Category: Economics: Ch 26

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The costs of Brexit: a clearer picture

At the time of the 2016 referendum, the clear consensus among economists was that Brexit would impose net economic costs on the UK economy. The size of these costs would depend on the nature of post-Brexit trading relations with the EU. The fewer the new barriers to trade and the closer the alignment with the EU single market, the lower these costs would be.

The Brexit deal in the form of the EU-UK Trade and Cooperation Agreement (see also) applied provisionally from January 2021, after the end of the transition period, and came into force in May 2021. Although this is a free-trade deal in the sense that goods made largely in the UK or EU can be traded tariff-free between the two, the deal does not apply to services (e.g. financial services) or to goods where components made outside the UK or EU account for more than a certain percentage (the ‘rules of origin‘ condition). Also there has been a huge increase in documentation that must be completed to export to or import from the EU.

Even though the nature of the Brexit deal has been clear since it was signed in December 2020, assessing the impact of the extra barriers to trade it has created has been hard given the various shocks that have had a severe impact on the UK (and global) economy. First COVID-19 and the associated lockdowns had a direct effect on output and trade; second the longer-term international supply-chain disruptions have extended the COVID costs beyond the initial lockdowns and acted as a brake on recovery and growth; third the Russian invasion of Ukraine imposed a severe shock to energy and food markets; fourth these factors have created not just a supply shock but also an inflationary shock, which has resulted in central banks seeking to dampen demand by significantly raising interest rates. One worry among analysts was that the negative effects of such shocks might be greater on the UK economy than on other countries.

However, the negative effects of Brexit are now becoming clearer and various institutions have attempted to quantify the costs. These costs are largely in terms of lower GDP than otherwise. This results from:

  • reduced levels of trade with the EU, thereby reducing the gains from exploiting comparative advantage;
  • increased costs of trade with the EU;
  • disruptions to supply chains;
  • reduced competition from European firms, with many no longer exporting to the UK because of the costs;
  • reduced inward investment;
  • labour market shortages, particularly in certain areas such a hospitality, construction, social care and agriculture as many European workers have left the UK and fewer come;
  • a reduction in productivity.

Here is a summary of the findings of different organisations.

The Office for Budget Responsibility (OBR)

The OBR has argued that Brexit as negotiated in the Trade and Cooperation Agreement:

will reduce long-run productivity by 4 per cent relative to remaining in the EU. This largely reflects our view that the increase in non-tariff barriers on UK-EU trade acts as an additional impediment to the exploitation of comparative advantage.21

In addition the OBR estimates that:

Both exports and imports will be around 15 per cent lower in the long run than if the UK had remained in the EU.21

Recent evidence supports this. According to the OBR:

UK and aggregate advanced economy goods export volumes fell by around 20 per cent during the initial wave of the pandemic in 2020. But by the fourth quarter of 2021 total advanced economy trade volumes had rebounded to 3 per cent above their pre-pandemic levels while UK exports remain around 12 per cent below.22

This assumption was repeated in the November 2022 Economic and Fiscal Outlook (p.26) 23. What is more, new trade deals will make little difference, either because they are a roll-over from previous EU trade deals with the respective country or have only a very small effect (e.g. the trade deal with Australia).

The Bank of England

The Bank of England, ever since the referendum in 2016, has forecast that Brexit would damage trade, productivity and GDP growth. In recent evidence to the House of Commons Treasury Committee5, Andrew Bailey, the Governor, stated that previous work by the Bank concluded that Brexit would reduce productivity by a bit over 3% and that this was still the Bank’s view.

His colleague, Dr Swati Dhingra, stated that, because of Brexit, there was a ‘much bigger slowdown in trade in the UK compared to the rest of the world’. She continued:

The simple way of thinking about what Brexit has done to the economy is that in the period after the referendum, the biggest depreciation that any of the world’s four major economies have seen overnight contributed to increasing prices [and] reduced wages. …We think that number is about 2.6% below the trend that real wages would have been on. Soon afterwards and before the TCA happened came the effects of the uncertainty that was unleashed, which basically translates into reduced business investment and less certainty of the FDI effects. Those tend to be very long-pay things.

She continued that now we are seeing significantly reduced trade directly as a result of the Brexit trade agreement (TCA).

Her colleague, Dr Catherine Mann, argued that ‘the small firms are the ones that are the most damaged, because the cost of the paperwork and so forth is a barrier’. This does not only affect UK firms exporting to the EU but also EU firms exporting to the UK. Reduced imports from EU firms reduces competition in the UK, which tends to lead to higher prices.

The Institute for Fiscal Studies

The IFS has consistently argued that Brexit, because of increased trade barriers with the EU, has reduced UK trade, productivity and GDP. In a recent interview6, its Director, Paul Johnson, stated that ‘Brexit, without doubt, has made us poorer than we would otherwise have been’. That, plus other convulsions, such as the mini-Budget of October 2022, have reduced foreigners’ confidence in the UK, with the result that investment in the UK and trade with the rest of the world have fallen.

Resolution Foundation

In a major Resolution Foundation report24, the authors argued that the effects of Brexit will take time to materialise fully and will occur in three distinct phases. First, in anticipation of permanent effects, the referendum caused sterling to depreciate and this adversely affected household incomes. What is more, the uncertainty about the future caused business investment to fall (but not inward FDI). Second, the Trade and Cooperation Act, by introducing trade barriers, reduced UK trade with the EU. But trade with the rest of the world also fell suggesting that Brexit is impacting UK trade openness and competitiveness more broadly. Third, there will be structural changes to the UK economy over the long-term which will adversely affect economic growth:

A less-open UK will mean a poorer and less productive one by the end of the decade, with real wages expected to fall by 1.8 per cent, a loss of £470 per worker a year, and labour productivity by 1.3 per cent, as a result of the long-run changes to trade under the TCA. This would be equivalent to losing more than a quarter of the last decade’s productivity growth.

Nuffield Trust

One of the key effects of Brexit has been on the labour market and especially on sectors, such as hospitality, agriculture, construction, health and social care. These sectors are experiencing labour shortages, in part due to EU nationals leaving the UK. In 2021, the Nuffield Trust looked at the supply of workers in health and social care25 and found that, as a result of increased bureaucratic hurdles, the number of EU/EFTA-trained nurses had declined since 2016. In social care, new immigration rules have made it virtually impossible to recruit from the EU. A more recent report looked at the recruitment of doctors in four specific specialties.26 In each case, although the number recruited from the EU/EFTA was still increasing, the rate of increase had slowed significantly. The reason appeared to be Brexit not COVID-19.

Ivalua

Research by Coleman Parkes for Ivalua18 shows that 80% of firms found Brexit to have been the biggest cause of supply-chain disruptions in the 12 months to August 2022, with 83% fearing the biggest disruptions from Brexit are yet to come. Brexit was found to have had a bigger effect on supply chains than the war in Ukraine, rising energy costs and COVID-19.

Centre for European Reform

Modelling conducted by John Springford27 used a ‘doppelgängers’ method to show the effects of Brexit on the UK economy. Each doppelgänger is ‘a basket of countries whose economic performance closely matches the UK’s before the Brexit referendum and the end of the transition period’. Comparing the UK’s performance with the doppelgänger can show the difference between leaving and not leaving the UK. Doppelgängers were estimated for GDP, investment (gross fixed capital formation), total services trade (exports plus imports) and total goods trade (ditto).

The results are sobering. In the final quarter of 2021, UK GDP is 5.2 per cent smaller than the modelled, doppelgänger UK; investment is 13.7 per cent lower; and goods trade, 13.6 per cent lower.

Economic and Social Research Institute (ESRI) (Ireland)

Similar results for UK trade have been obtained by Janez Kren and Martina Lawless in research conducted for the ESRI.28 They used product-level trade flows between the EU and all other countries in the world as a comparison group. This showed a 16% reduction in UK exports to the EU and a 20% reduction in UK imports from the EU relative to the scenario in which Brexit had not occurred.

British Chambers of Commerce (BCC) survey

According to a BCC survey of 1168 businesses33, 92% of which are SMEs, more than three quarters (77%) for which the Brexit deal is applicable say it is not helping them increase sales or grow their business and 56% say they have difficulties in adapting to the new rules for trading goods. The survey shows that UK firms are facing significant challenges in trying to trade with EU countries under the terms of the Trade and Cooperation Agreement. What is more, 80% of firms had seen the cost of importing increase; 53% had seen their sales margins decrease; and almost 70% of manufacturers had experienced shortages of goods and services from the EU.

Academic studies

Research at the Centre for Business Prosperity, Aston University, by Jun Du, Emine Beyza Satoglu and Oleksandr Shepotylo20, 29 found that UK exports to the EU ‘fell by an average of 22.9% in the first 15 months after the introduction of the EU-UK Trade and Cooperation Agreement’. The negative effect on UK exports persisted and deepened from January 2021 to March 2022. The research involved comparing actual trade with an ‘alternative UK economy’ model based on the UK having remained in the EU. What is more, the researchers found that there had been a reduction of 42% in the number of product varieties exported to the EU, with a large number of exporters simply ceasing to export to the EU and with many of the remaining exporters streamlining their product ranges.

Research at the LSE’s Centre for Economic Performance by Jan David Bakker, Nikhil Datta, Richard Davies and Josh De Lyon31 found that leaving the EU added an average of £210 to UK household food bills over the two years to the end of 2021. This amounted to a total cost to consumers of £5.8 billion. This confirmed the findings of previous research30 that the increase in UK-EU trade barriers led to food prices in the UK being 6% higher than they would have been.

Finally, a report from the Migration Observatory at the University of Oxford32 examined the effects of the ending of the free movement of labour from the EU to the UK. Visas are now required, but ‘low-wage occupations that used to rely heavily on EU workers are now ineligible for work visas, with some limited exceptions for social care and seasonal workers’. Many industries are facing labour shortages. Reasons include other factors, such as low pay and unattractive working conditions, and workers leaving the workforce during the pandemic and afterwards. But the end of free movement appears to have exacerbated these existing problems.

References

    Videos

  1. The Brexit effect: how leaving the EU hit the UK

    2. Financial Times film (18/10/22)

  2. What impact is Brexit having on the UK economy?

    3. Brexit and the UK economy, Ros Atkins (29/10/22)

  3. Why Brexit is damaging the UK economy both now and in the future

    4. Economics Help on YouTube, Tejvan Pettinger (5/12/22)

  4. Why the Costs of Brexit keep growing for the UK economy

    5. Economics Help on YouTube, Tejvan Pettinger (17/10/22)

  5. Treasury Committee (see also)

    6. Parliament TV (25/11/22) (see 15:03:00 to 15:08:12) (Click here for a transcript: see Q637 to Q641)

  6. UK economy made worse by ‘own goals’ like Brexit and Truss mini-budget, IFS economist says

    7. Sky News, Paul Johnson (IFS) (18/11/22)

    Articles

  7. Brexit and the economy: the hit has been ‘substantially negative’

    8. Financial Times, Chris Giles (30/11/22)

  8. ‘What have we done?’: six years on, UK counts the cost of Brexit

    9. The Observer, Toby Helm, Robin McKie, James Tapper & Phillip Inman (25/6/22)

  9. Brexit did hurt the City’s exports – the numbers don’t lie

    10. Financial News, David Wighton (9/11/22)

  10. Brits are starting to think again about Brexit as the economy slides into recession

    11. CNBC, Elliot Smith (23/11/22)

  11. Brexit has cracked Britain’s economic foundations

    12. CNN, Hanna Ziady (24/12/22)

  12. Mark Carney: ‘Doubling down on inequality was a surprising choice’

    13. Financial Times, Edward Luce (14/10/22)

  13. Brexit: Progress on trade deals slower than promised

    14. BBC News, Ione Wells & Brian Wheeler (2/12/22)

  14. How Brexit costs this retailer £1m a month in sales

    15. BusinessLive, Tom Pegden (22/11/22)

  15. Brexit Is Hurting The UK Economy, Bank Of England Official Says

    16. HuffPost, Graeme Demianyk (16/11/22)

  16. Brexit and drop in workforce harming economic recovery, says Bank governor

    17. The Guardian, Richard Partington (16/11/22)

  17. Brexit a major cause of UK’s return to austerity, says senior economist

    18. The Guardian, Anna Isaac (14/11/22)

  18. 80% of UK businesses say Brexit caused the biggest supply chain disruption in the last 12 months

    19. Ivalua (28/11/22)

  19. Brexit added £210 to household food bills, new research finds

    20. Sky News, Faye Brown (1/12/22)

  20. Brexit changes caused 22.9% slump in UK-EU exports into Q1 2022 – research

    21. Expertfile (8/12/22)

    Research and analysis

  21. Brexit analysis

    22. OBR (26/5/22)

  22. The latest evidence on the impact of Brexit on UK trade

    23. OBR (March 2022)

  23. Economic and fiscal outlook – November 2022 (PDF)

    24. OBR (17/11/22)

  24. The Big Brexit (PDF)

    25. Resolution Foundation, Swati Dhingra, Emily Fry, Sophie Hale & Ningyuan Jia (June 2022)

  25. Going it alone: health and Brexit in the UK

    26. Nuffield Trust, Mark Dayan, Martha McCarey, Tamara Hervey, Nick Fahy, Scott L Greer, Holly Jarman, Ellen Stewart and Dan Bristow (20/12/21)

  26. Has Brexit affected the UK’s medical workforce?

    27. Nuffield Trust, Martha McCarey and Mark Dayan (27/11/22)

  27. What can we know about the cost of Brexit so far?

    28. Centre for European Reform, John Springford (9/6/22)

  28. Brexit reduced overall EU-UK goods trade flows by almost one-fifth

    29. Economic and Social Research Institute (Ireland), Janez Kren and Martina Lawless (19/10/22)

  29. Post-Brexit UK Trade – An Update (PDF)

    30. Centre for Business Prosperity, Aston University, Jun Du, Emine Beyza Satoglu and Oleksandr Shepotylo (November 2022)

  30. Post-Brexit imports, supply chains, and the effect on consumer prices (PDF)

    31. UK in a Changing Europe, Jan David Bakker, Nikhil Datta, Josh De Lyon, Luisa Opitz and Dilan Yang (25/4/22)

  31. Non-tariff barriers and consumer prices: evidence from Brexit

    32. Centre for Economic Performance, LSE, Jan David Bakker, Nikhil Datta, Richard Davies and Josh De Lyon (December 2022)

  32. How is the End of Free Movement Affecting the Low-wage Labour Force in the UK?

    33. Migration Observatory, University of Oxford, Madeleine Sumption, Chris Forde, Gabriella Alberti and Peter William Walsh (15/8/22)

  33. The Trade and Cooperation Agreement: Two Years On – Proposals For Reform by UK Business

    34. British Chambers of Commerce (21/12/22)

  34. The Detriments of Brexit

    35. Yorkshire Bylines (June 2022) (see also)

Questions

  1. Summarise the negative effects of Brexit on the UK economy.
  2. Why is it difficult to quantify these effects?
  3. Explain the ‘doppelgängers’ method of estimating the costs of Brexit? How reliable is this method likely to be?
  4. How have UK firms attempted to reduce the costs of exporting to the EU?
  5. Is Brexit the sole cause of a shortage of labour in many sectors in the UK?
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A confluence of calamities

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.

Articles

Discussion (video)

Report

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?
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The economic fallout from war

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.

Articles

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.
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Inflation in Turkey: a self-inflicted problem?

Inflation has been rising around the world as a combination of a recovery in demand and supply-chain issues have resulted in aggregate demand exceeding aggregate supply. Annual consumer price inflation at the beginning of 2022 is around 2.5% in China, 3.5% in Sweden, 5% in the eurozone, Canada and India, 6% in the UK and South Africa, 7% in the USA and 7.5% in Mexico. In each case it is forecast to go a little higher before falling back again.

Inflation in Turkey

In Turkey inflation is much higher. The official annual rate of consumer price inflation in December 2021 was 36.1%, sharply up from 21.3% in November. But according to Turkey’s influential ENAGrup the December rate was much higher still at 82.8%. Official producer price inflation was 79.9% and this will feed through into official consumer price inflation in the coming weeks.

The rise in inflation has hit the poor particularly badly. According to the official statistics, in the year to December 2021, domestic energy prices increased by 34.2%, food by 44.7% and transport by 53.7%. In response, the government has raised the minimum wage by nearly 50% for 2022.

Causes of high and rising inflation

Why is Turkey’s inflation so much higher than in most developed and emerging economies and why has it risen so rapidly? The answer is that aggregate demand has been excessively boosted – well ahead of the ability of supply to respond. This has driven inflation expectations.

Turkey’s leader, President Erdoğan, in recent years has been seeking to stimulate economic growth through a mixture of supply-side, fiscal and monetary policies. He has hoped that the prospect of high growth would encourage both domestic and inward investment and that this would indeed drive the high growth he seeks. To encourage investment he has sought to reduce the reliance on imports through various measures, such as public procurement favouring domestic firms, tax reliefs for business and keeping interest rates down. He has claimed that the policy is focused on investment, production, employment and exports, instead of the ‘vicious circle of high interest rates and low exchange rates’.

With the pandemic, fiscal policy was largely focused on health, social security and employment measures. Such support was aided by a relatively healthy public finances. General government debt was 32% of GDP in 2020. This compares with 74% for the EU and 102% for the G7. Nevertheless, the worsening budget deficit has made future large-scale expenditure on public infrastructure, tax cuts for private business and other supply-side measures more difficult. Support for growth has thus fallen increasingly to monetary policy.

The Turkish central bank is not independent, with the President firing senior officials with whom he disagrees over monetary policy. The same applies to the Finance Ministry, with independently-minded ministers losing their jobs. Monetary and exchange rate policy have thus become the policy of the President. And it is here that a major part of the current problem of rising inflation lies.

Monetary and exchange rate policy

Despite rising inflation, the central bank has reduced interest rates. At its monthly meeting in September 2021, the Turkish central bank reduced its key rate from 19% to 18% and then to 16% in October, to 15% in November and 14% in December. These unprecedented rate cuts saw a large increase in the money supply. M1 rose by 11.7% in November alone; the annual growth rate was 59.5%. Broad money (M2 and M3) similarly rose. M3 grew by an annual rate of 51% in November 2021. The cut in interest rates and rise in money supply led to a rise in nominal expenditure which, in turn, led to higher prices.


The cut in interest rates and rise in nominal aggregate demand led to a large depreciation in the exchange rate. On 1 September 2021, 100 Turkish lira exchanged for $12.05. By 11 January 2022 the rate had fallen to $7.22 – a 40.1% depreciation. This depreciation, in turn, further stoked inflation as the lower exchange rate pushed up the price of imported goods. (Click here for a PowerPoint of the chart.)

Attempts were made to stem this fall in the lira on 20 December, by which point 100 lira were trading for just $5.50 (see chart) and speculation against the lira was gathering momentum. President Erdoğan announced a scheme to protect lira deposits against currency volatility, guaranteeing lira deposits in hard currency terms. The mechanism adopted was a rise in the interest rate on lira deposits with a maturity of 3 to 12 months, thereby encouraging people to lock in deposits for the medium term and not, therefore, to use them to speculate against the lira by buying other currencies. Other interest rates would be unaffected. At the same time the central bank used foreign currency reserves to engage in large-scale purchases of the lira on the foreign exchange market.

The lira rallied. By 23 December, 100 lira were trading for $8.79. But then selling of the lira began again and, as stated above, by early January 100 lira had fallen to $7.22. The underlying problem of excess demand and high inflationary expectations had not been solved.

It remains to be seen whether the President will change his mind and decide that the central bank needs to raise interest rates to reduce inflation and restore confidence.

Videos

Articles

Data

Questions

  1. Until the pandemic, the Turkish economy could be seen as a success story. Why?
  2. What supply-side policies did Turkey pursue?
  3. Use either an aggregate demand and supply diagram or a dynamic aggregate demand and supply (DAD/DAS) diagram to explain what has happened to inflation in Turkey in the past few months.
  4. Explain the thinking behind the successive cuts in interest rates since September 2021.
  5. Why did the measures introduced on 20 December 2021 only temporarily halt the depreciation of the lira?
  6. Choose a country with a higher rate of inflation than Turkey (see second data link above). Find out the causes of its high rate. Are they similar to those in Turkey?
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Hacking capitalism

The development of open-source software and blockchain technology has enabled people to ‘hack’ capitalism – to present and provide alternatives to traditional modes of production, consumption and exchange. This has enabled more effective markets in second-hand products, new environmentally-friendly technologies and by-products that otherwise would have been negative externalities. Cryptocurrencies are increasingly providing the medium of exchange in such markets.

In a BBC podcast, Hacking Capitalism, Leo Johnson, head of PwC’s Disruption Practice and younger brother of Boris Johnson, argues that various changes to the way capitalism operates can make it much more effective in improving the lives of everyone, including those left behind in the current world. The changes can help address the failings of capitalism, such as climate change, environmental destruction, poverty and inequality, corruption, a reinforcement of economic and political power and the lack of general access to capital. And these changes are already taking place around the world and could lead to a new ‘golden age’ for capitalism.

The changes are built on new attitudes and new technologies. New attitudes include regarding nature and the land as living resources that need respect. This would involve moving away from monocultures and deforestation and, with appropriate technologies (old and new), could lead to greater output, greater equality within agriculture and increased carbon absorption. The podcast gives examples from the developing and developed world of successful moves towards smaller-scale and more diversified agriculture that are much more sustainable. The rise in farmers’ markets provides an important mechanism to drive both demand and supply.

In the current model of capitalism there are many barriers to prevent the poor from benefiting from the system. As the podcast states, there are some 2 billion people across the world with no access to finance, 2.6 billion without access to sanitation, 1.2 billion without access to power – a set of barriers that stops capitalism from unlocking the skills and productivity of the many.

These problems were made worse by the response to the financial crisis of 2007–8, when governments chose to save the existing model of capitalism by propping up financial markets through quantitative easing, which massively inflated asset prices and aggravated the problem of inequality. They missed the opportunity of creating money to invest in alternative technologies and infrastructure.

New technology is the key to developing this new fairer, more sustainable model of capitalism. Such technologies could be developed (and are being in many cases) by co-operative, open-source methods. Many people, through these methods, could contribute to the development of products and their adaptation to meet different needs. The barriers of intellectual property rights are by-passed.

New technologies that allow easy rental or sharing of equipment (such as tractors) by poor farmers can transform lives and massively increase productivity. So too can the development of cryptocurrencies to allow access to finance for small farmers and businesses. This is particularly important in countries where access to traditional finance is restricted and/or where the currency is not stable with high inflation rates.

Blockchain technology can also help to drive second-hand markets by providing greater transparency and thereby cut waste. Manufacturers could take a stake in such markets through a process of certification or transfer.

A final hack is one that can directly tackle the problem of externalities – one of the greatest weaknesses of conventional capitalism. New technologies can support ways of rewarding people for reducing external costs, such as paying indigenous people for protecting the land or forests. Carbon markets have been developed in recent years. Perhaps the best example is the European Emissions Trading Scheme (EMS). But so far they have been developed in isolation. If the revenues generated could go directly to those involved in environmental protection, this would help further to internalise the externalities. The podcasts gives an example of a technology used in the Amazon to identify the environmental benefits of protecting rain forests that can then be used to allow reliable payments to the indigenous people though blockchain currencies.

Podcast

Questions

  1. What are the main reasons why capitalism has led to such great inequality?
  2. What do you understand by ‘hacking’ capitalism?
  3. How is open-source software relevant to the development of technology that can have broad benefits across society?
  4. Does the current model of capitalism encourage a self-centred approach to life?
  5. How might blockchain technology help in the development of a more inclusive and fairer form of capitalism?
  6. How might farmers’ co-operatives encourage rural development?
  7. What are the political obstacles to the developments considered in the podcast?