In the NYT it was stated that Moody’s are predicting that a tighter fiscal policy – cuts in government spending and increased taxation – will slow economic growth for 2013 by about 1.2 percentage points and prevent the unemployment rate from falling to 6.1 percent by the end of the year. Where is the effect of QE on these figures?
Lately there has been a lot of media coverage about an Excel error by academics Ken Rogoff and Carmen Reinhart – co-authors of ‘This Time is Different’ – 2009. A student from University of Massachusetts tried to replicate one their models regarding growth rates when a country has a public debt of greater than 90% of GDP. Rogoff and Carmen stated that with this level of public debt growth in a country falls to a mean of -0.1%. However using the same data the student found that a figure of 2.2% was applicable in this context.
However Rogoff and Reinhart have been cautious about saying that high debt causes slower growth rates but it does highlight the validity of analysis connecting debt and austerity to growth rates. Adam Posen in the FT stated that the claim of a clear tipping point for the ratio of Government Debt to GDP past which an economy starts to collapse doesn’t hold. Following the second world war the US, UK, Belgium, Italy and Japan had public debt greater than 90% of GDP but there was not much of an effect on their economies. In Italy and of late in Japan stagnation in economies led to slowly rising debt levels. In the UK and US in the 1950’s growth returned and debt levels declined. What this is suggesting is
Slow growth is at least as much the cause of high debt as high debt causes growth to slow.
But a certain amount public debt is necessary for future development of any economy especially when you think about the construction of infrastructure and government spending on education. Both of which contribute to future growth and in theoretical terms move the production possibility curve outwards. This in turn creates growth and subsequently income for a government.
USA – Mad Spending v EU – Nervous Austerity
With one side of the Atlantic – USA – involved in quantitive easing (printing money) and the other – EU – with severe austerity, maybe somewhere in between would be a logical way to go about things. But is moderation a choice for policy makers when they have already gone so far down the track of their respective plans?
What can be concluded is that too much debt has costs for growth but the degree of those costs is dependent on the reasons for debt accumulated and what path the economy is actually taking.
If you look at the labour market in Spain you would think that it resembles the German economy 10 years ago when Gerhard Schroder was its leader. Schroder was responsible for labour reforms that ignited the German economy into one of the strongest in Europe.
Spain is relaxing labour laws and cutting public spending and there are some positive signs here in that labour unit costs are falling as result of greater productivity. However German’s vocational education sector was a significant factor in its improved performance as the education and training system is more job orientated. Furthermore, with austerity measures in place and more to follow – pressure from the EU to introduce yet another sales-tax rise – Spain will find it hard to generate any sort of growth. But if it does grow will it generate any reduction in unemployment? Because of labour reforms some economists now believe that only 1.5% growth is required to bring about net job creation rather than 2.5% as previous.
The 10bn-euro (US$13bn) bailout of Cyprus’ economy, agreed by the EU and IMF, demands that all bank customers pay a one-off levy and has led to heavy cash withdrawals.
Under the currently agreed terms, depositors with:
* Less than 100,000 euros in Cyprus accounts would have to pay a one-time tax of 6.75%.
* More than 100,000 euros would pay 9.9%.
The BBC says the president may want to lower the former rate to 3%, while raising the levy on the larger depositors to 12.5%. Some EU source told Agence France-Presse there could be a three-way split on the level of levy, grouped into accounts holding less than 100,000 euros, between 100,000 and 500,000 and more than 500,000. The clip below is from Al Jazeera – it shows at one bank in the Limassol district, a frustrated man parked his bulldozer outside and threatened to break in.
The race for countries to devalue their currency (make their exports more competitive) has led to massive increase in monetary stimulus into the global financial system. We are all aware of the three rounds of Quantitative Easing from the US Fed and the indication that they would keep the Fed Funds Rate at virtually zero until 2015. To add fuel to the ‘dim embers’, in 2013 the US is going to inject US$1 trillion into the circular floe. However in China they have also embarked on some serious stimulus:
* More infrastructure development – US$60bn
* Additional credit – US$14 trillion in extra credit since 2009 (equal to entire US banking system)
Nevertheless even with all this artificial stimulus there might be some short-term growth but I can’t see it being sustainable when you consider the extent of global deleveraging. Also IMF figures show that the world saving rates are on the increase (* forecast):
With increased saving rates accompanied by significant austerity measures in many parts of Europe where is the consumer demand going to come from? Unemployment in Spain is 26% and predicted to hit 30% this year- more worrying is 50% of those under 25 are unemployed. Spanish protesters chanted “We don’t owe, we won’t pay” in a march against austerity. So in the US we have massive fiscal stimulus but across the water in Europe it’s all about “tightening the belt” and cutting government spending. Neither seems to be working and are we just putting off a significant downturn for a later date?
Free Exchange in The Economist debated this topic and went into detail concerning the Fiscal Multiplier. It refers to the change in GDP that is due to a change in government fiscal policy – taxes and spending. They use the following examples
Multiplier = 1.5 Government Spending down $1 = overall spending down = $1.5
Multiplier = 0.5 Government Spending down $1 = overall spending down = $0.5
Therefore the value of the multiplier is the crucial variable and a value that is greater than the level of GDP you maybe able to close the deficit but this results in a higher debt to GDP ratio than it started with. Estimates of the fiscal multiplier have been approximately 1% or below and the IMF have suggested that if you cut deficits by 1% of GDP it will have an impact of 0.5% of GDP – multiplier value of 0.5. What has been suggested is that:
Spending cuts may “crowd in” private-sector activity: if governments are using up scarce capital and labour then austerity creates room for private firms to expand. In open economies, austerity’s bite can be passed on to other countries through reduced imports. Most important of all, monetary policy can act as a counterweight to fiscal policy. Spending cuts that threaten to drag growth below a desired level should prompt monetary easing, limiting the multiplier.
However timing is everything and austerity measures now are not conducive to favourable outcomes for the following reasons:
1. With many economies implementing the same measures the impact can’t be deflected onto others.
2. Austerity measures normally might free up resources for private use but that mattered far less when unemployment and saving were high.
3. With interest rates at near-zero levels there was little scope for any additional monetary stimulus to offset the fiscal tightening. Monetary policy has run out of ammunition.
The table below from the Australian Markets Weekly (Published by National Australia Bank) shows the fiscal position of euro-zone and other developed nations. As you can see the PIIGS (Portugal, Ireland, Italy, Greece, Spain) of the euro-zone countries have very high gross debt to GDP levels except for Spain. Japan has the highest but is also the only economy involved in fiscal loosening – see column 4. Notice the severity of tightening in some euro-zone countries as austerity measures start to be implemented. It does seem a little strange that Australia’s tightening in fiscal policy is greater than that of the UK and the US and not that far from the IMF‟s estimate of “austerity” announced for Italy.
The memo items are also of interest in that they show the nominal GDP, debt and budget balance in $USbn. In nominal GDP you have USA, China, Japan, Germany as the leading economies by output levels. China overtook Japan this year.
It is important that you are aware of current issues to do with the New Zealand and the World Economy. Examiners always like students to relate current issues to the economic theory as it gives a good impression of being well read in the subject. Only use these indicators if it is applicable to the question.
Indicators that you might want to mention are as follows:
The New Zealand Economy
The New Zealand economy expanded by 0.6 percent in the June 2012 quarter, while economic growth in the March quarter was revised down slightly to one percent. Favourable weather conditions leading to an increase in milk production was a significant driver of economic growth over the June quarter. The current account deficit rose to $10,087 million in the year ended June 2012, equivalent to 4.9 percent of GDP. Higher profits by foreign-owned New Zealand-operated banks and higher international fuel prices were factors behind the increase in the deficit during the year. Unemployment is currently at 6.8% but is expected to fall below 6% with the predicted increase in GDP. Annual inflation is approaching its trough. It is of the opinion that it will head towards the top end of the Reserve Bank’s target band (3%) by late next year.
The Global Economy
After the Global Financial Crisis (GFC) the debt-burdened economies are still struggling to reduce household debt to pre-crisis levels and monetary and fiscal policies have failed to overcome “liquidity traps”. Rising budget deficits and government debt levels have become more unsustainable. The US have employed the third round of quantitative easing and are buying US$40bn of mortgage backed securities each month as well as indicating that interest rates will remain at near zero levels until 2015. Meanwhile in the eurozone governments have implemented policies of austerity and are taking money out of the circular flow. However in the emerging economies there has been increasing inflation arising from capacity constraints as well as excess credit creation. Overall the deleveraging process can take years as the excesses of the previous credit booms are unwound. The price to be paid is a period of sub-trend economic growth which in Japan’s case ends up in lost decades of growth and diminished productive potential. The main economies are essentially pursuing their own policies especially as the election cycle demands a more domestic focus for government policy – voter concerns are low incomes and rising unemployment. Next month see the US elections and the changing of the guard in China. In early 2013 there is elections in Germany. The International Monetary Fund released their World Economic Outlook in which they downgraded their formal growth outlook. They also described the risk of a global recession as “alarmingly high”.
Western European economies went back into recession (defined as two consecutive quarters of negative GDP) as the injection of demand into the circular flow was more than offset by public austerity programmes in certain countries. The conditions in the Euro-zone don’t seem to be very conducive to any sort of recovery – contractionary fiscal policy is prevalent in many countries and a lack of confidence across the region stifles any upturn.
Greece is still has serious concerns over any recovery – IMF boss Christine Lagarde stated that Greece should be given “a bit more time”.
“This is what I have advocated for Spain, Portugal and what we are advocating for Greece. An additional two years was necessary for the country to actually face the fiscal consolidation programme that is considered.”
However there is still some more hardship to come before any sort of economic recovery. I was surprised at the German growth levels over the last tow quarters. Quite like this graph showing annual GDP in the Euro-zone.
According to Business Week, as the US was embarking on a US$787bn stimulus package in 2009 Estonian authorities decided to march in the opposite direction and avoided running budget deficits and borrowing money to try and trigger higher growth levels. In order to maintain a balanced budget the government employed a contractionary fiscal policy and did the following:
- they froze state pensions
- lowered salaries by 10%
- raised the tax on goods and services by 2%
As a result of this:
- GDP in Estonia fell by 14% in 2009
- Unemployment in rose to 16%
GDP grew by 7.5% and unemployment down to 10.8% which is still worrying but not as bad as Spain or Greece. However, Estonia has shown that a contractionary monetary and fiscal stance by government does lead to economic hardship but does in the long run generate growth. The IMF praised the country’s export-led recovery and its sought after fiscal position. A lot of Estonia’s success has been its desire to become part of the west since it regained independence in 1991 after the collapse of the USSR and joined the European Union in 2004. The country employed free market policies and with an open, efficient, and wired infrastructure the World Bank ranks it 24th out of 183 countries in “The Ease of Doing Business Index” – see graph.
One area that Estonia is very different than its European counterparts is their ability to follow through on prudent measures. The average salary in Estonia is 10% below the minimum salary in Greece. Furthermore pensions are also much lower and civil servants retire 15 years later. Although the graph below shows the peak of the boom in 2007 Estonian economists believe that this was fueled by cheap household credit and not realistic growth. Whilst the growth from 2010 – 2011 came from mainly exports and therefore seen as genuine. Their belief is “no pain, no gain”.
Robert Frank author of “The Economic Naturalist” and “The Darwin Economy” recently wrote a piece in The New York Times advocating tradiitonal Keynesian stimulus policy. With the US election on the horizon both Obama and Romney will be focusing on how to kick-start the economy. Obama has been a keen believer in infrastructure investment as a way to get American back into work whilst Romney has recognised the clear link between spending and employment.
In 2009 it was estimated that US roads, bridges and other infrastructure were in disrepair by the order of $2 trillion. There are many with the skills to do these jobs that are currently unemployed. Furthermore the longer you leave the repairs the more expensive it becomes. Some have said that this just puts the government into further debt but Frank argues that:
The same logic applies to overdue infrastructure investments. Yes, paying for them requires more government debt. And while austerity advocates fret that such projects will impoverish our grandchildren, they concede that the investments can’t be postponed indefinitely, and that they’ll become much more expensive the longer we wait.
It seems that there is great opportunity to stimulate growth in the economy.
Finance can be a bewildering world. The mashinations of big business and government as they dice with huge amounts of money involves jargon and financial terminology that make the mind boggle. Here are some of his explanations:
Bankia – a bank in Spain which requires a bailout as it indulged in too much speculation in the Spanish real estate market or what is know as banky panky.
Capitalisation – using upper-case letters in an email expressing your rage a the lack of money in the bank’s reserves
Fiscal Compact – a rather shoddily built container where Europe hopes to have its make-up. If you examine it too deeply, the foundation falls out. However if you don’t have it, you’ll be going out without your face on. And things could get ugly.
EFSF – European Finance Sometimes Fails – a whip round for people in your social circle when they are in trouble.
ESM – Even Spain Might – if bigger friends get into trouble you are going to need a bigger whip round.
Eurobonds – the friends you make among opposing fans at the European Football Championship. These realtionships eventhough they are soaked in beer and you can’t speak the other person’s language can be very intense. These bonds stand a better chance of lasting than the actual eurobonds.
LTRO – long-term refinancing operation – the distribution of large sums of money to badly behaved recipients regardless of whether they deserve it or not. A bit like being a parent.
Maastricht – a previous European Treaty requiring financial discipline with regard to government deficits. Unfortunately it was ignored and so was called the “Mass Not So Strict Treaty”. So now Europe needs another agreement called the Stability or “Much Mass Stricter Treaty”.
Turning a corner – what an Irish economy does before something even worse happens – usually the reappearance of Greece.
Jame Surowiecki in the recent edition of The New Yorker likened the euro zone crisis to the fairness trap. With Greek politicians looking at renegotiating its aid package and austerity measures, the German government has indicated that they are running out of patience and money to lend to Greece. Policymakers have talked about a Greek exit from the Euro – Grexit – which would mean they would default on their debts and no longer be part of the Euro currency.
As many economists have pointed out when economies go through a recessionary or contractionary phase their exchange rate starts to depreciate. This makes exports more competitive and imports cheaper which ultimately helps growth. However for Greece to leave the Euro it would destroy vast amounts of capital as well as costly for the rest of Europe. Greece owes almost half a trillion euros and containing the damage would mean the recapitalisation of banks, continent-wde deposit insurance and more aid to Portugal, Spain, and Italy. However it seems that this would be a much more expensive option than Greece staying in the euro zone.
Rationally there should be some sort of compromise with maybe a relaxing of austerity measures and giving Greece a bit more time to bring about some serious structural reforms especially to its tax system. However according to Surowiecki Europe isn’t arguing just about what the most sensible economic policy is but what is fair.
The Germans see it as unfair that they have to bailout Greece especially as the Greeks have continued to live beyond their means – how did they afford to host the Olympic games in 2004? Borrow more money? Why should the Germans be obliging when there is no meaningful reform in Greece?
From a Greek perspective it is equally unfair that for them to suffer years of slim government budgets and high unemployment in order to repay foreign banks and richer northern neighbours.
This fous on fairnes could prove disastrous – remember the Ultimatum Game.
The Ultimatum Game by Werner Goth 1982
In this game somebody offers John £100 under the condition that he shares it with Sarah. The two of them cannot ex- change information and John can make a single offer of how to split the sum. Sarah, who is aware of the amount at stake, can say yes or no. If her answer is yes, the deal goes ahead. If her answer is no, neither John or Sarah gets anything. In both cases, the game is over and will not be repeated. You may not be surprised to learn that two thirds of offers are between 40 and 50 percent.
From research carried out (Karl Sigmund et al.), only four in 100 people offer less than 20 percent. Proposing such a small amount is risky, because it might be rejected. More than half of all responders reject offers that are less than 20 percent.
However, why should anyone reject an offer as “too small”? The only rational option for a selfish individual is to accept any offer, as £1 is better than nothing. A selfish proposer who is sure that the responder is also selfish will therefore make the smallest possible offer and keep the rest.
This game-theory analysis, which assumes that people are selfish and rational, tells you that the proposer should offer the smallest possible share and the responder should accept it. But this is not how most people play the game.
The fairness problem is exacerbated by the fact that our definition of what counts as fair typically reflects what the economists Linda Babcock and George Loewenstein call a “self-serving bias”. This is even more pronounced when both parties feel they are not part of the same community – known as “Social Distance”. For instance:
1. The Greeks’ resentment of austerity might be attenuated by the recognition of how much money Germany has already paid and how much damage was done by rampant Greek tax dodging.
2. The Germans might acknowledge that their devotion to low inflation makes it much harder for struggling economies like Greece to start growing again.
The pervasive rhetoric that frames the conflict in terms of national stereotypes is the following:
Hardworking, frugal Germans v frivolous, corrupt Greeks
Tightfisted, imperialistic Germans v freewheeling, independent Greeks
This makes it all the more difficult to reach a reasonable compromise.
Here are some interesting thoughts from the ASB bank with regard to the eurozone crisis situation. Predicted market outcomes as participants become concerned over potential contagion:
* The USD is likely to strengthen further.
* European Central Bank to cut interest rates 50 basis points to 0.50%.
* Bank of England to undertake further Quantitative Easing.
* Federal Reserve to undertake a third round of Quantitative Easing.
* Reserve Bank of Australia cuts rates 100 basis points to 2.75%.
* Reserve Bank of New Zealand cuts rates by up to 50bp to 2%,
Also look at the graphs below especially the one showing the withdrawal of money from trading banks.
Here is a clip from CBC in Canada that discusses the issues associated with a run on Greek banks. Shows UK Prime Minister David Cameron who must be pleased that they still have the UK pound. Some interesting facts:
$894 million was withdrawn from Greek banks last Monday – 14th May.
Total Greek deposits are $215bn
Deposits down 17% in 2011
Even with the G8 meeting at Camp David how can the Greek economy get out of this mess. I suppose it really is in the hands of the Germans and what they decide. To bail them out sets a dangerous precedent for the likes of Spain, Italy and Ireland.
With the change of government in France and the calamity of the Greek economy there has been a flight of Euros into the London property market. New French President Francois Hollande has proposed significant changes to the tax structure in France:
- 75% tax on income earned above €1million
- 45% tax rate for people making €150,000 more.
In recent months the real estate market in London’s most exclusive areas have become a safe haven for those holding euros as they fight to maintain the value of their money with the euro depreciating rapidly. Furthermore as Greeks start to withdraw euros from their own banks one wonders how long they can stay in the eurozone. What is for sure is that the London real estate sector is doing very well out of this. Below is a clip from CNN.
With increasing debt, out of control unemployment and a general strike Spain has some serious economic problems. However, before the financial crisis of 2008 Spain was seen as a prudent member of the Eurozone with GDP debt being half that of Germany at 36%, and a well regulated financial sector. But since the aftermath of the financial crisis it has been all downhill for the Spanish economy with unemployment now at 24% and public debt at 66%.
Causes of the downturn
Like most economies before the financial crisis Spain had access to cheap credit. This was especially prevalent since entering the Eurozone interest rates, which were set by the European Central Bank ECB) in Frankfurt fell from 12.75% in 1995 to 3% in 2005.
Spain’s banks and households realising that they had massive debts whose collateral was overpriced housing. Property values have fallen 27% and the building of new home is down 80% and given the size of the construction sector mentioned above this has some major implications for the Spanish fundamentals.
The Spanish economy is in serious trouble. With unemployment at 24% and the subsequent fall in consumer spending can it get much worse? Well, rating agency Standard & Poors have proceeded to downgrade Spain to BBB+ rating, which means “adequate payment capacity” and is only a few notches above a junk rating.
The above is a brief extract from an article published in this month’s econoMAX – click below to subscribe to econoMAX the online magazine of Tutor2u. Each month there are 8 articles of around 600 words on current economic issues.
Greece’s bailout by the EU and the IMF is the largest in history – €245 billion.
The seriousness of the Greek debt problem is clear to see – see graphic below. Next month the Greek government must make it clear to those euro-zone governments and the IMF that they have made €11.5billion worth of cuts to its own spending. If it doesn’t make these cuts access to further loans will be suspended and Greece will eventually have to print its own currency. For Greece there are two major challenges as well as paying back the debt:
Debt is still rising at 1.5 times the size of the economy and
Wages and prices need to be forced downward to make the country more competitive.
In the past 3 year the Greek economy has contracted by 14% and the expectation is that it will be 6.4% by the end of this year.
IMF v Germany
In order to protect the economy the IMF suggested that there should be:
– structural reforms to the economy and
– spending cuts but over a longer period of time.
However, Germany demanded that both the structural reforms and the austerity measures should take place at the same time. This involves bringing down the budget deficit from 15.8% of GDP in 2009 to under 3% by 2014. But the spending cuts and tax increases pushed the economy into such a deep recession that the deficit got stuck at around 10% of GDP.
The exchange rate problem with the euro.
It is usual that when the IMF imposes austerity measures, it makes a country devalue its exchange rate in order to make its exports more competitive and therefore offset weak domestic demand. However, Greece doesn’t have its own currency so this is policy option is not on the table.
So where does Greece go from here? With having to impose structural reforms as well as austerity measures the country is caught between a ‘rock and a hard place’. One wonders how they are going to generate any government income with virtually no growth and increasing unemployment.
The major concern for the world economy is that if major economies are going to follow austerity programmes at the same time it will be left to the private sector to generate aggregate demand. But if they don’t borrow and increase consumer spending there is a real risk of an economic depression.
Here is a graphic from the WSJ. There are some serious problems in the spanish economy with 48.56% unemployment of those under 25 and 22.85% being the national figure. Also from the NYT:
- 1.6 million Spanish households ended last year without a single member holding an official job.
- 33% of those unemployed aged below 30.
- 5.72 million are unemployed.
- The Bank of Spain recently forecast that the Spanish economy would shrink 1.5 percent this year, with employment recovering only in the second half of 2013.
This is worrying news for the Spanish as another recession seems likely which in turn means more pressure on jobs.
Recently a lot has been written about how Ireland could be the model economy of how to overcome a debt crisis by using austerity measures. Interesting to note that in the 1990’s the ‘Celtic Tiger’ was heralded as a shining example of how to run a successful modern economy. Now that the economy has become one of the basket cases of Europe it is ironic that they are, according to Angela Merkel and Nicolas Sarkozy, providing the antidote.
Although the economy is performing better there is still a lot of pain being suffered especially from those who can least afford it – as within most eurzone countries it is the “working” person who suffers the most. However a year after its €67.5bn bailout economic conditions have been improving in the Emerald Isle.
- Exports are up 5.4%
- GDP is up 1.2% in Q2 2011
- Budget deficit is down from 32% of GDP in 2010 to 10% of GDP in 2011
But the bad news is still there:
- Salaries of nurses, teachers, civil servants etc have been cut 20%
- 2012 will see €3.8bn in tax increases and spending cuts
- Retail sales fell 3.8% in October from a year earlier
- Unemployment is now at 14.5%
- The above figure would be higher except for the increasing numbers leaving the country
However although Ireland is making gains in rectifying the economic problems in their economy, it could be all in vain when you consider what might happen to the eurozone.