20/8/2012: Hungary - a country that can't?..

An interesting blogpost by Professor Steve Hanke on Hungarian economy's adventures in the crisis land.

Here's another look at Hungary (all data is via IMF WEO). Green boxes show ranges of values required for Hungary to effectively converge in economic development with top EU12 states and those that are consistent with long-term sustainability of public finances.

Fron the first chart it is clear that Hungary did well during the period from 1997 through 2006 in terms of real economic growth, but severely underperformed in terms of external balances. In fact, for the period 1995-2017 (incorporating IMF latest forecasts) Hungary operates within its means (in terms of current account balance) in only 4 years.

While current account deficit remained steady at worse than -7.0% of GDP in 1998-2008, little of this relates to investment supports. In fact, current account deficits vastly exceed the portion of the economic investment not financed by savings.

Per chart above, it is also clear that Hungarian investment has declined precipitously, as a share of GDP, from the peak 27.65% in 1998 to 23.54% in 2008 and fell to around 18% from 2012 on. Meanwhile, savings too trended down over the period 1995 through 2017. The economy is becoming less and less capable of generating investment-driven growth (and that is ignoring the issues of credit supply in the banking system etc).

Hungary's Government debt was relatively benign, compared to many european counterparts during the period of 1997-2006. However, the metric used (debt around 60% of GDP) ignores the reality of an economy that is still in catching up with the more advanced European states (including some post-transition economies, such as Czech Republic and Slovenia) in terms of income per capita and other macroeconomic parameters. Such catching up can only be aided by lower debt to GDP ratios and more investment.

In line with external deficits highlighted above, Hungary has run some extremely severe imbalances on both structural government deficit and net government borrowing (ordinary deficit) sides, as shown in the chart below. In terms of government deficit, Hungary was in the red, on average by 3.48% of GDP in the period pre-accession to the EU. Between 2001 and 2007 the deficit averaged massive 6.92% annually, declining to 2.3% of GDP in 2008-2012. The benign level of current deficit (2012 expected deficit of 3% of GDP comes on top of surplus of 3.96% in 2011) is only highlighting the fact that short-term corrections are no substitute for longer-term prudence. Between 1995 and 2012, Hungarian Government was operating within 3% deficit criterion for only 2 years.

Cumulated, the twin current and government deficits from 2000 on through 2012 are severe:

All of this suggests that Hungary suffers (at 80.45% of GDP in 2011) from a classic debt overhang problem exacerbated by the long-term poor performing fiscal deficits and current account dynamics. That these effects should be felt even at the level of debt traditionally considered to be relatively benign (Hungary's 5-year average Government debt through 2012 stands at 78% of GDP compared to 62% for the 5 year period between 2003 and 2007) is probably best explained by the country relatively lower ability to sustain even these levels of debt.

26/02/2012: What happens when debt is too high and taxes are distortionary?

An interesting paper: Public Debt, Distortionary Taxation, and Monetary Policy by Alessandro Piergallini and Giorgio Rodano from February 7, 2012 (CEIS WorkingPaper No. 220 ).

In traditional literature, starting with Leeper’s (1991):

• if fiscal policy is passive (so that it simply focuses on a guaranteed / constitutionally or legislatively mandated public debt stabilization irrespectively of the inflation path), 
• then monetary policy can independently be set to focus solely on inflation targeting (ECB) ignoring real economy objectives, such as, for example, unemployment and growth targeting. 

The twin separate objectives of fiscal and monetary policy can be delivered by following the Taylor principle. This means if the monetary authorities observe an upward rise in inflation, they can hike nominal interest rates by greater proportion than the rise in inflation. This is feasible, because in the traditional setting, fiscal policy objective of sustaining public debt at stable levels can be achieved - in theory - by raising non-distortionary taxes that are not linked to inflation (for example, distortionary VAT and sales taxes yield revenues that are linked to inflation, so monetary policy to reduce inflation will lead to reduced economic activity and reduced revenues for the Government at the same time; in contrast, non-distortionary lump sum taxes yield fixed revenue no matter what income or price level applies, so that anti-inflationary increase in the interest rates is not going to have any impact on tax revenue).

Of course, if fiscal policy is active (does not focus on debt stabilization), monetary policy under Taylor rule should be passive (so interest rates hikes should of smaller percentage than inflationary spike). Such passive monetary policy will allow Governments to inflate their tax revenues without raising rates of distortionary taxation and

In many real world environments Governments, however, can only finance public expenditures by levying distortionary taxes (progressive taxation). So in this environment, the question is - what happens to the 'passive fiscal - active monetary' policies mix? According to Piergallini and Rodano, "It is demonstrated that households’ market participation constraints and Laffer-type effects can render passive fiscal policies unfeasible. For any given target inflation rate, there exists a threshold level of public debt beyond which monetary policy independence is no longer possible. In such circumstances, the dynamics of public debt can be controlled only by means of higher inflation tax revenues: inflation dynamics in line with the fiscal theory of the price level must take place in order for macroeconomic stability to be guaranteed. Otherwise, to preserve inflation control around the steady state by following the Taylor principle, monetary policy must target a higher inflation rate."

Ok, what does this mean? It means that if you want passive rules (public debt targeting - e.g. fiscal compact EU is trying to legislate) you need inflation (to transfer funds to the Government from the private individuals and companies).

Per authors: "The analytical results derived in this paper give theoretical support to the argument recently advanced by Cochrane (2011) and Davig, Leeper and Walker (2011) that the large fiscal deficits decided by governments to offset the crisis can lead to the “Laffer limit” beyond which inflation must endogenously jump up according to the fiscal theory of the price level."

Now, we often hear the arguments that in the near term there will be no inflation as slow growth will prevent prices from rising. Sure, folks. Good luck with that.