Productivity – cutting both ways

Far from being a cure-all, productivity gains are instead cutting into the number of jobs

Higher productivity seems like the answer to all of our economic woes but being more productive is not all good.  Doing more with less is a way of making us wealthier by getting more out of the limited resources available.  Improvements in productivity often thus translate into more profits or lower prices (or both).  But there is also a nasty side in that one of the resources that can be done away with is workers.  Trends such as greater globalization and improvements to technology have resulted in many (well paying) jobs being put to the chop and we should not be expecting any respite soon.

Doing more with less

Economics is a discipline which is based on the notion of scarce resources.  It is no surprise then that economists rave about how improvements to productivity are the key to prosperity.  Any business that can produce the same products using fewer inputs is bound to do well.  Being more productive as a worker is also opens up the way for the opportunity to demand higher wages.  Any gains from higher productivity are split between companies, employees, and consumers but it is not always the case that everyone gets a share.

My favourite example of productivity gains where everyone got their cut was Henry Ford and the motorcar.  Ford did not invent the automobile or the assembly line but he did figure out a way of manufacturing cars cheaply.  The continued existence of the Ford Motor Company is testament to how much he and his family have thrived.  On top of this, workers at the firm also benefited from the new jobs that were created as well as the higher wages on offer.  Cars also became available to many more people thanks to the mass production of the Model T resulting in a lower price tag.

Suffering from cut backs

The example of Henry Ford and the Model T shows how more can be produced cheaply using more workers.  But this is only a viable way of making money when there is a rapidly expanding consumer market and an appetite for more and more goods.  This seemingly came to an end in the richer countries when most households became wealthy enough to buy the basics such as a car, a fridge, and a TV.  Without being able to tap into economies of scale by producing more and more, the emphasis has since shifted to producing goods at the lowest cost. 

One of the main avenues for cutting costs has been outsourcing manufacturing and some services to countries where wages are lower.  Computers and the Internet have also helped companies save money by better optimising their operations and reducing the need for some clerical work.  Companies have obviously benefited from this and we have as consumers (due to lower prices) but not as workers.  There is no modern-day version of the Model T that might provide a new source of lucrative job opportunities.  Instead we spend our money on services (eating out or going away on holiday) or goods where much of the value is in design rather than the goods themselves (such as clothing or electronic gadgets).

Cut yourself free

The challenge for developed countries is to create more high paying jobs for its educated workforce.  Instead, the opposite seems to be happening and the economic recovery after the global financial crisis has been characterized by a proliferation of jobs with low pay.  Higher unemployment allowed companies to hire workers on the cheap and this has dulled incentives for business investment.  It is easier to get things done using cheap labour than spending money on making your current workers more productive. 

Unemployment in countries such as the US and the UK has fallen but this has yet to translate into significantly higher wages.  Neither is a rapid improvement likely as companies are still timid about investing due to the weak momentum of the economic recovery.  Government policy is also a hindrance due to the focus on austerity measures rather than taking advantage of low interest rates to invest.  

The only way out for beleaguered workers seems to be setting up their own business which has become increasingly more popular.  The jump in entrepreneurship may be one of the few silver linings as people cut themselves free to become their own boss and to have productivity gains there for the taking.

Low Oil Prices – Feeding the Addiction

Cheaper oil will bring about much cheer but it will help keep key oil producers happy in years to come

Oil is like a drug that the world economy cannot do without and we are in the midst of a turf war over who will call the shots.  A few dealers have had a stranglehold over the market for oil and have been able to set prices as they please.  The arrival of new kids on the block (with the rise of fracking in the US) has triggered a fight for control of the oil market.  The result has been a plunge in oil prices which is a blessing for the global economy but is part of a bigger strategy to keep us all addicted to oil for years to come.

Not a buyers’ market

The sharp drop in oil prices will provide a welcome boost to the economic recovery in many countries.  Oil is like a drug in that it is always in demand and buying continued despite high prices in the aftermath of the global financial crisis.  Prices for oil have only recently eased off (playing havoc with inflation) as demand from energy-hungry China has weakened while supply from the US has expanded.  Oil is also plagued by a further similarity to drugs in that the suppliers of oil tend to be some ugly characters such as Russia, Iran, and Venezuela (as well as some nice ones such as Canada and Norway).  But the kingpin of the oil market is Saudi Arabia due to the size of its reserves of oil and its willingness to adjust its output to market conditions.

Saudi Arabia is the top dog of a club called OPEC where some of the major producers of oil banded together to wrestle control of the oil market away from Western energy firms.  OPEC came to prominence in the 1970s when the countries cut oil output as a protest against Israel.  Along with the devastation wrought due to the resulting surge in oil prices, efforts to conserve energy also acted to weaken the need for oil.  Once oil prices returned to normal, OPEC has looked to set its output so as to make the most money while also suppressing incentives to cut back on oil consumption. 

Sticking to the optimal level of output was always going to be tricky when cheating would bring in extra cash.  This meant that not all members of OPEC stuck to their quotas set to manage the supply of oil and it was left to Saudi Arabia to shoulder the burden of larger cuts to production when required.  Saudi Arabia could pull this off due to its revenues from oil being more than enough to fund its government spending.  In contrast, governments in countries such as Venezuela and Iran spend big to support their anti-Western antics which tend to max out the cash from their energy sectors.

Trying to stay on top

The arrangements behind this oil cartel have been bust wide open due to the surge in oil output coming out from the US.  New fracking technology has unlocked previously inaccessible oil reserves and turned the US into a big player in the oil market.  Faced with a choice of cutting its output or suffer falling prices, OPEC chose the latter.  The Saudis, in particular, were not willing to take a hit and lose out in terms of market share.  As Saudi oil is typically cheap to get out of the ground, their hope is that a lower price for oil will drive others out of business.  A drop in oil prices will also scare away any investment in oil fields that would boost output in the future.

It pays for Saudi Arabia to take a long term view of the market seeing that it has so much oil still underground.  An abundance of new sources of oil or new technologies that eliminate the need for oil would take a big chunk out of the value of its underground stash.  Saudi Arabia is in a strong enough position to sacrifice short-term gain to lock in future control over the oil market.  Be thankful that the Saudis want oil to be cheap for now and keep us all addicted but don’t expect it to last (much more than a few years).

Fiscal Policy – Not fighting back

The government has been subdued in the fight to revive the economy despite a change in strategy being long overdue

Considering the trouble we are having fighting back against the aftermath of the financial crisis, it seems strange that the government is not using its full arsenal.  Central banks have come out all guns blazing with their monetary policy but governments have held back from firing up fiscal policy.  Worries about their levels of debt were behind this tepid response by governments but such concerns have eased while the economic recovery struggles to pick up momentum.  Why should be suffer further losses while saving our ammunition?

Hit and miss

Central banks launched themselves into the front line while governments remained in the background due to self-inflicted wounds.  Monetary policy had been enough to deal with past recessions and resulted in a belief that central banks were infallible in this regard.  High levels of debt along with a banking sector under attack meant that low interest rates had little effect and quantitative easing was not much better.  Along with not making much headway, monetary policy also caused considerable collateral damage in the form of financial instability.  This was a sign that central banks were being asked to do too much in the face of a once-in-a generation economic slump.

Most governments were happy to sit back having mismanaged their finances resulting in high levels of government debt prior to the crisis.  The Eurozone crisis prompted governments to further retreat amid worries that investors would shun any government with too much debt.  This pushed governments off on a trajectory of austerity which continued even though fears about government debt abated within several months.  The economic recovery has been muted due to weak demand with companies not willing to invest despite low interest rates and consumers hurting due to large debts and stagnating wages.

Time for a new battle plan

Monetary policy was always likely to struggle to make much ground while there is little impetus to spend, let alone borrow.  This shortfall could be overcome by the government which fixes problems, from crime to pollution, that are caused by others.  Keeping the economy ticking over when spending would otherwise be weak would prevent more damage being done to the economy.  Otherwise, the economy becomes less productive as firms stop investing in new technologies and the skills of people out of work deteriorate.

It seems an even more obvious solution at a time when there is so much that the government could spend its money on such as improving Internet access, accelerating the uptake of renewable energy, and updating transport infrastructure.  The low interest rates provide the perfect opportunity to invest for the future especially when companies are not up to doing so.  Investment projects could be set up to boost output in the economy for a few years until spending from other picks up the slack. 

A winning strategy

Despite the still faltering economic recovery, governments loathe changing direction and austerity continues to reign in Europe and the UK (as well as US to a lesser extent).  Moves to fix government finances made sense following the jump in interest rates on government debt in the Eurozone but this turmoil in the financial markets has long passed.  Weak overall spending and the threat of deflation setting in is now the dominant problem facing many countries. 

Higher spending by the government that lifted the productivity of the economy could be funded through borrowing at low interest rates and repaid through higher taxes that a more efficient economy would generate.  This is the opposite of what is happening in the UK where austerity is hurting the economy and efforts to reduce the government deficit are being thwarted due to a fall in money from taxes. 

There is still time for a change of strategy to have an impact in the fight for an economy recovery that improves the lives of us all.  Even if it is too late, investing for the future when interest rates are at record lows seems like a no brainer.  A change is due as this is a battle that no one wants to lose.

Inflation – Hard to ignore again

Low inflation is a nuisance for central banks looking to increase interest rates but they would be wrong to dismiss it

Family get-togethers over Christmas often involve naughty children but it is inflation that is making trouble for central banks.  Inflation unexpectedly shot up in the aftermath of the global financial crisis but is now surprisingly falling despite a burgeoning economic recovery.  Central banks ignored the jump in inflation in 2011 and are now stuck figuring out how to deal with persistently low inflation.  The antics of inflation will be difficult to disregard a second time around considering that the causes for static prices are not all external.

Inflation acting up

The level of inflation is used as a measure to check whether all is well with the economy.  There should neither be too much inflation (suggesting an overheating economy) nor too little (which is a sign of weak overall demand).  With countries increasing sourcing goods from overseas, prices levels in any country can be influenced by prices of commodities on global markets.  This can push inflation in a different direction to the particular circumstances of any economy.

The best recent example of this was a plague of high inflation in 2011 when the economies of many countries were still in the doldrums.  The Chinese economy was still humming along despite financial turmoil elsewhere and China continued to buy up commodities on the global markets.  The result higher prices were most prominent in the UK where inflation topped five percent in 2011.  This bout of inflation was not just a brief spike with prices rising by more than four percent for over a year.  Despite inflation being well above its target of two percent, the Bank of England maintained its loose monetary policy to support the weak economy.  The argument behind this was that the inflation was temporary and not related to the underlying economy. 

Behaving badly again

Inflation is currently misbehaving in a different way and is causing concern due to being too low.  Prices are not rising by much due to lower commodity prices with the spurt of growth in emerging countries having run its course.  While this is a positive for consumers who benefit from a boost in spending power, low inflation is a source of anxiety for central banks.  The Federal Reserve and the Bank of England are getting set to increase interest rates to more normal levels.  Even the prospect of the economic recovery gaining further momentum would not provide central banks with enough of a reason for higher interest rates when inflation is around one percent. 

This irritation is not likely to go away anytime soon if the high inflation in 2011 is any guide.  Inflation is likely to slip even lower in 2015 as the effects of the plunging price for oil feeds through into the economy.  On top of this, swings in commodity prices tend to last for a few years so that inflation is unlikely to pick up for the next couple of years.  This would suggest that inflation will be below target for 2015 and 2016 which is the two-year time frame that central banks look at when deciding interest rates. 

Ignoring inflation would be naughty

Low inflation should imply low interest rates but central banks could choose to ignore this and raise interest rates away.  This is because the same argument as in 2011 could be applied – disregarding trends in inflation that are attributed to outside sources.  It is a convenient strategy for central banks worried about the economic recovery triggering a jump in inflation due to the potential for wages to rise as unemployment falls.  Such an outcome does seem optimistic considering that wages are not budging by much even as the economy picks up steam.

A further problem with turning a blind eye to inflation is that it is tough to gauge what the inflation level would be without the fall in commodity prices.  It is not as if consumers have money to spurge having been stuck with stagnating wages and considerable debts from the pre-financial crisis spend-up.  Sluggish prices are harder to dismiss considering that low inflation is also caused by weak domestic demand.  With inflation likely to continue to play up for a while yet, central banks will need to be patient and bide their time before raising interest rates or else it will be the central banks that may be the ones getting into trouble.

Bargain Low Interest Rates to Continue in 2015

Borrowing is likely to stay cheap in 2015 as a drop in inflation puts pay to talk of higher interest rates

Christmas is usually followed by a rush off to the sales but borrowers need not hurry as cut-price loans are likely to remain for most, if not all, of 2015.  Acting like retailers with surplus stock to sell after Christmas, central banks slashed interest rates after the global financial crisis.  Six years later, there are growing calls for this to be reversed in countries such as the US and the UK due to as a strengthening economic recovery backed by more people finding jobs.  Yet, plans for higher interest rates have been way laid with falling inflation suggesting that all is not well with the economy.  With unemployment and inflation likely to fall further in 2015, there seems to be few reasons for any changes to be made to interest rates over the next 12 months.

Shopping around

The Federal Reserve and the Bank of England are in the midst of a dilemma – like a shopper not sure of where to head first to snap up some bargains after Christmas.  Unemployment data suggests that the economic recovery is becoming more entrenched with the proportion of Americans and Brits without jobs now below 6%.  Yet, despite more workers being hired, companies are still holding back from investing to expand output.  Aggregate demand is also suffering due to cuts to government spending resulting in an economic recovery that is still patchy.

If the stuttering economy is giving central banks reason to worry, it is inflation that is the real sticking point getting in the way of higher interest rates.  The extent at which prices are rising (or falling) has been adopted by central banks as a gauge for the health of the economy.  It is thus a point of frustration that inflation is heading downward as other signs, such as lower unemployment, suggest that the economy is picking up.  These mixed signals from the economy mean that Federal Reserve and the Bank of England are caught in two minds in terms of what do to with interest rates.

Best to stay put

Things are not likely to get any easier for central banks considering that the trends in unemployment and inflation are not likely to change any time soon.  With companies not yet willing to spend big on new equipment, it makes sense to employ more workers (who are relatively cheap) to get things done.  Lower commodity prices is the main cause behind falling inflation and a rebound in commodity markets is not likely as shifts in demand and supply of commodities taking years to change.  Neither are consumers in any mood for higher prices considering that wages have not kept up with inflation over the past few years. 

All this suggests that 2015 will be more of the same and interest rates are also unlikely to change.  Some will argue that interest rates need to rise to give central banks leeway to act in case of other threats to the economy.  Others will claim that the economic recovery means that inflation will be just around the corner and central banks need to pre-empt any jumps in prices.  But these are risky strategies considering that a bit of inflation in the future will do less damage to the economy than a premature hike in interest rates. 

A still fragile recovery means that, like any shopper out after Christmas, the economy could also do with a bargain (in the form of low interest rates).

Let's not (Christmas) party like it's 2007

The heady days leading to the global financial crisis were never meant to last so there is no point in expecting to turn back the clock

It is the time for great merriment but Christmas office parties across London still leave many wishfully thinking back to the good old days.  Despite much talk of an economic recovery, it can still be tough to find reasons to be cheerful about and less cash being spent by companies on seasonal festivities is another reminder of this.  But we should not be asking Santa for a return to the days of lavish Christmas dos with workmates and big entertainment budgets (if they ever did exist).  The economy of old which allowed such excesses could only bring in a few good years of partying before the good times inevitably turned bad. 

Living the high life on borrowed time

The boom times that were still in swing a decade ago seem a long way off.  It was a time when all seemed good with the economy and nothing much would go wrong.  This spirit seemed best exemplified by the exuberance among economists who (mistakenly) thought that their ideas had conquered the ups and downs of the economy.  The great evil of past decades, inflation, had been kept in check and the recession following the dotcom bust passed without much strife. 

This new stable economic environment seemed to benefit the finance sector most of all.  Banks came up with new ways of making lots of money with bankers themselves reaping much of the rewards.  Even some among the rest of us got to enjoy a sprinkling of the good life with many companies splashing out the odd treat on their workers (especially around Christmas time) even if this generosity was not reflected in wages.

The enthusiasm was infectious and we all wanted our share.  The result was loads of new debt as our spending reflected these new aspirations even if our income was lagging behind.  Even the governments in many countries spent beyond their means and got their finances in a mess.  Since inflation remained subdued despite the elevated spending, interest rates never rose by much enabling the debt levels to soar beyond what was prudent.  And banks were only too happy to lend since new financial products, such as mortgage-backed securities, allowed them to pass on increasingly dubious loans to others.

Not banking on trouble

This was one party that could not go on for ever.  An increase in debt is good for spurring the economy along but this can only go so far until lending becomes more reckless.  The final straw was mortgage lending in the United States where new rules encouraged housing loans to individuals who were never likely to be able to afford repayments (so-called sub-prime mortgages).  The many who lost their jobs (including Your Neighbourhood Economist) and even their homes in the ensuing financial turmoil ended up with little to show from the good years.  Yet, on the other hand, the exorbitant pay packets received by many bank employees left them sitting pretty whatever was to happen.

We should all feel repentant like Christmas drinks where we get carried away and make a fool of ourselves.  One way of stopping ourselves getting into trouble is to rein in the banking sector.  This does not mean the equivalent of alcohol-free Christmas festivities but just stricter rules to make sure that things don’t get out of hand.   The perils of too much debt should have always been obvious but it is inability of the banking sector and the financial markets to suitably regulate lending that is perhaps the biggest lesson that we need to address.

Time to sober up

Any economic growth does not count for much if we have to give back most of the gains after a few good years.  Yet, giving up on this easy way of making ourselves richer also means that we cannot expect the economy to grow like in the past.  It will take hard work and sensible policies rather than financial wizardry to make genuine improvements in our standard of living.  The trade-off being that we can create a world where our jobs and what we make for ourselves is more secure.

The government could have a big role to play in this especially since companies are not investing as much as they used to.  Greater spending on infrastructure and education as well as lower medical costs would be a good start to help increase productivity (and wages) as well as going some way to propping up spending.  The solution sounds simple enough but politics is never easy especially at a time when the easy option is for politicians to offer up false promises.  It is voters most of all that need to be realistic in terms of what is achievable.  No party is worth a hangover on the scale of the global financial crisis.

Getting more from Monetary Policy

Japan has made lots of mistakes and it is time that Europe learnt from them

We can all learn from watching others make mistakes and the experiences of Japan continue to provide valuable lessons.  Japan has stumbled into another recession following a hike in taxes to fix the government’s finances.  The other key policy doing the rounds in Japan, using expansive monetary policy to put an end to deflation, also seems to be flagging.  It is Europe that has most to learn from the unfortunate trials and tribulations in Japan since many of the same problems are shared by both.  What should Europe do to avoid making the same mistakes and decades of stagnation?

Following in the same footsteps

Japan has been hit first with many of the same problems that are increasingly expected to plague Europe and other Western countries.  For starters, new-borns in Japan are increasingly outnumbered by pensioners which have pushed the population into decline in recent years with an aversion to immigration further accentuating this trend.  This translates to fewer workers to provide the taxes needed for the rising costs involved with taking care of old people.  The situation is made worse by government debt which is already more than double GDP due to years of inefficient government spending.

Japanese consumer prices have been falling for years as a reflection of the weak demand.  There are few opportunities to profit from in Japan due to the falling population and even Japanese firms are looking elsewhere to invest.  Weak global demand means that even one of Japan’s strengths, exporting, offers only limited respite even with a weaker yen due to its loose monetary policy.  All of this means that the Japanese economy itself is like a tottery pensioner - even a small rise of sales tax from 5% to 8% was enough to push Japan back into recession.  This does not bode well for Europe where the economy is sputtering along due to many of the same problems while the governments there are also trying to get a grip on their finances.

Trying different directions

Having been stuck with these problems for longer, policy makers in Japan are increasingly more aggressive in coming up with solutions.  The current prime minister, Shinzo Abe, launched a raft of new measures dominated by a massive expansion of the money supply to target falling prices.  This new aggressive approach to monetary policy was facilitated by the government installing a new governor to the Bank of Japan who was willing to give up its independence and toe the line.

This is the complete opposite to the situation in Europe.  The head of the European Central Bank is eager to do more with monetary policy but is prevented from doing so by the German government.  German politicians want to reforms to come first due to an expectation that their neighbours will not implement the necessary policies. Whereas, in Japan, the aim was to use the loose monetary policy to help build momentum that will allow the government to implement reforms. 

Yet, the Abe government has been disappointing in its reform efforts (as Your Neighbourhood Economist predicted) and this will bolster the stance taken by Germany.  With the Bank of Japan finding it tough to generate sufficient inflation despite a rapidly expanding money supply through quantitative easing, many will question about the reasons behind using a similar policy in Europe.  Central banks are struggling to have much influence in a world that is already awash with surplus cash.  

Time for Plan C

It seems like the key lesson from Japan is that monetary policy cannot do much by itself.  Japan still languishes despite the best efforts of the central bank as the Abe government shirks the much needed measures to free up the economy.  Yet, bullying countries in Europe to reform by withholding the full extent of monetary policy is not helpful either.  A grand bargain marrying reforms with looser monetary policy, as was supposed to be the case in Japan, seems the obvious solution. 

This takes more political willpower when the many countries of Europe are involved but is not something beyond the realms of possibility.  Ironically, the chances for such a deal may be improving as deflation becomes more of a concerns and the economic stagnation in Europe also spreads to Germany.  Japan has already paid the price for years of economic mismanagement – there is no reason for Europe to do the same.