Externalities and the free market

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Readers Question: I understand “externalities” and why certain economic actors will tend to dispute the scale/existence of them. What about the complementary idea, of benefits conferred by many societies which are centrally planned and financed (roads, defence etc.)? Libertarians of any political stripe may downplay/deny their importance though benefitting. My question: is there a technical term for all this? “Internalities” would be logical. Some of these are easier to perceive and defend than others. Roads are “good”. NHS more controversial. Hardest to define, benefits of a society which is liberal, promotes trust, provides robust safety net etc. Thanks, Mark

I’m sure most economists would accept the existence of externalities, both negative and positive. If there are negative and positive externalities, there is a clear argument that this will lead to market failure. For example:

I would argue that health care is a clear case of a service which has a strong positive externality. If you look at standards of public health in the Ninenteenth Century, death rates were much higher. It is in everyone’s interest to provide a minimum level of public health because everyone benefits. If you have a situation where people catch infectious disease because the free market has failed to provide decent sewage or vaccination, everyone is more susceptible to catching infection too.

Solution to Externalities

The solution to externalities may differ. I’m not too aware of extreme Libertarian ideas because I find it difficult to take them too seriously. I know the presidential candidate Ron Paul argued there was no need for public health care because in the absence of government, local communities would chip together to offer local charitable provision.

A libertarian may also argue, that even if there is a theoretical case for government intervention to overcome market failure, the government should still nothing. The argument is that the costs of government intervention (such as incentive reducing income taxes), poor information, and the ‘inevitable’ government corruption will always outweigh the benefit.

Personally, I don’t accept this idea. Health care workers, such as nurses and doctors don’t become inefficient because they are working for the government NHS rather than a profit making health firm. In fact, perhaps the opposite.

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The depth of the European recession

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Interesting graph which shows the depth of the EU recession compared to the great depression of the 1930s.

depth-euro-recession Source stats | via Krugman

UK recession compared

This graph is from the start of 2013. Since, then the UK economy is showing signs of  picking up. But, it is still worth bearing in mind the length of the decline in GDP since the start of the recession.

recessions-different-recoveries

Comparing different recessions

For the first 15 months, the decline in real GDP is comparable to the great depression of the 1930s. The great depression shows a bigger fall in GDP (-8.0%) from peak. But, during the 2008- recession, GDP stagnated the longest. 

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Causes of Europe’s deflation problem

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The European Union is facing the prospect of a serious bout of deflation (or at least, very low rates of inflation / disinflation) Deflation occurs when prices fall. But, very low rates of inflation are considered to raise problems associated with deflation.

In the Eurozone, the main index of inflation has fallen to 0.7% –  This is well below the ECB’s inflation target of 2%. Some regions and countries in the Euro, such as Greece are already experiencing deflation. In Greece prices fell 1.8% last year and the consumer price index reached the lowest level for 51 years (FT Link). Spain and Italy in particular, are nervous about the prospects of experiencing deflation in the future.

EU inflation

Inflation ECB – Inflation has since fallen to 0.7%

Causes of deflation in Europe

Eurozone-unemployment

1. Unemployment. Unemployment in Europe has increased significantly since 2008, with the unemployment rate now reaching 12.2%. High rates of unemployment put downward pressure on wages, as the unemployed are more likely to accept lower wages.

2. Internal devaluation. A striking feature of the Euro is that countries which became uncompetitive in the boom period, can not devalue their currency to regain competitiveness. Therefore, the only option is for them to pursue internal devaluation. This means reducing prices and costs in the economy – primarily cutting wages. By reducing costs, they can make their exports more competitive and regain competitiveness. But, with weak external demand, it is proving a difficult and slow process for southern Europe to restore competitiveness compared to northern Europe.

3. Weak demand. The fundamental cause of deflation is weak demand within the Eurozone. Firstly, several Eurozone economies are pursuing fiscal austerity to try and reduce budget deficits. These spending cuts and tax increases are causing a significant drop in demand. Because of the relatively tight monetary policy, and strong Euro, demand is not coming from other sectors of the economy.

4. Fear of inflation in Germany. With inflation falling to 0.7% and unemployment of 12%, you would expect economists to be unanimous in the desire to overcome the threat of deflation and promote growth in Europe. But, in Germany the prevailing economic orthodoxy is still to worry about inflationary pressures and a possible loss of ‘confidence’ – should the ECB promote monetary loosening. Recently The ECB cut interest rates by 25 basis points, after the fall in inflation rate from 1.1 to 0.7%, but several Germany economists dissented arguing that it is wrong to cut interest rates given the possibility of ‘inflationary’ pressures in Germany. In the past, Angela Merkel has argued that Germany would need an interest rate increase if the German economy was taken in isolation. (FT link) The underlying fear of inflation means there is tension within the ECB and a reluctance to loosen monetary policy to target deflation.

eu-inflation-krugman1-blog480

Source: Eurostat: via Krugman

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Sustained economic recovery?

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Readers Question: Seeing the recent releases of positive UK data come through, I’ve been thinking whether these are signs of a recovery or it is too soon to say. To what extent is the recent run of positive data across sectors a sign of a balanced & sustained recovery in the UK? (question 7th. Nov)

It is a good question. If we look back to 2010, there were signs of economic recovery, but this was not sustained – with the economy going back into recession. In 2013, the evidence is mixed though a little more hopeful. In summary, the UK economy recovery is being primarily driven by consumer spending, the service sector and a vibrant housing market (especially in London). There is weaker growth in manufacturing, exports and investment. The economy is also being helped by ultra-loose monetary policy (Q.E. and zero interest rates). Fiscal policy is more neutral, though over the next few years, the government plans to restrict the growth in government spending so this is liable to be a drag on growth.

These blog posts are also relevant to this question:

Lending and the housing market

A key feature in the nature of the recovery will be the health of the banking sector. The sharp fall in bank lending was a major factor behind the prolonged recession of 2008-12. Signs of improved bank lending will help the economy. However, although mortgage lending shows signs of growth, this is less helpful than bank lending to business. For sustained recovery, increased mortgage lending and squeezing house prices higher is not particularly helpful. Squeezing house prices higher through increased mortgage lending is not increasing productive capacity. If anything rising house prices in London are reducing geographical mobility and the cost of housing in London will adversely hurt the London labour market. Also, house price to income ratios (especially in the south) are close to historical highs; some fear house price growth is unsustainable. Any fall in house prices would knock consumer confidence and spending.

Real Wage growth

In 2013, there has been growth in consumer spending, but this has come despite slow growth in real wages. A feature of the prolonged recession has been very low / zero nominal wage growth. This means, combined with inflation above the government’s target,  many consumers have seen a prolonged fall in real wages. With stagnant real wages, there is a limit to how much consumer spending can lift the UK economy. A sustained recovery will need a return to real wage growth. This may come if inflation falls and firms feel more profitable and able to increase wages. Real wage growth will also require a change in the UK’s very poor productivity growth rate over the past five years.

labour-productivity-growth-annual

GDP statistics

Firstly, the latest GDP statistics (preliminary from Q3 2013) were promising:

economic-growth-uk-ons-quarter

Source: ONS

In particular, data from Q3 suggested growth across the main industrial sectors of the economy.

In output Q3 compared to Q2, output increased by 1.4% in agriculture, 0.5% in production, 2.5% in construction, and 0.7% in services. This was a rare sign of a more balanced growth. Future growth figures are also looking more optimistic, with analysts predicting strong growth in the next quarter.

But, we always need to add a disclaimer to be wary of quarterly statistics. Firstly, we have to be careful about inferring too much from quarterly economic statistics (especially provisional figures which could be revised up or down later) If one swallow doesn’t make a summer, one or two positive quarterly growth figure don’t overcome a prolonged economic stagnation.

Growing current account deficit and weak exports

Ironically, one day after asking this question, data on exports and the current account deficit was disappointing – raising concerns that the UK recovery was still fragile and unbalanced.

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Will the Bank of England be able to sell gilts from Q.E?

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Readers Question: In  Risks and benefits of Quantitative easing  one point the programme mentioned was:
The scale of quantitative easing could make it impossible to sell bonds back to market and this will damage the UK’s ability to borrow in the future. If the UK’s ability to borrow is constrained, this will lead to higher interest rates and reduce economic growth.
Readers Question: Why won’t we be able to sell bonds because of the size of QE? it surely is not that big as % of total?
Firstly, Bank of England gilt holdings are getting close to 30% of the total public sector debt, £375bn so it is a significant total.
Bank of England gilt holdings as % of total

percent-gilt-holdings

Gilt holdings by Sector £m

This data is from 2012, but it gives an indication of the scale of bond buying by the Bank of England. Since then the gilt holdings have risen. – In October 2013, the quantity of gilt holdings have risen to £374,991 mn or £374 billion. (HM Treasury)

Will the Bank of England be able to sell these gilts on the open market when the economy recovers and the Bank of England wants to reverse quantitative easing?

Firstly, I’m not entirely sure how it will go. There is no precedent for a Central Bank in the UK adopting such a policy of quantitative easing. I can only suggest there will be a few factors at play

  • The Bank of England can take its time, and decide when it wants to sell. It won’t have to sell £374 billion in a short time frame. I suppose it is possible the Bank of England will never fully sell off its gilt holdings or it will allow inflation to slowly reduce the real value of the gilt holdings.

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The irritating monopoly power of Apple

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I’m a good Apple consumer. Over the past few years, I’ve bought three Apple mac laptops and two iPhones. I appreciate the quality of the product and have been willing to pay more than the average price for a laptop and mobile phone. Yet, although their products are generally very good, they do irritate me for the way they exploit their monopoly power.

apple-iphone-cable

A while back I lost my original 9pin cable used to charge my iPhone. I bought a replacement from a local shop in Oxford. I think it cost about £10, but it worked and I was happy.

Yesterday, I updated my iphone to IOS7 (new software for Apple). It was all looking very nice, but when I tried to charge the phone it didn’t work! A quick look on the internet and many people are in the same situation. (My iPhone 5 won’t change)

Basically, Apple have deliberately blocked third party chargers. The logic behind this is that, by blocking third party chargers, Apple can make more money selling their own chargers and licensing other firms to produce them. They don’t want third party companies offering cheaper chargers which Apple don’t get commission from. These cables are very expensive if you buy from an Apple store – £25. This price sounds to be suspiciously like monopoly pricing.

To me this is a clear exploitation of Monopoly power. Apple are using their market power to introduce vertical restraints and prevent a competitive market in the area of charging cables.

It reminds me of printers who prevent other firms selling compatible ink cartridges. This enables firms making printers to sell printers cheaply and then make high profits selling ink to a captive market.

From an economic perspective this decision by Apple, is highly inefficient.

  • Allocative inefficiency. At £25 for an official Apple cable, the price is much higher than the marginal cost of producing it.
  • Wasted resources. The cable I bought is now useless, I’ll probably have to throw it away.. There is no good reason for Apple to prevent this cable being used. It is just ensuring that there is a wastage of resources. It is also bad news for the firms who have been producing these cables without an Apple chip.

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