Category: Economics for Business: Ch 30

As the news item, A Greek tragedy reported, the level of debt in Greece and also in Portugal, Spain, Ireland and Italy, has caused worries, not just for their creditors, but also for the whole eurozone. Here we give you the opportunity to listen to a podcast from the Guardian in which some of the paper’s main economic columnists, along with Observer commentator, William Keegan, discuss the effects of this debt on the euro. To quote the introduction to the podcast:

“In Brussels, European leaders have pledged ‘determined and co-ordinated’ action to help Greece – they won’t let it fail. Our Europe editor Ian Traynor says the announcement of a deal was designed to keep the markets happy.

But leaders of wealthier euro nations like Germany are hoping they won’t have to ask their voters to bail Greece out. Kate Connolly, our Berlin correspondent, explains why Germans are so reluctant to provide financial assistance.

It’s being seen as a defining moment for the euro. Economics editor Larry Elliott says not signing Britain up to the single currency was the best decision Gordon Brown ever made.”

The debt crisis facing the Euro Guardian daily podcast (12/2/10)

Questions

  1. To what extent is Greece’s debt a problem for the whole eurozone?
  2. Consider the arguments for and against bailing Greece out (a) by stronger eurozone countries, such as Germany and France; (b) by the IMF.
  3. What support for Greece would minimise the problem of moral hazard?
  4. How would you set about establishing whether the current eurozone is an optimal currency area?
  5. How do the current problems of debt affect the arguments about whether Britain should adopt the euro?

Over the past week, Greece has been hogging the headlines when it comes to debt crisis. However, there is concern that there are a number of other countries ‘where credit defaults swaps are unusually high, suggesting there is risk in terms of default’. Greece’s deficit stands at 12.7% (£259bn), which is over 4 times higher than EU rules allow and its debt levels are expected to reach 120% of GDP this year if help is not given. Furthermore, if Greece’s debt problems are not tackled, there is a worry that other countries with big deficits, such as Portugal and Spain will become vulnerable. Public spending in Greece had been rising for some time but the tax revenue hadn’t increased to match this. As government spending rose and tax revenues fell, the growing debt was inevitable.

What is just as concerning is the cost of servicing this debt. This is costing Greece about 11.6% of GDP and the Greek government has estimated that it will need to borrow €53bn this year to cover budget shortfalls. Strikes by public-sector workers have also affected the country, as figures show that the unemployment rate has increased to 10.6%.

However, there are now reports that an agreement has been reached at the EU summit to rescue Greece and help it tackle its debt problems. Herman Van Rompuy, the European Union’s President, said that an agreement had been reached. The news was immediately welcomed by jittery markets, with the euro regaining some of its losses. Initially, it was thought that British taxpayers would be a part of any bailout package, but Alistair Darling, said there was no plan to use UK taxpayers’ money to support Greece. When asked about the comparison of the UK with Greece, Alistair Darling commented that:

“I don’t think you can compare the UK with Greece. We have different policies. We have a very good track record and, most importantly, the maturity of UK debt is much longer.”

The EU summit was officially meant to cover medium-term European economic strategy, but it was dominated by the Greek crisis. Germany and France are likely to stand together and pledge to come to Athens’s aid by guaranteeing Greek solvency, but only time will tell whether this will happen or will work.

EU leaders reach deal to rescue Greece from debt crisis, President Barroso says Telegraph, Bruno Waterfield (11/2/10)
Mervyn King on Greece, Britain’s deficit and a hung Parliament Telegraph (10/2/10)
FTSE rises amid Greece rescue hopes The Press Association (11/2/10)
Greece’s unemployment rate hits 10% BBC News (11/2/10)
Debt crisis: Experts see more skeletons tumbling News Center (11/2/10)
EU deal ‘agreed’ on Greece debt woes BBC News (11/2/10)
Greek bailout deal reached at EU summit Guardian, Ian Traynor and Graeme Wearden (11/2/10)
Greek bailout would hurt Eurozone – Germany’s Issing Reuters (29/1/10)
Greece must meet deficit target to get aid Reuters (11/2/10)
Could bailout be on the cards for Greece BBC News (10/2/10)
Germans must start buying to save Europe’s stragglers Financial Times, Martin Wolf (10/2/10)
Thinking the unthinkable BBC News Blogs, Stephanomics, Stephanie Flanders (11/2/10)
Angela Merkel dashes Greek hopes of rescue bid Guardian, Ian Traynor (11/2/10)
Greece faces devaluation, default or deflation. Next stop the IMF Guardian, Larry Elliott (11/2/10)
Germany demands austerity, not bailout, for spendthrift Athens Guardian, Ian Traynor (11/2/10)

See also the Guardian podcast in the news item, Debt and the euro
See too the news item from October 2008, The eurozone – our economic saviour?

Questions

  1. What is the cause of Greece’s debt problems?
  2. According to the European Central Bank chief economist Otmar Issing, a Greek bailout would weaken the euro and hurt the reputation and image of the eurozone. How can we explain this?
  3. What do we mean by servicing a debt?
  4. How could Greece’s debt problems cause problems for other countries with large debts, such as Ireland, Portugal and Spain?
  5. Which country is better off: the UK or Greece?
  6. Who will be the loser from a bailout?
  7. Are the EU rules about debt and deficit levels a good thing or are they too restrictive to be helpful?
  8. What are the arguments for and against the ECB increasing its target rate of inflation, say to 4%, as a means of stimulating recovery?

Over the weekend of the 5 and 6 February, the finance ministers of the G7 countries (Canada, France, Germany, Italy, Japan, the UK and the USA) met to discuss the state of the world economy. They agreed that the recovery was still too fragile to remove the various stimulus packages adopted around the world. To do so would run the risk of plunging the world back into recession – the dreaded ‘double dip’.

But further fiscal stimulus involves a deepening of public-sector debt – and it is the high levels of debt in various countries, and especially the ‘Piigs’ (Portugal, Ireland, Italy, Greece and Spain), that is causing worries that their debt will be unsustainable and that this will jeopardise their recovery. Indeed, the days running up to the meeting had seen considerable speculation against the euro as worries about the finances of various eurozone countries grew.

Of course, countries such as Greece, could be bailed out by other eurozone countries, such as Germany of France, or by the IMF. But this would create a moral hazard. If Greece and other countries in deep debt know that they will be bailed out, this might then remove some of the pressure on them to tackle their debts by raising taxes and/or cutting government expenditure.

Group of 7 Vows to Keep Cash Flowing New York Times, Sewell Chan (6/2/10)
Forget cuts and keep spending, Brown told Independent, Sean O’Grady (9/2/10)
European debt concerns drive dollar higher during past week Xinhua, Xiong Tong (6/2/10)
G7 prefers to stay on stimulants Economic Times of India (7/2/10)
G7 pledges to maintain economic stimulus Irish Times (8/2/10)
Mr. Geithner, On What Planet Do You Spend Most of Your Time? Veterans Today (6/2/10)
Gold Price Holds $1,050 – Gold Correction Over? Gold Price News (8/2/10)
Darling ‘confident’ on economic recovery at G7 meeting BBC News (7/2/10)
Britain has to fight hard to avoid the Piigs Sunday Times (7/2/10)
Europe needs to show it has a crisis endgame Financial Times, Wolfgang Münchau (7/2/10)
Speculators build record bets against euro Financial Times, Peter Garnham (8/2/10)
The wider financial impact of southern Europe’s Pigs Observer, Ashley Seager (7/2/10)
Medicine for Europe’s sinking south Financial Times, Nouriel Roubini and Arnab Das (2/2/10)
Yes, the eurozone will bail out Greece, but its currency has taken a battering Independent on Sunday, Hamish McRae (7/2/10)

Questions

  1. What is meant by a ‘double-dip recession? How likely is such a double dip to occur over the coming months?
  2. Why has there been speculation against the euro? Who gain and who lose from such speculation?
  3. Why might the ‘gold correction’ be over? Why might gold prices change again?
  4. What is meant by ‘moral hazard’? Does bailing out countries, firms or individuals in difficulties always involve a moral hazard?
  5. What is the case (a) for and (b) against a further fiscal stimulus to countries struggling to recover from recession?
  6. Would there be any problems in pursuing a tight fiscal policy alongside an expansionary monetary policy?

Since March 2009, the Bank of England has engaged in a process of quantitative easing (QE). Over the period to January 2010 the Bank of England injected £200 billion of new money into the economy by purchasing assets from the private sector, mainly government bonds. The assets were purchased with new money, which enters the economy as credits to the accounts of those selling the assets to the Bank of England. This increase in narrow money (the monetary base) is then able to form the basis of credit creation, allowing broad money (M4) to increase by a multiple of the increased monetary base. In other words, injecting £200 billion allows M4 to increase by considerably more.

But just how much more will M4 rise? How big is the money multiplier? This depends on the demand for loans from banks, which in turn depends on the confidence of business and households. With the recovery only just beginning, demand is still very dampened. Credit creation also depends on the willingess of banks to lend. But this too has been dampened by banks’ desire to increase liquidity and expand their capital base in the wake of the credit crunch.

Not surprisingly, the growth in M4 has been sluggish. Between March and Decmber 2009, narrow money (notes, coin and banks’ reserve balances in the Bank of England) grew from £91bn to £203bn (an increase of 123%). M4, however, grew from £2011bn to £2048bn: an increase of only 1.8%. In fact, in December it fell back from £2069bn in November.

Despite the continued sluggishness of the economy, at its February meeting the Bank of England announced an end to further quantitiative easing – at least for the time being. Although Bank Rate would be kept on hold at 0.5%, there would be no further injections of money. Part of the reason for this is that there is still considerable scope for a growth in broad money on the basis of the narrow money already created. If QE were to continue, there could be excessive broad money in a few months’ time and that could push inflation well above target. As it is, rising costs have already pushed inflation above the 2% target (see Too much of a push from costs but no pull from demand).

So will this be an end to quantitative easing? The following articles explore the question.

Bank of England halts quantitative easing Guardian, Ashley Seager (4/2/10)
Bank calls time on quantitative easing (including video) Telegraph, Edmund Conway (5/2/10)
Bank of England’s time-out for quantitative easing plan BBC News (4/2/10)
Shifting goalposts keep final score in question Financial Times, Chris Giles and Jessica Winch (5/2/10)
Bank halts QE at £200bn despite ‘sluggish’ recovery Independent, Sean O’Grady (5/2/10)
Easy does it: No further QE BBC News blogs, Stephanomics, Stephanie Flanders (4/2/10)
Leading article: Easing off – but only for now Independent (5/2/10)
Not easy Times Online (5/2/10)
Quantitative easing: What the economists say Guardian (4/2/10)

Questions

  1. Explain how quantitative easing works?
  2. What determines the rate of growth of M4?
  3. Why has the Bank of England decided to call a halt to quantiative easing – at least for the time being?
  4. What is the transmission mechanism whereby an increase in the monetary base affects real GDP?
  5. What role does the exchange rate play in the transmission mechanism?
  6. Why is it difficult to predict the effect of an increase in the monetary base on real GDP?
  7. What will determine whether or not the Bank of England will raise interest rates in a few months’ time?

It’s not just the roads in the UK that were frozen, as the Bank of England unsurprisingly decided to keep interest rates frozen at 0.5%. Furthermore, many economists do not expect to see interest rates increase for some time. Roger Bootle has predicted that rates could stay low for up to 5 years and this will contribute to a continuing weak pound and spell further trouble for importers and their customers.

The Bank of England also left its money-creation programme of ‘quantitative easing’ unchanged, but next month it will have to decide whether to extend quantitative easing beyond the limits of £200 billion that it set back in November.

Whilst we are supposedly beginning our economic recovery – with 2009 quarter 4 figures showing the first rise in output since the first quarter of 2008 – its strength remains questionable. Indeed, the rise in output in the last three months of 2009 was a mere 0.1%. So how important are interest rates in helping to sustain the recovery? Can they really pull us out of the recession by remaining at just 0.5%? Read the articles below which look at freezing interest rates and quantitative easing.

FTSE unaffected by interest rate decision In the News (7/1/10)
Freeze on UK interest rates BBC News (7/1/10)
Bank of England may raise interest rates as soon as March, leading economist predicts Telegraph (7/1/10)
Interest rates and quantitative easing on hold Guardian, Larry Elliott (7/1/10)
Bank of England extends quantitative easing by £25bn – but is it enough? Guardian, Larry Elliott (5/11/10)
Questions for QE BBC News blogs, Stephanomics, Stephanie Flanders (7/1/10)
Interest rates could stay low for 5 years, says Bootle BBC News (7/1/10)

Questions

  1. How do low interest rates contribute to a weak pound? How does this affect exporters and importers?
  2. What is quantitative easing? Should the QE programme be extended? What are the arguments for and against this in terms of economic recovery and public debt?
  3. How much of an impact do you think the recession will have on government policy over the next few months?
  4. Explain the transmission mechanisms by which changes in interest rates affect the goods market.
  5. If the Bank of England were not independent, what do you think would be happening to interest rates?