Will China challenge the West?

by

Readers Question: 1. Does state capitalism as practised in China pose a fundamental challenge to the Western model of liberal-democratic capitalism?

No, I don’t think so. From a political perspective, no matter how economic successful China might be, there will never be any enthusiasm to replicate China’s one party political system. In fact, it is most likely to be the other way around. Increased economic living standards in China are likely to cause increased demand for political and democratic freedom within China; there is already growing resentment at corruption within the state apparatus. It make take a few years or a few decades, but it is China’s political system which will be challenged by its own economic success.

That’s enough on politics, what about the economics? Does China’s growth pose a threat or benefit to the rest of the world?

From an economic perspective, Chinese state capitalism has been successful in creating very high rates of economic growth over the past few decades. Depending on which measure of GDP you use, China is forecast to overtake US economy at some stage (though recent downward revisions to China’s growth may mean it doesn’t occur until the next century. But, nevertheless, the growth of the Chinese economy has been very significant and has many impact on the world economy.

Challenges from Chinese rapid economic growth

Increased price and demand for raw materials. The global recession of 2008-12 was unique in having a period of recession, but rising commodity prices. Usually, when the western economic go into recession, demand for raw materials falls, and therefore the price falls – cushioning the impact of the recession. However, this time, rising demand from China and Asia, meant in the recession, we saw rising commodity prices – making the recession more difficult. Over the medium term, China’s economic growth will put increased pressure on raw materials and push up oil and other commodity prices. There will be greater competition for limited supplies of raw materials

  • However, this will spur the Western economies to increase fuel efficiency and look for alternatives to fossil fuels, which in the long term is desirable.

Environmental challenges. As Chinese GDP grows, there will be rise in greenhouse gases and other environmental costs, making it more challenging to deal with global warming.

  • However, the biggest levels of pollution still come from Western economies.

Global imbalances from high saving rates. In the boom period of 2000-2007, China experienced a large current account surplus. The Chinese kept their currency undervalued through using surplus foreign currency and purchasing US bonds. Arguably, these large capital outflows distorted markets. Artificially pushing down US interest rates contributing to a boom in US lending – and reducing US exports through keeping the dollar overvalued.

  • However, these global imbalances have been significantly reduced in recent years. The Chinese currency has steadily appreciated as the government have tried to contain inflationary pressures. This shows that Chinese growth can evolve from relying on cheap exports to more balanced with a growing middle class willing to spend and buy imports.

    Read more

Latvia to join the Euro

by

After enduring a deep economic crisis, Latvia are poised to be ‘rewarded’ with membership of the Euro in 2014.

latvia-eu

The Latvian miracle story

It seems a strange that countries are so keen to join the Euro, when membership of the Euro has been a major factor in creating a real depression amongst many Euro countries. Yet, the debate about Latvian joining seems to be from a parallel universe, where the ongoing crisis is neatly forgotten.

Prime Minister Valdis Dombrovskis said that the European Commission (EC) had given the go ahead for Latvia for adopt the euro from early 2014. “Joining the eurozone will foster Latvia’s economic growth for sure,” Mr Dombrovskis said. I’m sure that is what the Greek, Spanish and Portuguese political leaders said when they joined in 2000.

latvia-czech-republic

There is opposition – with many in Latvia concerned about ‘rising prices’ after joining the Euro. But, given the experience of the Eurozone in the past few years, rising prices are likely to be the least of Latvia’s concerns over the next few years.

From an outsiders perspective, it’s hard to understand the attraction of joining the Euro. I think the underlying motive must be a desire to join up with Europe and move away from Russia and the East. Given Latvia’s past, this is understandable. What is unfortunate is that being a good European citizen seems to involve joining an unworkable single currency and monetary policy.

Despite the European obsession with meeting fiscal deficits, there has been much less concern about whether the Eurozone is fundamentally an optimal currency area. An optimal currency area is a geographical area where the benefits of one currency are greater than the downsides. An optimal currency area will need:

  • Strong labour and capital mobility
  • Lack of geographical barriers
  • Fiscal transfers from strong regions to weak ones
  • Similar labour costs and similar inflation rates.
  • The ability to cope with a single monetary policy (interest rate)
  • The ability to retain competitiveness within the fixed exchange rate.

Read more

If the UK had been in the Euro – how would it affect the economy?

by

Readers Question: my question is If the UK. had joined the Euro back when it first started would the UK. have benefited like Germany or would we be in the same situation as Greece, Italy, and Spain?

If the UK had joined the Euro from the start in 1999, the UK economy would definitely have been affected in a variety of ways. Firstly, in the Euro we would have a fixed exchange rate, no independent monetary policy, fiscal policy would be severely curtailed, and the UK bond market would have had no intervention from the Central Bank.

In short, we could have expected – a bigger housing boom and bust. A deeper recession in 2009. Rising bond yields in 2010-12, leading to greater austerity. No devaluation and less competitive exports.

Housing Bubble

ECB Interest Rates

The years 2000 to 2007 were relatively stable for the Eurozone and Euro. However, due to stronger growth in the UK, ECB interest rates were lower than the Bank of England interest rates. Between 2003 and early 2005, ECB interest rates were 2%, UK rates were higher at around 4%.

UK base interest rates

If the UK had been in the Euro, we could have seen a bigger asset bubble during the years 2003-06. Lower interest rates would have encouraged more people to enter the housing market, causing an even bigger increase in house prices. These lower interest rates would have caused higher economic growth in the period 2000-07, but at the cost of a bigger credit and housing boom. The UK is particularly sensitive to interest rates because so many homeowners have a variable mortgage.

If house prices had risen faster (04-07), they would have been a bigger fall, post 2008. The fall in house prices post 2008 was a drag on consumer spending and contributed to bank losses. If house prices fell at a great rate, then the financial crash would have been more painful and banks lost even more money.

Response to recession of 2008

The economic and financial crisis of 2008 hit the UK more than most other European economies. This was partly because the UK’s economy has a bigger reliance on banking and finance – sectors adversely affected by the credit crunch. Other European economies, such as Germany also saw a big fall in GDP during 2009, but were able to bounce back from recession quicker than the UK and southern Europe.

eu econ growth

In response to this fall in output, the UK pursued a different monetary and fiscal policy to the rest of Europe. If the UK had been in the Euro, we would not have been able to pursue this independent monetary and fiscal policy.

Read more

Abenomics – a Japanese recovery?

by

Abenomics refers to the economic policy of the current Japanese prime minister Shinzō Abe. The aim of the policy is to stimulate strong economic recovery and help the Japanese economy to escape a cycle of deflation, and low growth.

japan economic growth

Can Japan break the cycle of low growth?

The range of policies include:

  1. Expansionary monetary policy (Quantitative easing, negative real interest rates, and an inflation target of 2%)
  2. Expansionary fiscal policy (higher government spending financed by borrowing)
  3. Weakening the value of the Japanese Yen to boost the export sector.
  4. Supply side policies ‘new growth measures’

japan-inflation-60-22

How it is supposed to work

  • Japan has suffered from a prolonged period of deflation or very low inflation. Since early 1997, the GDP deflator (a broad measure of the price level) has declined by 17 per cent. (FT) This deflation has increased the real debt burden of firms, consumers and the government and acted as a continued depressing factor on spending. (See: problems of deflation) By pursuing expansionary monetary policy and targeting higher inflation, they hope to change expectations of inflation and encourage more private sector investment and spending.
  • Expansionary fiscal policy. Fiscal spending will increase by 2% in 2013, increasing the budget deficit to 11.5%. The aim of the expansionary fiscal policy is to make sure that the extra money supply feeds into the real economy. There is concern that quantitative easing alone, just leads to increased bank reserves. But, the extra government spending will provide a direct injection into the economy and provide a stimulus to aggregate demand (AD)
  • Confidence and expectation. An important feature of ‘Abenomics’ is trying to change the economic mood and overcome the prevailing ‘economic defeatism’. Opinion polls suggest that many people are supportive of the attempts to overcome recession. This positive effort and talk of economic recovery is improving business and consumer confidence, and will act as a spur to increase consumer spending and private sector investment.

    Read more

Would it help to have a higher inflation rate?

by

Economists generally agree that a high inflation rate has various economic costs and therefore, we should use economic policy to keep inflation low. Since the mid 1980s, governments have increasingly set strict inflation targets, e.g. ECB inflation of less than 2%. The Bank of England targeting inflation of 2% +/-1.

However, some economists argue that in certain conditions, inflation can be too low. Targeting a higher inflation rate can help the economy to grow and overcome problems of a liquidity trap, such as debt deflation, high unemployment and low growth.

However, other economists are less impressed. They argue that targeting a higher inflation is irresponsible. It doesn’t do anything to overcome problems of low growth, but will create additional problems of uncertainty and lost confidence in economic policy.

Eurozone inflation

Eurozone inflation fell to 1.2%, in April 2012 but GDP also fell and unemployment rose to record 12.1%. Why are the ECB so keen on keeping inflation low?

Arguments for a higher inflation rate

  • After a period of deflation, the price level may have been below its long term average. Example, suppose we had three years of 0% inflation. The price level will be 6% less than we would expect with our target inflation rate of 2%. Therefore, in this case, we need higher inflation to ‘catch up’ with the long term price level target.
  • Higher inflation can help overcome a stagnant economy. If economies are stuck with zero or negative growth, then it may be necessary to tolerate a higher inflation rate to  enable a loosening of monetary and fiscal policy. If the economy has a large negative output gap, then there is no need to fear runaway inflation. For example, in Europe at the moment, GDP has been falling, unemployment very high, but the ECB are mistakenly still targeting low inflation. If they could tolerate slightly higher inflation, it would make it easier for the economy to recovery. Although, there are some costs of a slightly higher inflation rate, the costs of unemployment are much higher.
  • Cost push inflation misleads underlying inflationary pressures. Sometimes, Central Banks face a high headline inflation rate, but this is due to cost push factors (e.g. higher oil prices). Therefore, even though the economy is stagnant (not growing), inflation may be high because of these misleading cost-push factors. In this case it is a mistake to target inflation of 2%. One alternative may be to target core inflation – which strips away these misleading cost-push factors.
  • In liquidity trap, higher inflation can encourage spending. In a deep recession, we see a rise in savings because people don’t want to spend. The problem is that savings can rise too quickly causing a recession. Higher inflation discourages excess saving and encourages spending, which the economy needs.
  • Higher inflation reduces debt burdens. A higher inflation rate makes it easier to reduce debt burdens – both private and government debt. If inflation is too low, we risk debt deflation. This means spending will fall because we are struggling to deal with rising debt burdens. With low GDP growth, Europe is facing rising debt to GDP ratios, despite austerity. Targeting higher nominal GDP, which may require higher inflation, makes it less painful to reduce debt to GDP ratios,without the cost of high unemployment.
  • In normal circumstances, targeting inflation of 2% may be best. But, in a liquidity trap / prolonged recession, governments need more flexibility to evaluate changed circumstances.
  • Eurozone. The Eurozone present a particular dilemma. Many countries are trying to restore competitiveness through internal devaluation (cutting wages and prices). This is made more difficult by the low Eurozone inflation rate. With Eurozone inflation of 1%, for Portugal to restore competitiveness may require an inflation of -2%. But, this deflation in Portugal is very damaging. A higher inflation rate, would make it easier for the periphery to adjust, without requiring a prolonged slump and deflation.

Read more

Plan B for the economy

by

I’ve never been in favour of the government’s Plan A for the economy – austerity in a recession was also going to risk pushing economy back into double dip recession and simultaneously fail to reduce the budget deficit. Even if the austerity was mild by comparison to the rest of Europe, it was just enough …

Read more

Money Supply in the credit crunch and recession

by

Question: re: article on the great recession. How did the money supply affect the credit crunch and recession?

Firstly, we can look at the statistics for the money supply growth rate in the UK.

m3-m4

Source: Bank of England

This shows strong growth in the broad money supply in the years leading up to the credit crunch. – An annual growth rate of 10%. By 2010, broad money supply growth had become negative. This is a result of the fall in bank lending we saw in the recession, and the corresponding effect on broad money supply growth.

Did money supply growth play a role in the credit boom? The main issue was the rise in bank lending, and the type of unsustainable bank lending. The growth of the broad money supply didn’t give a clear sign of an underlying boom. If you look at the money supply from a historical perspective, it has always been difficult to see an easy link between the money supply and the rest of the economy.

Broad money supply over past 100 years.

UK broad money supply

source: Bank of England

Money Supply in the credit crunch

This first graph suggests that at the heigh of the credit crunch 2008 to May 2009, the money supply was rising at a fast rate, which you wouldn’t expect. This is true, but it only tells half of the story.

Money supply and velocity of circulation

The money supply is the stock of money in the economy. However, it is also very important to know the velocity of circulation of money. The velocity refers to the amount of times this money changes hands in a year. The velocity of circulation has been in long-run decline because of various changes to financial sector. But, in the credit crunch, the velocity fell sharply.

Read more

Continue Shopping →
Item added to cart.
0 items - £0.00
Checkout