Below are some interesting graphs and comments from a recent ANZ Bank presentation which address the issue of
Both cyclical and structural factors seem to have played an important role in the recent recession. From a cyclical point of view output and the unemployment rate of the economy reflect this and should recover to pre recession levels. Structural change involves the shift of resources from slower growing areas of the economy to faster growing areas. Indicators such as the savings rate and employment in the different sectors of an economy, seem to be driven more by structural changes and might not return to levels seen before the recent recession.
Economists spend a lot of time talking about the “cycle”, but this can be at the expense of the “trend”.
- And isn’t it the trend that is more important for businesses?
- We can get bogged down in the detail and forget about some of the high level themes that dominant
- Often these trends or themes can be relatively clear. But a lot of the time they are not.
- Arguably, today’s economic backdrop is one where there are more questions over the overarching trends than the cycle itself (although that is not that clear either!).
I got this very informative image from a colleague. Put together by the ANZ Bank it shows how New Zealand, Australia, USA, Euro area and the UK rank over a range of variables. How it works is that 1st place in each category shaded dark blue, 2nd place shaded light blue, and last place shaded red.
When they are combined the overall rank has: 1st New Zealand – 2nd Australia. However in the major indicators of Growth, Inflation and unemployment has Australia ranked one in each. As for the Euro area it is ranked last in three categories and ultimately last overall. A useful exercise for students would be to research these categories in major economies and get them to rank them as below.
There has been research to suggest that climatic conditions can have a significant effect on economic growth although they tend to be inconsistent. A paper published by the journal Nature suspects that researchers in the past have been looking at the directly relationship between temperature and economic growth. In this paper they approached the research looking for an optimal temperature, on the assumption that both extreme cold and extreme heat can harm growth. Researchers found that:
Hotter-than-usual years benefit countries, rich and poor alike, up to an average annual temperature of 13°C, after which hotter weather begins to reduce growth.
This data allowed them to deduce the likely effect of climate change – see chart.
Brazil – an increase in temperature of 3°C (from 22°C to 25°C) = GDP 3% down
Germany – an increase in temperature of 4°C (from 9°C to 13°C) = GDP 1% up
As countries like Germany and France are on the colder side of the optimum (13°C) they tend to grow faster in hotter years in contrast to the USA and Australian whose normal temperature is the hotter side of 13°C. Some economists have argued that with global temperatures changing there is no firm baseline for comparison. However in the primary sector the growing of agricultural produce is most productive at particular temperatures. In the US those involved in jobs such as construction and manufacturing tend to leave work an hour earlier when the temperature rose above 29°C. Therefore in order to maintain the hours worked either more people have to be employed or employees are paid extra. It is estimated that 28% of the US workforce are exposed to the weather so this may mean higher costs for businesses.
Global warming also means that the sea-level will rise and countries and cities face the decision as to whether to build costly flood defences or accept the consequences. Moreover, even if rich countries manage to fend off the worst effects of global warming, they will still feel its repercussions. Trade with more vulnerable places would decline; refugees would proliferate.
If the global economy continues to function in a smilier vein to the recent past. climate change is expected to reshape the global economy by substantially reducing output and amplifying inequalities relative to a world without climate change. Innovation or defensive investments might reduce these effects but social conflict or disrupted trade – either from political restrictions or correlated losses around the world – could worsen them.
Nature- Global non-linear effect of temperature on economic production – 15th September 2015
The Economist – Putting Goldilocks to work – 24th October 2015
- 33% of railway bridges in Germany is over 100 years old
- 50% of London’s water mains are also over 100 years old
- In the US the average bridge is 42 years old and the average dam 52.
The American Society of Civil Engineers rates around 14,000 of the country’s dams as “high hazard” and 151,238 of its bridges as “deficient”. As well as being dangerous it is also expensive as traffic jams on urban highways cost America over $100 billion in wasted time and fuel each year; congestion at airports costs $22 billion and another $150 billion is lost to power outages.
The G20 economies will need to spend between $15 trillion-20 trillion by 2030 to upgrade infrastructure. McKinsey, a consultancy, reckons that in 2007-12 investment in infrastructure in rich countries was about 2.5% of GDP a year when it should have been 3.5%. This was a missed opportunity to upgrade infrastructure for the following reasons:
- Interest rates have been a extremely low levels
- There has been a lot of spare capacity in the construction industry which in turn means that the costs of contracting companies to do the work is low.
Investment in infrastructure can provide a tremendous boost to an economy:
- Paving roads has helped double school attendance by girls in Morocco;
- Improved sanitation has helped reduce child mortality in India by over 50%.
- Increased government spending on infrastructure by 1% of GDP would increase GDP, after 3 years, in the USA by 1.7%, 2.5% in the UK and 1.4% in the Euro Zone.
Politics vs Practicality
Politicians still seem to favour investment projects that attract attention. Rather than upgrading bridges, roads, subways etc the priority is more eye-catching ventures. The USA post stimulus spending on infrastructure dedicated $8bn to a high speed rail service but only $1.5bn to small more practical projects.
Below is a very informative video from the Reserve Bank of New Zealand about smoothing out the boom bust cycles in the New Zealand economy. There are some notes that follow which have been edited from the transcript.
Objectives macro prudential policy.
- To build resilience of the financial system so that it can cope with the business cycle if it turns from boom to bust.
- To be proactive in dampening the risk to begin with. This could include dampen the growth of credit, house prices or other asset prices. An example of this was in New Zealand in the late 1980’s – share market crash and the plunge in commercial property prices.
Macro Prudential Tool Kit – 4 Tools
1. Counter-cyclical capital buffer
This is where the banks are required to hold an extra margin of capital during the boom part of the cycle so that if the boom turns to bust the banks have an extra margin of capital that they can then call on to meet loan losses.
2. Sectorial capital overlay
This is very similar to a counter-cyclical capital buffer but it is about holding extra capital against a particular sector that the banks might be leaning to, for example the household sector, the farming sector, or potentially the commercial property sector.
3. Loan to value ratio for residential housing lending
This is a limit on the amount of high loan to value ratio lending or low deposit lending that the banks are able to do for the household sector. High LVR lending potentially fuels rapid house price growth and so that might be another reason why you would use that particular instrument.
4. Core funding ratio
This is a tool that has been a permanent fixture for the banks. There are a number of reasons why the core funding ratio might change. Potentially if the banks are facing an increase in risk, the Reserve Bank could require them to hold more core funding, funding that would be more likely to remain in the system during a downturn. By holding more of that stable funding, they’d be less likely to stop lending in a downturn because the funding would remain in the system.
Boom bust cycles are cycles in the economy and in the financial system are of course a fact of life. Macro-prudential policy certainly won’t prevent those cycles from occurring. What it will do is provide some cushioning to the cycle. It will hopefully clip the highs and the lows to some extent so that the flow of credit and the flow of financial services in the economy continue through time. It’s not about preventing the cycle or dampening it completely. It’s about taking some of the extremes out of the cycle.
A recent piece by Edmund Phelps in the New York Review of Books argues that Western economies have generally failed at giving the labour force access to jobs that provide self-respect.
The classsical idea of political economy is to let wages rates fall to what the market determines and then provide everyone with a safety net of unemployment benefit, healthcare etc. Although this policy does assist those in need, it negates the desire for people to do something with their lives besides consuming goods and leisure time. A lot of people have a desire to participate in a community in which they can interact and develop new skills and self-esteem.
People need to ‘flourish’
He goes into the notion of “flourishing”( defined as “using one’s imagination, exercising one’s creativity, taking fascinating journeys into the unknown, and acting on the world”), and how current Western economies act to deter such human activity. Phelps refers to this as the good life which typically involves acquiring mastery in one’s work and using imagination, creativity and taking the journeys into the unknown. These benefits are in experience and not in material reward – he quotes Kabir Sehgal “Money is like blood. You need it to live but it isn’t the point of life.”
He argues that individuals prospered in the 19th Century when in Europe and America, economies emerged with the dynamism to generate their own innovation. Participants were constantly trying to think of new ways to produce things. What made innovating so powerful in these economies was that it was not limited to elites. It permeated society from the less advantaged parts of the population on up. People of ordinary background might be involved in innovations, large and small. George Stephenson was illiterate, John Deere a blacksmith, Isaac Singer a machinist, Thomas Edison of humble origins. People of ordinary ability could also have innovative ideas.
The Mechanical Model of Economics
Today most companies are highly efficient and labour that are reasonably well off, have gone on saving pushing up their wealth to very high levels. As a consequence the supply of labour contracts as does the labour force participation rate. However many people although comparatively rich are poor in the conditions for the good life of flourishing and prospering. With the absence of innovation comes decreased investment and an underutilised labour force. This is especially prevalent in Europe where figures for levels of happiness are indicative of unemployment levels and job satisfaction – Spain (54), France (51), Italy (48), and Greece (37).
This is in contrast to nations which are labeled as ‘emerging’—Mexico (79), Venezuela (74), Brazil (73), Argentina (66), Vietnam (64), Colombia (64), China (59), Indonesia (58), Chile (58), and Malaysia (56).
The US has a similar syndrome with a productivity slowdown and the decline of job satisfaction but more significant is the loss of indigenous innovation in the established industries like traditional manufacturing and services that was not nearly offset by the innovation that flowered in a few new industries—digital, media, and financial. You may think that companies on Silicon Valley offer jobs that are very creative and forward thinking but companies like Google and Facebook account for only 3% of national income.
Causes of the narrowing of innovation?
Phelps looks at two possible causes of this narrowing of innovation.
- There has been a suppression of innovation by vested interests. Professions have had instituted regulation and licensing to curb experimentation and thus reducing innovation. He uses the example of the US car industry which was able to regain their positions in the market by government bailouts. This meant that companies like BMW and Toyota lose money in their attempts to be more innovative in order to acquire market share. Consequently companies would be skeptical of being innovative in the US car market. Furthermore stakeholders use lobbyists to regulate and implement patents which increases the barriers to entry for new entrants.
- Schools are doing less to expose the young to the great books of adventure and personal development. Parents teach their children from infancy to be careful and stay close to the family. There is discussion now of the overprotected child: the need for a return to “free range” children who are allowed to explore, to try things and take chances
The problem is that young people are not taught to see the economy as a place where participants may imagine new things, where entrepreneurs may want to build them and investors may venture to back some of them. It is essential to educate young people to this image of the economy.
We will all have to turn from the classical fixation on wealth accumulation and efficiency to a modern economics that places imagination and creativity at the center of economic life.
In explaining the differences between internal and external balances I came across an old textbook that I used at University – Economics by David Begg. It was described as ‘The Student’s Bible” by BBC Radio 4 and I certainly do refer back to it quite regularly. Part 4 on macroeconomics has an informative diagram that shows the impact of booms and recessions on the internal and external balances.
Internal Balance – when Aggregate Demand equals Aggregate Supply (potential output). And there is full employment in the labour market. With sluggish wage and price adjustment, lower AD causes a recession. Only when AD returns to potential output is internal balance restored.
External Balance – this refers to the Current Account balance. The country is neither underspending nor overspending its foreign income. For a floating exchange rate, the total balance of payments is always zero. Since the balance of payments is the sum of the current, capital, and financial accounts, saying the current account is in balance then also implies that the sum of the capital and financial accounts are in balance.
The top left-hand quadrant shows a combination of a domestic slump and a current account surplus. This can be caused by a rise in desired savings or by an adoption of a tight fiscal policy and monetary policy. These reduce AD which cause both a domestic slump and a reduction in imports.
The bottom left-hand corner shows a higher real exchange rate, which makes exports less competitive, reduces export demand and raises import demand. The fall in net exports induces both a current account deficit and lower AD, leading to a domestic slump.
In a downturn a more expansionary fiscal and monetary policy can hasten the return to full employment eg. Quantitative easing, tax cuts, lower interest rates. However one could say that today it doesn’t seem to be that effective.