Economics and the environment

Readers Question: Is it possible to construct the economic system so that does not rely upon expanded growth which as we all know, is damaging the environment? causing pollution e.t.c.

Photo: Takver

Photo: Takver

Could we have a society without economic growth? or as economists might prefer to answer – Can we have environmentally sustainable economic growth?

To promote an economic system without economic growth isn’t necessary. It is possible to have economic growth (increased output and living standards) whilst at the same time improving the environment we live in. But, this requires a much more conscious decision to place the environment as a primary economic objective. If you leave economic growth to the free market, inevitably we will see economic growth leading to environmental problems.

One of the great challenges of modern economics is to protect the environment. Part of the motivation is a simple moral case for being good guardians of the earth. But (fortunately for economics) there is a strong case of intrinsic self-interest. Protecting the environment nearly always makes good economic sense – as long as we look at issues in the long-term and not just from a short term / selfish perspective.

The environmental costs of economic growth

Rapid economic growth combined with a rapid population growth has placed great stress on the environment. If we are not careful – damage to the environment will threaten future living standards. For example:

  • Air / land / water pollution causes health problems and can damage the productivity of land and seas.
  • Global warming leads to rising sea levels,  volatile weather patterns and could cause significant economic costs
  • Deforestation damages soil and makes areas more prone to draught.
  • Economic growth leads to resource depletion and loss of biodiversity
  • Creation of waste and toxins.

What economic system could help promote environment?

The first essential aspect is for society and governments to recognise all the external costs and external benefits of the environment.

If we leave it to a free market, consumers and firms will ignore the external costs of their actions and we will get overconsumption, environmental costs – and a decline in economic welfare.

We need to put a monetary value on the cost of pollution / environmental damage and make sure that is reflected in the price people pay (e.g. tax on negative externalities). This will mean the cost of burning fossil fuels will increase – reducing demand. The biggest problem is making sure that we actually include all environmental costs in the price of goods and services we use.

For example, if burning fossil fuels is causing global warming and sea levels to rise. The effect could be devastating to future generations. In this situation, we are underestimating the external cost of this pollution. We are not paying the full social cost, and in the long-term we are failing to correctly price goods.

The long term view

A difficulty is that we are used to pricing the cost of a good in terms of present value. Many environmental problems are cumulative and the costs are to future generations and people elsewhere in the world. Because we ignore these future costs, we are underestimating the potential social cost of current actions.

Another difficulty in calculating future costs is that we don’t know for certain. There is an element of uncertainty. This means we have to deal with probabilities. However, if we are dealing with the environment, there is a good case for being risk averse and not gambling on the hope that global warming will be less damaging than some scientists predict. Reducing CO2 emissions can be done with only marginal cost to current consumers. But, damaging the environment in the long-term could lead to a devastating high cost to future consumers.

Positive technology

On the other hand, we need to encourage the production and consumption of technologies which don’t damage the environment.

To give a simplistic example – we could increase tax on petrol (which causes pollution). Then use this tax revenue to subsidise solar powered/electric cars which don’t pollute.

This will ensure that our society seeks to reduce the consumption of goods which are damaging to the environment. We can enjoy the same level of transport, but it will be supported by a different energy source which doesn’t damage environment.

People often ask how economic growth can help the environment. Technology is the key. If we develop technology which creates a more efficient source of energy, but without pollution – this would enable higher output, and reduce pollution levels.

e.g. a steam train caused high pollution levels. An electric train powered by solar powered energy plants can go much faster and doesn’t create pollution – that is economic growth and less pollution.

Limits of tax and subsidy

However, the use of tax and subsidy is not enough to deal with all environmental problems. For example, if we take the problem of deforestation of land in South America / Africa, a different response is needed.

For example, it may require governments to actually ban the process. It also requires a strong degree of international co-operation. Developing countries may feel a strong economic need to cut down forests or mine precious metals. However, it would be in the interest of the whole world to protect forests. Therefore, there may be a need for transfers to very poor countries in return for adopting less environmental damaging operations. Alternatively, it may just be a case of the need to educate about long-term sustainable practices.

As well as government action, there needs to be a change in consumer behaviour. A willingness to shift consumption patterns and be willing to pay higher prices and / or avoid consumption of certain products. e.g. only buy in season fruit, adopt a vegetarian diet. People want to protect the environment, but are we willing to pay an extra 10% increase in fuel bills?

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Economic system to improve income distribution

Readers Question 1) Can an economy that factors in the need for government funded public services and to offer people a living wage, and other more distributive economic strategies such as taxing the rich more, etc. Can it work in purely economic terms?

Essentially the question is

  • Can we have economic growth and greater income redistribution to ensure everyone benefits from the proceeds of growth?

Redistribution

Economic growth (rising real GDP) makes it easier for the government to spend money on public services and welfare payments. With economic growth, tax revenues rise, as the government will collect more VAT and income tax. This can help reduce absolute poverty. If you compare UK society – 50 or 100 years ago, there have been great strides made in reducing the worst forms of poverty.

However, to reduce relative poverty and inequality may require different policies, such as a more progressive tax system and more generous means tested benefits.

Welfare payments can help economic growth

Unemployment benefit enables people to survive economic turbulence. It helps support them in finding a new job suited to their qualifications. Removing benefits would reduce income and could cause serious social problems as people feel totally excluded from society.

Government funded public services like education and health care play a major role in improving a nations productive capacity and helping long-term economic growth.

A living wage / minimum wage can help prevent monopsonistic exploitation. By increasing workers wages also creates more demand in society for goods.

Factors other than government policy

Also, fairness in society doesn’t just depend on government policy. It depends on the attitudes of firms, workers and society. If people in society value an element of redistribution it is more likely to happen. For example, do firms make workers shareholders in the company or is society dominated by powerful monopolists who want to maximise profits?

In the Nineteenth Century, the Dickensian idea of firms was that they were happy to pay as low wages as they could. The proceeds of economic growth did little to ‘trickle down’ to the poorest workers.

Post Second World War, economic growth was more consistent with reduced inequality; this was partly due to government welfare policies – e.g. unemployment benefit, but also firms were perhaps more likely to see it in their ‘enlightened self-interest’ to pay workers well and look after their welfare. Success in society became a little less judged by monetary gain, but also how you treated other people. Continue Reading →

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Effect of minimum wage on AD/AS

Readers Question I realise that at the maximum wage, (minimum wage) for labour – Qty supplied would exceed quantity demanded. Therefore, from the labour market diagram there is an obvious fall in Qty of labour, given that there would be an unwillingness to supply labour at the lower wage rate.

Diagram showing minimum wage above the equilibrium

n-minimum-wage

I think you mean minimum wage. It is a minimum wage that causes excess supply of labour and lower demand.

If labour markets are perfectly competitive and if there is a national minimum wage (NMW) above the equilibrium wage, you would expect a fall in demand for labour (Q1 to Q2) and therefore, there would be excess supply of labour (Q3-Q1) (Known as real wage unemployment)

My question is how would I show this impact on an Aggregate demand and Aggregate supply (AD AS) diagram?

If we assume labour markets are competitive and if we assume that a minimum wage does cause lower employment, the most likely scenario is a negative impact on aggregate demand. People who become unemployed would spend less, leading to lower aggregate demand. To some extent, this would be counter-balanced by some workers having higher wages, leading to more consumer spending. But, I think the unemployment effect would be greater than the higher wages effect.

From the firms perspective, they would have higher costs, which could be passed onto consumers, higher wage costs could see SRAS shift to the left, leading to higher prices and slightly lower real GDP.

That is most likely analysis of AD/AS

 

Real World Analysis

In the real world, I think a minimum wage would have only a marginal impact on AD/AS analysis.

Firstly, a minimum wage may not cause any unemployment. Labour markets may not be competitive, but monopsonistic.

Demand for labour may be wage inelastic. Firms just pay higher wages and there is little fall in demand.

Only a small percentage of workers are affected by a minimum wage.

If anything, I would expect a minimum wage to increase AD. I’m doubtful UK Minimum wage causes any significant levels of unemployment. But, with a higher NMW some workers would receive higher real income and spending would rise. (Low income workers tend to have higher marginal propensity to consume / low propensity to save)

It is possible a rise in minimum wags could cause inflation due to two factors

  1. - higher spending by workers (demand pull inflation)
  2. - higher costs for firms, leading to wage push inflation.

But, overall, the effect on inflation would be fairly limited because a minimum wage would only alter AD by a small amount.

Essentially a minimum wage has little macro-economic effects (unless, it was a really big increase in the minimum wage)

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Maximum wage

If you did mean a maximum wage, the analysis for maximum wage is entirely different, I will do a post on maximum wages next.

But, demand for labour may fall. Firms may have lower costs, but some workers would have lower wages.

Maximum wages are rarely talked about. I can only think of professional footballers having a maximum wage until 1960s.

 

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Scotland post referendum

An independent Scotland would have made an interesting economics case study. How would Sterlingisation  or a Currency Union have affected the Scottish economy? Now we may never find out. There were undoubted risks involved, though I’m not sure how much the issue affected the outcome. The Eurozone is also an interesting economics case study, but it has been a disaster for those who are at the receiving end of austerity and mass unemployment. I’m glad we don’t have a situation where five years down the road Scotland is marooned by English monetary policy and a lack of a Central Bank. Perhaps the SNP lacked the confidence to go all out for independence which means their own currency and Central Bank.

Last week, I made a rare foray away from economics in writing about why I emotionally I hoped Scotland would stay part of the UK

However, I watched an interview of Alex Salmond a few days later and was surprised at how much I agreed with him. I agreed with his views about nuclear weapons, the Iraq War, vague notions of social justice and what constitutes a good nation. I was reassured by his homilies  about Scottish independence would mean England losing a surly neighbour and gaining a good friend. He is a talented politician – probably very skilled in knowing what his audience would like to hear. I suppose he’s not always been so forthcoming in promoting English / Scottish oneness. But, as the campaign went on I was impressed by the optimism of  the Scottish independence movement – even if I was glad Scotland voted no.

There are times when you feel a bit small minded for always thinking of economic risks, pension funds and optimal currency areas.  There are more important things than economics and financial stability, but whether Scottish independence is, I’m still not entirely sure.

Referendum Question

If the question had been:

Do you want to remain part of the UK?

The campaign and outcome may have been quite different. It would have been easier for the Better Together campaign. The Better Together Campaign were criticised (with a degree of fairness) for being ‘negative’ – but when you campaign for a “No” vote – it does lend itself to a certain negative slant.

If the Scottish Independence movement were campaigning for a no, they would have found it much harder. In some senses it was quite a generous question that the UK government agreed to put on the ballot paper.

Democracy

Looking through human history, it is remarkable to have an independence debate which is wholly democratic and – despite rising tempers towards the end, remarkably good natured and peaceful. It is a powerful example of democracy in action; it is something that both Scotland and the UK can be proud of.

There are many regions looking in envy on both Scotland and the UK

Post referendum Squabbles

There will be inevitable post-referendum squabbles, especially revolving around the last minute vow of the three main parties. But, however difficult and problematic – they are nothing compared to the bitter divisions which would have been created by independence. The SNP had already put on the table walking away from their share of the national debt. Osborne had already ruled out Currency Union (without making much effort to explain why it wouldn’t be good for Scotland). A split in the union would have been a messy divorce. This is probably best outcome of the result – at least it’s clear and we can move on.

I haven’t read so many political articles since I was 18 and actively involved in politics. It certainly has touched something deep in Scotland and Great Britain. A very interesting experience.

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Does inflation cause unemployment?

Readers Question: Does inflation causes unemployment?

There are a few different scenarios where inflation can cause unemployment. However, there is not a direct link. Often we will notice a trade off between inflation and unemployment – e.g. in a period of strong economic growth and falling unemployment, we see a rise in inflation – see Phillips Curve.

Also it is important to bear in mind, (especially in the current climate) If the economy has deflation or very low inflation and the monetary authorities target a modest rate of inflation, then this may help boost growth and reduce unemployment.

Inflation can cause unemployment when:

  1. The uncertainty of inflation leads to lower investment and lower economic growth in the long term.
  2. Inflationary growth is unsustainable leading to a boom and bust economic cycle.
  3. Inflation leads to decline in competitiveness and lower export demand, causing unemployment in the export sector (especially in a fixed exchange rate).

 

Inflation creates uncertainty and lower investment

One argument is that a period of high and volatile inflation discourages firms from investing. Because inflation is high, firms are less certain investment will be profitable. It is argued that countries with higher inflation rates tend to have lower investment and therefore lower economic growth. Therefore, if there are poor levels of investment this could lead to higher unemployment in the long term.

It is argued that countries with low inflation rates, such as Germany have enabled a long period of economic stability which helps to attain a long term low unemployment rate. Low inflation in a country like Germany also helps them to become more competitive within the Eurozone, which also helps create employment and reduce unemployment.

See also: costs of inflation

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Unemployment Stats and Graphs

A selection of graphs and statistics on UK measures of unemployment. Also, looking at factors that explain UK unemployment and why unemployment has fallen in recent years.

UK unemployment-rate

Current UK Unemployment rate

  • Unemployment rate of  6.2%, (July 2014) –  the lowest since late 2008. (page updated Sept 18th, 2014)
  • 2.02 million – (ONS)  (a fall of 468,000 since 12 months ago – biggest fall since 1988)
  • (Scottish unemployment of 6%)
  • Average Eurozone unemployment – 11.5%

Recent Unemployment Trends

UK-unemployment

Raw data:  Labour market data  | ILO unemployment % rate at ONS

UK Employment Rate

  • 73.0% of people aged from 16 to 64 were in work (May to July 2014) up from 71.6% for a year earlier.
  • There were 30.61 million people in work.

Participation Rate

  • 22.1% per cent inactivity rate for those aged from 16 to 64. 8.95 million economically inactive people aged from 16 to 64. In activity means that people are either not working or not seeking employment (e.g. students, parents bringing up children, early retirement, long term sickness) See also: Participation rates

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Currency substitution – Dollarisation / Sterlingisation

Currency substitution occurs when a country uses another currency without any official backing and without a Central Bank – instead of using its own currency.

For example, Panama uses the US Dollar as its currency. Even though it has no formal currency union with the UK. Jersey uses Sterling unofficially too.

The advantage is that a country like Panama gets to use a currency which has a stable value and international respect. The disadvantage is that it has little control over monetary policy and doesn’t have a Central Bank to act as lender of last resort to print money during periods of liquidity. Also, you lose the ability to devalue the exchange rate (which some may argue has advantages too)

Sterlingisation for Scotland

If Scotland vote for independence, Sterlingisation is seen as the best outcome for an independent Scotland. (Possibly as a precursor to a second stage where Scotland creates its own Central Bank and print its own ‘Scottish Pound’)

Sterlingisation would mean Scotland continues to use the Pound, but without a Central Bank as lender of last resort. It also means monetary policy would be set by the Bank of England.

Does it matter if Scotland doesn’t have a lender of last resort?

Given the problems of the Eurozone in recent years, there is an unfortunate precedent of countries being severely damaged by a lack of a Central Bank willing to act as a lender of last resort. However, there are two possible factors which could help Scotland.

  1. Firstly, some argue that having no Central Bank encourages banks to act more responsibly and avoid taking on excess risks. The Adam Smith Institute have produced a paper which is optimistic about the potential of ‘Adaptive Sterlingisation’ arguing that the period of free banking in Scotland in the eighteenth century was largely successful – with banks secured by shareholders. – How sterlingization and free banking could help Scotland flourish at Adam Smith – Institute.
  2. Would the Bank of England want to allow banks in the British Isles to fail? If Scotland gained independence, the Bank of England would have no compulsion to act as lender of last resort, but the UK banking systems is closely integrated; a collapse in confidence north of the border would have implications south of the border too. Would the Bank of England want to allow a failure of our near neighbour – when the financial and economic fortunes of the two countries are so closely tied together?

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Difficulty in switching from fossil fuels and oil

Question and answers on the difficulty of switching from non-renewable energy sources, such as fossil fuels. (from – finding alternatives to fossil fuels)

solar-power-houses

photo Dean

Readers Question: Why is it that on a global scale, alternative fuels are somewhat being ignored?

 

Firstly, fossil fuels are still cheaper. However, the gap is narrowing. For example, see how solar panels are coming down in costs.

There can be a reluctance to switch from one mode of production to another. Even if an alternative became cheaper, it requires significant investment to switch from one mode of power to another. For example, the UK kept steam trains running into the mid 1960s. Diesel was more efficient and cheaper many years previously, but it required a lot of investment in infrastructure to buy new diesel trains. Often it’s easier to keep going with old technology out of habit and merely because it is what has been used in the past. In some parts of the world, steam power is still used.

But, on the other hand, if we look back in history, we can see that a dominant technology can quite quickly lose its position. America quite quickly switched from steam trains to the petrol powered car. Once a tipping point is reached the momentum can swing to the new technology.

Also, a factor is that oil and petrol companies are very profitable and it is in their interests to keep oil based industries strong. If they can delay a switch to alternative fuels they might try. How much ability they have to delay an energy switch is open to question. But, there are powerful lobbyists to support the US coal and oil industries.

Readers Question: If it is not being ignored, Why is research and development is somewhat slow?

Alternatives to fossil fuels are generally not profitable in the short term. Therefore, private enterprise has limited incentives to research alternatives. This is an example of market failure, because the market ignores:

  1. The long term importance of developing alternatives to fossil fuels, which will one day run out.
  2. The external benefits of developing alternatives to fossil fuels, e.g. improvement in environment and reduced pollution.

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Scotland in the UK

Generally I try and remain politically uncommitted. But, in the past few weeks, I’ve been surprised at how much the issue of Scottish independence has affected me. Despite a mental desire to feel nationalistic identity as unimportant, I feel deep down it really means a lot – and I hope Scotland votes to remain part of the UK.

scotland

Edinburgh – Clatie K

Essentially, I like the fact the United Kingdom is a union of different nations who celebrate both their uniqueness and common shared heritage. I feel Great Britain is stronger through maintaining this unique union. To split up and go it alone would feel like a regressive, backward step, which would accentuate division rather than the potential for oneness between the constituent parts.

I admire Socrates’ immortal quote:

‘Neither an Athenian or a Greek, but a citizen of the world.’

To me this is something to aspire for – to move on from sectarian nationalism to appreciate the greater possibilities of working together. I get joy from seeing groups with seek to bring nations together – from the United Nations to the ideals of a European union of nations.

I get more joy in thinking of myself as British than English. I prefer thinking of myself as British because it means we can celebrate a family of nations and this feels more to me than just a narrower ‘Englishness’. I also know this is perhaps a bit of anachronism – it seems the modern trend in the world is to split up and ‘go it alone’ (And, after all, I have to admit to being a secret member of the Yorkshire Independence movement, Oxford branch).

It does seem a shame to split up the United Kingdom. To me, it is hard to perceive Scotland as an independent separate country with borders and the like with England. I would hope Scotland still sees value in the union, even if they are at the same time proud of their Scottish identity.

The union of Scotland and the rest of the UK has lasted over 300 years. It has been a formidable union from the Scottish Enlightenment to the defeat of Hitler in WWII. The British Empire was bad in nearly every way, but I am proud of the fact that we gave it up and more or less moved towards a progressive democratic society with a strong welfare state. It is a unique union with surprisingly little internal division. For all the faults of the Westminster elite – how many nations offer a better standard of living? There is always corruption and poor politicians – no matter how small your governing nation. But, if you look at the rest of the world, the UK is a relatively good place to live in.

Mutual need

Whether we like or not, we have an indivisible mutual need to get on with our neighbours. John Donne wrote no man is an island, and this is particularly true in the modern world. Scotland has such a long tradition of merging with England, there are so many mutual ties that these cannot be passed aside. We benefit from Scotland and Scotland benefits from the rest of the UK. Just a few years ago, the whole UK banking system was on the verge of collapse. Scottish banks needed a massive bailout from the whole UK government. A real crisis was averted, but it was an example of how there is strength through union.

Independence means an independence currency

There has been a recent debate about whether prices will rise in Scotland after independence – this is an irrelevance – they may rise 0.5% they may stay the same. The real issue is whether the Scottish economy will be damaged by severing ties with Britain. The Eurozone is standing as a painful example of what happens when currency unions go wrong. I am fairly confident UK and Scottish unemployment would be close to double the current rate of 6.5%, if we had joined a currency union with Europe. An independent country without control over its – currency, monetary policy and fiscal policy is a essentially a vassal of the more powerful country. Some people worry about prices rising 0.5%, I worry about economies stuck in recessions with no ability to get out of it. Portugal, Greece, and Spain are currently economically failed nations.

It seems the strongest argument for Scottish independence is that Scottish people want to be free from Westminster influence and – for better or worse – be responsible for their own destiny. If this is the case, an independent Scottish currency and Central Bank is essential. What is the point of independence if Scotland shares –

  • The British currency,
  • Has monetary policy set by the Bank of England,
  • Relies on the Bank of England as lender of last resort
  • Has fiscal rules dictated by Westminster and the City of London?

This is the worst of both worlds.

In some respects a new Scottish currency will be a regressive step, – not least transaction costs will be a pain for people travelling between the two countries. But, at least the costs are more certain. A currency union or Sterlingisation would be a disaster for Scotland – maybe not straight away, but at some time. Scotland is lucky to have the painful failure of the Euro experiment to learn from. It would be a mistake to wave away problems with a rose tinted optimism – that is exactly how the Eurozone disaster was created.

Currency unions don’t work without very close economic and political union. A bad currency union only creates political and economic disharmony.

My fear is that Scotland will get independence and five years later will be bitterly complaining that rUK monetary policy is inappropriate. It will be inevitably bitter and tortuous arguments with both sides exasperated at each other. Just look at how much periphery Eurozone nations resent being told by the EU to implement austerity and ‘internal devaluation’

If Scotland choose independence – go the whole way, but don’t fall in between the gap.

 

Conclusion

It is easy to dislike the tone of the political debate on both sides, I worry at the strength of feeling generated. I don’t mind admitting, I would be reluctant to visit Scotland in the current climate. But, this is an issue that shouldn’t be decided on political point scoring or the temporary appeal of political leaders. It is about the best outcome for the future of Scotland and the UK. I do hope that Scottish people will vote to remain part of the UK. And we promise not to elect a Mrs Thatcher again!

Maybe I am wrong, maybe it doesn’t matter if Scotland becomes independent – maybe it’s a good thing for Scotland; perhaps if I lived in Scotland I would see things differently. I don’t know. Nations are always changing – such is life. Perhaps the only important thing is how we get on with people, whatever their nationality. However, spending the next five years squabbling over the national debt and national assets will probably not be the best way to promote a sense of oneness between Scotland and the rest of Great Britain. The union is worth preserving.

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EU inflation and deflation

The Eurozone inflation rate is 0.4% (ECB database)  (Sept 2014)

Eurozone HCIP inflation rate

eurozone inflation

HCIP (Harmonized consumer index prices) Source:| (ECB Inflation graphs, sometimes a few months outdated)

Food inflation

food inflation

Food inflation is currently negative. Food inflation tends to be one of the most volatile components. This negative food inflation is one factor reducing the headline rate.

Reasons for low inflation in the Eurozone

1. Temporary factors – lower food / energy prices. Core inflation is currently higher than the headline rate. Excluding energy, food, alcohol and tobacco, the inflation rate is 0.9%. However, even this core inflation is still well below the government’s target. Also, the headline rate of 0.4% is important for anchoring low inflation expectations. M. Draghi wrote about his concern of an inflation rate permanently below 1%-  which will anchor low inflation expectations (Der Spiegel interview)

2. Sluggish growth

Economic growth in the European Union has been very weak since the start of the great recession in 2007. Weak economic growth has put downward pressure on wages and prices.

Eu-growth

EU Real GDP Source: St Louis Fred

3. Unemployment

eurozone-unemployment

Eurozone unemployment has been above 10% since the middle of 2009. Persistently high unemployment rates create downward pressure on wages. With large pools of unemployed labour – there is downward pressure on wages, which is big factor in keeping overall inflation low.

4. Inflation expectations

Despite the on-going recession, the ECB and European officials have placed great stress on keeping inflation low. This is one factor that has helped anchor low inflation expectations throughout the Eurozone.

5. Monetary policy

The ECB has recently cut the interest rate, but in 2011 – concerned at a blip in inflation – they increased interest rates. The ECB have always erred on the side of caution with regard to inflation, but the effect has been a relatively tight monetary policy which has kept nominal GDP growth low. The other big difference between Europe and other areas such as the UK and US is that whilst the UK has US have embraced quantitative easing to increase the money supply, the ECB has not sought to create more money to deal with deflationary pressure. There is great resistance to this idea, especially in Germany. This is a reasons Eurozone inflation is lower than elsewhere.

6. Internal devaluation

In the Eurozone, many countries such as Portugal, Greece, Spain became uncompetitive in the Single currency. This led to large current account deficit. But, in the Eurozone, these countries can’t allow their currency to devalue. Instead they are pursuing internal devaluation – trying to restore competitiveness through lower wages, and cutting prices. However, this process inevitably causes lower inflation. Both Greece and Portugal have outright deflation as a consequence of this policy.

6. Austerity measures

The Eurozone crisis led to many countries implement austerity to cut budget deficits. In a recession, austerity measures have slowed down economic growth contributing to lower nflation.

7. Reluctance to reflate the economy

The Eurozone has a big trade imbalance – with Germany having a large current account surplus – indicating domestic demand is relatively low compared to export demand. Germany has room to boost domestic spending which would help the south of Europe restore competitiveness and increase exports. But, Germany is not keen on risking any inflation, so they have held back on domestic spending, keeping overall Eurozone GDP growth low.

Problems of low inflation rate

In one sense a low inflation is good news for consumers who are enjoying low food prices e.t.c. However, the problem is that this low inflation is entrenched and so we are likely to see this leading to wage freezes. Low inflation does not help consumers if wages are not growing (something UK is experiencing at the moment)

The bigger problems of low inflation is that it is increasing EU wide debt burdens. A moderate inflation rate would help reduce nominal debt to GDP ratios. But, with zero inflation, the effective debt burden becomes much harder to reduce.

Very low inflation is also likely to hold back spending and investment. Consumers may prefer to wait before spending – in the expectation prices will continue to fall. Firms may be reluctant to invest given the poor prospects for economic growth. This all contributes to deflationary pressures – which is exactly what the Eurozone should be trying to avoid.

More detail – Problems of deflation

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