Wednesday, 29 February 2012

One alternate view of why recent IMF-induced adjustments have been that painful

Last month I had written a post about sectoral balances, with the aim to discern what lies behind the current account balance. I now want to come back to sectoral balances but approach the whole issue from a slightly different angle this time.

That is the angle of the current process of deleveraging (or the effort to deleverage). In some countries the sector doing (or trying) to deleverage is the general government, in others the private sector, in others both. This approach can help us explain the current situation that numerous “developed” or “emerging” economies find themselves in.

I will mostly focus on countries that have (or used to have until recently) an IMF program in place or have undertaken a similar process on their own accord.

First one up is my native Greece. Here is the sectoral balances chart again.

source: AMECO, own calculations
A look at the chart tells us that the general government is trying to deleverage but is not able to do so yet, as is the household sector. 

Before analyzing the current situation further I‘d like to take a look at the last time when the Greek general government tried to reduce its deficits, in the 90s. There was no recession involved back then. One thing is that the whole effort then was countercyclical but even as a result of it no recession ensued. One further point that can be made is that this was a program undertaken in order the country to become a member of the EMU and as a result people morale was high. That may well be true but we should not overlook one other fact. The very fact that the household sector was a net lender back then, hence was not stretched, while at the same time no other sector besides the general government tried to save more. As a result of the general government's effort to reduce the deficit, surpluses of households and corporations fell.

Let’s look at what happened in Latvia.

source: AMECO, own calculations

Latvia entered an agreement with the IMF in late 2008, so the internal devaluation process was essentially initiated in 2009. As we can see besides general government, all other sectors (corporations and households) embarked on an effort to save more since 2008 and became net lenders in 2009. The general government started an effort to slash the deficit in 2009 and as a result all other sectors saw their surpluses contract. This serves as evidence that it’s difficult for all sectors to increase their saving at the same time.

Next one is Estonia, that decided to undertake the internal devaluation approach on its own accord, without entering a financing agreement with the IMF (internal devaluation was chosen due to, among others, the fact that there was a large household debt load in foreign currency that would skyrocket if currency devaluation was pursued).

source: AMECO, own calculations

Admittedly, the general government deficit was meager, when compared with Greece and Latvia, but all the same the deleveraging attempted by households and corporations was rather sizeable. Households and corporations swung into surplus during 2009 and remained there in 2010, when general government did so too. Of course, as I mentioned before, the general government deficit was not structural, since the said balance was in positive territory for the span of the 00s and was also rather small. One could say that the effort for Estonia, was relatively easy, but this is not the case when all domestic sectors try to save more at once (and recorded such large deficits in the run-up to the crisis). The exact opposite is more like it. A look at real GDP growth for the years needed so that the private sector became a net lender will convince you.  

Our last stop is Ireland. 

source: AMECO, own calculations

Ireland initiated a program with the IMF in late 2010. Irish public finances were in order during the 00s but were totally derailed due to the bail-out of the monstrously-sized banking sector of the country. The households sector was a net borrower for the span of the 00s but started its efforts to deleverage and save more in 2006-2007 and swung into surplus in 2009. The corporate sector also embarked on an effort to save more. At the same time the general government deficit exploded downwards and was not possible to be contained. 

One takeaway from the charts is that in the wake of the crisis (2008) households and corporations, in all the countries featured in the chart above, started an effort to deleverage (or save more) and by 2009 they were net lenders. In all countries save for Greece, where only corporations managed that. Households only managed to reduce their deficit in 2009. The result was that in all other countries, recessions in these 2 years were significantly deeper than in Greece. When the Greek general government started an effort to deleverage in 2010 (mind you an effort, to actually deleverage means either a budget surplus or high enough GDP growth that ensures it grows faster than debt) Greek households found it much harder to save more and didn’t manage to record a surplus, the exact opposite rather. The result: Greek recession was deeper in 2010 while GDP in said countries either marginally declined or grew. 

source: Eurostat

As I mentioned when talking about Greece earlier, one period when general governments saved more and reduced fiscal deficits was in the run-up to the Euro introduction, in order to meet accession criteria. 

Let’s take a look at Italy.

source: AMECO, own calculations

I think we should start after the 1992 Lira devaluation. When Italian government started its quest for more saving, surpluses for households too fell sharply. The takeaway here is pretty much the same, the effort of the Italian government to save more was made easier by the fact that no other sector did so at the same time, while the households’ surplus fell sharply as a result.

The lesson from the Portuguese experience is pretty much the same. Just look at the chart below.

source: AMECO, own calculations

This is what makes the whole process so painful. In their effort to deleverage, households slash consumption expenditure and/or fixed investment while corporations cut down on fixed investment and/or employees’ compensation. Finally for general government that means cutting down all kinds of expenditures and/or increasing taxation. When all these sectors do so at the same time, it becomes more than apparent that the result is going to be a very deep recession.

It would be preferable then if one sector deleveraged at a time or if all sectors did so at the same time, that the pace of that deleveraging was slower. Currently conversation is revolving around this point. People demanding less austerity, actually ask for the private sector to deleverage on its own and not simultaneously with the general government, or that this deleveraging is slowed down. Other people claim that this is just not realistic. For better or for worse, since entering an IMF agreement means that funding comes (solely or mainly) from the official sector, this is a political process also, so we should not forget that. Either way, as long as deleveraging goes on (and depending on how it is conducted) the developed world could be in for some years of slower growth at the very least. After most parties people usually have to nurse their hangovers and this is very much the case now...

P.S. If you’re wondering why Greek households were that stretched in the run-up to the crisis, then look no further, the reason is twofold, over-consumption and over-investment.

source: AMECO, own calculations

That showcases the extent of over-investment and the next chart displays over-consumption in terms of purchasing power.

source: AMECO
You can see that in terms of purchasing power, private final consumption for Greece, in the early 00s overtook the Euro Area 12 average. This would have been perfectly feasible, bar for the fact that gross disposable income (in terms of purchasing power) was way lower than the Euro Area 12 average.

source: AMECO

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