The article below looks at the economy of Brazil. The statistics do not look good. Real output fell last year by 3.8% and this year it is expected to fall by another 3.3%. Inflation this year is expected to be 9.0% and unemployment 11.2%, with the government deficit expected to be 10.4% of GDP.
The article considers Keynesian economics in the light of the case of Brazil, which is suffering from declining potential supply, but excess demand. It compares Brazil with the case of most developed countries in the aftermath of the financial crisis. Here countries have suffered from a lack of demand, made worse by austerity policies, and only helped by expansionary monetary policy. But the effect of the monetary policy has generally been weak, as much of the extra money has been 
used to purchase assets rather than funding a growth in aggregate demand.
Different policy prescriptions are proposed in the article. For developed countries struggling to grow, the solution would seem to be expansionary fiscal policy, made easy to fund by lower interest rates. For Brazil, by contrast, the solution proposed is one of austerity. Fiscal policy should be tightened. As the article states:
Spending restraint might well prove painful for some members of Brazilian society. But hyperinflation and default are hardly a walk in the park for those struggling to get by. Generally speaking, austerity has been a misguided policy approach in recent years. But Brazil is a special case. For now, anyway.
The tight fiscal policies could be accompanied by supply-side policies aimed at reducing bureaucracy and inefficiency.
Article
Brazil and the new old normal: There is more than one kind of economic mess to be in The Economist, Free Exchange Economics (12/10/16)
Questions
- Explain what is meant by ‘crowding out’.
- What is meant by the ‘liquidity trap’? Why are many countries in the developed world currently in a liquidity trap?
- Why have central banks in the developed world found it difficult to stimulate growth with policies of quantitative easing?
- Under what circumstances would austerity policies be valuable in the developed world?
- Why is crowding out of fiscal policy unlikely to occur to any great extent in Europe, but is highly likely to occur in Brazil?
- What has happened to potential GDP in Brazil in the past couple of years?
- What is meant by the ‘terms of trade’? Why have Brazil’s terms of trade deteriorated?
- What sort of policies could the Brazilian government pursue to raise growth rates? Are these demand-side or supply-side policies?
- Should Brazil pursue austerity policies and, if so, what form should they take?
The Bank of England’s monetary policy is aimed at achieving an inflation rate of 2% CPI inflation ‘within a reasonable time period’, typically within 24 months. But speaking in Nottingham in one of the ‘Future Forum‘ events on 14 October, the Bank’s Governor, Mark Carney, said that the Bank would be willing to accept inflation above the target in order to protect growth in the economy.
“We’re willing to tolerate a bit of an overshoot in inflation over the course of the next few years in order to avoid rising unemployment, to cushion the blow and make sure the economy can adjust as well as possible.”
But why should the Bank be willing to relax its target – a target set by the government? In practice, a temporary rise above 2% can still be consistent with the target if inflation is predicted to return to 2% within ‘a reasonable time period’.
But if even if the forecast rate of inflation were above 2% in two years’ time, there would still be some logic in the Bank not tightening monetary policy – by raising Bank Rate or ending, or even reversing, quantitative easing. This would be the case when there was, or forecast to be, stagflation, whether actual or as a result of monetary policy.
The aim of an inflation target of 2% is to help create a growth in aggregate demand consistent with the economy operating with a zero output gap: i.e. with no excess or deficient demand. But when inflation is caused by rising costs, such as that caused by a depreciation in the exchange rate, inflation could still rise even though the output gap were negative.
A rise in interest rates in these circumstances could cause the negative output gap to widen. The economy could slip into stagflation: rising prices and falling output. Hopefully, if the exchange rate stopped falling, inflation would fall back once the effects of the lower exchange rate had fed through. But that might take longer than 24 months or a ‘reasonable period of time’.
So even if not raising interest rates in a situation of stagflation where the inflation rate is forecast to be above 2% in 24 months’ time is not in the ‘letter’ of the policy, it is within the ‘spirit’.
But what of exchange rates? Mark Carney also said that “Our job is not to target the exchange rate, our job is to target inflation. But that doesn’t mean we’re indifferent to the level of sterling. It does matter, ultimately, for inflation and over the course of two to three years out. So it matters to the conduct of monetary policy.”
But not tightening monetary policy if inflation is forecast to go above 2% could cause the exchange rate to fall further. It seems as if trying to arrest the fall in sterling and prevent a fall into recession are conflicting aims when the policy instrument for both is the rate of interest.
Articles
BoE’s Carney says not indifferent to sterling level, boosts pound Reuters, Andy Bruce and Peter Hobson (14/10/16)
Bank governor Mark Carney says inflation will rise BBC News, Kamal Ahmed (14/10/16)
Stagflation Risk May Mean Carney Has Little Love for Marmite Bloomberg, Simon Kennedy (14/10/16)
Bank can ‘let inflation go a bit’ to protect economy from Brexit, says Carney – but sterling will be a factor for interest rates This is Money, Adrian Lowery (14/10/16)
UK gilt yields soar on ‘hard Brexit’ and inflation fears Financial Times, Michael Mackenzie and Mehreen Khan (14/10/16)
Brexit latest: Life will ‘get difficult’ for the poor due to inflation says Mark Carney Independent, Ben Chu (14/10/16)
Prices to continue rising, warns Bank of England governor The Guardian, Katie Allen (14/10/16)
Bank of England
Monetary Policy Bank of England
Monetary Policy Framework Bank of England
How does monetary policy work? Bank of England
Future Forum 2016 Bank of England
Questions
- Explain the difference between cost-push and demand-pull inflation.
- If inflation rises as a result of rising costs, what can we say about the rate of increase in these costs? Is it likely that cost-push inflation would persist beyond the effects of a supply-side shock working through the economy?
- Can interest rates be used to control both inflation and the exchange rate? Explain why or why not.
- What is the possible role of fiscal policy in the current situation of a falling exchange rate and rising inflation?
- Why does the Bank of England target the rate of inflation in 24 months’ time and not the rate today? (After all, the Governor has to write a letter to the Chancellor explaining why inflation in any month is more than 1 percentage point above or below the target of 2%.)
- What is meant by a zero output gap? Is this the same as a situation of (a) full employment, (b) operating at full capacity? Explain.
- Why have UK gilt yields soared in the light of a possible ‘hard Brexit’, a falling exchange rate and rising inflation?
The IMF has just published its six-monthly World Economic Outlook. It expects world aggregate demand and growth to remain subdued. A combination of worries about the effects of Brexit and slower-than-expected growth in the USA has led the IMF to revise its forecasts for growth for both 2016 and 2017 downward by 0.1 percentage points compared with its April 2016 forecast. To quote the summary of the report:
Global growth is projected to slow to 3.1 percent in 2016 before recovering to 3.4 percent in 2017. The forecast, revised down by 0.1 percentage point for 2016 and 2017 relative to April, reflects a more subdued outlook for advanced economies following the June UK vote in favour of leaving the European Union (Brexit) and weaker-than-expected growth in the United States. These developments have put further downward pressure on global interest rates, as monetary policy is now expected to remain accommodative for longer.
Although the market reaction to the Brexit shock was reassuringly orderly, the ultimate impact remains very unclear, as the fate of institutional and trade arrangements between the United Kingdom and the European Union is uncertain.
The IMF is pessimistic about the outlook for advanced countries. 
It identifies political uncertainty and concerns about immigration and integration resulting in a rise in demands for populist, inward-looking policies as the major risk factors.
It is more optimistic about growth prospect for some emerging market economies, especially in Asia, but sees a sharp slowdown in other developing countries, especially in sub-Saharan Africa and in countries generally which rely on commodity exports during a period of lower commodity prices.
With little scope for further easing of monetary policy, the IMF recommends the increased use of fiscal policies:
Accommodative monetary policy alone cannot lift demand sufficiently, and fiscal support — calibrated to the amount of space available and oriented toward policies that protect the vulnerable and lift medium-term growth prospects — therefore remains essential for generating momentum and avoiding a lasting downshift in medium-term inflation expectations.
These fiscal policies should be accompanied by supply-side policies focused on structural reforms that can offset waning potential economic growth. These should include efforts to “boost labour force participation, improve the matching process in labour markets, and promote investment in research and development and innovation.”
Articles
IMF Sees Subdued Global Growth, Warns Economic Stagnation Could Fuel Protectionist Calls IMF News (4/10/16)
The World Economy: Moving Sideways IMF blog, Maurice Obstfeld (4/10/16)
The biggest threats facing the global economy in eight charts The Telegraph, Szu Ping Chan (4/10/16)
IMF and World Bank launch defence of open markets and free trade The Guardian, Larry Elliott (6/10/16)
IMF warns of financial stability risks BBC News, Andrew Walker (5/10/16)
Backlash to World Economic Order Clouds Outlook at IMF Talks Bloomberg, Rich Miller, Saleha Mohsin and Malcolm Scott (4/10/16)
IMF lowers growth forecast for US and other advanced economies Financial Times, Shawn Donnan (4/10/16)
Seven key points from the IMF’s latest global health check Financial TImes, Mehreen Khan (4/10/16)
Latest IMF forecast paints a bleak picture for global growth The Conversation, Geraint Johnes (5/10/16)
IMF Report, Videos and Data
World Economic Outlook, October 2016 IMF (4/10/16)
Press Conference on the Analytical Chapters IMF (27/9/16)
IMF Chief Economist Maurice Obstfeld explains the outlook for the global economy IMF Video (4/10/16)
Fiscal Policy in the New Normal IMF Video (6/10/16)
CNN Debate on the Global Economy IMF Video (6/10/16)
World Economic Outlook Database IMF (October 2016)
Questions
- Why is the IMF forecasting lower growth than in did in its April 2016 report?
- How much credibility should be put on IMF and other forecasts of global economic growth?
- Look at IMF forecasts for 2015 made in 2013 and 2012 for at least 2 macroeconomic indicators. How accurate were they? Explain the inaccuracies.
- What are the benefits and limitations of using fiscal policy to raise global economic growth?
- What are the main factors determining a country’s long-term rate of economic growth?
- Why is there growing mistrust of free trade in many countries? Is such mistrust justified?
In our blog What can we read into signs of easing consumer confidence? we noted the slight easing in consumer confidence that had occurred since the autumn of last year. Nonetheless, at that time, survey data from the European Commission was continuing to show consumer confidence levels still well above their long-run average. However, following the UK vote to leave the European Union consumer confidence has fallen sharply and now the headline confidence indicator has fallen below its long-term average for the first time since June 2013.
We take this opportunity to update our May blog to better understand the extent and nature of the decline in confidence. The importance of confidence changes is typically modelled by economists in their models of the macroeconomy as a demand-side shock. Falling consumer confidence would be expected to dampen an economy’s output levels since aggregate demand falls as households spend less. Consequently, a marked fall in confidence amounts to a negative demand-side shock.
The European Commission’s confidence measure is collated from questions in a monthly survey. In the UK around 2000 individuals are surveyed. Across the current 28 member states over 41 000 people are surveyed.
In the survey individuals are asked a series of 12 questions which are designed to provide information on spending and saving intentions. These questions include perceptions of financial well-being, the general economic situation, consumer prices, unemployment, saving and the undertaking of major purchases.
The responses elicit either negative or positive responses. For example, respondents may feel that over the next 12 months the financial situation of their household will improve a little or a lot, stay the same or deteriorate a little or a lot. A weighted balance of positive over negative replies can be calculated. The balance can vary from –100, when all respondents choose the most negative option, to +100, when all respondents choose the most positive option.
The European Commission’s principal consumer confidence indicator is the average of the balances of four of the twelve questions posed: the financial situation of households, the general economic situation, unemployment expectations (with inverted sign) and savings, all over the next 12 months. These forward-looking balances are seasonally adjusted.
Sometimes other combinations of the 12 questions are averaged to produce alternative headline confidence numbers (see, for example, the newspaper articles below). These may include a mix of forward and backward-looking questions. However, in this blog we report on the European Commission’s principal confidence indicator as outlined above. The intention is that this or any other confidence indicator tracks developments in households’ spending intentions and, in turn, likely changes in the rate of growth of household consumption.
Chart 1 shows the consumer confidence indicator for the UK. The long-term average of –8.7 shows that negative responses across the four questions typically outweigh positive responses.
In July the confidence balance stood at –9.2 down from –1.2 in June. This 8 point fall is the largest monthly fall in this particular headline indicator since January 1991 when it fell 11 points. The fall also means that not only do negative responses now dominate but more so than is usual. The fall in confidence is therefore very stark indeed. (Click here to download a PowerPoint of the chart.)
Chart 2 is important because it enables us to see what drives the European Commission’s headline confidence indicator for the UK by looking at its four component balances. The sharp decline in confidence is reflected in a deterioration in all four components. (Click here to download a PowerPoint of the chart.)
The most notable change in the individual confidence balances is the sharp deterioration in expectations for the general economy. In July the forward-looking general economic situation balance fell to –29.9 having stood at –15.7 in June. As recently as last December it registered –1.4. This is the lowest forward-looking general economy confidence balance since October 2012, though still some way above the –50.1 reported in July 2008 when the financial crisis was unfolding.
Alongside the 14 point drop in the balance for general economy expectations, the UK experienced 8 point drops in both the balances for households’ financial expectations and the expectations of saving over the next 12 months. In other words, households expect to become financially poorer and less able to save.
The monthly survey contains other questions that can help to predict future spending patterns. For example, we might expect the responses to questions relating to perceptions around what the survey call ‘major purchases’ to give us some important insight in households’ financial well-being and spending plans. ‘Major purchases’ are taken to be items such as furniture, electrical goods and electronic devices.
Chart 3 shows the balances to both whether now is the right time to make major purchases and to whether respondents expect to spend more on major purchases in the coming 12 months compared to the past 12 months. July’s data show a marked deterioration in sentiment towards making major purchases. The balance relating to whether now is the right time to make major purchases fell by 6.5 points, the largest fall since December 2011, while the forward-looking major purchase balance fell by 4.6 points, the largest fall since January 2011. (Click here to download a PowerPoint of the chart.)
The fall in the major purchases balances is consistent with the idea that households are feeling a sense of heightened uncertainty. The implication of this is that households will tend to be more cautious, cutting back on expenditures, including major purchases.
The magnitude of the fall in UK consumer confidence following the outcome of the EU referendum on 23 June is even more stark when compared to developments in consumer confidence across the 28 member states of the European Union and in the 19 countries that make up the Euro area.
Chart 4 shows how UK consumer confidence recovered relatively more strongly following the financial crisis of the late 2000s. The headline confidence indicator rose strongly from the middle of 2013 and, as we noted earlier, was consistently in positive territory during 2014 and remained so at the start of this year. The slump in consumer confidence in the UK means that the headline confidence measure has now fallen below that across the EU as well as that in the euro area. In fact, confidence in the euro area has been consistently between –7 or –9 for the past six months. (Click here to download a PowerPoint of the chart.)
Interest now turns to whether the slump in confidence in the UK will persist or, worse still, deepen further. The implied negative impact on aggregate demand would be expected to translate into weaker growth. The concern therefore is the extent to which we can expect UK growth to weaken in the months ahead. The prospect of weaker growth is likely to influence economic policy.
The government has already talked about ‘resetting fiscal policy’ which can be taken to mean a relative loosening in its fiscal policy relative to the Government’s original plans. Similarly we might yet see a further loosening of monetary policy. While the Bank of England’s Monetary Policy Committee held the official Bank Rate at 0.5 per cent at its July meeting, many commentators expect a cut sooner rather than later. The confidence data will be one important consideration in the Bank’s calculations.
Articles
UK sees biggest fall in consumer confidence for 26 years after Brexit vote The Guardian, Katie Allen (29/7/16)
UK consumer confidence takes biggest drop since 1990s ITV News (29/7/16)
Consumer confidence suffers biggest drop in 26 years after Brexit vote The Telegraph, Szu Ping Chan (29/7/16)
Consumer confidence slides at fastest pace in 26 years after Brexit vote Indepedent, Ben Chu (29/7/16)
Housing Outlook ’Uncertain’ as Brexit Hits Consumer Confidence Bloomberg, Charlotte Ryan (28/7/16)
Brexit Sees U.K. Consumer Confidence Fall Most Since 1990 Bloomberg, Charlotte Ryan (29/7/16)
Consumer confidence nosedives in Scotland in wake of Brexit vote Herald Scotland, Helen McArdle (29/7/16)
Data
Business and Consumer Surveys European Commission
Questions
- Draw up a series of factors that you think might affect consumer confidence.
- Analyse the ways in which consumer confidence might affect economic activity.
- Explain what you understand by a positive and a negative demand-side shock. How might changes in consumer confidence initiate demand shocks?
- Which of the following statements is likely to be more accurate? (a) Consumer confidence drives economic activity. (b) Economic activity drives consumer confidence.
- What macroeconomic indicators would those compiling the consumer confidence indicator hope that the indicator would help to predict?
- Analyse the possible economic implications of the fall in consumer confidence following the EU referendum vote.
- What economic effects might any persistence in the fall in consumer confidence have?
The Brexit vote has caused shockwaves throughout European economies. But there is a potentially larger economic and political problem facing the EU and the eurozone more specifically. And that is the state of the Italian banking system and the Italian economy.
Italy is the third largest economy in the eurozone after Germany and France. Any serious economic weaknesses could have profound consequences for the rest of the eurozone and beyond.
At 135% of GDP, Italy’s public-sector debt is one the highest in the world; its banks are undercapitalised with a high proportion of bad debt; and it is still struggling to recover from the crisis of 2008–9. The Economist article elaborates:
The adult employment rate is lower than in any EU country bar Greece. The economy has been moribund for years, suffocated by over-regulation and feeble productivity. Amid stagnation and deflation, Italy’s banks are in deep trouble, burdened by some €360 billion of souring loans, the equivalent of a fifth of the country’s GDP. Collectively they have provisioned for only 45% of that amount. At best, Italy’s weak banks will throttle the country’s growth; at worst, some will go bust.
Since 2007, the economy has shrunk by 10%. And potential output has fallen too, as firms have closed. Unemployment is over 11%, with youth unemployment around 40%.
Things seem to be coming to a head. As confidence in the Italian banking system plummets, the Italian government would like to bail out the banks to try to restore confidence and encourage deposits and lending. But under new eurozone rules designed to protect taxpayers, it requires that the first line of support should be from bondholders. Such support is known as a ‘bail-in’.
If bondholders were large institutional investors, this might not be such a problem, but a significant proportion of bank bonds in Italy are held by small investors, encouraged to do so by tax relief. Bailing in the banks by requiring bondholders to bear significant losses in the value of their bonds could undermine the savings of many Italians and cause them severe hardship, especially those who had saved for their retirement.
So what is the solution? Italian banks need recapitalising to restore confidence and prevent a more serious crisis. However, there is limited scope for bailing in, unless small investors can be protected. And eurozone rules provide little scope for government funding for the banks. These rules should be relaxed under extreme circumstances. At the same time, policy needs to focus on making Italian banking more efficient.
Meanwhile, the IMF is forecasting that Italian economic growth will be less than 1% this year and little better in 2017. Part of the problem, claims the IMF, is the Brexit vote. This has heightened financial market volatility and increasead the risks for Italy with its fragile banking system. But the problems of the Italian economy run deeper and will require various supply-side policies to tackle low productivity, corruption, public-sector inefficiency and a financial system not fit for purpose. What the mix of these policies should be – whether market based or interventionist – is not just a question of effectiveness, but of political viability and democratic support.
Articles
The Italian Job The Economist (9/7/16)
IMF warns Italy of two-decade-long recessionThe Guardian, Larry Elliott (11/7/16)
Italy economy: IMF says country has ‘two lost decades’ of growth BBC News (12/7/16)
What’s the problem with Italian banks? BBC News, Andrew Walker (10/7/16)
Why Italy’s banking crisis will shake the eurozone to its core The Telegraph, Tim Wallace Szu Ping Chan (16/8/16)
If You Thought Brexit Was Bad Wait Until The Italian Banks All Go Bust Forbes, Tim Worstall (17/7/16)
In the euro zone’s latest crisis, Italy is torn between saving the banks or saving its people Quartz, Cassie Werber (13/7/16)
Why Italy could be the next European country to face an economic crisis Vox, Timothy B. Lee (8/7/16)
Forget Brexit, Quitaly is Europe’s next worry The Guardian, Larry Elliott (26/7/16)
Report
Italy IMF Country Report No. 16/222 (July 2016)
Data
Economic Outlook OECD (June 2016) (select ‘By country’ from the left-hand panel and then choose ‘Italy’ from the pull-down menu and choose appropriate time series)
Questions
- Can changes in aggregate demand have supply-side consequences? Explain.
- Explain why there may be a downward spiral of asset sales by banks.
- How might the principle of bail-ins for undercapitalised Italian banks be pursued without being at the expense of the small saver?
- What lessons are there from Japan’s ‘three arrows’ for Italy? Does being in the eurozone constrain Italy’s ability to adopt any or all of these three categories of policy?
- Why may the Brexit vote have more serious consequences for Italy than many other European economies?
- Find out what reforms have already been adopted or are being pursued by the Italian government. How successful are they likely to be in increasing Italian growth and productivity?
- What external factors are currently (a) favourable, (b) unfavourable to improving Italian growth and productivity?
