European unemployment crisis

Unemployment in many European countries has risen sharply due to the credit crunch and global recession. The worst hit countries include Spain (ES) and Greece (EL), who both have unemployment rates of over 24%. In the past few months, there has been a slight reduction in European unemployment, but, the prolonged period of mass unemployment is leaving significant social and economic problems for the whole Eurozone.
  • Unemployment rate in the Eurozone area: 11.5% (July 2014)
  • EU-28 Unemployment is slightly lower at 10.2% (July 2014)
  • Total unemployment in the EU-28 is 24.850 million (July 2014)
  • The Eurozone  (EA-18) jobless total is now 18.409 million. (link) The highest since records began.
  • Youth unemployment rates in the EU 27 is 21.8% (July 2014)
  • The lowest unemployment rates are in Austria (4.9 %) and Germany (4.9 %). The highest rates are in Greece (27.2 % in January 2014) and Spain (24.5 %).
  • By comparison, unemployment in Japan is 3.6%, and in US 6.8%. UK unemployment is 6.5%
  • Eurostat unemployment figures

EU unemployment

Source: ECB

 Causes of European unemployment crisis

After falling to 7.5% in 2008, the prolonged recession of 2008-13, has caused a sharp rise in unemployment.  The continent seems to be stuck in a deflationary spiral and is facing a prolonged double dip recession. Hardest hit debtor countries, such as Spain, Greece, Portugal and Italy are facing stringent budget cuts – which are depressing demand.

Will Eurozone break up?

But, in the Eurozone, there is little relief available to boost demand. Countries are unable to devalue. Monetary policy set by the ECB has been unflinching in targeting low inflation and offering little monetary easing – despite the prolonged recession. Also, depressed demand throughout the region is making it difficult to grow through increasing exports. Even northern Europe, which has had large current account surpluses are engaging in modest austerity. The result is that demand has remained depressed across Europe.

Despite its potentially damaging social and economic impact, throughout the 2008-13 European crisis, unemployment has had a relatively low profile –  European policy makers have always given the impression they are more concerned about appeasing bond markets and low inflation than tackling the more pressing problem of unemployment. There has  been a reluctance to tackle the fundamental deficiency of aggregate demand which is leading to lower growth and falling employment. Efforts to reduce unemployment have centred on talk of more flexible labour markets. This may be part of the solution for structural unemployment, but increasing labour market flexibility alone cannot deal with the cyclical unemployment.

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Why is the Aggregate demand (AD) curve downward sloping?

Readers Question: I have read the following:“The AD curve is downward sloping. This is not because ‘people buy more things when they are cheaper’ (the most common misunderstanding about the AD curve )”. I don’t understand this as I thought that the quantity /price relationship for demand is inverse.

 

AD-curve

From a micro perspective it is true that a lower price will encourage you to buy more of that product. If the price of potatoes falls, you may buy more potatoes instead of pasta because potatoes are now relatively cheaper. This is an example of a fall in the price of a particular good.

However, from a macro perspective a general fall in prices (deflation) can have different effects. Firstly, a fall in the general price level means all prices are falling (there could be exceptions, but on average prices are falling).-  This is different to one good becoming relatively cheaper.

Firstly, why do we draw a downward sloping AD curve?

  1. At a lower price level, consumers are likely to have higher disposable income and therefore spend more. (Note this assumes that wages are constant and not falling with prices)
  2. If there is a lower price level in the UK, UK goods will become relatively more competitive, leading to higher exports. Exports is a component of AD so AD will be higher.
  3. At a lower price level, interest rates usually fall, and this causes higher aggregate demand

In practise do lower prices cause higher aggregate demand?

  • A period of deflation (falling prices) can often cause lower aggregate demand – especially if falling prices is accompanied with falling wages (or at least stagnant wages)
  • If prices are falling, consumers may delay purchases because they expect prices to be cheaper in the future
  • If prices (and wages) are falling, then consumers may see an increase in the real value of debt. Deflation increases the effective debt burden, leaving less for spending.
  • Falling prices may increase real interest rates - if nominal interest rates can’t fall any further.

Falling prices could be compatible with rising aggregate demand

If falling prices are due to technological improvements and enabling  higher real wages. In this case, we could get lower prices, but AD continues to increase.

If falling prices are caused by a recession and spare capacity, then we are much more likely to get lower AD. In a recession, wage growth will be weak and consumers nervous to spend. Falling prices will be not sufficient to encourage spending because confidence is low.

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The problems of a Scottish currency union

If Scotland gains independence, the Yes campaign has argued that their preferred option is to keep the Pound Sterling and enter into a currency union with the rest of the UK.

This means sharing the same currency Pound Sterling, and having the same monetary policy. Monetary policy would continue to be set by the Bank of England. There would be no exchange rate between the two countries.

Currency Union with the rest of the UK

However, currency unions are problematic. The Eurozone has been a disaster for many European countries who have been saddled with high unemployment and stagnant economies. See all problems of Euro here.

A big problem with currency unions is that in the absence of a lender of last resort, you face pressure to limit budget deficits. Since the Euro was created, Southern Europe has been pushed into more austerity than is desirable. It has left their economies vulnerable and with limited options to deal with trade imbalances and economic downturns.

The Bank of England governor, Mark Carney insisted a currency union with a sovereign, independent Scotland was impossible. “You only have to look across the Continent to look at what happens… A currency union is incompatible with sovereignty.” (Guardian)

Paul Krugman has stated there are great risks of sharing a currency.

Economists (starting with my late colleague and friend Peter Kenen) have long argued that sharing a currency without fiscal integration is problematic; the creation of the euro put that theory to the test. And the results have been far worse than even the harshest critics of the euro imagined, with euro Europe doing worse at this point than Western Europe did in the 1930s:

090914krugman2-tmagArticle

Krugman goes on to argue that Scotland’s position could be worse than the Eurzone because there is no guarantee that the Bank of England will be interested in acting like Mario Draghi in his support for debtor countries.

An independent Scotland would be dependent on the kindness of the Bank of, um, England, with no say whatsoever in that bank’s policy. (Scotland and the Euro omen)

Currency unions also exacerbate political tensions. People in southern Europe feel let down by economic policy of the ECB and northern Europe.  Germany on the other hand is not happy with the perceived need to bailout its profligate neighbours. Currency unions have not been an effective system for encouraging harmony amongst nations – in fact the opposite. There is a real fear that after independence – Scotland could feel exacerbated and frustrated at being at the mercy of English monetary policy.

But could a currency union between Scotland and the UK work?

Tejvan-adam-smith

Me underneath statue of Adam Smith in Edinburgh

There are some reasons to believe that a currency union between Scotland and the UK would work better than the Eurozone.

Firstly, there is much better labour mobility between Scotland and England than say between Greece and Germany. If the Scottish economy is relatively depressed, workers could move south and vice versa.

A big problem of the Eurozone was  the divergence in wage costs and relative prices. This left southern Europe uncompetitive but without the option of devaluation to restore competitiveness. This is perhaps less likely to be a problem between Scotland and England. If there is a significant divergence in wage costs, readjustment is easier because of the greater capital and labour mobility. Continue Reading →

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Real effective exchange rate

The real effective exchange rate measures the value of a currency against a basket of other currencies; it takes into account changes in relative prices and shows what can actually be bought.

sterling-90-10

Nominal exchange rate

The nominal exchange rate measures the current value of a currency against another. For example, in Sept 2014

£1 – $1.61 or $1 = £0.62

Effective exchange rate

The effective exchange rate measures a currency against a basked of other currencies. This is usually trade-weighted. When looking at the effective Sterling exchange rate we will compare the value of Sterling against our main trading partners – The Euro, the Dollar, the Yen e.t.c and give a weighting depending on how much we trade with that country, e.g. Eurozone 60%. A weighting will be given to different trading countries depending on how significant they are.

The effective exchange rate is good for looking at the overall performance of a currency. For example, the Pound may appreciate against the Dollar – but this  may be due to just temporary weakness in the Dollar. However, if the overall effective exchange rate increases, it suggests the Pound is becoming stronger.

Real exchange rate

The real exchange rate measures the value of currencies, taking into account changes in the price level. The real exchange rate shows what you can actually buy. It is the value consumers will actually pay for a good.

RER = E.R *(price level in country A/Price level in country B)

Increase in real exchange rate

  • If a countries real exchange rate is rising it means its goods are becoming more expensive relative to its competitors.
  • An increase in the real exchange rate means people in a country can get more foreign goods for an equivalent amount of domestic goods.
  • Therefore an increase in the real exchange rate will tend to increase net imports. Foreigners will buy our less expensive exports. It now becomes more attractive to buy imports. This can cause a widening of the current account deficit and lower domestic AD. It will also help reduce inflation.
  • Similarly a fall in the real exchange rate should increase net exports as domestic goods are more competitive.

(Readers Question: Does an increase in Real Effective Exchange Rate increase or decreases international competitiveness for the country? An increase in the real effective exchange rate will decrease international competitiveness. It means the country has relatively more expensive exports, leading to a fall in net Ex)

Inflation and the exchange rate

If the UK experienced inflation of 10% and US had inflation of 0%. We would expect the nominal value of the Pound to fall 10%. In this case, the real exchange rate would stay the same. The Pound has fallen 10%, but British goods are 10% cheaper. The amount of goods you can buy stays the same.

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Money and credit

Readers Question: In simple terms what is the difference between credit and money?

 

Credit

Credit is any form of deferred payment. For example, if you purchase on a credit card – a bank effectively pays for you, anticipating you will pay the credit card company back the credit in six weeks time.

If a bank lends money to a consumer, this is a form of credit. The consumer is given money, which it later has to pay back to the bank.

Money

Money is any item or electronic record that can be used for the purchase of goods,  provide a store of account, and used as a medium of exchange.

If you buy on a debit card, you are using actual money in your bank account. You have a certain amount, and once your bank account is depleted you can’t spend any more money. People will accept your money as legal tender in that country.

Example

If you buy on a credit card, the amount you can spend depends on the generosity of your credit card company. For example, you may spend £3,000 on credit (money you may or not have). However, the credit card company may decide to increase the amount of credit that it gives you, it can increase your credit card limit to £5,000 and more credit is created. But, you have to pay this back. This credit is not negotiable, you can’t go to a shop and directly offer them some of  your credit card limit.

You can’t increase the amount of money you have (without earning it), but you can increase the amount of credit you receive – if banks are willing to lend it to you. In this sense, you could think of money as more tangible, credit is more intangible.

As a youngster, you will be told ‘money doesn’t grow on trees’. You can’t personally create money out of thin air.

But credit in a way can be created out of thin air. If a bank decides to lend more.

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Reasons firms invest in very competitive markets

Readers Question: Why invest capita in purely competitive industries with equilibrium margins that are razor thin and entrants that erode quasi profits? Suppose volume is not exceptionally large, why then?

Battle_of_the_pound_shops

Economic theory suggests that firms will invest in industries where there is supernormal profit being made. Investment will be more attractive in industries where there is a degree of monopoly power and higher profit margins.

However, in the real world, firms can make decisions based on other factors and decide to enter an industry with low profit marigins.

Why might a firm invest in a very competitive market with low profit margins?

Self belief. An entrepreneur may have great self-belief that it can do better than all the incumbent firms. For example, the coffee shop market may be very competitive in a certain town, but someone with great passion for coffee may feel he can still do it better than all the incumbent firms. Therefore, even though the market is already competitive, they may still enter. This is something that economic theory may not give too much weight to – personal ambition, pride and self-belief – but it is a quite common that people think they can just be better than the competition. This self-belief may even be a motivation for a firm to enter a loss making industry.  It’s not quite the same, but recently restructuring specialist Hilco tookover HMV – a record shop making a loss. But, Hilco had the confidence to turn the firm around; initial reports suggest they have been successful.

Expand the market. An entrepreneur may see a very competitive market with low profit margin, but feel they can still expand the market. For example, in the 1990s, the coffee shop industry was probably quite competitive with a low profit margin. But, Starbucks still saw a gap in the market and opened a lot of new coffee shops (often right next to existing coffee shops). They felt they could grow the market, sell extras and increase profit margins. That industry has expanded and become more profitable in recent years.

Multinational companies can afford low profit margins. Many entrepreneurs would be reluctant to risk entering a market with very low profit margins. However, some big companies can afford to enter an industry even if they don’t expect to make much profit. For example, big supermarkets entered the petrol retail industry. They drove down already slim profit margins. Petrol retail is not there core business. They are probably happy for petrol to be a ‘loss leader’ to attract customers to the store. In other words, people come to fill up with petrol at Tesco, and then spend £80 to do their weekly shop. The profit on petrol maybe zero, but if Tesco gain more customers spending £80 on groceries it is a good business decision. It wouldn’t make sense for someone to set up an independent petrol station because profit margins are so poor (in fact many independent petrol retailers have closed down in recent years) There may be many other examples where multinationals feel there is strategic benefit to entering a competitive market with low profit margins.

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Competition in the seafood industry

Readers Question. I came across a company recently which farms mussels of the coast of a small town in Bulgaria, and I started thinking about its structure in the economy. I know since it produces a homogeneous product along with hundreds of other mussel farmers, it must be in perfect competition, however this mussel company also sold locally on top of selling to suppliers. This means it was the only mussel supplier (locally) in the town, and as far as I know that’s a monopoly. My question is, what would this company’s graphs look like? Would it be more like a perfect competition, or a monopoly? Although it is the only supplier in the town, it sells the mussels at the same price if not cheaper to locals as it does to suppliers, which I know unlike monopolies. Would there be any deadweight loss in a company like this? Is it inefficient or is it more efficient than normal? Consumers can buy mussels from the supermarket, but local supermarkets all get their supply of mussels from this one local company. Please help me understand!

mussels-mtsofan

Firstly, this is the first time I’ve been asked about the Bulgarian mussel market so I can’t claim any specialist knowledg.

But, Selling mussels does look like it exhibits features of perfect competition.

  • There are many farmers (sellers)
  • It is an homogeneous product
  • Buyers are likely to have good information about the product and price.

The market price is likely to be determined by a simply supply and demand curve

supply-demand

Selling locally – Is it inefficient or is it more efficient than normal?

If the local mussel farm sells to a local town, I don’t think makes it a monopoly. I’m sure that local restaurants and supermarkets could choose to buy from other distributors. But, local restaurants probably find that the local mussel farmers can undercut distributors because effectively they are cutting out the ‘middle man’ and transport costs

If the local mussel farmers sold above the nationwide price, restaurant owners would buy from the more traditional distributors. So there is still a degree of competition.

In this sense it is more efficient than normal because you can go from supply direct to retail, and cut out transport costs and the efficiency loss of selling on to a distributor.

In one sense the mussel farmer may have local monopoly power, but this is far outweighed by the lower costs and greater efficiency of being able to supply direct to the local market.

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Is the Euro really a failure or is it a failure of policy?

Readers Questions: Could you not also argue not that the Euro is a failure but that it’s members/ECB are pursuing the wrong policy? Predictions of the death of the Euro seem to have been much exaggerated & surely Europe has the potential to be a world economic superpower to rival the US or China?

It is an interesting question, and to some extent inappropriate policy is a considerable factor in the ongoing European difficulties. However, there are still structural problems surrounding the Euro, which make economic stagnation more likely than in a floating exchange rate with independent monetary policy.

Poor Policy decisions in the Eurozone

1. Failure of ECB to intervene in bond market. One example of poor policy decisions is the failure of the ECB to stop rising bond yields earlier.

eu-bond-yields

In 2011 and 2012, we saw a sharp spike in bond yields – because the ECB was, at the time, unwilling to act as lender of last resort and purchase any bonds or supply liquidity. This lack of intervention by a Central Bank meant that investors became nervous and bond yields rose to very high level. This rise in bond yields caused higher debt interest payments, but most damagingly were the motivation for deep austerity which caused a deeper recession in the affected Eurozone countries.

In 2012, the ECB changed its policy and became willing to intervene in the bond market. Bond yields fell – showing that decisive Central Bank intervention was needed. Therefore, despite higher government borrowing, bond yields are now much lower than in 2011 and 2012.

Before 2012, the ECB were partly blaming the constitution of the Eurozone where it seemed the Central Bank did not have a clear mandate to intervene and provide necessary liquidity in the bond market. However, the fact that bond yields have fallen in recent months suggests that the Euro can be more successful, if the Central Bank is given the authority and mandate to provide the necessary liquidity. Some Germany bankers are still unhappy at the ECB’s intervention – fearful it may encourage fiscal profligacy.

However, it is still more difficult in the Single Currency to intervene in bond markets. It is more complicated for a European wide Central Bank –  how much should it intervene? which countries should be supported ?e.t.c.

But, if the ECB had understood the necessity of intervening earlier, then we could have avoided that period of high interest rates, and partly avoided the lurch towards austerity and lower aggregate demand.

Exchange rate imbalances

A structural problem of the Eurozone is that without exchange rate fluctuations the south became uncompetitive. This led to large current account deficits in Portugal, Spain and Greece, and large current account surplus in Netherlands and Germany.

A better policy for the Eurozone would be for Germany to increase domestic demand – boost consumer spending and allow a moderately higher inflation. This would help the Eurozone to rebalance. It would lead to higher demand for southern exports and help deal with the trade imbalance in the Eurozone. It would help southern Europe restore competitiveness without just relying on deflationary policies. Continue Reading →

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Questions on monopsony

“Readers Question – A microeconomics question. In you labour market section you discuss a monopsonist.You say that “in order to employ one extra worker the firm has to increase the wages of all workers”- why? You give a coal mine as a possible example of a monopsonist, do you really think that a coal mine owner hired an extra worker(the marginal cost) and then increased the “wages of all workers”? Can you clarify this.

Just think of an upwardly sloping supply curve of labour.

supply curve

  • If the firm offers a wage of £100, it can employ 10 workers.
  • To employ 11 workers, it would have to increase the wage rate to £110.

Therefore, according to this supply curve, if the firm needs to employ 11 workers the firm has to pay every worker £110. Therefore the marginal cost of employing an 11th worker is £210 (11*110 = £1,210 – 10*100). The marginal cost of the 11th worker is greater than the average cost

Theory and in practice

1. Wage discrimination. One exception would be if a monopsonist could wage discriminate – i.e. pay £110 to the extra worker, but continue to pay £100 to the existing mine workers. In reality this could be possible. For example, the firm could introduce a special post or job title which pays £110, whilst the existing workers get stuck on £100. If the monopsony can get away with this, then it will not have to pay every worker £110.

2. Elastic supply. Also, another possibility is that the supply curve is very elastic, therefore there may be infinite (or at least a very large) supply of labour at £100. For example, in a period of high unemployment, there are probably many workers willing to supply there labour at £100. Many coal mine owners may find, even at low wages, a large pool of unemployed workers willing to take a job at £100.

However, the theory of an upward sloping supply curve suggests that the marginal cost of employing an extra worker will increase faster than average cost.

Readers Question: My confusion gets worse as on the same page you say that one of the problems with a monopsonist is it can “lead to lower wages for workers”. Doesn’t this contradict your above point about a monopsonists increasing all workers’ wages as it employs one extra worker?

The key thing is that a monopsonist is reluctant to hire extra workers, precisely because it would have to increase wages of all workers (high marginal cost). Because of this prospect the monopsonist prefers to employ less workers and pay lower wages. To profit maximise, it avoids the extra marginal cost of paying all workers more.

monop

This diagram shows a theoretical monopsony. It’s profit maximising decision is to employ only Q2 workers at a wage of W2. (where MRP = MC). This is a lower wage and lower quantity of workers than in a perfectly competitive market.

See: Monopsony for more explanation

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Thanks for questions – back from holiday

Thanks for the questions, which have been building up in Readers Questions

During the summer holiday, I find it difficult to get into writing economics, but now the new term has started I will get back into the flow. Feel free to ask any more questions.

photo Dave haygarth

photo Dave haygarth

By the way, away from economics, the highlight of the summer was watching the Tour de France go through Yorkshire. That was quite an event.

 

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