The Bermuda economy has been mired in a depression now for six years, with its levels of demand and output still far below its peak seen in 2008. There is growing concern among many that the Bermuda economy could suddenly decline from the simultaneous threat of a weakening and slowing global economy, a lack of true domestic reforms and the untimely move to more fiscal constraint.

Over the longer term, whether Bermuda can overcome its economic difficulties and grow again depends crucially on whether the Government and private sector can effectively reform the fundamental structure of the economy that attracts foreign investment and the establishment of new businesses. However, in the short run, any restructuring is likely set to marginally add to some economic pressure and deflationary forces. In other words, Bermuda is caught between a rock and a hard place, with very limited room to manoeuvre for policymakers. The outlook for the economy looks rather stagnant overall but at least not excessively negative. The bottom continues to be carved out but growth is not assured.

STRUCTURAL ISSUES

Bermuda has seen its annual real GDP growth decrease over time from around 5 per cent in the 1990s to 2.5 per cent in the 2000s to a depressing average of negative 3.5 per cent from 2008-2013 (official figures for 2014 have not been published yet). The sharp reduction in the Island’s structural growth has been mainly the result of what we have discussed many times in the past: the reduction in the population and associated labour force. Weak productivity growth, however, has also contributed to the slowdown on the margin as well. Bermuda’s demographic profile is similar to most Western developed nations and explains a great deal of the economic deceleration and decline. The country’s population growth is estimated to decline at an annualised rate of 0.4 per cent from 2010 based on the Department of Statistics latest report titled “Bermuda’s Population Projections: 2010-2020”. In fact, Bermuda’s fertility rate is estimated to fall to 1.58 children per woman by 2020, far below the desired replacement rate of 2.1. This presents an enormous headwind to growth on the Island.

Productivity in Bermuda has been poor over recent years and has not helped in growth.

There are many reasons to explain the lagging and poor performance of Bermuda’s productivity. Rigidity and excessive labour market protection (although somewhat more relaxed recently), as well as a chronic lack of capital investment in the local Bermuda economy has a lot to do with the labour force’s lagging performance. It also, of course, has to do with a series of economic blunders that hurt the Island such as Madoff and the financial crisis. The other aspect, however, is the growth in the size of Bermuda’s government sector versus the overall economy.

GOVERNMENTS AND GROWTH

There is a clear negative correlation between average real GDP per-capita growth and the size of government across some developed countries. Empirically speaking, the non-existent growth in per-capita GDP in Bermuda over the last decade is partially due to the outsize growth of the Island’s public sector. Bermuda’s government spending as a percentage of GDP has climbed from about 16 per cent of GDP to nearly 20 per cent of GDP since 2000. Its per-capita real GDP has basically rolled over during that same period with little progress.

There is probably not much argument to suggest that the public sector is less efficient and more bureaucratic when compared with the private sector. A larger Government sector tends to incur greater efficiency losses for the economy than a smaller public sector. One key reason is the increased taxation that is imposed on business and households that is necessary to support a big government. Increased government taxation or the “potential threat” born from escalating debt tends to bring about disincentives for private businesses to invest and for labour to work. Needless to say, cutting the size of the government over time is a necessary step in the right direction if Bermuda ultimately wishes to increase its potential growth rate. We do not underestimate the Herculean task that is faced with reforming Bermuda’s public sector. There are numerous vested interest groups that will wage a fierce battle against any efforts to reduce entitlement spending or downsizing of any form. The public-sector unions are not likely to tolerate large cuts in public sector jobs and thus this will restrict and has restricted how fast the government can push through reforms. Extensive austerity also brings the risk of hysteresis and further stagnation.

So if government offers only one aspect, albeit an important one, to reignite the productivity fire for Bermuda, what else is necessary?

INTERNAL DEVALUATION

After enormous balance-sheet recessions, an economy needs to regain competitiveness in order to generate an export boom because its domestic demand often stays muted for years as the private sector de-levers. This is exactly the circumstance Bermuda finds itself in today. To regain competitiveness, the country in crisis must cheapen its currency either through nominal devaluation, where foreign exchange rates drop or via real depreciation, where wages and prices undergo a painful and severe downward adjustment. The end result of either form of devaluation is a much lower cost base and a corresponding increase in the countries level of competitiveness with the export sector and global competitors. This adjustment allows the economy to grow out of its troubles.

For Bermuda, currency devaluation is not easy as we have essentially outsourced our monetary policy to the US Federal Reserve. With our peg to the US dollar, we could only revalue if we underwent devaluation by pegging to a lower ratio. With the dollar’s recent surge in value, the hope for a cheaper currency to make various export industries such as tourism more competitive is sliding away. Lowering the peg or any form of monetary devaluation brings a host of other problems. A weakened currency can negatively affect our economy through rising import prices that burden smaller companies and households. This immediate hike in inflation could more than offset any positives gained by the export sectors. Furthermore, most of Bermuda Government debt is denominated in US dollars and Bermuda dollar devaluation would increase the debt load in local currency and potentially cause an increasing risk of the nation’s ability to pay.

Real devaluation requires wage and price structure deflation to a point where the economy becomes competitive again. On the nominal devaluation front, Bermuda has not really made much progress as well. Inflation on the Island has been extremely sticky but has recently declined due to the fall in energy prices. On the other hand, Bermuda’s nominal wages have actually increased 7.5 per cent since 2009 and are down approximately 2 per cent from their peak in real terms.

Other crisis stricken countries have suffered far in excess of this. Greece, for example, has seen nominal devaluation in wages of nearly 25 per cent so far. Bermuda’s top talent or “C-suite” is not price sensitive but it’s also not scalable or really amendable to significant job growth. You don’t, for example, add another chief financial officer to a growing business but you do add additional actuaries or accountants. The problem, of course, is it makes far greater sense to add an actuary for $75,000 rather than one for $250,000 plus housing allowance.

Thus Bermuda’s high labour costs really limit its ability or attractiveness for middle-class expansion. On the margin, we continue to see most expansion of existing domiciled business outside of Bermuda where there is a much deeper and cheaper labour pool. Thus the growth in “bodies” the Island needs to maintain sustainable economic growth is likely to remain elusive without some form of competitive devaluation.

The problem, of course, with internal devaluation is that it is extremely difficult and leads to further stagnation. The reason why fiscal austerity and/or devaluation does not produce a downward spiral in some cases seen in history is that a country’s export boom offsets much of the fiscal drag. Some countries continue to struggle because they have not been able to restructure their cost base to relaunch a competitive export-led growth cycle that generates foreign investment flows or income. Any strategy where local Bermuda businesses or operations try to make up lost volume with increased prices seems counterproductive to the recovery and is misplaced. What is needed is a focus on efficiency.

Thus we are stuck between a rock and a hard place. Assuming we do not use any form of currency devaluation, it is likely that we need to undergo some form of internal devaluation and government rationalisation to regain competitiveness with all “export” products we offer. But internal devaluation and government constraint makes a recovery difficult and exasperates stagnation. Do we take the pain now or wallow longer?

Nathan Kowalski is chief financial officer of Anchor Investment Management Ltd.