The ‘Classical’ Treasury view of the 1920s and 30s was that extra government spending or tax cuts were not the solution to depression and mass unemployment. Instead, it would crowd out private expenditure if the money supply were not allowed to rise as it would drive up interest rates. But if money supply were allowed to rise, this would be inflationary. The solution was to reduce budget deficits to increase confidence in public finances and to encourage private investment. Greater price and wage flexibility were the answer to markets not clearing.
Keynes countered these arguments by arguing that the economy could settle in a state of mass unemployment, with low confidence leading to lower consumer expenditure, lower investment, lower incomes and lower employment. The situation would be made worse, not better, by cuts in public expenditure or tax rises in an attempt to reduce the budget deficit. The solution was higher public expenditure to stimulate aggregate demand. This could be achieved by fiscal and monetary policies. Monetary policy alone could, however, be made ineffective by the liquidity trap. Extra money might simply be held rather than spent.
This old debate has been reborn since the financial crisis of 2007/8 and the subsequent deep recession and, more recently, the lack of recovery. (Click here for a PowerPoint of the chart.)
The articles below consider the current situation. Many economists, but certainly not all, take a Keynesian line that austerity policies to reduce public-sector deficits have been counter-productive. By dampening demand, such policies have reduced national income and slowed the recovery in both investment and consumer demand. This has at best slowed the rate of deficit reduction or at worst even increased the deficit, with lower GDP leading to a reduction in tax receipts and higher unemployment leading to higher government social security expenditure.
Although monetary policy has been very loose, measures such as record low interest rates and quantitative easing have been largely ineffective in stimulating demand. Economies are stuck in a liquidity trap, with banks preferring to build their reserves rather than to increase lending. This is the result partly of a lack of confidence and partly of pressure on them to meet Basel II and III requirements of reducing their leverage.
But despite the call from many economists to use fiscal policy and more radical monetary policy to stimulate demand, most governments have been pre-occupied with reducing their deficits and ultimately their debt. Their fear is that rising deficits undermine growth – a fear that was given weight by, amongst others, the work of Reinhart and Rogoff (see the blog posts Reinhart and Rogoff: debt and growth and It could be you and see also Light at the end of the tunnel – or an oncoming train?.
But there is some movement by governments. The new Japanese government under Shinzo Abe is following an aggressive monetary policy to drive down the exchange rate and boost aggregate demand (see A J-curve for Japan?) and, more recently, the European Commission has agreed to slow the pace of austerity by giving the Netherlands, France, Spain, Poland, Portugal and Slovenia more time to bring their budget deficits below the 3% of GDP target.
Of course, whether or not expansionary fiscal and/or monetary policies should be used to tackle a lack of growth does not alter the argument that supply-side policies are also required in order to increase potential economic growth.
A Keynesian Victory, but Austerity Stands Firm The New York Times, Business Day, Eduardo Porter (21/5/13)
With Austerity Under Fire, Countries Seek a More Balanced Solution Knowledge@Wharton (22/5/13)
Keynes, Say’s Law and the Theory of the Business Cycle History of Economics Review 25.1-2, Steven Kates (1996)
Is Lord Keynes back in Brussels? The Conversation, Fabrizio Carmignani (31/5/13)
Keynes’s Biggest Mistake The New York Times, Business Day, Bruce Bartlett (7/5/13)
Keynes’s Not So Big Mistake The New York Times, The Conscience of a Liberal blog, Paul Krugman (7/5/13)
The Chutzpah Caucus The New York Times, The Conscience of a Liberal blog, Paul Krugman (5/5/13)
Keynes and Keynesianism The New York Times, Business Day, Bruce Bartlett (14/5/13)
Japan Is About To Prove Keynesian Economics Entirely Wrong Forbes, Tim Worstall (11/5/13)
The poverty of austerity exposed Aljazeera, Paul Rosenberg (24/5/13)
Britain is a lab rat for George Osborne’s austerity programme experiment The Guardian, Larry Elliott (26/5/13)
Eurozone retreats from austerity – but only as far as ‘austerity lite’ The Guardian, Larry Elliott (30/5/13)
Europe’s long night of uncertainty Daily Times (Pakistan), S P Seth (29/5/13)
Abenomics vs. bad economics The Japan Times Gregory Clark (29/5/13)
European countries to be allowed to ease austerity BBC News (29/5/13)
U.K. Should Restore Growth, Rebalance Economy IMF Survey (22/5/13)
Now everyone is a Keynesian again – except George Osborne The Observer, William Keegan (2/6/13)
Austerity Versus Growth (III): Fiscal Policy And Debt Sustainability Social Europe Journal, Stefan Collignon (30/5/13)
Questions
- Explain what is meant by Say’s Law and its implication for macroeconomic policy.
- Why have many governments, including the UK government, been reluctant to pursue expansionary fiscal policies?
- What is meant by the liquidity trap? What is the way out of this trap?
- In the first article above, Eduardo Porter argues that ‘moral views are getting in the way of reason’. What does he mean by this?
- Explain what are meant by the ‘paradox of thrift’ and the ‘fallacy of composition’. How are these two concepts relevant to the debate over austerity policies?
- What are the dangers in pursuing aggressive Keynesian policies?
- What are the dangers in not pursuing aggressive Keynesian policies?
The new Japanese government under Shinzo Abe, which took office on 26 December 2012, has been pursuing a policy of weakening the yen. Using a combination of low interest rates, quantitative easing, expansionary fiscal policy and a declared aim of depreciation, the government has succeeded in driving down the value of the yen.
Since mid-November last year, the yen has depreciated by 28% against the dollar, 30% against the euro and 21% against sterling. The effective exchange rate index has fallen by 22% (see first diagram below: click here for a PowerPoint of the diagram).
But will this depreciation succeed in stimulating the Japanese economy and will it improve the balance of trade? The hope is that the falling yen will boost export sales by making them cheaper abroad, and will reduce the demand for imports by making them more expensive in Japan. The balance of trade will thereby improve and higher exports (an injection) and lower imports (a withdrawal) will stimulate aggregate demand and economic growth.
Traditionally Japan has run balance of trade surpluses, but since July 2012, it has been running monthly deficits – the longest run of deficits since 1980. But depreciation cannot be expected to turn this position around immediately. Indeed, theory suggests that the balance of trade is likely to deteriorate before it improves. This is known as the J-curve effect and is illustrated in the second diagram below. As page 768 of Economics, 8th edition states:
At first a devaluation or depreciation might make a current account deficit worse: the J-curve effect. The price elasticities of demand for imports and exports may be low in the short run (see Case Study 25.1 in MyEconLab). Directly after devaluation or depreciation, few extra exports may be sold, and more will have to be paid for imports that do not have immediate substitutes. There is thus an initial deterioration in the balance of trade before it eventually improves. In Figure 25.12 [the second diagram], devaluation takes place at time t1. As you can see, the diagram has a J shape.
Evidence suggests that the first part of the ‘J’ has been experienced in Japan: Japan’s balance of trade has deteriorated. But there is debate over whether the balance of trade will now start to improve. As the article by James Saft states:
But a look at the actual data shows Japanese companies, like British ones during a similar bout of currency weakness in 2008, appear to be more eager to use a newly competitive currency to pad profits through higher margins rather than higher export volumes. Thus far, Japanese exporters appear to be doing just that. Despite yen falls the price of Japanese exports in local currency has barely budged.
“Japanese companies have not actually cut the foreign currency prices of their exports. Just as with the UK exporters, the Japanese have chosen to hold foreign prices constant, maintain market share, and increase the yen value and thus the yen profit associated with yen depreciation,” UBS economist Paul Donovan writes in a note to clients.
The extra profits earned by Japanese companies from export sales may be stockpiled or paid out in dividends rather than reinvested. And what investment does take place may be abroad rather than in Japan. The net effect may be very little stimulus to the Japanese economy.
As stated by Saft above, the UK had a similar experience in the period 2007–9, when sterling depreciated some 27% (see the second diagram). The balance of trade improved very little and UK companies generally priced goods to markets abroad rather than cutting overseas prices.
But times were different then. The world was plunging into recession. Now global markets are mildly growing or static. Nevertheless, there is a danger that the upward slope of the J-curve in Japan may be pretty flat.
Articles
Weak yen a boon for investors, not Japan Reuters, James Saft (14/5/13)
Japan’s Trade Data Suggest Even Lower Yen Needed Wall Street Journal, Nick Hastings (22/5/13)
2 Misunderstandings About Japanese Trade Seeking Alpha, Marc Chandler (22/5/13)
Japanese trade deficit widens Financial Times, Ben McLannahan (22/5/13)
Data
BIS effective exchange rate indices Bank for International Settlements
Japan’s balance of trade Trading Economics
UK Trade, March 2013 ONS
Questions
- Explain the J-curve effect.
- Why is there some doubt about whether the Japanese balance of trade will improve significantly?
- What will be the consequences for Japanese growth?
- If foreign currency prices of Japanese exports do not change, what will determine the amount that Japan exports?
- What other measures is the Japanese government taking to stimulate the economy? What will determine the size of the multiplier effects of these measures?
- Using data from the ONS plot the UK’s quarterly balance of trade figures from 2007 to the present day. Explain the pattern that emerges.
High levels of government debt and the adverse effect this has on the economy has been a key influencing factor in the fiscal consolidation efforts across the world. A key factor providing evidence in support of the connection between high government debts and low economic growth was a paper by two Harvard economists. However, the data used in their research has been called into question.
As we saw in a previous post, It could be you, Carmen Reinhart and Kenneth Rogoff presented a paper back in January 2010. Their research suggested that when a country’s debt increases above 90% of GDP, economic growth will slow considerably. (Click here for a PowerPoint of the above chart.) As you might expect, given the timing of this research, policymakers were intrigued. For those governments in favour of cuts in government spending and increases in taxation to bring the government debt down, this research was dynamite. It seemed to provide the evidence needed to confirm that if left to grow, government debt will have a significantly adverse effect on growth. Here was evidence in favour of austerity.
But, did a simple error create misleading information? A student at the University of Massachusetts Amherst was trying to replicate the results found by Reinhart and Rogoff, but was unable to do so. Thomas Herndon contacted the Harvard professors and they sent him the spreadsheets they had used in their calculations. Looking through it, an error in calculating the average GDP was spotted. However, the student and his supervisors also engaged in further research and came across other inconsistencies. This led to a draft working paper being published in April. The paper did find the same correlation between high debt levels and low growth, but the outstanding results found by Reinhart and Rogoff disappeared. Responding to the error, the Harvard professors said:
We are grateful to Herndon et al. for the careful attention to our original Growth in a Time of Debt AER paper and for pointing out an important correction to Figure 2 of that paper. It is sobering that such an error slipped into one of our papers despite our best efforts to be consistently careful. We will redouble our efforts to avoid such errors in the future. We do not, however, believe this regrettable slip affects in any significant way the central message of the paper or that in our subsequent work.
So, how might this correction and the implications affect government policy? Are we likely to see a reversal in austerity measures? Only time will tell.
Articles
Seminal economic paper on debt draws criticism Wall Street Journal, Brenda Cronin (16/4/13)
Reinhart, Rogoff … and Herndon: The student who caught out the Profs BBC News, Ruth Alexander (20/4/13)
Reinhart and Rogoff publish formal correction Financial Times, Robin Harding (8/5/13)
The 90% question The Economist (20/4/13)
Reinhart and Rogoff correct austerity research error BBC News (9/5/13)
Harvard’s Reinhart and Rogoff publish formal collection CNBC, Robin Harding (9/5/13)
Rogoff and Reinhart should show some remorse and reconsider austerity The Guardian, Heidi Moore (26/4/13)
The buck does not stop with Reinhart and Rogoff Financial Times, Lawrence Summers (5/5/13)
Meet Carmen Reinhart and Kenneth Rogoff, the Harvard professors who thought they had austerity licked – and Thomas Herndon, the student who proved them wrong Independent, Tim Walker (22/4/13)
Papers
Growth in a time of debt American Economic Review (May 2010)
Does high public debt consistently stifle economic growth? A critique of Reinhart and Rogoff Political Economy Research Institute, Herndon, Ash and Pollin (April 2013)
Questions
- How do high government debts arise?
- In order to reduce government debts, cuts in government spending and increases in taxation are advocated. How does theory suggest that these changes in fiscal policy will affect economic growth?
- What are the arguments (a) in favour of and (b) against austerity measures?
- How might the correction made by Reinhart and Rogoff affect policymakers and their austerity plans?
- What are the key messages from Reinhart and Rogoff’s paper?
Interest rates have, for some years, been the main tool of monetary policy and of steering the macroeconomy. Across the world interest rates were lowered, in many cases to record lows, as a means of stimulating economic growth. Interest rates in the UK have been at 0.5% since March 2009 and on 2nd May 2013, the ECB matched this low rate, having cut its main interest rate from 0.75%. (Click here for a PowerPoint of the chart.)
Low interest rates reduce the cost of borrowing for both firms and consumers and this in turn encourages investment and can boost consumer expenditure. After all, when you borrow money, you do it to spend! Lower interest rates will also reduce the return on savings, again encouraging spending and for those on variable rate mortgages, mortgage payments will fall, increasing disposable income. However, these above effects are dependent on the banks passing the ECB’s main interest rate on its customers and this is by no means guaranteed.
Following the cut in interest rates, the euro exchange rate fell almost 2 cents against the dollar.
Interest rates in the eurozone have been at 0.75%, but a 0.25 point cut was widely expected, with the ongoing debt crisis in the Eurozone continuing to adversely affect growth and confidence. A lack of trust between banks has also contributed to a lack of lending, especially to small and medium sized enterprises. The ECB has injected money into financial institutions with the aim of stimulating lending, but in many cases, banks have simply placed this extra money back with the ECB, rather than lending it to other banks or customers. The fear is that those they lend to will be unable to repay the money. In response to this, there have been suggestions of interest rates becoming negative – that is, if banks want to hold their money with the ECB they will be charged to do it. Again, the idea is to encourage banks to lend their money instead.
Small and medium sized businesses have been described as the engine of growth, but it is these businesses who have been the least able to obtain finance. Without it, they have been unable to grow and this has held back the economic recovery. Indeed, GDP in the Eurozone has now fallen for five consecutive quarters, thus prompting the latest interest rate cut. A key question, however, will be how effective this quarter of a percent cut will be. If banks were unwilling to lend and firms unwilling to invest at 0.75%, will they be more inclined at 0.5%? The change is small and many suggest that it is not enough to make much of a difference. David Brown of New View Economics said:
The ECB rate cut is no surprise as it was well flagged by Draghi at last month’s meeting. Is it enough? No. The marginal effect of the cut is very limited, but at least it should have some symbolic rallying effect on economic confidence.
This was supported by Howard Archer at HIS Global Insight, who added:
Admittedly, it is unlikely that the trimming of interest rates from 0.75% to 0.5% will have a major growth impact, especially given fragmented credit markets, but any potential help to the eurozone economy in its current state is worthwhile.
Inflation in the eurozone is only at 1.2%, which is significantly below the ceiling of 2%, so this did give the ECB scope for the rate to be cut. (Click here for a PowerPoint of the chart.) After all, when interest rates fall, the idea is to boost aggregate demand, but with this, inflation can emerge. Mr Draghi said ‘we will monitor very closely all incoming information, and assess any impact on the outlook for price stability’. The primary objective of the ECB is the control of inflation and so had inflation been somewhat higher, we may have seen a different decision by the ECB. However, even then, 5 consecutive quarters of negative growth is hard to ignore.
So, if these lower interest rates have little effect on stimulating an economic recovery, what about a movement away from austerity? Many have been calling for stimulus in the economy, arguing that the continuing austerity measures are stifling growth. The European Council President urged governments to promote growth and job creation. Referring to this, he said:
Taking these measures is more urgent than anything … After three years of firefights, patience with austerity is wearing understandably thin.
However, Mr. Draghi urged for policymakers to stick with austerity and continue to focus on bringing debt levels down, while finding other ways to stimulate growth, including structural reform. The impact of this latest rate cut will certainly take time to filter through the economy and will very much depend on whether the 0.5% interest rate is passed on to customers, especially small businesses. Confidence and trust within the financial sector is therefore key and it might be that until this emerges, the eurozone itself is unlikely to emerge from its recession.
ECB ready to enter unchartered waters as bank cuts interest rate to fresh low of 0.5pc The Telegraph, Szu Ping Chan (2/5/13)
Draghi urges Eurozone governments to stay the course on austerity Financial Times, Michael Steen (2/5/13)
Eurozone interest rates cut to a record low of 0.5% The Guardian, Heather Stewart (2/5/13)
ECB’s Draghi ‘ready to act if needed’ BBC News (2/5/13)
Eurozone interest rates cut again as ECB matches Bank of England Independent, Russell Lynch (3/5/13)
Margio Draghi urges no let-up in austerity reforms after Eurozone rate cut – as it happened The Guardian, Graeme Wearden (2/5/13)
ECB cuts interest rate to record-low 0.5% in desperate measure to drag Eurozone out of recession Mail Online, Simon Tomlinson and Hugo Duncan (2/5/13)
ECB cuts interest rates, open to further action Reuters, Michael Shields (2/5/13)
Eurozone loosens up austerity, slowly Wall Street Journal (2/5/13)
ECB cuts interest rate, not enough to pull the region out of recession The Economic Times of India (2/5/13)
Euro steady ahead of ECB interest rate announcement Wall Street Journal, Clare Connaghan (2/5/13)
European Central Bank (ECB) cuts interest rates BBC News (2/5/13)
All eyes on ECB as markets expect rate cut Financial Times, Michael Steen (2/5/13)
Questions
- How is a recession defined?
- Using an aggregate demand/aggregate supply diagram, illustrate and explain the impact that this cut in interest rates should have.
- On which factors will the effectiveness of the cut in interest rates depend?
- Using the interest rate and exchange rate transmission mechanisms to help you, show the impact of interest rates on the various components of aggregate demand and thus on national output.
- What would be the potential impact of a negative interest rate?
- Why did the low inflation rate give the ECB scope to cut interest rates?
- What are the arguments for and against austerity measures in the Eurozone, given the 5 consecutive quarters of negative growth?
The latest growth data for the UK is somewhat difficult to interpret. It’s positive, but not that positive. The Conservatives say it shows that the economy is moving in the right direction. Labour suggests it is evidence that the Coalition’s policies are not working. With a return to positive growth, the UK has avoided the triple dip recession and here we take a closer look at the economic performance of other key nations.
In the final quarter of 2012, the US economy grew at 0.4%, but in the 3 months to March 2013, economic growth in America picked up to 2.5%. Consumer spending significantly increased, growing at an annualized rate of 3.2%, according to the Commerce Department. This figure helped boost the growth rate of the US economy, as consumer spending accounts for around two thirds of economic activity.
However, the growth figure was lower than expected, in part due to lower government spending. Furthermore, there are suggestions that the positive consumer spending figures are merely a positive blip and spending will fall as the US economy moves through 2013.
If this does prove to be the case in the USA, it will do little to further boost UK economic growth, which was recorded at 0.3% for the first 3 months of 2013. The Chancellor has said that the growth figures are encouraging and are evidence that the government’s policies are working.
Today’s figures are an encouraging sign the economy is healing … Despite a tough economic backdrop, we are making progress. We all know there are no easy answers to problems built up over many years, and I can’t promise the road ahead will always be smooth, but by continuing to confront our problems head on, Britain is recovering and we are building an economy fit for the future.
While the USA and UK have recorded positive growth, expectations of growth throughout Europe remain uncertain. Spain has revised its forecasts downwards for 2013, expecting the economy to shrink by over 1%. Even after 2013, growth is expected to remain very weak, forecast to be 0.5% in 2014 and 0.9% in 2015. To make matters worse, Spain’s unemployment continues to move in the wrong direction, with data for the first 3 months of 2013, recording an unemployment rate of 27.2% – the highest on record.
However, it’s not just Spanish unemployment that is on the rise. Figures for March show that in France, 3.2 million people were out of work, a 1.2 % rise compared to February. In the UK, 2.56 million people were recorded as unemployed, representing just under 8% of the working population. The German economy continues to outperform its European partners, but eurozone growth continues to look weak for the rest of 2013.
Despite much bad news in Europe, growth in other parts of the world remains buoyant. South Korea has recorded economic growth that is at its highest level in 2 years. Economic growth was just under 1%, but construction and investment both increased, perhaps a sign of an economy starting its recovery.
The Chinese economy has seemed relatively unaffected by the economic downturn, yet its economic growth has slowed. Averaging over 10% per annum for the last decade, the growth for January – March 2013 was only 7.7%. This is a decline on the previous 3 months and is lower than expected. If the Chinese economy does begin to slow (relatively speaking), this could present the global economic recovery with an unwelcome obstacle.
Many Western economies are reliant on exports to boost their growth figures and with such high demand in China, this is a key export market for many countries. If the Chinese economy continues to slow, consumer spending may even fall and this could mean a reduction in Chinese imports: that is, a reduction in other countries’ exports to China. However, for China’s competitors, the news is better, as with China’s move from a low to middle-income country, other countries will now see an opportunity to grasp a competitive advantage in the production of cheaper products. David Rees from Capital Economics said:
Trade data show that Chinese imports of commodities, and industrial metals in particular, have been falling in recent months … That is bad news for those emerging markets in Latin America, the Middle East, and Africa that predominately export commodities to China. It is not all bad news … To the extent that China’s structural slowdown reflects its transition from low to middle-income status, opportunities will present themselves for other EMs as China moves up the value chain. We are particularly upbeat on the manufacturing-based economies of South East Asia, along with Mexico, Poland, and Turkey.
News is better in Japan, where growth forecasts have been raised to 2.9% over the same period and the economy is expected to grow by 1.5% throughout both 2013 and 2014. Furthermore, suggestions that inflation may also reach 0.7% have boosted confidence. This might be the end of Japan’s troubles with deflation.
So, we have something of a mixed picture across the world, although the IMF predicts a global rate of growth of 3.5% for 2013, which would be an improvement on 2012 figures. The following articles consider the global situation.
Spain slashes economic growth forecast Sky News (26/4/13)
UK avoids triple-dip recession with better than expected 0.3% GDP growth The Guardian, Heather Stewart (26/4/13)
US economy grows 2.5% on buoyant consumer spending BBC News (26/4/13)
Poor French and Spanish jobs data but UK economy returns to growth – as it happened The Guardian, Graeme Wearden and Nick Fletcher (25/4/13)
UK economy avoids tiple-dip recession with 0.3pc GDP growth The Telegraph, Szu Ping Chan (25/4/13)
South Korea economic growth hits two year high BBC News (25/4/13)
S. Korea economy grows at the fastest pace in two years Bloomberg, Eunkyung Seo (25/4/13)
Spain revises down its economic forecast BBC News (26/4/13)
US economy sees broad growth Financial Times, Robin Harding (25/4/13)
Germany’s private sector shrinks as Eurozone decline continues – as it happened The Guardian, Graeme Wearden and Nick Fletcher (23/4/13)
China economic growth lower than forecast BBC News (15/4/13)
China’s slowing economy: what you need to know Bloomberg Business Week, Dexter Roberts (25/4/13)
Modest Growth Pickup in 2013, Projects IMF International Monetary Fund (23/1/13)
Questions
- How is economic growth measured?
- What is meant by a triple-dip recession?
- What has caused the small increase in growth in the UK? Do you think this signifies the start of the economic recovery?
- In the USA, what has caused the growth rate to reach 2.5% and why is it lower than expected?
- Why are growth rates in countries across the world relevant for UK forecasts of economic growth?
- Which factors have allowed the Chinese economy to achieve average growth rates above 10% for the past decade?
- Using an AD/AS diagram, illustrate the desired impact of the Coalition’s policies to boost economic growth.
- With unemployment rising in countries like Spain and France, how might Eurozone growth be affected in the coming months?
- Japanese growth is looking positive and inflation is expected to reach about 0.7%. Why is it that Japan has suffered from deflation for so many years and why is this a problem?
But there is some movement by governments. The new Japanese government under Shinzo Abe is following an aggressive monetary policy to drive down the exchange rate and boost aggregate demand (see A J-curve for Japan?) and, more recently, the European Commission has agreed to slow the pace of austerity by giving the Netherlands, France, Spain, Poland, Portugal and Slovenia more time to bring their budget deficits below the 3% of GDP target.
