Readers Question is recession causes unemployment or unemployment causes recession?

Essentially, it is a recession which causes unemployment. As output and demand falls, firms cut back on hiring new labour. This leads to a rise in unemployment as there are less job vacancies.

Also, some firms may have to shed labour through redundancies, directly creating unemployment.

As unemployment rises, this can worsen the recession. The unemployed will have less income to spend leading to lower consumer spending, lower Aggregate Demand and lower growth rates. This in turn can lead to more job losses as firms have to cut back even further on employment levels.

This is an example of a negative multiplier effect in operation.

It is possible a rapid rise in structural unemployment (e.g a large industry like the coal mines close down) could be a factor in triggering a recession (but, this is rare). Generally, it is a recession which is the cause of a rapid rise in unemployment. The problem is that the rise in unemployment can reinforce the downturn in economic growth.

A while back, I looked at why unemployment has not increased by more in this recession.

A recent report (BBC link) suggests the recession has had a deep impact on jobs. According to The Chartered Institute of Personnel and Development (CIPD), the recession caused the loss of 1.3 million jobs – this is higher than official rise in unemployment because many of those made redundant were able to find new jobs.

But, it does show the recession has created much uncertainty in the job market.

When teaching A level economics, we often need to look for evaluation of a question. In macro economics one of the most effective strategies is to consider the impact of consumer confidence and expectations.

For example, suppose you have a question about the impact of a rise in VAT to 17.5%. The simple analysis is to say that the higher rate of tax will reduce consumer disposable income leading to a fall in consumer spending and economic growth.

However, the impact of a tax rise does depend on other factors.

UK Consumer Expectations

Consumer Expectations: Source: Nationwide

At the start of 2009, consumer expectations was at a record low. An index of 60 implies more people are negative about future economic expectations. With such a negative outlook for the economy, a tax rise would have led to a big fall in consumer spending.

In that period, interest rates were cut to 0%, but even these interest rates cuts did little to improve spending – because many consumers were pessimistic about the future so they were saving any increase in disposable income. Therefore interest rate cuts were  largely ineffective.

However, if you increased taxes when consumer expectations were very positive, the impact of a tax rise may have less impact. If consumers are confident about the future, they may reduce their saving rates and borrow more rather than reduce their spending.

Many ask why the government can increase the money supply and not create inflation. In usual circumstances an increase in the money supply of £2o0bn would be inflationary. But, these are not usual circumstances, banks are unwilling to lend, consumers are not keen to borrow. Therefore, the increased money supply is not increasing inflationary pressure at the present time. In other circumstances they would

Summary

Economics is never straight forward. The impact of a policy can be very different in different circumstances. We always need to take into account other variables such as consumer expectations.

Related

• Consumer Confidence.

Note: Consumer Confidence index is compiled from 5 questions about current and future state of economy. The consumer expectations just asks about outlook for 6 months ahead. This shows people are expecting economy to be better in 6 months.

Past Exam Question for those interested: Discuss the idea that an economy can think itself into a recession?

Readers Question: Discuss the Impact of A Decrease in Government Spending?

Due to the high levels of government borrowing, many analysts suggest the UK government (and also many other countries) need to cut government spending. What would be the economic impact of a cut in spending?

Firstly, government spending (G) is a component of Aggregate Demand (AD). In 2007-08, UK spending totalled £557,400m.  So (G) is a significant component of AD

The demand side impact of a cut in government spending will depend largely on the state of the economy.

The problem is government borrowing is often highest during a recession, but, this is the worst time to reduce (G) and AD.

Impact of a Fall in AD

If the government made plans to cut spending at the end of 2010, early 2011, there is a fear this could damage a fragile economic recovery. If house prices are falling, if consumer confidence is still low, if banks are still unwilling to lend then a cut in government spending could push the economy back into recession. This return to negative growth would also increase the size of government borrowing – In this case a cut in government spending could be counter-productive for reducing a deficit.

However, if the economy recovers strongly, if banks see an increase in their liquidity and become willing to lend, then the economy may be strong enough to shrug off a cut in spending. (e.g. imagine C, I and E components of AD are rising.)

Therefore, we need to be very careful about cutting spending, especially when some economists argue the degree of spare capacity in the economy suggests we need further fiscal stimulus not less.

However, if we have a weak pound (to boost exports) and loose monetary policy, then it may be possible to cut spending and maintain strong growth.

Spending and the Deficit

One of the main benefits of cutting government spending is that it will help reduce annual government borrowing and help the total public sector debt. In fact some economists argue it is essential to cut spending because borrowing is becoming dangerously high and the bond markets may start to downgrade UK debt because they feel it is too high. However, if a cut in spending does cause a further downturn the improvement in finances will be limited

Depends What Areas of Government Spending We Cut?

This question is open ended, it doesn’t say what areas of government spending will be reduced. In the run up to the election, you can guarantee all political parties will be talking about reducing bureaucracy and redtape e.t.c. But, when you have to wield the spending axe, you suddenly find many vested interests and/or public opinion against you. It is easier to talk of reducing government spending than actually to do it.

Some government spending e.g. roads, infrastructure, transport arguably have an important effect on the long run productivity of the economy. If we cut these areas of spending, then the UK’s productive capacity may suffer in the long term. (Aggregate Supply AS will increase at a slower rate)

From an economic perspective cutting spending on Social Security (£133m 2008) will have the least impact on economic productivity. In fact you could argue cutting spending on welfare benefits might actually increase the incentive for those on benefits to join the labour force. This could actually increase productivity.

However, cutting spending on welfare benefits risks increasing the level of inequality and relative poverty.

(Note: it is rare for governments to actually cut spending in real terms. In practise, we usually get a smaller rise in government spending. For example, for all the rhetoric of the Reagan and Thatcher governments about rolling back the frontiers of the state – government spending grew in real terms during the 1980s.)

One aim may be to reduce government spending as a % of GDP. Assuming GDP growth of 2.5%. Government spending can increase by 1.5% in real terms and still be a smaller share of the national cake.

Related

• Reasons for government spending

The UK economy is slowly emerging from the worst recession since the Great Depression of the 1930s. The recovery is being helped by:

• A weak pound and rising demand for exports
• Unprecedented loose Monetary policy – zero interest rates, quantitative easing.
• Loose Fiscal Policy

As the economy recovers, there is a chance of the Bank of England putting up interest rates towards the end of the year. This may finally start to make the Pound look more attractive. However, the Bank is likely to delay interest rate rises for quite a time. They will be reluctant to raise interest rates because:

The recovery is predicted to be anaemic (around 1% growth for 2010). This growth rate is still below the economies long run trend rate so spare capacity will still increase.

Peter Spencer, chief economic advisor to ITEM, has said the British consumer has very little cash to spend and the economy has a worrying dependence on foreign demand for UK exports. (see: Telegraph article)

The government need to show signs of tackling the fiscal deficit which has grown to record peace time levels (current annual budget deficit is around 14% of GDP). To reduce deficit will require higher taxes / lower spending. This will reduce weak consumer demand and therefore low interest rates will be necessary to avoid a second recession.

The weakness of the UK economy suggests that the Pound will continue to be weak against the Euro in 2010. It must be remembered this credit crunch hit the UK with its reliance on finance sector more than our European partners.

Of course, a weak pound is, in these circumstances, a blessing in disguise. It helps provide some demand in the economy. Our Greek, and Italian partners may not admit it. But, they must wish they had some of the UK’s flexibility in dealing with high budget deficits and a weak recovery.

See: Problems Greece has with being in Euro and trying to deal with high debt.

Readers Question: What would be the impact of a bust in China on UK and global economy?

China’s economy continues to break records with its break neck records. Depending which measure you use, China is likely to be the world’s biggest economy very soon. Yet, there is no guarantee that this impressive growth will always continue. How would the world economy be affected by a slowdown in Chinese growth?

China is the world’s largest exporter. Despite  a slowdown in 2009, China now accounts for 10% of global exports. This is predicted to rise to 12% in  2014. (Chinese exports at Economist.com)

Many people forget but, China is also a significant importer. Chinese imports from the US grew 14% in 2009. It is true China has a large current account deficit over 6% of GDP. But, if the Chinese economy did stop growing and go into recession, the UK and other countries would see a fall in exports.

This fall in exports could lead to a fall in aggregate demand and lead to lower growth. For the UK, exports to China are still a relatively small % of total exports. Therefore, on it’s own, a slump in China need not cause the UK to go into recession however, it would depend on other factors affecting the economy.

When China Sneezes?

In the post war period, there was a well known phrase ‘when America sneezes – the rest of the world catches a cold’ – However, America is no longer the dominant economic superpower. Maybe China will the world’s talisman. The point is a slump in China could adversely affect world economic confidence causing a range of problems.

Commodity Prices

To oversimplify, China imports raw materials and exports cheap manufactured goods. If China did go into recession, demand for commodities such as oil and precious metals would fall. This would cause lower commodity prices. It would particularly affect commodity exporting countries like Australia and Canada. Of course, some countries would benefit from lower commodity prices.

Related

• Should China revalue its currency?
• US China economic relations

Readers Question: What is the Economic significance of the construction industry to the UK economy, how it impacts, with respect to trend in economy.

According to BIS The UK construction industry   contributed 9.2% of the nations GVA (Gross Value Added) in 2007.

The UK construction industry consists of over 250 000 firms employing 2.1 million people in a multitude of roles. (I assume that they are including people indirectly involved in industry e.g. supply chains) – It doesn’t mean there are 2.1 million builders….

The construction industry tends to be volatile. In a recession, firms will tend to put off or delay large construction projects, therefore in a recession, construction output can fall significantly.

Purchasing Managers Index PMI

One measure of the construction sector is the PMI. A value of greater than 50 indicates the sector is expanding. A value less than 50 indicates contraction. In December of 2009, it was 47.1 – the 22nd month of falling output. (link Telegraph) This shows that the construction sector has been one of the hardest hit sectors of the economy during this recession
However, during periods of economic growth, the construction industry is likely to benefit from rising confidence and rising investment.

The construction industry plays a key role in both aggregate demand and aggregate supply. A fall in demand for construction projects will effect the 2.1 million people involved either directly or indirectly in the construction section. A rise in unemployment in this sector could also cause a negative multiplier effects with lower demand throughout the rest of the economy.

The level of construction will influence the long term productive capacity of the economy, especially for construction of transport and communications e.t.c.

A significant part of the construction industry is the housing sector.

I spent a lot of last year, saying how much tax revenues had fallen. The credit crunch and recession caused many traditional sources of revenue to dry up. Especially higher rate of income tax, stamp duty on housing purchases e.t.c.

Alistair Darling will be feeling somewhat relieved that his windfall tax on bank bonuses has netted the government an extra £2bn in tax revenue (higher than the estimated £550m)

This windfall tax revenue has occured because banks have been paying record bonuses – despite only 12 months since the banking sector was bailed out by the government.

It is interesting that the tax of 50% has not deterred the bonus culture. The Guardian article even suggests banks have paid out more so workers don’t lose out from the higher tax.

It’s a strange situation – our national debt has increased significantly because of the bailouts and yet major investment banks are still able to pay out a global bonus of £40bn

I woke up this morning to the site of 8 inches of snow. My first thoughts were great! – no school today. (teachers enjoy a day off as much as students).

Quite a few county councils have been alarmed at how quickly their stocks of salt for gritting the roads has dwindled. There appears to be a mixture of responses. Some ministers and councils say there is no shortage, others say there is a real problem. Often the issue seems to be local bottle necks with some councils struggling to get supplies. (Guardian story on salt stocks)

The local paper in Oxford ran a story of how the price of salt has been rocketing as people try to get their hands on dwindling supplies.

Salt is one commodity which traditionally has a very inelastic demand. – There are few alternatives to salt and it is generally quite a small % of income. As price of salt rises, people (and county councils) are going to be willing to pay the higher prices.

The elasticity of supply appears to be reasonably responsive, with councils taking imports from abroad. The main supplier in the UK is the Winsford mine in Cheshire which can produce about 30,000 tonnes of rock salt a week – a figure equal to the amount councils are spreading.

However, the supply of rock salt is being hampered by blocked roads around Cheshire. Also, councils are reducing the amount of roads that they grit. I doubt they will ever get round to my road.

The bad weather could be good news for some people. I bought a mountain bike with big fat tyres. And I guess the people gritting the roads have a lot of opportunity to get overtime….

I was having problems with my web hosting company – the site had periods when it was, offline so yesterday I moved the site to a much better server and is now working well. However, I did lose a few recent comments, so sorry if yours didn’t appear.

Readers Question: Have you seen question 16 on AQA’s objective test (multiple choice) paper from last January? – link below. I can’t see the logic in the correct answer being B, as per the mark scheme. Any idea?

16 Which one of the following is associated with a missing market?
A.  A monopoly restricting output
B. The production of a negative externality

A missing market is a type of market failure. A missing market means that there is some obstruction to an efficient free market which would enable a pareto efficient distribution of resources but for various reasons this market doesn’t exist. This obstruction could involve poor information, high transaction costs or the inability to price all social costs / benefits e.g. through externalities.

Example of Missing Market. – Negative Externality

Suppose a firm produces chemicals but pollutes a river as a by product.
When producing the good, the firm ignores the external cost. This will cause a cost to fisherman who will lose revenue from the fact fish are dying.

If the fishermen had property rights they could sue the chemical firm for the external costs they create. This would mean the external costs would be included in the price of the chemicals. This would enable a pareto efficient outcome – either the firm would not pollute or they would give fishermen compensation for their lost revenue.

Training workers may create a positive externality. This can lead to under provision of training because firms will not want to undertake training if they may not benefit but worker leaves and works elsewhere. If firms could be rewarded for the positive externalities they create it would lead to a socially efficient outcome.

Moral Hazard could lead to a type of missing markets. Firms don’t want to insure goods because the insurance encourages reckless behaviour.

I find the terminology of ‘missing markets’ somewhat obscure. I wouldn’t teach externalities as a missing market, but just market failure. With externalities it feels more accurate to talk about a partial market which fails to account social costs and social benefits.

AQA do have a habit of asking questions on rather obscure terminology like composite demand, which many AS students haven’t heard and are not mentioned in some textbooks.