Author: John Sloman

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Saving the eurozone? Saving the world? (Part A)

As European leaders gather for an emergency summit in Brussels to tackle the eurozone debt crisis, we consider the issues and possible solutions. In Part B we’ll consider the actual agreement.

There are three key short-term issues that the leaders are addressing.

1. The problem of Greek debt

With fears that the Greek debt crisis could spread to other eurozone countries, such as Italy and Spain, it is vital to have a solution to the unsustainability of Greek debt. Either banks must be willing to write off a proportion of Greek debt owed to them or governments must give a fiscal transfer to Greece to allow it to continue servicing the debt. Simply lending Greece even more provides no long-term solution as this will simply make the debt even harder to service. Writing off a given percentage of debt is known as a ‘haircut’. The haircut on offer before the summit was 21%. Leaders are reportedly considering increasing this to around 60%.

2. The size of the eurozone bailout fund

The bailout fund, the European Financial Stability Facility (EFSF), stood at €440 billion. This is considered totally inadequate to provide loans to Italy and Spain, should they need a bailout. France and other countries want the ECB to provide extra loans to the EFSF, to increase its funds to somewhere between €2 trillion and €3 trillion. Germany before the meeting was strongly against this, seeing it as undermining the rectitude of the ECB. A compromise would be for the EFSF to provide partial guarantees to investors and banks which are willing to lend more to countries in debt crisis.

3. Recapitalising various European banks

Several European banks are heavily exposed to sovereign debt in countries such as Greece, Italy and Spain. It is estimated that they would need to raise an extra €100 billion to shield them against possible losses from haircuts and defaults.

But there is the key longer-term issue as well.

Achieving long-term economic growth

Without economic growth, debt servicing becomes much more difficult. The austerity measures imposed on highly indebted countries amount to strongly contractionary fiscal policies, as government expenditure is cut and taxes are increased. But as the economies contract, so automatic fiscal stabilisers come into play. As incomes and expenditure decline, so people pay less income tax and less VAT and other expenditure taxes; as incomes decline and unemployment rises, so government welfare payments and payments of unemployment benefits increase. These compound public-sector deficits and bring the possibility of even stronger austerity measures. A downward spiral of decline and rising debt can occur.

The answer is more rapid growth. But how is that to be achieved when governments are trying to reduce debt? That is the hardest and ultimately the most important question.

Articles

Brussels summit: the main issues to be resolved The Telegraph (25/10/11)
EU crisis talks in limbo after crucial summit is cancelled The Telegraph, Louise Armitstead (25/10/11)
Euro zone summit likely to give few numbers on crisis response Reuters, Jan Strupczewski (25/10/11)
Factbox: What EU leaders must decide at crisis summit Reuters (24/10/11)
Hopes low ahead of EU summit Euronews on YouTube (25/10/11)
Euro crisis: EU leaders hope to reach debt plan BBC News (26/10/11)
The deadline Europe cannot afford to miss BBC News, Nigel Cassidy (26/10/11)
Why EU summit is crunch day for the eurozone BBC News, Paul Mason (26/10/11)
Southern European banks need most capital BBC News blogs, Robert Peston (23/10/11)
Will Germany insure Italy against default? BBC News blogs, Robert Peston (26/10/11)
Plan B for the eurozone? BBC News blogs, Stephanie Flanders (26/10/11)
‘No such thing as Europe’ BBC Today Programme, Stephanie Flanders and Martin Wolf (26/10/11)
Markets to eurozone: It’s the growth, stupid BBC News blogs, Stephanie Flanders (24/10/11)
Fears euro summit could miss final deal Financial Times, Peter Spiegel, Gerrit Wiesmann and Matt Steinglass (26/10/11)
Time to unleash financial firepower or face euro breakup Guardian, Larry Elliott (25/10/11)
The Business podcast: eurozone crisis Guardian, Larry Elliott, David Gow and Jill Treanor (25/10/11)
Why is Germany refusing to budge on the eurozone debt crisis? Guardian blogs, Phillip Inman (26/10/11)

Questions

  1. In terms of the three short-term problems identified above, compare alternative measures for dealing with each one.
  2. To what extent would the ECB creating enough money to recapitalise European banks be inflationary? On what factors does this depend?
  3. Does bailing out countries create a moral hazard? Explain.
  4. What possible ways are there of achieving economic growth while reducing countries sovereign debt?
  5. Would you agree that the problem facing eurozone countries at the moment is more of a political one than an economic one? Explain.
  6. What are the arguments for and against greater fiscal integration in the eurozone?
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Is the demand for petrol becoming more elastic?

The price of petrol at the pumps has risen substantially over the past few years. In the UK, according to the AA, the average price between January and June 2011 was 133.13p. In the same period in 2010 it was 116.68p; and in the same period in 2008 it was 109.00p.

Over the first six months of 2011, the amount of petrol sold fell by 5.2 per cent. This was on top of the decline in consumption over the previous four years. Between 2006 and 2010 consumption of petrol fell by 17.4%. The consumption of petrol and diesel are given in the following table.

UK consumption of petrol and diesel (tonnes millions)

2006 2007 2008 2009 2010
Petrol 18.14 17.59 16.68 15.76 14.99
Diesel 20.15 21.07 20.61 20.06 20.87
Total 38.29 38.66 37.29 35.82 35.86

Source: Digest of United Kingdom energy statistics (DUKES) (Department of Energy and Climate Change)

So what has caused this decline in petrol sales? Are there multiple factors at work here? Have a look at the articles and consider the explanations.

Articles
Cash-strapped drivers cut petrol use by 15 per cent Channel 4 News (5/10/11)
Sales of petrol slump as skint motorists cut costs Daily Record, Jamie Grierson (5/10/11)
Petrol Sales Plunge As Cash Squeeze Tightens Sky News (6/10/11)
Fuel cost rise ‘forcing change in driver habits’ TRL News, Mary Treen (6/10/11)

Data
Digest of United Kingdom energy statistics (DUKES) Department of Energy and Climate Change
Fuel price report (monthly) Automobile Association
Brent Crude spot prices Energy Information Association

Questions

  1. What factors have caused a fall in consumption of petrol?
  2. If you choose to spend a set amount on petrol, what is your price elasticity of demand?
  3. What determines the price elasticity of demand for petrol?
  4. Why has the consumption of diesel fallen less than that of petrol?
  5. Under what circumstances would an increase in tax on road fuel of 3p per litre (as planned for January 2012), result in a decrease in tax revenue? Why would the price elasticity of demand for road fuel have to be significantly greater than 1 (ignoring the minus sign) and not merely above 1 for this to be the case?
  6. Why is it likely that people’s price elasticity of demand for road fuel will become less elastic the more they have cut back on consumption?
  7. Why is the demand for petrol likely to be more elastic with respect to (a) price, and (b) income over the longer term?
  8. To what extent is the demand for road fuel a ‘derived demand’?
  9. To what extent is the fall in the consumption of petrol a reflection of a movement along the demand curve for petrol or a shift in the demand curve? Explain.
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When recession becomes depression: a case of déjà vu?

The global economic mood is darkening. Levels of consumer and producer confidence have declined and forecasts of economic growth are being downgraded. Mervyn King, Governor of the Bank of England, stated that “this is the most serious financial crisis we’ve seen, at least since the 1930s, if not ever” (see).

So will slow recovery turn into a second recession (a double-dip)? And will recession turn into depression – the persistence of low or negative growth over a number of years? The following articles consider this frightening prospect and whether there are similarities with the Great Depression of the 1930s.

But let’s not be too downhearted. If we all are, the world could end up talking itself into depression. Consumers would seek to claw down their debts and cut back spending; producers would invest less as their confidence wanes; banks would be unwilling to lend. So is there any cause to be cheerful? Well, at least world leaders are increasingly aware of the possibility of world depression and minds are increasingly being focused on how to avoid the situation. The EU summit on 23 October and the G20 summit in Cannes on 3/4 November have EU sovereign debt problems and the global crisis at the centre of their agenda.

But if they do decide to act, what should they do? Is the answer a Keynesian stimulus to aggregate demand through fiscal policy and through further quantitative easing? Or is the approach to act more decisively to reduce sovereign debt and convince markets that governments are serious about tackling the problem – a policy response much more in accordance with new classical thinking and the type of policy that would be recommended by Thomas Sargent and Christopher Sims, winners of this year’s Nobel Prize in Economics?

Thinking outside the 1930s box BBC News blogs, Paul Mason (7/10/11)
Britain faces slowest recovery in a century Guardian, Katie Allen (12/10/11)
The Depression: If Only Things Were That Good New York Times, Sunday Review, David Leonhardt (8/10/11)
Recovery has ‘stalled’, say leading economists Financial Times, Sarah O’Connor (11/10/11)
Nobel prize in economics Republica, Opinion (Nepal), Sukhdev Shah (11/10/11)

Questions

  1. In what ways is the current global economic situation similar to that in the early 1930s?
  2. In what ways is it different? Do these differences provide more or less cause for hope for avoiding a global depression?
  3. Explain the following quote from the first article above: “I think that we face the quite real prospect that the market is removed as the determining mechanism for setting the price of capital within the eurozone at the sovereign level.This would put internal credit creation back under the control of the state.”
  4. How is the supply side of the economy relevant to (a) the short-run prospects for economic growth; (b) the long-run prospects?
  5. If technological progess slows down, what will be the implications for employment and unemployment? Explain.
  6. How is policy credibility relevant to the success of the decisions made at G20 and EU summits? (See last aricle above.) How would a Keynesian respond to the analysis of Sargent and Sims?
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Capping the CAP

The total EU budget in 2010 was €123 billion. Just under half of this (€58 billion) was spent on supporting agriculture. The programme of support – the Common Agricultural Policy (CAP) – has changed over the years. For a start, despite its being a large proportion of the EU budget, this proportion has actually been falling. In 1980, the CAP accounted for 69% of the EU budget; in 1990 it was 60%; in 2000 it was 52%; in 2010 it was 47%.

The types of support have also changed. The main method in the past was effectively to set minimum prices for various foodstuffs and for Intervention Boards to buy up any surpluses that arose from such prices being above the market equilibrium. Massive food ‘mountains’ resulted. Sometimes these surpluses were dumped on the world market; sometimes they were thrown away; sometimes they were simply kept in storage. Export subsidies and import levies (taxes) were also used to reduce surpluses. This, of course, was highly damaging to farmers in many countries outside the EU, especially in various primary exporting developing countries.

Reforms have taken place in recent years. The most important has been to replace high intervention prices with direct payments to farmers unrelated to current output. Whilst such payments still provide a substantial outgoing from the EU budget, being unrelated to current output, they do not encourage farmers to produce more and thus do not generate surpluses. Prices in most cases are allowed to be determined by the market.

The EU has just announced further reforms. These include:

&#8226 Capping total CAP spending at current levels until 2020
&#8226 Capping the total payment to any one farm to €300,000
&#8226 Relating subsidies to acreage rather than previous output
&#8226 Making 30% of the direct payments dependent on farmers meeting environmental criteria.

The following videos and articles examine the proposals and assess their likely benefits, their likely drawbacks and their likelihood of being implemented.

Videos
EU plans to reform Common Agricultural Policy for farmers BBC News, Jeremy Cooke (12/10/11)
EU unveils controversial agricultural reforms Euronews (12/10/11)
Towards a new Common Agricultural Policy Euronews (14/10/11)
Queen to lose out in shake up of Europe’s farm payments Channel 4 News (12/10/11)
Cautious welcome for EU agriculture policy shake-up STV News (12/10/11)
CAP reform proposals YouTube, Dacian Cioloş, European Commissioner for Agriculture and Rural Development (in French with English subtitles) (12/10/11)

Articles
EU farm chief: CAP plans represent profound reform Reuters, Charlie Dunmore (12/10/11)
UK to dismiss Common Agricultural Policy reforms as inadequate Guardian, David Gow (11/10/11)
EU Farm Policy Debate Pits Top Receiver France Against U.K. Bloomberg Businessweek, Rudy Ruitenberg (12/10/11)
EU plans CAP reforms for ‘greener’ farm subsidies BBC News (12/10/11)
Common Agriculture Policy farm subsidy plan unveiled BBC News (12/10/11)
Q&A: Reform of EU farm policy BBC News (12/10/11)
CAP reform: Shepherd and steward of the land BBC News, Jeremy Cooke (12/10/11)
EU agriculture policy ‘still hurting farmers in developing countries’ Guardian: Poverty Matters blog, Mark Tran (11/10/11)
EU aid to farmers to continue over next decade Financial Times, Joshua Chaffin (12/10/11)

EU publications
CAP Reform – an explanation of the main elements Europa Press Release (12/10/11)
The European Commission proposes a new partnership between Europe and the farmers European Commission Press Release (12/10/11)
EU farm policy after 2013: Commission proposals welcomed with reservations European Parliament Press Release (12/10/11)
Legal proposals for the CAP after 2013 European Commission: Agriculture and Rural Development (12/10/11)

Questions

  1. Explain why the old system of price support under the CAP led to food surpluses. Use a diagram to illustrate your analysis.
  2. What is the significance of price elasticity of demand and supply in determining the size of these surpluses?
  3. What reforms have been introduced to the CAP in recent years? What effects have these had?
  4. Explain the new proposals for the CAP after 2013.
  5. What are the likely benefits of these proposals?
  6. What are the likely drawbacks of the proposals?
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Shock and awe with the launch of QE2

With economic growth in the UK stalling and growing alarm about the state of the world economy, the Bank of England has announced a second round of quantitative easing (QE2). This will involve the Bank buying an extra £75 billion of government bonds (gilts) in the market over the following four months. This is over and above the nearly £200 billion of assets, mainly gilts, purchased in the first round of quantitative easing in 2009/10. The purchase will release extra (narrow) money into the economy. Hopefully, this will then allow more credit to be created and the money multiplier to come into play, thereby increasing broad money by a multiple of the £75 billion.

In his letter to the Chancellor of the Exchequer seeking permission for QE2, the Governor stated:

In the United Kingdom, the path of output has been affected by a number of temporary factors, but the available indicators suggest that the underlying rate of growth has also moderated. The squeeze on households’ real incomes and the fiscal consolidation are likely to continue to weigh on domestic spending, while the strains in bank funding markets may also inhibit the availability of credit to consumers and businesses. While the stimulatory monetary stance and the present level of sterling should help to support demand, the weaker outlook for, and the increased downside risks to, output growth mean that the margin of slack in the economy is likely to be greater and more persistent than previously expected.

… The deterioration in the outlook has made it more likely that inflation will undershoot the 2% target in the medium term. In the light of that shift in the balance of risks, and in order to keep inflation on track to meet the target over the medium term, the Committee judged that it was necessary to inject further monetary stimulus into the economy.

But will increasing the money supply lead to increased aggregate demand, or will the money simply sit in banks, thereby increasing their liquidity ratio, but not resulting in any significant increase in spending? In other words, in the equation MV = PY, will the rise in M simply result in a fall in V with little effect on PY? And even if it does lead to a rise in PY, will it be real national income (Y) that rises, or will the rise in MV simply be absorbed in higher prices (P)?

According to a recent article published in the Bank of England’s Quarterly Bulletin, The United Kingdom’s quantitative easing policy: design, operation and impact, the £200 billion of asset purchases under QE1 led to a rise in real GDP of about 2%. If QE2 has the same proportionate effect, real GDP could be expected to rise by about 0.75%. But some commentators argue that things are different this time and that the effect could be much smaller. The following articles examine what is likely to happen. They also look at one of the side-effects of the policy – the reduction in the value of pensions as the policy drives down long-term gilt yields and long-term interest rates generally.

Articles
Bank of England launches second round of QE Interactive Investor, Sarah Modlock (6/10/11)
Britain in grip of worst ever financial crisis, Bank of England governor fears Guardian, Larry Elliott and Katie Allen (6/10/11)
Interview with a Governor BBC News, Stephanie Flanders interviews Mervyn King (6/10/11)
The meaning of QE2 BBC News, Stephanie Flanders (6/10/11)
Bank of England’s MPC united over quantitative easing BBC News (19/10/11)
Bank of England’s QE2 may reach £500bn, economists warn The Telegraph, Philip Aldrick (6/10/11)
‘Shock and awe’ may be QE’s biggest asset The Telegraph, Philip Aldrick (6/10/11)
Quantitative easing by the Bank of England: printing more money won’t work this time The Telegraph, Andrew Lilico (6/10/11)
BOE launches QE2 with 75 billion pound boost Reuters, various commentators (6/10/11)
Shock and awe from Bank of England Financial Times, Chris Giles (6/10/11)
More QE: Full reaction Guardian, various commentators (6/10/11)
Quantitative easing warning over pension schemes Guardian, Jill Insley (6/10/11)
Pension schemes warn of QE2 Titanic disaster Mindful money (6/10/11)
Calm down Mervyn – this so-called global recession is really not that bad Independent, Hamish McRae (9/10/11)

Bank of England publications
Asset Purchase Facility: Gilt Purchases Bank of England Market Notice (6/10/11)
Governor’s ITN interview (6/10/11)
Bank of England Maintains Bank Rate at 0.5% and Increases Size of Asset Purchase Programme by £75 billion to £275 billion Bank of England News Release (6/10/11)
Quantitative Easing – How it Works
Governor’s letter to the Chancellor (6/10/11)
Chancellor’s reply to the Governor (6/10/11)
Minutes of the Monetary Policy Committee meeting, 5 and 6 October 2011 (19/10/11)
Inflation Report
Quarterly Bulletin (2011, Q3)

Questions

  1. Explain how quantitative easing works.
  2. What is likely to determine its effectiveness in stimulating the economy?
  3. Why does the Bank of England prefer to inject new money into the economy by purchasing gilts rather than by some other means that might directly help small business?
  4. Explain how QE2 is likely to affect pensions.
  5. What will determine whether QE2 will be inflationary?
  6. Why is the perception of the likely effectiveness of QE2 one of the key determinants of its actual effectiveness?