As European leaders gather for an emergency summit in Brussels to tackle the eurozone debt crisis, we consider the issues and possible solutions. In Part B we’ll consider the actual agreement.
There are three key short-term issues that the leaders are addressing.
1. The problem of Greek debt
With fears that the Greek debt crisis could spread to other eurozone countries, such as Italy and Spain, it is vital to have a solution to the unsustainability of Greek debt. Either banks must be willing to write off a proportion of Greek debt owed to them or governments must give a fiscal transfer to Greece to allow it to continue servicing the debt. Simply lending Greece even more provides no long-term solution as this will simply make the debt even harder to service. Writing off a given percentage of debt is known as a ‘haircut’. The haircut on offer before the summit was 21%. Leaders are reportedly considering increasing this to around 60%.
2. The size of the eurozone bailout fund
The bailout fund, the European Financial Stability Facility (EFSF), stood at €440 billion. This is considered totally inadequate to provide loans to Italy and Spain, should they need a bailout. France and other countries want the ECB to provide extra loans to the EFSF, to increase its funds to somewhere between €2 trillion and €3 trillion. Germany before the meeting was strongly against this, seeing it as undermining the rectitude of the ECB. A compromise would be for the EFSF to provide partial guarantees to investors and banks which are willing to lend more to countries in debt crisis.
3. Recapitalising various European banks
Several European banks are heavily exposed to sovereign debt in countries such as Greece, Italy and Spain. It is estimated that they would need to raise an extra €100 billion to shield them against possible losses from haircuts and defaults.
But there is the key longer-term issue as well.
Achieving long-term economic growth
Without economic growth, debt servicing becomes much more difficult. The austerity measures imposed on highly indebted countries amount to strongly contractionary fiscal policies, as government expenditure is cut and taxes are increased. But as the economies contract, so automatic fiscal stabilisers come into play. As incomes and expenditure decline, so people pay less income tax and less VAT and other expenditure taxes; as incomes decline and unemployment rises, so government welfare payments and payments of unemployment benefits increase. These compound public-sector deficits and bring the possibility of even stronger austerity measures. A downward spiral of decline and rising debt can occur.
The answer is more rapid growth. But how is that to be achieved when governments are trying to reduce debt? That is the hardest and ultimately the most important question.
Articles
Brussels summit: the main issues to be resolved The Telegraph (25/10/11)
EU crisis talks in limbo after crucial summit is cancelled The Telegraph, Louise Armitstead (25/10/11)
Euro zone summit likely to give few numbers on crisis response Reuters, Jan Strupczewski (25/10/11)
Factbox: What EU leaders must decide at crisis summit Reuters (24/10/11)
Hopes low ahead of EU summit Euronews on YouTube (25/10/11)
Euro crisis: EU leaders hope to reach debt plan BBC News (26/10/11)
The deadline Europe cannot afford to miss BBC News, Nigel Cassidy (26/10/11)
Why EU summit is crunch day for the eurozone BBC News, Paul Mason (26/10/11)
Southern European banks need most capital BBC News blogs, Robert Peston (23/10/11)
Will Germany insure Italy against default? BBC News blogs, Robert Peston (26/10/11)
Plan B for the eurozone? BBC News blogs, Stephanie Flanders (26/10/11)
‘No such thing as Europe’ BBC Today Programme, Stephanie Flanders and Martin Wolf (26/10/11)
Markets to eurozone: It’s the growth, stupid BBC News blogs, Stephanie Flanders (24/10/11)
Fears euro summit could miss final deal Financial Times, Peter Spiegel, Gerrit Wiesmann and Matt Steinglass (26/10/11)
Time to unleash financial firepower or face euro breakup Guardian, Larry Elliott (25/10/11)
The Business podcast: eurozone crisis Guardian, Larry Elliott, David Gow and Jill Treanor (25/10/11)
Why is Germany refusing to budge on the eurozone debt crisis? Guardian blogs, Phillip Inman (26/10/11)
Questions
- In terms of the three short-term problems identified above, compare alternative measures for dealing with each one.
- To what extent would the ECB creating enough money to recapitalise European banks be inflationary? On what factors does this depend?
- Does bailing out countries create a moral hazard? Explain.
- What possible ways are there of achieving economic growth while reducing countries sovereign debt?
- Would you agree that the problem facing eurozone countries at the moment is more of a political one than an economic one? Explain.
- What are the arguments for and against greater fiscal integration in the eurozone?
With all the doom and gloom of recent economic data, including rising inflation and higher unemployment, there’s finally a small speck of light and that’s in the form UK retail sales. The latest data from the ONS suggests that sales in the UK in September were higher than previously forecast and reversed the 0.4% decline we saw in August. A big contributing factor to this positive data was a boost to online sales, but this small glimmer of hope is unlikely to be sufficient to keep the economy going – unless sales keep rising, we are unlikely to see any significant increase in economic growth.
The data, while positive, is still unlikely to have any impact on economic policy. The minutes from the Monetary Policy Committee showed that there was unanimous support for further quantitative easing, as the threat of weak growth and financial instability and uncertainty remains. An economist from Barclays Capital said:
‘We don’t think the recent strong growth in monthly sales is likely to be sustained…The environment for retailers is likely to remain challenging as consumer spending remains depressed driven by low confidence and slow earnings growth.’
The data from September is positive, but it does little to offset the decline in sales seen in August. It was revised down from 0.2% to 0.4% – some blame the hot weather, which discouraged consumers from hitting the high streets in preparation for the winter. The key data to look out for will be sales figures for the next few months. Only then will we have more of an indication about exactly which direction the economy is moving in. The following articles consider this latest economic data.
Retail sales in UK unexpectedly increase at fastest pace in five months Bloomberg, Scott Hamilton (20/10/11)
UK retail sales see stronger-than-expected rise BBC News (20/10/11)
Nothing expected from today’s UK retail sales figure FX-MM, Richard Driver (20/10/11)
Retail sales: what the economists say Guardian (20/10/11)
£1 in every £10 now spent online, says ONS Telegraph, Harry Wallop (20/10/11)
Retail sales rise more than expected Financial Times, Sarah O’Connor (20/10/11)
Retail sales up but good weather has a price Sky News (20/10/11)
Questions
- Which factors have contributed to the higher than expected sales figures for September?
- Why do economists not believe that the higher growth in sales means signs of recovery for the UK economy?
- How has higher inflation impacted UK households?
- To what extent do you think the warm weather held back retail sales?
- What could explain why there has been a significant growth in online sales?
No, bonfire night hasn’t been moved, but the 30th November could certainly be a day to remember. This day has been ‘selected’ by Unions for a nationwide day of action in response to government plans to increase workers’ pension contribution. The action would undoubtedly lead to massive disruption to public services across the UK and if an agreement is not reached with Ministers, we are likely to see further days of industrial action. In the words of the TUC boss, Brendan Barber, if no agreement is forthcoming, there will be ‘the biggest trade union mobilisation for a generation’.
The so-called pensions crisis has been an ongoing saga with seemingly no end in sight. As the UK population gets older, the strain on the state pension will continue to grow. The dependency ratio has increased – there are more and more pensioners being supported by fewer and fewer adults of working age. If the level of benefits is to be maintained, workers must either work for longer or make larger contributions to make up the deficit.
Plans are already in motion to increase the retirement age, but this in itself will not be sufficient. If pension contributions do increase, workers will undoubtedly find themselves worse off – a larger proportion of their gross income will be taken and hence net incomes will be lower. With less disposable income, consumer expenditure will fall, and given that consumption is the largest component of aggregate demand, the economy will take a hit. This is even more of a concern given the pay freezes we have already seen, together with rising inflation. People’s purses will get squeezed more and more, So, while raising pension contributions may help plug the pensions deficit, it could spell trouble for the economic prospects of the UK economy.
In addition to the potential longer term effects, there will also be a significant short term effect, namely, the loss of output on the day of the strike action. If workers are absent, the company will produce less than their potential and in some cases, the lost output can never be regained. If the postal workers go on strike, businesses may find packages go undelivered, customers experience delays, bills are not paid and so on. In all, strike action on the scale that is planned will have an impact on everyone, so it is in the interests of the economy for some sort of agreement to be reached. As Mr. Barber said:
‘If there’s no progress, then potentially we will see very widespread industrial action across the public services’
The following articles look at this conflict.
Unions plan ‘day of action’ over pensions Financial Times, Brian Groom (14/9/11)
TUC: ‘Strikes will be the biggest for a generation’ says Brendan Barber Telegraph (14/9/11)
Unions call for ‘national day of action’ over pensions BBC News (14/9/11)
Unions call collective day of strike action in November Guardian, Helene Mulholland and Dan Milmo (14/9/11)
Ed Miliband to warn trade unions that they must modernise Independent, Andrew Grice (13/9/11)
Trade unions plan day of action over pensions on Nov 30 Associated Press (14/9/11)
Are the trade unions about to save Britain? Telegraph, Mary Riddell (12/9/11)
Pension row unions in day of action The Press Association (14/9/11)
Unions set date for pensions strike as ‘unprecedented ballot begins’ Telegraph, Christopher Hope (14/9/11)
TUC to attack ministers over public sector pensions BBC News(14/9.11)
Secret plan for union strikes to cripple the country Telegraph, Christopher Hope(14/9/11)
Questions
- What are the main costs of strike action to (a) the individual going on strike (b) the firms which lose their workers (c) small businesses (d) the economy?
- What is meant by the dependency ratio? What action could be taken to reduce it? For each type of action, think about the costs and benefits.
- If pension contributions do increase, explain how workers will be affected. How will this affect each of the components of aggregate demand?
- Based on your answer to the above questions, what is likely to be the impact on the government’s macroeconomic objectives?
- What other action, besides striking, could unions take? Is it likely to be as effective? Do you think strikes are a good thing?
- Illustrate on a diagram the effect of a trade union entering an industry. How does it normally affect equilibrium wages and employment?
Cutting the budget deficit is a key government objective, but at the moment it seems to be in conflict with another objective, namely economic growth and thereby avoiding a double-dip recession. In order to raise tax revenue and meet the cries for more equity, the 50% tax rate above £150,000 was imposed, affecting some 310,000 people. However, in a recent letter from some top economists to the Financial Times, they called for the scrapping of the top rate of tax. They argue that it is hindering entrepreneurship and encouraging potential top rate tax payers to leave the UK, thereby hindering the economic situation. George Osborne has asked HMRC to evaluate just how effective the top rate of tax has been at generating government revenue.
In contrast to these calls for scrapping this top rate of tax, some of the richest people in the world have said that they would be happy to pay this rate of tax. In the words of Sir Stuart Rose, the ex-boss of Marks and Spencer:
“How would I explain to my secretary that I would pay less tax on my income, which is palpably bigger than hers, when her tax is not going down.”
Those against scrapping the tax argue that it will be ‘monstrously unfair’ and ‘phenomenally immoral’. This, combined with official figure that suggest by 2015/16 the top rate tax will bring in an extra £3.2bn more revenue than had the tax remained at 40%, certainly adds weight to their argument. In total, over the five year period, it is predicted to bring in an extra £12.6bn.
The policy to increase the tax threshold to £10,000 will meet with the critics’ approval, but less so, if it is accompanied by a scrapping of this top rate tax. Furthermore, the government’s coffers will take a significant beating if both of the above occur!
Another option to replace the 50% tax rate is a higher tax on high value homes – the so-called ‘mansion tax’. Whatever happens with taxation, one thing is clear: the government needs to find a way to generate tax revenue, without putting the economy back into recession. If the 50% tax rate encourages people to leave the UK to avoid the tax or to forego entrepreneurship, it will directly be acting as a disincentive. Fewer jobs will be created due to a lack of entrepreneurship, output may be lower and hence growth will not reach its potential. Crucially, the international competitiveness of the UK economy is being badly affected, as it becomes a less attractive place for investment and talented workers. The following articles consider the 50% tax rate and the controversy surrounding it, despite it only being a temporary policy.
Stuart Rose ‘would pay more tax’ BBC News (9/9/11)
Lawson: ‘dangerous’ and ‘foolish’ to keep 50p tax rate Telegraph, Louisa Peacock (10/9/11)
Rose calls 50p tax rate ‘only fair’ Financial Times, Elizabeth Rigby (9/9/11)
Top 50p tax rate damages economy, say economists BBC News (7/9/11)
George Osborne loses nerve on plan to cut 50p top tax rate Independent, Nigel Morris (8/9/11)
Top tax rate will raise £12.6bn more in revenue, official figures reveal Guardian, Polly Curtis (7/9/11)
Laffer curves and the logic of the 50p tax Financial Times, Tim Harford (9/9/11)
Row over ending of 50p tax rate threatens to spark Tory rebellion Guardian, Patrick Wintour and Polly Curtis (7/9/11)
I’d happily pay more tax, says former M&S boss Sir Stuart Rose Independent, Andy McSmith (10/9/11)
Questions
- What are the main arguments in favour of keeping the 50p tax rate?
- What are the main arguments in favour of scrapping the 50p tax rate?
- What does the Laffer curve show? Is it relevant in the case of the 50p top rate of tax? What does it suggest about the ability of the tax to generate income?
- How does the top rate of tax affect the international competitiveness of the UK economy?
- Why is there a trade-off between raising tax revenue and boosting economic growth through the use of the 50p tax rate?
- Why is there concern about the highest rate of tax actually causing tax revenue to fall?
- What are the equity arguments concerning the scrapping of the 50p tax and raising the tax threshold? Is there an equity argument in favour of the 50p tax rate?
The Brazilian economy is an emerging superpower (see A tale of two cities), but even its growth slowed in the second quarter of the year, although the economy still appears to be growing above capacity. In reaction to that latest economic data, the central bank slashed interest rates by 50 basis points to 12%. The Central Bank said:
‘Reviewing the international scenario, the monetary policy committee considers that there has been a substantial deterioration, backed up, for example, by large and widespread reductions to the growth forecasts of the main economic regions.’
Rates had previously been hiked up 5 times in the year to tackle rising inflation, which has been some way above its inflation target. Such tightening policies have become commonplace in many emerging economies to prevent overheating. However, following this reversal of policy, questions have been raised about the independence of the central bank, as some politicians have recently been calling for a cut in rates, including President Rousseff himself. As Tony Volpon at Nomura Securities said:
‘They gave in to political pressure. The costs will likely be much higher inflation and a deterioration of central bank credibility…It has damaged the inflation-targeting regime.’
Many believe the rate cut is premature and the last thing the economy needs given the inflationary pressures it’s been facing. Huge spending cuts have been announced to bring inflation back under control, together with the previous rate rises, so this cut in interest rates to stimulate growth is likely to put more pressure on costs and prices. Only time will tell exactly how effective or problematic this new direction of monetary policy will be.
Brazil’s growth slows despite resilient consumers Reuters, Brian Ellsworth and Brad Haynes (2/9/11)
Brail in surprise interest rate cut to 12% BBC News (1/9/11)
Rousseffl’s ‘Risky’ rate cut means boosting Brazil GDP outweighs inflation Bloomberg, Arnaldo Galvao and Alexander Ragir (2/9/11)
Brazil makes unexpected interest rate cut Financial Times, Samantha Pearson (1/9/11)
Brazil rate cut stirs inflation, political concerns Reuters (1/9/11)
Questions
- What is the relationship between the macroeconomic objectives of inflation and economic growth?
- Why are there concerns that the recent reduction in the interest rate may worsen inflation? Do you think that a decision has been made to sacrifice Brazil’s inflation-targeting regime to protect its economic growth?
- Why are there questions over the independence of the central bank and how will this affect its credibility? What are the arguments for central bank independence?
- Growth in Brazil, although lower this year, still remains very strong. Why has the Brazilian economy been able to continue its strong growth, despite worsening economic conditions worldwide?
- What type of inflation are emerging economies experiencing? Explain how continuous hikes in interest rates have aimed to bring it back under control.
- What is meant by overheating? How will the central bank’s past and current policies contribute towards it?