Category: Economics for Business: 8e Ch 24

World politicians, business leaders, charities and pressure groups are meeting in Davos at the 2022 World Economic Forum. Normally this event takes place in January each year, but it was postponed to this May because of Covid-19 and is the first face-to-face meeting since January 2020.

The meeting takes place amid a series of crises facing the world economy. The IMF’s Managing Director, Kristalina Georgieva, described the current situation as a ‘confluence of calamities’. Problems include:

  • Continuing hangovers from Covid have caused economic difficulties in many countries.
  • The bounceback from Covid has led to demand outpacing supply. The world is suffering from a range of supply-chain problems and shortages of key materials and components, such as computer chips.
  • The war in Ukraine has not only caused suffering in Ukraine itself, but has led to huge energy and food price increases as a result of sanctions and the difficulties in exporting wheat, sunflower oil and other foodstuffs.
  • Supply shocks have led to rising global inflation. This will feed into higher inflationary expectations, which will compound the problem if they result in higher prices and wages in response to higher costs.
  • Central banks have responded by raising interest rates. These dampen an already weakened global economy and could push the world into recession.
  • Global inequality is rising rapidly, both within countries and between countries, as Covid disruptions and higher food and energy prices hit the poor disproportionately. Poor people and countries also have a higher proportion of debt and are thus hit especially hard by higher interest rates.
  • Global warming is having increasing effects, with a growing incidence of floods, droughts and hurricanes. These lead to crop failures and the displacement of people.
  • Countries are increasingly resorting to trade restrictions as they seek to protect their own economies. These slow economic growth.

World leaders at Davos will be debating what can be done. One approach is to use fiscal policy. Indeed, Kristalina Georgieva said that her ‘main message is to recognise that the world must spend the billions necessary to contain Covid in order to gain trillions in output as a result’. But unless the increased expenditure is aimed specifically at tackling supply shortages and bottlenecks, it could simply add to rising inflation. Increasing aggregate demand in the context of supply shortages is not the solution.

In the long run, supply bottlenecks can be overcome with appropriate investment. This may require both greater globalisation and greater localisation, with investment in supply chains that use both local and international sources.

International sources can be widened with greater investment in manufacturing in some of the poorer developing countries. This would also help to tackle global inequality. Greater localisation for some inputs, especially heavier or more bulky ones, would help to reduce transport costs and the consumption of fuel.

With severe supply shocks, there are no simple solutions. With less supply, the world produces less and becomes poorer – at least temporarily until supply can increase again.

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Discussion (video)

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Questions

  1. Draw an aggregate demand and supply diagram (AD/AS or DAD/DAS) to illustrate the effect of a supply shock on output and prices.
  2. Give some examples of supply-side policies that could help in the current situation.
  3. What are the arguments for and against countries using protectionist policies at the current time?
  4. What policies could countries adopt to alleviate rapid rises in the cost of living for people on low incomes? What problems do these policies pose?
  5. What are the arguments for and against imposing a windfall tax on energy companies and using the money to support poor people?
  6. If the world slips into recession, should central banks and governments use expansionary monetary and fiscal policies?

The suffering inflicted on the Ukrainian people by the Russian invasion is immense. But, at a much lower level, the war will also inflict costs on people in countries around the world. There will be significant costs to households in the form of even higher energy and food price inflation and a possible economic slowdown. The reactions of governments and central banks could put a further squeeze on living standards. Stock markets could fall further and investment could decline as firms lose confidence.

Russia is the world’s second largest oil supplier and any disruption to supplies will drive up the price of oil significantly. Ahead of the invasion, oil prices were rising. At the beginning of February, Brent crude was around $90 per barrel. With the invasion, it rose above $100 per barrel.

Russia is also a major producer of natural gas. The EU is particularly dependent on Russia, which supplies 40% of its natural gas. With Germany halting approval of the major new gas pipeline under the Baltic from Russia to Germany, Nord Stream 2, the price of gas has rocketed. On the day of the invasion, European gas prices rose by over 50%.

Nevertheless, with the USA deciding not to extend sanctions to Russia’s energy sector, the price of gas fell back by 32% the next day. It remains to be seen just how much the supplies of oil and gas from Russia will be disrupted over the coming weeks.

Both Russia and Ukraine are major suppliers of wheat and maize, between them responsible for 14% of global wheat production and 30% of global wheat exports. A significant rise in the price of wheat and other grains will exacerbate the current rise in food price inflation.

Russia is also a significant supplier of metals, such as copper, platinum, aluminium and nickel, which are used in a wide variety of products. A rise in their price has begun and will further add to inflationary pressures and supply-chain problems which have followed the pandemic.

The effect of these supply shocks can be illustrated in a simple aggregate demand and supply diagram (see Figure 1), which shows a representative economy that imports energy, grain and other resources. Aggregate demand and short-run aggregate supply are initially given by AD0 and SRAS0. Equilibrium is at point a, with real national income (real GDP) of Y0 and a price index of P0.

The supply shock shifts short-run aggregate supply to SRAS1. Equilibrium moves to point b. The price index rises to P1 and real national income falls to Y1. If it is a ‘one-off’ cost increase, then the price index will settle at the new higher level and GDP at the new lower level provided that real aggregate demand remains the same. Inflation will be temporary. If, however, the SRAS curve continues to shift upwards to the left, then cost-push inflation will continue.

These supply-side shocks make the resulting inflation hard for policymakers to deal with. When the problem lies on the demand side, where the inflation is accompanied by an unsustainable boom, a contractionary fiscal and monetary policy can stabilise the economy and reduce inflation. But the inflationary problem today is not demand-pull inflation; it’s cost-push inflation. Disruptions to supply are both driving up prices and causing an economic slowdown – a situation of ‘stagflation’, or even an inflationary recession.

An expansionary policy, such as increasing bond purchases (quantitative easing) or increasing government spending, may help to avoid recession (at least temporarily), but will only exacerbate inflation. In Figure 2, aggregate demand shifts to AD2. Equilibrium moves to point c. Real GDP returns to Y0 (at least temporarily) but the price level rises further, to P2. (Click here for a PowerPoint of the diagram.)

A contractionary policy, such as raising interest rates or taxes, may help to reduce inflation but will make the slowdown worse and could lead to recession. In the diagram, aggregate demand shifts to AD3. Equilibrium moves to point d. The price level returns to P0 (at least temporarily) but real income falls further, to Y3.

In other words, you cannot tackle both the slowdown/recession and the inflation simultaneously by the use of demand-side policy. One requires an expansionary fiscal and/or monetary policy; the other requires fiscal and/or monetary tightening.

Then there are other likely economic stresses. If NATO countries respond by increasing defence expenditure, this will put further strain on public finances.

Sentiment is a key driver of the economy and prices. Expectations tend to be self-fulfilling. So if the war in Ukraine undermines confidence in stock markets and the real economy and further raises inflationary expectations, this pessimistic mood will tend in itself to drive down share prices, drive up inflation and drive down investment and economic growth.

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Questions

  1. If there is a negative supply shock, what will determine the size of the resulting increase in the price level and the rate of inflation over the next one or two years?
  2. How may expectations affect (a) the size of the increase in the price level; (b) future prices of gas and oil?
  3. Why did stock markets rise on the day after the invasion of Ukraine?
  4. Argue the case for and against relaxing monetary policy and delaying tax rises in the light of the economic consequences of the war in Ukraine.

The UK left the EU on 31 January 2020 and entered an 11-month transition phase during which previous arrangements largely applied. On 30 December 2020, the UK and the EU signed the Trade and Cooperation Agreement (TCA) (see also), which set out the details of the post-Brexit trading arrangements between the UK and the EU after the ending of the transition period on 31 December 2020. The new arrangements have been implemented in stages so as to minimise disruption.

A major change was implemented on 1 January 2022, when full customs controls came into effect on imports into the UK from the EU. Later in the year a range of safety and security measures will be introduced, such as physical checks on live animals.

Not surprisingly, the anniversary of the TCA has been marked by many articles on Brexit: assessing its effects so far and looking into the future. Most of the articles see Brexit as having imposed net costs on the UK and the EU. They reflect the views of economists generally. As the first FT article linked below states, “The debate among economists on Brexit has rarely been about whether there would be a hit to growth and living standards, but rather how big a hit”.

The trade and GDP costs of Brexit

The Office for Budget Responsibility in October 2021 attempted to measure these costs in terms of the loss in trade and GDP. In October 2021, it stated:

Since our first post-EU referendum Economic and Fiscal Outlook in November 2016, our forecasts have assumed that total UK imports and exports will eventually both be 15 per cent lower than had we stayed in the EU. This reduction in trade intensity drives the 4 per cent reduction in long-run potential productivity we assume will eventually result from our departure from the EU.
 
…the evidence so far suggests that both import and export intensity have been reduced by Brexit, with developments still consistent with our initial assumption of a 15 per cent reduction in each.

This analysis is supported by evidence from John Springford, deputy director of the Centre for European Reform think-tank. He compares the UK’s actual performance with a ‘doppelgänger’ UK, which is an imaginary UK that has not left the EU. The doppelgänger used “is a subset of countries selected from a larger group of 22 advanced economies by an algorithm. The algorithm finds the countries that, when combined, create a doppelgänger UK that has the smallest possible deviation from the real UK data until December 2019, before the pandemic struck.” According to Springford, the shortfall in trade in October 2021 was 15.7 per cent – very much in line with the OBR’s forecasts.

Explanations of the costs

Why, then, have have been and will continue to be net economic costs from Brexit?

The main reason is that the UK has moved from being in the EU Single Market, a system of virtually friction-free trade and factor movements, to a trade agreement (the TCA) which, while being tariff and quota free for goods produced in the UK and the EU, involves considerable frictions. These frictions include greatly increased paperwork, which adds to the cost of trade. This has affected small businesses particularly, for whom the increased administrative costs generally represent a larger proportion of total costs than for large businesses.

Although EU tariffs are not imposed on goods wholly originating in the UK, they are imposed on many goods that are not. Under ‘rules of origin’ regulations, an item can only count as a British good if sufficient value or weight is added. If insufficient value is added, then customs charges are imposed. Similar rules apply from 1 January 2022 on goods imported into the Great Britain from the EU which are only partially made in the EU. The issue of rules of origin was examined in the blog A free-trade deal? Not really. Goods being moved between Great Britain and the EU are checked at ports and can only be released into the market if they have a valid customs declaration and have received customs clearance. This involves considerable paperwork for businesses. As the article below from Internet Retailing states:

UK and EU importers need to be able to state the origin of the goods they trade between the UK and EU. For some goods, exporters need to hold supplier declarations to show where they were made and where materials came from. From January 1, those issuing statements of origin for goods exported to the EU will need to hold the supplier declarations at the time that they export their goods, whereas up till now the those declarations could be supplied later.

Brexit has had considerable effects on the labour market. Many EU citizens returned to their home countries both before and after Brexit, creating labour shortages in many sectors. Also, it has become more difficult for UK citizens to work in the EU, with work permits required in most cases. This has had a major effect on some UK workers. For example, British touring musicians and performers find it difficult to tour, given the lack of an EU-wide visa waiver, ‘cabotage’ rules that ban large UK tour vehicles from making more than two stops before returning to the UK and new paperwork needed to take certain musical instruments into the EU.

Another issue concerns investment. Will greater restrictions in trade between the EU and the UK reduce inward investment to the UK, with international companies preferring to locate factories producing for Europe in the EU rather than the UK as the EU market is bigger than the UK market? So far, fears have not been realised as inward investment has held up well, partly because of the rapid bounce-back from the pandemic and the successful roll-out of the vaccine. Nevertheless, the UK’s dominance as a recipient of inward investment to Europe has been replaced by a three-way dominance of the UK, France and Germany, with France being the biggest recipient of the three in 2019 and 2020. It will be some years before the extent to which Brexit has damaged inward investment to the UK, if at all, becomes clear.

The TCA applies to goods, not services. One of the major concerns has been the implications of Brexit for financial services and the City of London. Before Brexit, financial institutions based in the UK had ‘passporting rights’. These allowed them to offer financial services across EU borders and to set up branches in EU countries easily. With the ending of the transition period in December 2020, these passporting rights have ceased. The EU has granted temporary ‘equivalence’ to such institutions until June 2022, but then it comes to an end and there is no prospect of deal on financial services in the near future. Indeed, the EU is actively trying to encourage more financial activity to move from the UK to the EU. Several financial institutions have already relocated all or part of their business from London to the EU.

The articles below examine these costs and many give examples of specific firms and how Brexit has impacted on them. As you will see, there are quite a lot of articles and you might just want to select a few. Or if this blog is being used for classes, the articles could be assigned to different students and used as the basis for discussion.

The future

Whilst the additional costs in terms of trade restrictions and paperwork are clear, it is too soon to know how well firms will be able to overcome them. Many of those who support Brexit argue that the UK now has freedom to impose lighter UK regulations on firms and that this could encourage economic growth. Other supporters of Brexit, however, argue that Brexit gives the UK government the opportunity to impose tougher environmental, safety and employment protection regulations. Again, it is too soon to know what direction the current and future governments will move.

Then there is the question of trade deals with non-EU countries. How many will there be? When will they be signed? What will their terms be? So far, the deals signed have largely been just a roll-over of the deals the UK previously had with these countries as a member of the EU. The one exception is the deal with Australia. But the gains from that are tiny – an estimated gain of between 0.02 and 0.08 per cent of GDP from 2035 (compared with the estimated 4 per cent loss from leaving the EU’s Single Market). Also there are fears by the UK agricultural sector that cheaper food from Australia, produced under lower standards, could undercut UK farmers, especially after the end of a 15-year transitional period. So far, a trade deal with the USA seems a long way off.

Then there are uncertainties about the Northern Ireland Protocol, under which there is an effective border between Great Britain and the EU down the Irish Sea, with free trade across the Northern Ireland–Republic of Ireland border. Will it be rewritten? Will the UK renege on its treaty commitments to impose checks on goods flowing between Northern Ireland and Great Britain?

Difficulties with the Northern Ireland Protocol, highlight another uncertainty and that is the political relationships between the UK and the EU, which have come under considerable strain with various post-Brexit disputes. Could these difficulties damage trade further and, if so, by how much?

What is clear is that there is considerable uncertainty about the future, a future that for some time is likely to be affected by the pandemic and its aftermath in both the UK and the EU. As the OBR states:

It is too early to reach definitive conclusions because:

  • The terms of the TCA are yet to be implemented in full, meaning trade barriers will rise further as more of the deal comes into force. For example, the introduction of full checks on UK imports has recently been delayed until 2022.
  • The full effect of the referendum outcome and higher trade barriers will probably take several years to come through, with businesses needing considerable time to adjust.
  • The pandemic has delivered a large shock to UK and global trade volumes over the past 18 months, making it difficult to disentangle the separate effect of leaving the EU.
  • Finally, trade data tend to be relatively volatile and are revised frequently, rendering any initial conclusions subject to change as the data are revised.

Analysis

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Survey

Questions

  1. Summarise the reasons why the volume of trade between the UK and the EU is likely to be below the level it would have been if the UK had remained in the Single Market.
  2. How can economists disentangle the effects of Brexit from the effects of Covid? How is the ‘doppelgänger UK’ model used for this purpose?
  3. Are there any economic advantages of the UK’s exit from the EU? If so, what are they and how significant are they?
  4. The OBR forecasts that there will be a long-term reduction of 15 per cent in both UK imports from the EU and UK exports to the EU. What might cause this figure to be (a) greater than 15 per cent; (b) less than 15 per cent?

Shipping and supply chains generally have experienced major problems in 2021. The global pandemic disrupted the flow of trade, and the bounce-back in the summer of 2021 saw supply chains stretched as staff shortages and physical capacity limits hit the transport of freight. Ships were held up at ports waiting for unloading and onward transportation. The just-in-time methods of delivery and stock holding were put under considerable strain.

The problems were compounded by the blockage of the Suez canal in March 2021. As the blog, JIT or Illegit stated “When the large container ship, the Ever Given, en route from Malaysia to Felixtowe, was wedged in the Suez canal for six days in March this year, the blockage caused shipping to be backed up. By day six, 367 container ships were waiting to transit the canal. The disruption to supply cost some £730m.”

Another major event in 2021 was the Glasgow COP26 climate conference and the growing willingness of countries to commit to decarbonising their economies. But whereas electricity can be generated from renewable sources, and factories and land transport, such as cars, vans and trains, can run on electricity, it is not so easy to decarbonise shipping, especially for long journeys. They cannot plug in to the grid or draw down from overhead cables. They have to carry their own fuel sources with them.

So, have the pandemic and the Ever Given incident exposed weaknesses in the global supply chain and in shipping in particular? And, if so, in what ways is shipping likely to adapt? And will the pressure to decarbonise lead to a radical rethinking of shipping and long-distance trade?

These are some of the issues considered in the podcast linked below. In it, “Shipping strategist Mark Williams tells Helen Lewis how examining the challenge of decarbonising shipping reveals a future which looks radically different to today, in a world where population, oil extraction and economic growth have all peaked, and trade is transformed”.

Listen to the podcast and have a go at the questions below which are based directly on it.

Podcast

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Questions

  1. Why should we care about the shipping industry?
  2. What lessons can be drawn from the Ever Given incident?
  3. What structural changes are needed to make shipping an industry fit for the long-term demands of the global economy?
  4. Distinguish between just-in-time supply chains and just-in-case supply chains.
  5. What are ‘reshoring’ and ‘nearshoring’? How have they been driven by a growth in trade barriers?
  6. What are the implications of reshoring and nearshoring for (a) globalisation and (b) the UK’s trading position post-Brexit?
  7. What is the contribution of shipping to global greenhouse gas emissions? What other pollutants are emitted from the burning of heavy fuel oil (or ‘bunker fuel’)?
  8. What levers exist to persuade shipping companies to decarbonise their vessels?
  9. What alternative ‘green’ fuels are available to power ships?
  10. What are the difficulties in switching to such fuels?
  11. What economies of scale are there in shipping?
  12. How do the ownership patterns in shipping benefit decision making and change in the industry?
  13. Are ammonia or nuclear power the answer to the decarbonisation of shipping? What are their advantages and disadvantages?
  14. Why are President Xi’s views on the future of shipping so important?
  15. How will the decarbonisation of economies affect the demand for shipping?
  16. What is likely to happen to Chinese demand for iron ore and coking coal over the coming years? What effect will it have on shipping?
  17. How and by how much is the European Emissions Trading System likely to contribute to the decarbonisation of shipping?
  18. What is the Sea Cargo Charter? What difference is it likely to make to the decarbonisation of shipping?
  19. In what ways do cargo ships optimise productivity?
  20. What impact is slowing population growth, or even no population growth, likely to have on shipping?


Boeing and Airbus have called a truce in their 17-year battle over subsidies. During this period, both have accused each other of unfair government subsidies to their respective plane makers.

The long-running trade dispute

In October 2004, the USA requested the establishment of a WTO panel to consider whether Airbus was providing unfair subsidies to develop its new super-jumbo – the A380. This provoked a counter-request by Airbus, claiming unfair subsidies of $27.3 billion for Boeing by the US government since 1992. In July 2005, two panels were set up to deal with the two sets of allegations.

In June 2010, the WTO panel circulated its findings on Boeing’s case against Airbus. It found Airbus guilty of using some illegal subsidies to win contracts through predatory pricing, but dismissed several of Boeing’s claims because many of the subsidies were reimbursable at commercial rates of interest. However, some of the ‘launch aid’ for research and development was given at below market rates and so violated WTO rules. The report evoked appeal and counter-appeal from both sides, but the WTO’s Appellate Body reported in May 2011 upholding the case that ‘certain subsidies’ provided by the EU and member states were incompatible with WTO rules. In June 2011, the EU accepted the findings.

In March 2011, the WTO panel circulated its findings on Airbus’s case against Boeing. The EU claimed that ten specific measures amounted to subsidies to Boeing, which were inconsistent with the WTO’s rules on subsidies (the SCM agreement). It upheld three of ten alleged breaches, including subsidies between 1989 and 2006 of at least $5.3 billion. These subsidies were adjudged to have resulted in adverse effects to the EU’s interests, specifically in lost sales, especially to third-country markets, and in significantly suppressing the price at which Airbus was able to sell its aircraft.

But these rulings were not the end of the matter. Various appeals and counter-appeals were lodged by both sides with varying degrees of success. Also the disputes extended to other wide-bodied jets and to narrow-bodied ones too with claims by both sides of unfair subsidies and tax breaks.

On 9 June 2017 the WTO’s compliance panel rejected several EU claims that the USA had failed to withdraw all illegal subsidies to Boeing. However, it also found that the USA had not complied with an earlier ruling to abolish illegal tax breaks. Both sides claimed victory. Airbus claimed that the ruling had seen the WTO condemn non-compliance and new subsidies. In particular, it focused on the WTO ruling that Washington State subsidies had resulted in a significant loss of sales for Airbus. On the other hand, a Boeing press release spoke of a US win in a major WTO compliance ruling. Boeing claimed that that ruling meant that the United States had complied with ‘virtually all’ of the WTO’s decisions in the counter-case that the EU had filed against the USA in 2006.

On 27 June 2017, as expected, the EU challenged the WTO decision. This meant that the EU’s case would go back to the WTO’s appellate body, which was still considering a separate US case over state aid to Airbus.

On 15 May 2018, the WTO ruled that Airbus did not use unfair subsidies for narrow-bodied jets, such as the A320, which competes with the 737, but did for wide-bodied jets. The EU said that it would comply with the WTO ruling over the support for wide-bodied jets.

In 2019, the WTO ruled that the EU had illegally provided support to Airbus. The USA responded with tariffs of up to $7.5bn on a range of goods imported from the EU. In a parallel case, the WTO ruled that the US benefits to Boeing also violated trade rules, authorising the EU to impose tariffs on US imports worth roughly $4bn. Then in March 2020, the USA imposed a 15% tariff on Airbus aircraft.

The truce

Agreement was reached on 15 June 2021 in trade talks between the USA and the EU in Brussels. Both sides recognised that the dispute had been a negative-sum game, with both sides losing. It was thus agreed to suspend for five years all tariffs on aircraft and on a range of other goods, such as EU cheese and wine and US tobacco and spirits. The agreement did not include ending EU tariffs on US steel, however.

It was also agreed to work on an overarching agreement on subsidies, which would allow fair support by governments on both sides, and to co-operate in finding ways to counter unfair state investment in aircraft by China. US Trade Representative Katherine Tai said that the agreement ‘includes a commitment for concrete joint collaboration to confront the threat from China’s ambitions to build an aircraft sector on non-market practices’. China’s state-sponsored aerospace manufacturer, the Commercial Aircraft Corporation of China, or Comac, sees its C919, now in late stages of development, as a direct rival to the Airbus A320neo and the Boeing 737 Max.

To work out the details of US-EU collaboration, a working group will be set up. It will consider ways of ensuring that finance is provided on market terms, that R&D funding is transparent and that support given to aircraft manufactures will be equivalent by each side and will avoid harming the other side. It will consider just how the two sides can co-operate to address unfair competition from elsewhere.

Two days later, an almost identically worded deal was reached between the USA and the UK to end tariffs on a range of goods and join the EU-USA co-operation on aircraft manufacture.

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Questions

  1. Choose any one particular complaint to the WTO by either Boeing or Airbus and assess the arguments used by the WTO in its ruling.
  2. Are subsidies by aircraft manufacturers in the interests of (a) passengers; (b) society in general?
  3. Is collaboration between Boeing and Airbus in the interests of (a) passengers; (b) society in general?
  4. How is game theory relevant to the long-running disputes between Boeing and Airbus and to their relationships in the coming years?
  5. Would cheaper aircraft from China be in the interests of (a) passengers; (b) society in general?
  6. Explain what is meant by ‘strategic trade theory’. How is it relevant to aircraft manufacture?