Entries Tagged 'economics' ↓

Joining the Euro is supposed to be an irreversible decision. But, individual countries could always pass individual acts of parliament to leave the Euro. However, leaving aside all the political issues, there are many economic stumbling blocks.

One problem is that countries generally would only consider leaving when there was a real economic crisis – but, it is during  an economic crisis, when it would precisely be most difficult to leave.

I have covered this question in more detail at: Leaving the Euro.

But, essentially the problems of leaving the Euro include:

• Transaction costs of converting cash and machines.
• Difficulty of deciding exchange rate to leave at
• Difficulty of converting all contracts, mortgages, bank accounts from Euro to native currency.
• Possibility of capital flight in anticipation of Euro exit and subsequent devaluation
• Issues of loss of confidence in economy.

The greatest difficult of leaving the Euro, would come for those economies which are uncompetitive, trade deficits, large budget deficits and who need to devalue. (i.e. the likes of Greece, Spain, Italy).

The problem is that if Greece announced it was going to leave the Euro, investors and savers would withdraw from Greek banks to protect against devaluation.

A strong economy like Germany would find it easier to leave. A new D-Mark would appreciate so there would be no capital flight, in fact they would benefit from capital inflows.

This would enable the Euro to devalue and help it’s neighbours regain competitiveness.

Although the idea of Germany leaving the Euro sounds pure fantasy. The Euro economy is unbalanced.

Germany’s trade surplus is by far the largest in Europe, reaching 135.8 billion euros ($184.9 billion) in 2009, – Eurostat, the European Union’s statistics office.

The countries with the biggest trade deficits are also the ones with biggest economic problems: Britain, Spain, Greece and Portugal.

Readers Question: Does it (financial crisis) have any possible positive effects for the future?

It is an opportunity to repair a broken financial system and put in safeguards to prevent future boom and busts.

For example, we could have policies which banks automatically hold more deposits during a boom to provide  counter cyclical instruments.

Better Regulation. We can have regulation to avoid mortgage products which have a high likelyhood of default.

It is another reminder of the fallibility of the free market and the psychology of booms and busts. Though this interesting book – This time is different – 800 years of financial crisis. Suggests it won’t be the last time, irrational exuberance will lead to market crisis.

A combination of factors made this crisis severe. It certainly provides an opportunity for reform of financial system, but, it is often harder in practise than principle. Markets have an ability to get around regulation. They still have political power in influencing government legislation. Also, the negative effects of the crisis will be felt for a considerable time. – Where did all the money go – article in Telegraph suggests bank lending is likely to remain constrained for a considerable time

A new Era of Frugality? – Another potential benefit is that maybe consumers and society in general will be more thoughtful of the long term rather than short term consumption. A higher saving ratio may enable a higher investment rate and a more balanced economy. The UK and US economies were both geared towards consumer spending, partly financed through rising house prices. The recession may steer the economy in a different direction.

Better Macro economic policy. Policy makers are having to rethink the limitations of relying on a simple interest rate tool and 2% inflation target. Macro economics is more complicated than such a simplification.

Readers Question: Is the recession an urgent wake up call?

Yes, A few main issues arose.

1. Need for Better financial regulation. The primary cause of the recession was a credit crisis brought about by a raft of defaults on mortgages. This was worst in the US, where many subprime mortgages were sold to people who couldn’t pay back. If the mortgage industry had been properly regulated these kind of absurd mortgages could never have been lent.

The whole financial system was affected because global banks were buying these risky assets with little awareness of their toxic nature. There was a very poor awareness of risk.

See: Economic Lessons from Financial crisis of 2008-09

2. Bank Strategy. Many banks in the UK had pursued high risk growth. Traditional bank models were ignored as money was borrowed on money markets to lend mortgages. Bank reserve ratios fell on the assumption of continued growth. The banking system only survived due to extensive public support, placing a large burden on taxpayers.

See: Problem with Bank bonuses – the problem of the risk culture endemic in banking

Problem of Bank bailouts

What can we learn from financial crisis?

3. Boom and Bust in Asset Prices.

It was hoped controlling inflation would be sufficient to prevent a boom and bust. What this recession shows is how a bubble in asset prices (houses, and shares) can have a significant impact on macro economy.

Unfortunately, macro economics is much more complicated than just adjusting interest rates to keep inflation at 2%.

Related

- Is inflation really so bad?

What is optimal inflation rate

As the old saying goes there are two certainties in life – death and taxation.

So why not combine the two and raise revenue from inherited wealth?

I have written on this topic before

• The Death of Inheritance Tax
• Why are we reluctant to tax Wealth?

But, I would like to make another case for why a ‘death’ tax meets the criteria of a ‘good’ tax

Principles of a Good Tax

• Effective in raising revenue
• Non Distortionary (efficient)
• Perceived as Fair – helping to promote greater equality
• Simple and Easy to Understand

Firstly a tax on inheritance doesn’t distort economic behaviour. Increasing income tax to 50% may discourage people from working in UK / working overtime. However, a tax on wealth, should make no difference to incentives to work during your lifetime. In this sense the tax is efficient and non-distortionary.

A tax on wealth, is one of the best ways to redistribute wealth inequality. Wealth inequality is greater than income inequality. A report by, World Institute for Development Economics Research at the UN University, suggests that 2% of population own 50% of global wealth (BBC). An inheritance tax is the best way to redistribute wealth and raise revenue. It is fairer than raising VAT which is paid disproportionally by people on low incomes.

There is popular opposition to inheritance tax, yet, the majority of inheritance tax is paid for by the wealthiest section of society. It is strange that a tax on bank profits would be so popular, but, an inheritance tax so unpopular.

It is easy to criticise taxes, but, we need to find ways of paying for an ageing population, and an expanding health care system.

Personally, I would much rather pay taxes when I’m dead and no longer need it, than pay taxes when I’m alive.

Readers Question: If I have to get economic master degree,what kind of job İ will apply in real life . can you give me list of economic job?

The most common questions I get asked by students is either?

• Why didn’t you get a better paid job in the city?
• What Job can I get with an economic Degree?

It is important to bear in mind an Economics degree will provide you with many skills desirable by employers. These include:

• Maths skills
• Ability to understand key issues affecting business
• Ability to analyse, understand and interpret data
• Ability to evaluate and solve problems.
• Communication skills

Many employers don’t look for particular degrees, but, evidence of the ability to learn fast, be articulate and have the above qualities. In reality, the degree you choose is not as critical as students sometimes feel. For certain professions like medicine – your choice of degree is pretty limited. But, for many other professions a variety of degrees are possible. With an economic degree, you will have a variety of options open to you, especially in the business and accounting world

According to prospect magazine, the most popular destination for economic graduates are – 20% of economics graduates going straight into employment become business and finance professionals, and 17% become commercial, industrial or public sector managers. Almost 18% go on to further studies or training of some sort. (source: Why Study Economics?)

So, you will not just be limited to a poor economics teacher or jobs as an economists. And if all else fails, you can always set up a blog on economics…

Readers Question: I really wanted know more about private, public, free and merit goods not luxury,normal and inferior goods.that makes absolutely no sense at all. well by the thanks for your answer.

Free Good. A free good is a good needed by society but available with no opportunity cost. It is a good without scarcity. For example, air is a free good, because we can breathe it as much as we want. Water is usually another free good. Though in some countries, water can become scarce – then it is no longer a free good.

• Note: a good may be given away for no charge (e.g. health care is free at the point of use) However, it is not a free good because there is an opportunity cost – health care paid for out of taxes

Public Good – A public good has two characteristics

• Non rivalry – consuming good doesn’t reduce amount available to other people
• Non excludable – once provided you can’t stop anyone consuming it.

Examples include street lights and national defence. Typically they are not provided in free market because firms cannot charge people.

(Note: Goods provided by the public sector (government) are not necessarily public goods. e.g. government provide education, but, education is a merit good not a public good)

Private Good – This is the opposite of a public good. It is a good which has rivalry and excludability. E.g.  a bottle of water is sold to one individual who will consume it all. These goods are provided in a free market because a firm can make profit from them.

Merit Good – A good where people underestimate the benefits of consuming. Merit goods usually have positive externalities.

Eg. Education is a merit good. People underestimate benefits of studying and so there is underconsumption.

Note Merit goods may be provided in a free market – but in insufficient quantities.

Inferior, Normal and luxury goods are to do with income elasticity of demand.

See: Different types of Goods

• Normal good – occurs when an increase in income leads to an increase in demand
• Inferior good – when an increase in income leads to fall in demand.
• Luxury good – when an increase in income causes a bigger percentage change in demand. YED >1

A few people have asked why don’t government’s just default and not pay their debt back?

Firstly, a government could effectively default just by printing money, creating inflation and making it easier to pay debt back. But, if the government does create inflation (print money) to pay off its debt or simply refuses to pay, there are real problems.

Debt Defaulter If a government defaults on its debts, who is going to lend it money in the future? Once you get a reputation as being a defaulter, it will be very difficult to encourage people to buy your bonds again.  That means the government will not be able to borrow in the future. Or if it does borrow more money then it will have to pay a much higher interest on the debt.

Reduction in Living Standards. Weimar Germany in the 1920s and Zimbabwe in 2008, both had high levels of government debt which led to hyperinflation. But, this kind of inflation destabilises the economy. Money becomes worthless and people resort to a barter economy. This kind of inflation damages economic activity.

Reduction in Value of Currency. If you default on your debt, there will be a sell off of your currency. This will make imports more expensive and reduce living standards.

Confidence in Single Currency

In a single currency, the default of one nation, would damage the exchange rate for all member states. If one country defaulted, markets would lose confidence in other countries will similar situations. It would become more difficult and more expensive for all member countries to borrow.

Note: In a period of deflation, it is possible for a Central Bank to pursue quantitative easing (creating money) without causing inflation. To some extent, in certain circumstances, a government may be able to create money to buy a proportion of its debt. But, to completely default on your debt would create many problems, and you would probably never be able to borrow again.

via [1]

The Budget deficit is the amount a government has to borrow in a particular year. Total Debt (known as public sector debt or referred to as national debt is the total amount of debt that the government owes – to private sector, Central Bank e.t.c)

In the case of Greece, they already had a high debt, before the onset of the crisis. Even during reasonable growth, they had a high budget deficit and national debt as a % of GDP.

Note, if you had a budget deficit equal to 3% of GDP and economic growth of 3%, then national debt as a % of GDP would remain the same. Negative growth in this recession is another factor that has increased the debt as a % of GDP in many countries.

An international comparison of debt via Spanish Tragedy

• Understanding Government Debt

Readers Question: Can you please discuss the nature of the current account deficit and the exchange rate in the UK along with the theory that would suggest there is a relationship between the exchange rate and the current account.

In theory, the exchange rate will have an impact on the current account.

If there is a depreciation in the exchange rate. Then that particular country will experience a fall in the foreign price of its exports. It will appear more competitive and therefore there will be a rise in the quantity of exports.

Assuming  demand for exports is relatively elastic then a depreciation will lead to an increase in the value of exports and therefore improve the current account deficit.

Similarly a depreciation of the exchange rate, will also lead to an increase in the cost of buying imports. This will lead to a fall in demand for imports and also help to reduce the current account deficit.

Therefore, in theory, a depreciation in the exchange rate should improve the current account and an appreciation should worsen the current account.

However, in practise this might not happen for a variety of reasons.

1. Elasticity of Demand. The impact of a depreciation depends on the elasticity of demand. The Marshall Lerner condition states that a depreciation in the exchange rate will only improve current account – if combined PEDx and PEDm is greater than 1.

e.g. if demand for UK exports is very inelastic. They a depreciation will lead to only a very small increase in demand.

2. Profit Margins. A depreciation means exports can be cheaper. However, a UK firm may decided to keep the same foreign price and just make a bigger profit margin. This often occurs in the short term. Firms don’t adjust prices to consumers but have exchange rate movements absorbed in their own margins. This is one reason why a movement in the exchange rate often takes time to effect the current account.

The J Curve effect states how a depreciation can worsen current account in short term because demand is inelastic, but, over time, demand becomes more elastic and therefore the current account improves.
See also: Terms of Trade – Using example of UK, a depreciation in the Pound did not effect the terms of trade as much as might be expected.
See: Terms of Trade Effect

3. Global Demand.

The depreciation in the Pound Sterling didn’t effect the UK current account deficit. One reason was the sluggish global growth. There was little foreign demand for UK exports

Some selected levels of Public Sector debt in different countries

• US Gross Debt 2008 12,867.5bn 90.8% of GDP (EST) (US Debt)
• Japan National Debt 192% of GDP 2009 est) 836,521 trillion yen 2007
• Italy National Debt 115% of GDP (FT)
• UK National Debt 68% of GDP (UK)

Continue reading →