Factors that determine international competitiveness

A look at factors affecting international competitiveness. International competitiveness is a measure of the relative cost of goods/services from a country. Countries which can produce the same quality of goods at a lower cost are said to be more competitive.

1. Relative Inflation

If the inflation rate is relatively lower than in other countries, then over time you become more competitive because your goods will be increasing at a slower rate. For example, in the post-war period, Japan and Germany had relatively lower inflation rates than major competitors, this helped them to become more competitive.

 

This graph of relative inflation rates showed that during the period shown, inflation in Greece fell from close to 5% to below 2%. This suggests that Greece will have become slightly more competitive in this period.

2. Productivity

Productivity is a measure of output per input. The most common measure would be labour productivity. For example, with improved technology and education, a country can enjoy higher labour productivity and therefore produce goods at a lower cost. Higher labour productivity is the key to increasing competitiveness and living standards at the same time.

 

German vs Italian labour productivity. During this period, Italian labour productivity growth has tended to lag behind Germany, leading to lower competitiveness of Italian exports.

This shows labour productivity index for the UK and Germany. Between 1990 and 2005, Germany labour productivity increased 25 base points. UK labour productivity increased by 35 base points. Showing that the UK had faster improvements in labour productivity during this period.

3. Exchange Rate

Movements in the exchange rate will determine competitiveness. For example, a sharp depreciation will make exports cheaper and more competitive. An increase (appreciation) in the exchange rate, makes the foreign currency price more expensive.

Often movements in the exchange rate reflect relative costs. For example, if a country has lower inflation, this will lead to an appreciation in the exchange rate, making exports relatively more expensive. Thus a floating exchange rate helps to maintain relative competitiveness levels.

However, sometimes economies can artificially maintain a lower value of the exchange rate to maintain competitiveness. For example, China has been accused of exchange rate manipulation. China buys large quantities of US securities, this causes an increase in the value of the dollar and helps to keep the Yuan undervalued. Therefore, this helps Chinese exports to be more competitive and explains the large Chinese current account surplus

Government has used supply-side policies to increase productivity. E.g. education and training.
However, there is a limit to what the government can do to increase productivity. Increased productivity can be due to other factors.

Competitiveness in the Euro

In the Euro, countries have a permanently fixed exchange rate - they cannot devalue to restore competitiveness. Therefore divergences in labour costs and productivity will have a bigger impact on competitiveness than in a floating exchange rate.
.

Source: Krugman, How overvalued is southern Europe? link

This shows inflation in Spain is higher than Euro area - leading to a decline in Spanish competitiveness.

See: EU Competitiveness

4. Tax Rates

Tax rates on labour and corporations will be a factor in determining competitiveness. For example, higher labour taxes will increase the unit cost of labour faced by firms, leading to lower competitiveness.

5. Cost of Doing Business

It is argued that countries with more labour market regulations, and regulations about doing business will have higher costs and lower competitiveness. For example, the difficulty in gaining planning regulations to expand a factory.

The World Bank produces a list of countries which are the 'easiest places to do business'. The criteria include factors such as flexibility of labour markets, degree of regulations, protection of private property.

 Top 10 ease of doing business

1. Singapore
2.  Hong Kong
3.  New Zealand
4. United States
5.  Denmark
6.  Norway
7.  United Kingdom
8.  South Korea
9.  Iceland
10.  Ireland

6. Infrastructure

A key factor in determining competitiveness is the cost of transport. For example, some argue the UK's competitiveness is undermined by bottlenecks in transport, such as limited airport capacity in London and traffic jams on major roads.

7. Tariffs and non-tariff barriers

A key factor is the cost of tariffs and non-tariff barriers. For example, after the UK leaves the Single market, if it has regulatory divergence, then British business may have higher costs as a result of differing standards.

Related

• Government policies to increase competitiveness
• International Competitiveness

The Effect of the Housing Market on the UK Economy

The UK housing market has a significant impact on the UK economy because:

1. 78% of households are privately owned. Home ownership rates are amongst the highest in Europe
2. Housing is the biggest form of wealth in the UK.
3. Mortgage debt accounts for the largest section of UK debt. Average mortgage debt is £21,000 per person.
4. House Prices have a significant effect on consumer confidence and expectations. (house prices and house price predictions are often front page news)

Effect of Rising House Prices.

Those who own houses will see an increase in their wealth. This is likely to increase their confidence, thereby causing higher levels of consumer spending.

In addition, if house prices rise, consumers can increase spending by remortgaging. This means they take out a bigger loan, against the value of their house. This means that the difference between, the current price and their buying price, is available for spend. Mortgage equity withdrawal has been a significant determinant of consumer spending in the UK

Higher levels of consumer spending lead to rising Aggregate Demand and therefore higher economic growth. Consumer spending accounts for 66% of AD, therefore, the effect of rising house prices can be quite significant in determining economic growth.

Higher house prices may cause inflation. This is because, if AD increases then the economy may get close to full capacity, and grow faster than the long run trend rate.

However rising house prices no not necessarily cause inflation. Firstly, it depends upon other factors affecting consumers. For example, if real wages are growing very slowly, or taxes have been increased, then consumer spending will be moderated. Since 2001, House prices in the UK have doubled, however, this has not caused inflation; the reason is that other inflationary pressures have low. For example:

• Independent MPC target low inflation, they have raised interest rates to moderate demand where appropriate
• Real wage growth has been low, (especially in public sector.)
• Low global inflation - helped by cheap manufacturing imports from China, and low commodity prices.
• Improved supply side policies increasing competitiveness of the UK economy.
• UK manufacturing sector in recession.
• UK economic growth close to long run trend rate.

Note: in the 1980s, rising house prices did contribute to inflation (inflation reached over 10% in 1990), because it was combined with loose monetary policy, and buoyant levels of consumer confidence.


Rising house prices are likely to cause a current account deficit. This is because rising house prices increase consumption and therefore consumers will spend more on imports from abroad. Equity withdrawal tends to be spent on luxury imported goods. The UK has a marginal propensity to import. The UK current account deficit recently increased to 3.5% of GDP.

Slump in Housing Market effect on Circular Flow

A fall in house prices will have the opposite effect. Falling house prices will reduce consumer wealth, creating a negative effect on consumer spending and consumer confidence. Therefore, there will be a fall in AD and a reduction in injections into the circular flow. This will lead to lower economic growth, unless other factors override this.

1. Why House prices may continue to rise?
2. How do House Prices effect Consumption
   

UK Economy under Mrs Thatcher 1979-1984

When Mrs Thatcher came to power in 1979, the economy was generally considered to be facing severe structural problems including:

* Inflation in double figures
* Powerful Trades unions causing wage inflation and time lost to strikes.
* Unemployment increasing to a post war record of 700,000
* High levels of government debt that required politically sensitive borrowing from the IMF.

On coming to power in 1979, Mrs Thatcher lost no time in seeking to make a clean break with the past. Mrs Thatcher was heavily influenced by the idea of Monetarism and free market economics. In addition, she wished to “destroy” the power of the “Socialist / Communist” trades unions. On coming to power, the first policies of the Conservative administration were to tackle both inflation and the budget deficit.

CPI Inflation UK 1980s

The belief of Monetarism was that to control inflation you needed to control the money supply. To control the money supply, it was necessary to reduce any government deficit. Therefore, extreme deflationary policies were implemented. Firstly taxes were raised and government spending cut. Interest rates were also increased, as the government sought to reduce inflation. These deflationary fiscal and monetary policies did have the effect of reducing inflation; however it was at a cost of falling Aggregate Demand and lower economic growth. In the middle of 1980 the economy had been plunged into full scale recession, but the government still pursued its deflationary policies.

UK Unemployment 1980s and 1990s

As unemployment reached the unprecedented level of 3 million (1) There was widespread criticism of the government. During 1981, in a famous letter to the Times, 365 economists signed a letter calling on the government to alter its economic policy and put an end to the recession. (3)

With criticism mounting, even from her own party, Mrs Thatcher was under pressure to change course (a little like Edward Heath had in the early 1970s) However, in a now famous speech at the 1980 Conservative party conference, Mrs Thatcher stood up and defiantly said.

”You turn if you want to, but this lady is not for turning.”(2) It encapsulated her stubbornness and resolve. Fiscal policy and monetary policy remained tight, and unemployment remained close to 3 million until 1986.

The deflationary fiscal and monetary policies were exacerbated by 2 factors.

1. Firstly in the late 1970s and 1980s sterling became an important petro currency; with the production of oil in the north sea, the Pound Sterling rose rapidly. Combined with rising interest rates, sterling appreciated from £1 to $1.5 to $2.5 in 1980. This appreciation in the pound adversely affected Britain’s exports and manufacturing sector. It was in manufacturing, that the UK suffered the worst effects of the 1980-81 recession.
2. Secondly, controlling the money supply proved to be much more difficult than theory predicted. Despite rising interest rates and falling AD, growth in the money supply remained stubbornly high. This encouraged the government to maintain a tight fiscal and monetary policy. Inflation fell but the money supply didn’t; the link between money supply and inflation proved to be very tenuous, but by trying to reduce the money supply they reduced AD by more than was necessary.

On the one hand, inflation was reduced, but arguably it could have been done with much less pain. In seeking to meet spurious money supply targets they caused an unprecedented level of unemployment. This unemployment caused not only personal loss but widespread social problems. The mass unemployment, associated with inner cities, was very closely responsible for the riots which sparked across Britain in 1981.

Public anger at the Conservative economic record was to a large extent mollified by the patriotic success of the Falklands War. Riding on the back of a successful military victory, and a Labour party hopelessly divided, Mrs Thatcher was returned to power in 1983; ready for her next challenge - to take on the miners.

References

(1) Highest since Great Depression
(2) BBC 1980 - Mrs Thatcher
(3) Economist letter to Times

Related

• Economy of the 1980s
• Thatcherite Economics
• Thatcher Economic policies
• Economics, Mrs Thatcher and the British voter at Amazon.com
• Recession of 1991-92
• Causes of Recessions - Economic Theory
• Decline of the coal industry

Economic Record of Gordon Brown.

Since becoming Chancellor in 1997 Gordon Brown has presided over the longest period of economic expansion in the UK since records began. He is widely credited for having been a model of fiscal prudence which has allowed the UK to go from the laughing stock of Europe to one of the best performers in the OECD.

Is Gordon Brown Britain’s best chancellor ever? Or is it more a case of being lucky to inherit a promising economic situation? Or is it as some people suggest an opportunity wasted, storing up economic problems for the future?

This is a short economic evaluation of Gordon Browns’ record as Chancellor.

Achievements of Gordon Brown as Chancellor of Exchequer.

1. Independence of Bank of England.

4 days into his job he handed over control of Monetary policy from no.11 to the Bank of England Monetary Policy Committee. This is widely regarded as being a key factor in creating economic stability and a low inflationary environment for the long period of economic expansion. (Note the Conservatives had made moves towards independence, making the step easier to make)

2. Longest Period of Economic Expansion on record.

Economic Growth has averaged 2.8% between 1997 – 2006 also the growth has been remarkably stable, the boom and bust cycles which characterised the 80s and early 90s have been completely avoided. The success of high growth and low inflation has earned generous praise from the IMF and World Bank. The chief economist of OECD, Jean-Philippe Cotis, described Britain as a "goldilocks" economy – This means they had the perfect balance of strong growth and low inflation. "It is in fact surprising how stable the UK economy has been. It is doing very well." (i)

3. Unemployment has fallen to the lowest level since the early 1970s.

In May 1997 the number unemployed was 1.7 million, this has now fallen to 925,000. (However it is worth noting the ILO measure, which doesn’t rely on govt statistics shows a higher figure.)

4. Fiscal Prudence.

On coming to power Gordon Brown imposed a rule of fiscal prudence saying government borrowing should never exceed more than 3% of GDP over the course of the economic cycle. This justified some tough public spending decisions in the early years. However in recent times he has been close to breaking his own fiscal rule due to more extravagant spending on health and education.

5. Avoided potentially difficult economic situations.

Although certain global factors have helped the UK economic performance Gordon Brown would point to potentially destabilizing influences which could have made things worse. For example; the dot com Boom and bust; the housing boom which threatened inflation; and the mild recession in Europe our main trading partner. None of these knocked the economy of target.

6. Inflation on Target.

Inflation has remained within the government’s target of CPI 2% +/-1. This is a remarkable record considering the recent inflation history of the UK. True much of the credit can be given to other sources. But unlike the previous Conservative governments, Gordon Brown never allowed himself to get carried away into thinking there had been an economic miracle. The Conservatives belief the economy could grow at 4%+ in the 1980s caused the boom and bust of the 1991.

7. Avoided Joining the EURO as the Eurozone went into recession.

His 5 economic tests were designed to prevent premature entry. There seems little interest in reviving such as idea. The UK has not been burdened with an interest rate unsuitable for the UK economy.


See also:

• Criticisms of Gordon Brown's Economic Record as Chancellor

References


i) Gordon Brown's Record

Gordon Brown's 5 Economic Test for Joining Euro

As Gordon Brown approaches his last budget as chancellor many are reviewing his tenure as Chancellor and evaluating his success or failure. One important contribution he made was to steer the UK away from joining the Euro on the ground that "it would not be in Britain's economic interest". The justification for this was based on his 5 economics tests.

Before deciding whether the UK should join the Euro the Chancellor, Gordon Brown drew up 5 economic tests which the UK must pass for the UK to join. The main principle behind these 5 economic tests was whether the UK would cope with a common monetary policy. The 5 tests are in some ways superfluous. The main test being is really whether the UK has a degree of economic harmonisation with the rest of Europe.

5 Economic Tests for Joining the Euro

1. Economic Harmonisation.
   
   The UK economy must be harmonised with the Euro zone. If the UK economy was growing much faster than EU then UK interest rates would need to be higher. For example, at the moment if the UK joined interest rates would fall and this may cause inflation. Therefore it is essential that the UK has a similar economic cycle to Europe. Even if there is temporary harmonisation there is no guarantee it will continue on a permanent basis.
   
   
2. Is there sufficient Flexibility?
   
   If the UK went into recession could it be able to cope? It would have no influence over Monetary policy but also Fiscal policy is limited by the growth and stability pact. This limits the amount of government borrowing and therefore limits the scope for expansionary fiscal policy.
   
   
3. Effect on Investment.
   
   Would joining the euro create better conditions for firms making long-term decisions to invest in Britain? UK inward Investment has not suffered since the UK decided not to join
   
   
4. Effect on Financial services.
   
   What impact would entry into the euro have on the UK's financial services industry? London as a financial centre has boomed in recent years.
   
   
5. Effect on Growth and Jobs
   
   Would joining the euro promote higher growth, stability and a lasting increase in jobs? There is no clear evidence that it would. UK economy has done better outside the Euro than in the Euro.

At the moment the weight of economic opinion is that the UK is better off not joining the Euro. One important factor is that the UK housing market is very sensitive to interest rates. Many UK householders are homeowners and also many mortgages are variable. Therefore the cost of mortgages fluctuates with changes in the base rate. Thus a small change in European interest rates could potentially have a damaging effect on UK economy. For example, if the UK was to join now, interest rates would fall causing a potentially harmful inflationary boom.

See also:

• Why the UK will never join the Euro.
• Benefits of Joining Euro
• Costs of Joining Euro

What determines effectiveness of Monetary Policy in UK?

The aim of monetary policy is to achieve the governments inflation target of CPI= 2% +/-1. They will also consider impact on economic growth and unemployment. But control of inflation is their primary objective.

Factors which determine success of Monetary Policy

1. Accuracy of inflation forecasts. Monetary policy is pre emptive which means they try to reduce inflationary pressures before they occur. If inflation is higher than predicted, then interest rates will be too low to control inflation. Inflation predictions could be wrong if there is an unexpected rise in cost push inflation, for example an increase in the price of oil. In the past 15 years the MPC have benefited from generally low global inflation, However some economists feel that this “golden era” of price stability may not continue indefinitely. E.g. economic shocks associated with rising commodity prices.
   

2. Time lags. It is estimated interest rate changes can take upto 18 months to have their full effects. For example if interest rates rise then people who are currently spending on investment will not stop straight away. They will continue with their project. However higher interest rates may deter future projects from starting. By the time interest rates have had their desired effect it may be too late to reduce inflation. (This is why the MPC is always trying to predict future inflation trends)
   

3. Interest Elasticity of Demand. This measures how responsive demand is to a change in interest rates. For example if consumer confidence is very high then higher interest rates may not deter consumer spending. This is because people expect to make more money in the future so are willing to borrow at higher levels of interest.
   

4. Effects of interest rates not equally shared. The effect of rising interest rates effects some much more than others. For example in the UK many have high levels of debt through mortgages. Thus first time buyers with large mortgages will be effected by interest rate changes much more than older people who have paid off most of their mortgages. To reduce inflation may cause financial hardship for a small % of the population who have very high levels of mortgage debt.

5. Other Variables. Interest rates effect other variables in the economy. Higher interest rates increase the value of the £ (through hot money flows). This causes problems for exporters and may worsen current account. Higher interest rates also have a disproportionate effect on the volatile UK housing market.

6. Inflation expectations. The success of monetary policy depends upon credibility of the Monetary authorities. If people have low inflation expectations then it is much easier to keep inflation low. Since independence the MPC have benefited from a reduction in inflation expectations. This is partly due to the credence people give to an independent body rather than politicians with a poor track record of keeping inflation low.

7. Levels of Government debt. High levels of government debt generally put upward pressure on interest rates. This is because to attract enough people to buy government bonds interest rates on these securities need to rise. This puts upward pressure on interest rates throughout the economy.

Note in Japan Monetary policy became ineffective because they experience deflation. Because interest rates cannot fall below 0% this meant the Japanese real interest rates were too high for the state of the economy. Monetary policy could not be used to reflate the economy. However deflation is unlikely to be a real problem in UK for the foreseeable future.

See also: Should primary objective of the UK be low inflation of 2%?

Why the UK will never join the EURO.

From a political perspective the UK has always been reluctant to submerge itself in a European identity. The EU, with its prescriptions on the shape and size of bananas,(1) remains an easy target for UK tabloids and satirists. The idea of giving up the £ for a nondescript EURO would hardly make for a populist political agenda. However, political arguments aside, there is increasingly little if any support for the EURO, even from a purely economic point of view.

Firstly the supposed benefits of joining the EURO are becoming increasingly marginal.

1. Exchange Rate Stability. A main advantage of joining the Euro is that it reduces exchange rate volatility with our main EU trading partners. However since 2003 the £ has displayed very little exchange rate volatility. In this article. Stephen King, Chief Economist at HSBC claims that in effect the UK has already in effect joined the Euro. Anyway it is also relatively easy to insure against exchange rate movements through the purchase of currency on the open markets. Therefore at the moment there is little risk associated with exchange rate fluctuations.

2. Inward Investment. Inward Investment has continued to soar even outside the EURO. It was thought joining the EURO was necessary to attract sufficient inward investment. However it appears that a separate currency has not been a deterrent to further inward investment. See: Inward investment in UK

3. Low inflation. There was a time when the UK was known as the “sick man of Europe” its economy characterised by, boom and bust cycles and high inflation. It was thought that joining the EURO would give the UK a strong anti inflation framework. However since the MPC was given independence in 1997 inflation has remained close to the government’s target of 2%. Furthermore this low inflation has been consistent with an enviably high growth rate. When your economy is outperforming the Euro Zone there seems little reason to join.

Joining the Euro would give the UK a small gain in terms of lower transaction costs and greater exchange rate stability. However it must be emphasised for many businesses, both domestic and foreign, these costs are a small % of total costs. However many economists fear that joining the Euro could lead to some significant economic problems.

Disadvantages of Joining Euro

1. Loss of Independent Monetary Policy. On joining the EURO interest rates would no longer be set by the MPC. They would be set by the European Central Bank. The ECB look at the whole EURO economy and not what is best for the UK. Thus if the UK joined now interest rates would fall from 5.25% to the ECB rate of 2.25%. This fall in interest rates could cause and further boost the buoyant Housing Market and cause future inflationary pressures.

2. Difficulty in getting out of a recession. On the other hand if the UK suffered a recession they would be unable to cut interest rates. It would be difficult to boost demand and get out of the recession. To an extent this occurred in 1992; the UK was in a recession but because they were in the ERM (2) they were trying to maintain a high value of the £. Thus interest rates were far too high (15%) these high interest rates exacerbated the UK’s recession.

3. Sensitivity to interest Rates. The nature of the UK housing market means the UK economy is sensitive to changes in interest rates. Unlike European countries most UK householders own their own house, their variable mortgage is a high % of their income. Thus even a 0.25% change in interest rate can significantly affect disposable income. If the UK were to join now and interest rates were to fall by 2% it would very likely cause a further boom in the housing market which would feed through into higher inflation.

4. Loss of independence of Fiscal Policy. The growth and stability pact limits the levels of government borrowing to 3% of GDP. This is another difficulty in getting the economy out of a recession. However it would not affect the UK at the moment. Also France and Germany have conveniently been able to sidestep this rule when necessity demanded.

The UK economy is doing relatively well, by historical standards the UK economic performance is quite remarkable. Thus there seems little incentive for a British politician to take on the entrenched Euro scepticism prevalent in British media and society. There is little to be gained by joining and there are many potential problems, the Queen’s head is safe for the foreseeable future.


By: R.Pettinger

See also:

Benefits of Joining EURO

Costs of Joining Euro

(1) This is actually a myth. The EU never had a regulation about the shape of bananas, but the point is it has entered British folklore.

An Evaluation of the MPC in Controlling Inflation

How Effective have the MPC been in meeting the Governments inflation target?

The MPC are responsible for setting interest rates and determining UK monetary policy. They seek to keep inflation close to the government’s target of CPI 2% +/-1 %

Currently (Feb 2007) inflation in 2.7%
Note: I've updated this post in the aftermath of the credit crisis (2013)

Advantages of MPC in setting interest rates.

1. They are independent. They are not subject to political pressures. E.g. they are not tempted to keep interest rates low before an election. This used to be a problem for UK economy, with many experiences of boom and bust economic cycles.

2. Monetary Policy is pre-emptive. They try to prevent inflation before it occurs. They predict future inflation trends. If inflation looks to be increasing above the govts target then they can increase interest rates to reduce consumer spending and keep inflation on track.

3. MPC have reduced inflation expectations. People have confidence that inflation will remain low. Therefore wage demands are lower and it becomes easier to keep inflation low.

4. By targeting inflation directly they get the best overall picture of the economy rather than focusing on small aspects like the money supply.

5. Since 1997 UK inflation has remained close to the government’s target of 2%. This is much lower than UK inflation in the 1980s which reached 10%

6. Interests rates have a powerful effect in influencing UK consumer spending. This is because many people have mortgages or other types of loans.


Limitations of the MPC’s Effectiveness

1. Inflation is low but this is partly due to global pressures keeping inflation low. E.g. globalisation, low prices of raw materials and better technology. If these factors were to increase it would be much more difficult for the MPC to keep inflation low.

2. Interest rates have a time lag. It is estimated it takes 18 months for interest rates to have an effect. Therefore it becomes difficult to control inflation solely through interest rates.

3. Some sections of the economy do not respond to higher interest rates. For example the recent rises in interest rates have not stopped house prices rising. Many older people have a small mortgage therefore changes in interest rates have little effect. However interest rates have a disproportionate effect on people who have just joined the housing market ladder.

4. It depends upon other components of AD. E.g. if consumer confidence is high then raising interest rates may have little effect on reducing consumer spending.

MPC have done a good job so far. However the real test may come when there is a rise in structural inflation or global instability.

See: Evaluation of MPC and ECB in aftermath of the credit crisis (2013)