The European Union - Worth fighting for!

The recent announcement that the European Union (EU) would be awarded the Nobel Peace Prize may seem strange – the Prize typically goes to an individual whereas the EU is an organization which governs relationships between countries in Europe.  And why now?  The EU has done nothing of late that was worthy of the Prize and is on the verge of irrelevance due to political infighting.  But the Norwegians who dish out the Nobel Prizes are not shy of making a statement and Your Neighbourhood Economist supports their stance which can be seen as a timely reminder of what the EU has achieved and what the governing body of Europe still has to offer.

The reason behind why the EU has been awarded the Nobel Prize is its role in promoting peace and reconciliation.  The origins of the EU stem from the aftermath of WWII when leaders in Europe looked to increase the ties that bind the former foes of Europe as a counterweight against the feverish nationalism that brought about the War.  The political impetus behind the growing notion of community in Europe also took on economic ramifications with the European common market.  The EU itself was formed in 1993 out of the precursor organizations and this was followed by the launch of the euro in 2002.  The size of the membership has increased from an original six back in the first agreements in 1951 to 27 with Romania and Bulgaria as the last to join and Croatia set to join in July 2013.  The Eurozone countries make up a smaller subset of these countries and currently number 17.

Much has been made of the cooperation between France and Germany along with the United Kingdom as one of the profound benefits stemming from the EU.  Yet, it is unclear the extent to which the EU has contributed in getting the major powers of Europe to work together rather than fight among themselves.  Your Neighbourhood Economist would argue that it is the outward spread of democracy and the rule of law and order to the growing number of countries which have joined the EU which has provided a greater bounty. 

To be accepted into the EU, candidate countries must meet certain standards which include institutions to guarantee democracy and the protection of human rights as well as a functioning market economy.  Many of the countries have been pushed to apply these rules to a greater extent than would have happened otherwise and this has brought political emancipation and economic prosperity to many that would have otherwise remained side-lined.  Entry into the EU also comes with funds to be spent on infrastructure which helps the newer members to economically integrate to the good of all.

But the expansion of the EU is not over.  The EU has already absorbed a large portion of the old Soviet bloc but there are still countries such as Ukraine which would benefit from the carrot of entry into the EU to reform their political system.  But bigger challenges and benefits wait in the prospect of membership for countries which made up part of the old Yugoslavia in the Balkans.  Many of these countries are still mired in conflict and need the prospects of EU membership for politicians to help the region to shape up.  And then there is Turkey whose entry is controversial in the EU but who would also add a growing economy and a link to the Muslim world.

What should be clear from the above paragraph is that there is still considerable scope for the EU to do good things in the periphery of Europe even disregarding its work elsewhere in the global.  And it is for this reason that Your Neighbourhood Economist believes that the EU is worth fighting for.  Yet it is euro that could be the key.  If the current members are not willing to make the sacrifices to hold together the Eurozone, the outlook for the inclusion of new countries would be bleak.  Furthermore, a squabbling and inward looking Europe would unravel much of the good work from the past sixty years and would signal an end to the principles that earned the EU its well-deserved Nobel Prize as well as its hopes for a role as a dominant player on the world stage – if only the politicians in Europe could look further than their front door steps.  

Tale of two recessions

Imagine (again) the outbreak of a common disease but as a new strain and on a scale not yet seen before.  What makes diagnosis even more difficult is that not only to the symptoms change over time but the disease itself mutates.  What started as a banking crisis in 2008 has morphed into a crisis of confidence in capitalism.  The world is awash with cash as central banks pump money into the economy but firms and banks prefer to hoard their funds than put it to use.  Yet the global financial crisis is not the whole story and is different to the problems that are plaguing the global economy recently.  And that is why Your Neighbourhood Economist is going to tell the tale of two recessions.

The story starts what seems like a long time ago with the boom period before the banking crisis.  Rising house prices and stock markets seemed to be ushering in a new era of prosperity and more and more investors followed the mirage of easy money.  Deregulation in the finance sector allowed for more creative ways to make money which made banks so complicated that the banks themselves did not understand their inner workings and which exacerbated the problem by increasing the amount of debt held by firms and households. 

But with the gains in asset prices based on an increasing amount of debt, all it would take was the slightest bit of trouble and the house of cards would come tumbling down.  The trigger seems to have been excessive mortgage lending in the United States where banks competed to push mortgages to individuals with low credit ratings.  The new creative streak among banks means that this dubious debt could be passed on to others by being turned into bonds which was supposed to spread the risk but also diluted lending standards.  Cracks started to appear in banks across the globe and the arteries of global finance began to clog up as banks did not lend even to each other due to the possibility of problems luring in their complex structures.  The crucial role of lending by banks as the life blood of any economy mean that it was like the global economy suffering a heart attack.

Governments everywhere were jolted into action – billions were thrown at banks to stop them going bust and the US government even had to save the country’s largest car maker.  Countries even banded together for a global fiscal stimulus in 2009.  But governments in Western countries had also been found wanting – politicians too had believed the good times would last and had been reckless in their spending. 

Economies rebounded in 2010 with help from the limited stimulus packages that governments could manage but a bigger boost came from continued growth in emerging markets which had not been caught up in the same hubris as the West.  But the hangover from the previous debt-fuelled party still lingered as excessive amounts of borrowing prompted firms to go bust and consumers to be weighed down by mortgages worth more than their homes.  And the situation was made worse as bankers were targeted as the bad guys of the crisis and the banking sector were hit with a battery of new regulation which further restricted its ability to lend (refer to Another reason not to bank on Europe). 

The weak recovery has been like an infection which has sapped the willingness of firms to invest and to take on new workers.  Investment in particular is typically the driving force of economic growth (for more detail on investment in the economy - Investment in China) but companies need to be confident of a return on their investment.  Problems such as the sovereign debt crisis in Europe and the lack of a plan to deal with growing government debt in the US have added to the debilitating degree of uncertainty which is plaguing firms.  The lack of confidence in future growth is creating the circumstance for a downward spiral where hoarding of cash by firms further drags on growth and brings down confidence.

Governments are also limited in their ability to act by the overload of debt.  Austerity seemed to offer up a cure through easing concerns in the bond market but cuts to government spending seem to be more like a treatment of leeches – a bit out-of-date and likely to do more harm than good.  But the belief in austerity still holds sway despite the IMF suggesting it may not be the best course of action (see Time for Plan B?).  Without a clear consensus on the need for an alternative, decisive action such as another global stimulus package looks unlikely.  No happy ending is likely any time soon.

Time for Plan B?

Imagine the outbreak of a common disease but as a new strain and on a scale not yet seen before.  Symptoms vary depending on the patient which makes it difficult for even the best doctors across the world who are unsure of the cure.  The patients are treated in different ways in different countries but nothing seems to be working.  There does however seem to be a consensus that one form of treatment is causing unnecessary harm to the patients.  This could be an analogy for the global economy with austerity being the treatment that has fallen out of favour.  But, while the appetite for more painful government cuts may be on the wane among some policy makers, other policy options are limited.

The biggest sign of the shift in views was the head of the IMF, Christine Lagarde, making a call for austerity measures to be eased if growth continues to remain weak.  The IMF is an international body which has funds to help bail countries out if their governments cannot get access to cash from elsewhere.  The change in stance by the IMF has all the more meaning because the IMF itself has a reputation for imposing harsh measures on countries which require help such as in the Asian crisis in 1997. 

The change in opinion follows new research which brought into question the effects of austerity measures.  It was previously thought that austerity through cuts to government spending (or higher taxes) would reduce GDP by less than the actual measures themselves but the IMF research suggests that this may be too optimistic and such policies may reduce GDP by more than the amount the government benefits from austerity.  This could create a downward spiral in the economy - lower government spending resulting in a bigger fall in GDP which in turns means that further government cuts are necessary to reach targets for budget deficits and so on. 

The most interesting case with regard to austerity is the United Kingdom where the government has adopted austerity policies of their own volition while other countries in the midst of government spending cuts have been forced into such measures due to high interest rates on their government debt.  The coalition government in the UK headed by the Conservative party has advocated the need to reign in government spending using the debt crisis in places like Greece and Spain as examples of what could happen otherwise and emphasizing the need to maintain a good credit rating as justification for cuts.  Yet, the interest rate on government debt in the UK is near a record low which means that there is less of a need for urgency in dealing with the government budget deficit which is expected to be 5.5% of GDP in 2012 with government debt at 89% of GDP.

The rightward bent of the Conservatives means that the party has an ideological inclination toward wanting to reduce the size of government.  The debt crisis in Europe has provided a useful tool for the Conservatives to convince voters that this is the right course of action.  But Your Neighbourhood Economist would argue that fervour with regard to austerity in the UK is based more on right wing ideology of the government than on economic practicalities.  And the repercussions of austerity on the economy have become evident in the change in stance by the IMF and a further 10 billion pounds in cuts which were announced by the Conservatives in early October. 

The worst may not yet be over with the IMF becoming more pessimistic with regard to the outlook for the UK economy with a 0.4% fall in GDP predicted for 2012 compared to a 0.2% rise forecast in April.  Growth of 1.1% is predicted for 2013 which is lower than the 1.4% estimate in April.  A further deterioration in the economic outlook for the UK is a real possibility if austerity measures continue to do more hindrance than help. 

Yet, while less austerity would help to ease the burden on many, it is more depressing to consider that a change in tact by the UK government may have only a minimal effect.  The malaise of the UK economy is due to not only the government cuts but also a sluggish global economy and a high degree of uncertainty which limits the appetites of companies to invest.  So the effects of measures implemented in individual countries may be limited unless there is a certain degree of coordination between governments in the larger economies.  But this seemly unlikely – more on that in my next posting (but mostly bad news sorry).

The end of the end of the world

For manufacturing firms in developed countries such as the United States and the United Kingdom, the rise of China as a manufacturing base was seen as the end of the world.  With a seemingly endless supply of low-wage and diligent Chinese workers, manufactures elsewhere have been forced out of business and those that survived retreated to more high-tech products which were still beyond the reach of Chinese firms.  But the end is no longer nigh.  The bountiful supply of cheap labour has dried up and wages in China are rising along with demands for better working conditions.  Not only does this suggest the end of Armageddon for manufactures in developed countries but may also open up new business opportunities.

The industrialization of any economy whether it be Britain during the industrial revolution in the eighteenth century or modern day China involves the mass migration of workers from the agricultural sector into manufacturing.  The increase in productivity (the ability for workers to produce more in the same amount of time) generates a surge in wealth which typically first goes mostly to the owners of factories employing the cheap labour.  But there comes a point in time when the supply of workers from the countryside starts to fall off and firms have to compete more to keep workers which results in wages starting to rise.  This is crucial for the formation of a consumer society as workers gain spare cash to spend.  This is where China is positioned at the moment and it is a trend that is likely to pick up in the future. 

Along with the typical momentum involved with industrialization, demography is another factor that is adding to the upward pressure on wages.  Population growth is slow due to China’s one-child policy which limits the available pool of labour.  With most families only having the one child, parents are investing more in the education of their single progeny and this combined with the bright prospects for the Chinese economy mean that younger workers are aspiring to more than menial factory jobs.  The trade-off is that higher wages are required to attract and maintain employees.  

Rising wages are a boon for China as its new-found wealth begins to be dispersed to its citizens to a greater degree.  And higher pay for Chinese workers also offers some respite for competing firms - both in other low-wage countries and in developed economies.  Wages are now lower in other countries in Asia such as Vietnam and Cambodia.  This will attract factories to move there and help spread the benefits of industrialization. 

But a mass exodus from China is not expected.  China provides not only cheap labour but excellent transport links and suppliers of various components required for manufacturing which have been developed as China has become a key cog in the global supply chain.  Instead, China is expected to increasing replace workers with machines as pay rates increase further.  This will also be accompanied with a shift toward more high-tech products.  But this opens up the chance for big pay-offs for Western firms that can supply the machinery to Chinese factories as well as companies that can tap into the growing consumer market as employees get paid more. 

Doing business in China will still continue to present difficulties.  The Chinese government is doing its best to control the economy during this unprecedented surge in growth (for details, see Why China needs a slowdown) but that is like trying to steer the proverbial bull through a china shop.  The politics generated by a rise of China as a new power can also be problematic such as in the case of Japanese firms struggling with a nationalistic backlash over issues dating from over 60 years ago.  The growing pains involved in the coming of age of a country of 1.3 billion were never going to be easy but changes in the economy in China are offering up a new wealth of opportunities.

Where is all the money going?

Central banks in the world’s largest economies, the European Central Bank and the Federal Reserve in the United States, have recently announced plans for creating an unlimited amount of money.  A third central bank, the Bank of Japan, also has announced its intent to pump even more cash into the Japanese economy.  The funds from the central banks are used to buy bonds with the goal of pushing down interest rates (for details – see The Demand and Supply of Money).  The money received by those selling the bonds has to go somewhere.  But it is not always clear where the money will go.  Image pumping more and more jam into a donut – some of the jam will go where it is supposed to but the jam will at some point spurt out in unintended directions and make a bit of a mess.

The buying of bonds by the central banks will increase the prices of bonds and decrease the interest rates which mean that bonds will be a less attractive investment.  The shift of funds away from the bonds being brought by the central banks to other sectors of the economy is seen as an added benefit along with the lower interest rates.  It will help to reduce the borrowing costs of companies which would make them more likely to invest.  But the anaemic state of the economy suggests that such investment is still muted. 

Money has also moved from the bond market into shares.  This also has an upside due to what is known as the wealth effect – consumers will spend more when they perceive themselves to be wealthier (when their shares are worth more).  But any gains in the stock market due to this can only be temporary as the underlying value of the shares which depends on the profitability of the companies can only improve along with the economy.  This had not stopped the stock markets reacting vigorously to the perceived intentions of the central banks.

Considering the global nature of finance, the money does not only stay within the same country but spans the globe looking for the highest return.  However, the bond buying policies add to the colossal amount of funds that can potentially cause havoc in the economies which are their final destinations.  A flood of money surging into a country will increase the value of its currency while putting downward pressure on the currency in the country where the bond buying is taking place.  This dents the exports of the former while boosting the exports of the latter and the bond buying has been labelled as a protectionist policy at a time when sluggish economies make most countries desperate to boost exports.

A previous victim has been Brazil where the value of its currency, the real, climbed to above R$1.6 against the US dollar in July 2011 after having dropped briefly to below R$2.4 against the US dollar at the end of 2008.  The volume of its exports has suffered as a result and the Brazilian economy has slowed.  A strong currency is also a problem in Japan where the central bank followed the lead of central banks in Europe and the United States with its own bond buying plans with one eye on its currency.  The Japanese yen is still close to its record high of around Y76 against the US dollar which was reached in October 2011. 

In the old economic textbooks, the value of currencies would be dictated by the relative competitiveness of different economies.  More competitive economies would be able to export more and the funds drawn in from overseas as a result would increase the value of the currency.  The opposite would hold true for less competitive economies and the system of global trade would trend toward equilibrium as a higher currency would make more competitive economies less so and vice versa.  However, the flow of money across borders now overwhelms the flow of goods and it is the cash that is sloshing around in the global financial system which dictates movements in the currency markets. 

These funds are often completely separated from the reality of the underlying economy and the same forces that push the overall system to equilibrium are not at work as would be the case when trade in goods dominates.  This combined with the ability for cash to be moved almost instantaneously has profound and often chaotic effects on the global economy and our understanding of the economy still lags behind these new circumstances – a humbling reality for any economist.

The Demand and Supply of Money

Economists love the idea of demand and supply.  It is one of the basic concepts we use to describe almost everything.  Yet, thinking about demand and supply with regard to money may seem strange.  Money is something that everyone wants more of and there is never enough of the stuff.  But with central banks across the globe printing more money but banks and companies being cautious about using the bundles of money they have, there is plenty of it around but no one wants to spend it.

The supply of money has been on the rise due to the policies of quantitative easing which central banks have used to try to revive sluggish economies.  The central banks have been creating money from nothing to buy bonds in an attempt to push down interest rates so as to prompt firms and households to borrow more. 

Typically, an increase in the money supply will result in inflation as more money chasing the same number of goods pushes up prices.  But much of the extra cash is being hoarded by banks and companies who are too scared to put it to use.  On the other hand, consumers are being squeezed with downward pressure on wages for those that manage to hold onto their jobs.  Any extra money for households is typically being used to pay off debt after a borrowing binge in the build up to the global financial crisis. 

Central banks have tried to boost the demand for money by lowering interest rates.  It may sound like a bizarre concept but the interest rate is the price of money as it is the cost involved in obtaining cash that is not yours.  The interest rate is determined by the demand and supply for money in a market environment.  That is, an abundance of savings (excess supply) will push down the interest rate while lots of borrowing (excess demand) will have the opposite effect.  In practice, interest rates are also influenced by central banks that set the interest rate, which acts as a base rate for the interest rates on different types of debt, to keep inflation within a target range – typically inflation of around 2.0%. 

The global financial crisis in 2008 and 2009 can be seen as the result of interest rates deviating from what would have been appropriate.  There were massive inflows of savings from China in the banking system in the United States as the Chinese government built up foreign currency reserves which were in US dollars and invested in US government bonds.  This kept interest rates artificially low and resulted in increasing levels of debt as companies, households, and even the government took advantage of cheap borrowing.  Fingers have also been pointed at the US central bank, the Federal Reserve, for not acting faster to clamp down on the excessive borrowing by increasing the interest rate.  But it proved difficult for even the Federal Reserve to end the debt fuelled party – the results of which have only become obvious with hindsight. 

But now interest rates cannot be low enough.  The central banks have set the interest rate close to zero but this is still too high to prompt companies to borrow considering that it is unclear whether investments will generate profits given the uncertainty that clouds the global economy.  Central banks have tried printing more money through quantitative easing which is another way of pushing down interest rates which firms actually pay when borrowing.  While this new cash has helped somewhat in this regard, much of the money has gone elsewhere – some to stocks which has helped to boost the share market but some of the funds have headed overseas with undesirable effects (but more on this in my next posting).

The nitty gritty of economic is not for everyone, and while it may not be that interesting (Your Neighbourhood Economist cannot work miracles), hopefully the workings of the economy will make a little bit more sense (and please comment or email if you would like to know more).

Why China needs a slowdown

The rise of China will be the most momentous shift in economic power of a generation and it is only a matter of time until China will be the largest economy in the world.  For a long time, the concerns regarding China have been over its relentless rise and how its insatiable appetite for raw materials has pushed up commodity prices.  But the world economy has become dependent on China as an engine of growth as economies in Europe and elsewhere stumble.  So the worry now is not about China expanding too fast but China not expanding fast enough as sluggish global demand begins to hurt China’s economy and the Chinese government is not acting to maintain the previous hectic rate of economic growth.

As a capitalist economy with a communist government, China has the best of both worlds.  Rampant entrepreneurism, which Your Neighbourhood Economist has always associated with Chinese people (positive racial stereotyping?), has resulted in wealth creation on a massive scale and dragged millions out of poverty.  Yet, the communist government maintains a level of control over the economy to help the country through a period of unprecedented growth.  As such, the government stepped in when the global financial crisis hit in 2008 with a colossal economic stimulus worth 16% of GDP over two years.  It may seem a strange notion for a communist government to be propping up a capitalist economy but it is the best way for the communists to provide higher income for its citizens and maintain their grip on power.  And a strong central government helps to keep much of the messy politics out of the way (for an example of politics getting in the way - One step forward and two steps backwards)

Yet, as the global economy weakens, China itself is in the midst of a significant economic slowdown but the government has held back from throwing its full weight behind another economic rescue mission.  The Chinese government has the capacity for further action as it does not have the debt of governments in other large economies.  Punters in the media have suggested that it is the change of the top government posts that has resulted in the leaders in China being distracted.  Others have pointed to the possibility that more of a stimulus would not have any further effect.  But Your Neighbourhood Economist would argue that the Chinese government is smarter than that and still has the capacity to generate growth in the economy.

It is not that the Chinese economy wouldn't get a boost from more stimulus but that such measures would create more problems than it would solve.  The economy in China is like a weightlifter on steroids – more steroids would typically help to lift heavier weights but too much can cause severe damage.  Investment is the steroids that have been driving the Chinese economy.  Investment is typically what fuels any economic expansion.  Companies build factories and shops if there are products to make and sell but this will only happen if consumers have enough money to buy the goods.  So investment surges when an economy is booming but companies will stop investing if times turn bad.

Companies in China not only provide goods and services for the 1 billion people that live in China but also export products for retailers across the globe.  As such, investment in China has reached unprecedented levels - around 50% of GDP compared to around 15% in the United States.   Much of the stimulus package in 2008 went toward spending on infrastructure and was combined with lower interest rates and increased lending by state-owned banks.  A bit more of the same has been tried in 2012 but without the same fervour. 

The leaders in China could try more of the same but a further boost to investment may result in one shot of steroids too many.  That is not to say that it would not have an effect but rather than the effect would be to exacerbate imbalances in the Chinese economy.  Investment that outpaces growth in the economy risks not only being a waste of money but distorting the development of the economy.  Excessive spending to build factories which end up producing goods that no one wants will result in bad debts.  Spending on infrastructure is another possible form of investing but this also needs to expand along with a growing economy so as to go to areas where it is actually required rather than roads to nowhere.

Considering that global banking system got in trouble following a period of debt fuelled expansion, Your Neighbourhood Economist hopes that lessons have been learnt and that the Chinese economy is not pushed to expand too rapidly.  But only time will tell – stay posted.

One step forward and two steps backwards?

Economics can often provide solutions to problems while the study of politics can be about why the solutions are not always easy to implement.  This could be seen as a bias interpretation but the changes in the fate of Spain over the past month could possibility be an example.

The interest rates on Spanish government debt tumbled at the beginning of September following the announcement of plans by the European Central Bank (ECB) to buy an unlimited amount of bonds of indebted countries in Europe (refer to “Whatever it takes”).  This should have been the beginning of the end of the debt crisis in Europe.  But the mood turned sour as Spain once again hit the front pages of the papers as politicians in Madrid and in the region of Catalonia positioned themselves amidst the changing political landscape.  As a result, the Spanish government is having to fight to stay in the Eurozone as well as trying to hold the country together. 

The ECB made a bold stand in its willingness to stand behind countries like Spain who suffer from excessively high interest rates as a result of concerns over a possible breakup of the Eurozone.  If the ECB makes good on its pledge to do “whatever it takes” to save the euro, investors have less to worry about and renewed buying of Spanish bonds should help bring down the interest rates on the government debt.  But in practice, the best laid plans do not always work out.

The backing of the ECB required countries to submit to supervision from the EU and the IMF which makes the help offered by the ECB less attractive.  Losing control of their own affairs is a fate that those in power do not welcome and the Spanish government is holding off on asking for help from the ECB.  But the daunting nature of the economic problems in Spain suggests that help from outside is inevitable.  Real GDP in Spain is expected to shrink by 1.5% in 2012 and 0.7% in 2013 according to the IMF while the government debt continues to increase.  The Spanish government is expecting to borrow 207.2 billion euros in 2013 which is more than its plans for 186 billion euros in new debt in 2012.  An examination of Spanish banks this week suggests that a further 60 billion euros are needed to stabilize the banking sector and some of these funds may have to come from the government.

However, help from the ECB may be on the way as the Spanish government is making moves in the right direction and is in the process of implementing many of the policies that would be required of it if the country needed assistance from the ECB.  This may be crucial as the Spanish prime minister Mariano Rajoy has remained firm in his stance that he will not accept conditions being imposed from outside.  Yet, if the prescribed policies had already been put in place, the outside help need not require any further harsh measures.  But the policies of austerity have resulted in protests in Spain so the government is treading a fine line and the possibility of turmoil is never far away but at least efforts towards a solution are in the process of being made. 

The political difficulties of cutting government spending and raising taxes would be more than enough to deal with.  But the tough measures taken by the government have triggered another crisis – the perennial issue of secession in Spain.  Catalonia which is centred on Barcelona is both the wealthiest region in Spain as well as the region which has the most debt.  Its prosperity means that Catalonia provides more tax revenue to the central government in Madrid than it receives in government spending.  But, at the same time, the regional government in Catalonia has had to ask Madrid for just over 5 billion euros as investors will no longer lend the region any money.  This contraction has been jumped on by politicians in Catalonia who want to push for independence for the region and a snap election for the regional government in Catalonia has been called for November which is being seen as a proxy referendum on the possibility of secession.   A crisis is always a good opportunity for politicians to push for change even if it adds to the mayhem.

But such is politics.  Politicians must keep voters happy to stay in their jobs while others will take their opportunity to grab for power.  But this is not always conducive to action.  It is no coincidence that the ECB has been able to make bold policy shifts while governments in the various countries in Europe (including Germany) have been squabbling on the sidelines.  The messy politics in democracies can get in the way of doing what is required.  If only economists ruled the world!