Readers Question: Is it a good idea for the Baltic states to adopt the Euro before they have met the convergence criteria?

Latvia and Lithuania have a target date of 2013 for joining the Euro. Estonia by Jan 1 2011.

The four main convergence criteria for the joining the Euro are:

• Low inflation
• Low Government borrowing
• Stable Exchange Rate – no devaluations in past 2 years
• Interest rates – close to ECB interest rates
• more details at:  convergence criteria

Problems of Joining Euro before Convergence Criteria are met

Interest rates unsuitable for Economy. Membership of the Euro involves a common interest rate for the whole Eurozone area, but, this interest rate may be unsuitable for countries who have not converged with the Eurozone.

Until 2008, Latvia was the fastest growing economy in Europe, with Real GDP growth touching double figures. This fast rate of growth may require a higher interest rate to prevent inflation. In 2007, Latvian inflation was running at 20%.

Since 2008, Latvia experienced a dramatic decline in output. Latvia’s GDP has declined 20%, with an extra 16% fall suggested. The IMF have suggested a devaluation to help stabilise the economy.

With such a volatile economy, joining the Euro could create significant problems. It would reduce the number of policy options available to Latvia

Also, Latvia has seen a rapid growth in government borrowing. Fears of bankruptcy have caused a credit rating downgrade to BB+. This means that it is more expensive to finance Latvian debt because of the greater risk involved.

It seems the Baltic countries are not just narrowly missing the convergence criteria but are facing a real economic crisis.

Joining the Euro may give an impression of exchange rate stability, but, it wouldn’t solve the underlying economic problems and imbalances. If anything, membership of the Euro would give less flexibility in dealing with its problems.

Also, if Latvia joined it would have implications for the existing Eurozone area.

Related

• Why UK would not benefit from Euro
• Costs of Joining Euro
• Benefits of Joining Euro

Readers Question: Is it possible the phenomenon to have a relationship between GDP and house prices where an increase of the mean GDP to lead to decreased house prices?

Yes,

An interesting phenomena is that UK house prices have shown an increase during 2009 – despite a prolonged recession.

Typically, in a recession, you would expect house prices to fall.
In particular a rise in unemployment often means people can’t afford mortgage payments, therefore, more houses are sold and prices fall. Confidence is also low, deterring people from buying

When the economy is growing and unemployment falling, demand for houses usually rises.

However, economic growth, is not the only factor that determines house prices.

House prices are rising in the middle of this recession because

• There is an acute shortage of houses on the market. Meaning that house prices are being pushed higher because of low supply (rather than rising demand)
• Interest rates are nearly 0%, meaning mortgages interest payments are low. Mortgage defaults have been lower than expected in 2009, because banks have tried to avoid repossesssion and very low interest rates have made mortgage payments easier to meet.
• House prices did fall 25% from their 2007 peak.

Could house prices fall when we have an economic recovery?

It is quite possible to envisage falling house prices during an economic recovery.

• Firstly, the rising prices may encourage many to put their house on the market (which they have been avoiding during past two years)
• Economic recovery will lead to inflation and therefore interest rates could rise from 0% to 5%. This means mortgage payments will rise causing many who just survived to struggle to meet mortgage payments.
• A large increase in supply could reduce prices during economic growth. Though, in the UK’s case a large increase in supply is unlikely to occur in the foreseeable future.

Related

• Why House prices have stopped falling

Fear is a powerful emotion which can have significant economic implications.

Often real fears are ignored in a wave of over-exuberance. See: Economics of herding and irrational exuberance. Sometimes, if people had greater fear of getting into debt and falling asset prices e.t.c, the economy would be less prone to bubbles and the consequent mess. Perhaps fear isn’t the right word. – People just need greater awareness of the potential pitfalls of seemingly one way investment bets.

On the other hand, fear can create a powerful wave of pessimism and negativity which can prolong economic downturns and make it difficult to create an economic recovery.

The fear of future unemployment is a powerful motive which discourages spending and creates a paradox of thrift and liquidity trap.

For example, if people fear being made unemployed, they will be reluctant to spend even if interest rates are cut to 0.5%. This is one reason why interest rate cuts have not worked in creating an economic recovery.

Political Fears and Economic Fears.

Political campaigning is often most successful when focusing on people’s fears. But, politicians may exaggerate certain fears and concentrate on the wrong problem.

For example, there are many problems currently facing the UK Economy.

One of these is the size of the budget deficit. Certainly a budget deficit of £200bn in one fiscal year is no insignificant problem. Yet, the depth of the recession is arguably even more serious.

A report by Fathom Consulting argues that the Conservatives plans to cut spending may cause serious problems for economic growth and push the economy back into recession. (link at Telegraph)

In other words, we need to be concerned about the problem of rising levels of government borrowing, but, we have to keep things in perspective and worry about the biggest problem first. It can be dangerous to fear one problem ignoring other issues.

Another example, is the fear of inflation. When Quantitative easing was announced, some immediately feared future inflation. But, recent money supply figures suggest inflationary pressures are almost non-existent. In other words, it can be dangerous to fear the wrong thing (perhaps a lesson for the ECB)

Related

• The economics of fear

Readers Question: Hi – I hope to explain the fiscal multiplier effect to a bunch of non-economists (business professionals). I’m planning to start with the Keynesian GDP equation and work from there. Where I am stumped is how to represent the effect of a reduction in tax (lump sum or whatever) on the GDP equation.

AD = C+I + G + X – M

The multiplier effect states than an injection (e.g. government spending) into the economy can lead to a bigger final increase on Real GDP. E.g. if Government spending of £1bn led to an increase in real GDP of £1.5bn, the multiplier effect would be 1.5

• A tax cut has no effect on government spending, but, it should effect C and I.
• For example, imagine the government cut VAT from 17.5% to 15%. This has two effects.
• Firstly, if consumers maintain the same spending habits, they will have more disposable income left over to buy more goods. Secondly, they may be encouraged to buy goods (especially expensive electrical goods) e.t.c because they are cheaper.
• Therefore, in theory, a tax cut should boost consumer spending and this leads to an overall rise in AD.
• This means firms will get an increase in orders and sell more goods. This increase in output, will encourage some firms to hire more workers to meet higher demand. Therefore, these workers will now have higher incomes and they will spend more. This is why there is a multiplier effect. Extra spending benefits others in the economy.

The size of the multiplier will depend on what % of the extra income people spend on UK goods.

For example, if people buy imports or save the extra money, the multiplier will be limited.

Monetarists argue the fiscal multiplier will be limited by the crowding out effect. E.g. governments increase AD through higher spending or tax cuts, but, the rise in borrowing leads to a decline in private sector investment. Therefore, there is no overall increase in AD.

However, in a recession, the private sector typically has a glut of non productive savings, therefore, the crowding out effect is limited.

Related

• National Income Multiplier

It’s not been a good week for UK economy. Whilst other major economies look to be exiting their recessions, the UK experienced its 6th quarter of negative growth (UK still in Recession)

Money Supply data gives a rough guide to economic activity. I say rough guide because it can be hard to measure, and often changes in the money supply may be due to different factors such as changes in the way people bank. Another complication is that the Bank of England publish many different versions of the Money Supply; it can be hard to know which one to use.

M4 Money Supply data is published here at the Bank of England

However, one measure of adjusted M4 shows that M4 fell by 0.9pc in September, resulting in an annual fall of 1.7pc . This is the worst figure since comparable statistics began. A sign of the sluggish economic activity

This fall in the Money Supply  has occured despite £160bn of asset purchased by the Bank of England. In theory, creating money to buy illiquid assets should help to boost the Money Supply (see Asset Purchase Scheme and Money Supply) This suggests that the government may need to approve further measures of quantitative easing.

It also suggests that the link between creating money and inflation is complicated.

Related

• Overcoming a Liquidity trap
• Why increasing the money supply creates inflation
• Link between Money Supply and Inflation
• Money Supply data

Readers Question: Why isn’t trade among countries like a game with some winners and some losers?

Often in the political world, trade is seen as a game of tit for tat. e.g. US places tariffs on imports of Chinese chickens, China retaliates by placing tariffs on US cars e.t.c

However, the theory of comparative advantage and free trade suggests, that a country can increase its economic welfare by cutting tariffs – even if these tariff cuts are not reciprocated. In other words cutting tariffs is a win win situation.

The below example shows how reducing import tariffs leads to a net gain in economic welfare for the country (even if others don’t respond by cutting their import tariffs)

Diagram for Trade Creation

• The removal of tariffs leads to lower prices for consumers and an increase in consumer surplus of areas 1 + 2 + 3 + 4
• Imports will increase from Q3-Q2 to Q4-Q1
• The govt will lose tax revenue of area 3
• Domestic firms producing this good will sell less and lose producer surplus equal to area 1
• However overall there will be an increase in economic welfare of 2+4 (1+2+3+4 – (1+3))

However, it is not as simple as this.

There are some losers from free trade.

- Domestic firms protected by tariffs will lose out – these are often politically vocal. They will make more fuss than consumers who benefit from marginally lower prices.

It is true that countries benefit from cutting tariffs, but they would benefit even more if it is part of a mutual tariff reduction, helping to increase exports. Countries may not want to unilaterally cut tariffs, preferring to use them as a bargaining chip in trade negotiations.

Also, free trade can be damaging under certain circumstances. This is especially true for developing countries seeking to diversify their economy.

See:

Disadvantages of Free Trade

Benefits of Free Trade

I think most people have heard of The Dismal Prophecy of Malthus. (though Economics was termed the ‘dismal science’ for different reasons) Writing in the late eighteenth century, T.Malthus argued that the human population was doomed because the population was growing faster than the ability to grow food. He argued the simple equation of rising population and static land mass meant the world would soon be facing a shortage of food, high prices and famine. Malthus saw this as an inevitability. Yet 150 years on, his prophecy’s look ridiculously pessimistic. Despite, rapid population growth, food supply has, until now, more than kept pace with rising demand. In fact, places like the EU were producing so much surplus food we had the much publicised butter mountains and milk lakes e.t.c.

What Malthus failed to appreciate was that food production was not limited to the amount of fertile land. Relatively modest improvements in technology, and farming techniques could significantly boost food production.

Despite frequent dire warnings, since the time of Malthus, the impending  food crisis had never really materialised (with regional exceptions). Yet, just because Malthusian fears have proved wrong in the past, doesn’t meant that it will always be the case.

• Firstly, population growth continues a pace. Every year the global population rises by an estimated 60-70 million people. (another Britain to put it into perspective)
• At the same time, the amount of fertile land is under threat from a combination of global warming and desertification.
• Also the marginal gains from better technology are starting to diminish. Like anything, the use of artificial fertilisers are subject to diminishing returns. There is only so many chemicals you can use before you reach a plateau of rising production.

It is true, that the world’s capacity to produce food is still way off its maximum.

• Many countries such as India and Africa have not yet adopted many of the simplest technologies to improve food production.
• There is also the contentious issue of GM crops. GM food has potentially many problems, but, also the potential to significantly increase crop yields. A real shortage of food, could well make GM food more likely to occur.
• There is also the possibility of the world shifting to a less intensive food diet – a shift from a meat diet to vegetarian diet would require much less resources.
• Also, as food shortages lead to higher prices (as long as government don’t distort markets by subsidising cheap food), there will be greater economic incentives for countries to increase food production.

See also:

• Dealing with food scarcity
• The Real Economic Crisis – Food

Source: ONS

You can view the latest statistics on UK GDP by visiting the Office of National Statistics here

The latests statistics make for depressing reading, with evidence that the UK economy has now been in recession for 6 quarters, making it one of the longest recessions on record. The decline in output was 0.4%, less severe than at the start of the year, but, still bad news.

The continued recession means:

• Unemployment likely to continue to rise
• Higher government borrowing. Tax receipts will remain depressed, and welfare benefits will be higher.
• Prospect for Interest Rates to remain at 0.5% for the foreseeable future.
• Will keep downward pressure on Pound Sterling. This is because the length of the recession increases the likely hood of further quantitative easing (increasing money supply) and low interest rates.

More on Still in Recession and prospects for recovery

Question: Is the growth of Monopoly Power always a bad thing?

In recent years, many industries have seen a growth in monopoly power and market concentration. For example, in the supermarket industry, Tesco’s market share has grown; I believe they now have over 30% of market share. The Merger of Morrison’s and Safeway has also decreased the number of competitors in the market.

The banking sector has seen a significant growth in monopoly power, due to the recent mergers. The merger of Lloyds TSB and HBOS has created a firm with over 30% of the retail banking market. It is a significant reduction in competition, and has created a banking sector with strong monopoly power.

Generally, growth in monopoly power is seen as harmful thing, especially for the consumer. Monopoly power enables firms to:

• Charge higher prices because of the lower levels of competition
• Offers less choice of service and products to consumers.
• Make High profits at the expense of the consumer.
• more disadvantages of monopoly

A growth in Monopoly Power can be beneficial if:

Economies of scale. A larger firm may be able to benefit from lower average costs. Hence consumers may benefit from lower prices

Diagram showing lower average costs.

Higher profits can be used for Research and Development. e.g. drug companies may need high profit to invest in risky research techniques.

Dynamic Monopoly. If the growth in monopoly power occurs due to the success, efficiency and dynamism of the firm this can benefit consumers. For example, Google gained monopoly power through arguably developing the best search engine. Google is not generally considered to be a lethargic, inefficient monopoly like say an old nationalised monopoly like British Rail.

Monopoly Power In Banking.

If we take the banking industry, the problem is that these advantages seem rather feeble. Certainly there are economies of scale in offering a national banking network. But, I would imagine Lloyds TSB have already exploited most of the economies of scale. A further merger does little to benefit from further economies. If it was a merger of two steel firms, which has much higher fixed costs, the economies of scale may be greater. But, I really can’t see consumers getting lower bank charges because of economies of scale.

If two pharmaceutical firms or airplane manufacturers merged, there could be a good case to say they would use their combined profit for reasearch and development. But, it is hard to justify this for the Banking sector. Profit isn’t needed to invest in new products, it will generally go to the shareholders.

So in the case of banking it seems the growth in monopoly power has many of the disadvantages without any of the advantages. In fact, the only real reason it was allowed to go ahead was the fact, it was seen as a less bad alternative to nationalisation at the time.

So although, it was a convenient solution at the time, the effect of more monopoly power will be felt for many years to come.

The important thing to be aware of is that the benefits of greater monopoly power really depends on the industry in question. We have to look at each merger and firm separately.

Definition of disinflation. This is a fall in the inflation rate. It means that the general price level is increasing at a slower rate.

If the inflation rate is already very low, then disinflation could lead to deflation. Deflation is where there is actually a fall in the price level.

For example in the period 1977 -78, we had a period of disinflation, though prices were still rising.

Since the peak in oil prices in early 2008, the UK inflation rate has continued to fall. CPI inflation has now fallen to 1.1%, from a peak of over 5% in 2008.

The worry is that if this disinflation continues, we could see deflation – a negative inflation rate soon.

However, the Bank of England’s recent decision to halt the policy of quantitative easing, suggests they feel the threat of deflation is not too strong and they see signs of economic recovery.