Crucial questions on policy

Despite appearances to the contrary most economists do not spend their time on designing policy. They actually spend their time on the 'basic science' of economics. The answers they come up with allow others to design policy accurately.

In a recent FT article by Lord Skidelsky and Felix Martin suggest a 'Plan C' is needed for the UK economy.

Plan A was cut the deficit and by this remove prssure on the hard pressed 'wealth creating' sector.
Plan B was print money to reduce interest rates and encourage investment (Quantitative Easing).


The authors argue that Plan B would not work due to theoretical issues raised by Keynes. They then back this up with evidence from the experience of QE, principally pointing out that confidence is the main determinant of capital investment, not interest rates.


They present Friedman's argument that liquidity is a key element of preventing depression, but don't give it the credit it deserves. Perhaps because it is a short piece, or perhaps because they are both Keynesians and have been waiting thirty years for a chance to get their own back.


Whatever their motives their piece is an excellent survey and shows the requirement to understand how the relationships in the economy actually work before policy is designed. Sadly the theory often lags reality.

The FT article is here

Chinese have been reading the Development textbooks

One of the pieces of advice given to Less Developed Countries (LDC's) by the 'First World' in the 1960's was to invest in 'leading sectors'. This was based on the view that certain sectors have high second round effects and so a high multiplier value.

While this advice was largely ineffective, and in many cases disastrous, the idea of government intervention and 'unbalanced growth' to kick start under developed economies has remained in the literature. Clearly the Chinese have read about it as they now wish to invest in British infrastructure in order to help boost economic growth.

The Chinese are, of course, acting in their own best interests. They need Europe to grow so they can buy more Chinese goods. They also need somewhere to invest their considerable wealth. They have established 'sovereign wealth funds' to do this, a very sensible move as China cannot possibly use all the profits currently earned by their exports.

There are several ideas to explore here. Will there really be a big multiplier effect as a result of the proposed new investment? Is this the golden goose the Public Private Partnership programme has been looking for (it has totally failed to attract significant private funds for nearly ten years)? Are sovereign wealth funds a good idea? And of course how long has China considered the UK an LDC?

Whatever the answers it is clear that old copies of Todaro have a ready market in China.

The BBC cover the story here

Welcome to a future built in BRIC

Please read the attached article by Jim O'Neill. It is a follow up to his original paper 10 years ago about his prediction of the potential growth of the BRIC Economies (Brazil, Russia, India and China). He makes us question the role of the G7, with China now the second biggest economy in the world and Brazil set to surpass France and Britain to become the 5th largest economy. Also Russia and India are bigger than Canada. The world order is changing as he states that by 2020 the GDP of the 8 Growth Nations will equal that of the G7. Whilst the European crisis is important for the future of the United Kingdom it is important not to neglect other parts of the world as O'Neill argues this may be where the future lies.

The Telegraph Article Here

One million reasons to study harder

The figures released last week of record unemployment of over 2.6 million (8.3%) indicates the economy is stuttering along. Unemployment figures record the economic performance of the past and illustrate the impact of sluggish economic growth. However, the youth unemployment figures (over 1 million for the first time) is even more disturbing as it gives a window into the the productive capacity of the future. The NEETs (Not employed, educated or trained) lend themselves to a bleak future. Opportunities need to be created for the youth otherwise the economy will need to deal with and try to overcome the difficult problem of hard-core or long term unemployment. For you as a student you may be entering the workforce during a very tough economic climate. Education will become a vital bargaining chip in gaining employment.
The Telegraph Article Here

Growth, inflation and government budgets

The Bank of England have slashed their growth forecast and predicted a rapid fall in inflation over the next two years. At the same time the governments aim at reducing the government budget deficit now appears optimistic due to the slowdown in the Eurozone economies.

This latest news illustrates the relationship between economic variables.

Economic growth leads to upward pressure on prices as demand rises, while slow growth exerts little inflationary pressure. The slowing of the Eurozone economies has affected Britain because Europe is the main market for British exports. Lower export growth has led to a stalling of British growth as net exports are a component of Aggregate Demand. The general uncertainty of the whole crisis is making UK households save and pay off debt rather than spend so reducing Consumption, another component of AD.

The result is that the Government is not gaining as much revenue as they thought (through lower income tax, VAT and corporation tax receipts) and are spending more than they hoped (on unemployment benefits for example). The result is the government budget deficit is larger than predicted.

Of course this is exactly what should happen and is caused by the operation of automatic stabilisers. For the Bank of England there are new problems. Inflation is well above target but threatening to drop below over the next two years. It means that interest rates will not rise anytime soon and more Quantitative Easing is possible.

The Guardian lead article is here

Watch the latest Inflation Report presentation here

Free trade makes a comeback

The leaders of the Asia-Pacific region are meeting in Hawaii. Might sound insignificant but together the member nations account for over 40% of the worlds trade and population.

Unlike the EU trade agreements in the area are fairly rudementary. They consist of a series of bilateral agreements and a few small Free Trade Areas - FTA's (although NAFTA is an obvious exception). Now nine members of APEC are talking about extending the TPP - a small free trade association set up in 2006 - to include the USA and Japan among others.

Economists like free trade. They don't see trade as a 'zero-sum' game, where losers and winners cancel each other out. Rather everyone gains from trade, the buyer and the seller both think they are better off as a result of an exchange, otherwise they wouldn't do it. And so it follows that the more trades that take place the more people that are better off.

At the most fundamental level trade allows specialisation and exchange. As everyone already knows that is the basis on which the economy of the world has been able to improve the standard of living of everyone since before the industrial revolution.

But free trade meets significant opposition. In the recession there were fears that 'economic nationalism' would lead to a new round of protectionism in the misguided belief that it would help keep jobs in countries experiencing difficulties. Despite the lessons of history some countries continue to have strong protectionist lobbies that value short-term protection over long-term prosperity and a political system that rewards such views (such as Australia).

The move to a nine-member Pacific FTA is therefore to be welcomed. In theory FTA's are the lowest rung on a ladder towards full economic integration. The next rung up is a customs union and then a common market and above that the EU style 'monetary union'. The aim is to increase the well being of all members by allowing more trade and so more specialistion. FTA's tend to be about trade in goods only, but represent a significant advance and the new TPP will include some non-goods trade provisions.

The NDTV article explains some of the advantages here.

 The Wikipedia page on Free Trade Areas is here

Another chapter in the Euro crisis?

I am not sure if this is a new chapter or just another plot twist, the Euro saga has continued for so long its critical importance is sometimes forgotten.

The crisis deepens as Italy is now on the brink. Italy isn't like Greece or Ireland, it is a big economy with their government owing 120% of GDP to creditors. Italy is the third biggest economy in the Euro zone and even the enhanced €1 trillion bailout fund is nowhere near enough to save it if default comes.

Italy has no credible plan to resolve the problem and the market knows it. The market is demanding higher and higher interest rates (6.69% is the latest) to fund their overspending and the likelihood is that that rate will rise as Italy must borrow over €300bn next year.

There is a solution. Let the European Central Bank (ECB) lend the money to Italy. The ECB could buy Italian Government bonds and can theoretically supply all of Italy's needs. The Germans, at least, completely oppose this move.

If the ECB buys Italian debt they will do so with money they simply create. As with Quantitative Easing this raises the supply of Euro's in circulation (its printing money). The Germans always have in their minds the hyperinflation of the 1920's caused by printing money and the post-war Deutchmark which was managed so well that inflation was only an issue after the costs of unification with East Germany. They don't want the ECB to start a potentially inflationary process.

Most people disagree with the Germans. They see the need to save the Euro as far greater than the risk of inflation. They also point out that the Germans can only be right when the rate of rise in the money supply is faster than the rate of rise in real output. So far in this period of instability monetary growth has been sluggish and over the period 2009 - 10 the money supply would have fallen but for central bank action. The graphic at the top is a little small but shows M1 and M3 growth in the EU.

It is clear that if the ECB does not act and the Italian government does not change then the danger of a collapse in the Euro is imminent.

The Guardian has details here

The really difficult aspect of unemployment

People become unemployed for a number of reasons. Their industry declines, their firm is competed out of the market, or labour saving technology reducing the need for workers are all possible causes. A general fall in demand, such as in a recession, means all firms require fewer workers. The result is cyclical or structural unemployment.

Cyclical unemployment is short lived, structural unemployment is less easy to deal with and older workers in particular may find themselves out of work for prolonged periods. But there is one group who don't have to lose their jobs to become unemployed; the new entrants to the work force.

Youth unemployment is very difficult to solve and, because each year of high unemployment adds another cohort of new job seekers to the stock of those who have never worked, gets worse and worse. As one commentator notes in the linked article:

"For a young person, being out of education, employment or training can have major ramifications, including long-term reductions in wages and increased chances of unemployment later in life, as well as social or psychological problems arising as a result of sustained unemployment." 

Once a recession is over employers have the choice of new jobseekers or those who have been unemployed for some time. Fearing that those who have had long periods of enforced idleness may have been 'unemployed for a reason', or will have lost the work ethic,  firms will usually opt to employ more recent school leavers and graduates. This leaves the economy with a large group of long term unemployed who are 'detached from the workforce'.

Only supply-side policies, such as increased training provision, can deal with this problem but it does so very slowly. To make matters worse the problem is concentrated in some areas, because a higher proportion of new jobseekers failed to find work in those places in successive years.

The BBC report highlights this problem and identifies the worst affected areas. For you the lesson is that you must achieve the highest possible qualifications from the best universities in order prove to employers you are the person to hire.

The BBC report is here

On the bright side for Africa

So much bad news makes many recall Carlyle's view of economics as 'the dismal science'. But there is some good news out there.

Africa has really had the worst deal in the second half of the last century. Real incomes actually fell in some parts of Africa from the 1980's to the early 2000's. But now Africa is growing and there are several reasons for hope.

China's demand for raw materials has pushed up the price of commodities, improving Africa's terms of trade considerably. This has already raised the real incomes of countries which export these minerals, rising living standards. Africa has large reserves of these commodities and is benefiting from international investment to expand capacity, especially from China, which sees the chance of both influence and cheaper supplies.

Now there is news of an ambitious plan to expand the production of renewable energy from North Africa. The energy produced will be used locally and exported to Europe. Northern Europe isn't a great place to produce solar power efficiently, but North Africa is.

One problem that particularly holds Africa back is the lack of domestic saving due to the very low real incomes of the population. Saving is needed to provide the investment funds required for growth. With the funds coming from Europe, a process known as Foreign Direct Investment (FDI), Africa can grow more quickly.

The benefit to Africa comes in two ways. 

1. They get a better energy infrastructure which will allow them to build other industries and provide power to their own population raising the standard of living. 

2. There will also be the multiplier effects on local economies as the investment in the infrastructure takes place. Local incomes will rise improving employment and so reducing poverty. 

For Europe this also helps to reduce the use of damaging fossil fuels in energy production and so aids the efforts to mitigate climate change.

The Guardian covers the project here.

Growth improves, but one swallow does not make a summer

The UK economy grew 0.5% in the third quarter (July to September) which was a welcome relief after the second quarter growth of just 0.1%.

While 0.5% may not seem like a lot it is actually a huge improvement and a welcome sign in an economy that needs growth badly. Unfortunately part of the improvement is a 'rebound' from the poor second quarter - a 'catch - up' rather than a clear upward trend.

The figures hide differences between sectors. Services and finances showed their strongest growth since 2007, but manufacturing continues to struggle.

There is talk of recession. Let's be clear on what that means - falling GDP, not slower growth. A rule of thumb is that a recession is two consecutive quarters of falling GDP. This remains a possibility, especially if the Euro collapses.

It may be useful to talk about the stages of a recession and policy responses. This can be illustrated in the excellent BBC graphic on the linked article showing the path of previous recessions.

Stage 1 - Falling GDP. Here there is falling output and the immediate policy response to slow the fall in GDP. At this stage fiscal and monetary policy are set to expansionary settings and the challenge is to stop the recession being as deep as it otherwise would be.

Stage 2 - Levelling out. Here the crisis is not over but the economy has stopped shrinking. Fiscal and monetary policy continue to try to boost Aggregate Demand to help use up spare capacity. Unemployment will continue to rise, probably faster than in Stage 1 as firms let worker go and adjust to the new level of demand. Workers entering the workforce find it difficult to find jobs as firms are not hiring.

Stage 3 - Recovery. In this stage the economy begins to grow. Unemployment remains a problem, continuing to rise, especially among young workers. They have no experience and are expensive to employ. Firms are cautious and confidence is low among consumers as well.

This is the most challenging phase in terms of policy. The challenge in this phase is coping with unemployment and preventing a large group of long-term unemployed. Expanding AD may not work and supply side measures, that will target the structural and youth unemployment, take a long time to work. Productivity increases alone may mean few extra workers are needed for the modest rises in GDP.

Stage 4 - Return to growth. This stage is elusive. Productive capacity begins to increase as well as demand. It is not clear when normality will return and as the BBC graphic shows it is taking longer to get there than in previous recessions. This is mainly due to the greater extent of the recession and the fact it originated in the financial and not the goods market which makes fiscal stimulus largely ineffective in stages 2 and 3.

None of these stages has a fixed time-frame of course, adding to uncertainty.

Apologies for a long post, this has been on my mind for a while!

The BBC article is here