Are we getting too old?

Reading time: 8 minutes

Did you know that Millennials make up about 27% of the world’s population? Maybe you didn’t but this information comes from a science that we all know and yet often don’t give its due value: Demography. 

Demography is, by definition, the study of statistics such as births, deaths, income, or the incidence of disease, which illustrate the structure of populations. The individuals that study these factors are called demographers. 

In fact, this science led to curious conclusions, like the one at the beginning, but this science is much more and more complex than that. As we will show to you later in this article, demography has a very close link to the economy, as it is with the data collected and treated that, for example, financial, banking, or even insurance institutions establish their rates and conditions.

There are many factors that demography considers, but the most important ones are population size, population density, age structure, fecundity, mortality and sex ratio. All these factors affect the economy: for instance if population size decreases the working-age population will also decrease, which reduces labor input and leads to a slowdown in economic growth, resulting in the end in a decreasing growth rate of GDP per capita.  

Different Countries, different demographics

During the last 20 years, the global demographic landscape has suffered several changes in terms of population, age structure and wealth. Nevertheless, these changes are not linear across the globe, so there are various countries with very different demographic trends due to other variables such as culture and climate.

Demographics in developed countries

Developed countries, such as the United States, Japan, and European Union member countries are generally characterized by their high level of industrialization and high income per capita.   Their population structure is estimated to have already peaked and so, the total population is expected to gradually begin to decline due to low birth rates and rising average age. In fact, it is estimated that in the most developed countries the population over 65 years old will reach 25% of the total population by 2040. In relation to Europe, the projected average age is 47 years, although it is estimated that the people in Greece, Italy and Spain will age faster. Japan and South Korea will reach average ages of 48 and 44, respectively. In these circumstances, a slowdown in productivity is expected, as well as an increase in the GDP share earmarked for pensions and medical care for the elderly.

During the next 20 years, a strong trend of immigration to developed countries is estimated due to their stability, quality of life and economic incentives despite not being able to change the overall structural direction.

Demographics in emerging countries (China, India)

In emerging countries, some Asian countries follow the same trend as European ones, although slower. That is, while European countries have already passed their populational peak, Asia will see its population increase exponentially until 2040 and then gradually decrease. Besides, it is expected that by 2027 India will be the country with the most population, surpassing China.

In terms of their human development evolution from demographic scenario, it is expected drastically improve given the increase in the proportion of working-age adults, greater female participation in the workforce and higher social stability in the most advanced age groups. However, the increase in development is thought to be faster than the increase in income, particularly in China, posing some challenges for governments.

Demographics in Underdeveloped Countries

The reality of developing countries is completely dichotomous from that of developed countries, not only at the economic level, as the former have a very limited level of industrialization and low per capita income, but mainly at the demographically. For example, countries like Sub-Saharan Africa have an infant mortality rate 18 times higher than the average of developed countries, whose infant mortality, on average, is less than 1%. Moreover, other differences strongly affect both birth and death rates, which are quite high, due to weak and limited health services, lack of access to information and contraceptive methods and few professional prospects, resulting in a short average life expectancy.

Developing countries are expected to increase their level of urbanization in the coming years, as their key development factor. In fact, according to the UN Report, the number of urban workers will increase from 1 billion to 2.5 billion in 2040, which suggests a huge boost in the development of these countries. However, the speed of urban growth is not enough to keep up with population growth – like in the case of Sub-Saharan Africa, whose population is expected to double by 2050, so these countries will probably overload their capacity to provide infrastructure and educational systems, necessary to enhance economic growth and human development.

Graph 1 – Historical and projected labor force change per region.

Impact of demography on interest rates, savings and investment

Demography, particularly in aspects such as population ageing, will have a determinant impact on interest rates, bringing attached serious consequences for household savings and investment. Therefore, it is fundamental to take into account how current demographic trends like increasing life expectancy and the decline in fertility rates (with the baby boom generation moving higher up in the demographic pyramid) will impact the savings and investment market.

First, it is crucial to understand how net savers and net borrowers are usually distributed in an economy across different age groups. In accordance with the life cycle model developed by Franco Modigliani, savings are expected to vary across a person´s lifetime in a U-shaped form, suggesting that younger people and the elderly are usually those that actively save the least, whereas the middle-aged are responsible for the biggest share of savings. This is related to the notion of consumption smoothing over a person´s life, making it intuitive that people are more prone to save when they have higher incomes to then use these resources for times in which their incomes are relatively lower (during retirement or in the early years of their careers when their wages are usually lower).

Related to the notion of population dynamics, we can start by exploring how life expectancy will influence the savings market. Considering the case of increasing life expectancy that has been more or less experienced all across the globe in recent years, keeping the retirement age constant, it would imply that people would have to spread out their accumulated resources over the course of their lives over a longer retirement period. This, in turn, will trigger two different scenarios: one in which people anticipate this and increase their savings rate to offset the impact – resulting in a lower interest rate – and another in which they do not adjust their savings accordingly, leading to lower resources in the long-run and a higher interest rate.

On another note, we can also look at the effect of birth rates on savings and investment. Taking into account a reduction in birth rates, we can distinguish two effects. On one hand, it results in lower population growth, consequently contributing towards a lower GDP growth and thus a decrease in demand for investment – pressure for a lower interest rate. On the other hand, it contributes towards a higher number of the elderly/middle aged relative to the young; with the elderly usually being associated with lower savings rate but higher accumulation of capital, this will make it so two contrasting forces will clash, with the lower savings rate contributing towards a higher interest rate but a higher volume of accumulated savings/capital having the opposite effect. As for the fact that the middle aged are also to occupy a much more preponderant role in the population composition, as the savers of the economy, they will contribute to a higher demand for financial securities, hence pushing interest rates downwards.

With so many forces at play, the overall impact of demographics on the investment/savings market is rather unclear, even though all seems to point out that the current downward pressure on interest rates that has been felt in the past decades/years in developed (and ageing…) economies is likely here to stay, probably being itself already a manifestation of the impact of demographic trends on this facet of the economy.

Graph 2 – Historical and projected population aged 15-64 and Household savings rate

Can productivity save the weak demographics in developed countries?

Increases in productivity can lessen the impact of such population shifts, and technological advances are the ideal source of productivity boosts. This, however, is a double-edged sword. On one hand, technological progress increases productivity, but at the same time, it can eliminate jobs, increasing unemployment.

Since the 2008 financial crisis, year-on-year productivity growth has slowed. Still, even though the rate of productivity growth has slowed, the absolute output per worker is now the highest it has ever been in real economic terms. This highlights the offset of productivity on demographics as there are fewer and fewer people in the workforce but a higher productivity per worker.

Conclusion

Demographics do not determine the fate of economic growth, but they are certainly a key determinant for an economy’s growth potential. An ageing population coupled with a declining birth rate in the developed world points to a decline in future economic growth.


Sources: Office of the Director of National Intelligence – Global Trends, Harvard Business Review, Caixa Bank Research, Warwick, Fraser Institute.

Diogo Almeida

João Baptista

Sara Robalo

Inês Lindoso

João Correia

Equal, but different: what’s up with inequality?

Reading time: 6 minutes

Concerns about inequality are not a novelty and we see signs of it everywhere. Some billionaires are flying to space while some people scramble for money to make ends meet. We see voices of support for more progressive tax systems and even talks of universal basic income to support the poor, while others claim tax burdens are already too high. Inequality is right in front of us and independently of how big we consider this to be problematic, it is endemic in the developed world.

Ever since the 1980’s there has been an increasing gap between the rich and the poor. The top 10% have been receiving more income compared to the bottom 50% of the population in North America. Without any intervention of the tax system to correct asymmetries, the top 10% in North America in 2020 earned more than the triple of what half of North Americans combined did. The data we present shows inequality has been increasing since the 80s, but in fact, this trend can be observed ever since the post-war period. Yet, albeit less serious, this is also an issue in Western Europe. In this corner of the world we see that, before intervention through the tax system, in 2020 the top 10% received already 1.75 times more than the entire bottom 50%.

Why have income inequalities increased?

Naturally, there is not one simple cause for this phenomenon. Although there might be some appeal to the idea that capital income can benefit the richest and help increase socioeconomic cleavages, it is likely that the current trend of increasing inequality is, at least for now, due to deep differences in labor earnings as well (Piketty 2006, Piketty & Saez 2014). 

 One possibility is that the technological progress of the last decades, in part caused by the introduction of information technologies, increased the demand for highly specialized skills that were then compensated with higher wages. Therefore, high-skilled wages increased at a higher pace than low-skilled wages and so the income gap between highly educated workers and the rest of the population widened. 

 Nevertheless, if we look at the very top incomes such as the top 1% we might consider other factors. Particularly in the US, top executive compensation has been increasing and even though CEOs undoubtedly have highly sought-out skills, they also have the bargaining power that regular workers do not have when negotiating their wage or accepting job offers. Standard economic theory would predict workers receive a wage equal to their marginal product of labor, but companies don’t have benchmarks on which to expect how much a CEO will contribute to their production activities. Consequently, incomplete information can leave some room for top executives to bargain greater wages (Piketty et al., 2014).

Inequality in Portugal 

Although data stops at 2017 and from there onwards we only have extrapolated data, it seems that the Portuguese case has two relevant features. First, compared with the aggregated data for Western Europe, inequalities are greater in Portugal as in the last decade the top 10% received twice the pre-tax national income that accrued to the bottom 50%. 

However, contrarily to the aggregated data observed for the United States and Western Europe, it seems that the trend of increasing inequality in Portugal observed since the 1980s has slowed down, started falling in 2005, and has stabilized in the last decade. Whether this is a short-term phenomenon or not is still uncertain, and it will depend on the policy stance of the government. 

In short, even though a pessimistic account might identify Portugal as having inequality levels above those of Western Europe, the inequality growth spur has been calmed down for now.

Inequalities go far beyond income

It is often the case that we use income to assess inequalities because it is a unidimensional measure that is easy to understand. However, inequalities go way beyond what people receive at the end of the month. Income inequalities are associated with other asymmetries which might be even more concerning. 

Families of high socioeconomic status can often provide more stimulating environments for their children to grow. Consequently, children from disfavored backgrounds might lack resources such as cognitive stimulation and appropriate interaction with family members that are vital at early stages in life where key cognitive and behavioral traits are being developed.

One finding is that children from wealthy families have more cognitive capabilities than their peers in families of lower socioeconomic backgrounds. By age 6 socioeconomic status is already associated with math capabilities, and evidence suggests the school system is not particularly effective at fighting them over time (Heckman, 2006). If any measure needs to be taken, it might be more effective to start at a very young age. The environment in which a child grows during their first years of life has structural influences on their development and consequently on long-term life outcomes. 

Taken from Heckman (2006), using data from Carneiro & Heckman (2003)

How early is very early? As soon as the child is born, the environment is already exerting its effect. Even when kids are 3 years old, we can already see a relationship between socioeconomic status and cognitive capacities being formed. In particular, 3-year-olds from poorer families have worse verbal skills and even though attending kindergarten can help them improve their skills they still fall behind their peers (Becker, 2011). 

Inequalities in family income are also associated with different long term health outcomes. Children born in poorer families tend to have not only poorer health compared to their wealthier peers when they are young, but these differences persist and even widen in magnitude as they become older. In other words, income inequalities might not only be related to differences in health levels but might also be widening the health inequality gap even further (Case, 2002; Heckman 2007).

We can think this might lead to feedback loops, as poor families raise individuals with lower capabilities and worse health, which then makes them weaker in the labor market. As a consequence, they receive lower incomes, and the cycle continues. On the other hand, more affluent families can guarantee a better path to help their children attain higher wages in the future. Hence, it is natural to wonder if higher income inequality now will not be, in itself, a cause of higher income inequality in the future.

So what?

 We have seen that inequality in incomes has been around for the last decades and likely came to stay unless any action is taken. Moreover, even though current debates both in the media and in public society are often about differences in income, it is much more than that. Inequality is a very broad phenomenon, but indeed income inequalities are related with many other differences we observe in society. 

 Yet, we can always ask: why care? This is where no clear answer exists. We all have different preferences and views for what we consider to be tolerable levels of inequality, and so the debate can never be just about economics. Our concerns of equity and fairness must come into play too and the discussion can never be settled through facts alone. The decision of whether we want to stay in the age of inequality or leave it is not only a question of which actions to take, but also on whether there is collective will to take them.


References:

  • Becker, B. (2011). Social disparities in children’s vocabulary in early childhood. Does pre‐school education help to close the gap? 1. The British journal of sociology62(1), 69-88.
  • Heckman, J. J. (2006). Skill formation and the economics of investing in disadvantaged children. Science312(5782), 1900-1902.
  • Heckman, J. J. (2007). The economics, technology, and neuroscience of human capability formation. Proceedings of the national Academy of Sciences104(33), 13250-13255.
  • Heckman, J., & Carneiro, P. (2003). Human Capital Policy. In J. Heckman & A. Krueger (Eds.), Inequality in America: What Role for Human Capital Policies? (pp. 77–240). MIT Press Books, 1.
  • Piketty, T., & Saez, E. (2006). The evolution of top incomes: a historical and international perspective. American economic review96(2), 200-205.
  • Piketty, T., & Saez, E. (2014). Inequality in the long run. Science344(6186), 838-843.
  • Piketty, T., Saez, E., & Stantcheva, S. (2014). Optimal taxation of top labor incomes: A tale of three elasticities. American economic journal: economic policy6(1), 230-71.
  • Case, A., Lubotsky, D., & Paxson, C. (2002). Economic status and health in childhood: The origins of the gradient. American Economic Review92(5), 1308-1334.

Nuno Gomes

The Economic Side of the Russia-Ukraine Crisis

Reading time: 7 minutes

“A Russian invasion to Ukraine seems more and more probable day after day.”

This phrase was initially written as we started to prepare this article. Time ended up confirming the worst. The conflict escalated quickly, and, on the 24th of February, Russia invaded Ukraine. This is one of the worst disputes in Europe since 1945.

In this article, we do not aim at exploring the history and motivations of the conflict. Instead, we focus on the potential economic impact of this crisis for Europe. It is important here to mention that the EU/NATO condemn the Russian military action and are providing military supplies to Ukraine. This way we can understand the motivations behind the sanctions and the importance of the commercial trading patterns between these countries.

Trade Balance

Ukraine and the EU

The EU is Ukraine’s largest trading partner, accounting for more than 40% of its trade in 2019. Total trade between EU and Ukraine reached €43,3 bn in 2019.

Ukraine exports to the EU amounted to €19.1 bn in 2019. The main Ukraine exports are raw materials (iron, steel, mining products, agricultural products), chemical products and machinery. This is a considerable increase of 48,5% since 2016.   The EU exports to Ukraine amounted to over €24.2 bn in 2019. The main EU exports to Ukraine include machinery and transport equipment, chemicals, and manufactured goods. EU exports to Ukraine have been subject to a similar impressive increase since 2016 of 48,8%.

Russia and the EU

In 2020, Russia was the fifth largest partner for EU exports of goods (4.1 %) and the fifth largest partner for EU imports of goods (5.6 %). Among EU Member States, Germany was both the largest importer of goods from and the largest exporter of goods to Russia in 2020. China is the largest Russia trading partner.

Over time the trade balance between Russia and EU has been getting closer to zero due to the decrease in imports from Russia while the exports remained steady. The balance has been always negative but is now closer to zero than ever before.

Figure 1 – EU goods trade balance with Russia from 2010 to 2020. Source: Eurostat

The more meaningful exported commodity from Russia is mineral fuels and mineral oils followed by pearls, iron, and steel. Russia also represents around 40% of Europe’s gas, being the biggest gas supplier, and for 26% of EU’s oil imports, crude oil and coal delivered through a sprawling pipeline network. This is one of the main points giving Russia bargaining power over EU. On the counterpart, the EU is the largest investor in Russia.

The Russian secret weapon

Oil (and gas) are the oil of the gears of today’s economies. No different is the case for the European machine which needs to maintain lubrification amid a period of rising oil and gas prices and rising inflation (partly driven by the increase in the price of these commodities). In addition, it needs to do all of that while attempting to punish a nation, which supplies around 35% of its oil and gas.

Figure 2 – Map of the major existing and proposed Russian natural gas transportation pipelines in Europe. Source: Samuel Bailey 

The networks of oil and gas pipelines from Russia to Europe are extensive. Main pipelines include the Yamal-Europe which travels by land across other countries and into Germany and Nord Stream 1 which crosses the Baltic Sea directly to Germany. As of recently, flows of oil from Russia have been slow. Adding to this, Europe has had a winter with especially weak wind which has made its renewable energy production weaker and its energy reliance on oil and gas bigger. Oil reserves are at low levels, all of which is contributing to higher energy prices. These high energy prices give Mr. Putin an ability to exert significant leverage on Europe with a single turning of the tap.

By its very nature, energy reliance is something that is slow to adjust: it takes time to build more diverse energy infrastructure. And, as it stands now, short-term options which may include obtaining oil and gas from other places such as pipelines from Norway (although infrastructure capacity there seems to be already near the maximum), or from the pipeline in the Adriatic Sea or the pipeline through Turkey. Switching to more usage of coal is also a potential option. The EU also has plans to deal with an oil and gas supply emergency and alleviate some of its impact.

As of the 22nd of February, the approval process of a new pipeline – Nord Stream 2, which has been criticized for contributing to more European energy dependence on Russia – has been halted following the recent actions of Russia with regards to Ukraine.

On the same day, Mr. Putin remarked that Russia planned to continue the supply of oil and gas to the markets without interruptions. Still, this remains as one of the biggest weapons that Putin has in this conflict over the EU.

The EU/NATO Economic sanctions to Russia

As a way to punish Russia from moving forward with the invasion of its neighboring country, and even looking to possibly cause a de-scalation of Russian military actions, EU/NATO applied economic sanctions. 

Figure 3: NATO members

Some of the first measures aimed at putting an immediate stop to the newly installed Nord Stream 2 pipeline, targeting “Russia where it hurts the most” given that it’s a big exporter of energy to the EU. Furthermore, the EU, the UK and the US have gone ahead with blacklisting specific individuals and companies with close ties to the governing. Adding to that, the US have acted upon its threat against Russia’s government debt by blocking the county’s access US capital and financial markets, effectively “cutting it off from western financing”, as per President Biden’s words. 

A second package of sanctions was announced later that included actions on the connection to the US financial system for Russia’s largest financial bank, Sberbank (holds nearly one-third of Russia’s banking sector assets); sanctions on Russia’s second-largest financial institution, VTB Bank (holds nearly one-fifth of Russia’s banking sector assets); similar full-blocking sanctions on Bank Otkritie, Sovcombank OJSC, and Novikombank and dozens of its subsidiaries; New debt and equity restrictions on 13 critical Russian financial entities; Additional full-blocking sanctions on Russian elites and their family members and individuals “who have enriched themselves at the expense of the Russian state”; Two dozen Belarusian individuals and entities were also sanctioned for supporting the attack on Ukraine; Russia’s military and defense ministry restricted from buying nearly all US items and items produced in foreign nations using certain US-origin software, technology, or equipment; Defense, aviation, and maritime technology subject to Russia-wide restrictions aimed at choking off Moscow’s import of tech goods.

Later, a major sanction was applied by excluding a selected group of Russian banks from the SWIFT global payment system. Swift has a total of 291 Russian members that represent 1,5% of the messages sent in the platform. This new sanction was announced together with the blocking of Russia Central Bank assets.

The impact of these sanctions does not stay restricted to Russia. Europe is in the front row of potential losers as a side effect of the sanctions. Most of the losses are tied to the energy dependency of some European countries to Russia. Other commodities that are exported by Russia will also likely see an increase in price. This side-effect is especially important given the rampant inflation in the Eurozone and US, contributing to further price increases and pressuring policy makers.

Moreover, in terms of sanctions covering the banking and financial sector, those with subsidiaries operating on Russian soil and/or with close financial ties would also fare badly under these conditions, with once again Europe as the most affected one, particularly Italy, France and Austria, being the most exposed international lenders to Russia.  

Effect on financial markets

The uncertainty that surrounds the whole conflict is being reflected in all major international financial markets which have been quite volatile in the past weeks, driven by multiple factors including geopolitical risk.

The invasion of Ukraine by Russia caused an initial panic in risk assets, including European and US equities whose main indices started the day down more than 2 or 3%. They ended up recovering intraday, with Nasdaq index closing the day up more than 1%. Also, the day saw a strong dollar (risk-off asset) and a rally in bonds. On the other side we saw the Russian Stock Market index plunging as much as 50% intraday, a weak Rubble and bond spreads exploding up for Russian debt. Commodities also rallied higher, namely oil.

Conclusion

This conflict recalls some of the darkest times in European history which has lived an extended period of peace. The true cost of this conflict goes well beyond the economic cost and is centered mainly around the lives of those fighting in this conflict. The side-effects caused on European countries by the sanctions seem to be the lowest price possible to defend democracy and liberty from those who want to take it from us.


Sources: CNN, European Commission, Politico, Reuters

Scientific revision: Patrícia Cruz

Diogo Almeida

João Baptista

Inês Lindoso

João Correia

Back to the basics: How is inflation measured?

Reading time: 6 minutes

Inflation has been making headlines all around the globe, as prices increase at unprecedent rates. But how is inflation measured? Are the measures presented by policy makers trustworthy?

Inflation has always been a hot topic of discussion – and a particular favourite of central banks all over the world. Indeed, with price stability as one of the core objectives of virtually all central banks across the globe, it comes as no surprise that inflation targeting is seen as the key guiding point for monetary policy.

So, if inflation is such a key determinant of economic activity in the eyes of most central banks, how do they go about measuring it? Multiple measures are generally and simultaneously used, with the most common being undoubtedly the CPI (Consumer Price Index) – used for example by the FED in the US – as well as its EU counterpart, the HICP (Harmonised Index of Consumer Prices), favoured by the ECB.

One may ask to what extent are all these measures able to fully capture the actual inflation that is being felt in the economy, and what role do central banks play in assessing inflation and its respective expectations, seeing as the ultimate decision of when and how to act when it comes to inflation targeting falls entirely upon them.

Figure 1 – Euro Area Annual Inflation and main components. Source: Eurostat

Measuring Inflation – From the CPI to more complex metrics

Most Central Banks stated primary objective is to maintain price stability. In the Euro Area and in the U.S., the European Central Bank and the Board of Governors of the Federal Reserve normally have their eyes set on a long-run target of 2% annual inflation. For Central Banks to keep track of the effect that their monetary policy is having on current inflation they need measures of… well, inflation[1]! Unfortunately, there is not one which is truly accurate or one which could take everything into account, and commonly used measures, such as the CPI (Consumer Price Index), are regularly subject to criticism of their methodologies and their over or under-estimation of inflation, depending on when and who you ask.

The CPI is one of the most mentioned measures of inflation and, generally, consists of, at a first stage, obtaining a set of weights to give to different expenditure items based on the consumption pattern of the average consumer (In the U.S., the U.S. Bureau of Labour Statistics, which publishes the CPI, calculates this based on its Consumption Expenditure Survey). Next, in the case of the U.S., for example, the U.S. Bureau of Labour Statistics obtains data on the prices of over 90,000 goods. Based on the previous weights, the index is then calculated and with it, we should get an idea of how the price of the average consumer’s basket of goods has changed.

Figure 2 – The 8 major groups of the Consumer Price Index

However, there are many pitfalls associated with its interpretation, especially in the context of informing monetary policy. For example, a considerable percentage of consumers’ income is spent on energy consumption. As has become quite apparent recently, these commodities are subject to wild price fluctuations. However, despite being largely caused by factors other than the monetary policy of Central Banks, the recent price increase in energy has reflected strongly on the CPI. To combat this, we may remove energy and food (which may also be quite volatile) items from the CPI and present only the Core CPI.

And we may go even further and say that, in fact, the Core CPI may still be providing a biased estimate of inflation due to large changes in specific items and that, instead, we should look at the Trimmed CPI, which has the top 8% and bottom 8% biggest price increases and decreases chopped off. Others may say that we should look also at the Median CPI which measures the price change of the 50th percentile good on the basket list.

Taking all these different measures into account we can build a better, more complete picture of whether recent inflation measured by headline CPI in the U.S. is simply related to wild swings of a few items due to supply shocks, or whether it is a broad-based, demand-driven phenomenon resulting from expansionary monetary policy.

Beyond the usual metrics – The importance of Inflation Expectations

The focus of Central Banks to meet their inflation targets is highly correlated with inflation expectations. These are simply the rate at which people expect prices to rise in the future. They matter because actual inflation depends, in part, on what we expect it to be. Let’s say that everyone expects prices to rise at a 4% rate over the next year; then, businesses will want to raise prices by at least that amount, and so will want workers to increase their wages. All else equal, if inflation expectations rise by one percentage point, actual inflation will tend to rise by one percentage point as well.

This means that for Central Banks it is important to anchor expectations at their inflation targets. The absence of anchoring, in a period of high inflation, can create a wage-price spiral. This term defines the cause-and-effect relationship between rising wages and rising prices. The wage-price spiral suggests that rising wages increase the demand for goods and cause prices to rise. These price rises will then increase the demand for higher wages and the cycle repeats.

Figure 3 – Household inflation expectations and HICP inflation. Source: ECB

Conclusion

Most of the younger European generations have never experienced high inflation. Still, the inflation rate was not always stable and low. In the ’70s, with deregulation of the international monetary system and two oil shocks, inflation had climbed to values never seen before (around 12% – 13%) only declining in the next decade (80’s). With some fluctuations over the years, this measure has seen a downward trend over the years laying down values between 0.18% in 2016, 1.7% in 2018 and 0.5% in 2020. 

This trend can be changing. In the past months, inflation has been alarmingly increasing, now reaching values that are further away from the usual target, with the EU currently registering around 3.6% inflation rate and the US a concerning 5.4%.

The fact that inflation is rising is not entirely unexpected, as expansionary monetary policies such as the ones that have been conducted for the past year and a half as a response to the COVID-19 pandemic – characterized by massive bond-buying initiatives that provide ample injections of liquidity in the economy and incredibly low interest rates – are usually followed sooner or later by a rise in inflation as demand starts to pick up once again. Coupled with this, the skyrocketing energy prices that come as a natural response to the global energy crisis that we are currently facing have also contributed to pushing this raise in prices even higher.

Nevertheless, even though the inflation values that exclude these energy fluctuations are a bit more promising (EU = 1.8% and US = 4%), they are still off from the recommended ones (especially the US), which indicates that a Central Bank intervention should be imminent, particularly from the FED where the scenario appears to be worse. Still, Central Banks are in-between the sword and the wall. On one side we see rising inflation pressure but, on the other side, there is still an economy that is recovering from the impacts of the pandemic crisis. Nonetheless, it is clear that the current landscape would not be sustainable for long, so it could be said that the Central Banks’ reluctance to act upon it will inevitably have to come to an end in the near future.


[1] Central Banks also often look at measures of inflation expectations to guide their monetary policy.

Sources: EBC, Investopedia, IMF, Trading Economics

Diogo Almeida

João Baptista

Inês Lindoso

João Correia

The Pandora Papers

Reading time: 6 minutes

Tax revenue keeps civilization afloat but not all taxpayers play by the same set of rules. While some wealthy and well-connected people have avoided paying trillions of dollars in taxes, you are left to cover the bill.

            The Pandora Papers are a leak of almost 12 million documents that uncovered hidden wealth, tax avoidance and money laundering by some of the world’s rich and powerful. These include the King of Jordan, the presidents of Ukraine, Ecuador and Kenya, the prime minister of Czech Republic, and more than 130 billionaires from Russia, the United States, Turkey, and other nations. This leak comes years after the well-known Panama Papers.

            This is made possible by tax heavens. These are generally countries or places with low or no corporate taxes that typically limit public disclosure about companies and their owners. Independent countries like Panama, some areas within countries like the U.S. state of Delaware, or territories like the Cayman Islands are examples of such.

Figure 1 – Number of politicians named in the Pandora Papers per country.
Source: Statista

What is offshoring: technicalities and legalities

When investigations such as this come to light, talks about tax evasion or money laundering inevitably lead to discussions about the practice of offshoring and its legalities and technicalities. Offshoring can be succinctly defined as the practice of moving economic activities (be it a company or a bank account, etc.) from the country of origin towards a foreign jurisdiction overseas, separate from the one where the beneficial owner resides. Therefore, in its simplest form, as the name indicates, offshoring is primarily a geographic activity of moving operations from one country to another. However, the legal intricacies and moral aspects that revolve around it make it an activity quite frowned upon in the international community. 

Offshoring offers a number of enticing advantages to those who practice it, such as simpler corporate regulations and possibly lower costs for companies going offshore, as well as better asset and lawsuit protection. Moreover, and perhaps the biggest reason why people choose to move their enterprises and records of less than morally righteous business deals to countries such as Panama or the British Virgin Islands has to do with the tax benefits those countries provide to outsiders, as well as a promise of financial privacy and confidentiality that many appreciate in order to keep their financial transactions under the radar.

Concerning these taxation benefits, most of the so called “Tax Heavens”, terribly appealing to offshoring practices, allow these foreign entities to usufruct from an entirely different fiscal system from the national one, having to pay much less taxes (and in some particular cases none at all) and to collect tax-free capital gains from the operations conducted.

However, and as ludicrous as it may seem, the issue lies in the fact that this practice of moving operations from one country to another mostly to pay less taxes is entirely legal in many cases. In fact, despite all the scandal surrounding the Papers, most of those indicated are not infringing any law – rather they just opt to adhere to a judiciary and fiscal system quite different from the one in their home country. Hence, while tax evasion is illegal, tax avoidance by moving to a different jurisdiction is entirely legal, only not very morally accepted by society.

Why is this practice legal then?

That is a rather difficult question to answer as these offshore tax heavens have existed for many decades and not much seems to have been done to end them, despite all the investigations that have revolved around them in the past few years. In the end, it is very much the issue that many of the power players who could actually have a say in putting a stop to these practices – such as politicians and influential personalities – are also those that benefit the most from it, making it clear that it is really not much in their interest to limit offshoring in the near future.

From the Panama Papers to the Pandora Papers

The Pandora papers are similar to its predecessor, the Panama Papers, in that they both revealed the inner workings of offshore loopholes and shed light on many of the dealings that some high-profile, well-known figures engaged in.

Both the Panama and the Pandora papers consist of millions of files, 2.6 TB and 2.94 TB worth of information, respectively, which included legal and financial documents detailing many of the activities and property purchases of high-profile individuals, including billionaires, politicians, and world-leaders.

The Pandora papers were obtained and compiled by the International Consortium of Investigative Journalists (ICIJ) from a variety of different sources of information: 14 in total. ´

Meanwhile, its predecessor, the Panama Papers, came from a single source: Mossack Fonseca. Mossack Fonseca was a law firm and provider of corporate services, located in Panama (therefore, Panama Papers) that specialized in offshore financial services and that, before the leak, had a very relevant position in the industry. Because of this, it had access to large amounts of documents and files that detailed the activity that went on within the offshore dealings of many individuals. In 2016, a whistle-blower, whose identity is still unknown, leaked many of Mossack Fonseca’s documents to the International Consortium of Investigative Journalists.

While offshore activities are not, by themselves, illegal, they can be used to disguise and hide criminal activities. As a result, with the help of the information detailed in the Panama Papers, crime authorities in many different jurisdictions were able to uncover criminal activity and arrest and prosecute many suspects: In the U.S., the Panama Papers allowed the IRS to uncover several cases of tax evasion through offshore dealings, ultimately leading to the arrest of several people; U.S. authorities also found several cases of fraud. The Canada Revenue Agency also claims to have discovered 35 different cases of tax evasion. In late 2020, Germany issued two international arrest warrants for Juergen Mossack and Ramon Fonseca (the founders of Mossack Fonseca) for their involvements in the criminal activities of Mossack Fonseca, although they are unlikely to be extradited.

However, these types of investigations and legal procedures often take years to culminate in an arrest or a conviction and, so, we can expect that the Panama Papers will continue to aid authorities in investigations for many years to come. That will likely also be the case for the more recent Pandora Papers.

A possible solution – The Global Minimum Tax

A possible solution to tax heavens might be through a global minimum tax. A global deal to ensure big companies pay a minimum tax rate of 15% and make it harder for them to avoid taxation has already been agreed by 136 countries. The global minimum tax rate would apply to overseas profits of multinational firms with 750 million euros ($868 million) in sales globally. Governments could still set whatever local corporate tax rate they want, but if companies pay lower rates in a particular country, their home governments could “top up” their taxes to the 15% minimum, eliminating the advantage of shifting profits. A second track of the overhaul would allow countries where revenues are earned to tax 25% of the largest multinationals’ so-called excess profit – defined as profit in excess of 10% of revenue. Applying a similar version to individuals might just do the trick to combat tax avoidance by wealthy individuals.

 Conclusion

Offshoring allows companies and individuals to take advantage of low or no corporate taxes and limit public disclosure about companies and their owners. These practices are legal, but they pose a fundamental morality question. Offshoring practices provide benefits for the countries being used as the offshoring destination while negatively impacting the ones from which the money is being taken out off. This might create social unrest on these practices as taxpayers feel like not all citizens/companies are paying their fair share.


Sources: DW, Forbes, ICIJ, The Guardian.

Diogo Almeida

João Baptista

Jonathan Magzal

Inês Lindoso

João Correia

Does Europe have any energy left?

Reading time: 6 minutes

Europe is facing a record-breaking surge in energy prices after coming from historical lows in the second quarter of 2020. A series of market, geographic and political factors are weighting in and creating the perfect conditions for further rises. This not only threatens the post pandemic recovery and the European green transition but will certainly impact households’ income. Data from Eurostat showed that, in Europe, 37% of the total household energy consumption in 2016 was Natural Gas, with Dutch TTF Gas Futures up more than 350% this year. Electricity and petroleum products are also up 70% and 60% year to date. The trend observed in energy prices can have a serious impact on Portuguese households that pay some of the highest energy prices as percentage of income in Europe.

What factors are driving the surge in energy prices?

The Electricity Market

To understand the reasons behind climbing electricity prices it is important to grasp the basis of how the electricity market works in most of Europe. At the first level, we have production of electricity. In this part of the market, producers of electricity and sellers of electricity trade in the wholesale market. For the Iberian Peninsula this market is the MIBEL (Mercado Ibérico de Electricidade). At an intermediate stage, electricity needs to be distributed. Usually, there are single, state-regulated entities which handle the necessary infrastructure for the electricity grid. At a final stage, there is the retail of electricity, where electricity companies sell to final consumers.

The recent rapid rise in electricity price to consumers is mostly due to price increases in the wholesale market. This market is structured in a way where renewable energies are normally firstly supplied given their low costs per unit of electricity produced while sources like natural gas, coal and fuel oil are only supplied after since they are more costly.

The weak wind speeds in most of Europe during 2021 has reduced much of the available energy supply in renewables, making the price jump to higher levels of the supply schedule. In addition, the extra demand for natural gas, coal, and fuel, has raised the prices of these commodities considerably, leading to a further increase in the cost of producing electricity with these resources.

Germany, for instance, which is phasing out its nuclear power plants until 2022, has had to rely more on energy production using coal, whose price has greatly increased. In addition, the price of carbon emission allowances in Europe (EUA – EU Allowances) has also greatly increased. The need for burning fossil fuels and the increase in the cut of supply per year, dictated in July by the European Comission, have ratched up the demand for these allowances.

Natural Gas has also seen a surge in price due to high demand as industrial production surges. The price was also ramped up by natural disasters and geopolitical factors with Russia State-owned company Gazprom withdrawing some of its gas reserves located in the EU.     

Installing new renewable energy capacity can grasp as a possible solution yet it is unlikely to be an effective strategy to combat high energy prices in the short-run since it requires time to implement.

Figure 1 – European electricity markets price per MWh. Source: AleaSoft

The Oil Market

When it comes to what is undoubtedly the most used fossil fuel around the world, oil prices have been accompanying the increasing price trend that almost all energy sources have been experiencing all over the world lately. In oil’s specific case, this phenomenon can be clearly explained by the demand and supply forces/dynamics at play.  

On the consumer’s side of the equation, demand has been gradually growing after many months of stagnation during covid lockdowns in most countries. Indeed, with the recent lift of COVID restrictions, particularly in the US and the EU, there has been a boost in consumer’s demand for petrol fuel. Nevertheless, consumption levels are still significantly behind pre pandemic levels, with major oil-dependent industries such as air travel still slowly recovering.  

Combined with this scenario, on the supply side, OPEC+ producers have yet to improve much from the huge supply cut that was agreed upon last year to face off the drastic reduction in demand. Therefore, supply levels are still far below what would be the optimal level to respond to the current boost in demand, contributing henceforth to a spike in prices. Whether this restriction comes mostly from a strategic viewpoint so as to keep prices high, from recent disputes in OPEC+ meetings which have led to impasses in defining the quantity to be supplied by each member or to the impossibility of raising production due to underinvestment issues in countries like Nigeria and Angola is not entirely clear – most likely, it’s a combination of all of those three. Nonetheless, there is no doubt that this has greatly contributed to market instability and uncertainty, adding to the already high pressure on prices.

  Figure 2 – Brent Crude Oil Prices. Source: DailyFX

How do Portuguese Energy Prices compare with the EU?

Even though energy prices of EU countries differ from one another due to specific factors such as geographic location, taxation, network charges, environmental protection cost or severe weather conditions, the recent surge in prices was seen across all Europe. This surge was mainly driven by an increase in price of the raw commodity, which affects rather similarly all EU countries.

Analyzing the electricity price in EU over the last 10 years we can observe a general growth trend. In Portugal its price has increased 13%, with the UK having the most significant increase of 39%. On the opposite side there is Hungary that saw electricity prices fall 34% during this period.

In 2020, Portugal occupied the 14th place in terms of electricity prices without accounting for taxes and charges, below the EU-27 average. However, accounting for taxes and charges takes Portugal to the 8th place, barely below the European average. For Portuguese households, the taxes and charges on their energy bills accounts for almost half of the final price.

    Figure 3 – Electricity prices for domestic customers. Source: EDP

In the gasoline market the story is similar. In 2021, 60% of the price of gasoline is coming from taxes. This places Portugal among the top six for EU countries in terms of absolute value of taxes per liter.

The increase in the commodities’ price directly affects the living standards of the Portuguese population. As seen before, the prices practiced in Portugal are in line with the EU-27 average, yet one important factor is that the Portuguese purchasing power is below the European average. If we compare electricity prices with purchase power, Portugal has the 5th highest price in EU.

Conclusion

Despite the impressive surge in energy prices, it may just be the beginnings of a bigger move. The interactions between supply and demand, and the geopolitical factors may continue to have an imperative roll on the development of these prices in Europe. Also, Central Banks policies can also impact the dynamics seen in the energy markets. A weaker Euro will mean higher commodities prices, ceteris paribus.

The current prices of these commodities are already significant when compared to Portuguese households’ income and a persistence in this trend in prices may strain their budgets. Not only, but also Portuguese companies will suffer from the increase in costs and the consequent reduction in margins. This fact can be especially important given the predominance of low added value sectors in the Portuguese economy.


Sources: Busines, EDP, Markets Insider, Reuters

Diogo Almeida

João Baptista

Inês Lindoso

João Correia

Crisis after crisis, a short story of Argentina’s economy

Reading time: 7 minutes

Argentina seems to be constantly in a crisis and COVID-19 has not improved that record. Nonetheless, the untapped potential of the country remains there.

There are many countries which owe their success to their abundance of natural resources or geographic characteristics. However, there are also many which, despite all their natural fortunes, seem to be unable to fulfil their potential. There should not be a lot of countries embodying this reality as well as Argentina. The country is blessed with hundreds of thousands of square miles of extraordinarily fertile lands, as well as oil and natural gas reserves. Besides this, the country also has sizeable mining reserves of copper, aluminium, zinc and lithium. There is an old saying amongst economists that “throughout history, there have been only four kinds of economies in the world: advanced, developing, Japan and Argentina”, and, although Japan is no longer the bustling economy it once was, the South American country still remains very much economically unstable.

Argentina’s Belle Époque

Figure 1 – Streets of Buenos Aires in the early 20th century

Albeit struggling, Argentina has not always been economically troubled. In fact, in the late 19th and early 20th centuries the country was quite prosperous. This period was an era of rapid economic growth with large inflows of capital and labour from overseas, as a result of the expansion of the agricultural frontier, fueled by a surge in the world demand for commodities, particularly, cattle meat. This led to the country entering the 20th century as one of the wealthiest places on Earth. In 1913, the country’s GDP per capita was larger than France or Germany and was almost as large as that of Canada. However, it must be said it was also a very unequal society.

A story of economic instability

In spite of the expansion, as it often happens with commodity dependent economies, the boom was not to last and, by 1913, fortunes were already changing, starting with a major downturn that emerged in the London capital market and that spilled over to Argentina. The next year, WWI started, greatly constraining capital and goods markets, leading to a major recession.

Some years later, in 1929, the world was hit by the Great Depression, which led to further instability in external markets. Surprisingly, though, it was a shock that had a relatively mild effect on Argentina, when compared to the US, with unemployment never going above 10%. From 1929 to 1932, the country’s real domestic output “only” fell by 14% and, by 1935, it had already surpassed its 1929 level. Nonetheless, the Great Depression has ultimately led to a halt in the country’s relative prosperity, as it culminated in a military junta taking power in 1930, which would be a recurring theme throughout the 20th century. Throughout the 1930s and WWII, the economy would continue to be sluggish.

This increased instability eventually resulted in Juan Perón – a military general whose ideas still influence Argentinian politics to this day – taking power in 1946. His tenure was marked by flirtations with fascism, combined with the idea of self-reliance and import substitution of industrial goods. Nevertheless, even though the economy continued to grow, this growth was slower than that overall registered across the world and the quality of life of the average population declined. In the end, the regime lost popularity and was eventually overthrown.

“Instability” is the word that best describes the rest of the 20th century for Argentina. Throughout this time period, the country experienced constant upheaval, with weak democratic governments and military juntas being overthrown as quickly as they would rise. Needless to say, the country entered in a period of stagnation, only made worse by recurring inflation crises.

Troubles with inflation led Argentina to adopt a fixed exchange regime with a peg to the US dollar in 1992, which was accompanied by increased openness to trade and market reforms. For a short period of time, things seemed to be heading in the right direction, since the peg helped the country stabilize prices and get rid of high inflation, with large capital inflows following.

Unfortunately, the 90s also saw major recessions in Latin American economies that negatively impacted Argentina. Eventually, the country would find itself forced to drop its peg in 2001, leading, once again, to high inflation and to the worst economic crisis in the country’s history. GDP fell by nearly 20% in 4 years, unemployment reached 25%, the peso depreciated by 70% and the government defaulted on its debt. Savings of entire working-lives were wiped out, contributing to a dollarization that is still largely present.

Figure 2 – GDP per capita of Argentina as percentage of US GDP per capita. In the early 20th century, Argentina was close to US levels of GDP per capita, but since then it has only strained further away from the North American nation.

Fortunately, Argentina did recover from 2003 onwards, thanks to expansionary policies and, especially, to a surge in commodity exports and prices, with the economy nearly doubling by 2011. The following years were not as fortunate, though, and, by 2018, the government found itself asking for IMF intervention once more, as it had already done in 2001.

How is the Argentine economy currently doing?

With COVID-19 now impacting the economy as well, Argentina has struggled to recover. During 2020, the country suffered a new series of demand-side shocks, causing an already struggling economy to plummet, in one of the largest retractions in 2020 – GDP declined by 9,9%. The effects were also felt in the labor market, with nearly a third of the country’s workforce unemployed or that has given up on finding work. To counteract the impacts of the crisis, the Government implemented an emergency package, in order to protect the most vulnerable and support companies during lockdown.

Figure 3 – Inflation in Argentina throughout the past 25 years. Recent levels of inflation have been especially high, even surpassing the levels experienced following the break of its currency peg in 2001.

Meanwhile, as inflation nears 40% and its central bank is short on dollars, Argentina faces renewed pressures to devaluate its currency. Furthermore, the $30 billion bail-out that benefited the country in 2018 are part of the total of $44 billion in loans that the country owes to the International Monetary Fund and that President Alberto Fernández and his government are trying to renegotiate.

President Fernández has a chance to implement reforms to create opportunities for renewed investment, job creation and economic growth, but the delicate situation of Argentina implies extensive due diligence by investors to understand the country’s political risk dynamics and outlook.

What are the future preventive measures for the coming years?

As aforementioned, the risks associated with the political and economic outlooks have kept investors’ attentions out of Argentina.  Fernandez’s only chance to return to meaningful growth in the medium-term is to provide investors, both domestic and foreign, with legal and macroeconomic assurance.

One of the key elements to do so is a successful renegotiation of the IMF bailout in 2021. This should set a clear path for the reduction of the fiscal deficit and the gradual removal of major operating constraints on businesses. Among those are liberating the ARS/USD exchange rate, as well as capital and import controls, even if slowly. Deeper changes involving significant tax and labor reforms to improve doing business in the country should also be considered.

Final Remarks

With a history of political and economic instability, Argentina faces, once again, a tumultuous period, as the effect of the pandemic spreads through the economy. But there might be some light at the end of the tunnel. Rising commodities prices may give Argentina some breathing room to survive the devastating effects of the pandemic crisis and the renegotiation of the IMF bailout may be the first step of a series of reforms in public and monetary policy which may bring back the prosperity once seen in early 20th century.


Sources: Bloomberg, El País, Forbes, IMF, History Channel, Wikipedia, World Bank

Rodolfo Carrasquinho

João Diogo Correia

Raquel Novo

Is the Real Estate Market too heated?

Reading time: 6 minutes

Recently, the housing market in the US has been experiencing a major boom quite unlike anything that has been felt in the past 14 years.

According to the National Association of Realtors, demand has been skyrocketing for the past months, with prices hitting all-time highs: median sale prices close to $350,000 and asking prices even higher. This price-frenzy is in large part due to supply being unable to quickly catch up to the unsurmountable demand, with almost 50% of offers under contract just one week after listing. For all involved, this expansion of the real estate business after such a long-lasting stagnation is indeed cause for celebration; however, for those whose memory does not falter, this scenario may seem reminiscent of what the American economy was experiencing prior to the housing bubble burst of mid 2000s that paved the way to the 2008 financial crisis. Thus, this poses the question: are those concerns valid and if so, should we worry that a new crash may be on its way?

What forces have been triggering this spike?

Numerous reasons have been behind the current real estate rally. As we have mentioned, demand has been pressuring a relatively distressed supply in the past months, leading to an increase in prices that is far beyond the levels one would expected in an economic crisis of this dimension.

Starting on the demand side of the equation, experts point out to three different reasons driving this demand mania.

First, by decreasing interest rates as a way to ensure liquidity during 2020, the FED forced mortgage rates to fell considerably during this period, reaching a record low of 2.65% in 2021 (from 3.73% in February 2020). Now, a 1 pp decrease might sound small for non-homebuyers. However, imagine a homebuyer buying a $300.000 house just before the crisis began. In this situation, he would, most likely, be paying up close to $499.000 over a 30-year mortgage agreement. Now, if that buyer had done the same deal in January 2021, he would be paying around $436.000, a discount of more than $60.000 (or 12.5%). This effect has incentivized buyers to look for more expensive houses than before, as it pushed them into the market to lock these mortgage rates before the FED tightens its policies.

Figure 1: 30-year Mortgage Rates in 2020. Source: Freddie Mac

Second, as Millenials are entering the housing market more fearlessly, the largest generation on Earth is now dominating demand, as they are keen to either leave their parents’ or just quit rentals. According to the National Association of Realtors, the median age of first-time homebuyers is now 33, which turns out to be the median age of Millenials. Alongside this, despite some increase in unemployment levels, salaries and overall income were kept stable the past year, as loose fiscal and monetary policies helped mitigate losses in purchasing power.

Combine low interest rates policies with no decreases in disposable income, plus a generation looking to buy their first house, well… you just set up a buying frenzy.

Finally, this pricing boom couldn’t be made possible without a supply shortage. In fact, after several construction companies went bankrupt during the Great Recession, fewer homes were built in the 2010s than in any decade going back to the 1960s. This sluggish construction activity has now been left out in the open in a market where home sellers are seeing double digit offers in the first 24 hours of bidding.

Moreover, with the pandemic causing some uncertainty regarding future paychecks, homeowners have had some reservations regarding the possibility of selling their current house and move to a more expensive one. Besides this, with a contagious disease spreading as fast as COVID-19, people do not want strangers traipsing through their living areas during open houses.

Finally, one recent element causing prices to rise is actually related to its intrinsic cost. Recent commodities shortages have been rising its prices significantly, ultimately increasing building prices and delaying orders. Lumber has been the most recent commodity on the spotlight, with its 3-fold growth in the past year raising housing cost by tens of dollars.

Figure 2: Lumber prices skyrocketed in the past year. Source: Refinitiv

Is history repeating itself?

This resurgence of demand in US real estate and the booming prices currently being practiced have led many to fear that a new crash similar to that of 2007 may be on its way. However, all evidence points out that this current boom is quite the inverse to that of mid 2000s.

For once, the current boom is mostly motivated by an excess of demand over the supply (the reason why prices are being pushed up), whereas prior to the sup-prime crisis the opposite was verified: the market was over-flooding with houses and there were not enough high-rating buyers for them, which led to an opening of the market to low creditworthy buyers (which inevitably was at the root of the problem). Currently, the market is still experiencing a shortage of houses (definitely not enough to meet demand), as construction is still catching up to the slowdown that was prompted by the pandemic.

Moreover, nowadays, the type of buyers is also quite different from that of the previous boom. They are of a higher credit rating and much more willing to put on their own money to buy their house. As a matter of fact, real estate companies are reporting that a lesser amount of the houses is being paid with resort to loans, as customers put more cash up front. This poses a great contrast to the low-credit-rating buyers that dominated the housing market in mid-2000s, most of whom could not afford the houses they were signing contracts to acquire.

Finally, lending rules are much more restrictive, carefully attributing loans only to those with enough credibility to ensure future payments. Back then, risky mortgages were provided to households with a high default risk who had no means of paying for them and only small down payments were required most of the times. Therefore, prior to the financial crisis, the so-called NINJA loans (no income, no jobs, no assets) were the rule, which ended up being the downfall of the market.

All things considered, current circumstances are much different from what was observable in the past.

Is There a Bubble Though? And What Does the Future Hold?

Housing experts claim that the housing market is not yet in a bubble. This is despite home prices being soaring at historical highs across the country. However, some claim that a small price correction can take place.

On the one hand, while the housing market is composed by low inventories, high demand and a risk-averse lending environment, extreme spikes in home prices could result in some prices rolling back soon. Subsequently, in the future, these peaks in prices can disappear as people will return to their normal activities

The future will depend on the pace of new construction, the strength of the economy, the quantity of homeowners willing to sell their houses and overall demand in the market.

When it comes to buyers, people who could afford a home pre-COVID-19, will be, most likely, in good financial positions to buy a home after Covid, as the majority of this people is stable and financially comfortable.

On the contrary, people who lost their job or received low wages, even before the pandemic, could not buy houses, as they usually rent the places they lived in. So, unless there is a recession in the future, the level of demand will, most likely, not change anytime soon, causing housing prices not to decrease as well.


Sources: Better Homes & Gardens, The Wall Street Journal, VOX

Francisco Nunes

Alexandre Bentes

Inês Lindoso

The Hidden Champions of Germany

Reading time: 6 minutes

Germany’s success has been built on its SMEs, but why do they succeed? Will the pandemic put an end to this remarkable journey?

Today, Germany is the 4th largest economy in the world in terms of nominal GDP, enjoying the biggest current account surplus on Earth, in absolute terms, even greater than that of China’s, and a high level of quality of life. It is, therefore, no wonder that it is seen as a role model for aspirating economies to follow. However, unlike many others, the engine of the German economy is not the big multinationals, even though it is home to quite large corporations, such as Siemens, Bosch, Daimler and Allianz. Rather, what allows the German economy to have an edge are its Mittelstand.

The Mittelstand are small- and medium-sized companies, which often only employ up to 500 workers. In fact, while Germany only counts for 28 of the global 500 biggest companies worldwide, in terms of niche markets – the main focus of the Mittlestand strength – the economic giant is most definitely a market leader, accounting for around 48% of these small “hidden champions”. They are given this nickname, because, although the markets in which they operate are not very large and they themselves are not well known, they are the market leaders of these niche fields. Examples of Mittelstand include sausage packaging, cabin pressure control systems for passenger jets, realistic 3D anatomical models, food for ornamental fish and shoe manufacturing machines.

Furthermore, the Mittelstand are normally family businesses which are mostly export-driven, being the main contributor for Germany´s long-standing positive trade balance. These small- and medium-sized firms account for around 99% of the total companies in Germany and employ close to 60% of the total employed workforce of the country. Moreover, these approximate 3.3 million firms are responsible for about 35% of the total country turnover. 

Figure 1 – SME shares 2018 in Germany; Source – Federation of German Industries (BDI – Bundesverband der Deutschen Industrie)

Why the Mittelstand Succeed

First of all, they focus on customer satisfaction, they are committed to establishing a long-lasting relationship with their customers, striving to attend to their wishes and not solely focusing on the profit side of the trade.

Secondly, they invest a lot in state-of-the-art technology, deploying significant resourceson innovation and differentiation. Indeed, data shows that Mittelstand enterprises have five times more patents per employee than large businesses, but that these are also five times less costly. Innovation and efficiency are key to continue leading the market.

Thirdly, they are less focused on immediate and short-run profit, instead opting to think carefully on their business choices, maintaining high equity ratios and sometimes foregoing short-term success for perhaps a lower, but steadier and longer lasting growth. In fact, most prefer not to rely on debt as a means for growth preferring to avoid it and grow more slowly, in a more “sustainable” manner. This aversion to debt may arise due to deep rooted cultural factors, as the word for guilt and debt is the same in German, “schuld”.

Moreover, they also value the workplace, with their workers being a detrimental part of their business. As such, they employ a lot of resources into guaranteeing a healthy working environment, striving to keep their employees motivated and, hence, promoting productivity gains.

Besides, this appreciation of the workforce is also seen in the effort they put into apprenticeship programs, a lot of which are aimed at newly graduates looking for an entry in the job market. In most countries, there are either very qualified college educated workers or very low skilled ones, and not much in between. In Germany, thanks to the close connection between high school education and the Mittelstand, there is a sizable medium-skilled workforce, ideal for complex manufacturing jobs.

Furthermore, in Germany, it is also common for labor unions and workers to have a greater saying in how companies are managed. In fact, large companies with more than 2,000 workers are required to have union representatives on their administrative boards. This shows that, in Germany, there is greater cohesion and connectiveness between workers and management, allowing companies to sometimes take tough decisions, such as reducing salaries in times of crisis without as much unrest, as workers are more aware of the firm’s difficulties.

Finally, the fact that most of these firms are passed down from many generations serves as a guarantee that the future owners were born into the trade and are well aware of the goals of the company, as well as of the structure of their operations, ensuring a great knowledge of the market in question.

Challenges for the Mittelstand

However, as competitive as the Mittelstand are, they also face a myriad of challenges. The pandemic, in particular, is pushing these hidden giants to the brink. Here are some of them:

The Mittelstand do not have as much bargaining power with their suppliers as their larger, publicly listed rivals may have, which may lead to lower profit margins.

Secondly, due to increasing globalization and freedom of exchange of goods and services between countries, the Mittelstand are facing growing international competition, especially as China transitions its economy to the production of more added-value goods.

An ageing German population is also a cause for concern, as this will mean fewer consumers for the internal market and a smaller labor force from which to recruit young and talented workers, which may reduce the total production capacity of the Mittelstand and also stifle the fervorous innovation these companies need to stay on top. German companies are actually already facing shortages of skilled labor.   

Sometimes, the family business characteristic can also be a disadvantage, as it may lead to problems of succession or even disputes among future potential heirs of the business.

The Mittelstand face a growing challenge regarding the digitalization of the economy too, and increasingly important technologies, such as AI and Big Data, have not yet been adopted at a wide range. Overall, there is still much to be done if these companies want to stay on top when the Industry 4.0 takes flight.

Nonetheless, all the challenges referenced so far have been ones that the Mittelstand had been facing even before Covid. As suggested before, however, the pandemic is bringing a new array of challenges.

Figure 2 – Top issues of business associations; Source: IfM Bonn 2020

Among them, lack of liquidity has been of particular concern, as business activity has greatly fallen and, unfortunately, due to the slow resolution of the pandemic, businesses have not recovered much. Although lay-off programs and other support measures from the German government have mitigated some of these problems, the fact is that they are no full replacement for normal business activity.

Due to the spread of the virus, companies have also been forced to shut down their facilities, which has caused halts to their production. Some firms have been able to cope with this shutdowns better than others, though, as industries that mainly rely on the so-called “white collar” workers have been able to maintain part of their activity through remote working models. Models that have also come with their fair share of challenges with regards to adaptation one must admit, but still these companies have performed better than the many that rely on blue collar workers.

Finally, the Mittelstand have also had to cope with pressure on their supply chains, as these too have been subject to restrictions, therefore causing delays and problems in terms of acquisition of inputs and for the export of products. Going forward, many of these firms are rethinking their supply chains by possibly decreasing their reliance on overseas suppliers and switching to more local networks to a greater degree than before.

Final Remarks

Although the large German corporations may catch everyone’s eye, Germany’s success lays in the giants one does not see. The Mittelstand focus their attention on niche markets, too small for the big companies to get involved in, but too complex for the average smaller company. Their achievements are the result of many factors, but the challenges they face are equally as many. Nevertheless, one ought not to bet against them not coming out on top of those.


Sources: BBC, BDI, Entrepreneurial Living, Financial Times, IfM Bonn, McKinsey and Company, Harvard Business Review, PwC Reuters, The Economist

Rodolfo Carrasquinho

Inês Lindoso

Jorge Lousada

Economic and societal effects of military conscription

Every once in a while, there comes a time when the debate of whether we should bring back obligatory military service resurfaces in the mainstream societal discourse. However, opinions aside, what are the economic and societal effects of a conscription system?

Following the end of the Second World War, the number of countries that implement conscription (also referred to as the draft, or obligatory military service) has declined considerably. While most OECD countries have transitioned to all-volunteer militaries, many countries still have active conscription programs. In Europe, for instance, countries like Greece, Denmark, Austria, Lithuania, and Switzerland have some degree of mandatory service for males. Even as recently as 2017, Sweden reintroduced conscription due to fears caused by the Russian annexation of Crimea and its military exercises conducted at the border of Baltic states.

Figure 1 – Distribution of countries that still have some sort of conscription system; Source: Pew Research Center

Although the effect of geopolitical threats on reintroduction/continuation of conscription regimes in Europe is an interesting topic, we would like to take a broader look at some of the economic and societal consequences of obligatory service and discuss some of its advantages and disadvantages.

The true costs

 Proponents of conscription argue that a draft lowers personnel costs considerably, when comparing with an all-volunteer military. While it is true that the budgetary costs of conscription-based militaries are lower, this ignores all the economic costs that are imposed by this regime.

 In fact, the economic costs of drafting an individual will be equal to the value of his foregone production, were he not drafted, in addition to any disutility that may be caused to him by his service. These economic costs can be sizeable and even exceed the budgetary costs of a conscription-manned military. According to a paper that analysed the now-extinct Belgian draft, the authors estimated economic costs to be at least double the budgetary costs.

 In general, manning a country’s armed forces with conscription amounts to front-loading much of the costs onto the conscripts, as opposed to spreading costs more evenly and equitably through taxes, as it is done with an all-volunteer military. Furthermore, the artificially lowered price of draftees’ labour can lead to an inefficient organization of the armed forces, due to unduly high labour-to-capital ratios. These high ratios can manifest themselves as excessively manned army-units, for example.

Effects on human capital

We should also keep in mind that the economic costs that we previously mentioned were merely static (relating only to the time an individual spends in obligatory service). There are also dynamic effects caused by the draft (which relate to effects on periods after the draft). This is because drafting occurs at a very specific period of the lives of individuals (18-26 years of age) when they are making decisions about their education and when they begin to accumulate work experience. In essence, drafting coincides with a crucial period for the accumulation of human capital, which will have ramifications for the rest of the individual’s life. Therefore, conscription can have a negative dynamic effect on society in so far as it jeopardizes individuals’ accumulation of human capital.

 This is where advocates of the draft may argue that conscription, in fact, allows conscripts to accumulate valuable human capital due to the development of soft skills, such as team-work or personal discipline during their service. This argument has some merit. Indeed, a paper that studied the effect of the Portuguese peacetime draft found a positive impact of 4-5% on wages of conscripted men with only primary education.

 Furthermore, Israel’s military became a catalyst for the creation of specialized start-ups in fields like cyber-security, since it allows for the development of important technical skills and serves as a networking place, important for the creation of these new companies.

 Both examples illustrate the potential for the military to be a place for the accumulation of human capital by its service members.

 It is true that the military, as in the case of Israel, can be a good place for the acquisition of specialized skillsets that allow individuals to be more productive and innovative. It is also true that conscription can benefit low-education individuals by providing them with opportunities to accumulate human capital that they might not have access to otherwise.

 However, most conscripts never reach a level of specialization close to the one that is needed to create a start-up like the ones in the Israeli example. Furthermore, as economic activities evolve, and the jobs associated with them become more complex, educational requirements become longer and harder to achieve. This means that, going forward, the potential benefits of conscription will increasingly be overshadowed by the value of the education/experience that conscripts are forced to forego, and which they need to stay competitive in an ever more educated world.

 Also worth mentioning is a Dutch study that took advantage of a change in the drafting age of young men, which had the effect of exempting an entire birth cohort from obligatory military service in the Netherlands. The authors found that the draft had negative effects on individuals’ educational attainment and earnings.

 Contrary to the findings of this previous study, an interesting effect that the draft can have on educational choices and attainment is reported by a paper that analyses the effects of Germany’s re-introduction of conscription in 1937. The authors found a positive impact of conscription on the probability of individuals getting a college degree. The authors argue that this is likely due to draft-avoidance behaviour. Indeed, it was possible for young men to enrol in college in Germany, as a temporary safe-haven from the draft. After finishing their degree, the now-older men would be much less likely to be drafted. These types of effects of conscription on educational demand have also been documented in the United States and France.

Conscription does not reduce conflict

Supporters of the draft may also argue that an army manned by conscripts will decrease unnecessary belligerent behaviours by states, as this would impose casualties on all groups of society. However, this argument is empirically unsubstantiated. As Poutvaraa and Vagener, in their analysis of the economics and politics of conscription, put it:

Between 1800 and 1945, basically all wars in Europe were fought with conscript armies, and democratic countries like the U.S. and France even later used conscript military in unpopular colonial wars in Vietnam and Algeria.

Figure 2 – U.S. congressman drawing the first capsule for the Selective Service draft, during the Vietnam War, Dec 1, 1969; Source: Wikipedia

Final Remarks

There are many more economic and political dynamics related to this topic that could be discussed, though at the expense of making the article too long. However, we can say with some confidence that, all in all, peacetime conscription has a negative effect on economic performance in countries, and that this effect will, most likely, become more pronounced as time goes on.


Sources: Bloomberg, Bauer, Paloyo & Schmidt (2014), Card & Cardoso (2012), Financial Times, Hubers and Webbink (2015), Keller, Poutvara & Wagner (2006) Meyersmans & Kerstens (1991), Poutvaara & Wagener (2007).


Rodolfo Carrasquinho

João Baptista

Raquel Novo

Alexandre Bentes