Category Archives: Fiscal Policy

AS Economics – Hyperinflation causes and ends

Starting with a definition. In 1956 Phillip Cagan, an economist working at America’s National Bureau of Economic Research, published a seminal study of hyperinflation, which he defined as a period in which prices rise by more than 50% a month.

There seems to be common patterns when hyperinflation occurs in an economy. These include:

  1. Fiscal pressure – cost of funding a war, increased social welfare payments, corrupt officials taking money from the budget.
  2. Dependence of a particular resource – the resource curse. Some economies rely on exports of oil, iron ore or other resources to fund its spending. This has the effect of increasing the value of the currency and although this will make imports cheaper once the resource runs out or global prices start to drop the overvalued currency falls causing a large increase in imported prices. Furthermore governments come to depend on revenue from oil and a sudden drop in prices saw a massive drop in tax revenue – 90% of Venezuela’s revenue came from oil.
  3. Printing money – like Bolivia in the 1980’s, Venezuela overcame their shortfall in income by printing more money. The increase in the supply of money pushes up inflation. But what makes it worse is, as the inflation rate impacts the real value of government revenue, they continue to print money to finance the budget deficit which in turn exacerbates the problem – bigger budget deficit and further inflation.
  4. Exchange rate – at some stage the exchange rate will collapse as people lose confidence in the currency. Imports become ever increasingly expensive and feed into the inflation calculation.
  5. Inflationary expectations – In recent years more attention has been paid to the psychological effects which rising prices have on people’s behaviour. The various groups which make up the economy, acting in their own self-interest, will actually cause inflation to rise faster than otherwise would be the case if they believe rising prices are set to continue. This is evident in Venezuela as people become accustomed to higher prices and expect them to continue which makes inflation likely to continue.Workers, who have tended to get wage rises to ‘catch up’ with previous price increases, will attempt to gain a little extra compensate them for the expected further inflation, especially if they cannot negotiate wage increases for another year. Consumers, in belief that prices will keep rising, buy now to beat the price rises, but this extra buying adds to demand pressures on prices. In a country such as New Zealand’s before the 1990’s, with the absence of competition in many sectors of the economy, this behaviour reinforces inflationary pressures. ‘Breaking the inflationary cycle’ is an important part of permanently reducing inflation. If people believe prices will remain stable, they won’t, for example, buy land and property as a speculation to protect themselves.

Hyperinflation tends to end in two ways.

  1. The paper currency becomes so utterly worthless that it is supplanted by a hard currency. This is what happened in Zimbabwe at the end of 2008, when the American dollar took over, in effect. Prices will stabilise, but other problems emerge. The country loses control of its banking system and its industry may lose competitiveness.
  2. The second, hyperinflation ends through a reform programme. This was very much the case in Bolivia in the 1980’s – Government spending was slashed. Price controls were scrapped. Import tariffs were cut. Government budgets were balanced. Therefore this typically involves a commitment to control the budget, a new issue of banknotes and a stabilisation of the exchange rate—ideally all backed with confidence-inspiring foreign loans. Without such reform, Venezuela’s leaders, though scornful of America, may find that its people are forced eventually to adopt its dollar anyway.

Sources:

  • The Economist “The half-life of a currency” September 15th 2018
  • The Economist “The roots of hyperinflation” February 12th 2018

Repairing the Welfare State

Back in July The Economist had an article in its ‘International’ section on updating or repairing the welfare state. They identified 3 major challenges faced by welfare states in rich countries.

  1. Ageing population
  2. Immigration
  3. Adapting to changing labour markets

1. Ageing Population

Image result for old age dependency welfare stateThe rapid increase in life expectancy over the past century has become an issue for governments around the world in terms of financing pensions, social care, and health care – see graph. With the political opposition to a reduction of public services a solution could be to increase the tax base by mobilising the potential workforce so that a greater share of those of working age actually work, while another can be found in productivity growth. Yet another route is raising the retirement age in response to longer and healthier life expectancy. The challenge of funding the pension system appears particularly daunting, with an increasing share of the population spending a longer period of time in retirement. Although immigration is a problem it may be a solution to ageing as economic research from the UK and Denmark has shown that since 2002 EU migrants have contributed much more in taxes than they have cost in public services.

2. Immigration

Immigration poses another challenge to the welfare state. In 1978 Milton Friedman argued that you could have open borders or generous welfare states open to all, but not both, without swamping the welfare system. Moreover, taxpayers are more tolerant of benefits that are seen to look after “people like them”. Evidence suggests that there has been tension between diversity and generosity.

Welfare chauvinism has been evident in many countries – France, Sweden, Denmark – have curbed the rights to benefits of non-EU migrants since 2002. Reforms in the USA in 1990s limited illegal immigrants’ access to benefits and of late Sweden has limited paid parental leave for new immigrants and cut support payments to some asylum-seekers. Moreover, attitudes towards immigrants are volatile and swayed by the political climate. In 2011, for example, 40% of Britons said immigrants “undermined” the country’s cultural life, and just 26% said they enriched it. By last year, in the wake of the Brexit vote, only 23% went for undermined, compared with 44% for “enriched”.

3. Adapting to changing labour markets

Recent research by the OECD in seven of its members estimated that 60% of the working-age population had stable full-time work. Of the other 40%, no more than a quarter met the typical definition of unemployed: out of a job but looking for one. Most had dropped out of the labour market or worked volatile hours. In many countries when the jobless do find work, their benefits are withdrawn in such a way as to create a high effective marginal tax rate. Nearly 40% of the unemployed in the OECD face a marginal rate higher than 80% on taking a job. Welfare recipients also often suffer from bureaucratic traps. For example, some have to wait weeks between losing a job and receiving benefits.

Universal basic income (UBI) may be one way to avoid such problems. It takes many very different forms, but at its heart it replaces a plethora of means-tested benefits with a single, unconditional one, paid to everyone. Scotland and the Netherlands are running experiments involving UBI and many others are set to follow. But in no country is it yet the foundation of the benefits system for working-age adults.

The OECD recently modelled two forms of basic income. Under the first, countries’ spending on benefits was divided equally among everyone—a revenue-neutral reform. Under the second, everyone would receive benefits equal to the current minimum-income guarantee, and taxes would rise to pay for it, if necessary.

Welfare Policy – Trilemma

The results, as ever in welfare policy, reveal a “trilemma” between:

1. The overall cost,
2. How much it alleviates poverty
3. Its effect on work incentives.

They also show that the effects of introducing basic income vary hugely based on what welfare system it would partly replace. Countries such as Italy, Greece, Spain, Austria and Poland all spend more on welfare for the richest 20% than for the poorest. For them, spreading benefits more evenly would benefit the poor, even under a revenue-neutral model. But in countries that target welfare spending on the poor (such as Britain), UBI would either lead to large tax rises, to maintain a minimum income for everyone, or see benefits cut for the worst-off.

A more realistic alternative for many countries may be a negative income tax (NIT). Championed by Friedman, the NIT means that, below a certain income threshold, the taxman pays you. As you earn more, tax kicks in, tapering your income. The effect is similar to a basic income, especially since most UBI models assume that rich people would have to pay more tax to afford them. A NIT, however, is more efficient in that it does not give the rich a stipend only to take most of it back in tax.

Versions of a NIT have been part of welfare policy in Britain and America for decades, in the form of tax credits that are paid to those working on low incomes. Britain’s Universal Credit, a (sputtering) attempt to merge six working-age benefits into one, takes the approach further. A recent analysis by the OECD finds this a better way at targeting the poor than UBI.

Source: The Economist – Repairing the safety net – The welfare state needs updating. July12th 2018

Eurozone growth faster than US but not in good shape for the long-term.

According to the OECD the rate of growth in the eurozone has surpassed that of the US, UK and Japan and has surprised many with its resilience. However is the EU in a position of strength to cope with the challenges of another recession? The Economist ‘Free Exchange’ looked into this issue and identified some shortcomings. The crisis in the EU was severe and the impact financially was was around €1.4trn as this would have been the amount of GDP lost since 2007, assuming that most economies grow at 2% per year.

The damage was compounded by the fact that the EU’s monetary policy which has 3 main weaknesses:

1. Within the EU the printing of money is centralised through the European Central Bank in Frankfurt. Therefore countries who wanted to print more money to bail themselves out and stimulate the economy could no longer do it. Furthermore as there is no central fiscal budget it meant that individual countries were responsible for their own fiscal solvency. So if they ran up big deficits the risk of default was great and made markets react negatively to any concerning news on a country’s fiscal prudence. In reacting to this scenario the ECB said, as a last resort, that it would step in and buy government bonds to help ailing economies. On this news bond yields dropped as the ECB has brought about some stability.

2. In 2014 the EU was still struggling but was constrained by its inflation mandate. When economies go through major economic downturns they loosen monetary and fiscal policy – cut interest rates and increase government spending respectively to make up for the lost private spending. Although the ECB cut interest rates to 0% and government increased spending there was the problem of its mandate. The ECB was curbed by the 2% inflation ceiling unlike the 2% target for most other countries and by the fact that its strongest economy, Germany, was paranoid about inflation – memories of the post-war hyperinflation years. Only with the threat of deflation did stimulatory asset purchases start to happen.

3. This is the mismatch between the scope of its economic institutions and its political ones. No European institution enjoys the democratic legitimacy of a national government. The crisis meant greater reform in the financial sector but also led to increased authority of unelected institutions like the ECB. The frustration has been that countries in the eurozone have suffered significant amounts of pain by unaccountable European politicians. Countries don’t want to lose their sovereignty but it seems that any further integration is a catalyst to its demise.

The return to improving growth levels has been brought about by increasing export volumes – with a weaker euro. With consumer spending and investment on the decline foreign consumers have been the saviour of the EU. However this is dependent on global growth which cannot last forever and the euro area needs to be prepared politically to get through the next recession.

Source: The Economist – Free Exchange – The second chance. 2nd December 2017

Zero sum game – Tax cuts v Higher interest rates.

The recent tax cuts in the US by the Trump administration are estimated to create above 4% growth each year according to Gary Cohn – Director of the National Economic Council. If the US does achieve this level of growth, tax reform is said to have little impact as long-term growth – studies have estimated that the tax bill will have an impact of between 0.4% – 0.9% on GDP.

Textbooks that cover supply-side policies tend to suggest that lower taxes on labour income should raise its supply whilst lower taxes on capital income should increase saving and investment which should then increase labour productivity and competitiveness in the market place. But there is the income and substitution effect to consider. With tax cuts people’s income increase therefore there is the chance that the substitution and income effects come into play.

Substitution effect – if wages are higher workers may forgo some of their leisure time and work longer hours. SS1 on the graph

Income effect – if wages are higher workers may reduce some of their working hours as the demand for leisure time goes up – SS2 on the graph

Most textbooks favour the substitution effect with tax cuts although research shows that neither labour-force participation nor hours worked move in response to tax changes. However reported labour income does rise in response to income tax cuts, thanks largely to less tax avoidance. Furthermore savings rates have changed little with tax cuts in fact they have decreased in the US over the past 40 years. Savings rates are important for investment purposes although the current administration believes that this shortfall will be filled by overseas investors.

Oligopolists to benefit

With the lack of competition in US industry – especially in the banking sector – it is the these companies (many whom are oligopolists) and their shareholders who will reap the benefits of tax cuts. Research has shown that a cut in corporate tax of 10% would raise long-run output output by 0.15%. National Income would raise less with much of the addition to GDP going overseas.

What about higher interest rates?

Although tax cuts (increase in demand) do help out especially when there is a lot of spare capacity in the economy this is hardly the case at the moment. The US has limited spare capacity and the Federal Reserve fearing inflation have been more contractionary in their actions by recently increased interest rates which cancels out the stimulatory tax cuts.

Tax cuts and inequality

Although the republican rhetoric has been that tax cuts will benefit all they haven’t mentioned the distributional consequences. The cuts will reduce the tax burden of the top 0.2% by an average of $278,000 by 2017. This is in contrast to the bottom 20% of earners will get an extra $10 dollar by 2017.

New Zealand election: economic impact of new Government’s policies.

Since the election businesses seem to be unsure of the new direction of government policy and therefore this has led to a reduction in business confidence. This is not unusual especially with a change of political ideology and the more left leaning government which could make things – regulation, taxes etc – harder for businesses. The government plans to cancel next year’s scheduled tax cuts even though it would have added 0.4% to GDP. This could be partly offset by an increase in expenditure on Working For Families and the free tertiary education for first year students.

The new Government plans to spend more than the national government which is not unusual considering its position of the political spectrum – see graph. This will be partly funded by tax revenue and borrowing $7bn more over the next four years – this is a borrowing and spend fiscal stimulus. The impact of this spending will be influenced by the fiscal multiplier.

Fiscal Multiplier.
It refers to the change in GDP that is due to a change in government fiscal policy – taxes and spending. For example, if increased government spending of $1bn causes overall GDP to rise by $1.5bn, the multiplier effect is 1.5.

There are problems for the new Government in that:

1. Some of this extra spending will go on imports and this will mean an outflow of money from the New Zealand economy and therefore making no contribution to GDP. Remember that GDP expenditure approach = C+I+G+(X-M).

2. There is also the crowding out effect – this is when government spending fails to increase overall aggregate demand because higher government spending causes an equivalent fall in private sector spending and investment. This could include: extra spending on public healthcare leading to less spending on private healthcare; government employment creating labour shortages for firms; and government employment creating labour shortages for firms. Crowding out can also happen indirectly via fiscal stimulus increasing interest rates and consequently the exchange rate making exports less competitive and imports cheaper.

Ultimately the government debt must be repaid by the use of government revenue from taxation. A labour coalition government usually increase taxes during their time in government and this has the tendency to discourage private sector investment. The government’s borrow-and-spend plans will not necessarily make the economy any larger in the long-run but it is expected that government spending (G) will be a larger share of the economy with consumption (C) and investment (I) having a lower share – see graph below. Interesting to note the government spending as a % of GDP for Labour and National – goes up as a % of GDP when Labour are in office and goes down as a % of GDP when National are in office.

Source: Westpac Quarterly Economic Overview – November 2017

A2 Revision – New Classical to Extreme Keynesian

The main competing views of macroeconomics (Keynesian vs Monetarist) is part of Unit 5 in the A2 syllabus and is a popular topic in the essay and multiple-choice papers. Begg covers this area very well in his textbook. In looking at different schools of thought it is important to remember the following:

Aggregate Demand – the demand for domestic output. The sum of consumer spending, investment spending, government purchases, and net exports
Demand Management – Using monetary and fiscal policy to try to stabilise aggregate demand near potential output.
Potential Output – The output firms wish to supply at full employment after all markets clear
Full Employment – The level of employment when all markets, particularly the labour market, are in equilibrium. All unemployment is then voluntary.
Supply-side policies – Policies to raise potential output. These include investment and work incentives, union reform and retraining grants to raise effective labour supply at any real wage; and some deregulation to stimulate effort and enterprise. Lower inflation is also a kind of supply-side policy if high inflation has real economic costs.
Hysteresis – The view that temporary shocks have permanent effects on long-run equilibrium.

There are 4 most prominent schools of macroeconomics thought today.

New Classical – assumes market clearing is almost instant and there is a close to continuous level of full employment. Also they believe in rational expectations which implies predetermined variables reflect the best guess at the time about their required equilibrium value. With the economy constantly near potential output demand management is pointless. Policy should pursue price stability and supply-side policies to raise potential output.

Gradualist Monetarists – believe that restoring potential output will not happen over night but only after a few years. A big rise in interest rates could induce a deep albeit temporary recession and should be avoided. Demand management is not appropriate if the economy is already recovering by the time a recession is diagnosed. The government should not fine-tune aggregate demand but concentrate on long-run policies to keep inflation down and promote supply-side policies to raise potential output.

Moderate Keynesians – believe full employment can take many years but will happen eventually. Although demand management cannot raise output without limit, active stabilisation policy is worth undertaking to prevent booms and slumps that could last several years and therefore are diagnosed relatively easily. In the long run, supply-side policies are still important, but eliminating big slumps is important if hysteresis has permanent effects on long-run equilibrium. New Keynesians provide microeconomics foundations for Keynesian macroeconomics. Menu costs may explain nominal rigidities in the labour market.

Extreme Keynesians – believe that departures from full employment can be long-lasting. Keynesian unemployment does not make real wage fall, and may not even reduce nominal wages and prices. The first responsibility of government is not supply-side policies to raise potential output that is not attained anyway, but restoration of the economy to potential output by expansionary fiscal and monetary policy, especially the former.

Government debt as % of GDP – New Zealand amongst the lowest in the OECD.

In 2015 New Zealand’s government debt as a % of GDP was amongst the lowest amongst the OECD countries coming in at 35.6% – NZ$86.1bn. This gives the government the ability to borrow billions of dollars to stimulate growth in the economy and fund necessary infrastructure projects. This is important when a recession phase is threatening the economy. In 2015 the median level of debt to GDP was the Netherlands with 77.5% and Australia was 67.7%. The UK and the USA had debt to GDP of 112.6% and 125.9%. The standout countries are Japan with debt of 234% of GDP and Greece at 182%. High amounts of debts are only become a concern when the debt is mainly funded from overseas and issues in non-local currency and the country is unable to alter its exchange rates. For Japan a lot of the debt has been issued internally and been bought by the Bank of Japan (central bank) but this is not the case for Greece as they have had significant help from other countries.

Govt debt as % GDP

Does aggressive or cautious fiscal stimulus lead to higher debt-to-GDP ratio?

With low interest rates globally and liquidity trap conditions a more expansionary fiscal policy has become more prevalent for most governments. However the level of severity of fiscal policy – aggressive fiscal stimulus v cautious fiscal stimulus – is important with regard to a country’s debt-to-GDP ratio as recent experience shows. A paper by Alan Auerbach and Purity Gorodnichenko of University of California Berkeley found that short bursts of expansionary fiscal stimulus doesn’t necessarily lead to higher debt-to-GDP ratios or to higher interest rates. They noted that in some instances markets revised down their worries about creditworthiness in response to large scale stimulus.

Other research by Brad De-Long University of California Berkeley and Larry Summers Harvard University seems to support this view. Their research suggests that long periods of cautious growth eat away at an economy’s productive potential as investments don’t get finished and healthy workers drop out of the labor force.

In future the level of stimulus and its time periods should be automatic and proportionate to the severity of the downturn. Examples could include:

  • Labour tax rates could be linked to unemployment figures so that pay packets jump the moment conditions deteriorate.
  • Funding to local governments could be similarly conditioned, to limit painful cutbacks by municipalities.
  • To prevent a scramble for worthwhile, shovel-ready infrastructure projects, governments could make sure to have a ready queue, so spending could easily scale up in a downturn.

Sources:

  • The Economist – The Borrowers – 9th September 2017
  • BERL: New Zealand among lowest government debts in OECD – 26th September 2017

Types of Macroeconomic Policies

Just been doing some revision with my CIE AS class and discovered this diagram on macro policies. Mind maps like this are very useful ways of revising topics.

Fiscal policy can be distinguished from monetary policy, in that fiscal policy deals with taxation and government spending and is often administered by an executive under laws of a legislature, whereas monetary policy deals with the money supply, lending rates and interest rates and is often administered by a central bank.

Supply-side policies are mainly micro-economic policies aimed at making markets and industries operate more efficiently and contribute to a faster underlying-rate of growth of real national output

Macro Policies.png

A2 Economics – The Laffer Curve

New to the A2 syllabus last year was the Laffer Curve. PBS Economics correspondent Paul Solman explores the question of just how high U.S. tax rates should or shouldn’t be and examines the relationship between economic activity and tax rates. There is a good explanation of the Laffer Curve which is the relationship between economic activity and tax rates.

In between, a smooth curve representing Laffer’s pretty simple idea: Somewhere above zero percent and below 100 percent, there is a tax rate where government will collect the most revenue in any given year. Now, the Laffer Curve applies to everyone, but the top so-called marginal rate is only relevant to the rich. It’s now 35 percent on all taxable income in excess of about $380,000 a year. Does that 35 percent rate maximize total tax revenue for the government?