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.
In the blog The global economy we considered the economic performance of countries across the globe, including the UK. In the first estimate of UK economic growth for the first quarter of 2013, the economy grew at 0.3%, thus avoiding a triple-dip recession. This first estimate is always subject to change, but in this case, the data was confirmed.
The April 2013 figure provided by the ONS of 0.3% growth has been confirmed, once again indicating the slow recovery of the UK economy. Despite these more positive signs for the economy, the IMF has raised concerns of the weak performance of the UK and has urged the government to invest more in projects to stimulate growth. Although the economy has started to grow, economic growth has continued to remain weak since the onset of the financial crisis and recession. Martin Beck, an economist at Capital Economics said:
With employment and average earnings both dropping in the first quarter on their level in the previous quarter, the foundations for a sustained recovery, even one driven by consumers, still look pretty rickety.
Initial estimates by the ONS are always updated and there is still time for the 0.3% growth figure to be changed, as more data becomes available. (Click here for a PowerPoint of the chart.) This latest figure, although unchanged, has given a more concrete indication of where the UK economy is continuing to struggle. Consumer spending increased by only 0.1%, investment and exports declined, but in further signs of a weak economy, the building up of stocks by companies was a big contributor to the UK economic growth – a contribution of 0.4 percentage points. The service sector continued to growth with a 0.6 percentage point contribution to GDP.
So, what does the future look like for the UK? Although the estimate of 0.3% figure did prevent a triple-dip recession and the IMF did comment on the ‘improving health’ of the economy, signs of recovery remain weak.
Crucial to the recovery will be government spending, but more than this, the government spending must be in key growth industries. Data suggests that the UK invests less than other G8 countries as a percentage of GDP and this is perhaps one of the key factors that has prevented the UK recovery from gathering pace. The future of the UK economy remains uncertain and government policy will be crucial in determining this future course. The following articles consider the latest growth data.
Signs of weakness mar UK economic growth Reuters, Olesya Dmitracova and William Schomberg (23/5/13)
UK first quarter growth unchanged BBC News (23/5/13)
Concerns over underlying health of UK economy as 0.3% growth confirmed The Guardian, Philip Inman (23/5/13)
Statisticians confirm 0.3% UK growth for first quarter of 2013 Financial Times, Claire Jones and Sarah O’Connor (23/5/13)
UK GDP: concerns about underlying economy as 0.3pc growth confirmed The Telegraph, Philip Aldrick (23/5/13)
Britsh economy returns to growth in first quarter The Economic Times (23/5/13)
U.K. households not loosening purse strings Wall Street Journal, Ainsley Thomson and Ilona Bllington (23/5/13)
IMF: UK should push for economic growth BBC News (22/5/13)
Questions
- Why are numerous estimates of GDP made by the ONS?
- How is GDP measured? Is it an accurate measure of economic growth? What about economic development?
- Why does 0.3% growth in the first quarter of GDP not necessarily imply that the UK economy is recovering?
- Why have certain aspects of the UK economy performed better or worse than others?
- What areas should the government invest in, according to the IMF?
- Why would government spending in investment create economic growth? Is this likely to be short term or long term?
A key debate for some months has been the UK’s membership of the European Union. The debate has centred around the desire to return some powers back to the UK, but this has extended into the possibility of a referendum on our membership of the preferential trading area. So, let’s take a step back and consider why any country would want to be a member of a preferential trading area.
Preferential trading areas can be as basic as a free trading area or as advanced as a currency, or even political union. The eurozone is clearly a currency union, but the European Union, of which the UK is a member, is a common market. A common market has no tariffs and quotas between the members, but in addition there are common external tariffs and quotas. The European union also includes the free movement of labour, capital and goods and services. Membership of a preferential trading area therefore creates benefits for the member countries. One such benefit is that of trade creation. Members are able to trade under favourable terms with other members, which yields significant benefits. Countries can specialise in the production of goods/services in which they have a comparative advantage and this enables greater quantities of output to be produced and then traded.
Other benefits include the greater competition created. By engaging in trade, companies are no longer competing just with domestic firms, but with foreign firms as well. This helps to improve efficiency, cut costs and thus lower prices benefiting consumers. However, from a firm’s point of view there are also benefits: they have access to a much wider market in which they can sell their goods without facing tariffs. This creates the potential for economies of scale to be achieved. Were the UK to completely exit the EU, this could be a significant loss for domestic firms and for consumers, who would no longer see the benefits of no tariffs on imported goods. Membership of a preferential trading area also creates benefits in terms of potential technology spillovers and is likely to have a key effect on a country’s bargaining power with the rest of the world. As is a similar argument to membership of a trade union, there is power in numbers.
There are costs of membership of a preferential trading area, but they are typically outweighed by the benefits. However, estimates suggest that the cost of EU regulation is the equivalent of 10% of UK GDP. Furthermore, while the UK certainly does trade with Europe, data suggests that only 13% of our GDP is dependent on such exports. The future is uncertain for the European Union and Britain’s membership. There are numerous options available besides simply leaving this preferential trading area, but they typically have one thing in common. They will create uncertainty and this is something that markets and investors don’t like. Vince Cable warned of this, saying:
There are large numbers of potential investors in the UK, who would bring employment here, who have been warned off because of the uncertainty this is creating.
The impact of the UK’s decision will be significant and not just for those living and working in the economy. The world is no interdependent that when countries exist (or typically enter) a preferential trading area the wider economic effects are significant. While any change in the UK’s relationship with the EU will take many months and years to occur and then further time to have an effect, the uncertainty created by the suggestion of a change in the relationship has already sent waves across the world. The following articles consider the wider single market and the current debate on UK membership.
European Union: if the ‘outs’ get their way, we’ll end up like Ukraine Guardian, Vince Cable (16/5/13)
Conservative MP James Wharton champions bill to guarantee EU referendum Independent, Andrew Grice (16/5/13)
Nick Clegg shifts ground over EU referendum The Guardian, Patrick Wintour (15/5/13)
Cameron tells EU rebels to back referendum law Reuters, Peter Griffiths (16/5/13)
The EU and the UK – the single market BBC Democracy (4/3/13)
Single market dilemmas on Europe BBC News, Stephanie Flanders (14/5/13)
Lord Wolfson: I back the single market – but not at any cost The Telegraph, Lord Wolfson (19/1/13)
EU focuses on returning single market to health Financial Times, James Fontanella-Khan (8/5/13)
Questions
- What other examples of preferential trading areas are there? How close are they to the arrangement of the European Union?
- In each of the above examples, explain the type of preferential trading area that it is.
- What are the benefits and costs of being a member of a preferential trading area such as the EU? How do these differ to being a member of a) a free trade area and (b) a customs union?
- What options are open to the UK in terms of re-negotiating its relationship with the EU? In each case, explain how the benefits and costs identified in question 3 would change.
- Why is the UK’s decision so important for the global economy? Would it be in the interests of other economies? Explain your answer.
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 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.
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.