The Euro, the surrender of monetary sovereignty and the two lost decades (Part 1 of 3)

On the 2nd of May 2010 the "troika" agreed to a 110 billion bailout package for Greece, in what the European leaders hoped would draw a line in the sand in the sovereign debt crisis that would soon became known as the Eurozone crisis.  But contrary to their hopes, this was just the beginning of a wave that would also engulf Ireland and Portugal, threaten Spain and Italy; and with it the very existence of the Euro. The main causes of the market turmoil, according to the great majority of experts, were the "unsustainable" debt burdens and deficits. Yet, when one compares the debt burdens for the affected countries at the beginning of the Eurozone crisis to those this countries had back in 1995/96, one can easily see that 2008’s debt burdens were not significantly out of line with those in 1995/1996, and in some cases this were even lower, such is the case of Italy, but back then there was no talk of default; nor did these countries have any problems financing themselves.

Italy's debt burden, measured by debt-to-GDP, rose from 90% to reach a peak of 121% in 1995, following the recession of the early 90's, but it went down steadily since and at the beginning of the Great Recession, in 2008, it stood at 106% "only". With the onset of the recession the trend was inverted and the debt burden started to rise again, but in 2011, at 120%, this was still below the 1996 value.  On the other hand, the deficits, measured as deficit-to-GDP, have remained below the 5% mark which is a stark contrast with the 10% or more during the early 90's recession. 

In addition, while Italy's ten-year bond yields rose to their highest euro-area level after 2011, they remain well below the yields of 10% or more paid in the early 90's recession.  In 1995, with a debt burden of 121%, a deficit of 7% and paying yields of 12%, Italy had no problems financing itself, but in 2011 with a debt of 121%, a deficit of 3% and yields of 5%, Italy's debts costs were now considered unsustainable and markets started to see it as default risk, which led governments to impose austerity measures.

It’s reasonable to conclude that for these countries something fundamental has changed in relation to their recent past; somehow they are now subject to market forces they had never experienced before. Forces that can ultimately push theme to default, as in the case of Greece, or to adopt austerity measures in the middle of a recession with high levels of unemployment. All of a sudden the bond vigilantes became more important than the voters.

So the question is what changed?  Why are these countries subject to market discipline like they have never experienced before? Why are they having difficulties financing their debts when this was not a problem before?  Why are their debts and deficits now considered unsustainable while in the 90's, similar or worst levels, where not considered a serious problem? Why are these countries adopting austerity measures in the middle of a recession?  In addition, one has to wonder if the Maastricht limits on debt and deficits are so important, why were Italy and Greece ever allowed to join the Euro with debts well over the 60%?  Put simply, what changed was the Euro and the Maastricht limits never really mattered. To understand why, however, we must understand what changed with the introduction of the Euro.

Although the term Eurosceptic has been used to cobble together a diverse group of people and points of views, mostly non-economics related, there are at least two discernable groups of economists that were sceptical about the Euro experience on economic grounds. The mainstream view, that thought of the euro in terms of the theory of the “optimum currency area” , theory which was itself the basis of the monetary union, concluded within the framework that the costs could outweighed the benefits and as such were against the euro from the beginning; On  the other hand, despite arriving at the same conclusion, a fringe group of economists , the neo-Chartalists, takes a competitive approach to money as a starting point. While the implicit theory behind the Optimum Currency Area is the Metallits approach to Money that defends that Money was invented to facilitate trade, to the neo-Chartalists money is a creature of the state, and this mean not only that the state determines what is money but also that it drives its acceptance by demanding that taxes are paid in the currency of its choice. (For a presentation of the competitive approach and a critic to the optimum currency areas theory see Charles Goodhart ).

Even though, many others neo-chartalists and MMT's have long warned to the consequences of the faulty construction of the Euro, I want here to highlight in particular an article by the late Wynne Godley published in 1992 under the tittle Maastricht and All That, and a paper by Randall Wray with the title of Is Euroland the Next Argentina from 2001, both scholars of the Levy Institute, where several scholars issued warnings well in advance of the Euro area sovereign debt crisis. While Wynne’s article explains not only the flawed views that governed the constitution of the monetary union but also the consequences of not having a Central (Federal) government, the paper by Randall Wray, taking as a starting point the Argentina experiment with the dollarization and establishing some parallels with the Euro experiment, makes not only some insightful predictions to what would later became the Eurozone crisis but also possible solutions if the crisis came to materialize.

Monetary sovereign nations vs non sovereign states

Some aspects of the theory might be controversial and at times seem counterintuitive but the main idea can be resumed in Charles Goodhart corollary: "One government, one money" or one currency, one nation" to which we all can relate easily, once this is the model for most countries, or at least it was until the  introduction of the Euro, with the exception of some small states like Monaco, San Marino and the like. What derives naturally from the on-to-one correspondence between countries and currencies is the definition of monetary sovereignty, which can be understood as the" exclusive" and "unlimited" power of the government to issue its own money.

A Monetarily Sovereign government has the exclusively unlimited power to create its sovereign currency. This exclusive power, nowadays delegated in the central bank, means that it has a monopoly of currency issuance, as such no other government or entity can issue the sovereign currency. The unlimited part refers to the fact that it can create as much of it as it desires. This does not mean that it should, as it might have undesired effects, most important of all inflation, but only that there are no financial limits to its issuing power. There might be some legal restrictions, as the debt ceiling in the US or the budgetary process is most of the countries, but this are self-imposed rather than built-in restrictions. Government creates money by paying its bills and retires it by taxing.  Therefore, a monetary sovereign state does not have to tax or borrow money prior to spending it.

On the other hand, non-monetary sovereign states don't possess this exclusive and unlimited power to create the currency they use and so they have the status of a local authorities. These are users of the currency rather than issuers and as such they must borrow or tax before they can spend it. Us states and Swiss Cantons are a good example of non-monetary sovereign states.

The degree of monetary sovereignty depends as well on the exchange-rate regime.  When a country pegs it currency to a foreign currency or to a commodity like gold, it limits its power to create money as it must manage its holding of reserves of the foreign currency or commodity, if the promise is to be credible, otherwise, it might have to break its promise to convert at a fixed rate, as eventually always happens. As a result, a second important element of the monetary sovereignty is a flexible exchange-rate.  A flexible exchange rate is not only important to guarantee currency independency but also a condition to have fiscal independence.

Money financed deficit

"While we commonly think of a government needing to first receive tax revenue, and then spending that revenue, this sequence is quite obviously not necessary for any sovereign government." (Randall Wray)

Monetary sovereign countries can spend before they tax, this is actually necessary if one takes the view the state has a monopoly of money creation, as it must spend (lend) the money into creation before it can tax (borrow) it, which contradicts the current dogma that the government always needs to tax or borrow first before it can spent. A sovereign government it's not revenue constrained. This is easy to see if one thinks that the Government (Treasury) has a printing press and prints money as it needs to buy goods or services. However, if this was the case in the past, the introduction of the (1) Central Bank and (2) governments debt securities has blurred the picture. Picture that was already distorted by the fact that paper money and coins represent a small amount of the monetary base, which in addition to coins and paper money (both as bank vault cash and as currency circulating in the public), includes commercial banks' reserves with the central bank. This highly liquid government created money is also called high powered money (HPM). Thus, a more accurate version of the "printing money" is one that incorporates not only new issuance of paper currency but mainly the crediting of reserve accounts at the central bank as explained by Randall Wray:

"The sovereign government spends (buys goods, services, or assets, or makes transfer payments) by issuing a Treasury check, or, increasingly, by simply crediting a private bank deposit. In either case, however, credit balances (HPM) are created when the Fed credits the reserve account of the receiving bank. Exactly analogously, when the government receives tax payments, it reduces the reserve balance of a member bank (and, hence the quantity of HPM). Simultaneously, the taxpayer’s bank deposit is debited, and her bank’s reserves at the Fed are reduced. While we commonly think of a government needing to first receive tax revenue, and then spending that revenue, this sequence is quite obviously not necessary for any sovereign government. If a government spends by crediting a bank account (issuing its own IOU--HPM) and taxes by debiting a bank account (and eliminating its IOU-- HPM), then it is not as a matter of logic “spending” tax revenue. In other words, with a floating exchange rate and a domestic currency, the sovereign government’s ability to make payments is not revenue-constrained."

This institutional arrangement, with the central bank acting as both the banker's bank and the government's bank, opens a range of options for coordination between the Treasury and the Central Bank that would not be available if the Treasury had a bank account at any private bank. It not only allows that one part of the government (Central Bank) to "finance" other part of the government (Treasury) but also that both can coordinate when setting interest rates.  In other words, the central bank can help the government with the implementation of its fiscal policy and government can assist with monetary policy:

"The Federal Reserve influences the economy through the market for balances that depository institutions maintain in their accounts at Federal Reserve banks. Banks keep reserves at Federal Reserve banks to meet reserve requirements and to clear financial transactions." ( New York Fed)

The operations between treasury and Central Bank can take the form of overdrafts and cash advancements on the Treasury account at the Central Bank -"printing money"- and the purchase of government debt securities in the primary market or secondary market. Whether the government "prints money" or the government issues securities that are latter purchased by the central bank has the same end result as demonstrated by Stephanie Kelton:

"There is virtually no macroeconomically significant difference between the Fed providing the Treasury with an overdraft versus the Fed owning the short-term debt of the Treasury—the Fed will return any interest it receives on the T-bill or the overdraft to the Treasury along with the rest of its profits."

While in the past two decades  many countries have been passing legislation with a view to restricting this operations between the Treasury and the Central Bank, as a recent paper by the IMF on central bank regulation around the world highlights, MMT argues that this are self- imposed constrains and can be easily surpassed by the Treasury and central bank when needed, as quantitative easing has shown. However, this regulation has had the effect of reinforcing the belief that Treasury must tax or borrow before it spends as in effect, due to this self-imposed restrictions, the Treasury must maintain a positive balance in its account at the central bank, which it can do only by receiving tax balances or by issuing debt securities in the open market. Even if due to current legislative restrictions the Treasury is forced to keep a positive balance on its account at the central bank that should not distract from the fact that it all starts with the government spending first, as Frank N. Newman, former Deputy Secretary of the U.S. Treasury (1994-1995), explained ( by Stephanie Kelton):

"I recall from my time at the Treasury Department that the assumption was always that there was money in the fed account to start with. Nobody seemed to know where it came from originally or when; perhaps it was established in biblical times. But as a matter of practice, if the treasury wanted to disburse $20bn a given day, it started with at least that much in its fed account. Then later would issue new treasuries and rebuild its account at the fed.  (I do not recall ever using an overdraft.)

In my view, this is still consistent with the MMT perspective that you mentioned, and in my own book the explanation starts the cycle with government spending, thus adding to the money supply, and then issuing treasuries for roughly equivalent amount, thus restoring the money supply and the Treasury’s Fed account to the levels they were prior to that round of spending. Every cycle is: spend first, then issue treasuries to replenish the fed account. The fact that Treasury started the period with some legacy funds in its Fed account is not really relevant to understanding the current flow of funds in any year."

In practise, however, this is a bit more complicated but the essence is maintained:

"In practice, Treasury varies its issuance not only to match outlays, but also to deal with seasonal factors, and to avoid wide swings in new-issue sizes; so at one point of a year, treasury might actually issue some extra securities because the next month was expected to have low tax revenues, or might not fully replenish recent spending because the next month was expected to have high tax revenues. That seasonal process doesn't really affect the overall flow of funds over a year.  The substance of the cycle is still: spend then replenish. Debating that would seem highly philosophical, and would miss the practical aspects of the flows."

If the government spending always comes first why does the government need to issue government debt securities? This brings us to one of the central point of the MMT which is the fact that government debt securities don't serve the purpose of "financing" a sovereign government but are instead an instrument to implement monetary policy:

"Transactions in the federal funds market allow depository institutions with reserve balances in excess of reserve requirements to sell reserves to institutions with reserve deficiencies at an interest rate known as the fed funds rate. The FOMC sets the target for the fed funds rate at a level it believes will foster financial and monetary conditions consistent with achieving its monetary policy objectives and adjusts that target in line with evolving economic developments." ( New York Fed)

While Treasury spending leads to monetary creation (bank reserve balances at the central bank), taxation has the opposite effect as it involves monetary destruction. Therefore, if the treasury spends more then what it takes in taxes (i.e. runs a deficit), it creates net excess reserves in the interbank market -in excess of what banks want or are required to hold- as such putting downward pressure in the interbank rate (rate at which  banks lend reserves to each other), all the way to zero. Unless that's the target rate of the Central Bank, which in normal times rarely is, it must drain the excess reserves to achieve the desired rate. Treasury surpluses have just the opposite effect, they drain reserves and in this situation the Central Bank must supply reserves otherwise rates will rise above the target rate. The Central Bank supplies and drains reserves through its open market operations:

"The Fed uses three tools to implement monetary policy, the most important being open market operations. These “domestic operations” are conducted for the System only by the New York Fed under direction of the FOMC. Through open market operations, the Fed buys or sells U.S. Treasury securities in the secondary market to produce a desired level of bank reserves. These securities are held in the System’s portfolio, which is known as the System Open Market Account or “SOMA.”"( New York Fed)

This Open Market Operations consist mostly on the sell and purchase of government debt securities by the Central Bank. When the Central Bank wants to drain the excess reserve created by deficits, it sells government debt securities to the banks until demand and supply match at the target rate. On the contrary, when it wants to supply liquidity, it buys the government securities from the banks until they have their desired holdings of reserves at the target rate. As the holdings of government securities for the Open Market Operations by the Central Bank are limited, this opens the door for further cooperation with the Treasury, so the later can provide enough debt securities to allow effective rate targeting. This idea was resumed in Randall Wray:

"Note that the sale of its own treasuries by a sovereign government is not best thought of as a borrowing operation, even though it is frequently described as such. Rather, the purpose of such sales (even if policy- makers do not realize this) is to drain any excess reserves created by deficit spending. If the bond sales were not undertaken to drain excess reserves, the overnight rate would fall. Operationally, the Treasury and the Central Bank work together to ensure that the overnight interest rate target (set by monetary policy) is hit. They do this through security sales or purchases to drain or add reserves as necessary to allow the monetary authorities to hit rate targets."

Interest rate on government debt securities 

But what drives banks preference to hold governments securities instead of reserve balances at the Central Bank? The main reason it's interest payment: reserve balances at the Central Bank do not pay interest, at least they did not until the recent financial crises, while government debt securities do pay. So, for banks the choice it’s always between non-interest paying reserve balances at the Central Bank or interest bearing government securities. Profit seeking banks, with excess reserves, will want to hold any combination that maximizes their profit. Which simple means that besides any reserves they are required or want to hold they will want all the government securities they can get their hands on. This has important implications, namely that interest rate paid on government securities of a sovereign government are not subjected to market forces as explained by Randall Wary:

"The final point to be made regarding such operations by a sovereign government is that the interest rate paid on treasury securities is not subject to normal “market forces”. The sovereign government only sells securities in order to drain excess reserves to hit its interest rate target. It could always choose to simply leave excess reserves in the banking system, in which case the overnight rate would fall toward zero. When the overnight rate is zero, the Treasury can always offer to sell securities that pay a few basis points above zero and will find willing buyers because such securities offer a better return than the alternative (zero). This drives home the point that a sovereign government with a floating currency can issue securities at any rate it desires—normally a few basis points above the overnight interest rate target it has set. There may well be economic or political reasons for keeping the overnight rate above zero (which means the interest rate paid on securities will also be above zero) But it is simply false reasoning that leads to the belief that the size of a sovereign government deficit affects the interest rate paid on securities."

Japan is a case in point: since the 90's its budget deficit and debt increased steadily until 2005 but, contrary to conventional wisdom, this was accompanied by a fall in Government bond yields. In actual fact, government bond yields actually increased slightly when a reduction of the deficit was initiated in 2005. However, since the onset of the great recession, the budget deficit has reversed course and started to increase again and now stands above 10% of GDP, with little sign it will abate anytime soon. Once again, contrary to the mainstream view, bond yields have fallen further. The situation was made even worse with the earthquake in 2011, which prompt many to predict that the day of reckoning was around the corner:

Japan already has the largest debt burden of any industrialized country, at about 200% of GDP, and even though Japan is not yet showing signs of following Ireland, Greece and the rest of the euro zone periphery into a full-blown debt crisis, pressure has been mounting for Tokyo to finally put in place a credible plan to reduce its yawning budget deficits and contain its debt levels.

We are now in 2015 and that day has not yet arrived. On the contrary, Japan debt burden has increased and the IMF estimates that at the end  2014 it will be 242% GDP, yet there's no sign of the day of reckoning is closer than in 2011 as bond yields are  getting ever close to Zero despite the proposed record budget for 2014.

Demand for government debt securities

Another important point to be made from the graph above is that against all predictions there is no shortage of demand for Japan's debt securities as its outstanding debt just keeps on increasing. In fact, as Frank N. Newman, former Deputy Secretary of the U.S. Treasury (1994-1995), explains in the same post by Stephanie Kelton, there's never shortage of demand for sovereign government debt securities:

"In any case, the treasury can always raise money by issuing securities. The bond vigilantes really have it backwards. There is always more demand for treasuries than can be allocated from a limited supply of new issues in each auction; the winners in the auctions get to place their funds in the safest most liquid form of instrument there is for US dollars; the losers are stuck keeping some of their funds in banks, with bank risk. (I even try to avoid using the expression “borrow” when the treasury issues securities; the treasury is providing an opportunity for investors to move funds from risky banks to safe and liquid treasuries.)"

The reason why there's always demand for debt securities of a sovereign government that issues its debt in its own currency is that it produces the most safe and liquid of all the securities in that sovereign currency as explained by the Federal Reserve Bank of ST. Louis:

"As the sole manufacturer of dollars, whose debt is denominated in dollars, the U.S. government can never become insolvent, i.e., unable to pay its bills. In this sense, the government is not dependent on credit markets to remain operational. Moreover, there will always be a market for U.S. government debt at home because the U.S. government has the only means of creating risk-free dollar-denominated assets (by virtue of never facing insolvency and paying interest rates over the inflation rate, e.g., TIPS—Treasury Inflation-Protected Securities)."

This can easily be illustrated with an example that so many times has caused confusion because this is not understood. Contrary to Japan, where only 6% of outstanding bonds are held by non-residents, in the US non-residents hold more than 30% of outstanding Treasury securities, being China and Japan the biggest foreign holders, although only Chinese holdings are singled out as being a national threat. As China has been running trade surpluses with the US (US trade deficits) for years the accumulation of dollars or dollar denominated assets is just a natural consequence of that trade pattern.  As the Chinese exporters must be paid in renminbi (yuan), US importers must exchange their dollars for renminbis at the People's Bank of China (PBC), the issuer of renminbis. The transaction increases People's Bank of China (PBC) dollar reserves, that must be held in a bank account in a US bank (ignoring the Eurodollar market), unless it prefers to hold the dollar bills in its vaults, which for sure is not the case. At the end of the day, the PBC has only a couple of options: 1. Exchanges it for another currency (a bank balance in another country); 2. Keep the balance in dollars at a US bank, or 3. Buy dollar denominated assets (US Debt). Assuming it prefers to keep its balance in dollars, the choice is between the most liquid, most safe (no default risk), interest bearing asset in dollars-i.e. Treasuries- over less liquid, less safe (bank account carry default risk) that bear little or no interest- bank balance. There's little doubt which one is preferable. That's the choice faced not only by foreign deposit holders but also the decision that many other large surplus deposit holders face every day, from Social Security and other government funds to insurance companies, mutual funds, pension funds and the like. Not surprising all of them are big holders of Treasury Securities.

Non-Sovereign governments: deficit financing, interest rate and demand for debt securities

A non-Sovereign government, however, does not have unlimited power to create its currency as such rather than an issuer of the currency it is a user of the currency. Contrary to a sovereign government, a non-sovereign government must obtain "money" before spending it, which it can only do by taxing or borrowing. By drawing cheques on a private bank account, not at the Central Bank, a non-sovereign nation must ensure it has money on the account at all times otherwise the cheque might bounce. When it spends, its accounts at the private bank are debited and when it receives taxes its accounts are credited. Any shortfall of taxes in relation to spending must be borrowed from a bank or by issuing debt securities. Whichever the case, it will receive a deposit to spend. At the end of the term, it must have collected enough money to repay the principal and interest or be able to roll over the loan.  The issuance of debt by a non-sovereign government is truly a financing operation in the terms we are used to think of it. First implication is that interest rates for a non-sovereign are ultimately determined by market forces as Randall notes:

"Since it is borrowing dollars/euros, the rate it pays is determined by two factors. First there is the base rate on dollars/euros set by the monetary policy of the US government (the issuer of the dollar) or the ECB (issuer of the euro). On top of that is the market’s assessment of the nonsovereign government’s credit worthiness. A large number of factors may go into determining this assessment. The important point, however, is that the nonsovereign government, as user (not issuer) of a currency cannot exogenously set the interest rate. Rather, market forces determine the interest rate at which it borrows."

If markets perceive the credit worthiness of a government is deteriorating it can increase rates and ultimately turn off the tap. This can be especially worrying during recessions when tax revenues fall and borrowing increases. In such a situation, market sentiment can change very quickly and the government might find it difficult to borrow, whether for new spending or to roll over debt, and be forced to cut spending or even default if costs of borrowing became too high. Therefore, the ability of a non-sovereign government to pay its bills is not unlimited once it depends not only on its powers to tax but as well on "perceived" default risk.

Can demography explain Portugal's slump before the crash? Is the Eurozone suffering from a “Shortage of Japanese”?

In Portugal, unlike other countries now experiencing economic difficulties in the Eurozone - Spain, Greece and Ireland-, anemic economic growth was all too evident before the financial crisis of 2007-08.  Accession to the Euro club brought a significant reduction in interest rates in those countries that had maintained historically high interest rates, which triggered real estate bubbles - Ireland and Spain, and public overspending - Greece, allowing these countries to maintain rates of economic growth above the European average. In Portugal, who suffered not only a mild housing bubble but also from government overspending,  growth was much weaker than the group mentioned above and more in line with countries that  have had lacklustre performances in the European context: Germany; Italy. (See chart below)

What’s the reason for the low growth relatively to other countries that are now in the same situation? To put another way, what’s the cause that differentiated Portugal from the other countries before the crisis of 2007-08, and how it faded since? Some recent papers and articles attempt to explain the causes of this relative weak performance, but although some of the causes advanced can in part explain the weak growth in Portugal, they do not fully explain the low growth relatively to the group mentioned above because many of the issues were also present in the other countries before the crisis.

Long term economic growth can be split into labor force growth and productivity growth.  Invariably, the main cause cited for the Portuguese low growth has been productivity growth, or the lack of it, but although this certainly has been a problem in the last decade, not so much before, it hardly appears enough to explain the relative week performance. The differences in productivity gains don't seem big enough to justify the differences in GDP growth, even in the cases of Ireland and Greece, countries where productivity growth was higher than Portugal; but certainly this is true for Spain as its productivity growth was smaller than Portugal, as can be seen in the chart below. In the last decade, productivity growth in Portugal was threefold that of Spain but its growth was less than half. 

As such, we can safely conclude, that productivity on its own cannot explain the differences in economic growth between Portugal and the other group of countries. On the other hand, the stagnation and decline of the working-age population can not only explain the weak economic growth that afflicted Portugal, but also the GDP growth differences between several countries in the Eurozone before the crises.

As explained in the previous post, between 2003 and 2008, working-age population growth in Portugal was negligible and as such the “workforce effect” - contribution of labor force growth to GDP growth - was non-existent, as can be seen in the chart above.  Starting in 2008, working-age population growth became negative and thus the “workforce effect” began to act as drag on the economy. To maintain a healthy economic growth Portugal had to gradually increase its productivity growth, and/or alternatively increase its labor participation rates - to compensate for the declining workforce-, but this is not easily attainable, as such, trend growth will surely steadily fall. Therefore, when the labor force starts to stagnate or decline, economic growth stalls. This explains the weak economic growth in several European countries in the last decade. In particular, it explains why Portugal and Spain had very different economic performances before the 2007-08 financial crises and how this began to converge after this. 

Population change is comprised of natural growth, the difference between births and deaths, and net migration, the difference between immigration and emigration. Natural growth, both for Portugal and Spain, had been barely edging positive in the turn of the century since in both countries the total fertility rate fell below replacement level in the early 80’s. In Portugal, natural growth turned negative in 2007, the year that for the first time there were more deaths than births. On the contrary, Spain experienced a slight recover of its natural growth in recent years, as a result of an increase in its total fertility rate, as can be seen in the chart below, although this is due almost exclusively to foreigners, who have a higher fertility rate than the native-born.

As a result, both in Portugal and Spain, population growth in the last decades depended almost exclusively on having a positive net migration, and this resulted in a large influx of immigrants. But while in Portugal this growth began to slow down since 2002, in Spain immigration exploded until 2007, as can be seen in the chart below. "No modern country on Earth experienced such a massive increase in its immigrant population as Spain. In 1990, one in 50 people in Spain was an immigrant. Today, it's one in seven."

Portugal not only received fewer emigrants from 2000 onwards, but also witnesses a massive exodus of its nationals.  As Edward Hugh pointed out, the entry in the European Union was accompanied by steady emigration flows, which clearly sets Portugal apart from the other countries, Spain in particular (see map on page 11), and resembles more the path that would be later trodden by Eastern Europeans countries when of their accession to the European Union.  Consequently, and according to the Instituto Nacional de Estatística (Statistics Portugal), during the inter-census period, the resident population of Portugal increased by only 1.9% while in Spain, the increase was 12.9%. (Chart below)

With the accession to the European Monetary System and later the Euro, interest rates declined significantly for both Portugal and Spain and as a result the two increased their debt levels. According to the McKinsey report, Debt and deleveraging (see page 14), in the second quarter of 2011 Portugal and Spain had total debt of 356 and 363 (as % of GDP), respectively. The consequence of cheap and easy credit was to create a housing bubble, both in Portugal and in Spain, but while the Portuguese began to deflate in 2002, the Spanish continued to inflate until 2008. This outcome was the result of the substantial increase in Spain’s population as a result of immigration, many of them Portuguese, while the increase in immigration in Portugal was just enough to replace the ones who were leaving. This population growth allowed the housing bubble to continue for much longer in Spain, while in Portugal there were no longer enough people to buy the excess homes being built, and so prices didn't skyrocket; but the housing units were built regardless. As such, rather than a classical bubble with inflated house prices, in Portugal, it was more a case of oversupply, given that 800,000 homes were built in the last decade while the population only grew by 200,000. On the contrary, in Spain, in addition to the excess construction, prices went through the roof, with immigration having a great influence on both. It is estimated that the immigration inflow increased house prices by about 52% and was responsible for 37% of the total construction of new housing units between 1998 and 2008. From 2002 until the 2007-08 financial crises, the growth of the Portuguese economy began to be more in line with the growth of economies where the labor force was stagnant or declining, namely Italy and Germany, as can be seen in the chart below.

The chart above is easier to understand if we group countries into two groups: countries with weak economic growth – Portugal, Germany and Italy-, and countries with more healthy growth - Spain, Ireland and Greece.  With the exception of Greece, countries with sound economic growth before the recession were also the countries with higher labor force growth in the same period, as shown in the graph below.  By contrast, in countries where economic growth was weaker, the labor force growth was also more moderate or even negative, as in Germany. (Chart below)

However, the dynamics changed completely with the onset of the 2007-08 recession. In Spain, where working-age population growth depended exclusively on immigration, the rates of labor growth collapsed, only matched by the plunge of its GDP growth, and its workforce has actually started to shrink. In Ireland, despite a more abrupt fall, growth nonetheless remained positive, this was due to the fact that its population growth did not depend only on net migration but had an important natural component as well.  In fact, Ireland has the highest fertility rate amongst European countries and therefore, unless immigration returns to numbers only seen in previous centuries, growth of its working-age population should stabilize in positive territory, although at a level well below the pre-crisis.

In Portugal and Greece, even before the 2007-08 recession, the labor force growth already showed clear signs of a slowdown, as growth came to a standstill in 2005, and despite a slight recovery after, more pronounced in Greece than Portugal, working-age population went into decline with the onset of the recession.  Italy, which had reversed the decline of its working-age population initiated in the 90’s, appears once again to slide back into negative territory. On the other hand, in Germany, the workforce began to grow for the first time since 1998 due to an increase in immigration, many of them Portuguese, Spanish, Italian and Greek.

As explained by Daniel Gros, when comparing economic growth performance between countries with very different rates of population growth, the best indicator is undoubtedly GDP per Working Age Person (GDP/WAP).

Hence, if we compare the per working-age person GDP growth between the various countries in the last decade, as such taking working-age population growth out of the equation, it can be said that neither the growth of Spain and Ireland was so spectacular, nor the growth of Portugal, Germany and Italy fared so badly in comparison. In fact, only Greece seems to have had a spectacular growth, which would be in line with its productivity growth before the recession, but Greece’s population statistics might be underestimated, as Greece has not only a large population of illegal immigrants but some weakness in data collection have also been highlighted. Anyway, its growth was probably due to other unrepeatable factors, such as the Olympic Games. It also should be highlighted the economic growth achieved by Germany despite the decline of its workforce, proving that growth is possible with a declining population.

Despite some regional variations as a result of internal migrations, the reality is that working-age population in the Eurozone as a whole has initiate a long downward trend that will have major repercussions in terms of its economic growth, as explained in the previous post, and therefore, we can also conclude that Europe suffers from a "shortage of Japanese" as shown in the graph below.

As such we cannot fully comprehend the situation that Portugal, Spain and Greece face at the moment without looking into their adverse demographics.  This already exerted an disproportional role in the last decade, namely in Spain,  whose working-age population growth  goes a long way explaining its outstanding economic growth, while for Portugal the contrary it’s true, as the lack of population growth made its economy  lose steam  as it joined the Euro. More worryingly tough, is that working-age population in Europe as a whole has started a long, perhaps irreversible, path of decline that will act as a drag on its economic growth, making the economic recovery for these countries even more difficult.

Is Portugal Facing a “Shortage Of Japanese"?

“So, about the slow growth/debt connection: I’ve done a quick and dirty mini-RR for the period 1950-2007 ……focusing only on the G7……and if you look at it, you see that most of the apparent relationship is coming from Italy and Japan……And it’s quite clear from the history that both Italy and (especially) Japan ran up high debts as a consequence of their growth slowdowns, not the other way around.” – Paul Krugman, Reinhart-Rogoff, Continued


Despite so much intense debate about the ailment from which Portugal suffers, and the mountain of sacrifices currently being borne by the Portuguese people one fact has gone virtually unnoticed in amongst all the noise - for the first time, at least in the modern era, Portugal’s working age population has started to shrink. Demography and its possible impact on economic growth is a topic which has been largely ignored by practitioners of economic science in recent decades as population growth has by-and-large been on an upward trend. However, as we enter a new period in human history, one in which the upward trend has shifted towards stagnation or even in some cases towards long run decline, the economic and financial implications of this transformation can no longer be ignored. As Nobel economist Paul Krugman indicates in the above quote, some countries have large debt simply because they have low growth.

So what is the common thread that runs through these low-growth high-debt countries? Could it be decelerating labour force growth and eventual labour force contraction? The cases of Italy and Japan are well known. In the case of Portugal, it will be argued here, demographic trends can not only explain a significant part of the slow economic growth the country experienced during the first decade of this century, they can also help us understand the depth of the current recession. More important still, we need to think about the consequences of this continuing lose-lose dynamic for the country’s future in both the short and much longer term.

Economists didn’t always take the view that population dynamics were irrelevant to economic performance. The 1930s gave birth to a serious debate about the possible problem that would arise if many decades of strong population growth were followed by population stagnation and then decline, a debate which was provoked by the fact that birthrates in a number of countries fell below replacement level for the first time in human history during the economic depression. And among the names of those economists who took the problem seriously enough to think and write about it was none other than John Maynard Keynes.

“There are, indeed, several important social consequences already predictable as a result of a rise in population being changed into a decline. But my object this evening is to deal, in particular, with one outstanding economic consequence of this impending change; if, that is to say, I can, for a moment, persuade you sufficiently to depart from the established conventions of your mind as to accept the idea that the future will differ from the past.” J.M. Keynes, Eugen Rev. 1937 April; 29(1): 13–17.

While the phenomenon has arrived largely unnoticed Portugal’s total population has long been near to stationary.

As can be seen in the above chart, Portugal’s population has been struggling to find growth momentum since the mid 1980’s (the first time numbers actually dipped downwards) but the years 2010/2011 seem to mark a more fundamental turning point, since it was in that time interval that Portugal’s population started on a long, and possibly irreversible, path of decline. Having long had a total fertility rate of below 1.5 this was a more than predictable outcome, and one that should have been expected ever since the total fertility rate fell (and stayed) below the 2.1 replacement level in 1982.

As is well known, population change is comprised of two major components: natural growth and net migration. Natural growth, births minus deaths, became negative in 2007 and thereafter population growth has become exclusively dependent on having sufficient positive net migration. Up to 2010 this condition was satisfied given the continuing influx of immigrants into the country as can be seen in the chart below.

However, since the onset of the 2008 recession, not only have the immigration flows reversed completely, but emigration has started to increase again, thus reanimating a trend that has been constantly present in Portuguese history over decades, even centuries. This is perhaps the most critical factor driving the recent population decline. In fact the decline would have occurred much earlier had it not been for the return of thousands of refugees from the Portuguese colonies in the 1974-1981 period.

According to the European Commission's 2012 Ageing Report, projections for the Portuguese population during the period 2010 - 2060 anticipated that population would peak in 2034, but as we have seen, the latest data show the population unexpectedly reached its peak in 2010 (total population, previous chart), the year in which the population began to decrease (a similar phenomenon seems to have occurred in Spain in 2012, with again a reversal in migrant flows in an otherwise stagnant population being the trigger). This fact that this turnaround comes as a surprise is clearly the result over optimistic assumptions on the net migration front since the numbers for natural growth are well known and change little (although birth numbers are now dropping in many EU countries under the impact of the long recession). Clearly the unexpected factor here is the severity of the recession from which the country is suffering and the size of the exodus of young people who are leaving.

Just to highlight even more the speed with which all this is happening, in Japan, the interval between the beginning of the decline of the working age population and the beginning of total population decline was a full decade. In Portugal this interval was only two years.

Even more relevant than the decline in total population for the purpose of the present discussion is the decline in the working-age population. While the former gives us a good proxy for domestic consumption, it is the later which is important in terms of potential national output. All other things being equal a reduction in the working-age population means a reduction in output. Therefore, the most important detail to catch from the chart above is that the working-age population, defined as the population with ages ranging from 15-64, declined for the first time in Portugal between 2008 and 2009. As highlighted by both Daniel Gros and Paul Krugman if you want to compare economic growth performance as between countries with growing populations and those with declining ones the best indicator to use is undoubtedly GDP per Working Age Person (GDP/WAP).

In the Portuguese case if we take this ratio and compare it with both Real GDP growth and Working Age Population change (my calculations VM), we can get an impression of how variations in the Working Age Population affect the economic growth of a country. Surprisingly or otherwise, the data for Portugal viewed graphically not only confirms the existence of the “workforce effect” – the relationship seen between Real GDP and GDP/WAP - but also suggests that Portugal has already passed the point where this effect is beginning to have a negative impact on GDP growth.

As can be seen in the above chart, until 2008 the growth rate of Real GDP was always higher than the rate for GDP/WAP offering a strong suggestion that labour force growth was having a positive impact on GDP growth. It is noteworthy, however, that both in the period 1986 - 1991 and in the period 2003 - 2008, the growth rates of Real GDP and GDP/WAP almost overlapped. This phenomenon coincided with very low or zero rates of working age population growth and as such the “workforce effect” was mostly neutral. The first of these periods, 1986 - 1991, the stagnation in the workforce was the direct result of the increase in emigration that followed the entry of Portugal in the European Union. The second one coincides with the arrival of the turning point in long term WAP growth, as the size of the working age population irrevocably turns negative.

Indeed, during this early period of emigration towards the EU Portugal’s total population decreased, as shown in the chart Population by age group (above, blue line), but at the time, since the population in general was much younger, and many more new labour force entrants were arriving at working age, the growth rate of the workforce remained slightly positive. In other words, there were still enough Portuguese entering the labour market to replace those who were leaving it (either to retire or to seek a future abroad). In the second period, 2003 - 2008, the large exit of Portuguese nationals, about 700,000 between 1998 and 2008 according to research by the now Economy and Employment Minister Álvaro Santos Pereira, was to some extent offset by an inflow of immigrants, but these were only sufficient in number to maintain the workforce at a stationary level.

All this calm and stability disappeared, however, after 2008 when the growth rate of Working Age Population turned negative, i.e. the labour force began to decline (see graph below). Where the growth rates of Real GDP and GDP/WAP overlap we can surmise that working age population change is having no effect on real GDP growth. Subsequently, however, the growth rate of GDP/WAP becomes higher than the growth rate of Real GDP and thus the "workforce effect” starts to act as a drag on the economy steadily bringing the potential overall growth rate down. In other words, Portugal is now suffering from a "Shortage of Japanese" as Edward Hugh has called the phenomenon, after Paul Krugman originally coined the term to describe the underlying problem which has been afflicting the Japanese economy since the mid-1990s.

The fact that the three lines in the above chart happen to intersect at zero is perhaps just an unfortunate coincidence but is consequences are disastrous, since the downward trend that was already evident accelerated greatly after the onset of the recession. The resulting rise in unemployment not only caused a collapse in the immigration flow, it also led to a sharp increase in emigration. As a result workforce shrinkage intensified even further, as can be seen in the above chart by looking at the growing distance between the Real GDP and the GDP/WAP lines. That is, if the workforce had remained stationary the economy would be growing at similar rates to the GDP/WAP, i.e. above the current level as indeed happened in the period 2003 – 2008.

Naturally, the argument can be advanced here that the recession is a cyclical phenomenon, and this is surely true, there is an ongoing cycle, but the argument being used refers to long term trends – a reversal in direction (or change of sign) for inputs from the labour force component brings down the overall trend growth rate making booms weaker and recessions deeper, all other things being equal. This would seem to be a simple conclusion which stems from elementary growth accounting theory. Naturally, there are other factors which contribute to growth, like multi factor productivity, but again other things being equal you would need more of this to achieve the same growth rate as before under conditions of weakening in the labour force growth component.

Thus the argument is not that economic growth becomes impossible with a stagnant or slowly declining workforce, but simply that it becomes harder to achieve because it relies more on other factors, such as productivity and raising participation rates, but these change slowly over time, and more so in already developed countries. As such trend growth will surely steadily fall. This can be clearly seen in the following chart: while workforce growth was an important source of growth when Portugal was a developing country, its importance fell back as the workforce started to stagnate even as Portugal was approaching converge with other developed countries in terms of productivity. Other factors took over and increased their importance steadily as the economy started to converge with more advanced ones. Now that this catch up process seems to have come to a standstill as well the economy simply can’t growth, at least at rates considered normal. With a stagnant workforce, low growth or no growth is the new normal.

Following standard growth accounting procedures, during the 1970s workforce growth accounted for more than half of Portuguese economic growth (see chart above, my calculations VM), and this contribution had fallen to only 16% in the first decade of this century. However, since 2008 not only has this contribution reversed sign but also the magnitude of the negative effect has begun to increase rapidly. Such that, by 2011 the “workforce effect” could be considered to explain more than 29% of the GDP decline. This “negative drag” will continue, and the effect possibly become greater, as the working age population shrinks further. Had the workforce remained stationary we could surmise the 2010 recovery would have been more pronounced and the 2011 recession wouldn’t have been so deep. This is the principal reason why official growth forecasts have been being constantly revised to the downside, and this will continue to happen until the models the forecasters use adequately incorporate the effects of population decline on economic growth. Adding insult to injury, ignorance of the existence of such effects recently led Portugal’s Prime Minister Pedro Passos Coelho to suggested young unemployed Portuguese resort to emigration as an escape route from the crisis, advice thousands have now followed thus making a bad situation even worse.

Economic growth in Portugal appears to be on a long downward trend, a trend which will only be made worse by the onset of the decline in its working age population. Economic output is now at 2001 levels and thus we can now conclude that the last decade has been completely lost. More worryingly though, is that after such a bad start to this decade, it might not be unreasonable to conclude that this one is also in the process of being lost too.

At best the economy will stagnate in the years to come but the possibility is there that it will continue to regress – especially if nothing is done to stem the outflow of young educated people - and by 2019 it might even be back somewhere in the 1990’s. This is scenario simply cannot be excluded since, in addition to all the other problems the country faces, a situation that would be in any circumstance challenging is now being aggravated by one more variable whose contribution cannot be easily reversed in the short term – the decrease in the working age population. More than the fact in itself, it is the speed at which this is happening which is alarming, and the fact that policymakers appear unaware of the problem. In analyzing the low Portuguese economic growth issue the decrease in the country’s working age population can no longer be ignored! Or at least it is hoped that this will be one of the outcomes of this short report.

To return to where we started, Keynes concluded in his pioneering presentation that a stationary or slowly declining population could increase its standard of life while preserving the institutions society values most if, and only if, the process was managed with the necessary strength and wisdom. On the contrary, he argued, a rapid decline in population, of the kind that we are seeing in Portugal today, would almost inevitably result in a serious decline in living standards and a breakdown in highly valued social security mechanisms. The distinction Keynes drew some 80 years ago between rapid and managed rates of decline seems plausible, reasonable and highly relevant today. What we now need to see are urgent measures taken – initiated by the EU and the IMF - to counter the exodus which lies behind this dramatic decline which is occurring before our eyes, measures which at least try to decrease its speed, because once a process like this gains full velocity it will be very difficult to stop, and we have already seen it gather considerable traction. Ireland is a pointer and a great example to learn from, since it took that country more than a century to recover the population decline precipitated by the Great Famine which hit the country in the middle of the nineteenth century.