Index this!

We are lucky enough to be living in one of those marvellous and rare historical moments in which economists finally get a chance to have real life prove, or disprove, any of a variety of theories and axioms that heretofore had had to equivalate 'true' with 'my peers think I'm right'. That the capital asset pricing model (for which a Nobel was awarded) and various eternal verities of monetarist economics (for which a Nobel was awarded) have already failed to some degree or other to make the cut should serve as a warning... and we'd like to jump on that bandwagon.

The well-respected and much-lauded Harvard economist Dani Rodrik, using a painfully simplistic 15-slide Powerpoint presentation, brought to centre stage at a conference earlier this year the issue of Spain's lack of international competitiveness - coming to the boilerplate conclusion that the only exit from the country's malaise was the tool of internal devaluation, a wholesale and mandated redution in wages and prices. He showed the two accompanying graphs to prove his point. The charts illustrate what is known as the 'real effective exchange rate' - the first calculated using CPI as the deflator and the second, unit labour costs. Aside from the debating trick of placing the one that proves one's point the best last (so often mentioned by Umberto Eco in his rants against Berlusconni's control of Italy's media), the salient points to note are:

1). That they are indexes, referenced to the year 2000;

2). That the source for the information is the IMF.

The first is the problem that makes this 'data' less than acceptably useful. The second will turn out to be the proof of this assertion.

The technique of creating indexes, often called 'normalization', involves the (often arbitrary) act of creating a reference point in which the raw data is said to have a value of 100. This particularly facilitates the comparison of distinct sets having vastly different nominal values. We use it when we construct our mortgage issuance charts. The convenience it offers, however, comes at a cost - that the results up and down the line are very sensitive to the placing of the initial reference point with its assumption that all the data points on that date were equal. This is true to the degree that they probably won't be reliable proxies for real values, but will show trend. In the case of the REER, the IMF assumes that all economies were equally competitive in the year 2000.

To illustrate this effect, we've made up a graph showing the value of the 2009 CPI-based REER for 4 eurozone economies substituting, in turn, every year from 1994 to 2008 as the reference. Arguments that the selection of the year 2000 was not arbitrary, will have to deal with the fact that Eurostat, from whose data this was drawn, uses 1999 as the base year and with the interesting observation that the slightly less than 120 that results from using 2000 as the base corresponds very closely with the IMF figure and both are about 3 points higher than the 1999-based result.

The above may go some distance towards explaining how an economy that is functioning under a 16, or 19, percent exchange rate yoke - at a point in time in which buyers know they can squeeze margins for the last drop of blood - offers up the graph shown on the left.






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Ibex Salad regularly updated features...

• Eurozone Yields & Spreads
• Pending & Recent Spain Bond Issues
• Extra Lettuce - Spain Economic Charts