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Posts Tagged ‘Potential growth’

A gathering storm (Part 2)

In the second part of this blog, we look at an interview with the Guardian given by Robert Chote, Chair of the UK’s Office of Budget Responsibility. Like Mervyn King’s, that we looked at in Part 1, Robert Chote’s predictions are also gloomy.

In particular, he argues that if Greece leaves the euro, the effects on the UK economy could be significant, not just in the short term, but in the long term too.

The concern is that you end up with an outcome in the eurozone that creates the same sort of structural difficulties in the financial system and in the economy that we saw in the past recession, and that that has consequences both for hitting economic activity in the economy, but also its underlying potential. And it’s the latter which has particular difficulties for the fiscal position, because it means not just that the economy weakens and then strengthens again – ie, it goes into a hole and comes out – but that you go down and you never quite get back up to where you started. And that has more lingering, long-term consequences for the public finances.

The interview looked not just at the effects of the current crisis in the eurozone on the eurozone, British and world economies, but also at a number of other issues, including: the reliability of forecasts and those of the OBR in particular; relations between the OBR and the Treasury; allowing the OBR to cost opposition policies; the economic effect of cutting the 50p top rate of income tax; the sustainability of public-sector pensions; and tax increases or spending cuts in the long term.

In Part 3 we look at attempts by the G8 countries to find a solution to the mounting crisis.

Articles
Robert Chote interview: ‘I would not say in the past there’s been rigging’ Guardian, Andrew Sparrow (18/5/12)
UK ‘may never fully recover’ if Greece exits euro Guardian, Andrew Sparrow, Helena Smith and Larry Elliott (18/5/12)
British economy may ‘never quite recover’ from a severe Euro collapse The Telegraph, Rowena Mason (18/5/12)

OBR report
Economic and fiscal outlook Office for Budget Responsibility (March 2012)

Questions

  1. Why is it very difficult to forecast the effects of a Greek withdrawal from the euro?
  2. Why may Greek withdrawal have an effect on long-term potential output in the UK and the rest of Europe?
  3. Why are economic forecasts in general so unreliable? Does this mean that we should abandon economic forecasting?
  4. Why are public finances “likely to come under pressure over the longer term”?
  5. Why might the cut in the top rate of income tax from 50% to 45% have little impact on economic growth? Distinguish between income and substitution effects of the tax cut.
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A gathering storm (Part 1)

This has been a week of gloomy prognostications. On Wednesday 16 May, the Bank of England published its quarterly Inflation Report – and it makes worrying reading.

The forecast of UK economic growth for 2012 has been reduced from 1.2% in the previous report to 0.8%. But the rate of inflation is forecast to remain above the 2% target well into next year. However, at the two-year horizon, inflation is now forecast to be 1.6% – below the target, thus giving the MPC scope for further quantitative easing.

In the introduction to the report, the Governor, Mervyn King, writes:

Over the past year or so, two factors have hampered the recovery and rebalancing by more than expected. First, higher-than-expected world commodity and energy prices have squeezed real take-home pay, dampening consumption growth. Second, credit conditions, far from easing, have in some cases become tighter. The direct and indirect exposures of UK banks to the euro-area periphery have affected funding costs as the challenges of tackling the indebtedness and lack of competitiveness in those countries have intensified.

And at the news conference launching the report, he said:

We have been through a big global financial crisis, the biggest downturn in world output since the 1930s, the biggest banking crisis in this country’s history, the biggest fiscal deficit in our peace time history and our biggest trading partner – the euro area – is tearing itself apart without any obvious solution.

The idea that we could reasonably hope to sail serenely through this with growth close to the long run average and inflation at 2% strikes me as wholly unrealistic. We’re bound to be buffeted by this and affected by it.

The following articles look at the Bank of England’s predictions and at the challenges facing the UK economy as the crisis in the eurozone deepens and as inflation in the UK remains stubbornly above target. They also look at the issue of the extent to which capacity has been lost as a result of the continuing weakness of the UK economy. As The Economist article states:

Business surveys suggest only a small proportion of firms are operating below capacity. That finding looks odd given the economy’s output is still 4% below its level at the start of 2008, and is much farther below the level it would have reached if GDP growth had continued at its long-term rate. The picture painted by surveys could be right if a chunk of the economy’s potential has been written off for good. But Sir Mervyn King, the bank’s governor, doubts this. There is “no obvious reason” why the economy could not rejoin its pre-crisis path, though it might take a decade or two to get there, he said on May 16th.

We look in more detail at the question of lost capacity in Part 2.

Articles
Bank of England cuts growth forecasts: Sir Mervyn King’s speech in full The Telegraph (16/5/12)
Bank of England sees inflation up and growth falling Independent, Ben Chu (17/5/12)
Hard going The Economist (19/5/12)
Bank of England optimism dented again Financial Times, Chris Giles (16/5/12)
Eurozone is ‘tearing itself apart’, says Mervyn King. True, but the UK’s problems are as intractable as ever The Telegraph, Philip Aldrick (16/5/12)

Inflation Report
Inflation Report: portal page Bank of England
Inflation Report: May 2012 Bank of England (16/5/12)

Additional Data
Statistical annex to European Economy. Spring 2012 European Commission, Economic and Financial Affairs
Annual macro-economic database European Commission, Economic and Financial Affairs (11/5/12) (see particularly section 6.5)
Forecasts for the UK economy HM Treasury

Questions

  1. What explanations are given for the rate of CPI inflation remaining persistently above the 2% target?
  2. Why have the prospects for economic growth worsened since the publication of the February Inflation Report?
  3. How might it be possible to have a narrowing (negative) output gap and yet a stagnant economy?
  4. Why may capacity have been lost since the financial crisis of 2008?
  5. Why has M4 declined despite the programme of quantitative easing? (See M4 in record fall despite QE.)
  6. What scope is there for monetary policy in achieving faster economic growth without pushing inflation above the 2% target?
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IMF warns of the long-term need for fiscal consolidation

On the 14th May the IMF published its latest Fiscal Monitor. The key message coming out of this was the need for countries to reduce their public debt ratios, i.e. public debt relative to GDP. Specifically, the IMF is arguing that public debt ratios should be reduced to their ‘post-crisis levels’. In effect, this means countries need to undertake fiscal consolidation. The IMF recognises that the pace of fiscal consolidation should reflect underlying fiscal and macroeconomic conditions, but warns of the dangers of not doing so especially in those countries where the credibility of the current and medium-term fiscal position is weakest.

Underpinning the IMF’s argument for fiscal consolidation is their concern that higher public debt ratios necessitate higher interest rates in order to entice investors to purchase government debt. In those countries with weak fiscal credibility, a sizeable interest rate premium may be needed to entice investors to hold government debt over other types of investments. For instance, we have seen how the markets reacted to the perceived lack of fiscal credibility in Greece and how a series of measures, as discussed in Fixing the Euro: a long term solution or mere sticking plaster were needed to both restore normality to debt markets and to prevent contagion in markets for other country’s public debt.

The IMF argues that the impact of higher interest rates from high public debt-to-GDP ratios would be to reduce an economy’s potential growth. The mechanism by which this would happen would primarily be a reduction of labour productivity growth resulting from lower levels of investment and, hence, from slower growth in the country’s capital stock.

In short, the IMF is arguing that without credible fiscal consolidation plans, countries – particularly advanced economies – run a real risk of restricting their rate of economic growth over the longer-term. Of course, the challenge is to implement fiscal consolidation plans that protect short-term growth by cementing the current economic recovery but do not hinder longer-term growth. Now that is a real challenge!

Report
Fiscal Monitor, May 14 2010 IMF

Articles
IMF Says Rising Public Debt Risk ‘Cannot Be Ignored’ Bloomberg Businessweek, Sandrine Rastello (14/5/10)
US faces one of the biggest crunches in the world – IMF Telegraph, Edmund Conway (14/5/10)
IMF says that developed countries must curb their deficits BBC News (14/5/10)
Outlook for rich economies worsening – IMF Eurasia Review (14/5/10)
Britain’s public debt falls under IMF focus Financial Times, Alan Beattie (15/5/10)
Advanced Economies Face Tougher, Not Impossible, Fiscal Adjustment MarketNews.com, Heather Scott (14/5/10)
A good squeeze The Economist (31/3/10)

Data
IMF Data and Statistic Portal IMF
For macroeconomic data for EU countries and other OECD countries, such as the USA, Canada, Japan, Australia and Korea, see:
AMECO online European Commission

Questions

  1. Evaluate the argument put forward by the IMF that fiscal consolidation is necessary to prevent harming long-term economic growth.
  2. What are the economic dangers of consolidating a country’s fiscal position too quickly?
  3. What do you understand by short-run and long-term economic growth?
  4. What do you understand by potential growth?
  5. What could a government do to increase the perceived credibility of its fiscal position?
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