Thursday, August 07, 2008

The Irish-Spanish Divergence

According to the preliminary estimate, euro area inflation rose another 0.1%:point in July to 4.1%. It is for that reason that the ECB is unlikely to cut interest rates anytime soon despite many recent signs of weakening real economic growth (Although strong German export data today did contradict that general negative trend).

The first country-specific reports seem to confirm that inflation rose further. In Spain inflation rose 0.2%:points to 5.2% and in Holland, who for long have had the by far lowest rate in the euro area, it rose a full 0.7%:points to 3.0%.

However, in one country, Ireland, inflation fell from 3.9% to 3.6% (using the EU harmonized index). If the preliminary estimate for the euro area holds, this means that Irish inflation will be 0.5% below the average, while in June 2007 Irish inflation was 0.9% above the average.

The fact that Irish inflation falls relative to the rest of Europe when they experience a cyclical downturn is a good illustration of the Balassa-Samuelsson theory at work, whose conclusion is that the relative real exchange rate should correlate positively with economic growth. With fluctuating exchange rates, this would mean a falling nominal exchange rate, but for countries with fixed exchange rates and within monetary unions this would mean lower price inflation. As the relative real interest rate at the same time rises, this will provide a stimulus to increased savings in Ireland and thus help reduce its imbalances.

More puzzling then is why we haven't seen the same thing happening in Spain, at least not so far. Both Ireland and Spain had a housing bubble driven by low interest rates and large-scale immigration that have now turned into a bust, yet the Irish economy seem to cool in a more unambiguous way. One possible explanation lies in the composition of their immigrant populations. In Ireland most immigrants were (apart from returning Irish expatriates) Eastern Europeans, mostly Poles. In Spain by contrast, most immigrants were from North Africa and Latin America (although the number of Romanians in Spain rose sharply in 2007 following Romania's EU entry). High economic growth and a rapidly appreciating currency in Poland means that many Poles have found it worthwhile to return to Poland and many others yet to abstain from leaving the country in the first place, meaning that net emigration from Poland most likely (No recent actual statistics exist yet) have plummeted dramatically, or even stopped completely.

A comparable improvement in economic conditions in North Africa and Latin America haven't occurred, and the economic gap was much more dramatic to begin with, so there net emigration has probably continued. That means that population growth in Spain have probably held up far better than in Ireland, which in turn limits the decline in total economic growth. No figure for recent months exist yet, but in the year to January, population growth was 1.9% in Spain, far higher than in other parts of the EU.

As higher population growth means greater demand for housing, this will also limit the severity of the housing bust. On the other hand, the higher relative inflation this implies will make it more difficult to improve net exports in Spain.


Blogger Jim Driscoll said...

While Spain did experience an influx of immigrants, was it really as massive as the Irish immigration? I was in Ireland last year, and learned that the population had grown by 25% in the last 10 years. Spain, by the wiki search I did, had well under half that, as a percentage.

I mention this because the difference in degree of immigration would make a difference as much as the source countries - in the US, we're experiencing a drastic, rapid outflow of Mexican migrants, despite the fact that they have little to return home to. While the fact that they weren't legal certainly has something to do with that (unlike Ireland, but like much of Spain), it is something that should be accounted for.

Still, I wouldn't have thought of Irish emigration as a difference in the first place without your insight.

Love your blog.

6:58 PM  
Blogger CV said...

Hi Jim,

Yes, it was or the concentration was. Actually, before 2000 (and the EMU entry) Spain was set to become the oldest society on earth. But then, they got 6 million new people in as many years (or close to it that is) and suddenly Japan and Italy are the oldest societies on earth. This has made a huge impact on Spain's growth path only now of course ... there has been a structural break.

Actually, I would differentiate Stefan's poins a bit in the sense that Spain ALSO received a lot of immigrants from Eastern Europe. H'eck, from all over the world actually.

(well, he does mention Romania, so perhaps I am just fisking :)).

The bottom line I think is that the negative interest rate environment coinciding with what was essentially a huge and instant positive supply side shock laid the initial grounds to the Spanish housing boom.

Now this is important I think.

"On the other hand, the higher relative inflation this implies will make it more difficult to improve net exports in Spain."

This is exactly the main headache at the moment in Spain at one and the same time as the whole housing finance market is unravelling.

Another thing would be just what to do with those immigrants? I mean, look at unemployment numbers, and while I think that the prospects of them going back is not necessarily there Spain needs to put them to work. This won't be easy ...

Oh, and now that I am here Stefan. Nice post on the whole GDP discussion. I guess that national accounting often make makes economists complacent but then again, if we can't agree on the headline numbers, what the hell can we agree on?

Incidentally, did you ever get to follow the "dark matter" discussion about the underestimation of the US income balance / overestimation of the negative balance. Try googling it if you did not ... you will have a blast; I am sure :).

Oh, and a very final point ... I DID see that you fish-hooked (or tried to at least) me and Barry Ritzholt on the EUR/USD and Oil inflation story :). Those who stay silent concur (or something), but I am still not ready to concede the point just yet. So do expect a belated rebuttle at some point ...

best wishes


3:00 PM  
Blogger stefankarlsson said...

Claus, I'm still waiting for that rebuttal. Still, If you read this before publishing it, I would actually advice you to wait for another day as recent market developments have made me revise, or more correctly realize that my analysis only holds under a certain context. I'll explain this during a post on this Monday.

11:32 PM  

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