Boom and Bust Economic Cycles

Definition of Boom and Bust: A period of rapid economic expansion which is unsustainable leading to subsequent period of economic contraction and recession.

The Great Moderation

Was the great moderation a period of boom and bust?

 

Inflation stayed low between 1992 and 2009. It wasn't a classic boom. Economic growth was positive, but it wasn't significantly higher than the long run trend rate. Inflation stayed low.

However, although growth and inflation were stable in the 1990s and 2000s, there were still components of a boom and bust.

Housing Boom and Bust

In the late 1990s and early 2000s, there was a housing boom and bust. UK House prices rose much faster than inflation until Summer 2007, when the credit crunch completely changed the nature of the mortgage market. As mortgages were withdrawn, house prices started to fall. But, because mortgage affordability was stretched, people were not able to save the new size of deposits. Because prices had risen so much they had a long way to fall. The fall in house prices has played a crucial role in knocking consumer spending and consumer confidence. It has directly led to job losses in construction and estate agents.

The boom and bust in housing is quite clear and has played a key role in the current bust.

Unbalanced Economy A boom and bust suggests an unbalanced economy. In the growth years of 2000-08, there was a strong growth in consumer spending and consumer borrowing. This is reflected in the:

• falling savings ratio
• Rise in mortgage equity withdrawal.
• Higher consumer borrowing
• current account deficit. - financed by hot money flows and higher interest rates.

In other words, the main cause of UK economic growth was consumer spending. The economic growth was not balanced throughout different sectors. Because saving rates are so low, it means that the UK is particularly sensitive to the rising living costs and tighter credit conditions.

Lawson boom and bust of the 1980s.

In the late 1980s economic growth increased to 5% a year in 1988 and 1989. This was far above the long run trend rate and this excessive growth caused inflation to rise to double figures. In response to the inflationary spiral, the government joined the ERM and increased interest rates. This reduced inflation, but, at the expense of switching the boom into a painful bust. House prices collapsed (not because of a financial crisis, but because interest rates were so high). Unemployment rose and the government dithered in stimulating the economy because it was pursuing an outdated target for sterling against the D-Mark. See Lawson boom
Implications of Boom and Bust.

The UK did have its longest period of economic expansion on record - 1992-2008. In part this was due to avoiding a boom and bust cycles which have been frequent in the post-war period. However, you could say there was a boom and bust cycle in financial markets. Lending rose rapidly, but this later proved unsustainable.

This recent crisis, raises the importance of looking beyond headline inflation and economic growth statistics. Low inflation is not the only factor we need to look at. It is a mistake to ignore house prices bank lending and other indicators of economic / financial volatility.
There is also a danger of relying on consumer spending to fuel growth.
There is also a danger of attracting hot money flows to finance a current account deficit. And there is a danger of allowing lending criteria to become so relaxed that any tightening creates economic problems. 

• Causes of the Business Cycle

European Recession

After the first European recession in 2009, the EU is heading back into another recession only three years later. But, this recession is much more worrying. There is less room for maneouvre, attempts to solve the debt crisis have failed, and have left countries with both low growth, but continuing debt problems.

The cause of the second recession is depressingly simple.

• Austerity policies really do cause a fall in aggregate demand, higher unemployment and lower economic growth
• If you cut government spending, you need something else to boost demand in the economy. This could be devaluation, loose monetary policy, higher exports or stronger private sector demand and investment. 
• However, Europe has only deflationary policies. There is no devaluation for southern economies, no loosening of monetary policy and with very low confidence, the private sector has not compensated for even minor spending cuts. 
• The German economy is doing relatively well (though GDP still fell 0.2% in the last quarter). But, the German economy is helped by very strong export demand. Germany has a current account surplus of 6% of GDP. The problem is that some feel everyone should follow German's model of exports and high current account surplus. But, not everyone can have a current account surplus! 
• The flipside of strong German exports is a current account deficit in Greece and Portugal of 10% of GDP. To help economic growth in Greece and Portugal, there needs to be a revaluation of trade within the EU - but that is very slow to occur with a single currency.
• In a liquidity trap and period of very low private confidence, the private sector haven't taken the place of spending cuts. It is why Italy has gone into recession with GDP falling 0.7% in last three months of 2011, following 0.4% contraction in three months before.

Austerity and Lower Tax Receipts

Since Greece increased taxes, and cut spending, VAT receipts have fallen 18% in 201. Simply because 60,000 firms went out of business. This is an example of how austerity policies can be self-defeating in a recession. (Tragedy of Greece)

Yet, Daniel Mitchell, of the libertarian-minded Cato Institute, argues that Europe has not been austere enough and that much more is needed. "European countries talk about austerity but they don't mean cuts," he says. (Guardian Link). At least the IMF are aware that there can be too much of a necessary thing. (IMF blog)

Youth unemployment of 50% - just cut government spending a bit more. This is the logical policy of free market economics.

Yet, despite all the austerity of Greece, Italy and Ireland, they have failed to solve the 'debt crisis'

Depressed with the European economy, I had a look at the Indian economy in 2012 - at quite a different stage of the economic cycle. What India needs is to reduce its budget deficit and liberalise its complex bureaucracy. If India can lears anything from Europe - don't wait for an economic downturn to try and solve persistent budget deficits.

Keynesian economics may support fiscal expansion during a recession, but in India's case, a very different approach is needed.

Related

• Causes of recession
• Euro debt crisis Explained

Outlook for Euro

A look at some of the challenges facing the Eurozone and why the Euro is likely to remain weak over coming months.

The Euro has been weak ever since the debt crisis began at the start of 2010.

Challenges for the Euro

1. Current Account Imbalances


The single currency has created economic imbalances in the Eurozone.

• Germany has a large current account surplus (almost 6%) - suggesting German exports are undervalued.
• By contrast, Greece has a current account deficit of 11%.
• Portugal has a current account deficit of over 7%.
• In Q3, the UK had a deterioration in current account deficit to 4% of GDP (despite devaluation since 2009.
• To restore competitiveness in Greece and Portugal without devaluation would require a prolonged period of deflation. This deflation would lead to lower growth and higher unemployment.

2. Government Debt

Greece and Ireland have a high budget deficit. But, it also shows that the problems of the Euro are more than debt. Portugal and Spain have high bond yields - despite a relatively low budget deficit. Portugal and Spain have a budget deficit 50% less than similar deficits in the UK and US. Yet, US and UK don't have rising bond yields.

• List of government debt by country

3. Unemployment

Unemployment rates in the Eurozone present a real threat to social stability - especially since unemployment is more concentrated amongst young workers.

4. Low Economic Growth

Growth forecasts for the Eurozone have been downgraded. For southern Europe, there will be a double dip recession, making it harder to reduce debt to GDP ratios and increasing unemployment. Unfortunately, it is hard to see a strategy for growth. There will be no loosening of monetary policy. The exchange rate will remain overvalued for the uncompetitive south. And at the same time, they have to reduce spending to tackle budget deficits. Combined with a European wide slowdown, it will be a slow and limited recovery.

Related

• Problems of the Euro

Predictions for Pound Sterling to Euro

Predictions for Pound Sterling to Euro in 2012

Readers Question: I read a lot about the Dollar/Pound relationship but I want to know what the forecast is going to be for Euro/Pound. What is the factor that determines the value of the Pound down against the Euro?

The Main factors determining the value of the Pound Sterling to Euro

• Relative interest rates - If UK interest rates are higher than Eurozone, this will attract hot money flows from Europe to UK. This will increase demand for sterling, and sterling will appreciate
• Prospects for economic growth. If the UK economy grows quicker than the Eurozone, we would expect UK interest rates to increase faster than in Euro, causing an appreciation in Sterling.
• Prospect for inflation. If UK inflation is higher than in Eurozone, it will make UK goods relatively less competitive than Euro goods. This will cause less demand for UK goods and a devaluation in the value of Sterling.
• Government Debt. If markets fear government default, this makes them less willing to hold currency which the debt is denominated. If markets feared the UK government may default, foreign investors would sell UK bonds, pushing down the value of the exchange rate.
  

Graph showing Value of Euro to Pound

Reasons Why the Pound Devalued against the Euro in 2008/09

1. UK Economy in steepest recession. The UK economy experienced a rapid drop in GDP (Steeper than even Great Depression of 1930s). The UK was particularly hard hit by credit crunch because of the UK's exposure to financial services. Because of the sharp slowdown in UK GDP interest rates were cut to 0.5% in March 2000
   Lower interest rates are very important for weakening a currency. Lower UK interest rates make it less attractive to buy Sterling and save the money in the UK. Therefore, there are less hot money flows and a weaker value of Pound.
2. Housing Market. The UK Housing Market plays a crucial role in determining consumer confidence, spending and economic growth. The fall in house prices has reduced consumer confidence and with house prices forecast to fall or stagnate in 2012, it is another factor which will keep interest rates low.
   
3. Credit Crisis. The UK is heavily exposed to the credit crisis because mortgage lending accounts for a high % of disposable income. Mortgage lending is more important in the UK than the Eurozone where mortgage payments account for a smaller % of disposable income. With less mortgages becoming available, demand for housing is falling. Also those with existing mortgages are seeing the cost of remortgaging increase. This is putting pressure on the Bank of England to reduce base rates to compensate for the increased bank rates. As they explained the recent interest rate cut:
   
   "The disruption in financial markets could lead to a slowdown in the economy that was sufficiently sharp to pull inflation below the target."
   
   
4. UK Current account deficit. Relative to the EU, the UK is running a current account deficit, which puts downward pressure on sterling because of the outflow of foreign currency. UK's current account deficit is still 4% of GDP (Q3 2011) despite devaluation.
   
5. Large Rise in Government Borrowing. With government bailouts, fiscal expansion and tax cuts, government borrowing will be close to 9% GDP in 2012/13. This causes lower confidence in the UK economy to pay off debt (though UK public sector debt is still lower than many of our European counterparts)
   

Predictions for Pound vs Euro in 2012

The Euro has become increasingly weak since the onset of the Euro debt crisis in early 2010. Markets fear default in countries like Greece, Italy and Portugal. This could lead to countries exiting the Euro. This uncertainty and fear over default has pushed the Euro lower. There is no quick fix to the Euro debt crisis. Efforts to reduce government borrowing have caused a slowdown in economic recovery and prospects of a double dip recession make markets more nervous over the Euro.
The UK's recovery is being held back by the Eurozone downturn. The UK is highly reliant on the EU for our exports. However, the UK still has greater flexibility than the Eurozone and recovery is likely to be stronger in the UK than in the south of Europe.

The strength of the Euro is also causing problems for EU exporters.

Conclusion

The Pound has fallen on the back of depressing economic statistics. The whole Global economy is likely to experience recession, but, the UK recession has been deeper than most. Against this backdrop the pound has been weaker.

Related:

• Outlook for Euro
• What causes a currency collapse?
  

Reference
Picture from : Guardian - Pound falls to record low

Long Term Effects of Recession

A recession is a period of negative economic growth characterised by rising unemployment. In the short term, recessions can have various costs:

• Loss of income
• Firms going bankrupt.
• Psychological and health problems of the unemployed
• Higher government borrowing (lower tax receipts and higher benefit spending)

But, what about the long term effects of recession?

• Is there just a sweeping away of inefficient firms enabling a rebounding of economic growth and higher productivity? - or
• Is there a permanent loss of output and a persistent loss of economic welfare, even when the recession is officially over?
  

Long Term Effects of Recessions

Levels of Education. Studies in US, show that prolonged periods of unemployment lead to some students being unable to afford college education. It can also lead to lower levels of education amongst under 7s. If recession does effect levels of education then there will be a corresponding long-term effect on earnings of those affected. It will also lead to higher long-term inequality. Those without access to education will typically face lower income levels in later life.

• However, in the UK, student numbers have increased during the recession as students seek to avoid a difficult job market and go to university instead.. One factor is that education is more expensive in the US, therefore recession and lower income in the US leads to lower demand. However, as fees in the UK rise, recession may increasingly deter education.

Private Investment

Recessions have a significant deterrent effect on private investment. Investment has been particularly badly affected in the 2008-12 downturn because of limited access to bank credit. If the recession is prolonged, this can have a long-term impact on levels of capital and productive capacity.

Lost Output

In some short-lived recessions, output has often bounced back and caught up with the lost output. This has enabled the economy to keep the long-run trend rate of growth. For example, in 1994, the UK economy grew by nearly 4% which helped catch up 'lost output' of the 1991-92 recession, and maintain a long-run trend rate of 2.5%.

Bounce after recession of 1981 and 1991.

However, with a longer 'balance sheet recession', there is evidence that output has been permanently lost. This balance sheet recession has not just been a temporary fall in demand due to higher interest rates. It has involved a credit crunch, lower bank lending, and falling asset prices. It has lasted much longer and caused a much more prolonged fall in GDP.

Europe's Lost Output

source: Europe's Gap

US Output and Potential Output

source

Even the most optimistic forecasts for recovery suggest slow growth. There is going to be no bounce to catch up with lost output. The longer the recession lasts, the greater the risk that output will fall below the trend of potential output.

Business

Recessions make it more difficult for new firms to start. There are examples of firms who have been able to start in the middle of a recession (Microsoft 1975), CNN (1980) Disney (1923). But, in recession, typically business-starts fall dramatically. Also existing firms are at risk of bankruptcy. In 2008 in the US, 43,500 businesses filed for bankruptcy, up from 28,300 businesses in 2007. Some argue that a recession 'weeds out' inefficient firms. But, even good, efficient firms can go out of business due to temporary liquidity problems.

It is possible, some firms merely delay start-up, but for some firms, a few years may mean the window of opportunity passes and two years later is too late.

Impact on Government Borrowing

This permanently lost output also means permanently lost tax revenues. In this current recession, many economies have felt the need to reduce government spending as a result of the cyclical increase in their budget deficit (especially countries in the Eurozone). However, this cut in government spending has adversely affected capital investment and the rate of economic growth. It is part of the reason why the recession has been difficult to overcome. Therefore, if recessions cause an unsustainable rise in government borrowing, it may cause governments (rightly or wrongly) to cut spending and increase taxes which further damages economic growth in both the short term and long-term.

Inequality

The biggest cause of inequality and relative poverty is unemployment. A rise in in unemployment leads to lower income and can harm nutritional intake and quality of life. In the US, there are also impacts upon health care, with unemployment causing a fall in health care insurance. Poorer health care and nutritional levels can impact in the long-term.

Impact on Younger Generation

Effects of recession on younger workers. source

A recession tends to have a greater impact on younger workers rather than older workers.
In the long term, this will impact young peoples future earning potential. It is hard to recovery from a period of unemployment in early working life. It leaves a gap in your CV and damages future employment and promotion prospects.

In addition, highly concentrated youth unemployment can lead to a rise in social problems. Higher unemployment rates can lead to higher rates of crime, vandalism and social dissatisfaction. This feeling of social exclusion can be difficult to eradicate when the economy gets out of recession.

• A culture of unemployment amongst young people definitely has long-term effects.

Related

• What determines the long-term effects of recession?
  
• Causes of recession
• Problems of recovering from recession
  

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

Difference Between the EU and Euro

I often find people talk of the European Union and the Euro (single currency) as interchangeable ideas. Recently, the German leader Angela Merkel stated defending the Euro was essential for maintaining the post war gains of the European Union. The new Italian new 'technocrat' leader Mario Monti warned that a breakup of the Euro would bring its users "back to the 1950s." - (before the creation of EEC.) Yet, arguably, the European Union would be a lot stronger without the Euro or at least the Euro in a very different format.

The Ideal of European Integration

The post war development of Europe is one of humanity's great achievements. We went from a conflict perpetually at war, to a continent at peace (with the odd exception in the Balkans). The European Economic Community, for all its failings helped foster greater ideals of integration. With free trade throughout the European Union we benefited from a golden age of economic growth, low unemployment and prosperity. Whatever bureaucratic failings may occur in the EU, I will always remain a broad supporter of this ideal of bringing European countries together.

The Euro Is Not Aiding European Harmony and Prosperity.

The problem is that European leaders felt having a single currency (the Euro) was a natural extension of this ideal of economic and political integration. Southern European economies were particularly keen to gain the benefits of being tied to the German economy. (Italy was one of strongest supporters of Euro). Countries felt joining the Euro would be an easy ticket to low interest rates, low inflation and high economic growth. (in fact the opposite has occurred).

The EU were so keen to go ahead with the single currency that their own 'Maastricht Criteria' were pushed aside to let everyone join. (In 2000, the UK was actually one of few countries who met Maastricht Criteria, though we decided not to join). In the case of Greece the decision to ignore these criteria would prove most damaging.

The problem with the Euro is that it is fundamentally flawed, and because of these fundamental flaws it has an in built deflationary bias which is promoting low growth, high unemployment and increasing division between the different regions in the EU.

Fundamental Flaws of the Euro

1. No Lender of Last Resort. This means liquidity crisis come quickly and with great force. It is why Greece, Ireland, Portugal, Italy, Spain (and more to come) have see such a devastating rise in borrowing costs. If the UK had been in the Euro, the same would have happened to us. Problems of Euro in recession
   
2. Uncompetitive Countries. Countries in the south of Europe have seen a rise in inflation relative to Germany. This has left them uncompetitive, leading to lower exports and lower growth. But, because they are in the Euro, they can't devalue to restore competitiveness. They are left with sluggish growth.
3. Austerity. The response to the EU debt crisis has been to push spending cuts on country. No matter how steep the spending cuts, these have singularly failed to reassure bond markets. Bond yields have continued to rise regardless. THe only thing spending cuts have achieved is to push the south of Europe into a potentially damaging recession, lower tax revenues and higher debt to GDP. IN response the European bureaucrats and leaders shout 'more austerity'. The outcome is unemployment, recession and greater disharmony.
4. Not an Optimal Currency Area - geographical immobilities
5. No real fiscal union - only grudging promises of help
   

More: Problems of the Euro.

• The Germans don't want to bailout southern countries who have run up large budget deficits.
• The south don't want to be stuck in a deflationary trap.

Both, are right. It shouldn't be like this. With the single currency and common monetary policy, we only have a recipe for falling living standards and increased social division. This doesn't help Europe. It is the Euro and the failings of the ECB which is threatening the stability of Europe.

Related

• Why is EU trying so hard to saving the Euro - reasons to justify the defence of the Euro.

Is France Next Bond Crisis?

Despite similar public sector debt to Germany France (85% of GDP) is at risk of becoming the next target for bond investors, as sellers push the interest rate on French debt up.

In the real world, investors are selling all Eurobonds apart from Germany. France is looking like the next target for a panic sell off.

The ECB adamantly refuse to act as lender of last resort. As Rome burns, the ECB watch their inflation targets. But, if they don't intervene what will stop the Euro crisis? - ECB and Money Creation

One Year Bond Yields - Spread v Germany and France Bond Yields

French National Debt

• 
• In Nov. 2011, French national debt stands at 1.7 trillion Euros - 85% of GDP.
  • Forecast for end of 2012 is 90% of GDP.
  • France's budget deficit is 5.8% of GDP
• France National Debt
• Spiegel online

Related

• Euro Debt crisis

Inflating Away Our Debt

Inflation reduces the value of money. This reduces the real value of your debt and also the real value of your savings. Therefore periods of high inflation tend to be good news for borrowers, but bad for savers. This is particularly the case if we have high inflation during a period of very low interest rates.

Inflation and Interest Rates since 1900

In periods where inflation is higher than interest rates, savers are losing out.

UK 2011

From one perspective, it is curious that with inflation of 5%, investors are very willing to buy UK bonds pushing interest rates down to 2.2% on 10 year bonds (Nov, 2011). What this means is that investors prefer to hold bonds with a negative real interest rate rather than use their funds to invest in other areas.

The good news for the UK is that with inflation of 5%, we are effectively 'inflating' away part of our debt. With inflation it is much easier to reduce your debt to GDP ratio.

Simple Example Showing Affect of Inflation on Debt.

• Suppose government borrow £1,000bn and nominal GDP is £1,000bn.
• Supposed tax revenues = £400bn (40% of GDP)
• The debt to GDP ratio is 100%.

• Suppose then we have inflation of 100%, and the level of former debt stays at £1,000bn.
• Because of inflation, nominal GDP increases to £2,000bn.
• The debt to GDP ratio will fall to 50%
• Also, if tax rates stay the same, tax revenue will increase to £800bn, making it easier to meet debt interest payments.

This scenario, is bad news for savers who see a real fall in the value of their savings. In the above case, savers will see the value of their bonds fall by 50%. This kind of inflation is effectively a partial default.

But, for the government and borrowers, it is a 'lucky' event which makes the task of debt reduction easier. However, if a country gains a reputation for having 'unexpected inflation' it will become more difficult to sell future debt. It means in the future bond investors will demand higher interest rates to compensate for risk. - There are only so many times you can get away with 'inflating away your debt'

Usually, the threat of inflation would push up bond yields as investors don't want to have this kind of negative interest rate. However, at the moment, pension funds don't want to invest in the stock market or invest in long term capital investment. They only want the security of government bonds. Therefore, in the current liquidity trap, the government can take advantage of borrowing at low interest rates.

Also, part of the reason that investors are willing to buy bonds at such low interest rates, is that they really do expect inflation to fall next year. The current inflation of 5% in 2011 is due to temporary factors such as higher taxes and impact of devaluation. Because markets expect inflation to fall next year, they are more willing to hold UK bonds.

Also, markets fear UK growth will be very low. This risk of a second recession means that the stock market and other investments are still unattractive. Pension funds would rather have the security of bonds rather than risk putting money elsewhere.

Bond yields have also benefited from

• The governments stringent spending cuts.
• UK yields have also been helped by having a lender of last resort (unlike Italy).

Inflation Unfair on Savers

Inflation invariably reduces real wealth of savers. Many pressure groups representing savers argue for immediate action to protect the value of their savings i.e. higher interest rates to reduce inflation and increase real interest rates.

However, the government and Central Bank have to weigh up the different costs.

It is unfortunate the middle classes see a small fall in the value of their savings. However, arguably it would be a much bigger cost to society, if higher interest rates pushed economy back into recession and a significant rise in unemployment.

Low interest rates reduce living standards, but it is not comparable to the reduction in living standards from unemployment and a prolonged recession.

Savers Also need Economic Growth

Savers are getting such a poor deal because of feeble prospects over economic growth. If the economy recovered with strong economic growth, pension funds would have the confidence to invest in shares and capital investment. They wouldn't feel tied to buying bonds with negative real interest rates.

Therefore, although it is unfortunate savers have negative real interest rates, it is definitely not in their interest to have a sudden rise in interest rates which pushes the economy back into recession.

Related

• Definition of inflation
• Costs of inflation
• Historical interest rates
  

Options for the Eurozone and Euro

The EU gives the impression of stumbling through the crisis. There is an attempt to deal with issues as they come up, without tackling the fundamental issues underlying the crisis.

In particular, in response to rising bond yields, there is a rush to try to reduce budget deficits and reassure markets. But, this approach is not working. It is not working because:

1. It doesn't address the underlying lack of competitiveness and misaligned exchange rates in southern Europe.
2. It doesn't tackle the need to promote growth in GDP, which will help reduce Debt to GDP ratios.
3. It doesn't reassure markets there will be no liquidity crisis - because there is still no lender of last resort.

See more detail on: Euro Debt Crisis Explained

Options for the Eurozone

1. Internal Devalution, Austerity, Weak bailouts

The current option pursued by the European Union is to

• Reduce spending as much as possible to reduce budget deficits.
• Rely on internal devaluation (lower labour costs to restore competitiveness for the Southern economies)
• Implement structural reforms to restore competitiveness, although these tend to be vague.
  
• Offer a grudging and weak kind of bailout (i.e. the EFSF is guaranteed by countries like, er Italy)
  

The problem of this is that:

1. This is causing lower growth and falling tax revenues. Therefore, markets don't see how the likes of Italy are going to reduce their debt to GDP ratios.
2. Despite austerity measures markets still don't confidence in buying Italian debt because of the fears of recession, and also there is no lender of last resort.
3. The process of restoring competitiveness through this internal devaluation is very slow.
   

If the EU stick to this, we will get prolonged economic stagnation and a serious recession in the south of Europe. There will be a perpetual need to cut spending and try and reduce budget deficits. Internal devaluation may eventually restore some kind of competitiveness (Ireland has been more successful than other) and help promote some kind of economic recovery, but it will take a long time and cause very high levels of unemployment and instability. There will also be persistent pressure from the bond markets. Whether the Euro can surviving bailing out stagnant economies the size of Italy during a decade of economic stagnation is highly debatable.

2. Change the Role of the ECB

At the moment, the ECB seems only interested in preventing the non-existing inflationary threat. The ECB could be reformed to:

• Act as lender of last resort. Buy government bonds without hesitation and give markets confidence.
• Target a higher inflation rate (perhaps as likely as Berlusconi being made an honorary member of the Women's Institute) But, the ECB at least have to see the need to target growth, even at the risk of some higher inflation.
  

3. Break up of the Euro

Concentrate the Euro on only a small group of northern economies who have actually shown a degree of economic harmonisation (Germany, France, Belgium, Netherlands e.t.c). Countries who leave the Euro should honour current contracts in Euros, but new contracts should be based on their own currency (new Lira, New Drachma) These new currencies will significantly devalue. This has both costs and benefits.

• The rapid devaluation will restore competitiveness enabling an increase in export demand
• The devaluation would probably cause capital flight as investors seek safe havens in the 'strong Euro' and away from the south.
• The fragmentation of the Euro could cause great turmoil in the EU. However, it may still be a better alternative than the prolonged recession likely with current policies.

4. Fiscal Union

The other option is to go for broke and have a complete fiscal union. i.e. there would be no Italian bonds, no German bonds, only Euro bonds. This would prevent contagion for weak countries. It would reduce interest rates enabling a more ordered austerity program. It should give better chances for growth.

However, it opens a range of other issues.

• Can the EU impose a degree of fiscal discipline on countries with poor track records.
• Will German taxpayers be willing to bite paying for Italian profligacy.
• Is fiscal union enough? It still doesn't promote competitiveness and economic growth.
  

Related

• Potential impact of debt crisis on UK
• Solutions to EU crisis
  

Economic Problems of Italy

Italy is facing a economic serious crisis with bond yields rising close to 7%. They also face the prospect of recession and slow growth in the coming years.

Bond Yields on UK, Italian and German Debt


Firstly, there is a significant difference between Greece and Italy. Greece was fundamentally bankrupt. It's budget deficit, and public sector debt was too large for it to cope. A debt restructuring was inevitable.

source: budget debt EU

Italy is actually running a primary budget surplus (this means if we exclude the cost of interest payments on its debt, Italy has a 'primary' budget surplus - very different to the UK) Italy doesn't have the highest public sector net debt in the EU either.

source: FT

Italy's fiscal deficit is lower than many other countries.

It seems bizarre a country with a primary budget surplus can be facing a liquidity crisis that Italy is.

Reasons for Italian Crisis

Recession. Austerity packages (spending cuts) and fears about the prospects of the Eurozone have precipitated a fall in consumer spending and economic growth in Italy. It is forecast Italy will remain in recession in 2012 and 2013. This negative growth will lead to a fall in tax revenues and higher government spending on unemployment benefits. Markets don't want to buy Italian debt because of fears over lack of economic growth will make it very difficult to reduce their debt to GDP ratio.

Poor Growth Record

Due to a combination of political instability, corruption and poor productivity growth, Italy has developed a poor track record of economic growth in past two decades.

source: economist

Long Term Debt.

Though Italy's budget deficit (annual deficit) is quite low, public sector debt is over 110% of GDP, which is giving cause for concern. The problem is that it is quite difficult to reduce this debt / GDP ratio given - how much they spend on interest payments, and the poor prospects for GDP Growth.

Ageing Population.

The long term debt problem is not helped by Italy's ageing population. This will reduce income tax revenues and require greater commitment to state pensions over the next few years. Italy has one of the lowest birth rates in the world.

Fundamental Uncompetitiveness.

Since joining the Euro, Italy has seen its relative competitiveness decline. Labour costs have risen 40% compared to Germany; this has contributed to a 70% fall in direct investment since 2007. Like Greece and Portugal, Italy can't devalue so it is left with uncompetitive exports. This uncompetitiveness leads to lower economic growth and more pressure on debt/GDP ratio.

No Lender of Last Resort

Italy is not bankrupt, but it may experience a liquidity crisis (it may be unable to 'roll over its debt' i.e. sell enough bonds to meet current budget requirements in short term). This liquidity shortage should be quite a small risk. But, because there is no lender of last resort for Italy (i.e. ECB will not buy Italian bonds to roll over debt) Markets find Italian debt much less appealing. If there was a guaranteed lender of last resort, Italian bond yields would be much lower. People would have much more confidence in holding Italian debt. However, because there are fears over liquidity shortages this has pushed up bond yields; this increase in bond yields has increased the cost of servicing Italy's debt


Conclusion.

Italy suffers from:

• Having wrong exchange rate. They have lost competitiveness and can't devalue leading to lower growth
  
• Monetary policy is too tight for Italian economy.
• There is no lender of last resort.
• EU austerity measures (spending cuts) are forcing Italy back into recession leading to a predicted slump in tax revenues. This is making markets nervous about future prospects for Italy.
• There seem no practical solutions to returning to strong growth. Again the only medicine seems to be 'spending cuts' and internal devaluation. But, this will be a long drawn out process.
  
• Political instability. Lack of strong cohesive government makes markets more nervous to hold Italian debt.

Similarities between Italy and Greece.
Both countries:

• Share decline in competitiveness
• Would benefit from devaluation, but in Euro can't
• Are experiencing high unemployment and economic stagnation
• Must regret being in the Euro.
  

Related

• Facts on European Debt Crisis
• Bond Yields on EU debt
• Is the UK like Greece and Italy?
  

Is the UK like Greece and Italy?

With all the turmoil in the Euro, how likely is the UK to face similar debt crisis as Greece, Italy, Spain and Ireland?

On some measures there is a disturbing similarity.

Public sector debt as % of GDP

Facts on European debt crisis

Annual Budget Deficit


• The UK's budget deficit is one of highest in EU (after Greece and Ireland's 2010 budget deficit)
• The UK economy is very closely linked to the Eurozone; if Europe enters a recession, this is likely to adversely affect the UK economy.
• Despite recent growth figures there are signs that the UK economy is stuck in an economic slowdown.

However, I don't think we need to fear becoming the next Greece, Ireland or Italy. This is why

• Bank of England is willing to act as lender of last resort - buying bonds in a liquidity shortage. Markets have greater faith in countries who have independent Central Bank who is is willing to buy government bonds. If Italy experiences temporary difficulties in selling government debt, there is no Central Bank to step in. They have to go through the whole rigmorole of going to the EU asking for loan. But, this loan usually involves interminable political wranglings. Understandably, markets fear there is no mechanism to deal with liquidity shortages. Therefore, investors are less willing to hold debt held by Eurozone economies.

Bond yields have stayed low in UK

• • 
  • 
    

  Bond yields on EU Debt

• Low Interest Payments. UK Debt interest payments are manageable at only around 3% of GDP (£48bn)
• Longer debt maturity. The UK has a higher % of debt denominated on bonds with long maturity (e.g. greater than 10 years) therefore there is less pressure to sell new bonds.
• Historical national debt. As a % of GDP, UK public sector debt has been higher in the past. (National debt facts)
  
• Spending Cuts. Markets have been reassured government is committed to reducing structural deficit.
• Greater Flexibility. The UK has greater flexibility than Eurozone economies. Whilst the UK government cut spending leading to unemployment and lower demand, at least UK Central Bank have been able to pursue quantitative easing to provide some monetary stimulus. Also, the UK has benefited from the depreciation in sterling which helps to boost domestic demand.

It doesn't mean the UK economy is safe. The debt to GDP ratio will only improve when the UK economy returns to its long run trend rate of growth. However, it would require a very sharp deterioration in the UK economy for us to face the challenges facing some of the Euro member countries.

Related

• If UK had been in the Euro

Euro Bailout

The recent Euro Bail Out was greeted with some relief by markets. At least European leaders could agree on something. But, bond spreads have continued to rise and the fundamental problems remain.

Some notes from the recent bailout.

• Firstly, as many widely expected a European country (Greece 50% cut in debt) has defaulted on its debts for the first time since after Second World War. This is still quite a significant milestone sovereign debt default in an advanced country is very rare. - Note for many months, the EU had hoped to muddle on and avoid Greek debt, but this just shows a misplaced optimism.
• Now sovereign debt default is a reality, investors will be repricing many other countries debt. It is likely to put increased pressure on Portugal, Italy and Spain and lead to higher bond yields.
• The bailout does nothing to tackle the collapse in money supply that is occurring in countries like Portugal. As part of the deal, the Germans insisted that the ECB stop any bond purchases. (Presumably we still have to worry about inflation despite a collapse in the money supply and nominal GDP that is occurring in the south of Europe)
• A new dynamic is that The EU are hoping that China will become a major beneficiary of the new EFSF fund. China will demand in return free access to European markets and freedom to buy advanced technologies. No mention was made of political issues like human rights abuses, but if China is to become the EU's saviour expect the EU to suddenly go quiet on issues such as Tibet.
• As part of the new deal the EU has new regulations with the powers of 'rigorous surveillance and laws enforcing balanced budgets. Just what you need when when you've got a deep recession, some EU commissionaire to impose more spending cuts and austerity on you.

What The Bailout doesn't do

• This deal doesn't solve the 30% gap in competitiveness between the North and South. The EU kind of hope that a decade of 'internal devaluation' will eventually restore competitiveness. This means a decade of mass unemployment and stagnant growth.
• It Forbids any chance of monetary stimulus to help the beleaguered south escape debt deflation and mass unemployment.
• There is no fiscal union just a 'stability union' There is no joint bond issuance only greater scrutiny of other countries debt.

Related

• European debt crisis
• Problems with Greece Economy
• UK and Euro Crisis

Video Animation on Bailout

• Europe's Punishment Union Telegraph
• Problems of G20 Growth at Guardian
• EU Bailout animation
  

Failures of the ECB

I was writing a short piece on the functions of a Central Bank. The interesting thing is the extent to which the ECB is failing to carry out certain functions. This failure of the ECB threatens to undermine the whole EU economy.

Failures of

Ignoring Economic Growth. A Central Bank definitely has to target low inflation, but not to the exclusion of other macroeconomic objectives such as economic growth and unemployment. The ECB seem to give the impression that inflation is the only thing they care about. As the global economy was slowing down, the ECB increased interest rates this year. Yet, to keep inflation on target at the cost of a recession, is a pyrrhic victory - especially when the inflation is temporary anyway.

Unwillingness to Buy Government Bonds.

Why does the UK have low interest rates on government bonds, but countries like Italy and Portugal have much higher bond rates, despite similar levels of borrowing? Markets know the ECB wouldn't buy Italian bonds in a liquidity crunch. Even one month's shortage would cause great problems and therefore markets push up interest rates on Italian bonds. Occasionally, the ECB has bought bonds, but when they buy bonds they always do it with a loud feeling of guilt and they say they will reverse it as soon as possible. The ECB successfully lose any confidence the market may have in the operation. Paul De Grauwe explains in more detail at Vox

The impact of this decision, is that it puts greater pressure on European governments to pursue deflationary fiscal policy at a time when they need the opposite.

Unwillingness to Pursue Unconventional Monetary Policy

The ECB seem stuck in past economic situations. They don't seem to realise that in the Eurozone, especially south, there is a real threat of deflation and prolonged recession. Faced with this kind of crisis, a Central Bank should be galvanised to do everything in its power to avoid recession. This may mean a temporarily higher inflation target for countries in the north of Europe, it may mean unconventional monetary policies such as quantitative easing. But, the problem is they have an almost religious devotion to low inflation and can't see wider issues.

Related

• Criticisms of ECB

Historical National Debt

see: Historical national debt