More fighting talk

Along with the large amounts borrowed by governments, the younger generation are also set to be saddled with more debt which is not of their own making.

Talks of battles and fighting in the previous blog got Your Neighbourhood Economist thinking about a struggle so epic that it makes the currency wars seem like kids throwing toys in the playground (or, more literally, central bankers throwing money at the economy).  This fight pits a battle-hardened and organised army against a smaller force that increasingly has its back up against the wall.  So who is fighting over what?  It is a battle between old and young over pensions.  The money that government pay the elderly in their retirement adds a further weight to the mountain of debt already depressing the global economy but pensioners form a potent force in politics and loathe to give up what had been promised to them in the past.  Yet pensions that would have been tough to pay even in good times may be set to bankrupt a younger generation.

Pensions have traditionally been based on pay-as-you-go schemes where payments for pensioners come from the taxes paid by current workers.  This was an arrangement that was acceptable to workers to begin with because it was assumed that they would also be eligible for pensions after retirement.  This system relied on a growing population where the work force was expanding so that the burden of pensions was never too great.  This social contract has broken down due to the demographic accident of the baby boomers.  The surge in births following the end of the Second World War resulted in a bulge in the population due to the so-called baby boomers having fewer babies than previous generations.  The drop in child birth means that there will be fewer people in jobs paying taxes to fund the retirement of their parents’ generation.  Not only is the number of pensioners growing relative to the working age population, but the costs of pensions themselves are increasing as people live for longer.  The prolonged lives of the elderly will add bigger medical bills as well.  So something has to give – high taxes and less spending in other areas or a reduction in pay outs to the elderly.

As one would imagine, the baby boomers are not keen to give up what has been promised to them.  They believed that they paid their fair share of taxes, part of which funded the pensions of their parents’ generation, and now expect to receive the same treatment as they head into retirement.  Not only do baby boomers outnumber the younger generation but they also form a political force to be reckoned with.  The older generation have much higher voting turnout and are more politically active after experiencing dramatic changes during the post war years.  The young, on the other hand, are typically seen as being disillusioned with politics and can’t be bothered voting.

Politicians are aware of the potential shortfall in government finances with pension costs expected to balloon in the coming decades.  Baby boomers have added to the problem after years of voting for lower taxes.  There have been recent attempts to forge a solution through raising the retirement age but it is a political minefield (the new government in France even lowered the retirement age which was a reversal of the previous government).  Immigration would also help but voters in many countries can’t stomach the thought too many foreigners even if they are paying taxes.  So even though the elderly with their failing eye sight and walking canes may not seem to be able to wreck much havoc, they are set to demolish government finances. 

So it seems likely that young people will be left to foot the bill and they are already paying the consequences of a system that is geared toward their elders.  The older generation has benefited from rising property prices through their lifetime but now youngster struggle to buy their first home and end up stuck living with their parents.  The job market is also tough as unions protect the jobs of current workers who are typically older while the young miss out on work as no new jobs are being created due to economic stagnation.  And when people from the younger generation do find work, they have to pay taxes which go toward pensions as well as putting money into pension accounts to pay for their own retirement – paying for pensions for both themselves and for their parents.  This may be the first generation in centuries that will be worse off than their parents.  And you thought it was tough growing up!

Currency Wars – Japan’s Central Bank Strikes Back

Japan ups the ante with policy makers eyeing monetary policy as a means to weaken their currency but where will it end…

Currency wars is not exactly the stuff of the latest blockbuster showing at the cinema but the issue is making headlines and setting pulses racing.  And it is the normal staid world of monetary policy that is the cause of the tensions.  In the face of weak economic growth, most central banks in developed countries tend to set interest rates close to zero and have had to resort to the unconventional tactic of quantitative easing or the buying of bonds to increase the money supply.  Creating more money in this way has an added effect of also reducing the value of the currency (see Where is all the money going? for more on quantitative easing) and a lower currency is helpful for exporters trying to sell their goods overseas.  With more quantitative easing acting to prompt more exporting, it is an easy way to help out businesses who may be suffering from sluggish demand in their domestic market.  So with quantitative easing all the rage, are central banks set to battle it out to see who can print the most money?

Central banks are not typically caught up in efforts to stimulate the economy.  Their role typically involves maintaining inflation near a target level.  However, the persistent stagnation in the global economy combined with high levels of debt in many countries has taken away governments’ abilities to revive the economy through increased spending or lower taxes.  As such, central banks have been enlisted to combat the worst economic slump since the Great Depression.  Quantitative easing was initially called into service as a boost to the economy but its effects on the currency markets have not gone unnoticed.

The latest salvo which has ramped up tensions was the Bank of Japan (the central bank in Japan) raising its inflation target from 1% to 2% following political pressure from the newly elected government in Japan.  It is not the action of the Japanese central bank that is causing concerns but that the Bank of Japan acted under a barrage of pressure from the government.  It is seen as crucial that central banks are allowed to operate for the good of the economy free from outside influences.  This independence from political pressure is the crux of the argument for central banks being entrusted with monetary policy (see More Power to Economists for more on why this is the case).

The flip side of the coin is that Japan has fallen victim to peculiarities of the currency markets following the onset of the global financial crisis in 2008.  Normally, the value of a currency would fall when the economy is doing poorly but the opposite has happened to the yen which surged in strength from above Y120 per US$ in 2007 to below Y80 per US$ in 2012.  So, as well as a recession in their home market and a drop in global demand for exports, Japanese business were under fire due to a strong currency resulting in the prices of goods exported from Japan becoming more expensive in foreign markets (for more detail, refer to Yen as Weathervane).  As a result, Japan posted its largest ever trade deficit in 2012 which is a sharp turnaround for a country known for its exporting prowess.

The new stance by the central bank in Japan had the desired effect with the yen dropping back above Y90 per $US but the plunge in the yen is based on market expectations of what could happen as the Bank of Japan has yet to do anything.  Furthermore, it is even unclear on what Japan’s central bank will do to work toward a “medium to long-term” goal of 2% inflation.  The Bank of Japan has not had any luck in lifting the country out of deflation and reaching its prior target of 1% inflation so it remains to be seen whether the shift in stance will have any effect.  An immediate change is the further politicization of central banks who have gradually been given more responsibility for the economy than was part of their initial remit.  The use of monetary policy as means of manipulating the currency is now in the sights of policymakers across the globe.  This poses the question - do other countries dare follow Japan’s lead?  There might be a sequel: ‘Currency Wars - Return of the Printing Presses’?

When Keynesian Policies won’t work

Japan is set to try yet another fiscal stimulus but this is more about politics than following the ideas of Keynes.

Keynesian policies has made a dramatic return after been shunned as a viable policy option.  Firms and households have reined in their spending due to uncertainty over the future while banks cut back on lending after the global financial crisis.  The resulting slump in demand has opened up a role for governments to fill the gap in spending which is the core premise of Keynesian economics.  But this government action is only ever meant to be a stopgap to boost demand until normal economic conditions resume.

So a stimulus package after an economy has been stagnating for two decades is beyond what Keynes would proscribe.  But this is what the government in Japan is set to embark on.  As well as a likely waste of money, the extra government spending is also a worry considering the high level of public debt in Japan and previous stimulus policies which have resulted in a glut of public works being carried out leaving Japan with lots of roads and bridges which are hardly used.  But worst of all, it is used as an excuse to put off reforms needed to rejuvenate the economy and may doom Japan to another decade of missed opportunities for economic revival.     

The newly elected government, head by the new Prime Minister Shinzo Abe, released plans this month for a stimulus package worth 10.3 trillion yen (US$116 billion).  Abe has also bullied the Bank of Japan into lifting the target for inflation from 1% to 2% as part of a push toward more aggressive policy to get the country out of deflation.  But this is the same prescription that has been administered before in Japan and the outcome will probably be the same too – a short term boost bought with more debt.  To add to this, the Liberal Democratic Party (LDP) which Abe heads does not have the best track record.  Its previous numerous stimulus packages have been more notable for extending the LDP’s hold on power through building needless infrastructure in remote regions to secure votes.  The LDP maintained its stranglehold on Japan for over 50 years of almost uninterrupted rule and was only voted out of government in 2009 despite presiding over two decades of economic stagnation following the bursting of one of the largest ever asset bubbles at the end of the 1980s. 

The LDP is expert at looking as if it is doing something while not actually dealing with the core problems, but even more perversely, it is making things worse by adding to Japan’s mountain of debt.  Government debt in Japan which reached 237% of GDP in 2012 – the highest among developed countries.  Government debt is still increasing at a rapid rate with a budget deficit of 10% in 2012.  Japan’s only saving grace is that it is mostly Japanese banks buying government bonds and Japanese savers have tolerated the meagre returns which banks have been able to offer up as a result.  So Japan has been saved from a debt crisis like that which has plagued Europe but it has also allowed politicians to put off making the necessary changes and ballooning debt must eventually have consequences such as higher interest rates which may trigger bigger problems. 

The persistent sluggishness of the Japanese economy suggests that it is not a shortfall of demand that can be fixed by a fiscal shot in the arm but changes need to be made to help the economy work better.  For a country that relies heavily on exporting, it is relatively closed off to imports which reduces competition and results in higher costs for households and businesses.  Japan has many global firms but it is also a tough place to start a business.  Wages and prices also need to be able to move so the economy can adapt to new circumstances.  Change in Japan will not come from the policies enforced top-down but need to bubble up from below through the activities of individuals and start-ups and the government just need to put in place the reforms to make this happen.  Yet, there are few signs of this happening even after an economic slump lasting over two decades.  It is a scary look into the future for leaders in Europe.

More Power to Economists!

With sound economic policy out of favour, there may be an argument for giving economists more control in government.

Good economics is a hard sell.  Economists have tried their hardest to convince people that relative free movement of goods will benefit the economy as a whole but businesses battling against imports from overseas win out against typically tepid support for free trade.  The United States and Britain are cutting back on immigration and restricting the entry of even highly-skilled workers despite such individuals paying significantly more in taxes than they receive in government payouts.  Considering that some areas of government such as monetary policy have already been handed over to economists, is there an argument for more policy to be handled over to such unelected experts?

The independence of central banks in monetary policy is sacrosanct in many countries.  Politicians who already determine fiscal policy (government spending and taxation) are seen as being too unreliable to also have the power over the tools of monetary policy such as the ability to set interest rates.  For example, a government may be tempted to lower interest rates in the period before an election which would boost the economy as well as their chances of staying in power.  Politicians have instead handed over the control of monetary policy to their country’s central bank whose officials are seem as better at long-term economic policy due to not having to worry about reelection.  But politicians still get to stipulate the goals of monetary policy such as low inflation (or full employment in the case of the Federal Reserve in the United States).  

The handing over of monetary policy has been made possible by worries about the adverse effects of inflation.  Rising prices eat away at the value of savings and households and businesses may hold back on spending if prices jump around a lot.  The relative level of consensus over the need to rein in inflation has made monetary policy less controversial and enabled its outsourcing to central banks.  In comparison, fiscal policy involves more numerous components such as the level of taxation and spending along with what should be taxed and where money should be spent.  As such, there will always be winners and losers in fiscal policy as, for example, spending by the government will benefit some and exclude others depending on what is targeted.  To ensure that the majority of people are happy with the way in which the government goes about its business, politician parties have to outline their spending and taxation plans to voters in a democracy in order to get elected.

However, democracy does not mean that voters will choose the party with the best economic policies to govern with other issues also swaying the minds of voters.  There is a theory which espouses that voters have biases in the ways in which they vote such as a dislike of foreigners which leads to parties attracting voters with policies with lower trade and less immigration than would be optimal for the economy.  Other examples of biases could include an anti-tax bias where people dislike being taxed and a jobs bias where the number of jobs is seen as more important than the amount of overall production .  Yet, it would require a considerable investment for voters to acquire the knowledge to decipher which policy options would be best so it is easier to fall back on their inherent biases. 

The debt crisis in Europe has thrown up one example of a country giving up on politicians and handing over the government to an economist – Italy.  Mario Monti was appointed as the head of a government of technocrats in November 2011 after years of mismanagement had left Italy as the most indebted country in Europe and in threat of economic collapse amid the turmoil in Europe.  Italians initially welcomed Monti but his popularity faded quickly as the austerity policies his government introduced proved too much for Italians to bear.  Now, in a bizarre twist of fate, Italians have a choice in elections at the end of February between parties headed by Monti and Silvio Berlusconi who was the previous Prime Minister before he lost his majority in parliament and who is responsible for many of Italy’s problems (more background on Berlusconi’s follies at Bigger than Berlusconi).  

However, economists are not always prescribing austerity.  The IMF which is an international body stacked full of economists made a case for austerity measures in Europe to be eased if growth continues to remain weak (for a further explanation, refer to Time for Plan B?).  On the other hand, Angela Merkel, the German Chancellor, has been the toughest advocate for spending cuts in Europe as German taxpayers are unwilling to bail out the spendthrift countries in Europe.  Germany’s voters distrust of their fellow Europeans has resulted in the Eurozone crisis dragging on for much longer than it needed to (see Conspiracy Theory for your Greek Holiday for more) which has also been painful for the Germans themselves.  But Europe would have not gotten into this mess in the first place if government spending had been kept in check during the boom times preceding the crisis.  Your Neighbourhood Economist would not be as bold (or stupid) to argue that economists are without fault in the Eurozone crisis but having economists overseeing government spending levels could have helped stop government finances following the boom and bust of the economy.  The current debt crises in Europe and the United States may not be enough to facilitate such a role for economists but that does not mean it is not an idea worth considering.

Something else to blame on Bankers

Worries about a decline in productivity growth can also be pegged on a common villain

A popular topic these days among economists is to point to a decline in improvements being made by new technologies.  The claim is that the most substantial inventions such as electricity, telephones, cars and planes, and even the humble toilet are all things from the past and further innovations are either more difficult to bring into fruition or the economy is less geared to coming up with new gadgets.  The result of a lack of progress is that growth in productivity (for example, what each worker can produce in an hour) has been in decline since a peak around 1970.  Some counter arguments include that it takes time for new ways of doing things, such as making the most of the Internet, to have considerable influence on our lives and that the effects build up over time to make bigger and bigger contributions to productivity.  But there is one obvious culprit that is overlooked – the finance sector which not only caused damage to the global economy by collapsing in a crisis of its own making but also may have contributed to the slowdown in innovation by side-tracking the best and brightest of a generation and this is another reason to clamp down on the excesses of the banking industry.

To make a case against the finance sector, it is useful to consider how new inventions come into being in the first place.  Some happen just by chance but inventions typically require a significant amount of money and effort.  A system where this money and effort is rewarded is seen as being necessary to induce individuals or companies to invest their resources in such activities.  Individuals and companies will also have other options in terms of where to apply themselves and will only choose to undertake the development of a new technology if the rewards are deemed to be high enough.  Furthermore, it could also be argued that even more effort is required to come up with something new as the considerable amount of knowledge that has already amassed in different fields means it takes a big investment in time to become an expert in any field. 

Yet, in contrast to this, imagine a new industry where smart and ambitious people could make previously inconceivable amounts of money relatively easily compared to other pursuits - this is finance.  Deregulation of the banking sector which kicked off in the 1980s and picked up speed in the 1990s created an environment where clever minds could come up with new financial products which would make themselves and their employers very rich.  This innovation within finance allowed for increased borrowing which would have boosted the global economy by enabling better use of limited savings and lowering interest rates.  With ordinary people also benefiting through cheaper and more available mortgage lending, the banking sector had created a boom that everyone wanted to continue.  But the rapid increase in lending needed to be kept in check and it has become obvious in hindsight that debt level rose too high with disastrous consequences. 

As well as the global financial crisis in 2008 and 2009, the excesses of the banking sector may have also attracted talented individuals away from efforts to push forward the boundaries of progress.  Money and effort are key ingredients in innovation but many of the ideas which are the origins of something new come from a curious and creative person.  But with many of the sharpest minds lured in by the lavish rewards in banking, there would be fewer innovative ideas being realised outside of finance.  If the resulting creativeness had borne fruit in the form of faster growth, putting the best brains to work in banking would have been worth it.  But as we now know, the outcome was completely the opposite.

Along with the perils of excessive lending, the misuse of one of the most valuable resources available with dire results is another reason why banking should be limited in its scope.  Making money from money is easy compared to what is required to make a success out of a new product or service so the rewards for innovation need to be higher in areas which will make a substantial difference.  But for all of the reasons to clamp down on the finance sector, it is still a crucial part of the economy and too many restrictions on banking could be even worse than too few (refer to Another Reason not to Bank on Europe for more on this argument).  The bankers have been bad but we were all enjoying the party.

A New Inconvenient Truth

The reality which faces the West that politicians dare not speak of

The rise of countries such as China, India, and Brazil will be a tectonic shift in economic power but it is also a change that is long overdue.  The relative dominance of Europe and the United States in the global economy is a historical accident brought about by the early formation of capitalist economies in these parts of the world.  The response to these new challengers will define the role that the United States and Europe play on the global stage in the future and the initial signs do not look good. 

The Western world spearheaded by Europe and the United States have generated the bulk of the wealth in the global economy for most of the past century.  As early ago as 1990, the United States accounted for around 23% of global GDP and the countries which now constitute the European Union accounted for roughly 32% while respectively only making up 5% and 9% of the world’s population.  Yet, growth in the countries such as those grouped together under the label of BRICs (Brazil, Russia, India, and China) is the beginning of the end to this distortion in the distribution of global wealth.  The BRICs countries, who accounted for just 8% of global GDP despite making up 43% of the number of people worldwide in 1990, have seen their share of global GDP increase to 18% as of 2010.  The figures for the United States and the European Union have dropped back respectively to 23% and 26% in 2010 and this is a trend that will continue for decades into the future.

It is not that the economies in the United States and Europe have not been expanding in size but growth is not as easy to generate as elsewhere.  Loading up on debt helped to create a booming economy for a while but excessive lending eventually brought about a deep economic slump (for more info, refer to Tale of Two Recessions).  The global financial crisis has instead allowed other countries to catch up faster and to lay siege to the position of the United States and Europe at the top of the global pecking order.  The concentration of wealth in these Western countries has allowed them easy access to resources such as agricultural produce and mineral deposits from around the global as well as ready markets for their manufacturing goods.  But industrialization in countries which were previously just mainly sources of raw materials for the United States and Europe has given rise to competition – both in terms of other countries snapping up resources and of creating rivals to Western firms.  Economic power has also allowed Europe and the United States to shape global institutions to their liking. 

But this imbalance of wealth was never destined to last.  The gap between the rich and poor became too great and plummeting transport costs meant that goods could be manufactured anywhere.  The changes stemming from this will shape the world for generations to come and in ways which cannot yet be grasped.  Rather than bracing themselves to face the reality of this new challenge, both Europe and the United States have been embroiled in domestic issues as politicians struggle to deal with growing levels of debt. 

Economic theory espouses the benefits of free trade and an open economy where countries should specialise in what they are good at.  For the United States and Europe, this would be high-tech or high-value-added sectors such as product design, computer software, and precision manufacturing which make use of their skilled workers.  Yet, Western governments have shot themselves in the foot through mismanagement of their finances.  The resulting masses of public debt have restricted the ability of governments to invest in, for example, education which has suffered in many richer countries as governments focused more on cutting taxes.

Politicians in the United States and Europe need to be more honest with voters.  It is easy to convince voters that the good times will return and to try and hold off the inevitable.  But this will merely delay the day of reckoning and will make it so much worse than it needs to be when it does come around.  Many current policies, such as reducing immigration even for skilled overseas workers, run completely against what needs to be done and suggest that politicians either do not grasp the changes already underway or prefer to pander to the preferences of a public who is adverse to change rather than confront them with reality.  Sooner or later, this inconvenient truth will become apparent, but by then, it may be too late.

Both Good News and Bad News for Europe in 2013

Your Neighbourhood Economist predicts less panic about Europe in 2013 but much work still remains to be done

The turmoil in Europe dominated the headlines in 2012 as high levels of public debt and sluggish economic growth both acted to make investors nervous.  More than the actual problems with the economy in Europe, the real damage was done by a lack of decisive action by the leaders in Europe creating inflated fears about possible defaults and countries breaking away from the Eurozone.  But politicians managed to just muddle through with a big dollop of help from Mario Draghi at the European Central Bank (for a reminder - see "Whatever it takes").  There have been signs that enough has been done to stave off concerns over the immediate future of the Eurozone and its members.  An apparent return to normality is some good news for the Eurozone in 2013 but it is only the beginning.  The bad news is that there still remains a long slog for many countries in Europe to regain economic viability in the face of large and growing levels of debt and economies weakened by a lack of competitiveness. 

The economy in Europe was shackled in 2012 by worries about whether the Eurozone could hold itself together.  The uncertainty prompted firms to hold back from investing in Europe and companies in Europe have instead cut back on employing workers due to the weakening economy.  However, a possible breakup seemed to be less of a concern as 2012 drew to a close which was implied by the fact that investors are again buying bonds in countries that were once shunned such as Spain and Italy.  Draghi at the European Central Bank recently pointed to normalization in the finance markets such as bond prices having fallen (resulting in lower interest rates). 

Panic among investors and the resulting higher interest rates had added to the woes of troubled countries in Europe so an easing of stress levels and a return to a focus on economic fundamentals is a crucial step in the rehabilitation of Europe.  However, buyers of bonds can quickly cash out if the situation in Europe turns bad again so this is just the first (but still essential) phase of a recovery in Europe which will take considerably longer.  While anxieties in the markets about the near-term prospects for Europe have abated, the underlying problems in Europe still remain. 

First and foremost are the poor government finances and high levels of public debt.  Many countries in Europe are likely to suffer as their governments cut spending to reign in large deficits.  Even once government revenues and expenditure are back in balance, the actions of governments will be restricted due to a large mountain of debt and this will inhibit the ability of governments to deal with future crises and to invest in essentials such as education and infrastructure for the future.  The previous debt-fuelled boom period which peaked in 2007 resulted in some places in Europe such as Spain and Greece expanding too fast with wages and prices increasing more than what was sustainable.  The global banking crisis in 2008 and 2009 put an end to the excessive borrowing but the high wages and prices remain and require painful changes for these countries to regain competitiveness in the global economy. 

So while frantic headlines of a Eurozone breakup will hopefully be a thing of the past, the legacy of the sovereign debt crisis in Europe will continue in 2013 and beyond.  Sluggish growth is expected for a few years at least and harrowing adjustments in Europe will be required to create the foundations for renewed invigoration of the economy.  Furthermore, the trouble in Europe comes at an inopportune time – the economic rise of countries such as China, India, and Brazil has increased competition for resources and is a challenge to the dominant role of Europe in global affairs.  This places extra urgency for Europe to get back on its feet and Europe’s future role on the world stage depends on whether it can revive its economy or will fall into long-term decline (more on this soon).