Economics help blog – Page 206

Question: Why is the current recession (2012) in Europe so bad?

19 January 202011 April 2012 by Tejvan Pettinger

Readers Question: Why is the current recession in Europe so bad?

The recession in the Eurozone is one of the deepest recessions on record. For example, Greece are expecting 2013 to be the sixth consecutive year in recession (with on and off quarters of recovery)- this is one of the longest recession on record. Output in Greece is 16% lower than at the start. Other countries such as Spain, Ireland and Italy also face large falls in GDP, which have been much more prolonged than previous recessions.

There are a number of reasons why the European recession for Eurozone countries is so severe.

1. Spending Cuts

Faced with budgetary constraints, countries have been forced into ‘austerity measures’ For example, Madrid has been set a target by the European Commission of reducing the country’s budget deficit from 8.5 per cent to 5.8 per cent by the end of 2012, and to 3 per cent in 2013. This level of deficit reduction is difficult in normal circumstances. But, if you cut spending when economy is already in recession, then there will be a large fall in domestic demand and rise in unemployment. Spain already has an unemployment rate of 20%, spending cuts will inevitably worsen the unemployment problem.

2. Legacy of Asset Price Bubble and Household Debt.

In the boom years, countries such as Ireland and Spain both had a rapid increase in house prices. After the credit crunch, house prices have fallen by upto 40%, leaving many banks, business and homeowners facing higher levels of personal debt. This personal debt creates a big drag on spending. Households face the prospect of trying to pay off debt rather than spend. UK’s personal debt stands at £1.4 tn (close to 100% of GDP – up from 69% of GDP in 1997 link) This is known as a balance sheet recession.

A graph (EV) showing the rapid fall in real per capita housing equity in the US. – A major drag on US consumer spending.

Does low inflation always mean low interest rates?

19 January 20209 April 2012 by Tejvan Pettinger

Readers Question: Does low inflation always mean low-interest rates? Generally low inflation will lead to low-interest rates. Although in practice there may be some divergence. The UK has an inflation target of CPI = 2%. Therefore, interest rates are used to achieve this target. If inflation falls to below 2% the MPC will cut rates …

Austerity in Europe 2012

19 January 20206 April 2012 by Tejvan Pettinger

Most European countries have embarked on a range of austerity measures designed to reduce their budget deficits.

Why have austerity measures been pursued with great vigour in Europe?
What is impact of austerity measures on economic activity?

Why Austerity?

Pressure from Bond Markets. Investors have become nervous about holding debt in several Euro-zone countries. This has pushed up interest rates and increased risk of liquidity shortages. This pressure from the bond market is greater because there is no lender of last resort in Euro-zone.

bondyield (EU bond yields)

Cyclical Debt Issues. The recession of 2008led to a sharp rise in budget deficits across Europe. Combined with the credit crunch and fears over liquidity, these deficits have become harder to finance.
Long-Term Debt issues. Some countries have a long standing structural deficit that has concerned markets. For example, even before the crisis, Greece had substantial debt and a poor record of attracting sufficient funds. A country like Italy has a primary budget surplus, but long-term demographics create concerns over future spending commitments and ability to raise tax revenue (ageing population cause increased pension spending, but lower tax)
Commercial Bank Losses. In the case of Ireland, the Irish government took on significant losses from its own commercial banks. However, by taking on private bank debt, the government became overly-indebted itself. Therefore, it was necessary for Irish government to cut spending. One reason the Irish government took on Irish bank debt, is that other European banks could have faced very high losses had the Irish banks failed.
Demands of ‘Fiscal Union’. Concerned over debt crisis, the EU have responded by threatening to redraw the Lisbon treaty and imposing harsher penalties on countries who exceed budget limits.
Political Will. There is an old expression ‘if it’s not hurting, it’s not working.’ mentality. Perhaps this influenced the UK Conservative party – who were keen to make bold spending cuts in their first year of office. Certainly in US, calls for austerity agree with certain political ideologies which advocate lower government spending.

Prospects for Recovery in the UK economy 2012?

19 January 202027 March 2012 by Tejvan Pettinger

Given very low expectations, there are some encouraging signs for a weak economic recovery in the UK. The OBR increased growth forecasts to 0.8% in the UK for 2012. Helped by the recovery in the service sector, it looks like the UK will avoid a double dip recession. This still leaves GDP below the 2008 …

Explaining Paradoxes of UK Economy

24 February 202226 March 2012 by Tejvan Pettinger

Readers Question: There just seems to be many paradoxical actions taking place in markets and economies at the moment. How do we explain?

Paradoxes of UK economy

Low interest rates have not increased spending / economic growth
Despite recession, inflation has been above target.
Despite recession and depreciation of Pound, current account deficit increased in size in 2012
Spending cuts failed to reduce the budget deficit as the government hoped.
Despite a longer recession than great depression of 1930s, unemployment is lower than in other more moderate recessions.
Record levels of government borrowing have led to a record fall in government bond yields (the opposite of what some people predicted)
Quantitative easing (increasing money supply) has not actually increased the money supply !

How to explain these paradoxes

1. Zero interest rates have not increased spending

real gdp and trend

For the past few years, we have been experiencing an unusual combination of circumstances where many ‘ordinary’ rules of economics are not occurring. The economy is currently experiencing a liquidity trap. A liquidity trap involves:

Low-interest rates failing to increase demand. Usually, lower interest rates boost spending because it is cheaper to borrow; but in this current economic situation, even interest rates of 0.5% have failed to see a rapid increase in aggregate demand. Low-interest rates have failed to increase spending and investment because

Confidence is very low. People don’t want to invest when a double-dip recession is forecast. People are reluctant to spend when they fear unemployment
House prices and other assets have fallen. Therefore, this creates a negative wealth effect and discourages spending.
Banks are reluctant to lend because of their liquidity shortages. Therefore, although it is in theory cheap to borrow, it is difficult to get a loan in the first place (e.g. mortgage criteria have become much stricter)
Banks have a funding gap. This funding gap explains why extra money supply from Quantitative easing hasn’t led to higher bank lending – they have been trying to improve their balance sheet.
Although Central Bank base rates have fallen to 0.5%, many commercial banks haven’t passed these interest rate cuts onto consumers
See also: expansionary monetary policy
UK recession of 2008-13 is longest on record

2. Despite recession – inflation above target

Despite a prolonged recession, inflation in the UK has been above target. Firstly, inflation has only been moderately above target. But, with falling wages, many households have seen a fall in their real wages – inflation has been higher than income growth. Therefore, this moderate inflation has been much more noticeable than usual. If your incomes are rising, you don’t mind price increases. But, this recession has seen an unwelcome combination of rising prices and falling wages – reducing living standards.

But, usually in a recession, you would expect a lower inflation rate (lower demand leads to lower prices, higher unemployment leads to falling wages e.t.c). Why has this not occurred?

The inflation is not due to the usual causes of inflation (excess demand in the economy).

cpi-inflation

Inflation in the UK was high between 2008 and 2012 because

Rising price of oil – causing cost push inflation
Higher tax rates – causing one-off increases in tax
Impact of depreciation – causing a rise in import prices
Rising energy prices, such as gas and electricity.

When these temporary factors are stripped away, the underlying core inflation is actually quite low. See also: inflation stats

3. Despite recession and depreciation of Pound, current account deficit increased in size in 2012

current-account-quarterly-2007-2012

In the latter part of 2012, the UK pound fell in value. Also, the double-dip recession led to lower consumer spending. Usually, this leads to an improvement in the current account. A depreciation makes exports cheaper and imports more expensive. A recession reduces spending on imports. Both should improve the current account.

Global Imbalances

1 February 202017 March 2012 by Tejvan Pettinger

What are the Global Imbalances? US ran a large and persistent current account deficit (imports higher than exports) of up to 6.5% of GDP in 2006 Diagram of Current Account Surplus / Deficit in US and rest of world source: (1) 2. China ran a large current account surplus, accumulated foreign reserves, kept Yuan undervalued …

Do stock markets reflect the model of perfect competition?

1 February 202014 March 2012 by Tejvan Pettinger

Perfect competition is a market structure with the following features Many buyers and sellers – 1000s of firms. Freedom of entry and exit into the market Homogenous good Perfect information In a way, stock markets are an example of perfect competition. There are hundreds of buyers and sellers. When buying shares you can choose from …

Question: Why does economics create so many opinions?

10 March 202012 March 2012 by Tejvan Pettinger

Readers Question: Economics is a social science, it contains graphs, diagrams and statistics to make strong evaluations and at university level it also often seems to have a strong Maths content which allows for even stronger analysis, calculation of events and evidence of theories. So how is it possible that often economic events such as inflation or recession can be unexpected and that economists have different opinions on why, when such events may occur?

One part of economics is to look at data and try and create models out of this data. The aim is to try and understand why economic events occur and from these models predict the likely outcome of changes in policy. All models will be dealing with what has happened previously, for example, you might look at various indices related to inflation, and come to the conclusion that recent UK inflation was due to a combination of higher taxes, higher petrol prices and the effects of devaluation.

Therefore, all models risk being inadequate because they cannot guarantee to take all events into consideration. For example, in the mid-2000s, it appeared we had a great moderation – low inflation and low growth. But, from 2006, the credit crunch had a much bigger impact on the economy, than any previous situation. Models had failed to take into account the potential adverse consequences arising from a sudden drop in bank lending.

Difficult of Forecasting

When it comes to forecasting inflation, you can make the best estimates, but there is always an element of unpredictability. For example, in 2012, the Bank of England forecast the inflation rate would fall. This seems a reasonable forecast on the basis that

wage inflation is low
economic growth is low.
Temporary cost-push factors should expire.

However, you can never predict the future with certainty. There could be another oil price shock (e.g. war in Iran). If the economy recovered quicker than expected, we may also see a return of demand-pull inflation.

Another issue could be the inflationary impact of quantitative easing. Usually, economic theory would suggest that increasing the money supply would cause inflation (link between money supply and inflation). However, there are always many variables to take into account.