MEAN REVERSION, INTERNAL DEVALUATION FAIL

I've often wondered what the quickest way is of showing people how big the stakes are for Greece; how far we could fall.

So I've come up with a little test. It is based on a very basic understanding of growth theory and is a deliberately simplified model. The assumptions behind it are a) that the basic determinant of steady-state per capita income is the stock of capital (physical, human and social) per employee b) capital is mobile (financial more than human, more than physical, more than social) and will flow from countries less well-placed to embed it into production to ones better placed to do so (some evidence here).

Ergo, a broad-based measure of 'competitiveness' should correlate broadly with per capita income, after adjusting for purchasing power parity. And what do you know, it kind of does, as shown below (source here; similar findings here and here).

So here is the test:

1. Take the WEF Global Competitiveness Report for 2011 or any other broad-based comprehensive ranking of economies that you think is a good proxy for their overall ability to put capital to good use. See below for suggestions.

2. Take a sample of countries with a competitive ranking similar to that of Greece, say the five countries immediately above and below us on this ranking. The reason for benchmarking in this way is that the relationship between 'competitiveness' and GDP per capita, if such a thing exists, will be a very noisy one - anything, from oil bonanzas to debt binges, can disrupt it. You could run a regression analysis to smooth that stuff out of the way, and one of my commentators suggests a lot of other treatments below.

3. Look up their per capita GDP in PPP terms, a measurement of average output adjusted for the cost of living in each country. One reader has pointed out that in measuring export competitiveness the PPP conversion is not necessary; if you agree, you may want to use per capita GDP in 2010 dollars instead.

4. Work out the average of these income figures, including Greece.

5. Assume Greek GDP per capita in PPP terms will eventually revert to the mean unless our competitiveness ranking changes. Specify a time period over which the adjustment will take place. If you can't be bothered to, assume the adjustment is asymptotic (i.e. takes forever). The math gets more complicated but hey.

Work this one out and you get the following table:

GC Rank	Country	GDP per capita @ PPP dollars
78	Guatemala	4,885
79	FYR Macedonia	9,728
80	Rwanda	1,217
81	Egypt	6,354
82	El Salvador	7,430
83	Greece	28,434
84	Trinidad &  Tobago	21,239
85	Philippines	3,737
86	Algeria	6,950
87	Argentina	15,854
88	Albania	7,453
	Average ex GR	8,485
	Average	10,298

This means that, in real terms, Greek per capita GDP may be inflated by about 64% and would have to fall by this much to balance out our competitiveness rating. This ratio persists if you take the 2009 WEF data instead, even though the comparator countries are different. If you use the dollar version of this calculation you will get a 74% drop in per capita output.

Given that Greece is unlikely to experience a surge in either fertility or inward migration, all of this fall in per capita GDP will come from internal devaluation. Happily this won't happen overnight but even if it happens over 50 years it will be a serious drag on growth: some -2% annually compared to the baseline of potential growth (whatever that means).

Another way of looking at this is that it took two percentage points of artificially-generated growth per annum to keep Greece from collapsing under the weight of our own uncompetitiveness. Or that the last time GR GDP was at 36% of the current figures was in the late 1960s (triangulated from here and here).

An even better way of looking at this is to consider the graphic again: 

This suggests that we can try for a linear combination of two paths: try to become as competitive as Canada or Norway, or devalue to income levels below those of Latvia. For reference, 15% of the Latvian population live in homes with no shower, bath or indoor flushing toilet (source). If you go for something in between, you land in the not entirely horrible position of the Czech Republic (where the above percentage was less than half the Greek one, despite the Czechs being poorer on average).

Of course I realise not everything is about external competitiveness as exports only really make up a small part of the Greek economy. That said, the WEF competitiveness ranking measures a number of factors, such as infrastructure,  quality of governance and other forms of social capital which are just as relevant to the domestic economy as they are to exports. Also, with free movement of capital a loss of competitiveness can actually mean that the domestic economy shrinks as investment that would have targeted the domestic market is instead channeled abroad.

I also realise that a lot of the WEF data are survey-based and do not necessarily reflect any fundamental reality. I can't argue with this; if you've got a better bechmark please send it to me. Also, if you don't like the Global Competitiveness measures, another ranking that might work for you would be the Human Development Index, which is less likely to expose you to accusations of neoliberalism. You would have to use a weighted version that ignores GDP otherwise the whole thing becomes too self-referential, but the comparison is still possible.