British vs French Economy

A good Central Banker is supposed to be boring. But, the French are trying to make it a little more interesting by suggesting other economies are even worse than theirs. A kind of playground, 'my Dad earns more money than your dad'

Christian Noyer, the head of the Bank of France said: "When I look at our British friends, who are even more indebted than us and carrying a bigger deficit, what I see is that the ratings agencies so far don't seem to have noticed."

Now, the rating agencies have a pretty poor track record. It wouldn't be the first time the rating agencies have given a triple AAA rating where it wasn't deserved. Yet, the markets seem to agree with the rating agencies. Despite a bigger budget deficit, bond yields on UK debt have fallen in 2011, in France they have risen. There is great fear of any Euro bond (apart from Germany). But, outside of the Euro, the UK has been relatively insulated.



The difference between British and French situation is that France is in the Single Currency, the UK isn't. And it's rather worrying that the head of the Bank of France hasn't understood why there has been a sharp divergence in bond yields between Eurozone members and those outside.



It may be unfair. Perhaps UK doesn't 'deserve' such a low bond yield compared to other European countries. Perhaps the UK was just lucky to stay out of Euro. But, that's the drawback of being in a single currency, with no lender of last resort and no ability to devalue. The problem is that the EU never give the impression they appreciate why they are in such difficulty.

The American credit rating agency Fitch, concluded that a "comprehensive solution" to the eurozone crisis was "technically and politically beyond reach" And I tend to agree with them.

French National Debt

UK National Debt


UK debt has been increasing at a faster rate because of a bigger budget deficit.

• UK national debt
• French national debt

UK Economic Snapshot end of 2011

On my other blog, I published a range of graphs and data on current state of UK economy, and likely outcome in 2012. A look at current state of UK economy with forecasts for 2012

Rising inflation and unemployment.

UK Inflation 2012

Real Wages

Related

• UK Economy in 2012

Policies to Improve Eurozone economy

Readers Question: I read a lot about two suggested solutions to the Euro zone that seem to contradict each other:

1. Internal devaluation to restore competitiveness (which means wage and price deflation).
2. Create more inflation that will reduce debt overhang in real terms.

If you choose to 'deflate' you will gain competitiveness but will also increase debts in real terms, which could discourage spending. On the other hand, inflating debts will reduce them in real terms, but will further hurt competitiveness. How do you reconcile the two?

Internal Devaluation

At the moment, the Eurozone is choosing option one - internal devaluation.

There are many factors which are pushing Eurozone inflation lower.

• Spending cuts and attempts to reduce budget deficits.
• Wage freezes or wage cuts put downward pressure on wage inflation.
  
• Countries which are uncompetitive can't devalue to improve competitiveness. Therefore, inflation is pushed lower.

The problem for the Eurozone is that many Eurozone economies face substantially higher costs and uncompetitiveness. Spain, Italy and Greece are perhaps 20% overvalued. To restore competitiveness by internal devaluation means they face several years of low growth, high unemployment and social unrest.

Deflation increases Real Value of Debt

Yes, you are correct that deflation, would increase the real value of debt. Deflation will, ceteris paribus, increased debt to GDP ratios in these countries. They will have to devote more tax revenue to interest payments. It becomes a vicious cycle of austerity, lower growth and lower tax revenues.

If they had their own currency (like Iceland or UK) they could immediately restore competitiveness through a devaluation.

Eventually, internal devaluation will help to restore competitiveness and their will be economic growth of sorts. This process can be quicker and less painful if

• Labour markets are flexible
• Supply side policies to increase labour productivity and flexibility
• The working population agrees to the austerity
  

So far, Ireland has been less prone to striking than Greece or Italy.

Inflation

I would say the policy is not so much just to create inflation, but to put a higher priority on increasing nominal GDP, even if it leads to a little inflation. This may involve more expansionary monetary and fiscal policy. (i.e. not increasing interest rates in 2011 like ECB did).
The benefits of targeting higher nominal GDP

• Debt to GDP ratios reduce
• Higher economic growth helps reduce budget deficit in a much less painful way than spending cuts.
• Arguably, higher growth and tackling EU's chronic unemployment problem should be the highest priority.

There are risks involved in targeting higher inflation. If inflation became deep-seated it does have costs and can be difficult to reduce. But, at the moment, inflation is not a problem. Core-inflation is below target, and in 2012, there are only going to be more deflationary pressures.

See: Inflating away our debt

Combination of Policies

I feel the Eurozone needs a combination of policies

1. Target higher economic growth (higher nominal and real GDP)
   
2. Reduce pace of fiscal austerity (ECB should buy bonds and create money to reduce pressure for immediate spending cuts)
3. Supply side reforms to improve labour market flexibility in southern Europe.
4. Long term fiscal change which deals with long-term spending entitlements (e.g. higher pension age) will help improve long-term structural deficit without harming current growth.

The best solution would be higher economic growth, combined with increased productivity amongst uncompetitive countries. But, the problem is in a single currency, to actually restore competitiveness through internal devaluation takes a long time.

• Options for Eurozone
  

Outlook for UK Economy 2012

The Bank of England have done a good job in avoiding the temptation to tighten monetary policy, despite having to tolerate headline inflation rate of over 5%. Underlying core inflation has always been on target. There is no sign of wage inflation like in the 1970s or 1980s. To have tightened monetary policy in 2011, would have only made the recession deeper. In 2012, inflation is likely to fall considerably.

Inflation



After peaking at over 5% in 2011, UK inflation is set to drop sharply in 2012. This is because the inflation of 2011 was due to temporary cost push factors. By mid 2012, these will have vanished from the 12 month index. The temporary inflation has not changed inflation expectations, and it certainly hasn't caused wage inflation.

As a result, interest rates are likely to be held at 0.5% throughout 2012, unless there is an unexpectedly strong recovery

Economic Growth


Despite £275bn of quantitative easing, some forecasters, such as the OECD, predict the UK will slip back into recession in 2012. This prediction of recession in 2012 shows the limitation of quantitative easing and the limitation of monetary policy. (see: problems of quantitative easing) Despite the efforts of the Bank of England to keep interest rates low and create extra money, this has only had a limited impact on economy. There have been much greater deflationary pressures in the UK. These include:

• Government spending cuts
• Rise in unemployment to over 2.64 million.
• Squeeze in living standards from falling real wages
• Recession and uncertainty in Europe

Official groups like the Bank of England and OBR still predict the UK will avoid negative growth, but even most optimistic growth forecasts stick to growth of less than 1%. This will be insufficient to reduce unemployment. It will feel like a recession.

UK House Prices

UK house prices are likely to remain stagnant. Only the limited supply and low interest rates are preventing sharp falls in house prices to reflect the absence of demand (especially from first time buyers who are being squeezed out of market).

UK Isolated in Europe?

I follow economic news closely. But, if I think it is just politics, I gloss over it. I'm only interested in economics. Therefore, the recent European Treaty business, seems a bit of a non-event. I don't really see what the EU have proposed to 'save the Euro' I only see a recipe for prolonged austerity, low growth and deflationary pressure.

The Deal Excludes:

• No real Fiscal union with a common Eurobond which would mutualise the debt.
• No attempt to make ECB lender of last resort and help reduce interest rate yields and make markets have more confidence in Eurozone debt.
• No attempt to deal with fundamental disequilibrium in the Eurozone which is at the heart of the crisis. (Southern economies with overvalued exchange rate and suffering from fundamental lack of competitiveness and low growth)
• No plan to target a higher rate of economic growth and reduce unemployment.
  

The deal still assumes that the problem is only irresponsible spending and an issue of high government debt. It ignores the fact that Spain and Ireland had very low levels of debt at the start of the crisis.

The deal only seems to be a glorified 'growth and stability pact' with stricter rules and penalties for exceeding budget deficits. But, this growth and stability pact doesn't deal with the fundamental cause of the Euro problem with is this two speed Eurozone economy.

A disequilibrium between different areas in the Eurozone.

From a political perspective, Britain may have been moved to the edge of the EU. But, from an economic perspective, there already is a two speed Eurozone.

Relying only on stricter budget deficit penalties is recipe for either political wrangling about foreign interference in national budgets and or a recipe for prolonged spending cuts, austerity and lower economic growth.

It is unfortunate, if we lack a degree of harmony and understanding with our European neighbours, but there are some things which it might be better to be isolated from.

Related

• Two Speed Europe
• Problems of Eurozone
  

European Inflation

Graph showing inflation in EU. Source: Eurostat

German inflation has been very close to the EU average. German inflation is currently 2.9%

The interesting thing is that, even as late as July 2011, the ECB responded to the 'threat of inflation' by increasing interest rates. This was despite increasing evidence of a double dip recession.

Source: ONS

By contrast, the Bank of England have tolerated a much higher inflation rate. They have not increased interest rates from the low of 0.5%, but have pursued another round of quantitative easing.

This reflects different approaches to the management of the economy.

The ECB were worried that the temporary blip in inflation would lead to higher inflation expectations and feed through into a real inflation problem. Therefore, they took preventative action and increased interest rates.

Source: Eurostat

This graph shows 'core inflation' in the Eurozone was below target. But, the ECB still increased interest rates.

The rate rise to 1.5%, may seem small, but it sent a clear signal about the ECB's priorities. They were willing to tighten monetary policy - even if this risked underlying deflationary pressure.

The Bank of England, argued that the rise in inflation was purely due to temporary factors, and in 2012, the problem will be that inflation will rapidly fall below the government's target of 2%.

source: Eurostat

Deflationary Pressures in Europe

It is likely that the Eurozone will also see a rapid drop in inflation to close to 0% in 2012. This is because

• End of temporary cost push factors such as rising oil prices
• Underlying wage inflation is very low.
• Austerity measures - European wide spending cuts will cause higher unemployment and lower economic growth.
• The Euro is still strong making many countries, especially in south uncompetitive.
• There is no outlet for boosting demand in the Eurozone apart from internal deflation.

I agreed with the Bank of England stance, and believe the slowdown in growth that has occurred in 2012 will cause inflation to plummet in 2012. By contrast, the ECB have made a mistake, the result will be lower growth and higher unemployment, especially in the periphery areas of Europe.

More on this topic: ECB v Bank of England

How Does Austerity Affect the Economy?

Several countries have recently implemented 'austerity packages' - attempts to reduce government spending and increase taxes, in an effort to reduce their budget deficit. It was hoped, these austerity packages would 'restore confidence', improve countries fiscal position and enable long-term recovery.

austerity in the 1930s

Main Impact of Austerity

Lower Demand. A cut in government spending and higher taxes will lead to lower aggregate demand and lower economic growth. If there is a fall in output, firms will employ less workers leading to higher unemployment. Also, government spending cuts may involve making public sector workers redundant. In addition, media coverage of 'austerity measures' tend to reduce consumer and business confidence. Fears over job losses and expectations of lower growth will encourage consumers to save rather than spend . This will be a further drag on consumer spending and economic growth (paradox of thrift). As a result of austerity measures in 2011, the OECD now forecast negative growth of -0.8% for the Eurozone in 2012.

Lower inflation. Spending cuts will tend to lead to lower inflation. Firstly, the fall in aggregate demand (AD) will lead to lower inflationary pressures in the economy. Also, if the government limits public sector wages, this will put downward pressure on wages. Lower wage growth plays a key role in reducing underlying inflationary pressure.

Competitiveness. It is hoped that austerity measures will help create greater pressure to reduce costs. These lower costs can help improve competitiveness. This is important for countries in the Euro, such as Ireland, Greece and Spain. In the boom years, they became uncompetitive leading to lower export demand and a current account deficit. Measures to deflate the economy should make exports more competitive. Ireland has been relatively successful in improving competitiveness, this is reflected in their move from a trade deficit to trade surplus in recent months. However, this attempt to improve competitiveness through lower inflation may take several years, and involve a high cost of lower growth and unemployment.

Irish GNP

source: Ireland Triumphs, NY Times, Krugman, P.

Ireland has been one of more 'successful' countries which has embarked on austerity, but this shows GNP is still significantly below pre-crisis levels (when real GNP was growing at an average rate of close to 5% a year)

Budget Deficit. Higher taxes and lower spending will lead to an improvement in the government's budget deficit. This will help improve public finances in the long term.

However, if austerity measures cause lower economic growth, the government will also see a fall in cyclical tax revenues. e.g. increasing tax rates, should increase revenue. But, if higher taxes cause a recession, there will be less people working and so income tax revenue may actually fall. Also, if austerity measures cause unemployment, it will require higher government spending on benefits.

For example, the UK's budget deficit fell slower than expected. This was partly because growth forecasts proved overly-optimistic. The austerity measures led to a slowdown in growth.

What Determines the Impact of Austerity?

Labour market flexibility. If labour markets are flexible, it may be easier to cut wages, and labour costs. This may make it easier to restore competitiveness and restore economic growth. However, if there is great resistance to lower labour costs, it will be much harder to restore competitiveness.

What Spending is Cut? If a government cuts spending by raising the retirement age to 70, then this will not lead to lower growth. In fact it could help increase labour supply and increase productivity. However, if the government cut spending on current infrastructure investment, this will have a much greater impact on reducing domestic demand and lead to lower economic growth.

Monetary policy. Austerity involves lower domestic demand. However, if monetary policy can be loosened (e.g. lower interest rates or increased money supply) then the deflationary effects of spending cuts can be offset. For example, in the Euro, countries like Greece have fiscal austerity, but there is no corresponding loosening of monetary policy (e.g. the ECB increased interest rates in early 2011 and didn't pursue any quantitative easing). By contrast, the UK has more flexibility because the Bank of England pursued quantitative easing.

Exchange Rate. Austerity is not as damaging if a country can devalue the exchange rate. This devaluation helps to restore competitiveness much quicker than relying on internal devaluation. The depreciation helps boost export demand. Countries in the Euro, can't devalue and so have to rely solely on internal devaluation to restore competitiveness.

Global Growth. Austerity is not as damaging if the rest of the world economy is doing well. If global growth is strong, export demand will be strong. However, if all countries are experiencing a recession, then deflationary fiscal policy will have a greater impact in reducing domestic demand.

Central Bank Intervention. Countries in the Euro, without a lender of last resort, are having to cut spending much quicker than countries outside the Euro. This is because bond yields on Euro debt has risen very quickly because markets fear liquidity shortages.

Related

• Timing of Austerity measures
• Euro debt crisis