Archive | economics

Deflationary Bias in the Eurozone

Readers Question: Is there an inbuilt deflationary bias in the Eurozone?

Deflationary bias means that there is a tendency for economic policy to promote lower growth and lower inflation. It means there are pressures which keep demand subdued leading to lower inflation, higher unemployment and lower growth.

To a large extent, I agree that there is a deflationary bias in the Eurozone. This is proved by the long period of low economic growth (2007-14) and an inflation rate that is remaining well below target. As of April 2014, inflation in the Eurozone has fallen to 0.5% – well below the target of 2%. Growth is anaemic and unemployment well into double figures (11%) – higher in many countries.

EU inflation

Source ECB - inflation

Furthermore, certain countries on the Euorzone periphery are experiencing actual deflation as the burden of adjustment is felt by certain countries more than others.

Inflation Target

The ECB have very strong attachment to keep inflation less than the target of 2%. For example, in 2011, temporary cost-push inflation led to an increase in the EU headline inflation rate. The ECB responded by increasing interest rates. The Bank of England responded by keeping interest rates at 0.5% (even though inflation was much higher in the UK than EU). The Bank of England argued it was important to give importance to wider economic issues of growth and unemployment. The ECB were much less willing to accept, even a temporary deviation from the inflation target over fears temporary inflation would increase inflation expectations. It showed the ECB are much more willing to risk lower growth than risk higher inflation. (see also: ECB v Bank of England)

Whilst the ECB have an inflation target, they have no explicit target for unemployment or economic growth. EU Unemployment has risen to 12%, but there has been little action to increase aggregate demand.

Reluctance to pursue unconventional monetary policy

Despite a prolonged period of low inflation, the ECB are still reluctant to actually implement unconventional monetary policy  (e.g. Quantitative easing). With inflation of 0.5% April 2014, the ECB had still not taken any pre-emptive action to target higher inflation.

The ECB is reluctant to engage in any quantitative easing because

  • They are reluctant to create any possibility of future inflation, printing money is an anathema to German Central Bankers.
  • The ECB has a reluctance to start buying bonds of different countries, deciding which to buy.

The result is that countries with many deflationary pressures (strong exchange rate, fiscal austerity) don’t have any monetary stimulus to offset the fall in demand. (e.g. UK can pursue quantitative easing when we experienced deep recession). Countries in Eurozone can’t.

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UK Inflation Rate and Graphs

Current UK Inflation Rate

  • CPI  inflation rate: 1.7% (headline rate)
  • CPIH grew by 1.6% in the year to Feb 2014
  •  (page updated April 3rd, 2014)

monthly-inflation

CPI and CPIH

CPIH is a new experimental index from the ONS. It is based on CPI, plus it includes housing costs, such as mortgage interest payments. Owner occupiers cost (OOH) account for 12% of the CPIH weighting. Mortgage interest payments are the biggest part of OOH. Mortgage interest payments average 10% of household expenditure.

cpi-cpih-inflation

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How reliant is the UK economy on oil?

Readers Question: How reliant is the UK economy on oil?

There are two ways of considering this question – the consumption and production of oil.

  • Firstly, how much does the UK need to consume oil to maintain economic activity? Could we survive in a post-oil economy?
  • Secondly, how important is the UK oil industry and the production of oil?

Consumption of oil

UK_oil_production-consumptionThis shows that we are consuming a steady 1.5 to 1.7 million barrels of oil a day. Oil is an essential raw material for many key economic activities, such as:

  1. Transport – cars, lorries e.t.c. mostly rely on petrol / diesel. (In the US transport accounts for 66% of all oil used. I imagine it is a similar statistic in the UK.)
  2. Production of plastic
  3. Fertilizers
  4. Asphalt
  5. Polyurethanes
  6. Solvents
  7. Electrical generation

Reducing dependency on oil consumption

  1. There have been some attempts to reduce the dependency on oil. In transport, the government have encouraged the consumption of electric cars, with subsidies and encouraging electric car charging points.  But, between between 2010 and June 2013 only 5,034 electric cars have been registered. It is a small drop compared to the total number of cars sold.
  2. According to Calor, there are 160,000 LPG registered cars in the UK, and the number is on the rise.
  3. Energy efficiency. Cars have become more energy efficient with a high miles per gallon becoming a strong selling point. This has limited the growth in demand for petrol.
  4. Alternative forms of transport. Some see alternative forms of transport as a way to avoid reliance on oil based fuels. However, despite growth in cycling rates and increased use of trains, cars  / lorries still dominate the UK’s mode of transport.
4-modes-transport

The dominance of the car in the UK

However, the improvements in energy efficiency and attempts to introduce alternative fuel cars are only limiting the growth in demand for oil based fuel. Continue Reading →

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Top CO2 polluters and highest per capita

Readers Question: What country’s don’t use the carbon tax and with country produces the most carbon dioxide.

The biggest absolute emissions come from China, and the United States. In terms of CO2 emissions per capita, China is ranked only ranked 55th, at 6.2 metric tonnes per capita. The US is 8th at 17.6 per capita. India is the third highest country in terms of absolute emissions, but 127th in terms of per capita output with 1.7 metric tonnes per capita.

pollution-smog

Why don’t countries use the carbon tax?

  • Taxes are generally politically unpopular. A tax on carbon emissions will affect the living costs of many people. This can make the government reluctant to impose the tax.
  • There is also the free rider problem. A small country may think – what is the point in introducing carbon tax when their CO2 emissions are dwarfed by other countries like China and the US? Especially, when these bigger countries don’t seem inclined to do too much about the issue.
  • There is also differing opinions about the potential cost of CO2 emissions to the environment. In the US, there is a strong lobby which argues global warming is not scientifically proven. Therefore, there is a resistance to impeded CO2 emissions.
  • Another factor is that there are significant vested interests in the oil industry / other industries which pollute. They fear CO2 tax will reduce their profitability so they are willing to fight against moves to introduce taxes.
  • Another argument used is that a Carbon tax will harm jobs.

Highest CO2 emissions by country

List of countries by 2010 emissions
Country Annual CO2 emissions
Thousands of tonnes  % of world
1. China 8,286,892 26.43%
2.  United States 5,433,057 17.33%
 3. EU (27) 3,688,880 13.33%
 4. India 2,008,823 6.41%
 5. Russia 1,740,776 5.55%
 6. Japan 1,170,715 3.73%
 7. Germany 745,384 2.38%
 8. Iran 571,612 1.82%
 9. South Korea 567,567 1.81%
 10. Canada 499,137 1.59%
 11. United Kingdom 493,505 1.57%
 12. Saudi Arabia 464,481 1.48%
 13. South Africa 460,124 1.47%
 14. Mexico 443,674 1.42%
 15. Indonesia 433,989 1.38%
 16. Brazil 419,754 1.34%
 17. Italy 406,307 1.30%
 18. Australia 373,081 1.19%
 19. France 361,273 1.15%
 20. Poland 317,254 1.01%

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Policies to reduce unemployment in Greece

Readers Question: What policy strategy is good to reduce unemployment in Greece?

The Greek economy is experiencing grave problems, with record levels of unemployment. Unemployment in Greece is running at 27.5% – (end of 2013) This unemployment rate is even higher amongst young people.

The unemployment is primarily caused by the prolonged recession which has led to a substantial fall in output and decline in normal economic activity.

The Greek economy has also suffered from a lack of competitiveness in the Eurozone. Higher labour costs and rising production costs caused Greek exports to be relatively uncompetitive. But, in the Euro, there was no devaluation to restore competitiveness. This lack of competitiveness is a contributory factor to unemployment, and led to a current account deficit of close to 15% at the start of the crisis.

What can Greece do?

From a theoretical point of view, a country experiencing severe demand deficient unemployment, should seek to pursue policies to increase aggregate demand.

However, the difficulty is that in the real world, these three policies are all curtailed by membership of the Euro.

Greece is actually pursuing a very tight fiscal policy – cutting government spending in an attempt to reduce the budget deficit. These spending cuts are making the recession worse and increasing unemployment. But, in the Euro, they feel they have no choice because the have no other way of funding their deficits. One policy option would require the EU to give even bigger bailouts or wipe out Greek debt to enable them to stop austerity. However, this would require a degree of political willingness we are unlikely to see.

Monetary policy is not set by Greece, but the ECB. The ECB is considering the whole of the Eurozone and so is not setting monetary policy for what Greece needs. If Greece had a Central Bank, they could print money and pursue quantitative easing to try and reduce deflationary pressures and boost demand. But, this option is not currently available to them.

Several economists suggest that the ECB should be doing more to help the depressed Southern economies. They argue the ECB and Germany need to do more to boost demand in Europe and help those economies experiencing deflationary pressures. Higher growth and higher inflation in Germany / north of EU would help restore competitiveness without relying on extensive deflation in the south. But, the ECB and Germany are reluctant to do anything which might ‘risk’ inflation.

Devaluation of the exchange rate is not possible within the Eurozone. Therefore, leaving the Euro is a consideration. Leaving the Euro would enable loose monetary policy, and substantial devaluation. This could help increase aggregate demand in medium / long term. Therefore, it could be a solution to the mass unemployment.

However, leaving the Euro would cause massive disruption and possibility of capital flight. Many Greeks would wish to move their Euros out of Greece to protect against imminent devaluation. This could destabilise the economy and lead to even lower economic growth, unless sufficient capital controls could be introduced to keep capital in Greece. However, the advantage of leaving the Euro is that it would put the economy back into the hands of the Greeks, and avoid a similar repeat of this crisis in the future.

Other solutions

Supply side policies. The EU has called for supply side reform to help improve competitiveness and reduce unemployment. This can involve labour market reforms to increase labour market flexibility and reduce wage costs, encouraging firms to employ more workers. This policy may help a little, but, even the best supply side reforms will only make quite a small dent in the overall unemployment picture. The fundamental problem is lack of demand, supply side reforms will take a long time to have an effect on unemployment of 27%.

See: Supply side policies for reducing unemployment

Radical policies

In some aspects the Greek economy is changing quite rapidly. In some areas, people are avoiding normal economic channels and resorting to an almost barter economy. New employment may spring up as people create completely different economic channels such as selling directly to shops rather than through intermediaries. This may help reduce unemployment, but I’m not sure what policy can help create these ‘unorthodox’ jobs.

 

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Key measures of economic performance

Traditionally, the key measures of economic performance in macro-economics include:

  1. Economic growth – real GDP growth.
  2. Inflation – e.g. target CPI inflation of 2%
  3. Unemployment – target of full employment
  4. Current account – satisfactory current account, e.g. low deficit.

Of these indicators, economic growth is usually the most importance and given the greatest credence for economic performance. It is frequently used for international comparisons and is probably the most prominent statistic. Politicians can use GDP statistics as a trump card – as if a quarterly growth of 1.0% vindicates all economic policy.

However, real GDP has several limitations. Not least is the fact that it is not always a reliable guide to living standards. With stagnant wages, cost push inflation and a rising population, average median incomes have fallen in the recent decade. Between  2009-10 to 2011-12 median incomes fell  in the UK cumulatively by 5.9% from, taking average incomes back to levels seen a decade earlier. It means that despite the recovery in real GDP, some people feel that they are not benefiting from economic recovery.

Indicators for economic performance

The Fabian think tank believes that median income would give a better indicator to overall economic performance. They also state other indicators which would help give better impression of economy.

  • Rate of National debt reductions
  • Level of greenhouse emissions
  • Income inequality
  • Labour productivity
  • Intermediate skills
  • Affordable homes
  • Incidence of low pay
  • Employment rates

Pros and cons of GDP

For all its limitations, GDP is widely used across the world. It does gives a rough guide to the level of economic activity. The fall in GDP of 2008/09 was indicative of the recession. Prolonged growth of real GDP 1993-2007 was indicative of the relative prosperity and rise in living standards.

For all its faults GDP does give a useful guide to the economic cycle and is a indicator for monetary policy and fiscal policy.

GDP is also measurable – it is objective. For example, we could go to the other extreme and start a survey asking people whether they are happy with their economic situation? This may give an interesting insight into economic welfare. But, a raw statistics, such as GDP gives more confidence than a survey – which by its very nature is subjective.

The downside of GDP come when it is relied on too much. Rising GDP, could hide a fall in average incomes and a rise in poverty. GDP  doesn’t take into account income distribution. Growth in GDP could primarily benefit the top income strata.

For example, a problem the Fabian group identify is the rise in UK housing costs. In the past few decades, UK Housing has become less affordable. This is good new for home owners who see a rise in wealth and rents. It is bad news for people struggling to buy or pay rents. This is a classic example of how a rise in GDP can cause rising living standards for some, but falling living standards for others.

Don’t forget population. At the very least, we need to take into account population and real GDP per capita. The UK’s rising population is one reason for increasing GDP.

All statistics are limited

One problem is that all statistics have some limitation. Even employment rates can be partially misleading. For example is the employment temporary or permanent? Employment figures have been better than expected, but there has been a rapid rise in zero hour contracts causing an increase in labour market insecurity.

When I see national debt used as a measure of living standards I always start to worry. Countries which made enthusiastic attempts to cut their budget deficit, such as Greece and Portugal have seen a dramatic fall in living standards. It seems mistaken to use debt reduction as a measure of living standards when debt itself might be the necessary consequence of dealing with a demand side shock.

Overall

Overall, it is important for economists to look beyond the headline statistics. Real GDP will always be useful for showing the stage in the economic cycle. It is of some use in indicating living standards. But, it is far from the ultimate guide. There is always a need to look at similar statistics to give a better overall picture. In this case median income is definitely an important indicator to economic welfare. Similarly when looking at unemployment. It is insufficient to use just the raw unemployment data. We need to know the kinds and types of jobs created.

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Low economic growth and unemployment

Readers Question: Why is it that when there is low economic growth, unemployment rises?

A low rate of economic growth can cause higher unemployment. Though it is not always the case. During 2010-13 the UK experienced a slow rate of economic growth, but unexpectedly unemployment fell.

If there is negative economic growth (recession) we would definitely expect unemployment to rise. This is because:

  • If there is less demand for goods, firms will produce less and so will need less workers.
  • In a recession, some firms will go bankrupt making many people redundant.
  • Firms will be reluctant to hire workers, when there is uncertainty and negative growth

Why unemployment can rise even with positive but a low rate of economic growth?

In many cases, we may see a rise in unemployment, even if there is positive, but low economic growth. One reason is that economic growth may be lower than improvements in productivity growth.

Suppose, an economy like the UK has a long run trend rate of 2.5%. This means productive capacity tends to rise by an average of 2.5% a year. This growth in productivity comes from improvements in technology and improvements in labour productivity. It means that firms can produce more goods and services from the same number of workers.

However, suppose that the rate of economic growth was 0.5%. This means demand in the economy is only growing by 0.5% a year. This means that supply would be increasing faster than demand. Therefore, firms may have to lay off workers because there is insufficient demand.

In this situation, we will see a negative output gap (spare capacity)

ad-small-inc-as-big-incr-yfIn the above example, we have positive economic growth, but AS (Productive capacity) is increasing faster than AD. Therefore, there is a bigger negative output gap (the difference between actual GDP and potential GDP (Yf). Therefore, in this case the rise in spare capacity leads to unemployment.

China and unemployment

A good example of this is the case of China. It is estimated that if economic growth in China slips under 7% a year, then unemployment will rise. This is because China is making rapid productivity gains. Old inefficient state owned business are being privatised and there are easy efficiency gains to make. Workers who were unproductive are being made redundant from these state owned industries. Therefore, China needs rapid economic growth to absorb this growing supply of labour.

Technology and structural unemployment

If there is rapid technological and structural change in the economy, this can cause unemployment despite economic growth. For example, rapid improvements in technology can create increased output, but certain workers may have insufficient skills to take the new high-tech jobs. Therefore, we can see a rise in structural / technological unemployment in the period of economic growth.

Low Growth and falling unemployment

There is no guarantee that low growth will cause higher unemployment. It is quite possible for unemployment to fall, despite a period of low growth.

If we look at the UK, unemployment fell from 2011 to 2013 – despite low growth, and also the expectation that unemployment would lag behind the recession.

total-unemployment-2007-present

Reasons for this fall in UK unemployment during this period include:

  • Poor productivity growth. Labour productivity has been low during this period. Therefore, firms still need to employ workers, despite limited growth in output.
  • Rise in part-time and temporary work. The unemployment figures have been helped by a rise in under-employment, people accepting lower hours than they would like.
  • Low wage growth. Low wage growth means labour is relatively more attractive than you might expect.
  • See: more at UK Unemployment mystery

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Where is the money in the economy spent?

Readers Question: Why is public money (taxes) only 47% of the UK’s GDP spent on public spending?, where is the rest of my money being spent. This is a genuine question from a 58 year old who has no real concept of how it all works,but has an innate understanding that I am being screwed.

GDP is total national income. This is also the same as the total national output. In the UK total GDP is around £1.6 trillion. The government spend around £700bn (2012/13) or 43% of GDP.  See: UK government spending

It means the rest 57% £900bn is spent by the private sector – business investment and consumer spending.

To answer the question. After you have paid all the taxes to the government, the rest of the money is being spent by yourself.

In a very simple model, assume the average income in society is £10,000. The government collect £4,300 from you in tax, and then the government spend £4,300 on health, education, welfare benefits e.t.c. The government is spending 43% of average income. It leaves you £5,700 to spend on consumer goods and services.

g-spending-percent-gpd-96-14

Government spending as a % of GDP has fluctuated around 40% of GDP since the mid 1960s.

g-spending-percent-gpd-68-14

Government spending is financed by

  1. Tax
  2. Borrowing from the private sector – selling bonds to investment trusts e.t.c.

If government spending increases, it means they will have to finance it through higher taxes or borrowing.

Tax revenue as a % of GDP

Tax-Revenues-As-GDP-Percentage-(75-05)

Pre the First World War, government spending was a lower percentage of GDP. Perhaps around 10-15% around 1900. (this is a guess). In 1900, taxes were much lower. Income tax was relatively low and VAT hadn’t been introduced. This meant the government had much lower revenue. But, also there were few public services. If you were unemployed, there were no benefits, but you were probably sent to the workhouse.

Government spending as a % of GDP varies around the world.

For example, US public spending is around 35% of GDP. This is lower than many Western European economies, e.g. France 52%. But, the downside is that in the US you will have to spend considerable sums on private health care.

(List of government spending by country)

It is debatable whether you are better off paying higher taxes to the government  -or paying lower taxes + high private health insurance premiums.

Government spending as a % of GDP is no guarantee as to whether you are being ripped off or not.

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Should University Education be Free?

In recent years, the government has sought to increase the amount students pay for studying at university. In the UK, the government have phased out grants and introduced top-up fees. With tuition fees and rising living costs, students could end up paying £50,000 for a three year degree, and leave university with significant debts.

rc-shadows

Radcliffe Camera in Oxford, but should students expect to study for free?

Some argue this is a mistake. Charging for university education will deter students and leave the UK with a shortfall of skilled labour – and arguably this will damage the long term prospects of the UK economy. Furthermore, charging for university will increase inequality of opportunity as students with low income parents will be more likely to be deterred from going to university.

Arguments for Free University Education

  1. Positive externalities of higher education. Generally, university education does offer some external benefits to society. Higher education leads to a more educated and productive workforce. Countries with high rates of university education generally have higher levels of innovation and productivity growth. Therefore, there is a justification for the government subsidising higher education.
  2. Equality. There is also a powerful argument that university education should be free to ensure equality of opportunity. If students have to pay for university education, this may dissuade them. In theory, students could take out loans or work part-time, but this may be sufficient to discourage students from studying and instead may enter the job market earlier.
  3. Increased specialisation of work. The global economy has forced countries, such as the UK to specialise in higher tech and higher value added products and services. The UK’s biggest export industries include pharmaceuticals, organic chemicals, optical and surgical instruments, and nuclear technology (see: what does the UK produce?). Therefore, there is a greater need for skilled graduates who can contribute to these high-tech industries.

Arguments against free university education

  1. Opportunity Cost. If we spend billions on free university education there is an opportunity cost of higher taxes or less spending elsewhere. Arguably, there is a greater social benefit from providing vocational training – e.g. so people could become plumbers, electricians e.t.c. There is often a real shortage of these skills in an economy. The UK commission for skills and education report significant skills shortages in the basic ‘core generic skills’ such as literacy, numeracy and communication skills. This skill shortages are prominent in industries like building, health care, plumbing, social care and construction. Generally, the problem is not a shortage of graduates with art degrees, but lower level vocational skills. (See: BBC – skills shortage in the UK) Therefore, there is a case for charging for university, but greater public spending to tackle this lower level skill shortages. Continue Reading →
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Threats and opportunities of Chinese growth on UK economy

Readers Question: Hello I recently saw a programme How China Fooled the World – with Robert Peston and I was wondering what threats and opportunities does the growth of economies like China and India provide to the UK economy?

According to the IMF, in 2010, the Chinese economy was $5,878 billion – second only to the US economy. If we use GDP at purchasing power parity (PPP), the size of the Chinese economy is estimated to be even larger, at around $10,119 billion.

China also has a growth rate, averaging close to 10% a year. Even if there is a slowdown in this record rate of economic growth, China is forecast to become the dominant world economy within 10 or 20 years. India is another sleeping giant. Although India’s growth rate is slower than China it is the second most populous country and is still catching up with the rest of the world.

Opportunities of Chinese / Indian growth on UK economy

Low cost of manufactured goods. One major consequence of economic growth in China is that the UK has benefited from lower prices of many manufactured goods, imported from China. If you have ever wondered how Pound shops can sell so many goods for £1 – the answer is directly importing from China. China’s success in keeping costs low has created a downward pressure on prices. This helps to keep inflation in the UK low and improve living standards for UK consumers.

Growing consumer class. So far China’s growth has mostly concentrated on export led growth, leading to a large current account surplus. However, the next stage of Chinese economic development will likely see a growing consumer class who wish to purchase more luxury goods and services. This provides a significant opportunity for UK exporters of goods and services. Because of the size of the Chinese economy, there is strong latent demand. This could benefit UK exporters of  high value added goods, such as nuclear technology, chemicals, cars (see: what UK exports). Also, there will be growing demand for UK services, such as university education / learning English. So far China’s growth has been somewhat one-sided – we have seen UK manufacturing firms squeezed out of business, but the other side of the equation is that British firms will have a strong growing market in China.

Lower costs of production. Another big advantage of the development of the Chinese and Indian economy is that it provides UK firms with potential lower costs of production. For example, many UK service centres have been shifted to English speaking centres in India. This dramatically reduces labour costs, leading to lower costs for telephones e.t.c. Also, an English firm which innovates a new product can use the low cost manufactured process of China to bring the product to the market at a competitive price. This is speeding up the globalisation of production. Increasingly we see a product produced in different sections of the world. e.g. the most famous is probably ‘Apple – designed in California, produced in China.’

Alternative to US / Europe. Traditionally, the UK economy has been reliant on exports to the EU and US. With the EU and US economy relatively stagnant, growth in exports to non-EU countries suggests the economy will become more diversified and less reliant on the EU trading block.  (see: UK exports to non-EU countries)

 

Threats of Chinese growth

Increased competition for raw materials. Chinese growth has come at a cost of seeing rising price of raw materials. For example, during the recession of 2008-13, we saw periods of rising oil prices. This is unusual – usually during a recession in the West, oil prices fall. But, due to the growing demand from China and Asia, oil prices have been rising. This has squeezed living standards in the West. We faced both recession and rising prices. As the China and India economy grows, the pressure on raw materials is likely to exacerbate. Continue Reading →

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