From the Economist – good video on government bonds and debt through the ages with some great graphics.
It asks the question is government debt a concern today? They state that as long as a country’s GDP is growing faster than the country’s debt accumulating in interest then it grow its way out of debt with no fiscal cost. It also questions why interest rates today are low? Central banks such as the RBNZ and the US Federal Reserve set the interest rates and will keep them low until the economy starts some sort of recovery. They are able to do this as there is little to no inflationary pressure in the economy – remember most central banks have an inflationary target. This does mean that savers lose out as the return they get is very low. Furthermore implementing a programme of quantitative easing floods the market with cash which in turn leads to a lower cost of borrowing.
Part of the CIE A2 macro syllabus focuses on the wage price spiral which relates to the Phillips Curve. Here are some excellent notes that I picked up from Russell Tillson in my early days teaching at Epsom College in London. As from previous posts, the Phillips Curve analysed data for money wages against the rate of unemployment over the period 1862-1958. Money wages and prices were seen to be strongly correlated, mainly because the former are the most significant costs of production. Hence the resulting curve purported to provide a “trade-off’ between inflation and unemployment – i.e. the government could ‘select’ its desired position on the curve. During the 1970’s higher rates of inflation than previously were associated with any given level of unemployment. It was generally considered that the whole curve had shifted right – i.e. to achieve full employment a higher rate of inflation than previously had to be accepted. Milton Friedman’s expectations-augmented Phillips Curve denies the existence of any long-run trade off between inflation and unemployment. In short, attempts to reduce unemployment below its natural rate by fiscal reflation will succeed only at the cost of generating a wage-price spiral, as wages are quickly cancelled out by increases in prices.
Central banks have found that inflation has been the pest it has been in the past – most countries inflation rates have been short of its target rate. After the GFC the level of unemployment rose and inflation was quite subdues. However, with the post GFC recovery unemployment began to fall whilst the inflation rate was still showing no signs of accelerating which went against the original Phillips Curve. A further problem was that imported goods and services in one country have little relevance on the wages in another and the low levels of unemployment tempted people back into the labour force who hadn’t been counted as unemployed. This is particularly the case in Japan.
When there is an increase in job numbers, with a boom period, inflation may also be slow to rise. Although firms tend to be reluctant to lower wages when the economic climate slows as it is harmful to staff morale. The same could be said in good times as wages tend not to rise that quickly.
For many businesses changing the price of their goods or services can be costly especially for a small increase in price. Therefore the change in the business cycle tends not to be reflected in price changes as there needs to be major swings before prices will move at all. Central bank policy tends to manipulate interest rates to maintain a stable inflation causing unemployment to move up or down – unemployment is what changes not inflation.
The problem that central banks face today is that to keep the phillips curve flat they need to be able to cut interest rates to stimulate growth when inflation threatens to become deflation. However there is little room for further easing with rates so low. Central banks will need to work with the government’s fiscal policy to stimulate growth and spend the money that the central bank’s create.
The Economist ‘Briefing’ recently looked at what now for macroeconomic policy in the global economy. The GFC of 2008 and outbreak of COVID-19 has got policymakers scratching their head as what can be done to stimulate aggregate demand.
Keynes’ ideas of government involvement in managing the economy in the business cycle – spend in recessions and pay of debt in booms – was flavour of the month in the post-war period. However by the1970’s this policy was in trouble which the spectre of stagflation – high inflation accompanied by high unemployment. According to Keynes the two variables should move in opposite directions. In 1976 the UK Prime Minister James Callaghan in his speech at the Labour Party Conference said:
We used to think that you could spend your way out of a recession, and increase employment by cutting taxes and boosting Government spending. I tell you in all candour that that option no longer exists, and that in so far as it ever did exist, it only worked on each occasion since the war by injecting a bigger dose of inflation into the economy, followed by a higher level of unemployment as the next step. Higher inflation followed by higher unemployment.
The 1980’s saw monetarist ideas enter the scene with a focus on the control of inflation though constraining the money supply. University of Chicago economist Milton Friedman and US Federal Reserve Chairman Paul Volcker knew that in order the get inflation down that the economy would have to go through a recession and very higher unemployment in the short-run. However once inflation started to drop the Central Bank could relax monetary policy (interest rates) and then encourage more economic activity in the economy and thereby reducing unemployment. Previously policy had focused on equality of incomes which had a large impact of economic efficiency. Price stability was now the primary focus of a central bank and it was in New Zealand with the 1989 Reserve Bank Act that the first central bank became independent from government. Gone were the days where the Minister of Finance could get on the phone to the Reserve Bank Governor to change interest rates. Central banks had inflationary targets whilst fiscal policy was to keep government debts low and to redistribute income as the government saw fit.
This policy came unstuck after the GFC as central banks dropped interest rates to record levels and implemented a series of quantitative easing (QE) measures to no avail. Growth was stagnant for a long time but eventually demand for labour picked up. This would have normally been accompanied by higher inflation but it wasn’t the case. Just like in the 1970’s inflation and unemployment were not behaving according to the theory but at this time both were favourable – low inflation and low unemployment. However inequality was now gripping the attention of economists and there was concern about the monopoly position of some firms. The rich have a higher tendency to save rather than spend, so if their share of income rises then overall saving goes up and lower interest rates and QE were driving up inequality by increasing house and equity prices.
Once COVID-19 hit it was government’s fiscal policy which has been used to try and stabilise the economy and boost growth. Fiscal stimulus – government spending with running up large deficits might be required for a long period of time in order to support the economy. This is more acceptable amongst economists as low interest rates enable the government to service much larger debts and with such low inflation it is unlikely that rates will increase anytime soon. This resembles Modern Monetary Theory (MMT) – the situation where the government can create its own money therefore:
Cannot default on debt denominated in its own currency;
Can pay for goods, services, and financial assets without a need to collect money in the form of taxes or debt issuance in advance of such purchases;
Is limited in its money creation and purchases by inflation, which accelerates once the economic resources (i.e., labor and capital) of the economy are utilised at full employment;
Can control inflation by taxation and bond issuance, which remove excess money from circulation, although the political will to do so may not always exist;
Does not need to compete with the private sector for scarce savings by issuing bonds. Within this model the only constraint on spending is inflation, which can break out if the public and private sectors spend too much at the same time. As long as there are enough workers and equipment to meet growing demand without igniting inflation, the government can spend what it needs to maintain employment and achieve goals such as halting climate change.
Negative interest rates
Some governments have gone the way of negative interest rates (see graphic) to try and stimulate more aggregate demand. This would discourage saving and see a potential withdrawal of cash from the banking system leaving less money to lend out. Avoiding this scenario might involve abolishing high-denomination bank notes and making the holding of large amount of cash expensive and unfeasible. However in order to keep money in the banks might renege on interest rate cuts as customers might move their money to rival banks therefore high negative interest rates would severely dent banks’ profits.
The current economic environment may make negative interest more plausible as:
Cash is in decline.
Banks are becoming less important to finance.
Central bankers are looking at creating their own digital currencies
Greater government intervention is what the majority of economists want but it does carry with it risks of significant debt and high inflation. There is an opportunity to rethink the economics discipline and as stated in The Economist:
A level-headed reassessment of public debt could lead to the green public investment necessary to fight climate change. And governments could unleash a new era of finance, involving more innovation, cheaper financial intermediation and, perhaps, a monetary policy that is not constrained by the presence of physical cash. What is clear is that the old economic paradigm is looking tired. One way or another, change is coming
Sources: The Economist – A new era of economics – July 25th 2020 http://www.britishpoliticalspeech.org/speech-archive.htm?speech=174
With Auckland now at COVID-19 Alert Level 3 and schools operating online we continued going through the A2 syllabus and discussed Contestable Markets using Webex. I used this clip from Commanding Heights to show how regulated the US airline industry was during the 1970’s. Regulations meant that major carriers like Pan Am never had to compete with newcomers. However an Englishman named Freddie Laker was determined to break this tradition and set-up Laker airways to compete on trans-atlantic flights. He offered flights at less than half the price of what Pan Am charged. Alfred Kahn was given the task by the then President Jimmy Carter to breakup the Civil Aeronautics Board (the regulatory body) and he wanted a leaner regulatory environment in which the market was free to dictate price. There is a piece in the clip that shows how ludicrous some of the regulations were:
When I got to the Civil Aeronauts Board, the biggest division under me was the division of enforcement – in effect, FBI agents who would go around and seek out secret discounts and then impose fines. We would discipline them. It was illegal to compete in price. That means it was illegal to compete in the discounts you offer travel agents. So we regulated travel agents’ discounts. Internationally, since they couldn’t cut rates, they competed by having more and more sumptuous meals. We actually regulated the size of sandwiches. Alfred Kahn
When the CAB was closed down competition was the rule and the industry had vastly underestimated the demand for air travel at lower prices – a very elastic demand curve – see graph below.
In the A2 course contestable markets is a popular essay question and is usually combined with another market structure.
What is a contestable market?
• One in which there is one firm (or a small number of firms) • Because of freedom of entry and exit, the firm faces competition and might operate in a way similar to a perfectly competitive firm • The threat of “hit and run entry” from new firms may be sufficient to keep the industry operating at a competitive price and output • The key requirement for a contestable market is the absence of sunk costs – i.e. costs that cannot be recovered if a business decides to leave a market • When sunk costs are high, a market is more likely to produce an price and output similar to monopoly (with the risk of allocative inefficiency and loss of economic welfare) • A perfectly contestable market occurs only when entry and exit into and out of a market is perfectly costless • Contestable markets are different from perfect competitive markets • It is possible for one incumbent firm to dominate the industry • Each existing firm in the market produces a differentiated product (i.e. goods and services are not perfect substitutes for each other) There are 3 conditions for market contestability:
• Perfect information and the ability and or legal right to use the best available technology • Freedom to market / advertise and enter a market • The absence of sunk costs
Example • Liberalisation of the US Airline Industry in the 1970’s and the European Airline Market in late 1990s • Traditional “flag-flying” airlines faced new competition • Barriers to entry in the industry were lowered (including greater use of leased aircraft) • New Entrants – easyJet- Ryanair
In December 2014, then-President Barack Obama warned that the United States needed to prepare for an upcoming pandemic. This came a soon after the Ebola outbreak had threatened to spread worldwide. People knew of pandemics and their impact from history but Covid-19 took a lot of us by surprise. This can be seen as a ‘Black Swan’ event – an event or discovery whose existence was not predictable from the available data, and whose effect on society or the markets yields surprising and unexpected results. Just because all the data says that there are only white swans does not prove that Black Swans do not exist. Philosophers debated that they didn’t exist until explorers found a Black Swan in Australia. It was quite ironic that yesterday, whilst holidaying in Queenstown (South Island NZ), I saw a Black Swan – see photo. It immediately reminded me of Nassim Nicholas Taleb book ‘The Black Swan’ (2007). The book describes a black swan as a highly improbable event with three principal characteristics:
its massive impact; and
after it has happened, our desire to make appear less random and more predictable than it was.
The GFC unquestionably meet the criteria as a Black Swan. No one saw it coming and no one knows how it is going to end. The same can be said about Covid-19. This unexpected and hard-to-predict event was not within the range of normal expectations. However it will result in a major economic contraction on a global basis.
Economist Hyman Minsky once wrote a thesis about economic stability – more applicable to the GFC Black Swan event. “If you have a wonderful, stable world and, better yet, it is growing nicely and nothing is going wrong, you are likely as the years go by to take more risk. As time passes the cost of taking risk gets less and less because interest rates come down. You can imagine that people will get carried away into thinking such conditions are permanent and take on record levels of debt. They think conditions will always be good. And then all it takes is one small event to create instability.”
I have mentioned in previous posts the work of Ken Rogoff and Carmen Reinhart – co-authors of “This Time is Different” – 2009. Below is a summary from Amazon
Throughout history, rich and poor countries alike have been lending, borrowing, crashing–and recovering–their way through an extraordinary range of financial crises. Each time, the experts have chimed, “this time is different”–claiming that the old rules of valuation no longer apply and that the new situation bears little similarity to past disasters. With this breakthrough study, leading economists Carmen Reinhart and Kenneth Rogoff definitively prove them wrong.
However the rise of the coronavirus and the impact it is having on the global economy is not the same as previous recessions/ depressions in history. Ken Rogoff found it hard to think of a historical parallel and came up with the Spanish flu epidemic which killed millions of people worldwide. Rogoff talks to Paul Solmon of PBS about the impact of the coronavirus.
I came across this piece from a colleague on economic forecasting. The article below appeared in the Sydney Metropolitan Press in the late 1920’s. Although economic cycles don’t run to an exact time period the graph below would indicate that this model is not too far out of kilter.
The top line = years in which panics have occurred and will happen again
The middle line = years of good times, high prices and the time to sell stocks
The bottom line = years of hard times, low prices and good times to buy stocks
The past panic century of dates are 1911, 1927, 1945, 1965, 1981, 1999, 2019. Except for 1981, these were all pretty good years to sell stocks – The Big Picture blog. 2016 suggests the top of the present cycle with 2019 being a year of panic.
“The Ancient Art of Economic Forecasting” – Sydney Metropolitan Press 1920’s
The graph below professes to forecast the future trend of Australian business conditions, was first brought under the notice of the public in 1872. It was prepared by a Mr Tritch, whose origin and activities are shrouded in mystery.
The top line shows years in which panics have occurred, and will occur again. Their cycles are 16, 18 and 20 years.
The centre line shows the years of good times and high prices; the cycles are 8, 9 and 10 years.
The bottom line shows the years of depressions and low prices; the cycles are 9, 7 and 11 years.
The panic which occurred in 1893 is shown in 1891. Nevertheless, that year witnessed the beginning of the depression. 1915, just after the war started was a year of depreciation, and 1919, the year following the cessation of hostilities, was a period charcterised by good times.
As this chart was published in 1872, it is interesting to note the forecast of the panic in 2019 – coronavirus? It will be seen that there has been a general upward trend since 1926 with the panic occurring in 1927 after the high is reached. The bottom of the depression is reached at the end of 1930 and the upward trend begins in 1931.”
In light of what has been happening regarding Brexit here is a very amusing clip from the BBC series “Yes Minister” in which Sir Humphrey and Jim Hacker discuss Brussels and the notion of the UK trying to pretend that they are European. Also discusses why other European nations joined the common market in the first place.
I am off to the beach and out of internet range – will be back around 6th January. Merry Christmas and a Happy New Year.
Covered this topic today with my AS Economics revision class. What have been the formidable challenges facing eastern European countries (command) embracing capitalism? Here are some thoughts as well as an informative video from the IMF:
In planned some goods are provided free but not in a market economy
Corruption – widespread in communist countries in eastern Europe – Oligarchs
Inflation ↑ – privatised firms began to charge prices that reflected high costs
Lack of entrepreneurial experience
Rising unemployment as owners of businesses try to make them more efficient.
Labour relations – Poor as workers are in a new environment – Job security?
Consumer sovereignty – some industries decline/expand
Resources – surplus and shortage
Self-Interest – fewer merit goods and more demerit goods
Time Gap before framework of government controls can be developed
Expansion of industry – potentially for greater externalities
Old/disabled – vulnerable with the change of government role
Welfare system – limited support for unemployed etc. will take time to develop
Provision of public services – disruption to police and other public services
Moral Hazard – the state insure workers against risks of losing their job