Following the tradition of decomposing accounting identities, an exercise that can still provide some very interesting results, this post will decompose the Unit Labor Costs (ULC) paths for Greece and Spain during the past couple of decades. According to Ameco ULC can be decomposed as:

ULC = Compensation per employee / Real GDP per person or ULC = (Compensation of employees / Employees) / (Real GDP / Employment)


Looking at the first relationship we can observe that since 2009 ULCs were driven mainly by compensation per employee which dropped significantly while real GDP per person exhibited much smaller contributions:

Greece ULC

A much closer look at each factor which drives ULCs can provide important conclusions:

Greece Compensation per employee

Compensation per employee shows a large drop since 2009 which was driven by the fall in total compensation. Although employment was much lower each year, total compensation fell even more lowering the wage costs for each remaining employee.

Greece Real GDP per person

Real GDP per person shows a rather ‘cyclical’ behavior. Between 2008 and 2012 it fell mainly due to the general Greek recession and the drop in real GDP which was not compensated by a corresponding fall in employment (there was some form of labor hoarding). Nevertheless, during 2012 and 2013 the fall in employment was much larger which resulted into a marginal increase in real GDP per person (which can be regarded as ‘productivity per person’) and contributed to the decrease of ULCs.

Overall the ULC decrease since 2009 was accounted mainly by the large fall in employment (which has a positive impact on productivity) and the even larger drop in compensation. These forces probably fed on each other with the fall in employment and compensation eating real GDP and not allowing real GDP per person to contribute significantly to an improvement (fall) in ULCs.


The Spanish case seems to display rather different dynamics compared to Greece:

Spain ULC

Instead of compensation per employee (which only had marginal contributions), labor productivity was the main driver of ULCs in Spain after 2009.

Spain Compensation per employeeAlthough since 2009 compensation and employment show large changes, these forces managed to counteract each other pointing to the fact that compensation of current employers did not change significantly and only drops in employment lead to corresponding falls in compensation.

Spain Real GDP per personReal GDP per person developments show that productivity was improved mainly through the large fall of employment which was not accompanied by a corresponding drop in real GDP. Although Spain displays unemployment figures similar to Greece the drop in real GDP was only 7% between 2008 and 2013 compared to 24% for Greece.

In general it seems that the ULC improvement in Spain was accomplished on the back of the unemployed while in Greece employed persons also contributed significantly through a large fall of their compensation. This difference can probably also explain (combined with the state of the Greek banking sector) why the fall in Greek GDP was much steeper than Spain’s.

* I am also uploading the relevant excel file which might prove useful for any similar decomposition for other periphery countries such as Italy and Portugal.

I recently came across a very interesting and thorough research paper from the IMF on the Zimbabwe hyper-inflation episode. What was quite clear from the document was that the high inflation of the period was the result of very high quasi-fiscal losses by the country’s central bank and not of runaway fiscal deficits. Probably the most important factor was interest costs of open market operations while also subsidies (mainly in the form of free forex to public enterprises) and foreign losses (due to a mismatch between foreign assets and liabilities) played a significant role. The annual flows were enormous, close to 60-80% of GDP which explains why annual inflation quickly reached levels of 600% and 1200%.

The rest of the post contains the relevant parts (and figures) of the paper that explain the hyper-inflation process more clearly:

While central bank losses in most countries have not exceeded 10 percent of GDP, Zimbabwe’s flow of realized central bank quasi-fiscal losses are estimated to have amounted to 75 percent of GDP in 2006. Losses have arisen from a range of activities including monetary operations to mop up liquidity; subsidized credit; foreign exchange losses through subsidized exchange rates for selected government purchases and multiple currency practices; and financial sector restructuring. Quasi-fiscal losses of this sort, rather than conventional monetary or fiscal laxity, have been the mainly responsible for the surge in money supply in Zimbabwe during 2005-7. The power to create money to finance losses quickly run into conflict with any recognized monetary policy objective with official inflation reaching 1,594 percent as of January 2007.

The following are noteworthy features of the balance sheet:

  • Nonearning assets are substantial; they amounted to 83 percent of total assets as of October 31, 2006.
  • RBZ securities, introduced as a sterilization tool at the beginning of 2004, became the largest liability by the end of that year, overtaking currency in circulation, previously the largest liability.
  • Starting in 2004 sharp increases in statutory reserves to finance the concessional credit to favored sectors, such as agriculture, led to a steep climb in required reserves, which are not remunerated.
  • Foreign liabilities, largely represented by credits from international financial institutions, have for some time been much larger than foreign assets. In this situation any currency depreciation produces losses.
  • The smallest liability is capital and reserves which has been kept constant at a very low level. A central bank increases its capital through seigniorage and reduces it by operating expenses and distribution of profits to the government. Figure 1 shows the evolution of seigniorage since 2001 in Zimbabwe. For the RBZ, seigniorage has fallen from over 5 percent of GDP in 2001 to about 0.1 percent of GDP in 2005 because, given very high rates of inflation, real base money has declined drastically in relation to nominal GDP and the RBZ has invested in assets, including QFAs, with large negative real interest rates. Only the failure to apply a recognized accounting framework keeps the RBZ capital and reserve from being negative.

Most of the RBZ’s quasi-fiscal losses were incurred in connection with activities that go far beyond conventional central banking functions. There were four main sources of the losses:

  • Subsidies in terms of free foreign exchange to public enterprises; price supports to exporters to partially compensate them for an overvalued exchange rate; and subsidized credit to troubled banks, farmers, and public enterprises.
  • Realized exchange losses stemming mainly from the purchase of foreign exchange from exporters and the public at higher prices than sales of foreign exchange to importers (mainly government and public enterprises); and recognition of previously unrealized exchange losses upon repayment of external debt, including to the Fund.
  • Interest payments associated with open market operations to mop up liquidity.
  • Unrealized exchange losses reflecting official devaluations because foreign liabilities exceeded foreign assets.

To contain money growth, the RBZ sterilized the impact of the direct injection of liquidity into the economy that the QFAs represented. In January 2004 the RBZ started to issue its own bills at effective interest rates of over 900 percent per annum. These RBZ Financial treasury bills were naturally attractive to the market but too costly to the RBZ, so they were soon abandoned and replaced by Open Market Operation (OMO) bills, introduced in May 2004, and Special RBZ bills, introduced in June 2004. The OMO bills had the same interest rates as the existing government treasury bills but the accounting for them was clearly separated from holdings of government treasury bills since the interest cost was charged to the RBZ. The issuance of these bills escalated beginning in September 2004 after the large-scale financial or “liquidity” support to troubled commercial banks. The Special RBZ bills were introduced to absorb excess bank liquidity at the end of the day. They had a maturity of two years and carried an interest rate that was sharply negative in real terms. The long maturities deferred the monetizing consequences of the high nominal interest rates.

The RBZ has accumulated substantial domestic interest-bearing liabilities through open market operations to absorb liquidity. The vicious circle of rising losses and rising remunerated liabilities has resulted in inflation and increases in the interest rates of the bills, further accelerating the interest cost for the central bank. By 2005 the net interest cost of sterilization equaled 40 percent of GDP. In 2006 the interest cost grew further but its liquidity impact was partly alleviated as the authorities lengthened the maturity of treasury bills, thus deferring interest payments.


table 1.central bank balance sheet

table 2.contributions to changes in reserve money

figure 4.adjusted government financing requirementfigure 3.Reserve money growth and inflation

Recently we had to write a large essay on the bank loan pricing procedure of the banking system under imperfect competition (for the banking course we ‘re currently attending). The end result was quite interesting and we have posted it as a Working Paper on ssrn. The paper is heavily based on the relevant work of Ruthenberg and Landskroner (2008) which has been extended with more realistic assumptions such as a non-zero Recovery Rate on loans and a securities portfolio to match capital and reserves.

The paper first describes a few stylized facts of modern banking with sections on modern monetary policy implementation and the actual interbank market (where monetary policy acts as an interest rate cap on ‘competitive spreads’). This is followed by a general (stochastic) model for the term and credit risk premium added on loan rates.

The model assumes that a bank finances a new loan by borrowing in the interbank market under Cournot oligopoly and Basel capital requirements. We only examine the case of a properly functioning interbank market with very low excess reserves and liquidity hoarding. The end result is the following equation:

bank loan pricing under imperfect competition

where RL is the loan rate, Ps the borrower’s probability of survival, Rf the risk-free rate, θ the spread in the interbank market over the risk-free rate, k cost of equity (RoE), H the Herfindhal-Hirschman index of concentration in the loan market, ε the elasticity of demand in terms of RL for new loans by bank customers and φ is the risk premium per borrower which is equal to:

φ = PD x LGD

(PD: Probability of default or 1-Ps and LGD: Loss-Given-Default).

Based on the above equation, it is clear that the main drivers of the loan rate are the  Probability of Default and the risk-free rate (these two factors account for over 90% of the loan rate). PD enters the equation both as a ‘compounding factor’ and in the risk premium φ. The end result is that for PD higher than 5% the compounding factor increases substantially and a loan becomes very expensive. The obvious conclusion is that the PD is used as a ‘first line of defence’ by banks in order to determine if a loan will be offered in the first place and the amount made available (especially as a percentage of available collateral, proxied by the Loan-to-Value ratio).

This explains why credit crises and large recessions lead to a ‘credit crunch’ since a large enough PD will result in loan rejections and not in a (very large) increase of the offered loan rate. Updates to a borrower’s PD /LGD (after a loan has been extended) are usually large enough that a bank cannot include them in the loan rate risk premium (without pushing a borrower to an early default) and are incorporated in Loan-Loss provisions.

Under perfect competition (H close to zero) banks are not able to earn a premium over the risk-free rate (apart from the borrower risk premium) and only get their required RoE. If market power exists banks are capable of gaining an above normal profit which is rather marginal for H lower than 0.1 (usually lower than 10% of the risk-free rate). For large enough HHI the premium becomes quite significant.

Both the RoE and Basel capital requirements play a role in the loan rate offered although that depends mainly on the loan’s risk weight.

The model specification was followed by a simple application in the Greek banking system during the Euro era (and before the 2007-2008 credit crisis). Although we did not use any econometric techniques in this essay, the model performed quite well with an R² of 0.93. Given the current HHI of 0.214 it seems that banks have gained (through M & As) significant market power and are able to impose a premium of close to 30% over the risk-free rate in their quoted loan rates (based on the model’s projections).

Our next step is to use the model in order to look into the Greek banking system with more detail and estimate an econometric specification. Still, the basic stylized facts that can be drawn are quite significant and can explain why credit crises lead to a credit crunch and how higher probabilities of default eat into bank profits through loan-loss provisions. Obviously we would appreciate any comments on the paper and the outlined model.

Since Eurostat announced the Greek general government accounts for 2013 yesterday I would like to take a closer on the actual story so far. My source will be ELSTAT Quarterly Non-Financial Accounts of the Greek General Government.

Greek General Government Revene

Greek General Government Revenue

Greek General Government Expenditure

Greek General Government Expenditure

First let me state that the data released from ELSTAT are on a accrual basis (and not on a cash basis) so they should reflect actual transactions and liabilities of the Greek general government. Using VAT revenue as a proxy for nominal GDP developments one observes that the change in revenue was -8.5% during both 2012 and 2013 something that should reflect the large drop in nominal GDP through 2013 (the same is also evident from the -7.8% drop in social contributions).

Looking at individual categories in more detail:

  • Revenue: Both production and income taxes show a significant drop of €1.1bn and €1.9bn (for a total of €3bn) while social contributions fell by €2bn. What actually increased substantially was investment grants from EU by €1.42bn.
  • Expenditure: Fortunately Gross Capital Formation remained more or less stable during 2013 while intermediate consumption was lower by €1.5bn and compensation of employees kept its multi-year pattern with a further fall of €2.2bn. Interest expenses dropped significantly in 2013 with a drop of €2.5bn (after a fall of €5.3bn during 2012). What showed an impressive change was social benefits which fell by €5.9bn (compared to a fall of €3bn during 2012) despite the high rate of new pension applications and the deep recession.

All in all, the 2013 recession took its toll on the revenue side while the drop in expenditure came mainly from social benefits but also from consumption (both intermediate and compensation of employees) and interest payments. Investment grants contributed significantly to government revenue and plugged part of the ‘revenue hole’ from the recession. I find the large drop in social benefits quite puzzling and I ‘m not so sure if the current expenditure base can be sustained in the future. Among other factors there is talk that a huge backlog of pension applications has been created which obviously should be considered as future government liabilities.

In this short post I would like to emphasize the important role of the ECB (conditional) commitment for Outright Monetary Operations (OMT) in reducing tail risks and credit spreads in the Euro periphery bond markets. In order to do that I will analyze OMT in terms of option pricing and insurance.

The role and details of OMT are quite well known by now. The main factors that made the commitment so successful (without even having to implement them) were:

  1. The OMT portfolio will be pari passu with private bondholders. As a result, bonds purchases by the ECB do not create a senior debt-holder (as was the case for the SMP portfolio) while remittance of Eurosystem profits due to these operations allows troubled debt countries to effectively earn seignorage income and lower their debt servicing costs.
  2. Operations are conditional on an official bailout (which is usually accompanied by strict conditionality). Since bailouts tend to favor creditors at the expense of domestic citizens (with austerity measures targeting essential government services and private sector wages but usually not capital income and gains) they lower the risk of debt restructuring in the sense of making it much more difficult for the debtor country to prioritize its own citizens welfare. Furthermore, by having the ECB buy a large part of the country’s debt, private bondholders are not subordinated in the same way as a pure ESM bailout.
  3. The fact that the ECB will probably remit its OMT profits back to the debtor country plus the low interest rates in ESM loans (in contrast with the initial high rates of the Greek Loan Facility) mean that a large part of a country’s deficit reduction will come from interest expenses and not from savings in expenses or higher taxes with a much milder result on economic growth (and a positive impact on long-run debt sustainability).

Still a lot of people find it odd that OMT was able to lower spreads by such a large amount without any operations actually taking place in the bond markets. One has to realize that by committing to OMT, the ECB is essentially setting a ceiling on the spread of government bonds (although a bit vague) since any large increase in credit spreads will lead a country to ask for a bailout and an activation of OMT. As a result, a private bond holder is guaranteed that the price of her bonds will not fall lower than a specific floor, since in that case, she will have the option of ‘selling’ them to the ECB. In other words, the ECB is writing a set of ‘free’ put options on Eurozone debt, standing ready to buy bonds at current market prices after the relevant country has requested a bailout.

In order to look into the issue from a more technical angle, lets assume that the bond hazard rate (probability of default in a period conditional on survival until that period) follows an Ito process similar to the CIR process of interest rates (see Filipovic, chapter 13):

hazard processwhere W is a Wiener process. Given this process one can calculate the default probability which (although quite technical) obviously depends on the drift parameters (b,β) but more importantly on the volatility as well. As a result, if volatility is modeled in an autoregressive model such as GARCH(1,1), periods of high bond price volatility quickly lead to higher estimates of default probabilities. Since the default probability can be considered as the Ν(-d2) term of a credit risk put option (with a strike price equal to the expectation of the recovery rate), the model estimated probability can be used for option pricing and bond portfolio insurance.

By insurance I am referring to the policy of creating a synthetic put option (by shorting bonds) in order to insure a bond portfolio from downside risks.This has the advantage that the bond holder does not have to keep a matched book bond position but only short the proportion (determined by the default probability) of the portfolio needed to hedge against the tail risk of default (assuming of course that interest risks have already been hedged through an IRS for instance) while earning all upside gains. An increase in the default probability increases the proportion necessary to hedge the downside risk, a strategy that can create self-fulfilling issues since the bondholders sell when bond prices fall and might face difficulties in borrowing bonds (to short) through reverse repos.

By introducing OMT, the ECB becomes the writer of the above option (something very similar to a CDS) and removes the need for active hedging. This immediately reduces bond volatility (since bondholders do not need to increase their short positions) while a high σ actually makes the option more valuable and pushes bond prices higher. Periods of high volatility (such as the summer of 2012) are immediately followed by a drop in volatility under efficient markets. As long as the ECB commitment is not questioned, Euro bond prices include this put option and permanently increase in price by market forces without a need for any actual ECB operations.

Obviously, the stability of the ECB determination to implement unlimited bond purchases will play a decisive role in the future (given the recent German Constitutional Court case for instance) yet it is clear that at this point, OMT has played a decisive role in minimizing Eurozone tail risks and lowering Euro periphery countries debt costs.

UIP obviously stands for Uncovered Interest Parity. The following is a crude visualization of its explanatory strength. The graph depicts the difference between real 12-month Libor rates for Euro and USD against the change in the US/Euro exchange rate. An increase in the real spread should lead to a Euro appreciation with the two graphs moving in the same direction (data are monthly since January 2007):

real 12m-libor USD euro - exchange rate movement

It is quite evident that the two series are highly correlated (correlation coefficient of 0.65 with R² equal to 0.42). What is very interesting is the fact that the spread is driven by inflation differentials between the Eurozone and the US (as a result of current disinflationary forces in the Euro area), since nominal rates have converged in the two regions:

libor-euro minus libor-usd

Obviously the above graphs are rather crude and a better indicator of future inflation rates would be inflation swap rates. These might help explain recent exchange rate movements (which are not easy to explain in the first graph).

In any case, the relative unwillingness of the ECB to act upon the disinflationary forces in the Eurozone does have its toll on the exchange rate which might negate a large part of the improvement of the RER. How far inflation rates will remain weak is going to play a crucial role on future exchange rate movements.

I find studies of income inequality and economic growth especially interesting since, apart from anything else, they highlight the differences between the neo-classical consensus and the post-keynesian view of the world. In this context I found two papers by Simon Mohun published on the Cambridge Journal of Economics and focusing on income inequality due to supervisory wages growth and on capital productivity long-term movements very enlightening. The fact that the author uses simple accounting exercises instead of relying on heavy econometric work is also quite positive since it keeps the analysis simple and not easily questionable.

The author starts by looking at the evolution of the US profit share (defined as profits to the capital stock) since the early ’60s. The rate is decomposed in the profit share (profits to value added) and capital productivity (value added to the capital stock) using a simple chain rule:

pre-tax average rate of profit profit rate - profit share - capital productivity

What the author then does is to decompose the economy into ‘productive’ and un-productive sectors and the workers into supervisory and non-supervisory employees. It turns out that supervisory workers saw a large increase in their wage share especially after 1980 while non-supervisory workers experienced a large fall in their own share after a mild increase in the 1964-1979 period:

table 5 - growth in shares of MVA

If one expands the ‘capitalist class’ to also include supervisory workers which means that their wages should be included in the profit share, the actual path of the profit share turns out to be quite different than the original series:

profits and supervisory wagesAs a result, the ‘expanded’ profit rate actually shows a significant increase after 1980 with a large part attributed to the expansion of supervisory wages and not only to the increase of capital productivity:

expanded profit rate - profit share - capital productivityWhat should be stressed at this point though is that this expanded profit rate does not provide the financing means for an expansion in investment (which would be naively assumed to be the driver of the increase in capital productivity) but rather is appropriated by the supervisor ‘worker’ class.

In the second paper, Mohun takes a deeper look at capital productivity as well. Keeping with the productive/un-productive distinction, the capital productivity growth is decomposed into:

  • the expansion of the productive and un-productive fixed assets (which tend to explain a small part of the growth)
  • relative prices (between capital goods and general output) and
  • the ratio of labor productivity to capital deepening (the ratio of the capital stock to labor hours).

The findings on relative prices are in agreement with other studies on the subject which find that capital goods ‘got cheaper’ since 1980 and were a significant driver of the divergence between labor productivity and real wages. The author finds that during 1982-1998 relative prices contributed around 35% to the change in capital productivity:

price of net fixed assets and inventories relative to the price of output

The major driver though was the large change in capital intensity. While capital deepening (it is named technical composition of capital in the paper) grew close to 3% in the 1966-1982 period, it stagnated (-0.1%) in the 1982-99 period. Labor productivity growth remained roughly the same at 1.5% and 1.4% respectively.

table 5 - annual rates of growth - labor productivity - capital deepeningSo it seems that firms not only took advantage of lower capital goods inflation in order to increase their capital productivity but were actually able to maintain growth in labor productivity without investing into productive capacity (at least in relative terms). The paper speculates that this growth was achieved through the introduction of more efficient ‘management and organization techniques’.

In any case, the papers make it quite clear that the deepening income inequality since 1980 was driven primarily by the rise of the manager class whose renumeration grew at the expense of productive workers and normal profits. This growth was made possible by the lower relative fixed assets inflation and continued increases in labor productivity despite a complete reversal in capital intensity by corporations.

The above is also reflected in a more detailed study of income growth in the top income earners based on US tax return data:

Table 7 shows that the share of national income (excluding capital gains) received by the top 0.1 percent of income recipients increased from 2.8 percent in 1979 to 7.3 percent in 2005. Again, the shares received by executives, managers, supervisors, and financial professionals increased markedly, with the increase in the share of income among these occupations accounting for 70 percent of the increase in the share of national income going to the top 0.1 percent of the income distribution between 1979 and 2005. The pattern is similar in Table 7a when we include capital gains.

I ‘m going to take a quick look on the updated figures for Greek GDP 2013Q3:

Greek GDP 2013Q3 volume change

Obviously the lower volume loss is quite significant although it remains a fact that nominal GDP is still contracting at -5.9% (Q2 and Q3) with the lower volume contraction attributed exclusively to deeper deflation (which is now at -2.9%). Nevertheless, Gross Value Added is now dropping at -3.1%, almost half the rate during 2012. Looking into the expenditure breakdown the most obvious observations are:

  • Household consumption is still contracting significantly at -8.1%. The -6.6% change is attributed only to government consumption rising slightly at +0.1%.
  • Gross fixed capital formation is still at around -10/12% with inventories being the driver of the positive growth in GCF during Q3.
  • Exports of goods and services grew substantially (mainly exports of services) although imports also posted a positive sign, probably driven by the much larger tourist visits.

An alternative way to examine the GDP statistics is to calculate the relative contributions of each expenditure category:

Greek GDP 2013Q3 contributions to volume change

What is quite evident from the table above is that any positive contributions are the result only of inventories and the external sector (usually imports). During 2013Q3 household consumption contribution increased to -60% with the other two positive contributions coming from inventories (29.5%) and services exports (mainly tourism, 16.20%) while imports have now turned negative. Contributions of fixed investment and consumption will need to improve significantly in order for a Greek recovery to be sustainable.

Another interesting exercise is to take a look at the GDP deflators by category (nominal – real growth rates):

Greek GDP Deflators 2013Q3

Its is quite evident that especially during Q2/Q3, deflation accelerated significantly with rates close to -3%. Deflation is present in all expenditure categories while it seems that lower prices in exports are driven up to a point by corresponding import prices reductions. It is rather difficult to expect a turnover in the Greek recession without first observing a reversal of the deflationary forces in the major expenditure categories.

Overall, there are some marginally positive signs yet growth is the result of only a few categories (tourism and inventories) while the deepening deflation cannot easily be regarded as welcome news since it usually coincides with larger output gaps.

One recurring statement (usually related with the Euro-Drachma debate) is that the type of currency does not play a role, only the ability to efficiently produce competitive products and the presence of a modern institutional and organizational setting.

This type of reasoning is actually very similar to the ‘New Consensus’ (NC) macroeconomic view. The economy follows a supply-side driven natural growth path, subject to stochastic exogenous shocks which move the economy’s output gap far from zero and create inflationary (or disinflationary pressures). In a New Keynesian model, price and wage rigidities allow the central bank to change the short-term real rate (by changing the short-term nominal rate) which results in a deviation from the natural equilibrium (Wicksellian) rate of interest. This deviation eventually clears the output gap and returns the economy to its predetermined expansion path. The model as a whole contains the neutrality of money property, with inflation determined by monetary policy (that is the rate of interest), and equilibrium values of real variables independent of the money supply. The final characteristic is that the stock of money has no role in the model; it is merely a “residual.”

In essence, the NC world view can be summarized in the words of King (1997):

if one believes that, in the long-run, there is no trade-off between inflation and output then there is no point in using monetary policy to target output. …. [You only have to adhere to] the view that printing money cannot raise long-run productivity growth, in order to believe that inflation rather than output is the only sensible objective of monetary policy in the long-run” (p. 6)

The Keynesian view is quite different and stresses the fact that in reality the economy expansion path is not predetermined by supply-side factors, nor is money neutral. On the contrary:

  • Liquidity preference (see Arestis 2003) is an important issue. Financial assets are not close substitutes nor is credit risk negligible. As a result, relative prices and credit spreads play a decisive role since they determine the net worth of economic players (especially banks) and credit availability. Even the mere ‘creation of money’ by the central bank can have expansionary effects if it is targeted on specific, temporarily illiquid assets (with QE1 targeted on MBS being a strong example) since it expands the supply of ‘safe assets’.
  • Growth is to a large part endogenous while hysterisis effects are significant. The natural rate of growth is driven by demand growth (Thirlwall 1998) which generates hysterisis effects and path-dependence for the economy (Lavoie 2003). The NAIRU (if it exists at all) is closely related to the capital stock (since the elasticity of factor substitution is less than unitary) which suggests that effective demand and its effect on net investment strongly influences long-term employment (Arestis 2007).
  • Economic decisions are governed by genuine uncertainty and not by a known probability distribution, something evident especially in the case of long-term investment projects. Savings equal Investment only ex post and do not ‘drive’ expansion. That would require that while savers increase their preference for liquid assets, investors are more willing to part with liquidity, increase their leverage and hold actual illiquid assets (in the form of fixed investment and higher inventories), which is actually only possible if future profitability is increased and spare capacity is no longer available.

Even in the neoclassical tradition, post-2008 thinking acknowledges that monetary policy can have significant short and long-term effects on growth:

  • Long-term rates (which are relevant for investment) are not always closely linked to short-term money market rates, especially in stressed market environments. The central bank therefore needs to use balance sheet policies apart from setting the short-term rate in order to move long-term rate expectations.
  • The natural rate of interest is not known with any significant confidence level and is contingent on economic conditions, preferences and expectations (Federal Reserve 2001).
  • Disinflation (and even worse deflation) starting from already low inflation levels has strong effects on economic growth, since the output-inflation rate tradeoff is non linear (IMF 1998, Fed 1998), something which is highly relevant in the Greek case.

Furthermore, since the ECB target is of close to 2% annual inflation, strong deflationary expectations (which are now present in Greece) can only be considered a failure of its monetary policy. As long as the ECB does not act to correct this problem, it would be hard to suggest that monetary policy does not play a decisive role in the current Greek predicament.

Lastly, in cases of large real exchange rate devaluations (which is the stated target of the Greek adjustment program) the method of devaluation certainly plays a major role. Internal devaluations are usually followed by debt deflation effects with large output and employment losses and significant increases in non-performing loans and the (private and sovereign) debt burden (which is not deflated as are prices and income). External devaluations on the other mostly hurt the external sector claims while resulting in significant changes of the real exchange rate.

The following chart from the sdw facility of ECB shows that Greek deflation dynamics are ongoing and strengthening:

Greek Deflation

Ever since mid-2012 both the core inflation (HICP excluding energy and seasonal food) and the services inflation are in negative territory at an accelerating pace. Current core inflation figures stand at -2% while services at -3.5%. After dropping to -5%, durables goods inflation now reads  -3.5% showing relative signs of stabilization.

In general, core/services inflation rates of (negative) 2-3.5% can only suggest a very wide output gap which is certainly not an indication of imminent return to positive GDP growth rates. Furthermore, recent GDP figures show that nominal GDP/income continues to fall at close to -6% with the improvements in volume statistics being only the result of higher deflation (GDP deflator is now close to -2.5%). These are the typical elements of a debt deflation cycle with real debt burden increasing compared to a falling nominal income which eventually results in an increase of NPLs and debt-to-GDP readings and also to lower economic activity since consumers start to postpone purchases (especially of durable goods) in anticipation of lower future prices.


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Kostas Kalevras

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