Below is an article from The Economist that focuses on stagnation in the euro-zone economy. I have put together a worksheet on the passage that you may find useful.
THIS week’s figures for the euro-zone economy were dispiriting by any measure. An already feeble and faltering recovery has stumbled. Output across the euro area was flat in the second quarter. That followed a poor start to the year when the single-currency club managed to grow by just 0.2% (0.8% at an annual rate).
There were some bright spots in the bulletin of misery. Both the Dutch and Portuguese economies, which had contracted in the first quarter, rebounded, growing by 0.5% and 0.6% respectively. Spanish growth picked up from 0.4% in the first quarter to 0.6% in the second. But these perky performances were overshadowed by the poor figures recorded in the three biggest economies. Italy, the third largest, had already reported a decline of 0.2%, pushing it into a triple-dip recession. France, the second biggest, continued to stagnate. But the real blow came from Germany, the powerhouse of the euro zone, where output slipped by 0.2%.
The setback may reflect some temporary factors, as workers took extra time off after public holidays. German output was also depressed by a fall in construction, some of which had been brought forward to the first quarter thanks to warm weather. This effect should also be temporary. However, the tensions between Europe and Russia over Ukraine and the resulting sanctions may adversely affect German growth in the coming months.
The new GDP figures are yet more evidence that the euro-zone economy is in a bad way, not least since it has come to rely so heavily upon Germany, which had grown by 0.7% in the first quarter. It is not only that growth is evaporating; inflation is also extraordinarily low. In July it was only 0.4%, far below the target of just below 2% set by the European Central Bank (ECB). Consistently low inflation has prompted fears that Europe will soon slide into deflation. Prices are already falling in Spain and three other euro-zone countries.
Deflation would be particularly grave for the euro area because both private and public debt is so high in many of the 18 countries that share the single currency. Even if inflation is positive but stays low it hurts debtors, as their incomes rise more slowly than they expected when they borrowed. If deflation were to set in, the effects would be worse still: when prices and wages fall, debts, which do not shrink, become harder to repay.
The poor GDP figures will intensify pressure on the ECB to do more. Already in June it lowered its main borrowing rate to just 0.15% and became the first big central bank to introduce negative interest rates, in effect charging banks for deposits they leave with it. That has helped bring short-term, wholesale interest rates close to zero and has also weakened the euro. Both these effects will help to bolster the economy and restore growth.
As well as these interest-rate cuts, the ECB announced that it would lend copiously to banks for as long as four years, as long as they pledged to improve their own lending performance to the private sector. The plan, which resembles the Bank of England’s “funding for lending” scheme, has some merit but may not boost lending as much as expected due to the feeble state of the banks. It will also take a long time to work its way through the economy.
The ECB’s critics say that this is not enough and urge the central bank to introduce quantitative easing—creating money to buy financial assets. The ECB is likely to hold off; it seems to consider QE as a weapon of last resort. For his part Mario Draghi, the central bank’s president, urges countries like Italy and France to get on with structural reforms that would improve their underlying growth potential. Patience on all sides is wearing thin.
Read the article from The Economist and answer the questions below:
a) What happened to the GDP figures for the euro-zone economy in the second quarter for 2014? (2)
b) What have been the surprises in the contributions of the six countries mentioned in the articles? (3)
c) Although the GDP figures are dispiriting there is the indication that this is a temporary problem. Explain (2)
d) Comment on the level of inflation in the euro-zone and the target set by the European Central Bank (ECB). (4)
e) Why is deflation particularly grave for the euro area? (4)
f) Explain negative interest rates. Why has this policy been implemented by the ECB? (4)
g) What have the ECB’s critics suggested they should do and explain how this policy works. (4)
India’s new government have the challenge of trying to bolster its GDP from the industrial sector. For too long its economy has been going backwards with investment dropping and households shifting their money away from savings and into gold. The Economist identified 3 tasks for the incoming government:
1. Sort out the corrupt banks - bad debts have escalated and banks have chosen to “extend and pretend” loans to zombie firms. The cost of cleaning up the banks is estimated to be 4% of GDP. Healthy banks are needed to finance a new cycle of investment.
2. Stagflation must be dealt with – high inflation and high unemployment (see graph below). High borrowing has fueled inflation and consumers have run to the safety of gold as a store of value for their money. This has meant an increasing deficit in the balance of payments. The central bank is looking at introducing inflation targeting (1-3% in NZ)
3. Developing higher skilled jobs – a lot of Asian countries have benefitted greatly from low cost labour. With labour costs rising in China and 10 million people entering the labour force each year in India, there is a great opportunity to attract foreign investment. This is particularly prevalent when you consider that Japanese firms are now nervous about the on-going military tensions with China and therefore looking at other low cost countries.
For the Indian economy to move forward they will have to ensure investors that the factors of production – land, labour, capital – are reliable and at a competitive price.
I got this image from The Economist and used it for a recent A2 Test on Macro-Economic conflicts. Recently the OECD and the IMF have urged the European Central Bank (ECB) to cut the bank’s main lending rate from the already low 0.25% to zero. How might this effect countries in the Euro-area? It will tend to impact euro zone countries differently because of where they are in the business cycle. If you look at the unemployment and inflation figures from the graph you see the following:
Austria 4.9%, Germany 5.1%, well below the EU average of 11.8%.
Spain 25.3% and Greece 26.7% very high unemployment.
Some countries have had unemployment dropped significantly during the period –
Latvia approx. 22% to 11.6
Estonia approx.. 18% to 7.8%
Highest rate Malta &Austria 1.4%, Finland 1.3%
Lowest – Greece -1.5%, Cyprus -0.9%
Reducing the interest to zero is an expansionary monetary policy which is a tool to increase aggregate demand, economic growth and employment. Monetary Policy, which is determined by the ECB, will have different effects in different countries. The ECB responds to aggregate levels of inflation and unemployment, not individual country levels – Unemployment is 11.8% and Inflation is 0.5%. Therefore it is a one size fits all policy. However some member states maybe experiencing rising levels of inflation and lower levels of unemployment whilst others might be the opposite – falling levels of inflation and higher levels of unemployment.
Assume an EU member experiences an asymmetric shock. It will have a different inflation and unemployment rate than the rest of the EU. With the ECB setting a common interest rate for the whole area, countries have lost an important part of their monetary policy. This is a major problem if a countries economy is at a different stage in the business cycle. For instance in 2014, Austria and Germany are growing with falling unemployment and a further lowering of interest rates may not be the best option for them. This is in comparison to other countries who need lower interest rates and a more stimulatory environment. With low interest rates and falling unemployment, Austria and Germany could experience inflation levels above the 2% target of the ECB and also a tight labour market which could put pressure on prices. Furthermore a lower interest rate affects those who want to save money in those countries.
At the other end of the spectrum Slovakia, Portugal, Cyprus, Spain and Greece are experiencing deflation and very high levels of unemployment. They therefore require more stimulus through lower interest rates to try and boost growth and employment and get out of the dangerous deflationary cycle.
Other countries with low inflation and high levels of unemployment will benefit from the cut in interest rates – Ireland has had unemployment fall from approx. 15% to 11.8% and an inflation rate of 0.3%. Therefore monetary stimulus is warranted. However the interest rate whether expansionary, neutral, or contractionary is unique to where each country is in the business cycle. The loss of monetary sovereignty clearly poses problems for members states whose economy is out of line with the euro zone norm.
The Free Exchange column of The Economist recently had an article which addressed the concern that in order to create or revive economic growth developed economies will just create a bubble environment. However this concept was around in the 1930’s as economist Alvin Hansen thought a slowing of both population growth and technological progress would reduce opportunities for investment. Savings would then accumulate and growth would slow unless the government intervened to bolster demand in the economy. Today interest rates are low and therefore saving has limited avenues to earn reasonable returns from productive investment opportunities. But according to The Economist this story doesn’t fit the current conditions for the following reasons:
1. There is at present an IT revolution
2. Private investment has recovered since the GFC and technology investments are doing very well.
But some investment managers are paid by the value of the share price and these get boosted in the short -run. This encourages them to put large amounts of cash into buy-backs, which raises stock prices, rather than into productive investments that might do more to boost growth.
Saving could also be seen as a reason for secular stagnation. High levels of saving reflect the reduction in consumption and this is thought to have come about by an in the increase in income inequality - high income households save more than those on lower incomes. In 2007 – 23.5% of all American income went to the top 1% of earners – the highest percentage since 1929. Research has shown that saving by the top 5% has been surppressing demand since the mid-1980’s. Carmen Rheinhart and Ken Rogoff in their book “This Time is Different” (which I have blogged on in previous posts) concluded that post war banking crises are followed by weak recoveries, whether or not they were preceded by a surge in income inequality.
Since the Aussie dollar was floated in 1983 its value closely followed that of its commodity exports – see graph from The Economist. However since 2003 commodity prices have increased 400% but the dollar rose by much less and no longer had a direct relationship to commodity prices. There are 3 possible reasons for this:
1. The deregulation of financial markets which facilitates the ease of currency trading
2. The current account deficit in Australia which got to 6.2% of GDP in 2007
3. Interest rates in Australia up to the GFC were realtively low compared to other developed countries
2011 saw commodity prices drop but the Aussie dollar has remained strong. As most economies employed a lose monetary policy and proceeded to drop interest rates aggressively after the GFC, the Aussie economy didn’t in fact go through a recession and its interest rates remained relatively strong – see below.
Although a weaker exchange rate could help the Aussie economy especially as it has been susceptible to the resource curse – the strength of the exchange rate and higher interest rates is already putting pressure on some industries, particularly the tourism, manufacturing, education exports and retail industries.
Yale University economist and Nobel Laureate Robert Shiller describes a bubble as a “psycho-economic phenomenon. It’s like a mental illness. It is marked on excessive enthusiasm, participation of the news media and feelings of regret among people who weren’t in the bubble”
Others have suggested that bubbles are an increase in the price of an assets of no more than two standard deviations above the trend taking inflation into account. Bubbles have been a lot more prevalent since the 1960’s and this reflects the liberalising of financial markets and the end of the Bretton Woods system of fixed exchange rates in the 1970’s. Many economists have struggled to understand bubbles as in a rational and perfectly informed market assets that are overpriced should be sold. However the frenzy of the market can last much longer than investors think and the bursting of the bubble will be a gradual and slow process or a sudden drop in prices.
Housing bubbles tended to be supported by the banking industry.
* As most people take out a mortgage from a bank, rising house prices encourage banks to lend out more money as there is more security for them. However this greater availability of credit allows borrowers to afford higher prices.
* In contrast when the banks become reluctant to lend money and house prices can drop greatly. According to The Economist’s house price- indicators property in New Zealand (or should that be Auckland), Australia and Canada is overvalued. However could higher prices just reflect the level of income inequality that is clearly visible in most developed economies and conspicuous consumption. Thorstein Veblen wrote about this in his book The Theory of the Leisure Class (1899).
Very good video from Ray Dalio in which he believes that the three main forces that drive most economic activity are:
1) trend line productivity growth,
2) the long-term debt cycle and
3) the short-term debt cycle.
What follows is an explanation of all three of these forces and how, by overlaying the archetypical short-term debt cycle on top of the archetypical long-term debt cycle and overlaying them both on top of the productivity trend line, one can derive a good template for tracking most economic/market movements. While these three forces apply to all countries’ economies, in this study we will look at the U.S. economy over the last 100 years or so as an example to convey the Template.