Category Archives: Economic Cycle

What would happen if there was a Grexit?

The Greeks vote on Sunday whether to accept a June 25 offer from the International Monetary Fund, European Union and the European Central Bank (collectively known as “the Troika”) to provide Greece with desperately needed bailout money. In exchange, the Troika demanded that Greece implement a list of tax increases, spending cuts, and economic reforms. If there is a no vote then there could be the following scenario.

Negatives
* Overnight the Greek authorities would have to circulate a new currency (most likely the Drachma)
* The Drachma would depreciate against the Euro – according to some analysts this would increase Greek debt from the current level of 175% to 230% of GDP.
* Interest rates would increase causing businesses to go bankrupt – some have indicated that this would be around 50% of businesses
* The risk of a run on the banks would mean that the monetary authorities would have to introduce controls on money flows – especially abroad.
* Social unrest would no doubt escalate in the short-term and many Greeks will leave the country (if they can afford it).
* The Greek government would find it difficult to raise funds from overseas as investors become more prudent and see Greek bonds as an even bigger risk than before.
* A devaluation will would do nothing to change Greece’s structural problems.
* The euro will lose credibility in the long run and its weaker members will be exposed to bank runs which will ultimately extinguish any chance of a recovery.

Positives
* A weaker currency would make Greek exports a lot cheaper and may resurrect the textile industry that collapsed a few years ago.
* However the biggest benefit would be the tourism industry where holidays would become very cheap relative to similar destinations in Europe.
* The Greek government could keep printing money to finance the promises made Alexis Tsipras’ government – maybe an inflationary threat.
* Interest rates would no longer be determined by the ECB and a more expansionary monetary policy could be implemented by Greek authorities to tackle the downturn.

We’ve been here before as Jeff Sachs mentioned in his piece from Project Syndicate.

Almost a century ago, at World War I’s end, John Maynard Keynes offered a warning that holds great relevance today. Then, as now, creditor countries (mainly the US) were demanding that deeply indebted countries make good on their debts. Keynes knew that a tragedy was in the making.

“Will the discontented peoples of Europe be willing for a generation to come so to order their lives that an appreciable part of their daily produce may be available to meet a foreign payment?” he asked in The Economic Consequences of the Peace. “In short, I do not believe that any of these tributes will continue to be paid, at the best, for more than a few years.”

The Greek government is right to have drawn the line. It has a responsibility to its citizens. The real choice, after all, lies not with Greece, but with Europe.

Below is a chart from Bloomberg Business explaining the outcomes.
Greek referendum

Auckland housing market like the Dublin bubble?

Between 2007 and 2010 house prices in Dublin fell by 56% and had a devastating effect on the banking system in Ireland. Is there going to be a correction in the Auckland housing market of a similar ilk?

Brian Gaynor touched on this in his column in the NZ Herald on the 16th May. Today there are some similarities to the boom in Dublin house prices and that of Auckland. These included:

1. The media painted a picture of escalating house prices and a property boom
2. Purchasers queuing overnight to buy a section or a newly built house
3. Banks offering cash incentives on home loans.
4. Very low mortgage interest rates
5. Auckland’s house prices have increased by 12.4% in the last 6 months. By comparison Dublin’s house prices never increased by more than 12% in any six month period during the boom.
6. Mortgage debt in New Zealand is now above $200 billion – doubling in 10 years. The majority of the debt being in the Auckland residential region. Consumer mortgage debt to disposable income in 2012 was 147% as compared to 58% in  March 1991. In Ireland Bank lending it was 175% in 2008. Graph below shows a graph highlighting Ireland’s exposure to debt.

bank lending EU 1997-2008

Bank lending to households and non-financial firms as a percentage of GDP for
Eurozone economies and the UK, 1997 and 2008

What is a property bubble?
Property bubbles grow as long as buyers are willing to borrow increasingly large amounts in the expectation that prices will continue to rise. This process inevitably hits a limit where borrowers become reluctant to take on what start to appear as impossibly large levels of debt, and the self-reinforcing spiral of borrowing and prices starts to work in reverse.

WE THE ECONOMY – 20 short movies on economics

WE THE ECONOMY website provides a series of short films that explain economic concepts or key features of the modern economy. Each of the 20 movies focuses on some aspect of the U.S. economy or on some economic concept. The films are grouped into five ‘chapters’ covering the basics of the economy:

What is the Economy?
What is Money?
What is the Role of our Government in the Economy?
What is Globalization?
What Causes Inequality?

Every 5-8 minute video is well worth watching and useful for the classroom. Below is the trailer – very professionally done and excellent reinforcement when teaching certain topics.

Russian economy – Priests to halt slide of Rouble?

Russia OilWith oil prices heading to below $60 per barrel and inflation on the rise the Russian economy is bracing itself for some difficult times ahead. Oil is imperative to Russian growth rates and The Economist reported that in 2007, when oil was $72 a barrel, the economy managed to grow at 8.5%. Additionally between 2010 – 2013, when oil prices were high, the country’s net outflow of capital was $232bn – 20 times what it was between 2004 and 2008. See graph from The Economist.

But as oil prices drop so does the currency which mean imports become more expensive – the bigger the drop the more expensive they are. Russia imports a lot of goods – the value in 2000 was $45bn compared to in 2013 $341bn. This lower value of the Rouble fuels inflation and it is expected to reach 9% by the end of the year. To maintain peoples spending power the government will need to intervene in the economy and run bigger deficits.

But there is another problem a weaker Rouble makes debt servicing more expensive so in the long-term more money needs to be found. When there was a high oil price instead of increasing their reserves, money was spent on salaries and pensions and especially the armed forces where spending increased by 30% since 2008. One wonders why they spent so much on the Sochi Winter Olympics. However drastic steps are being taken to reduce the decline of the Rouble with priests blessing the servers at the Central Bank with holy water.

Russia CB

Data Response Question: The euro-zone cyclical stagnation

Below is an article from The Economist that focuses on stagnation in the euro-zone economy. I have put together a worksheet on the passage that you may find useful.
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euro zone stagnationTHIS week’s figures for the euro-zone economy were dispiriting by any measure. An already feeble and faltering recovery has stumbled. Output across the euro area was flat in the second quarter. That followed a poor start to the year when the single-currency club managed to grow by just 0.2% (0.8% at an annual rate).

There were some bright spots in the bulletin of misery. Both the Dutch and Portuguese economies, which had contracted in the first quarter, rebounded, growing by 0.5% and 0.6% respectively. Spanish growth picked up from 0.4% in the first quarter to 0.6% in the second. But these perky performances were overshadowed by the poor figures recorded in the three biggest economies. Italy, the third largest, had already reported a decline of 0.2%, pushing it into a triple-dip recession. France, the second biggest, continued to stagnate. But the real blow came from Germany, the powerhouse of the euro zone, where output slipped by 0.2%.

The setback may reflect some temporary factors, as workers took extra time off after public holidays. German output was also depressed by a fall in construction, some of which had been brought forward to the first quarter thanks to warm weather. This effect should also be temporary. However, the tensions between Europe and Russia over Ukraine and the resulting sanctions may adversely affect German growth in the coming months.

The new GDP figures are yet more evidence that the euro-zone economy is in a bad way, not least since it has come to rely so heavily upon Germany, which had grown by 0.7% in the first quarter. It is not only that growth is evaporating; inflation is also extraordinarily low. In July it was only 0.4%, far below the target of just below 2% set by the European Central Bank (ECB). Consistently low inflation has prompted fears that Europe will soon slide into deflation. Prices are already falling in Spain and three other euro-zone countries.

Deflation would be particularly grave for the euro area because both private and public debt is so high in many of the 18 countries that share the single currency. Even if inflation is positive but stays low it hurts debtors, as their incomes rise more slowly than they expected when they borrowed. If deflation were to set in, the effects would be worse still: when prices and wages fall, debts, which do not shrink, become harder to repay.

The poor GDP figures will intensify pressure on the ECB to do more. Already in June it lowered its main borrowing rate to just 0.15% and became the first big central bank to introduce negative interest rates, in effect charging banks for deposits they leave with it. That has helped bring short-term, wholesale interest rates close to zero and has also weakened the euro. Both these effects will help to bolster the economy and restore growth.

As well as these interest-rate cuts, the ECB announced that it would lend copiously to banks for as long as four years, as long as they pledged to improve their own lending performance to the private sector. The plan, which resembles the Bank of England’s “funding for lending” scheme, has some merit but may not boost lending as much as expected due to the feeble state of the banks. It will also take a long time to work its way through the economy.

The ECB’s critics say that this is not enough and urge the central bank to introduce quantitative easing—creating money to buy financial assets. The ECB is likely to hold off; it seems to consider QE as a weapon of last resort. For his part Mario Draghi, the central bank’s president, urges countries like Italy and France to get on with structural reforms that would improve their underlying growth potential. Patience on all sides is wearing thin.

Questions

Read the article from The Economist and answer the questions below:

a) What happened to the GDP figures for the euro-zone economy in the second quarter for 2014? (2)

b) What have been the surprises in the contributions of the six countries mentioned in the articles? (3)

c) Although the GDP figures are dispiriting there is the indication that this is a temporary problem. Explain (2)

d) Comment on the level of inflation in the euro-zone and the target set by the European Central Bank (ECB). (4)

e) Why is deflation particularly grave for the euro area? (4)

f) Explain negative interest rates. Why has this policy been implemented by the ECB? (4)

g) What have the ECB’s critics suggested they should do and explain how this policy works. (4)

India’s economy needs an overhaul

India’s new government have the challenge of trying to bolster its GDP from the industrial sector. For too long its economy has been going backwards with investment dropping and households shifting their money away from savings and into gold. The Economist identified 3 tasks for the incoming government:

1. Sort out the corrupt banks – bad debts have escalated and banks have chosen to “extend and pretend” loans to zombie firms. The cost of cleaning up the banks is estimated to be 4% of GDP. Healthy banks are needed to finance a new cycle of investment.
2. Stagflation must be dealt with – high inflation and high unemployment (see graph below). High borrowing has fueled inflation and consumers have run to the safety of gold as a store of value for their money. This has meant an increasing deficit in the balance of payments. The central bank is looking at introducing inflation targeting (1-3% in NZ)
3. Developing higher skilled jobs – a lot of Asian countries have benefitted greatly from low cost labour. With labour costs rising in China and 10 million people entering the labour force each year in India, there is a great opportunity to attract foreign investment. This is particularly prevalent when you consider that Japanese firms are now nervous about the on-going military tensions with China and therefore looking at other low cost countries.

For the Indian economy to move forward they will have to ensure investors that the factors of production – land, labour, capital – are reliable and at a competitive price.

Stagflation

Euro Zone’s Divergent Economies and Monetary Policy

I got this image from The Economist and used it for a recent A2 Test on Macro-Economic conflicts. Recently the OECD and the IMF have urged the European Central Bank (ECB) to cut the bank’s main lending rate from the already low 0.25% to zero. How might this effect countries in the Euro-area? It will tend to impact euro zone countries differently because of where they are in the business cycle. If you look at the unemployment and inflation figures from the graph you see the following:

Unemployment
Austria 4.9%, Germany 5.1%, well below the EU average of 11.8%.
Spain 25.3% and Greece 26.7% very high unemployment.

Some countries have had unemployment dropped significantly during the period –
Latvia approx. 22% to 11.6
Estonia approx.. 18% to 7.8%

Inflation
Highest rate Malta &Austria 1.4%, Finland 1.3%
Lowest – Greece -1.5%, Cyprus -0.9%

Euro divergent economies

The loss of monetary sovereignty has its problems

Reducing the interest to zero is an expansionary monetary policy which is a tool to increase aggregate demand, economic growth and employment. Monetary Policy, which is determined by the ECB, will have different effects in different countries. The ECB responds to aggregate levels of inflation and unemployment, not individual country levels – Unemployment is 11.8% and Inflation is 0.5%. Therefore it is a one size fits all policy. However some member states maybe experiencing rising levels of inflation and lower levels of unemployment whilst others might be the opposite – falling levels of inflation and higher levels of unemployment.

Assume an EU member experiences an asymmetric shock. It will have a different inflation and unemployment rate than the rest of the EU. With the ECB setting a common interest rate for the whole area, countries have lost an important part of their monetary policy. This is a major problem if a countries economy is at a different stage in the business cycle. For instance in 2014, Austria and Germany are growing with falling unemployment and a further lowering of interest rates may not be the best option for them. This is in comparison to other countries who need lower interest rates and a more stimulatory environment. With low interest rates and falling unemployment, Austria and Germany could experience inflation levels above the 2% target of the ECB and also a tight labour market which could put pressure on prices. Furthermore a lower interest rate affects those who want to save money in those countries.

At the other end of the spectrum Slovakia, Portugal, Cyprus, Spain and Greece are experiencing deflation and very high levels of unemployment. They therefore require more stimulus through lower interest rates to try and boost growth and employment and get out of the dangerous deflationary cycle.

Other countries with low inflation and high levels of unemployment will benefit from the cut in interest rates – Ireland has had unemployment fall from approx. 15% to 11.8% and an inflation rate of 0.3%. Therefore monetary stimulus is warranted. However the interest rate whether expansionary, neutral, or contractionary is unique to where each country is in the business cycle. The loss of monetary sovereignty clearly poses problems for members states whose economy is out of line with the euro zone norm.