The Atlantic Review recently postulated that there may be little use in the economic classification of countries. Citing the fracturing of BRIC nations and the PIGS investment blocks, blogger Andrew Zvirzdin asks, “How should we classify countries economically? Is there any value in grouping problem areas?” The confusion in the postulation lies not in the grouping of economically distressed countries, but in utilizing those groupings for analysis outside their original intent.
Economists, real money investors, and policy makers tend to think in macro and long-run scenarios, most investment bankers and hedge fund managers do not. The acronyms BRIC and PIGS were not invented for the sake of geographic long-run economic modeling, but for the sake of sovereign risk analysis. Traders, ever eager to capitalize on market fears and uncertainty, developed the acronyms to distinguish trading vs. investment strategies. By shorting weaker credits against strong, traders have been able to profit on a new sort of arbitrage in the government debt markets. These acronyms were never intended for long-run economic modeling but for short term leveraging of opportunities presented by an inability for a market to devalue their currency of choice through monetary easing.
But what of the long-run? As stated in the post, in addition to Ireland, “Portugal, Spain, and Greece are also all facing very different challenges.” I would add Italy to that list as well. An effective PR campaign doesn’t change the fact that Italy is facing real challenges that present debt traders with real temptation.
What of recovery? Which of these five models is best fit to rebound?
Greece
First, a Greek default probably isn’t going to happen. And this is where I take a principled stand against the implications of the Atlantic Review’s post. “The [PIGS] classification overlooks the more important–and legally binding—organizations already in existence, namely the EU and the Eurozone.” The EU made it clear that, although the TEU and the subsequent Lisbon Treaty do not expressly deny a country’s right of secession, Greece would not be allowed to default on it’s debt. So, state sovereignty has been sacrificed to the subsidiarity principle… Since only the Union can save Greece’s membership in the Union, Greece would not be allowed to leave the Union. The traditional Greek motto: Eleftheria i Thanatos, Freedom or Death, has become prophetic indeed. The sovereignty of Greece and her people is dead. The Greek collapse demonstrates that the subsidiarity principle detailed in Protocol 30 to the European Community Treaty was a lie intended to deny nations of their right to sovereign rule. Greece will be propped up, but at the cost of Germany’s superior productivity curve and lower unit labor costs. The reality though, is that by denying Greece the ability to default, and its fiscal policy to fail (thus shedding the non-productive parts of its economy), its own productivity will continue to sap the Union. And, as civil unrest mounts, the Union will have little stomach to cut wages necessary to bring Greece’s productivity in line with Germany’s. Greece will be saved, and talk of Union expansion will soon ensue using Greece as the poster-child. But stagnant productivity will retard real recovery. As long as the non-productive parts of the Greek economy exist, the nation will never rise to her potential.
Portugal
Portugal has its problems that will slow recovery. First, the top income tax is 42% coupled with a 26.5% corporate tax, a value added tax, and property taxes. The state sucks a whopping 37.8% of GDP into its public coffers. Most of that is used to finance legacy entitlements for its aging population and service interest on its national debt. Its government expenditures last year equated approximately 46% of GDP. That would be fine if its expenditures in the public-sector were efficient, but that is hardly the case. Couple that with the low public confidence in the private-sector, the state imposed high non-salary costs of labor, and inflexible labor regulations governing dismissal. The road to recovery will be long without private sector expansion.
Italy
Of the PIGS nations, Italy’s government expenditures are the greatest as a percentage of GDP. At more than 47% it is even worse than Iceland. Italy is burdened with the interest payments due on its national debt, which is the highest of the PIGS at 115% of GDP, relatively the same as the distressed US and lower than Japan’s. However, Italy’s savings rate is abysmal and a sizable portion of Italy’s debt is foreign controlled. 90% of the Japanese debt is owned domestically. Italy is facing a shrinking working population and an exploding entitlement burden promised to the nation’s aging. More than 20% of the population is over 65. Italy’s present is not totally bleak. Its norther regions have scaled back corruption in the investment sector significantly; however, according to Transparency International’s Corruption Perceptions Index investment and economic growth in Italy’s southern-tier is impeded significantly by corruption and organized crime. Economic expansion cannot occur without robust financing of and investment in the private sector. As Italy’s central government is forced to allocate resources on servicing of massive debt and entitlements, it can only hope that the non-municipal bond markets will deliver the investment necessary for small business to drive a rebound. That is precisely the type of arbitrage that hedge fund managers love to take advantage of, but it yields nothing but short term growth.
Spain
Spain’s problems are far from limited to the real estate bubble. With a 43% top income tax, 30% corporate tax, a VAT, property tax, and a sizable capital acquisition tax, foreign direct investment will not be what drives a recovery. Although, to its credit, the abolition of the wealth tax will not hurt its long term recovery. Spain’s public sector expenditures, including transfer payments is relatively high, but manageable at 38.8% of GDP. The recent Spanish Stimulus has yet to yield the promises of the Keynesian model on which it was constructed. Every fiscal expansion must be accompanied by an expansion in either savings or foreign direct investment. Spain’s saving rate is not expected to increase as a result of this stimulus. As such, it must be financed by foreign investment at a higher interest rate. This will in turn be contractionary because it will decrease consumers’ and investors’ confidence and raise, or reinforce, fiscal sustainability concerns. That is the perfect storm for a negative multiplier, the last thing a country seeking recovery needs to deal with.
Ireland
Ireland was left for last for a reason. Ireland has it’s problems. Its national debt is higher than Spain’s as a percentage of GDP at 63.7% and its government spending is roughly 63% of GDP. That combination has led to it’s grouping with the other PIIGS nations by IB arbitrage artists seeking to short sell government bonds. And as in Spain, Ireland’s banks were left highly exposed due to the rapid deflation of the property bubble. Ireland followed the American model of capital injection into the banking industry and nationalization of troubled assets. In doing so, they also consolidated governance of the financial sector into an integrated National Asset Management Agency. The nationalization of the banking industry cemented the already compromised competitiveness of these sectors.
The Irish, however, are all too knowledgeable about how to overcome cyclical economic downturns. After decades of playing the business cycle wrong, after centuries of leveraging the international influence of a colonial state with an emigrant population, Ireland learned what businesses need to thrive. It was that understanding that led to the greatest economic expansion the nation had ever experienced in the 1990s and early 2000s. The prowess of the Celtic Tiger was born on legs of high foreign direct investment, business freedom, and robust protection of property rights (including intellectual property). Today, Ireland is the most well positioned to receive FDI and foreign firms have equal legal protections as domestic firms. There are no regulatory barriers to foreign investment or capital inflows and repatriation of profits is 100% unrestricted. Starting a small business is a clear process, limited liability is preserved, and bankruptcy laws are completely transparent. Chattel rights are guaranteed, the legal system does not discriminate against foreign entities seeking enforcement of intellectual property rights. That courts are business friendly is an understatement. To top it off, Ireland boasts an amazing top corporate tax rate of 12.5%.
Perhaps Ireland’s greatest hindrance to a glorious recovery is the European Union’s trade policy itself. Upon the reluctant ratification of the Lisbon treaty, Ireland accepted increasing agricultural and manufacturing tariffs and forced agricultural and manufacturing subsidies. Regardless, in the case of Ireland, it will not be the Euro that saves the nation, it will not be the European Union, it will be the foreign corporation. The only threat posed in all of Europe to the Celtic Tiger’s resurrection is the flat tax revolution of the Baltic and Caucuses regions of Eastern Europe.
But recover she will. Of all the PIGS states, Ireland is the state most posed for long term economic expansion. She joins the list of other economically liberal nations recognized for long term growth, business cycle recovery, and economic sustainability: New Zealand, Singapore, Hong Kong, and Australia (notice the lack of the US on that list). For those long-run scenario economists, investors, and politicians out there, I present to you the NISHA nations.