Economic Change for Europe

Europe faces a fundamental problem. They have created an economic setup where the chance of economic recession is vastly increased. The Eurozone has a very limited solution for preventing economic stagnation and unemployment. They remain focused on an ideal of low inflation and lose sight of what is really important.

For example, Italy has a primary budget surplus (i.e. after debt interest payments they don't have to borrow) Italy has also made long term plans to raise retirement age inline with average life expectancy. Yet, despite facing high unemployment and spare capacity, they are being forced into cutting spending threatening lower economic growth.

Greece, Ireland, Spain and Portugal are all being forced to implement spending cuts at a time when the economy needs exactly the opposite.

Yet, despite fiscal austerity, countries in the Eurozone face no alternative for boosting growth.

• There is no chance to devalue and restore competitiveness
• There is no chance to print money and pursue quantitative easing.
• There is no ability to cut interest rates
• The lack of monetary independence means countries in the Euro face fiscal crisis

The Eurozone act as if the only important thing is low inflation and reducing budget deficits.

Eurobonds

Eurobonds are a suggested mechanism for sharing risk of borrowing. Instead of individual countries issuing their own bonds, their would be one Eurozone wide Eurobond. This would enable countries to benefit from greater security of Euro fiscal solvency. It would reduce interest rate costs and give countries more time to deal with structural deficits.

Eurobonds could definitely help. They would prevent the rising debt costs faced by countries threatened with deteriorating credit ratings. Eurobonds would prevent countries being forced into spending cuts when it could harm the economy.

Eurobonds will definitely be unpopular in Germany (Germany will face higher interest rate costs as a result). There are also real issues such as moral hazard and countries having less incentive to cut deficits. See: Pros and cons of Eurobonds

Also Eurobonds are not a panacea, but they would help mitigate the fact countries without independent monetary policy can more easily face credit shocks. But, it still leaves much to be done.

ECB

So far this year, the ECB has already raised interest rates twice. This is despite economic slowdown across the EU. Yesterday, Germany posted growth figures of 0.1% for Q2 2011. The ECB need to lose their irrational fear of inflation during a prolonged slump. They should go for growth.

See: EU Money Supply growth slowdown

Related

• Competitiveness in Europe - the supply side of the equation
  

Tax the Rich

Most of the economic news these days tends to be on the depressing side, especially from the US.

So I did smile when reading Warren Buffet's statements on tax rates on the richest Americans.

While the poor and middle class fight for us in Afghanistan, and while most Americans struggle to make ends meet, we mega-rich continue to get our extraordinary tax breaks

- Warren Buffet

Buffet claims that his average tax rate was just 17.4%. Whearas other people in his office (on much lower incomes, paid between 36-41% in tax). The reason is that those in ordinary employment have payroll taxes. Whereas 'investors' don't pay these income taxes.

He also makes the point that higher tax rates are not such a disincentive to work as some claim.

I have worked with investors for 60 years and I have yet to see anyone — not even when capital gains rates were 39.9 percent in 1976-77 — shy away from a sensible investment because of the tax rate on the potential gain. People invest to make money, and potential taxes have never scared them off. And to those who argue that higher rates hurt job creation, I would note that a net of nearly 40 million jobs were added between 1980 and 2000. You know what’s happened since then: lower tax rates and far lower job creation.

Original article at NY Times - Stop coddling the rich

The US has seen a large increase in income inequality in past few decades. The number of millionaires has soared, and yet the tax rates on the highest earners has fallen.

It is an important intervention as in the US, there is this almost religious intolerance of contemplating any tax increases. (religion of tax cuts)

Maybe Warren Buffet is being altruistic, maybe he is thinking of own self-interest. The US needs a budget realignment not just from spending cuts but also tax increases. If the US is unable to take reasonable steps such as increasing taxes on the richest, if will adversely affect economy in long term.

Related

• Why is US facing debt crisis?

Gold Price Bubble?

Readers Question: Gold prices have risen tremendously over the past 12 months, nearly 40% this year in GBP, and has risen 225% in just 5 years. Are we seeing a gold bubble? If so, what is the future for gold? 

Gold is highly volatile. From a historic graph, you can see in 1980, there was a gold price bubble, when the price reached over $600 ($2,500 adjusted for inflation). During the long period of economic stability from 1983-2003, the gold price fell.

There are definitely a few reasons to explain why the price of gold has increased in recent months, but whether these justify the magnitude of the price increase remains uncertain. See also: Factors that Affect the price of gold

Reasons to Justify Increase in Price of Gold

Unprecedented economic instability

The credit crisis has resulted in deep seated economic problems for both US and Europe. Previously established conventions are being challenged e.g. credit downgrade in US, and real fiscal crisis in Eurozone.

Decline in Stability of the Dollar

Arguably, the US debt is currently manageable - if they made realistic changes to long term spending and tax plans. However, markets are questioning whether the US is able to make reasonable long term budget changes. The recent threat to veto the US debt ceiling showed how the partisan nature of US politics could destabilise the US economy in future years. If the dollar and dollar assets (such as US Treasury bills / bonds) are no longer seen as secure with increased chance of default (or partial default through devaluation), then gold becomes an attractive alternative.

The US dollar is currently the most traded currency and biggest form of foreign exchange reserves; there is currently widespread demand for US assets like Treasury bills, but if people lose confidence in the dollar, there may be no alternative but to increase gold reserves.

Lack of 'Safe Havens'

For a long time, the US dollar has been treated as a 'safe haven'. If that is being challenged, it is not certain another currency could take its place. The Euro is currently undergoing more challenging problems than the US. The Yen has been attractive, but the Japanese economy is still very weak and they will be keen to avoid this appreciation. Similarly, the Swiss economy could not cope with the Swiss France becoming a currency of last resort. No currency stands out as offering a strong investment, so in times of uncertainty people may choose the alternative gold.

Quantitative Easing

Some argue that the unconventional monetary policy of quantitative easing (which involves increasing the money supply) could lead to future inflation. It is inflation that really makes gold attractive as it holds its value whatever happens to inflation.

However, at the moment, it is hard to envisage global inflation, if anything deflation looks a greater possibility. But, in the absence of alternatives, if countries embark on more QE, it may increase the risk of future inflation which makes gold more attractive. If nothing else, the uncertainty of what QE will bring is encouraging people to invest in gold.

Fiscal Crisis

In the post war period, government defaults have been confined to the odd emerging market such as Argentina. However, countries in the Eurozone now look very fragile, and Greece is almost certain to partially default. This has changed market perspectives on government default. There is a realisation being a member of the Euro or OECD is no automatic guarantee of solvency. Given how the financial system is interconnected, default in even a small country will adversely affect the global banking system and could lead to knock-on problems for other countries. This fiscal crisis is difficult to solve because even spending cuts create different kinds of problems - lower growth and more unemployment. The problem is also exacerbated by ageing populations and government entitlement spending. The increased threat of government fiscal policies (related to stagnant growth) is making gold more attractive.

Target of $2500

Given political and economic uncertainty, some gold analysts are already predicting the return of $2500 for gold.

Growth In India / China

The growth of the Indian and Chinese economy creates additional demand for gold. In the case of India this is also for consumer goods like jewellery. China has one of the lowest rates of gold reserves, but it has indicated it would like to increase its gold reserves.

Reasons Gold may by Overvalued

Inflation is not a problem. Despite QE in US and UK, there is no immediate prospect of inflation, traditionally a phenomenon that makes gold more attractive.

Economic Recovery. In aftermath of financial crisis, recovery was going to be slow and the next few years will probably give anaemic growth. However, as the global economy slowly grows with low inflation, gold will start to give a poor return compared to stock markets and other more traditional investments (like in 80s and 90s)

Conclusion

I can't see inflation being a problem. But, there are strong reasons for a double dip recession. The crisis in the Eurozone is quite serious as, given current set up, I don't see any easy solution to the twin problems of low growth and high deficits. I would imagine the uncertainty to continue for a considerable period. In this climate, gold is likely to keep rising. However, I do believe the global economy will return to more 'normal' rates of growth (may take a few years). Interest rates will return to normal levels and then gold may start a long decline like in 80s and 90s. But, it is hard to predict a few years time, as it depends on many factors that are unknown.

Related

• Factors affecting price of gold
• Investing in gold during recession
• Treasury bond bubble?
• Why do we fall for bubbles?
• Oil price bubble

Economics of Rioting

In the past few days, Amazon.co.uk have reported a 5,256% rise in demand for baseball bats, and I don't think this is due to a sudden surge of popularity for the American sport. Whatever happens, there is always someone who seems to manage to benefit....

When young people engage in random acts of violence, you inevitably seek to find causes and explanations. You get torn between the arguments of economic and social depravation and the other more obvious issues of individual moral and ethical failure.

The Scarman report after Brixton riots of 1981, did put much of the blame on high unemployment and economic deprivation. - The economy of 1981 was a period of exceptionally high unemployment, especially amongst some ethnic minority groups in London (In Brixton black youth unemployment was estimated at 55%). Comparatively in 2011, unemployment is lower.. Also, the first pictures of convicted rioters in court suggested there was a cross range of participants from school assistants to shop workers and bored teenagers. - Hardly evidence this was a riot by people desperate to get enough money to feed themselves.

What is the economists' response to rioting?

Whether there is rioting or not, an economist is concerned with the idea of creating full employment (or at least should be). But, there is a limitation, even the best policies to create full employment and economic stability cannot alone change people's behaviour.

As an economist a deeply ingrained principle is the idea that 'the polluter pays'. In other words the governments responsibility is to make people may the full social costs of their action. If you pollute the local rivers you have to pay for it. If you smash up windows and take part in looting, you should have to pay the full financial cost - repay shop-owners, cost of policing, cost of local magistrate courts.

If prison isn't a deterrent, impose fines which fit the cost, and if necessary take away there assets.

I looked into this in much more detail here Cost of Crime in UK
Basically, there are many crimes, where the criminals don't pay for the financial cost of their actions. If they did pay the financial cost, it would be one of the best deterrents, and what better form of justice but to make the cuplrits pay for the full cost of the damage?

Practical solutions to Economic Problems

A few suggestions as to approach for UK and US in dealing with- solutions to economic crisis

Basically, there is reason to be optimistic about long term prospects of UK and US. But, in the short term, I feel that the obsession with budget cuts has led to unnecessarily weak economic recovery.

Politicians must give economic recovery the highest priority and tackle long term structural deficits through long term changes - not short run cuts.

A Note on Growth Figures

Usually after a recession, you see a bounce in economic growth, e.g. after a fall of -2.0%, the economy may recover with growth of 4-5%. This kind of growth is not inflationary as it is dealing with the spare capacity created by the recession. This gives even more reason to be concerned with anaemic growth figures of 0.2%.

Real Debt / GDP ratios - a few examples showing that the impact of rising government debt depends very much on what is happening to GDP. The Real Value of Debt

Causes of Double Dip Recession

A double dip recession refers to a second period of negative growth (fall in output) that many economies are now facing. Some economies may just avoid a technical recession (with very low growth) but with spare capacity and in the aftermath of a recession, very weak growth will have all the signs of an actual recession. (i.e. higher unemployment, decline in living standards e.t.c)

Reasons for 2011 Double Dip Recession

1. Credit Crunch. The reasons for the credit crunch are well documented. In short banks lost billions through mortgage defaults. They either did this directly or indirectly through the whole complicated network of credit default swaps. The financial system has never fully recovered - bad loans and loss of confidence.

2. Balance Sheet Recession. The great recession of 2008, was not due to a temporary period of high interest rates or deflationary fiscal policy (like in UK in 1981 and 1991). The last recession was because of fundamental imbalances in the banking / housing sector. This is much more difficult to recover from. For example, interest rates were cut to zero in EU, US and UK, but low interest rates weren't enough to encourage strong lending; it remains an example of a liquidity trap. Banks are concentrating on improving their balance sheets, and even now, there is a greater reluctance to lend, and banks are being more cautious.

3. Budget Deficits

The 2008 recession was not caused by government borrowing. But, as a result of the recession, governments saw their deficits increase (lower tax revenues). Budget deficits also deteriorated because many governments took on the bad debts of private banks (especially in case of Ireland, and to a lesser extent UK, US)

After initial attempts of fiscal stimulus seemed to help economies recover. e.g. UK economy recovered in 2010 following tax cuts / lower interest rates, governments shifted their focus from boosting growth and reducing unemployment to targeting the budget deficit. (Austerity economics)

The new UK government came to power promising to make cutting budget deficit as highest priority. The spending cuts and tax increases definitely damaged consumer confidence and are a significant factor in UK growth being very disappointing.

EU Debt Crisis.

For various reasons, the EU has been sucked into a debt crisis.

• Euro member countries don't have a lender as last resort, thus liquidity problems can become insolvency problems. (see: problems of Euro)
  
• Markets worried over lack of political ability to deal with fiscal crisis.

EU Problem

In 2010, there were some hopeful signs for the EU economy. German manufacturing was bouncing back sharply. Many European banks had avoided the bad bank loans of US and UK. But, growth in the EU has remained depressed because:

• Countries focused on austerity (spending cuts) without corresponding monetary boost.
• ECB have remained bizarrely concerned with inflation and threatened to raise rates, despite stagnant growth and high unemployment.
• Lack of flexibility in the Euro. The Euro undoubtedly creates greater inflexibility. Countries which have lost competitiveness over time (Greece, Portugal, Spain) have few options to boost growth and exports through devaluing exchange rate.

Global Recession

The current downturn affects all major economies. Problems in Europe are feeding lower growth in US and vice versa. Some developing economies (China and India) are doing well, but they don't have the same spending power to boost exports in the west.

Commodity price Increases

The unbalanced nature of growth in the economy, combined to cause a rise in commodity prices (rising demand from the East) at the same time as economic stagnation in the West. Certainly this contributed to lower real wage and held back consumer spending. As well as the impact on disposable income, the cost push inflation (rising food / petrol prices) contributed to a general economic malaise - you can almost hear people say 'we've never had it so bad'

Housing Markets

In US and some EU countries like Spain and Ireland, housing markets have remained depressed, with house prices continuing to fall. This depression in house prices has led to bank losses, and lower consumer spending.

Government Policy and Priorities

To a large extent, I blamed the 2008 recession on the problems of the financial sector. In hindsight the government should have done more to regulate banks / mortgage firms (especially in US). But, the recession had a clear cause beyond the governments.

But, in the double dip recession, I don't feel the same. More than anything, governments have failed to target growth. The EU, the UK (after last election) and now the US, all see 'reducing budget deficits' as primary economic objective. Yet, the sad thing is that austerity policies at best do very little to improve debt / GDP ratios. Western economies do need structural change to deal with rising entitlement spending and ageing populations. But, you don't solve a long term structural deficit by slashing spending in the mouth of a recession.

The US and UK, at least have some hope that monetary policy (exchange rate) and quantitative easing can provide some monetary stimulus to offset the negative growth. (though there are problems to relying on more rounds of quantitative easing with uncertain effects). But, the periphery of Europe is facing a grim future.


Related

• Differences in response to great depression
• Causes of recession
  

Why Higher Interest Rates Reduce inflation

Readers Question: If consumer prices are rising due to higher fuel, energy (electricity & gas), fresh produce, basically core consumer consumption products, how does raising interest rates reduce these prices?

Higher interest rates doesn't reduce these prices directly. Higher interest rates tend to reduce the overall inflation rate through reducing aggregate demand in the economy (slower rate of economic growth). Therefore, higher interest rates reduce these prices indirectly (and there may be significant time lag.)

1. If interest rates are increased, then consumers will face an increase in the cost of borrowing (mortgage payments will be higher) therefore, they will have less disposable income and so will reduce their spending (e.g. decide not to buy new TV because they need to spend more on mortgage payments)
2. Also higher interest rates may make it more attractive to save money in the bank rather than spend.
3. In the UK, higher interest rates are also likely to depress house prices. Because mortgages are more expensive, people may decide to sell and rent instead. Falling house prices leads to a decline in wealth and therefore discourages people from spending.
4. Finally, higher interest rates are likely to lead to an appreciation in the value of the pound sterling. (It's more attractive to save money in UK banks because interest rates are relatively higher). Therefore, this increase in demand for sterling leads to an appreciation in the currency. When the currency increases in value, exports are more expensive leading to lower demand for UK exports.

The overall effect of higher interest rates is to reduce the rate of economic growth. This lower growth rate is likely to

• Depress wages (leading to lower wage growth and lower inflation).
• Encourage firms to discount unsold goods - putting downward pressure on prices.
  

Therefore this leads to lower inflation in the economy.

This is why it is difficult for the Bank of England when there is an increase in cost push inflation (higher food / oil prices). They would like to have a lower inflation rate, but to reduce inflation will cause other (bigger) problems - i.e. higher unemployment and lower growth.

It was suggested that reducing the UK inflation rate after 2008, would have caused a prolonged depression (why we tolerate higher inflation). Therefore, I would say the Bank of England did the correct thing to tolerate higher inflation rather than cause higher unemployment.

Also, it is still possible that some prices may continue to rise, despite a fall in growth and lower overall inflation. The price of food and raw materials is determined partly by overall macro factors, but also individual supply and demand. If we run out of oil, the price of oil may continue to rise, no matter how high interest rates are.

Related

• Will Higher interest rates reduce inflation

A Strange Fiscal Crisis in US

The US has seen bond yields on long term borrowing fall to exceptionally low levels. For some bonds there is a negative interest rate, which means you have to pay people to take them.

Yet, despite all the evidence of falling bond yields, some in America have tried to imagine they are going to suffer the same fate as Greece, and therefore, the US has to inflict severe spending cuts to reach some imaginary goal of attaining same level of government spending as during period of President Eisenhower.


source: St Louis - No evidence of debt crisis in US

Bond yields in EU

• Firstly the US does not face a debt crisis like Greece or other Euro members.
• The current rise in US debt is partly a response to the recession and current liquidity trap where investors are happy to buy at low rates.
• The necessity for the US economy is to promote sustainable and high economic growth. This will enable the economy to automatically reduce social security spending and receive higher taxes. In this position, the economy will be better able to sustain structural changes.
• The US economy does face problems from long term rises in entitlement spending (health care, pensions). This needs careful analysis for the long term. e.g. greater evaluation over automatic health care spending on expensive treatments / raise pension age. However, these long term structural changes won't be helped by panic spending cuts which will aggravate the economic downturn.
• If the US, through self-inflicted austerity, pushes itself back into an economic recession, then it really could start to face a debt crisis as debt to GDP ratio starts to rise.

Why is America so opposed to tax increases?

• Religion of Tax Cuts

It just feels there is a desire to inflict pain when there is no need. This austerity will prove self-defeating and just reduce living standards.

Different Solutions to Fiscal Crisis

A readers asked if I could explain the four different responses to a financial / fiscal crisis.

• Devalue
• Default
• Inflate
• Deflate

See: solutions to financial crisis

Essentially countries in the Euro have been trying to solve their fiscal crisis through deflation (i.e. austerity policies / cutting government spending). In the case of Greece, only when deflating the economy has proved to be a complete failure are they having to realise default is the only viable option left.

The problem for the Euro members is that they are trying to solve the fiscal crisis through deflation alone.

In the case of Iceland, the crisis was accompanied by a substantial devaluation. The UK and US have also seen a devaluation in exchange rate which has made deflation more palatable.

Related

• Default explained
• Problems of two speed Europe
  

Why We Tolerate High Inflation

Interesting study that says if we had stuck religiously to targetting inflation at 2%, interest rates would have been much higher during past two years.

Using Bank of England's Stimulation Tool, analysis by Fathom Consulting shows that the Bank Rate would have to have been around 3.5pc to 4.5pc since the recession ended in the last quarter of 2009 to have kept inflation within half a percentage point of the target.
But, with these interest rates, the economy would have been in a prolonged downturn.

The study suggests that with higher interest rates, growth would have been close to 0% and unemployment at 10%. It could have been longest recession since 1930s.

However, this analysis ignored the possible impact on the housing market of higher interest rates.
Higher interest rates would definitely have increased the rate of mortgage default. This would have led to more bank losses and lower consumer spending.

Inflation at 4% may be uncomfortable and unfortunate, but I can't see how it is possible to justify keeping inflation at 2% - if it means - a prolonged recession, higher unemployment, and a lower tax receipts (bigger budget deficit)

The Bank of England faced a difficult choice, but they definitely did the right thing in temporarily tolerating higher inflation. (something the ECB could learn from)

Related

• A Worse Trade off
• Difficult choices for Monetary Policy