inflation was rather popular in Greece these years. Views by practitioners and academics on that are mixed and not uniform but what really matters is what people believed since that would shape their behaviour, whether that belief was right or wrong is trivial.

source: AMECO
To continue the argument above, let’s not forget that given the underdeveloped and deficient Greek financial sector, investment choices for Greeks retail investors were virtually non-existent and for a significant part of them their investment of choice could very well have been real estate/housing. That could have propped up demand a bit more, but I suspect that this effect was more pronounced after the 1980s.

Now, I want to us to take a look at the reasons why fixed investment in equipment, for the whole period shown in the chart, was that low.

As a bit of background I want to say that capital accumulation or capital deepening is a significant positive driver of labour productivity growth. Even though it is in no case the sole positive catalyst for labour productivity and is characterized by diminishing returns, that does not render it trivial. Rather the exact opposite.

I want to point out a couple of things. Even initially, investment in equipment, for Greece, was significantly lower than the other countries in the chart. That is perfectly understandable if someone takes into account that Finland and Austria are two countries that had gone through the first industrialization stage rather early but what about Portugal? One could even say that given the fact that Austria and Finland had gone through early industrialization, then investment in equipment for Greece should have been higher. The next argument reinforces that view (in a way). I also want to remark that (as a % of GDP), for Austria and Finland, investment in equipment was in a downward trend for the whole timespan featured in the graph. For Greece it rose anemically till the early 1970s and then it was constant until the late 1990s when it rose again. As far as Portugal is concerned the upward trend kept for ten more years and then it plummeted too. What does that imply for the situation in Greece and its root causes?

The next chart can explain quite a lot.

source: World Bank

Industrial firms in Greece had very limited access to bank funding which can only mean that they had to finance corporate investments internally (through retained earnings). But why did lending to the private sector decline from the early 80s till the mid-90s? Well, one reason could have been that the Greek banking system was used to finance the huge fiscal deficits that Greece was running at the time, effectively crowding out the private sector, with all these knock–on effects that created the massive distortions highlighted above. Of course it takes two to tango. I have talked about that particular subject before (here, here and here).
Here’s a chart showing the extent of that crowding-out effect.

source: World Bank

After the mid-90s, due to the fiscal-adjustment program (I have talked about that too in an older post) and the up-coming EMU accession, the government’s need for financing was reduced while its ability to finance it externally increased. This gave the banking sector (and along with it the industrial sector) some breathing space and it was able to increase lending to the private sector. After the country became part of the Euro-Area, the sector was able to tap the interbank markets with unprecedented ease and increased lending accordingly. Now if you ask me if there were that many good investment opportunities for the (let’s not forget that, shrinking) industrial sector, I would tell you that I don’t know…

P.S.1. I now want to share with you the scatter plots from a few simple regressions showing the positive relationship between capital deepening and real labour productivity in the industrial sector. The relevant literature goes about the issue using fixed investment in equipment as a % of GDP. I think that this is wrong. In my humble opinion the aggregate that reflects capital deepening (as far as equipment is concerned) is real gross fixed capital formation. What gross fixed capital formation in equipment (as a % of GDP) reflects is the relative importance of that particular type of investment. Besides, let’s not forget that this particular aggregate belongs to the “flows” category, which means that any positive reading will add to the gross capital stock.   

source: AMECO, own calculations

source: AMECO, own calculations
source: AMECO, own calculations
source: AMECO, own claculations
I’ll let you draw your own conclusions about the link between missed opportunities for the Greek tradable sector and the regressions above…

P.S.2. All the above is a result of my own analysis based solely on figures but I could very well be wrong. In any case I don’t mean to imply anything political.

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