Finland's Economic Machine
Today we are headed to Finland, to see how the Economic Machine is working there.
As always, I will be looking at the Economy through “transaction-based” approach, which means at the bottom of everything, an economy is just someone selling something, and someone buying something. That is it.
As in all posts, I will look at 3 main factors to determine how the Economic Machine is working:
(1) Productivity Growth
(2) The Long Term Debt Cycle
(3) The Short Term Debt Cycle.
Let’s get started!
1. Productivity
Finland is a largely industrialized economy, with manufacturing making up much of the activity. Trade is also important, with exports accounting for around ⅓ of GDP. To begin our analysis we first look at Finland’s current GDP Growth Rate, which expanded at 0.20% in the 3rd quarter of 2014.
On average GDP growth rate has been around 0.53% since 1975, with a high around 5% and a low of -6.3%. At current levels we appear to be in a bit of a trough here, and levels typically rebound after low levels. So I would expect levels to rise in the future. But that of course is reliant on further analysis below.
Keep in mind, one of my pinnacle beliefs is that movements in GDP growth are typically due to expansions or contractions in credit. So, to really understand where productivity is going you have to examine the debt cycles.
Recessions/depressions don’t occur because a drop in Productivity, as many economists think. They occur because a drop in demand, and that is largely due to a drop in credit creation.
Additionally, the most important thing to keep in mind is that debt can’t grow forever, because eventually people can no longer afford to service the debt. The debt-service payments grow faster than incomes, and you have defaults. That is how we get cycles.
Lets look at the Long Term Debt cycle to clear up the picture a bit.
2. The Long Term Debt Cycle
Long Term debt cycles typically occur over a period of 50-75 years, and are a result of debts rising faster incomes, until you get to a point where people/countries can no longer afford to service their debts, usually because interest rates are low and can’t go any lower.
We look at the Long Term Debt Cycle because the availability of credit(debt) expands spending beyond income levels. And one person’s spending is another person’s income. So, an increase in credit, increases spending, which increases income levels, which increases spending, which increases demand, which increases production, and as production increases so should income levels.
The above events are what cause the long term debt cycle.
This cycle churns and churns, and the bubble inflates and inflates, and everyone is happy. But this cannot go on forever. Eventually debts grow faster than incomes, and debt service payments become too high and people/countries can’t afford to service that debt. That is when the entire thing comes crashing down, and everything works in reverse.
Knowing where a country is in this process, and where it is likely headed, will give you insights as to how certain assets will perform.
To begin, the below chart shows the Government Debt to GDP in Finland at 57% of GDP in 2013 (most recent data available), which is a moderate level, and somewhat healthy. When debt levels get too high government find themselves in situations where they can no longer afford to service their debt, and thus have to cut back on spending, which pulls down the economy. At these levels we seem to be in an environment where debt levels are falling. The government shouldn’t have any problems paying their future bills with debt at these levels, and can take on more debt to spur economic growth if they wanted. All good signs.
Now, lets talk about something very important, and that is deleveraging is the process of reducing debt burdens when they become too high (i.e., debt and debt service relative to incomes).
Deleveragings typically end via a mix of 1) debt reduction, 2) austerity, 3) redistributions of wealth, and 4) debt monetization.
A depression is the economic contraction phase of a deleveraging. It occurs because the contraction in private sector debt cannot be rectified by the central bank lowering the cost of money. In depressions,
a large number of debtors have obligations to deliver more money than they have to meet their obligations, and
monetary policy is ineffective in reducing debt service costs and stimulating credit growth.
Typically, monetary policy is ineffective in stimulating credit growth either because interest rates can’t be lowered (because interest rates are near 0%) to the point of favorably influencing the economics of spending and capital formation (this produces deflationary deleveragings), or because money growth goes into the purchase of inflation-hedge assets rather than into credit growth, which produces inflationary deleveragings.
Depressions are typically ended by central banks printing money to monetize debt in amounts that offset the deflationary depression effects of debt reductions and austerity.
One could consider Interest Rates in Finland, which are set by the ECB and are currently at 0.05%, which is as low as they can go, except if they go negative, which has happened in some countries recently.
With rates at this level, central bankers have no room to lower rates if needed to increase growth in debt, which ultimately spurs growth in the overall economy. That is a pervading problem throughout much of the developed world these days, and will come to the forefront in the coming years. But at the moment I wouldn’t worry about this too much.
Lets switch to Money Supply (M3) in Finland, which has see some cyclical moves over the last decade, but overall has been steadily rising since 1980.
With an increase in the money supply you will typically see an increase in purchases, increased incomes, increased demand, and fast economic growth. The only worry of this increase in spending and demand is of course inflation.
Currently, the inflation rate in Finland is at 0.50%, which is low and somewhat worrisome as the rate has been falling for decades and could potentially slip into negative territory or deflation. The problem with deflation is that if people want to buy, say, some shoes, but they think that tomorrow the shoes will be cheaper, they will hold off purchasing them today. That thought process ripples through the entire economy, and purchasing comes to a crashing halt and the economy slows considerably.
Deflation could pose a real problem here, and in much of the world, in the coming years. Watch this figure closely!!
As well, one can look at the Sovereign Bond yields to get an expectation of inflation in a market. The 10Y increased to 0.40% in February from 0.35% in January of 2015. The overall trend has been a flight to safety and a crashing of yields in Finland.
The yield on government debt indicates expectations on inflation and debt repayment. Inflation is typically seen as the primary killer of bond portfolios, as higher inflation typically drives interest rates up, and bond prices down. I think what we are seeing here, overall, is that the market does not anticipate inflation becoming a problem in the market, as bond yields have bottomed out.
Now, debt problems typically occur because financial assets are bought at high prices with credit. Let’s look at Finland Stock market to get a general picture of where financial assets are currently.
This chart clearly shows that the stock market in Finland is cyclical. We have been rising in the last couple of years, and are nearing the highs in the short term cycle I believe. This is extremely worrisome to me, as the turn will come at some point, and with such a run up in asset prices I would think we will see a drop sooner rather than later.
Another key indicator is how much the Government is spending, as the Government is one of the most important aspects of the economy. If the government is increasing its spending, that will increase demand, increased demand leads to increased incomes, which leads to more spending, and eventually an increase in prices.
As seen above, Government spending in Finland had been steadily increasing for 40 years, and just saw an enormous spike, which has finally begun to taper a bit. So government spending is falling in Finland and that may slow economic growth.
Now, the top of the long term debt cycle occurs when 1) debt service payments are high and/or 2) monetary policy doesn’t spur credit growth.
With Debt to GDP at good levels, interest rates low, and inflation low and could be leading to deflation, stock prices are high and the government is slowing their spending, there are some problems in Finland. With QE right around the corner I think it would be wise to look for inexpensive opportunities in Europe. Finland might not be one.
Let’s look at the Short Term Debt Cycle to better understand this economy.
3. The Short Term Debt Cycle
Short term debt cycles occur when you have 1) spending growing faster than 2) the capacity to produce, which then leads to 3) increases in prices (inflation), and that continues until 4) spending is slowed by tightening monetary policy, and that is when a recession happens.
Recessions typically arise from a contraction in private sector debt growth, which is typically the results of central banks tightening (increasing rates) to stave off inflation. If we work that backwards we see that increasing inflation will drive central banks to tighten, which will slow private sector debt growth and bring about a recession.
So, to begin, we want to examine the growth rate in Consumer Spending (money and credit) and Government spending, and see if total spending is growing faster than the growth rate of the capacity to produce.
Below is a chart showing Consumer Spending, which has been steadily increasing for a decade now, and recently saw a huge spike. I wonder if this is a peak?
Consumer Credit has also been growing for years, and looks to be plateauing a bit. Watch for a turn downward in this number.
As well, when discussing the short term debt cycle, we have to examine whether total spending is growing faster than the growth rate of the capacity to produce, because that leads to inflation, until spending is curtailed by tighten monetary policy, which brings about a recession.
Lets take a look at Capacity Utilization to get a picture of production. In Finland, levels increased to 78.6% in the 1st quarter of 2015.
Utilization levels have an upper bound of 100%, but never get there. Levels at 82-85% are seen as “TIGHT”, and typically forecast rises in prices or shortage of supply in the near term. Levels below 80% mean there is some slack in the economy, which could lead to recession worries and employment losses.
We can also look at Industrial Production, which decreased 0.90% in December of 2014. Not great for economic growth.
Now, lets pull it all together.
Conclusion:
So the recent growth numbers were ok, but not great, government debt to gdp is at a good level, consumer credit is at a healthy level, and consumer and government spending are strong, so I think that Finland is likely somewhere in the the “Mid-Cycle” - this lasts an average of 2-3 quarters:
economic growth slows substantially
inflation remains low
growth in consumption slows
rate of inventory accumulations declines
interest rates dip
the stock market rate of increase tapers off
the rate of decline in inflation-hedge assets slows.
But heck, I could be totally wrong. What do you think?