The bailout explained

The European bailout plan is complicated. This movie was created by Tom Meltzer of The Guardian to explain the situation.

A video is here

Saving the Euro or just delaying the inevitable?

I can't do justice to this subject in a post. The Euro crisis has so many issues and aspects. But the agreement reached yesterday is certainly important and adds to the story in a way that does sum it up to an extent.

The Euro area countries have agreed to

* Cut by half the amount Greece owes the banks (reducing their total debt and so not only the amount they will repay but also the annual interest).
* Recapitalise the banks so they are better able to withstand further shocks (say a default by Italy or Spain)
* Increase to €1 trillion the bailout fund available in case of potential default.

The markets love it and have soared, but should we be so sure?

The French President stated that 'Greece should have never been allowed to join the Euro' because they were not ready and falsified the figures. Well he is probably right and the fact that the Euro area is not an 'optimal currency area' has not gone away. Maybe this isn't the time to say France 'managed' the figures too to meet the joining criteria, but it is certainly true that Belgium and Portugal should not have the same currency.

The 'partial default' that the 50% cut in Greek debt represents is a managed way to prevent a full default. That would cause panic and probably the break up of the Euro area. That would be disastrous for trade - what does anyone do between the Euro and the 'new' currencies that would replace it? Months of lost trade, shutdowns and unemployment would be inevitable and that would affect the UK too, with 60% of visible trade done with the EU.

As one commentator said. 'What the Eurozone needs is growth'. This will solve many problems. The debt to GDP ratio will fall, and governments will have more revenue and lower expenditures, allowing them to service their debts. Growth will also allow confidence to return and the growth will become self-sustaining.

But the recapitalisation of the banks will slow growth. For banks to have more capital they have to keep more of their assets, and that means lower lending. Lower lending leads to a credit squeeze and firms can't get the capital they want. Interest rates will probably rise as firms demand more loans and the price rationing process kicks in.

Perhaps the most worrying aspect is that €1 trillion is nowhere near enough to bail out Italy let alone Spain and Italy together. The Euros inherent weaknesses remain and in all probability this is just a temporary lull in the crisis.

The BBC covers the issue here

Discrimination is not always conscious

The difference between the pay and job opportunities for different groups in society is not easy to explain. Despite legislation dating back to 1970 and numerous Act's since men are still payed more than women, whites more than black and those from the middle class get more than those from working class. The difference in unemployment rates are similar.

One way to overcome this is to allow free access to higher education and select those who can access this opportunity on the basis of academic ability and not the ability to pay. Then at least everyone has the chance to present qualifications to potential employers that makes their worth clear, regardless of race, gender or background.

The first indications of university applications this year, with the new higher fees, show a substantial drop. This is probably inevitable (straightforward law of demand), but has wider issues.

The drop in applications from women is roughly double that of men. This may reflect the, very old fashioned view, that education benefits women less than men as women will become 'homemakers' and so it is not worth spending as much on them. While this seems strange to us it was the received view up to the 1960's.

But the damage that will be done to Britain's long term productive capacity and competitive position, by a less well educated workforce, is the most worrying aspect of this data. In a knowledge based economy, as Britain's future economy must be, this move is akin to cutting off an arm in an attempt to lose weight. Effective in reducing short-term expenditure, but plain stupid as a strategy.

The problem of education is that it is an imperfect information good, people don't understand how good education is for them and how much their education benefits society as a whole. Education is a merit good therefore, the market will never provide the socially optimal amount and it needs to be encouraged by the government.

Notice in The Independent report below that overseas applications are up. Britain is a relatively cheap place to study in international terms and this has been enhanced by the fall in the value of the pound over the last two or three years.

The Independent story is here

Accuracy of inflation measures

Firstly I should declare an interest. This story affects my well-being in retirement and I'm not very happy about the pension changes currently proposed by the Government.

But the economics of this story, whether CPI or RPI should be used to annually adjust public sector pensions, is a relevant economic issue.

All price index's are compromises. They are based on the cost of a 'typical' basket of goods, discovered by a survey of consumer spending. However there are no 'typical consumers' the basket of goods is just an average. For some households the cost of living rises faster, for others slower.

The CPI was introduced when there were thoughts Britain might join the Euro (although it was never a serious option) and became the UK's 'official' measure of inflation. The CPI is more comparable with other EU countries measurement of inflation, but the British spend their money on slightly different things. So to construct the CPI the basket of goods had to be adjusted, reducing the impact of housing costs and including other items that did not actually affect UK residents.

The CPI is statistically more elegant. It reduces the effects of rouge price changes and deals with complex goods, such as the price of 'white bread' with its many varieties and easy substitution in a way that makes the RPI look clumsy, if not crude. But CPI will usually give a lower inflation rate than RPI (initially estimated at 0.5% it has actually been 0.75% since 2003).

The result of indexing pensions by CPI and not RPI will then lead to a 0.75% smaller rise in pensions each year and will save the Treasury £40bn in this parliament alone.

Actually neither CPI or RPI are the right measure to adjust pensions. A Pensioner Price Index should be used based on the typical basket of goods a pensioner household buys. For example fewer pensioners have mortgages and so both CPI and RPI overstate the effects of the housing market and mortgage rates on them. A Pensioner Index (PePI) is child's play to construct and indeed one already exists!

Of course the PePI may actually give smaller rises to pensioners!

The Guardian cover the story here

Tax boob?

VAT is to be applied to cosmetic surgery. The odd thing is that it wasn't before.

VAT is an indirect tax that, by its nature, is regressive (it takes a higher proportion of the income of poor households compared to the rich). The UK has always sought to mitigate the regressive nature of VAT by excluding things such as food, children's clothing, books and newspapers and taxing energy at a lower rate.

So not taxing cosmetic surgery undertaken for reasons of vanity only, that must be the preserve of the rich, seems odd. To my mind this is simply a fair application of the tax.

The problem of indirect taxes, such as VAT,  is that they change relative prices. The price mechanism is the means by which resources are allocated in the market. So when the relative price rises less resources are allocated to that product. Not taxing cosmetic surgery makes it relatively less expensive than goods that do attract VAT, so more resources are devoted to cosmetic surgery than would be in a free market.

Governments can get these things wrong by applying indirect taxes poorly and causing an inefficient allocation of resources. But using indirect taxes to reduce tobacco, alcohol and carbon consumption correct market failures. The important thing is to treat all goods appropriately and try to avoid making the distribution of real income worse. So I think this move should be applauded, although somebody should be asked why it has taken forty years to remove this anomaly.

The Guardian cover the story here

The protection of agriculture in the EU at what cost?

As an Australian who has seen our farmers locked out of the European markets through the Common Agricultural Policy it is difficult to understand why Europe continues with protection of this industry. The latest reform includes handing out €435bn of taxpayers' money over the next 10 years. This is during a time when many other Europeans can not find work. The CAP is the EU's single largest expense, making up nearly half of the EU budget (38.5% now, but down from 72% in 1985).

Whilst the protection for farmers is what the EU desires, it neglects the impact this will have on every other industry.


The Guardian Report

Who is unemployed?

The rise in unemployment to a 17 year high is very bad news for the UK economy. The cause of the unemployment is a combination of factors:

1. Cuts in public sector jobs
2. Slow private sector growth
3. Rising productivity

I am not going to get into the argument about how to solve this situation again. I am interested in two points that arise from The Guardian article linked below.

The economy is growing at 'about half the rate needed' to keep the unemployment rate stable according to one commentator. So the economy is growing, but unemployment is rising. How is that possible? The answer is that each year labour productivity improves, and so to produce the same amount of goods and services each year less workers are needed. A rule of thumb is that 1% Real GDP growth offsets productivity gains to maintain the level of employment.

Therefore the UK is not growing nearly fast enough to keep unemployment stable.

The other point is how we measure unemployment. The economic definition for being unemployed is that the worker is " Willing and able to work at the current wage rate, but cannot find a job". To meet this criteria someone who is unemployed must be able to start full time work in a suitable job at the wages offered in the market.

When someone wants to work but thinks the wage on offer is too low they are voluntarily unemployed (i.e. they fail the 'willing' part of the test). The way the Labour Force Survey measures unemployment means that it can count some people as unemployed when they actually are not willing to work. At this point I should point out that the LFS is more accurate than the Claimant Count which clearly understates unemployment.

The issue raised in the article is that over a quarter of a million of the youth unemployed are in full time education. The Minister thinks they are not properly unemployed as they fail the 'able to work' criteria. This is an issue that arises in every period of high unemployment. Education is often referred to as the 'employer of last resort', if you can't find a job keep busy on a course.

Here the difference between the official statistics and what economists mean by unemployment is highlighted and is useful material for examples when asked about the limitations and advantages of the measures of unemployment. This question comes up in about 50% of F582 papers.

The Guardian article is here

Don't forget the BBC website that provides interactive data in the useful links box on the bottom right

Barriers to entry and excess profits

A key difference between different market structures in the existence or not of barriers to entry. If a market has high barriers to entry then we expect to see only a few firms, each able to protect its market share and so charge higher prices. These higher prices mean lower sales but higher (excess) profits for the firms.

Where few, or no, barriers to entry exist new firms can enter a market and compete for a share of the profits earned by others. This leads to an increase in supply and a falling price. Consumers gain but excess profits are competed away.

The telecom companies used to be able to earn a lot of money from text messages (SMS), but this market is changing. There are no barriers to entry for free apps that allow free text or even calls. So the days when O2 or Orange can charge high fees for texts is going and so are their profits.

This, slightly odd, piece from The Age in Australia explains how this market is changing. Not news at all to you I'm sure, but an excellent example of how things you took for granted have an economic explanation.

The Age article is here

An expected Nobel Prize

Professors Tom Sargent and Chris Sims are the 2011 winners of the Nobel Prize for Economics. I was expecting it for years.

The important work for which they have received the prize is their contribution to modelling expectations. Prior to their work economists used a method known as 'adaptive expectations' to predict how households and firms would react to policy changes. This meant the computer models of the time used an equation that implied expectations moved slowly after a change in policy or events. Without being too technical this meant that policy changes could have big effects on behavior even though the policy was very predictable and mechanistic.

Sargent and Sims showed that expectations changed faster than previously thought and that by manipulating the expectations of firms and households policy, say to reduce inflation, would be much more effective. Many of you will have already looked at the importance of inflation expectations in the inflation process.

Today their work is very important in deciding macroeconomic policy, particularly in designing monetary policy. Take for example the debate on the pace of deficit reduction. Confidence is crucial in consumption and investment and based on their work it could be argued that more public spending and higher budget deficits will actually cause a worsening of confidence due to the effect it has on the expectations of households and firms.

The Nobel website has a Popular Information section, look at the 'Information for the Public' link and that allows you to download an excellent, non-technical,  summary of their work. (Pretty important for anyone considering Oxbridge/LSE/Warwick/Southampton/UCL economics.)

Nobel site link here

The Guardian coverage here

Meddling in markets

For some reason governments can't help interfering in agricultural markets. And most of the time they make things worse, an example of government failure.

Thailand are the latest government to distort a food market. They are offering a premium of about 50% to rice farmers to buy up rice in unlimited amounts. The claimed motive for this policy is to raise the income of farmers who are amongst the lowest paid in the country.

But such policies, however well intentioned, distort the market. This effectively raises the price in the local market, (see the diagram above) but will inevitably lead a situation of excess supply in Thailand and a distortion of the international market.

As a major rice exporter changes to the local market will inevitably lead to changes in the international price. Why would a Thai farmer sell on the open market when the government will pay more? So the supply of Thai rice to the international market will fall, forcing up the world price and causing problems for the poor of other nations.

There is also the question of what to do with the rice the government buys. Some schemes stockpile food in years of surplus to release in lean years. Doing so helps moderate price fluctuations and smooth out farm incomes. However the Thai floods mean production is actually down this year so its not the time to start buying up stocks.

The EU pursued a disastrous agricultural policy from the 1950's to the mid 2000's where they paid farmers far to high a price for food. This caused an inefficient over production in Europe and reduced the incomes of farmers in LDC's where the market would produce the food most cheaply and efficiently. The solution for the EU was to move to direct income payments, simply giving money to the farmers and so avoiding the incentive to them to produce ever more unwanted food.

Businessweek report the Thai policy here

Costs and benefits of a Heathrow-Gatwick rail link

There is a proposal to link Heathrow and Gatwick airports by a high-speed rail link. This suggestion will require a thorough cost-benefit analysis (CBA).

The idea is to help improve airport capacity and avoid building new runways or new airports to achieve that. While I am not really clear how much capacity it could add the costs and benefits are worth investigating.

A CBA identifies all the costs and benefits of a project, both private and external, gives them a monetary value and then decides if the investment is worth the cost. Perhaps the strongest advantage of CBA is that it allows comparison of projects. So in this case the Heathrow-Gatwick rail link can be compared to expanding Gatwick, or Heathrow or building a new airport somewhere.

For those doing transport economics this year it represents an excellent opportunity to apply CBA. Also it is not too late for this to be included in the June Transport paper, and is a certainty for 2013 otherwise.

The Telegraph reports the scheme here

Petrol consumption falls 15%

The AA has reported that petroll consumption was 15% lower in the period January to June this year. The AA say this is due to rising fuel prices.

AA President Edmund King said: "There is no downplaying the impact of record fuel prices on family's and other people's lives. A 1.7bn litre drop in petrol sales says just one thing - too many car owners cannot afford these record prices."

On an annual basis prices have risen about 20% for the period in question. So does this mean that the rise in price by 20% has led to a 15% fall in quantity? That would imply a price elasticity of demand (PED) of -1.3.

In this case simple PED cannot be applied. While quantity demanded has fallen 15% this is not just due to the rising fuel prices. Ceteris paribus does not apply because at least two vital factors have also changed:

1. Real  disposable income has fallen in the period due to high inflation, rising taxes and falling actual incomes due to higher unemployment.

2. Consumer confidence has fallen leading to a change in tastes and preferences.

Both of these changes mean the demand curve for fuel has shifted to the left meaning that less is demanded at all prices.

So the change in the amount of fuel consumed is a good example of how in the real world more than one factor can change at once. However we can understand the change as a combination of a move 'up' the demand curve as price rises and a movement of the demand curve to the left as some conditions of demand change.

The BBC report the AA findings here

Monetary boost to avoid inflation being too low

The Bank of England Monetary Policy Committee kept interest rates on hold today. No surprise there, nor in the announcement that that there would be more quantitative easing (QE).

The aim of the MPC is to keep inflation at 2% on the CPI measure. But they can't work in the short term, inflation is a complicated process and monetary policy takes up to two years to take effect, so the MPC must aim to keep inflation on target in two years time.

At the moment inflation is well above target and will go up rather than down in the next few months. So why not try to contain inflation? Well the horse is several fields away on that one and so the MPC look past he current inflation figures as they cannot affect them. They see the VAT rise dropping out of the index in January, weak economic growth around the world reducing export growth and domestic inflationary pressures being contained. They believe that without action inflation will drop below 2% in the final quarter of 2013.

So the MPC will boost the liquidity of the financial sector by pumping £75bn of new money into the economy. This will stimulate lending and demand and hopefully assist growth in aggregate demand.

The BBC have helpfully restored their Q&A on Quantitative Easing, explaining how it works, why it is used and why its not going to cause runaway inflation such as the German and Zimbabwe hyper-inflations. The BBC Q&A will answer the questions of Deps on what this measure means, but everyone should read the reports of this move carefully.

The BBC Q&A on QE is here

UK economic growth cut to 0.1% for April to June

These figures released yesterday have led to the usual argument over potential policies. These are the usual demand management options. The calls are coming for the government to increase spending and for the Bank of England to adopt QE. It is important to remember the source for the financial downturn which is greatly influenced by the poor economic performance in Europe.

Guardian Article Here

Is 15p enough (a tough balancing act)?

The National Minimum Wage (NMW) has risen by 15 pence per hour to give a pay rise for Britain's lowest paid workers.

With RPI inflation running at 5.2 per cent (CPI at 4.5%) the real income of these workers will fall. Inflation is high due to this year's VAT increase, increasing fuel prices and any number of other significant price pressures.  This years increase in the NMW won't allow Britain's lowest paid workers to maintain their standard of living.

However, before rushing to any judgement on this apparently about the small increase, consider that the Low Pay Commission (LPC) (which oversees increases in the minimum wage) had a truly tricky job on its hands. Given the poor GDP growth forecasts and rising unemployment, they couldn't risk making a tough labour market worse.

Therefore the key conflicting issues the LPC need to consider are:
What increase do we require to maintain the lowest income earners' standard of living?
and
What level would an increase in pay cost jobs in this economic climate?

Retailers take the view the NMW will cost jobs here

When is a single market not a single market?

Barriers to entry in a market allow firms some monopoly power and that gives them the chance to raise prices. produce at lower quality and earn excess profits. This is not good for the consumer and most countries attempt to prevent it through Competition Law. As the European Union is a 'single market' that means Competition Law is a European and not a national matter unless a firm operates only in one country.

The '1993' rules of the EU make it clear there can be no barriers to firms, workers or capital between member nations. All firms are free to operate in any other member state and all citizens of the EU can work where they like within the EU.

To illustrate this before 1993 a computer manufacturer had to produce 11 different models of the same computer to meet local regulations and a British lawyer could not appear in a court in Germany or Italy. The 1993 regulations said that such barriers were illegal.

However in many countries not all of these regulations were adopted. The Spanish banks continue to charge non-Spanish customers a higher interest rate, insurance companies are denied access to the Irish market and domestic broadcasters deny the right of foreign broadcasters to sell their services in the UK.

Yesterday the European Court ruled that the Premier League had no right to deny broadcasters other than Sky and ESPN to sell access to their broadcasts of football matches. To do so breached the 1993 EU regulations and EU competition law.

This is an example of the law removing a barrier to entry in the market. The result will be that more firms will enter the British market, competition will increase and everyone will have cheaper access to broadcasts. (Although the ruling is complicated and will take some time to work through.)

The actual case involves showing Premier League football in a Portsmouth pub. Of course Sky and the Premier League will protest, it will affect their profits, but the winner is the consumer. Just 38 years after Britain joined the European Union it is about to get one of the benefits it was promised!

 The BBC covers the story here

Dealing with a different sort of recession

Political debate usually generates more heat than light. That is one of the basic rules of life and the political debate over policy to deal with the recession illustrates this well. So we have to try and look through the politics of the latest announcement.

The last recession was caused by a collapse in financial markets which, by various means, led to a collapse in Aggregate Demand. A prudent response by most governments was to pursue an expansionary fiscal and monetary policy. This was to deal with the immediate effects of the crisis.

The debate now rages on how to continue to cope with the crisis, especially now that a 'double-dip' recession seems a possibility. Sadly at least one group in this debate have missed the point.

The Keynesians have, as usual, crawled out from under their stones and claimed they have the answer. 'Boost Aggregate Demand by the government spending more money', which they borrow. But Keynes was talking about a recession caused by a failure in the goods market in the General Theory, not one caused in the financial markets. (Read the General Theory if you like, it's pretty obvious. There is a copy at the back of Mr Lewis's room and online).

The time for old fashioned demand management has passed. It is necessary to deal with the financial market problems, such as the European Debt Crisis and Bank re-capitalisation. But this has led to a drying up of funds available for lending to businesses and this is preventing a timely recovery in the private sector.

Despite encouragement banks find they cannot both re-capitalise their balance sheets (so they can survive a second GFC or major default by Euro area countries) and lend to small and medium size businesses. This prevents those businesses expanding and reducing the unemployment problem.

Small and medium size businesses basically have two sources of capital, loans and retained profit. Unlike in the USA (where such bonds are a major source of funding) they cannot easily issue 'corporate bonds' as there is no established market for them.

So now the Chancellor is proposing to help develop this additional source of funding by offering to buy bonds issued by smaller firms. It is an unusual, and potentially far sighted, move to help recovery. It is, however, fraught with difficulties.

As the market for small firm bonds is currently tiny it is likely the costs of operating in this market will be high. It will also take time to establish and the firms that can benefit will find it is some time before they are ready to issue bonds. However they now have a guaranteed buyer in the government and so they can raise money with certainty and, presumably, at a lower cost than any alternative. The government hopes it will allow the development of a small/medium firm bond market that will persist in the future.

The measure is being called a credit easing plan. It directly addresses an issue caused by a financial market induced recession and so should be applauded. I would call it a 'supply side' measure as it is trying to help a market work, is specifically targeted at an issue, will allow the expansion of productive capacity and will take a long time to work.

Time will tell how effective it is.

The Guardian reports the measure here

Fat tax for Denmark - where next?

Denmark has just introduced a 'Fat Tax'. The aim is to raise the price of foods with a high saturated fat content.

The problem for markets is that they don't work properly when one side of the market does not have, or ignores, full information. A classic case is tobacco. Despite the known dangers of smoking people continue to smoke, imposing costs on themselves and others (negative externalities).

As with somoking a high fat diet imposes long term health problems on those who eat the food and costs on the rest of society as the cost of treating those health problems falls on the rest of the population through the NHS.

Traditional policies to tackle these 'lack of information' or 'demerit goods' include education, labeling of the products and, usually, tax. By raising the price of tobacco fewer people buy it. That's the law of demand. (Education and labeling shift the demand curve to the left, so the policies are complementary.)

Denmark has now taken the first step in introducing a tax on high fat goods. Any product with more than 2.5% saturated fat attracts the tax. How effective it will be remains to be seen. When tobacco was taxed at first demand was very inelastic (did not respond to the change in price very much) as people were addicted to smoking. Maybe there are more substitutes for high fat foods than there are to tobacco and so this will see a bigger response?

The Guardian reports the Danish tax here

Retirement age abolished

Supply side policies are far more important than managing aggregate demand when it comes to sustaining economic growth and achieving long term prosperity. Hence the focus of policy in the early 1980's (under the benign leadership of the Blessed Margaret) moved to improve the capacity of the UK economy. Despite the recent emphasis on maintaining aggregate demand that is just a short-term 'make-do and mend'.

The aging population means that there are two pressing factors to be dealt with. One is to ensure that the workforce is big enough to support a growing dependent (old) population. The second is how to pay the benefits and pensions the old will require without running an ever larger budget deficit.

One solution is to let everyone work longer. They get benefits later and pay more tax while they continue to work. The effect is that the Aggregate Supply curve (technically the Long-run AS curve) shifts to the right. It has positive effects on growth, employment and inflation.

The BBC explains that some firms may offer 'golden goodbyes' to get rid of staff they can't make retire. Personally I am open to offers now.

You may not have noticed but the National Minimum Wage also rose today. This is also a supply side policy, although unusually one that restricts markets rather than freeing them up. The NMW rose to £6.08 an hour for those over 21, that's 15p an hour more than before. For 16 and 17 year olds the rate is now £3.68 an hour.

The effect of a minimum wage depends on if the market would have set a lower or higher wage than the government minimum.  It can reduce employment if set too high, but can reduce poverty when firms would have set a lower wage, but can afford a higher one.

The BBC cover the retirement age abolition here