Category: Economics: Ch 26

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Should the post-Covid-19 recovery be a Green recovery?

Pre-Covid 19, the climate change movement had gathered momentum with climate activist Greta Thunberg regularly in the news and people around the world striking in protest of inadequate government action on the climate crisis. However, now in a world overtaken by the pandemic, climate change is no longer at the centre and appears a more distant threat. The majority of the large climate change events due to take place this year have been delayed and policy announcements are aimed at supporting the current economic hardships. This is not surprising nor debatable, but there is a risk that, as Covid-19 dominates the news, policy and debates for a long time to come, this will overshadow any environmental initiatives that were due to be implemented.

Governments around the globe are navigating their economies through the pandemic and starting to think about the future road to recovery. However, there is an argument that it doesn’t have to be a case of ‘either or’, as there is the potential for policies to address the Covid-19 crisis and climate change at the same time. How policy makers respond now could shape the fight against climate change for the future. One of the lessons from the pandemic is that quick responses to high impact risks are vital to reduce costs. With that in mind, and given the costs of climate change, it is arguable that now is the best time to address its challenges.

Climate change and Covid

It is estimated that there was a total global loss of $3tn caused by natural disasters over the past decade. By 2050, cumulative damages from climate change are predicted to reach $8 trillion, impoverishing the world as a whole by 3% of GDP and the poorest regions by more. Climate activists argue that despite the economic consequences of climate change, the action taken by governments has been insufficient. In 2015, the then Bank of England governor, Mark Carney warned: ‘Once climate change becomes a defining issue for financial stability, it may already be too late.’

However, since the pandemic struck all over the world, there have been positive consequences for the environment. Pollution levels started dropping fast as airlines grounded fleets, car travel came to a stop and industries shut down. With 2.6bn people living under restrictions under their country’s lockdown, there has also been an impact on the environment, not just the spread of the virus. Given that the lockdowns across the world have come at huge social and human costs, is now not the time to ensure that these improvements for the environment are not just temporary but ignite long-term changes?

Given the clear impacts and risks of Covid on peoples’ health, our ability to change our behaviour quickly has been striking. The importance of behaviour change has been brought to the centre and, arguably, it shows that we are capable of change when lives are at risk and are deemed more important than business-as-usual GDP growth. The application to climate change, however, is not as straightforward, as the costs to human lives are often viewed as a future problem.

Global cooperation

Dr Laure de Preux, Assistant Professor of Economics at Imperial College Business School, highlights the important role that cooperation across borders plays in the face of a global crisis like Coronavirus, and how that can be applied to the fight against climate change.

The big challenges the world is facing, including the climate change crisis, can only be dealt with efficiently through international cooperation. We cannot only act individually; the benefits of our actions are multiplied if integrated into a global strategy. In the case of COVID-19, social distancing measures can only be truly effective if they are adopted at a large scale.

World leaders are aware that their economies now face one of the most severe recessions in history as a consequence of the coronavirus restrictions. Governments are going to have to dedicate huge budgets to enable the economic activity to resume again. This presents a unique challenge, but also a massive opportunity for global cooperation. The question to be asked, therefore, is that if these stimulus packages are a one-off chance to transform the economy, how should the government spend it and what should be their focus? Should the recovery policies focus on creating a greener economy?

The European Union unveiled what it is calling the biggest ‘green’ stimulus package in history. Ursula von der Leyen, the European Commission president, told European Parliament members that this issue is about all nations and it is bigger than any one of them. The deputy Prime Minister of Spain, Teresa Ribera, states that there is a greater risk by not acting in this way. She argues that if the recovery is not green, then it will be nothing but a short-cut to solve the current problems rather than a true economic recovery.

It is not just in Europe where the recovery has an environment focus. Joe Biden is believed to be planning a similarly huge green stimulus package for the US. The model echoes the vast investment projects of the New Deal that helped lift America out of the Great Depression in the 1930s.

There are sound economic reasons why politicians see green technology as a prudent investment. Renewable energy is now often cheaper than fossil fuels in large parts of the world and the technologies are proven and can be built at scale today. The argument for renewables providing a pathway for clean future growth is based on the logic of much of manufacturing – the more you produce, the cheaper it gets. However, China does not appear to have similar plans for their recovery. China produces almost a third of the world’s emissions, as much as the USA and the EU combined. At the annual National People’s Congress, there was no indication that the big expansion of coal-fired electricity generation would be reversed, even though it is also expanding the production of renewable energy. China expanded its coal-fired power stations as a key part of its stimulus package after the 2008 financial crisis.

Policy decisions

The UK government receives ongoing pressure from energy companies. The boss of energy giant SSE, Alistair Phillips-Davies has warned that a failure to deal with climate change could eventually have a greater economic impact than coronavirus. SSE wants the UK government to encourage private investment in renewables by giving the green light to big new projects, such as hydrogen and carbon capture plants and boosting electric vehicles. Despite the impacts of climate change not being immediately felt in comparison to Covid-19, Phillips-Davies argues that a failure to deal with climate change could lead to great long-term impacts:

While it is still too early to predict with confidence the full human, social and economic impact of coronavirus, we can say with certainty that significant investment will be needed to rebuild the UK economy in its wake.

It is clear that any pandemic-induced financial decisions made over the next 12 months will shape the global economy for the next decade. The full impact of the virus on climate change will be determined by the world’s stimulus measures adopted post-pandemic. Following the 2008 financial crisis, the energy-intensive stimulus measures that followed, particularly in China, boosted emissions. Therefore, if we are to meet the reduction in emissions target our response needs to be green, helping to shape a sustainable future. Dr Alex Koberle, of the Grantham Institute at Imperial College London, argues that Governments should take time to reflect, learn from past mistakes and redirect development towards a sustainable future.

Shouldn’t growth be given priority?

With 1.6 billion people working in the informal economy worldwide reckoned to be in immediate danger of losing their livelihoods (according to the International Labour Organization), is now the right time to be focusing on the climate? Industries such as airlines and car manufacturing are strategic industries, employing millions of people. Headlines of longer-term environmental targets will be given less importance than headlines of job losses. Recovery relies on the government finding ways to employ lots and lots of people. There is a close relationship between real GDP, employment and energy consumption. Therefore, any policies aimed at reducing greenhouse gas emissions, unless carefully directed, could reduce economic growth and employment for both less and more developed economies. Such policies would increase the cost of conventional energy sharply.

Critics of a green energy policy for recovery argue that investing in renewable energy ignores the adverse effects of reduced investment and higher energy costs in other sectors. By governments prioritising policy to focus on the environment, they could harm the ability of most people to improve their own circumstances, especially given the terrible economic shock caused by the lockdowns.

Conclusion

With the majority of news in recent months providing little joy, there has been at least the positive impact on the environment. However, advocates say it not a cause for celebration and warn that any benefits are likely to be short lived. There have been some positive behavioural impacts but the true test will be what happens in the recovery phase. If the focus is returned to business as usual what happens to the targets actioned prior to Covid-19?

The immediate priority of all governments right now is to control the pandemic and to save lives. As their policy interventions have an impact and economies start to emerge from this crisis, then there is an important debate to be had about how new investments can help create a cleaner, greener recovery. We have learnt from the current pandemic that changes can be made when consequences are imminent, however, climate change is a threat that doesn’t go away, and is arguably just as urgent. Solutions to both crises can be integrated into a coherent response to propel the global economy towards sustainable growth and increased resilience.

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Questions

  1. Are government attempts to reduce the impact of climate change beneficial or harmful to UK firms?
  2. What policy instruments can the government use to increase economic activity?
  3. How does an increase in investment affect aggregate demand?
  4. What are the costs and benefits of economic growth?
  5. Why can climate change be described as a market failure?
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A global supply-side shock: the impact of the coronavirus (COVID-19) outbreak

The global economic impact of the coronavirus outbreak is uncertain but potentially very large. There has already been a massive effect on China, with large parts of the Chinese economy shut down. As the disease spreads to other countries, they too will experience supply shocks as schools and workplaces close down and travel restrictions are imposed. This has already happened in South Korea, Japan and Italy. The size of these effects is still unknown and will depend on the effectiveness of the containment measures that countries are putting in place and on the behaviour of people in self isolating if they have any symptoms or even possible exposure.

The OECD in its March 2020 interim Economic Assessment: Coronavirus: The world economy at risk estimates that global economic growth will be around half a percentage point lower than previously forecast – down from 2.9% to 2.4%. But this is based on the assumption that ‘the epidemic peaks in China in the first quarter of 2020 and outbreaks in other countries prove mild and contained.’ If the disease develops into a pandemic, as many health officials are predicting, the global economic effect could be much larger. In such cases, the OECD predicts a halving of global economic growth to 1.5%. But even this may be overoptimistic, with growing talk of a global recession.

Governments and central banks around the world are already planning measures to boost aggregate demand. The Federal Reserve, as an emergency measure on 3 March, reduced the Federal Funds rate by half a percentage point from the range of 1.5–1.75% to 1.0–1.25%. This was the first emergency rate cut since 2008.

Economic uncertainty

With considerable uncertainty about the spread of the disease and how effective containment measures will be, stock markets have fallen dramatically. The FTSE 100 fell by nearly 14% in the second half of February, before recovering slightly at the beginning of March. It then fell by a further 7.7% on 9 March – the biggest one-day fall since the 2008 financial crisis. This was specifically in response to a plunge in oil prices as Russia and Saudi Arabia engaged in a price war. But it also reflected growing pessimism about the economic impact of the coronavirus as the global spread of the epidemic accelerated and countries were contemplating more draconian lock-down measures.

Firms have been drawing up contingency plans to respond to panic buying of essential items and falling demand for other goods. Supply-chain managers are working out how to respond to these changes and to disruptions to supplies from China and other affected countries.

Firms are also having to plan for disruptions to labour supply. Large numbers of employees may fall sick or be advised/required to stay at home. Or they may have to stay at home to look after children whose schools are closed. For some firms, having their staff working from home will be easy; for others it will be impossible.

Some industries will be particularly badly hit, such as airlines, cruise lines and travel companies. Budget airlines have cancelled several flights and travel companies are beginning to offer substantial discounts. Manufacturing firms which are dependent on supplies from affected countries have also been badly hit. This is reflected in their share prices, which have seen large falls.

Longer-term effects

Uncertainty could have longer-term impacts on aggregate supply if firms decide to put investment on hold. This would also impact on the capital goods industries which supply machinery and equipment to investing firms. For the UK, already having suffered from Brexit uncertainty, this further uncertainty could prove very damaging for economic growth.

While aggregate supply is likely to fall, or at least to grow less quickly, what will happen to the balance of aggregate demand and supply is less clear. A temporary rise in demand, as people stock up, could see a surge in prices, unless supermarkets and other firms are keen to demonstrate that they are not profiting from the disease. In the longer term, if aggregate demand continues to grow at past rates, it will probably outstrip the growth in aggregate supply and result in rising inflation. If, however, demand is subdued, as uncertainty about their own economic situation leads people to cut back on spending, inflation and even the price level may fall.

How quickly the global economy will ‘bounce back’ depends on how long the outbreak lasts and whether it becomes a serious pandemic and on how much investment has been affected. At the current time, it is impossible to predict with any accuracy the timing and scale of any such bounce back.

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Questions

  1. Using a supply and demand diagram, illustrate the fall in stock market prices caused by concerns over the effects of the coronavirus.
  2. Using either (i) an aggregate demand and supply diagram or (ii) a DAD/DAS diagram, illustrate how a fall in aggregate supply as a result of the economic effects of the coronavirus would lead to (a) a fall in real income and (i) a fall in the price level or (ii) a fall in inflation; (b) a fall in real income and (i) a rise in the price level or (ii) a rise in inflation.
  3. What would be the likely effects of central banks (a) cutting interest rates; (b) engaging in further quantitative easing?
  4. What would be the likely effects of governments running a larger budget deficit as a means of boosting the economy?
  5. Distinguish between stabilising and destabilising speculation. How would you characterise the speculation that has taken place on stock markets in response to the coronavirus?
  6. What are the implications of people being paid on zero-hour contracts of the government requiring workplaces to close?
  7. What long-term changes to working practices and government policy could result from short-term adjustments to the epidemic?
  8. Is the long-term macroeconomic impact of the coronavirus likely to be zero, as economies bounce back? Explain.
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The costs of a No-Deal Brexit

There have been many analyses of the economic effects of Brexit, both before the referendum and at various times since, including analyses of the effects of the deal negotiated by Theresa May’s government and the EU. But with the prospect of a no-deal Brexit on 31 October under the new Boris Johnson government, attention has turned to the effects of leaving the EU without a deal.

There have been two major analyses recently of the likely effects of a no-deal Brexit – one by the International Monetary Fund (IMF) and one by the Office for Budget Responsibility (OBR).

IMF analysis

The first was in April by the IMF as part of its 6-monthly World Economic Outlook. In Scenario Box 1.1. ‘A No-Deal Brexit’ on page 28 of Chapter 1, the IMF looked at two possible scenarios.

Scenario A assumes no border disruptions and a relatively small increase in UK sovereign and corporate spreads. Scenario B incorporates significant border disruptions that increase import costs for UK firms and households (and to a lesser extent for the European Union) and a more severe tightening in financial conditions.

Under both scenarios, UK exports to the EU and UK imports from the EU revert to WTO rules. As a result, tariffs are imposed by mid-2020 or earlier. Non-tariff barriers rise at first but are gradually reduced over time. Most free-trade arrangements between the EU and other countries are initially unavailable to the UK (see the blog EU strikes major trade deals) but both scenarios assume that ‘new trade agreements are secured after two years, and on terms similar to those currently in place.’

Both scenarios also assume a reduction in net immigration from the EU of 25 000 per year until 2030. Both assume a rise in corporate and government bond rates, reflecting greater uncertainty, with the effect being greater in Scenario B. Both assume a relaxing of monetary and fiscal policy in response to downward pressures on the economy.

The IMF analysis shows a negative impact on UK GDP, with the economy falling into recession in late 2019 and in 2020. This is the result of higher trade costs and reduced business investment caused by a poorer economic outlook and increased uncertainty. By 2021, even under Scenario A, GDP is approximately 3.5% lower than it would have been if the UK had left the EU with the negotiated deal. For the rest of the EU, GDP is around 0.5% lower, although the effect varies considerably from country to country.

The IMF analysis makes optimistic assumptions, such as the UK being able to negotiate new trade deals with non-EU countries to replace those lost by leaving. More pessimistic assumptions would lead to greater costs.

OBR analysis

Building on the analysis of the IMF, the Office for Budget Responsibility considered the effect of a no-deal Brexit on the public finances in its biennial Fiscal risks report, published on 17 July 2019. This argues that, under the relatively benign Scenario A assumptions of the IMF, the lower GDP would result in annual public-sector net borrowing (PSNB) rising. By 2021/22, if the UK had left with the deal negotiated with the EU, PSNB would have been around £18bn. A no-deal Brexit would push this up to around £51bn.


According to the OBR, the contributors to this rise in public-sector net borrowing of around £33bn are:

  • A fall in income tax and national insurance receipts of around £16.5bn per year because of lower incomes.
  • A fall in corporation tax and expenditure taxes, such as VAT, excise duties and stamp duty of around £22.5bn per year because of lower expenditure.
  • A fall in capital taxes, such as inheritance tax and capital gains tax of around £10bn per year because of a fall in asset prices.
  • These are offset to a small degree by a rise in customs duties (around £10bn) because of the imposition of tariffs and by lower debt repayments (of around £6bn) because of the Bank of England having to reduce interest rates.

The rise in PSNB would constrain the government’s ability to use fiscal policy to boost the economy and to engage in the large-scale capital projects advocated by Boris Johnson while making the substantial tax cuts he is proposing. A less optimistic set of assumptions would, of course, lead to a bigger rise in PSNB, which would further constrain fiscal policy.

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Questions

  1. What are the assumptions of the IMF World Economic Outlook forecasts for the effects of a no-deal Brexit? Do you agree with these assumptions? Explain.
  2. What are the assumptions of the analysis of a no-deal Brexit on the public finances in the OBR’s Fiscal risks report? Do you agree with these assumptions? Explain.
  3. What is the difference between forecasts and analyses of outcomes?
  4. For what reasons might growth over the next few years be higher than in the IMF forecasts under either scenario?
  5. For what reasons might growth over the next few years be lower than in the IMF forecasts under either scenario?
  6. For what reasons might public-sector net borrowing (PSNB) over the next few years be lower than in the OBR forecast?
  7. For what reasons might PSNB over the next few years be higher than in the OBR forecast?
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EU strikes major trade deals

The EU has recently signed two trade deals after many years of negotiations. The first is with Mercosur, the South American trading and economic co-operation organisation, currently consisting of Brazil, Argentina, Uruguay and Paraguay – a region of over 260m people. The second is with Vietnam, which should result in tariff reductions of 99% of traded goods. This is the first deal of its kind with a developing country in Asia. These deals follow a recent landmark deal with Japan.

At a time when protectionism is on the rise, with the USA involved in trade disputes with a number of countries, such as China and the EU, deals to cut tariffs and other trade restrictions are seen as a positive development by those arguing that freer trade results in a net gain to the participants. The law of comparative advantage suggests that trade allows countries to consume beyond their production possibility curves. What is more, the competition experienced through increased trade can lead to greater efficiency and product development.

It is estimated that the deal with Mercosur could result in a saving of some €4bn per annum in tariffs on EU exports.

But although there is a net economic gain from greater trade, some sectors will lose as consumers switch to cheaper imports. Thus the agricultural sector in many parts of the EU is worried about cheaper food imports from South America. What is more, increased trade could have detrimental environmental impacts. For example, greater imports of beef from Brazil into the EU could result in more Amazonian forest being cut down to graze cattle.

But provided environmental externalities are internalised within trade deals and provided economies are given time to adjust to changing demand patterns, such large-scale trade deals can be of significant benefit to the participants. In the case of the EU–Mercosur agreement, according to the EU Reporter article, it:

…upholds the highest standards of food safety and consumer protection, as well as the precautionary principle for food safety and environmental rules and contains specific commitments on labour rights and environmental protection, including the implementation of the Paris climate agreement and related enforcement rules.

The size of the EU market and its economic power puts it in a strong position to get the best trade deals for its member states. As EU Trade Commissioner, Cecilia Malmström stated:

Over the past few years the EU has consolidated its position as the global leader in open and sustainable trade. Agreements with 15 countries have entered into force since 2014, notably with Canada and Japan. This agreement adds four more countries to our impressive roster of trade allies.

Outside the EU, the UK will have less power to negotiate similar deals.

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Questions

  1. Draw a diagram to illustrate the gains for a previously closed economy from engaging in trade by specialising in products in which it has a comparative advantage.
  2. Distinguish between trade creation and trade diversion from a trade deal with another country or group of countries.
  3. Which sectors in the EU and which sectors in the Mercosur countries and Vietnam are likely to benefit the most from the respective trade deals?
  4. Which sectors in the EU and which sectors in the Mercosur countries and Vietnam are likely to lose from the respective trade deals?
  5. Are the EU–Mercosur and the EU–Vietnam trade deals likely to lead to net trade creation or net trade diversion?
  6. What are the potential environmental dangers from a trade deal between the EU and Mercosur? To what extent have these dangers been addressed in the recent draft agreement?
  7. Will the UK benefit from the EU’s trade deals with Mercosur and Vietnam?
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A vision of global governance


Late January sees the annual global World Economic Forum meeting of politicians, businesspeople and the great and the good at Davos in Switzerland. Global economic, political, social and environmental issues are discussed and, sometimes, agreements are reached between world leaders. The 2019 meeting was somewhat subdued as worries persist about a global slowdown, Brexit and the trade war between the USA and China. Donald Trump, Xi Jinping, Vladimir Putin and Theresa May were all absent, each having more pressing issues to attend to at home.

There was, however, a feeling that the world economic order is changing, with the rise in populism and with less certainty about the continuance of the model of freer trade and a model of capitalism modified by market intervention. There was also concern about the roles of the three major international institutions set up at the end of World War II: the IMF, the World Bank and the WTO (formerly the GATT). In a key speech, Angela Merkel urged countries not to abandon the world economic order that such institutions help to maintain. The world can only resolve disputes and promote development, she argued, by co-operating and respecting the role of such institutions.

But the role of these institutions has been a topic of controversy for many years and their role has changed somewhat. Originally, the IMF’s role was to support an adjustable peg exchange rate system (the ‘Bretton Woods‘ system) with the US dollar as the international reserve currency. It would lend to countries in balance of payments deficit to allow them to maintain their rate pegged to the dollar unless it was perceived to be a fundamental deficit, in which case they were expected to devalue their currency. The system collapsed in 1971, but the IMF continued to provide short-term, and sometimes longer-term, finance to countries in balance of payments difficulties.

The World Bank was primarily set up to provide development finance to poorer countries. The General Agreement on Tariffs and Trade (GATT) and then the WTO were set up to encourage freer trade and to resolve trade disputes.

However, the institutions were perceived with suspicion by many developing countries and by more left-leaning developed countries, who saw them as part of the ‘Washington consensus’. Loans from the IMF and World Bank were normally contingent on countries pursuing policies of market liberalisation, financial deregulation and privatisation.

Although there has been some movement, especially by the IMF, towards acknowledging market failures and supporting a more broadly-based development, there are still many economists and commentators calling for more radical reform of these institutions. They advocate that the World Bank and IMF should directly support investment – public as well as private – and support the Green New Deal.

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Questions

  1. What was the Bretton Woods system that was adopted at the end of World War II?
  2. What did Keynes propose as an alternative to the system that was actually adopted?
  3. Explain the roles of (a) the IMF, (b) the World Bank, (c) the WTO (formerly the GATT).
  4. What is meant by an adjustable exchange rate system?
  5. Why did the Bretton Woods system collapse in 1971?
  6. How have the roles of the IMF, World Bank and WTO/GATT evolved since they were founded?
  7. What reforms would you suggest to each of the three institutions and why?
  8. What threats are there currently to the international economic order?
  9. Summarise the arguments about the world economic order made by Angela Merkel in her address to the World Economic Forum.