Europe's Economic Contraction Intensifies In February

Hopes that Europe's battered economies might be about to turn themselves around took another sharp knock today (Friday), as the preliminary flash reading on the purchasing manager survey signaled that activity in both the manufacturing and the services sectors are contracting at a new record pace in February.

The preliminary Markit euro-zone manufacturing purchasing managers index, or PMI, fell to a record low of 33.6 in February from 34.4 in January, while the services PMI also fell to a record low, dropping to 38.9 from 42.2 in January. As a consequence the euro-zone composite PMI reading dropped to its own record low of 36.2 from 38.3 in January. Any reading below 50 on these indexes indicates month on month contraction.

Barring some spectacular (and entirely improbable) turnaround in March it now seems likely that the Q1 GDP contraction will be worse than the Q4 2008 one. If we consider that the eurozone contracted by 0.2% in Q3 2008, and by 1.5% in Q4, then, in my humble opinion, the data we are seeing for this quarter are entirely consistent with a 2% quarterly contraction (or an annualised 8% rate of contraction). Not quite Japan territory yet, but not far behind. And for those who simply don't believe the PMIs can tell you so much, here is Markit's own chart, showing the strong underlying relationship between movements in GDP and the *flash* composite PMI. Pretty impressive I would say.




Germany's Contraction Intensifies


The German service PMI came in at at 41.6, showing the fifth consecutive month of contraction. This was a sharp drop from last months 45.2 reading, and means that the recession is now feeding through from manufacturing to services. The difficult conditions have lead service business owners to hold to the grimmest outlook in the last decade, that is since the index was started. More ominously, the recent data points to a strong reduction in the employment level.



On the other hand February saw the tiniest of upticks in the manufacturing sector, since the PMI came in at 32.2, from January's 32 , the best that can be said here is that the rate of contraction may have stabilised.



France Holds Up Slightly Better Than Most

In France, the manufacturing sector (see chart below) gave up on most of January's rebound, and the PMI fell to 35.4 from 37.9 in January, while services (see chart above) slipped to a record low of 40.1 from 42.6 in January. Nonetheless France is visibly performing rather better than Germany, and when all this is over we will have plenty of time to hold the debate as to why that has been.

Why We All Need To Keep A Watchful Eye On What Is Happening In Greece

In view of Greece's EMU membership, the availability of external financing is not a concern, but the correction of cumulating indebtedness could weigh appreciably on growth going forward. While the risk of transmitting vulnerabilities to the euro area is very small reflecting Greece’s small relative size, large persistent current account deficits would increase the vulnerabilities to a reversal in market sentiment, leading to a corrective retrenchment of private sector balance-sheets in the face of rising indebtedness, and a possible appreciable rise in the cost of funding over time. These developments would have significant negative implications for growth.
Greece: 2007 Article IV Consultation - IMF Staff Report

The above quited paragraph from the IMF is a very good example of what used to be the orthodox wisdom about Greece's economic imbalances - that given EMU membership the availability of external financing should not be a concern, and that the Greek economy is effectively too small for it to constitute a menace to the stability of the eurozone itself, even on a worst case scenario. Well, if we look at the growing yield spreads you can see in the chart above (please click for better viewing) the first premiss seems to be in real danger of falling, EMU membership no longer gives an automatic guarantee of oncost-free external financing, and if you look at the names of the other countries lining up in the queue behind Greece - Italy, Spain and Portugal in particular - you can begin to see the outline of a contagion mechanism whereby the coming to reality of the worst case Greek scenario might just extend itself into a problem of sufficient magnitude to transmit Greek vulnerabilities across and into the entire euro area. No one is too small to be a problem when it comes to financial crises, and if you think I am exaggerating just look at how the "pipsqueak" Baltic economies have paved the way and opened the door to much bigger problems right across Central and Eastern Europe even as I write.

But just what are the problems Greece faces, and just what are the risks of transmission of these elsewhere?

Bank Credit Downgrades

The first of the things which has changed since the IMF wrote the staff report I cite above (back in 2007) is the soundness and stability of what was then seen as being a very well funded and liquid banking system. Only last Friday Moody's Investors Service announced they had changed the outlook on the bank financial strength ratings (BFSRs) and long-term deposit and debt ratings of four Greek banks - to negative from stable. The banks in question are National Bank of Greece, EFG Eurobank, Alpha Bank and Piraeus Bank. This move follows decisions earlier in the week by EFG Eurobank and Piraeus Bank to participate in the Greek government's 28 billion euro (about 12% of GDP) bank bailout scheme the aim of which is to provide capital injections to the participating banks via the sale of preferred shares to the state, guarantees on debt issuance, and liquidity support. The decision by these two banks now brings to six the number of Greek banks who have decided to seek refuge in the government scheme, with the other banks being National Bank, Alpha Bank and the smaller ATEbank and Proton Bank.

Piraeus Bank has said it will hold a shareholders' meeting on January 23 to seek approval for a 370 million euro issue of preferred shares to be sold to the state. Under the terms of the bailout plan, the Greek government may spend up to 5.0 billion euros (of the 28 billion euros total, or a little over 2% of GDP) on boosting bank capital ratios via the purchase of preferred shares. These shares will pay the government a 10 percent dividend, and banks using the facility will need to accept a state representative with a right to veto dividend policy and executive pay on their boards. Banks will also have the right to buy back the preferred shares no sooner than July 1, 2009.

In addition to the evident weaknesses which have now come to light in the Greek financial system, the other worrying development we are seeing in Greece at the present time - apart that is from the largescale social conflict that has been hitting the headlines in recent weeks - is the movement in what is know as the yield spreads. These spreads are the interest rate difference a national government has to pay for borrowing money (over ten years say) when compared with that paid by the (benchmark) German government. What this means is Greek government bonds are sold cheaper (ie the government receives less for them) than their German counterparts, but their yields are higher and this is because external investors increasingly see Greece as a less creditworthy country. If Greece itself was fully self sufficient in finance (like say Japan is) then this wouldn't present a problem for bond yields (as we can see in the case of an equally indebted Japanese govenment) since domestic investors could be relied on to buy up the bonds (in a process known as "home bias"), but Greece is not self sufficient, and has to depend on external finance to fund a current account deficit of around 15% of GDP. Thus the opening up in these spreads over the last two months most now constitute the biggest headache those responsible for managing European Monetary Union have had to face since the creation of the eurozone, since according to the well know neo-classical theory of contingent convergence they should be disappearing, and not increasing.

But increasing they are, in what is only the latest example of reality defying received theory, and the Greek 10-year bond, for example, was yielding 4.89% at the close of European trading last Tuesday, while the 10-year German issue returned just 3.23%. The spread between Greek and German bonds has now more than doubled since October and indeed hit its highest level ever since the launch of the euro last Thursday - reaching 190 basis points, up from 168 before the rioting began.

These widening spreads mean more expensive bond auctions for the Greek government, and this is just where the trouble comes, since Greece has a very hefty accumulated debt to continually refinance (around 90% GDP), and it is partly because investors don't see how a government with a damaged banking system and an economy which may soon start shrinking as the recession bites can shoulder the weight of this debt, especially given the evident difficulty faced by the Greek government in enforcing measures to reduce it, that the widening is occuring.

Twin Deficit To Beat All Twin Deficits?


Basically, if I could sum all this up in a nutshell I would ask, just why are we seeing rioting out on the streets of Greece, and calm placidity down there on the Spanish highway. Well, apart from the evident differences in national cultures (which I am certainly not in any way equipped to get into) I would say there is one single fact that marks out the difference: Spanish Prime Minister Jose Luis Rodriguez Zapatero can still sign any cheque he wants to to try to fend off the worst of the Spanish crisis, while Greek Prime Minister Kostas Karamanlis no longer can. Words of warnings left unheard are now coming home to roost and the Greek government's room for fiscal manoeuvre is very very limited indeed at this point. Undoubtedly time will also run out on the Spanish Prime Minister too if we continue on the present course (as I argue in this post) but my point here is that we should be aware that events in Greece, depending on how badly things go, or how quickly they go bad, could end up cutting the available time for Spain even further, via a nasty little process which is ferquently known to go to work during financial crises: regional contagion.

We have already seen just a process at work in Eastern Europe, following the ill-advised excursion of Russia's tanks through the Roki tunnel in early August, are we now about to see something similar happen in Southern Europe following the course of the ill-gotten police bullet which ripped life and lung out of a poor young 15 year old schoolboy in Athen's Exarcheia district this week? Actually I doubt it, that is I doubt we are likely to see a similar chain reaction process just yet, but the severity of the social backdraft we have scene following the incident should serve as a warning to us all of just how delicate this situation now is, and just how easily things could be knocked off balance.

The core of the problem we have before us lies in the Greek twin defict - Greece has a very large and continuing current account defcit (around 15% of GDP, see chart below) and a very large accumulated government debt (around 90% of GDP, see second chart below).



Part of the reason for the recent surge in Greek external debt has been a rapid rise in domestic investment which was not matched by a similar increase in national saving - in fact household savings have been more or less stagnant - and this has meant that the gap between national saving and investment has been steadily growing since 2001 - increasing from 10.5% of GDP in 2001 to nearly 15% in 2006. Most of the additional gap has been due to a rise in net indebtedness by the household sector. To a large extent the decline in household saving and the increased demand for housing as a private investment vehicle can be explained by the increased access to and demand for credit in the context of financial liberalization and the lower interest rates which have followed from Greece's euro participation. Undoubtedly during the years in which Greece "enjoyed" negative real interest rates, it seem a much more attractive proposition to buy a piece of property whose price it was imagined would "never fall" rather then watch savings steadily lose their value in time deposits which were effectively being ravaged by infaltion attrition. On the other hand it is worth bearing in mind that gross Greek household debt - at a little over 40% of GDP - never reached the heady levels attained in Spain of around 90% of GDP.

In contrast, the Greek corporate sector has been running a net savings surplus throughout the entire period (and this of course is another big difference from Spain), with rising saving repeatedly exceeding investment. This notable increase in corporate saving has largely been the result of the strong profitability in the shipping and financial sectors, and it is this profitability which is now, suddenly, under threat in the current downturn.

Greek government debt, on the other hand is somewhere in the region of 90% of GDP, while the deficit is currently somewhere around 3% of GDP, but none of us (including the European statistics agency Eurostat or the EU Commission) can really be too sure of all this, since the goalposts seem to be being constantly moved in more than the football stadia down in Greece, and while it would be an exaggeration to say the data changes on a weekly basis, sometimes it seems we are not so far away from that point. Such shortcomings in Greek public finance statistics (and economic data from Greece generally I would say, if you look at all the regular omissions in the Eurostat short term data relases) are by now a reasonably well-known problem - the general government deficit for 2007 has only in the last month been revised upwards yet one more time - from 2.8% to 3.5% of GDP (much to the furor and chagrin of the EU Commission, since this put Greece in technical breach of its committments to the Commission, yet one more time), while for 2008, the official public deficit target has already been revised up by 0.75% of GDP, compared with the initial budgetary target of 1.6% of GDP, and of course with the historic record to go by and bank bailouts and the economic slowdown to think about, it hardly seems to be credible that this year will be the year, the year we finally make it back under the 3% deficit limit on a consolidated basis. The latest upward adjustment in the forecast reflects expenditure overruns of 1% of GDP and revenue shortfalls of 0.5% of GDP, although at the present time these are supposedly being partially compensated for by a series of measures implemented in September (with unknown outcome at the time of writing, but with an evident adverse impact on Greek public opinion if the images on our TV screens are anything to go by).

The September package consisted of both revenue enhancing and public consumption cutting measures with a projected budgetary impact of some 0.75% of GDP - and hence in part of course the recent furor on the Greek street. If the intended outcome were to be achieved - something which is, as I say, very unlikely under the present economic circumstances and given the government's track record - then the Greek government deficit for 2009 would be somehwere in the region of 2.5% of GDP. But the point about all this rigmorole, is that the end result of all this coming and going, and too-ing and frowing down the years is that Greece is still not completely out of its EU excess deficit procedure, and this at the end of what has been one hell of a "good times" boom, so what can we seriously expect now that the bad time have most definitely come?

Greek consolidated debt has been steadily coming down, as can be seen in the above chart (the brown line, right hand scale, please click on image for better viewing) but the problem that is facing decision makers is, will getting to grips with the heart of the financial problem imply measures which once more reverse this trend, and if it does, just how will the ratings agencies respond, and assuming we already know the answer to the last question, what will this mean for the yield spread?

Greek Economic Performance

The Greek economy has been buoyant for several years, and the gap in real per capita income between Greece and the EU–15 has narrowed significantly. Real GDP growth averaged 4.25 percent during 2000–06, and is estimated at 4 percent in 2007. Solid gains in employment and handsome real wage increases have underpinned strong consumption growth. Rapid credit expansion that followed financial sector liberalization and the drop in interest rates associated with euro adoption have fostered rising residential investment by households, while strong profitability has fueled corporate sector investment. However, the external sector has been a drag on growth; external imbalances have remained large throughout and widened.
Greece: 2007 Article IV Consultation - IMF Staff Report

Recent Greece economic performance, as measured in terms of growth in per capita income and GDP (see chart below) has been - as the IMF indicate - strong, with average annual growth running at a little over 4%, but looking at the macro imbalances which have been accumulating, we need to ask ourselves, as in the case of Spain, will there be a payback to be made for all of this good news?

If we examine the inflation chart (see below), we will find that Greek annual inflation has also been hovering around the 4% mark since the start of the century, a clear two percentage points above the ECB inflation target, and also two percentage points over the ECB policy rate during the key period from June 2003 and December 2005 (when the rate was held at 2% offering monetary conditions which were far too loose for several key members of the eurozone and in the process fuelling housing bubbles in a number of zone member states). Thus with GDP running way above what might be considered a reasonable trend level, interest rates were being adminstered at what was a real rate of minus 2%, despite the evident inflationary symptoms that there was significant "overheating" going on. Thus the Greek economy was given a pretty significant monetary stimulus during what could only have been perceived as the height boom, and at a time when the fiscal stance was also very expansionary. If any of this could work, then we would have to admit that most of what we claim to know in terms of economic theory was simply wrong - although the ECB at the point may simply have taken the IMF view that "the risk of transmitting vulnerabilities to the euro area is very small reflecting Greece’s small relative size". However since I certainly do not think that Greece is "too small to matter" and since I also think the part of our current body of economic knowledge about what you should and shouldn't do during overheating episodes is among the most tried and tested portions of our theoretical heritage,the Greek economy now seems likely to suffer from some rather severe macro problems in the course of the unwind of this particular binge, and I doubt the knock-on effects from the unwind for the rest of the eurozone will simply be too benign to notice.

We might, of course like to ask ourselves whether it wasn't a pragmatic case of "simply nothing to be done"? I would argue that there most certainly was something to be done, and it was on the fiscal side, since interest rate policy was effectively under ECB control. The Greek government, on noting the signs of overheating should have moved to a restrictive fiscal stance - in other words it should have been running a surplus, and a big one, of possibly 2% or 3% of GDP - but as we have seen, just the opposite was the case, and at the same time as monetary policy was excessively accommodative fiscal policy was busy pumping in even more juice.

And so it went on, until it simply couldn't go on any more, which is where we are now, and why Prime Minister Karamanlis cannot simply keep signing the cheques to buy social peace and satve off the downturn, although it is quite clear that this evident reality still hasn't been gotten across to Greece's two largest union federations who last week held a nationwide general strike to protest a set of government's remedial policies which, if they are anything, are already too little and too late. To give you a flavour of what is involved, here is a selection of some of the reforms that are currently causing so many problems.

The Much Needed Pension Reform

Unless the social security system is fundamentally reformed, the long-term costs of population aging are expected to threaten the sustainability of the public finances. The completion of the actuarial studies of the major pension funds has been further delayed, and the authorities are proceeding with a narrowly focused reform agenda which is nonetheless already drawing considerable protest. They have ruled out reduction of the replacement rate and increases in the contribution rates. Instead, the focus is on obtaining efficiency gains through the merger of pension funds, tightening provisions for early retirement (the list of “heavy and unhealthy” occupations and the disability pension code would be reformed toward this end), increasing the incentives for people to stay employed longer, and tackling contribution evasion. In the absence of an assessment of the cost savings, it was not clear to what extent the current reform proposals would suffice to restore the pension fund to financial viability.
Greece: 2007 Article IV Consultation - IMF Staff Report

Despite strong opposition from the main trade organisation unions, the Greek parliament last March approved a law which aimed at a long overdue overhaul of the country's ailing social security system whose longer run actuarial deficits are now estimated to be running at more than twice Greece's 240 billion euro GDP. Experts predict a collapse of the system in 15 years unless something is done to prevent this and have warned that even the current reforms may not be enough to guarantee the system. We should remember that Greece has long running low fertility (around 1.3tfr) and has a rapidly rising population median age. The working age population is soon set to start declining as a proportion of the total population. Many of Greec's working population, however, simply do not understand this rather harsh and complex reality, and are angry about being asked to increase pension contributions for what they feel may well be reduced pension entitlements later, especially at the present time as they are already feeling the pinch of the global economic downturn. The changes included merging the country's myriad 133 pension funds to form a mere 13, raising retirement ages, eliminating special and supplementary pensions, and introducing incentives to encourage people to work additional years.

Privatisations To Pay Down Some Of The Debt

Greece's New Democracy government has already auctioned stakes in Greece's largest ports in Piraeus and Thessaloniki, and sold a stake in telecoms company OTE. It has also pledged to push ahead with the privatization of several state-owned companies, such as Olympic Airways and Postal Savings Bank. Other assets to go on the auction block may include Athens International Airport. These sales have been pushed forward despite strong opposition by unions who fear job losses and wage reductions, but really - apart from the competitiveness arguments which underpin such moves - the government really have little alternative since something or other has to be sold here.

Wages and Salaries

Wage moderation and enhancing wage flexibility are important challenges. The authorities will continue with the policy of containing increases in basic wages of government employees and are hoping for a favorable signaling effect on private sector wage settlements. However, in recent years, wage increases in the private sector have been relatively large and often exceeded productivity growth.
Greece: 2007 Article IV Consultation - IMF Staff Report

One of the key areas of controversy in recent weeks has been a law which effectively ends the employees' right to collective wage contracts (Spain, be warned) and which won approval in the Greek parliament last August. The government said it wanted to clean-up debt-ridden state companies and overhaul protective employment laws in an attempt to attract more foreign investment. The Finance Minister Alogoskoufis recently told parliament the reform should be pushed ahead "for the sake of the Greek economy and society," since higher wages have added to state companies' debts, which ordinary Greeks had to cover with their taxes.

Are We A Bunch Of Hypocrites In Southern Europe?



One question I often ask myself when speaking with Spanish government employees who timidly ask me the predictable "crisis, what crisis? Can't you see, all the bars are still full!" question is just what is meant by that much used and little understood word "solidarity". We are proud to note down here in Southern Europe that we have a complex set of collective institutions which are driven by objectives of "social solidarity", not like those nasty little anglo saxon types (you know, the "neo-liberals") who live up north. But why is it, I ask myself, that I don't here this "crisis, what crisis" stuff from those working in the private sector, who spend the best part of the day at the present time looking across the factory or office floor at their colleagues and asking themselves who it is who will find themself going out of the door this week?

Solidarity means, if it means anything, that everyone shoulders some part of the burden in difficult times, and that people behave responsibily with their national resources and heritage, and accepting that when there is no money to pay for something, then there simply is no money to pay for it. If you find yourself having to depend on the stringent demands of others from outside your country, then the best thing you can do is to get your country out of the debt which is the cause of the problem, and then you can freely decide your own future for yourself. But while I can well understand how a relatively poor country like Ecuador gets itself into such a dependence-based mess, I am at a loss to understand how comparatively rich countries like Spain, Greece and Portugal have allowed things to come to the pass they have now come to, or how their citizens have let them get to the point they are at now.

One good example of the ways you get into such difficulty comes from Spain where the government now wants power companies to pay off one third of the latest tranche of a multi-billion euro deficit which has been created by utilities charging small consumers less than the cost of generation. At the present time, and following the partial deregulation of Spain's electricity sector, the government continues to set tariffs for small consumers. This deficit is estimated by the Spanish energy regulator CNE to be running at 5 billion euros for 2008 alone.
The government has no immediate plans to oblige utilities to pay for a further third of the 11.2 billion euros of tariff deficit accumulated pre 2008, since this deficit is provided for in Spansih law and appears on the companies' books as a long term credit which they are expected to eventually claw back gradually through their customers. The government has been trying to finance this deficit through quarterly debt auctions, but these have met with mixed results, and the government had to declare null and void an attempted sale of 3.85 billion euros of debt amid market turbulence in back in September. The scandalous part about all this isn't that the government could use any funds it could raise at auction for other and better purposes right now, rather it is the fact that this 5 billion euro debt which has been incurred in 2008 by selling energy to customers below cost has only been adding to the hole in the current account deficit, since the energy it pays for effectively needs to be imported.

One key feature in all this woe has to be a political process that is extremely ineffective, and driven by the fact that no one likes to hear bad news, and that the last thing a politician is able to say is tighten-up your belts now lads and lasses, we are in for a rough ride. But isn't this just how the IMF gets such a bad name for itself, since the IMF doctors get called in just where the domestic political process breaks down, and where local politicians haven't the ability to stand up in front of their citizens and say, it's going to have to be like this, I'm afraid. Isn't this what just happened in Ukraine, Hungary and Latvia? And then people say, those "nasty folk" at the IMF, they cut pensions everywhere they go, and wages are down 8% in Hungary, and 15% in Latvia once the IMF get to run the show. That is the IMF make for a convenient scapegoat, but people seldom ask themselves why wages needed reducing, or why there is no money to pay the pensions. Oh, I know.................

The Greek Economy Is Slowing Rapidly

Greek economic growth is now slowing rapidly. Quarter on quarter growth in Q3 2008 was 0.4%, and almost all the growth the economy has been getting this year (including that sharp spike you can see in Q2 in the chart below) comes from earnings from shipping services, earnings which are now falling dramatically as global trade starts to contract. The economy is expected to decelerate further in Q4, and may even contract slightly, with a best case scenario of remaining around the stationary level. Thus the Greek economy should start contracting - and thus formally enter recession in Q1 2009, at the latest.

Given the difficulties Greek banks are having in raising finance in the global financial and capital markets, the ensuing tightening credit conditions are bound to lead to a further slowdown in private consumption. Government consumption is expected to move more or less in line with GDP, while public investment is expected to rebound in 2009, largely reflecting an accelerating pace in the implementation of EU Structural Funds. Household borrowing has - as we have noted - increased at a rapid rate between 2003 and 2007, but during 2008 the rate of increase has been slowing steadily (see chart below).

This reality is reflected in the recent statement by central bank govenor George Provopoulos that he hoped the bank bailout plan would be able to keep the country's credit expansion pace at 10 percent next year (down from around 18.1 percent currently). Even were this to be achieved (which is far from clear), as we have seen in Spain it will lead to a sharp contraction in an economy which had grown accustomed to new credit generation at twice that rate, and especially given the governments inability to step in and offer any fiscal support.



In addition, the Greek construction sector - which, it should be noted, never became so bloated as a share of GDP as it did in Spain and Ireland (where it hit around 11%) - has now been slowing since Q3 2007, when it hit around 7.5% of GDP, and was down to 5.4% in Q3 2008, and was dropping year on year at an annual 6.7% rate in September 2008 according to the latest data from the national statistics office.

Industrial output is also now falling, by 4.5% in October, and the November manufacturing PMI registered a series low of 42.3 indicating even faster contractions in the pipeline. Greek industry has been getting some uplift from the economic boom in South Eastern Europe, and since that is now well and truly over, we should expect the manufacturing downturn to be sharp and sustained.

In the shipping sector, a significant jump in world freight rates and a rise in shipping volumes on the back of a hefty increase in world demand for oil and other minerals both boosted the sector’s profitability, and increased it's importance in GDP growth (indeed growth in the last couple of quarters has been virtually all about shipping). This favourable position has now very much turned. George Economou, Greek shipping billionaire and Chairman and CEO of DryShips recently characterized the current collpase in the Baltic Dry Index (of bulk charter cargo rates) as something like "a nuclear explosion" for those in the shipping industry. The index, which measures world shipping charges for raw materials, has plummeted from a high of 11,793 in May to 672 (see chart below), its lowest level since soon after the index was established, back in 1985. Daily-rental rates for the largest Capesize category of carrier have plunged from $234,000 just two months ago to $2,320, a fall of a staggering 99%.



Even more worrying for the mid-term outlook is the rush to cancel orders of new ships. In November, New York–based Genco Shipping and Trading willingly agreed to say adios to a $53 million deposit simply to get out of a half-a-billion-dollar deal to buy six new vessels. Clarkson Plc, the world's largest shipbroker, announced that while 378 ships were ordered during October 2007, only 37 were ordered in October 2008. And back in Greece Kriton Lendoudis, managing director of Athens-based Evalend Shipping Co., estiamets that in Greece there are currently some 100 applications by shipowners to lay up their vessels. Lendoudis concludes, "The next 24 months do not look very optimistic." It's hard to disagree.

So my feeling is that - taking all the above elements into account - we should expect Greek economic performance to deteriorate at a rate and to an extent which may surprise the casual observer of economic events. Those who have already been following closely what has happened in countries like Spain, Latvia and Romania should, however, be fully prepared for what is now to come. The first signs are there, in the EU confidence chart I close with (below). As can be observed, a slow and steady deterioration has suddenly, after the summer, changed course, and become a sharp downturn. I fully expect that we will now see this general shift in confidence find its reflection in the real economy data that comes rolling in over the next three or four months.

Merry Xmas and A Happy New Year

Well, a Merry Xmas and a Happy New Year to all my readers. Thank you for taking the time and trouble to pass-by. This blog will now - failing major and surprising new developments in the global economy - be offline till the end of the first week in January, or till after the festival of Los Reyes Magos in Spain (for those of you who know what this is all about). Come to think of it, maybe this is just what our ever hopeful central bankers are in need of even as I write - some surprise presents from the three wise men - but I fear that this year if these worthy gentlemen do somehow show at the next G7 meet, the star in the east which draws them will not be the one described in the traditional texts, but in all likelihood the rising star of India.



Credit crunch, did someone use the expression credit crunch?

Building Activity in Greece

I'm trying to get a measure on the extent of the construction slowdown in Greece and its likely impact on the general level of economic activity in Greece. Building permits conceded give one indication. The latest data we have is from June. Looking at the chart, the slowdown from the middle of last year is clear enough.




The year on year growth graph also says it all I think.





We don't have too many other measures for Greece at this point, but the Greek Statistical Office do use cement output as a proxy for the level of construction, and a glass at the volumes used does tell its own story.




Even though in June and July there was a recovery from the lower level of earlier in the year (when remember the government deficit reduction was affecting civil engineering projects and the interest rate tightening at the ECB new home starts), the level is way down across the board from a year earlier, as can be seen clearly from the year on year chart.




And remember all of this is pre the sub-prime turbulence in August, since the latest month we have any kind of data here for in July.

The Greek Deficit Outlook

The Greek government on Monday unveiled its 2008 draft budget, which aims to cut its deficit to 1.7 per cent of gross domestic product in an attempt to balance its public finances by 2010. Eurostat is reported to be near to large a big upward revision in the valuation of Greek GDP by 20 per cent or more. The effect of this will be to drive down the 2008 budget deficit-to-GDP ratio considerably.

The draft budget did not contain any big surprises. It counts on a projected double-digit increase in tax revenues and a smaller rise in expenditures to bring the general government budget deficit below 2 per cent of GDP in 2008 from an estimated 2.5 per cent this year.

This year’s budget deficit goal was set at 2.4 per cent of GDP, but spending overruns related to the destruction caused by the summer’s forest fires and the cost of general elections pushed it up to 2.5 per cent.

George Alogoskoufis, finance minister, told reporters the initial estimate for the direct cost of the fires on the 2007 budget was €300m (£209m, $428m), but this figure is expected to rise further.

The big question is what is now likely to happen to future Greek GDP growth? The government forecast is for the economy to grow by 4 per cent next year and by an anticipated 4.1 per cent this year following the 4.3 per cent recorded in 2006.

But there must be significant downside risk on all this in the current global and European climate. Especially given the dependence of the Greek economy on construction and its vulnerability to any global slowdown in the demand for shipping services, so all of this now needs to be watched carefully.

The Greek Economy Under The Microscope

Well, as was widely predicted Costas Karamanlis has now been re-elected prime minister of Greece. He was helped in this, some say, by the recent strong performance of the Greek economy.

According to an impressive array of economic data assembled by the Economist he deserves the applause:

During his first term, George Alogoskoufis, the canny finance minister, got public finances back in order and removed bureaucratic obstacles that were preventing Greece from receiving its full share of EU funding. The economy is growing by more than 4% a year. Tourism is headed for a record year, with more than 16m visitors expected. Unemployment fell at the start of the tourist season to 7.7%, the lowest rate in memory.

But does he? Is the Greek economy really so sound as some pretend. And will there be enough meat in the traditional diet of institutional reforms to really get to grips with the underlying issues which confront the Greek economy. It is fashionable in economic circles to talk about imbalances and twin deficits. Well if ever there was a text book example of such problems it is certainly the case of Greece, as we will see.

So the purpose of this post is to dig a little below the surface and take a detailed look at that "other" Greek economy, the one lurking out there just behind all the recent glowing headlines. Let's see if we can try and discern some of the longer run tendencies which may be at work in Greece, tendencies which, if we can identify them accurately, may actually help us to determine the general outline of Greece's economic future in the medium and longer term.

Since I want to put this post up today, and given that time is at the moment is a really precious commodity, since, among other things, the growing emerging market credit crunch seems now to be steadily closing in on the Romanian Leu (as predicted here in this post)and it now seems to be in danger of entering into some kind of free-fall, I will, just for a change, try to be a man of few words. Lets see if, in this case, the charts don't largely speak for themselves.


Greek GDP


Lets start with a look at recent performance of Greek GDP. As we can see this has been growing pretty strongly in recent years. Although one thing that can be seen immediately from the charts is that Greek GDP certainly is extremely volatile.




and here what it all looks like when you iron out some of that volatility. The quaterly year on year growth rates:



This volatility in Greek GDP growth can be observed stretching all the way back across the years:



However this examination of Greece's GDP growth since the late 60s, also reveals another highly characteristic feature, very high levels of growth with then slowly and steadily begin to drop. Thus we can see that despite the relatively strong growth rates of recent years things have slowed a lot since the heady days of the 60s and 70s. This evolution is of course reasonably normal, and for two reasons. Firstly developing economies tend to experience quite rapid rates of "catch up growth" (you can see this process at work now in Turkey or China) as they converge on the more developed economies. This catch up growth is largely technologically and efficiency driven. But there is another component at work here, a demographic one. As societies develop they move through a series of age structure changes. Initially these changes are almost all favourable - this is the so called demographic dividend period, which as we can see was more or less to be found in Greece in the 1960s and 1970s. Then comes the mature - peak performance - stage, when participation rates are high, dependency ratios are low, and a high proportion of the workforce are in the prime age 30 to 50 group. This has been the Greek case since the early 1990s.

But then comes the mature demographic phase, with life expectancy at birth over 80, and median ages moving up through the 40 to 50 range. This is the stage that Greece is now entering, and this stage presents particular features and problems as we will now see.

Components of GDP Growth

One of the areas in which this changing age structure of a population can be monitored and studied at the economic level is in the evolution of the relative shares of the different components of GDP.

And, as could be expected, if we take a closer look at the composition of Greek GDP in recent years we can see some interesting lines of development. In the first place if we look at private domestic consumption we can see that this has been growing quite steadily over the years.



But if we dig a little bit deeper and take a look at private domestic consumption as a share of GDP we will notice something very interesting and potentially significant, since we we will see that in recent years this has been falling, slowly but steadily:



Now those of you who are regular readers of this blog should not in fact be surprised by this discovery, since Greece, like many other European societies is in the process of ageing, and one of the characteristics that Claus Vistesen and I have been trying to draw attention to in those societies who have moved up through the 40 year median age frontier is that the consumption share steadily starts to drop off as a component in GDP growth. This process seems to be constant, relentless and irreversible. It is, at the end of the day, one of the principal drivers of the growing problem of global imbalances.

So if we now take a quick look at Greece's median age, we will see, not surprisingly, that this has now started slowly but steadily to nudge up over the 40 frontier:



So Greeece is now, it would seem, like other ageing societies - and most notably in this context Germany and Japan - destined to have to live increasingly from increasing exports as a share of GDP, and getting growth from leveraging its export potential. But this is just where the problem arises. Let's look at the chart for export share:




Now as we can see, Greece is a long way from being where Germany and Japan are. Indeed it looks like a much worse case - on the surface at least - of where Italy is. Exports are if anything also trending down very slightly in terms of GDP share, and they are certainly not picking up the slack left by the gap in domestic consumption.

So if exports and private consumption are trending down, and if government spending given the huge debt which has been accumulated (more on this later) is now being tightly reined in, just where exactly has Greece been getting all that GDP growth from in recent years. Well that question isn't too difficult to answer, it comes from fixed capital formation, that's where it comes from.



And what exactly does fixed capital formation mean in the Greek context? Well that can be summed up in just one word - yes you guessed it - cement. Tha is the economy has been increasingly driven by construction activity.

(A curious detail here, the Greek statistical office, in constructing its construction activity index, actually uses the cement volume as a key proxy measure for activity).



So now lets take a look at the evolution of Greek construction activity in recent years:




As we can see, the high point in recent construction activity was in 2002 (not too surprising really, what with the Olympics and all that). Since 2004 the level of activity has clearly been well below the level attained in 2002 and 2003. This becomes even clearer if we look at the chart for the year on year changes in the activity level:




What we can see is that since the end of 2006 there has been some recovery in the civil engineering sector, but housebuilding has not recovered dramatically, despite a generally favourable environment in 2006.

Now lets look at house prices. Firstly if we look at the recent annual data we will see that prices rose significantly in 2001 and 2002, and then subsequently slowed.



So obviously Greece has been living from some sort of construction boom or other. But just how much of a boom has Greece "enjoyed" in recent years. Well, one measure of this would be the rate of change in house prices, so lets take a look. Looking at the quarterly data for 2003 to 2005 what we can see is that the rate of price growth dropped to a low in 2003/04 and then subsequently recovered to some extent in 2005.



If we now look (see below)at the more recent data for urban areas ex-Athens (which is the only data we have for this period at this point. All of this comes from the Bank of Greece, Bulletin of Conjunctural Indicators) we can see that the rate of price increase seems to have peaked in the last quarter of 2005, and since that time it has been steadily slowing, and of course this evolution is consistent with the steady tightening of interest rates from the ECB. So what we can discern here is that while - post 2000 - Greek house prices have not been exactly stationary - they have averaged increases of what, something in the 10% range - these rates of increase are well below the levels attained in the main EU housing boom economies - Ireland, the UK, Spain - and this should not surprise us if we take demography seriously, and compare Greece's median age with that of the other countries involved. Greece may now have touched base just on the other side of the "partage des Eaux" in the median age sense, and housing booms may be effectively "done" as a future driver of growth.

Indeed if we look at the latest data on the national construction index which is posted on the Greek Statistical Institute website we will find that construction posted an annual drop year on year in June 2007 of 7.9%. Given what we know about the global market for credit for construction activity, and given the constraints on the Greek government debt, it is extremely unlikely that this situation is going to improve greatly in the coming months, and to this whole topic we will return at the end of this post.



Greek Demography

Now one of the points I am highlighting here is just how the economic activity of a society changes as the age structure changes. As median ages of societies pass the critical 40 mark, as we are seeing in the Greek case two things happen. The domestic consumption share starts to decline, and the role of private construction activity (ie housing) as a driver of economic growth starts to decline. Thus the society starts to depend increasingly on exports to be able to achieve economic growth. And if there are weaknesses in the export capacity, then there are weaknesses in the whole structural profile of the economy, and this, of course, is the Greek case.

But before we go on to look at this, let's stop for a moment and examine the drivers of the upward movement in median ages. Essentially there are three key parameters here: fertility, life expectancy, and immigration.

Lets take fertility first. As can be seen from the following chart, Greek fertility (in terms of TFR) dropped below replacement in the early 1980s, and has subsequently fallen to the lowest-low level (the 1.2 - 1.3 range) where it has stubbornly remained.




Basically sustained low level fertility impacts on the economic system via its influence on the labour suppply and via the demand related influence on population age structure (ie the relations between savers and borrowers). With less people being born, and increasing numbers of people in the older age groups, the ration between births and deaths steadily changes until a point is reached where more people die are being born (ie the natural rate of increase in population turns negative). Greece reached this stage in the mid ninetees, as can be seen from the next chart.



As I say though, fertility is only one of the factors which influences age structure and median ages, life expectancy is also important, and, as we all know, life expectancy has been increasing steadily in recent decades across the developed world. In this Greece is no exception to the general picture, as can be seen from the next graph.




The third factor is immigration. Really due to the extensive operation of the informal sector in the Greek economy it is very difficult to get accurate information on the scale of immigration in Greece in recent years. The information we do have is provided by the Greek Statistical institute, and such as it is I present in the chart below:



As can be seen, there has been a steady rise in the level of immigration into Greece in recent years, pulled essentially by the relatively strong level of economic growth. As can also be seen the vast majority of the migrants come from Albania (and a good chunk of the rest come from the Balkans I could add) and I mention this as significant since in the main inward migration into Greece has been of ethnic relatives. This detail is significant, since it gives us a cultural measure of societal flexibility, a measure which may be important when we come to think about the issues of reform and change which inevitably face Greece as a rapidly ageing society. In this sense the Greek migration model seems to follow a pattern which is to be observed in Japan, Germany and Russia, where the temporary availability of culturally close "diaspora" groups may serve to postpone the longer term opening towards a more culturally diverse environment. This could be regarded as a rather key institutional structural indicator.

Eurostat also provide information on annual migration into Greece, and I have made an additional chart based on this information. As I say, migrant data need to be handled with care, and it isn't really clear why, if the Greek statistical agency can provide such systematic and accurate information to Eurostat they have such shabby data on their own site, but still, such is the nature of things, and it is not for us mere mortals to ask why. Anyway, here is the chart:



What is quite revealing about this graph is the fact that there seems to have been far more migration into Greece in the early ninetees than there was in the first years of this century. As I say, I wouldn't want to make too much of this data, since I am not sure of its level of reliability, but if it is at all accurate then it is very consistent with the story Claus and I are trying to tell, since it would seem that Greece did not have the kind of housing-driven pull, migrant-arrival push between 2001-2006 that say the UK, Ireland and Spain did, and the general situation begins to look increasingly more like the Italian profile, but this really awaits further investigation and confirmation before I personally would want to jump to any hard and fast conclusion.

Coming back to the general issue of inward migration into Greece in recent years, really there is no big mystery as to why Greece should be receiving migrants. Basically, and as can be seen below, the rate of increase in Greece's working age population has started to slow dramatically in recent years. It is too early at this point to say when this number will turn negative, since essentially it depends on the rate of inward migration, and since the rate of inward migration depends essentially on the rate of economic growth we are in danger of going round and round in circles here.




Obviously there is another key factor to be taken into account at this point, and that is the age structure of the workforce. Essentially in the Greek case this has been largely positive in recent years (and hence the reasonably good productivity statistics) as the share of the population in the 35 to 50 age group has risen steadily.

This situation, however, is not set to continue. If we look at the down trend shown in the following chart in each of the key younger groups, then it is obviously only a matter of time before the share of the 35 to 50 group starts to fall, and with it Greek collective productivity.





Now going back to the stagnating working age data, as we can see below the Greek economy has been steadily generating employment in recent years:





So, with the total population in the relevant age group stagnating, and new jobs being created, three things tend to happen: unemployment goes down, immigration goes up, and participation rates go up. The second of these we have already looked at. Here is the unemployment data:



Basically It is pretty much what we would expect. It is important to remember though that this drop in unemployment has two components, an economic growth "feelgood" one, and a demographic, ageing society, one. The impact of each of these components is quite distinct.

As might have been expected participation rates in Greece have also increased over the years, but it is important to continually bear in mind that in the context of an ageing society this process has limits, since there must both be an upper ceiling to the aggregate level of labour market participation, and the human capital (or value added) component of those who enter in the higher age ranges (or re-enter, as in Japan, after an initial retirement) is well below that of workers in the prime age categories.



Finally, going back to the 35 to 50 age group for a minute we can see from the floowing chart that this group has been steadily growing as a proportion of the working population in recent years, but that recently the rate of increase has slowed, and must be now near its peak:




This very favourable demographic situation is, of course, reflected in the Greek productivity figures, which have been pretty good:



The point of all the demogrphics, however, is that, in productivity terms, Greece is now near its peak potential, and this is why the longer term outlook has to be preoccupying, since if you reach such as structurally distorted position, and accumulate so much public debt during your "heyday", then it is hard to see how you can easily correct and "sweat off all those extra kilos" of debt later.



Returning to our main topic which is perhaps where we might expect growth to come from in the Greek economy in the coming future - given that domestic consumption is now unlikely to be a driver, and for the same reason construction activity is now unlikely to be the engine that pulls the train, we are left with two possibilities, government consumption, and exports.

Well, if we look at the government angle, we will rapidly see that the goose is already pretty much cooked, in the sense that a massive debt has been run up during what were the rather favourable years, and that now, as the going gets tougher the room to maneuver will be much less (as is also the case in, for example, Italy and Japan). If we look at the evolution of the Greek government deficit over the years, we will see that it has been substantial:



As a result of this, the Greek government debt has climbed steadily as a % of GDP.





It might be worthwhile addressing at this point a standard argument that arises in these cases that societies like Greece and Italy are much richer than actually appears due to the existence of a large informal sector. I have to reply to this in advance by saying that in terms of government debt dynamics this is essentially irrelevant, since this sector, by definition, does not pay taxes. The only road to go down is to formalise the sector. But formalising involves adding non-direct wage costs to output, and is thus likely to reduce total activity, and, of course, that activity which is formalised also brings new contributors into the social security system, who at some stage also have a claim on government outgoings, so two points are clear. Firstly the situation is much more complicated than some imagine, and secondly, the informal economy is unlikely to be able to rescue the formal economy in its ability to maintain government solvency.

Lastly, let's take a look at exports and the trade balance. The first chart shows the evolution (in value trems) of Greek exports and imports in recent years.




As is obvious, there has been a significant trade deficit. This is not the point for an in-depth analysis of the Greek current account situation, but let us say that, in the short term at least, the export sector is unlikely to rescue Greece from a looming growth slowdown.



Greek Inflation and Monetary Policy

One of the points which has not received any attention so far in this review is the impact on Greece of participation in the eurozone system. A brief examination of some of the imbalances - in trade, in the government deficit etc - we have identified here should be sufficient to illustrate the superficiality of those approaches which focus on eurozone wide aggregate data, and lose all the little devils (of which there are many) lying around just waiting to be uncovered in the details.

Now as of the turn of the century the Bank of Greece effectively lost control over monetary policy, as a zone-wide rate of interest was applied from the ECB. One of the impacts of this policy has been - as we can see in the chart below - that Greece has not for a single year since the introduction of the common currency had an inflation rate which falls within the ECBs much vaunted 2% target.




Actually if we now come to look at recent inflation, we will see that, as the ECB has tightened, so the rate of inflation has gradually started to come down, although it is still however stubbornly stuck around 50bps above the 2% target:




This situation seems to suggest that the Greek economy has for some years now been growing at somewhat over domestic capacity. This process is also reflected in the steady ongoing wage cost push pressure, since wages as can be seen in the chart below, have been consistently rising at well above the rate of productivity increase:



This situation, however, does seem to be rather inbuilt into a one size fits all monetary policy. I reproduce below, courtesy of the kind data collection efforts of the bank of Greece, a chart comparing the overnight Eonia loans rate offered by the bank (which is effectively the ECB refi rate plus a few BPs) with the Greek CPI on a monthly basis since January 2001. As will be seen the rate dropped below the Greek CPI in early 2002(hardly an advisable state of affairs for a country with an inflation problem and a twin deficits one) and effectively remained there till the late summer of 2006. The big question is, what is the long term consequence of such a long period of above capacity growth?



Obviously capital inflows, and inward movements of migrants can help offset the limitations of the domestic economy, and the inward movement of migrants can help slow down the upward march of the Greek median age (as might a substantial pro-natality policy Scandinavian or French style, if Greece only had one). It is hard to say at this point, but it would seem the monocultural characteristics of the inward flows into Greece and the relatively lower levels than those achieved in say Spain or the UK or Ireland may well mean that migration is not slowing ageing sufficiently in Greece, and that the danger of an "italian" evolution is now a real one. We basically need more data and more analysis on this process, and more detail on the connection between excess economic growth fuelled by ultra-low eurozone interest rates and inward migration rates (a work in progress).



Short Term Prospects

Well, as we have already noted Greek GDP growth in the second quarter of 2007 slowed down considerably, and indeed turned negative. It is difficult, as has been said above, to draw any hard and fast conclusions from this given the long term volatility of Greek GDP output. However the June and July building index data point should already serve as an initial warning. Other data tend which we do have to hand only serve to confirm this slightly uncertain and mildly preoccupying outlook.

First off, let's look at retail sales. Here's the most up to date version we have of the short term index:



if we now look at the year on year changes since Jan 2006, then I think it is clear that there are definite signs of a slowdown since the middle of 2006.





If we come to industrial output it is clear that Greek industry was ramping up production again quite nicely in the first six months of this year after the slowdown in the second half of 2006, although since April the rate of growth seems to have slowed considerably:




But if we come to examine year-on-year rates of change, then we can see that the real expansion took place in the first six months of 2006, and since then things have obviously been slowing considerably:




So, to return to where we started, and Mr Karamanlis, and his recent election victory, can we agree with the verdict of Economist that the handling of the economy has been more or less what Greece needed? I'm afraid we can't. Severe problems seem to be lying out there just waiting to be addressed, and unfortunately, whether we like it or not, these problems are going to make their presence felt. Worse, people don't even seem to be thinking about the right sort of problems. Certainly pension reform is urgently needed, but so too are other reforms to felxibilise migration and to try and encourage an increase in fertility, topics not normally found on the hitlist of the institutional reformers whether these be staff journalists of the Economist, or economists at the world bank. Meantime the global headwinds are turning. Next year is already looking to be a difficult and complicated one. The Greeks - who to some extent still live from shipping - have long been renowned mariners, so lets just hope they can learn some of the key lessons, and sail these choppy seas with out taking on-board too much water. Unlike the Presige, they will be well advised to deck themselves out a double and well re-inforced hull to try to get themselves through the coming storm.