Category Archives: Fiscal Policy

A2 Revision – Fiscal Policy

With the exam season just about to start in New Zealand I thought it appropriate to do some revision blog posts. In the CIE A2 paper there is always a macro policy question and it usually focuses on the conflicts between the different objectives. Below is a mindmap on fiscal policy that might be useful. Fiscal Policy involves the use of Government Spending and Taxation in order to influence the level of economic activity. The Government receives money through Taxation (T) and spends money through Government spending (G).

  • A budget deficit occurs when G > T
  • A budget surplus occurs when T > G

Should Central Banks still be independent?

Video from CNBC looking at why central banks became independent and if it still should be the case – very informative and they use the Phillips Curve in their explanation. WIth the ongoing inflation problems in the 1970’s and 80’s it was thought that giving central banks independence of government control should be implemented. It was argued that policy makers would struggle to convince the public they were serious about containing inflation if politicians retained a say on setting interest rates. In 1989 New Zealand become the first country to introduce an independent bank with the 1989 – Reserve Bank Act. The mandate was to keep inflation between 0-2% but later changed to 1-3%.

With the GFC in 2008 it was central banks who slashed interest rates and implemented several rounds of quantitative easing to stimulate demand. However the GFC could have been prevented if central banks intervened to stop the biggest asset-bubble in history instead of focusing purely on keeping inflation low. Furthermore the European Central Bank were slow to act and the recovery was stymied. The fact that Germany is under the threat of deflation means that the ECB have cut interest into negative territory and are relaunch another round of quantitative easing – they are running out of options. Economists are focusing on fiscal stimulus – tax cuts and government spending. Therefore monetary and fiscal policy should be working together. According to Larry Elliott of The Guardian. central bank independence is a product of the neoliberal Chicago school of economics and aims to advance neoliberal interests. More specifically, workers like high employment because in those circumstances it is easier to bid up pay.

Hyperinflation – can be controlled with a different government.

Venezuela has been in the news for sometime with its economy spiralling out of control with the inflation rate last year at 100,000% – doubling roughly once a month. The occurrence of hyperinflation in economies has become more common with governments now printing money rather than that money being backed by the amount of gold that they held – gold standard. Because the gold supply is quite inelastic, being on the gold standard would theoretically stop government overspending and keep inflation under control. The country effectively abandoned the gold standard in 1933, and completely severed the link between the dollar and gold in 1971 – this was around the time of the Vietnam War.

The more recent hyperinflation in Zimbabwe, Bolivia, Argentina etc have come about through government’s not been able to control the printing presses and succumbing to the desire to stay in power at the expense of crippling the economy. Huge fiscal deficits and excessive borrowing are the common denominator here – see flow chart below:

Hyperinflation usually happens amongst chaotic domestic conditions, whether social unrest or that country being involved in conflict – e.g. post war Germany. However as reported by The Economist hyperinflation can occur under more mundane circumstances. For instance in Bolivia’s inflation reached 60,000% which was started by a commodity boom which allowed them to borrow heavily from overseas but once resource prices tumbled there was a significant reduction in government revenue. The  government under Hugo Banzer increased spending to satisfy the voters who supported them in the election and this created further inflationary pressure. In a way this is similar to the Venezuela experience with high oil prices generating significant revenue for the government but once the oil prices fell the printing presses started to work overtime. And once inflation starts to accelerate Inflationary expectations kick in and then it becomes very difficult to control. However these inflationary expectations could reflect the lack of seriousness of government policy to rectify the problem as a change of government which is focused on prices can end hyperinflation in weeks. This reflects the trust in the incoming regime and was true of Bolivia (see video below).  Here the incoming government under Gonzalo (Goni) Sánchez de Lozada were serious about the ravages of inflation and to deal with it  didn’t use highly sophisticated economic theory.  See below:

  • Government spending was slashed
  • Price controls were scrapped
  • Import tariffs were cut
  • Government budgets were balanced.
  • No borrowing from the Central Bank

As Jeff Sachs – advisor to the Bolivian government –  said:

“All this gradualist stuff just doesn’t work. When it really gets out of control you’ve got to stop it, like in medicine. You’ve got to take some radical steps; otherwise your patient is going to die.”

Sources:

The Economist – February 2nd 2019

Commanding Heights – PBS Video

Economic Developments for 2019

This is a good summary of economic developments to watch in 2019 – from Al Jazeera. Some of the key points are:

  1. Protectionist policies will remain and any truce between the US and China will be short-lived.
  2. The US is in an unsustainable boom – the fiscal stimulus will fade and this will be followed by two larger deficits – budget and external. The US is consuming far more that it is producing and it mirrors the 1980’s – Reaganomics.
  3. China is slowing down – as well as the protectionist issues as a result of the US trade policy there are tensions between the economic system of capitalism and the political system of communism. This combination is referred to as ‘Market Socialism’. The problems are associated with: economic growth v environmental problems, rural areas v urban areas, rich v poor. China’s movement away from oil to gas which benefits Qatar but to the detriment of the Saudi economy.
  4. The Gulf economies are taking a hit from the fall in oil prices and government budgets may have to be cut. Diversification from the dependence on oil is necessary to avoid the resource curse and with a growing youth population job creating is needed. Movement to a more knowledge-based economy and large infrastructure projects are becoming focus areas as a necessity.

Glossy projects vs Maintenance – Governments need to get the basics right.

Since the GFC economics has been dominated by fiscal and monetary policies to stimulate aggregate demand. Monetary policy has in particular been reinventing itself with low interest rates not being enough to stimulate demand and the introduction of numerous rounds of QE.

Other policy areas might lack the excitement of delving into the unknown but are just as important to an economy. Maintenance of a country’s infrastructure, assets and government accounts are essential to the long-term development but government’s tend to avoid them as they are not creating anything new and therefore not recognisable by voters. A new hospital, school or major road grab the headlines and inform the electorate that they have been busy putting tax payer money to good use. Maintenance lacks the glamour of innovation.

The US after the GFC did spend a lot of money on new vanity infrastructure projects but these were in sparsely populated areas. However, it was busy cities that really needed their transport infrastructure upgraded and you would think this would be a priority for governments. In the US the fraction of existing road surfaces that are too bumpy has risen from 10% in 1997 to 21% in 2018. Invariably if infrastructure is not maintained it causes significant costs for an economy and in some cases fatalities – the recent bridge collapse in Genoa, Italy. One of the issues for economists is that the typically used measure of an economy, GDP, doesn’t take into consideration the cost of wear and tear. In order to do this they must work out the lifespan of each asset and decide on its depreciation. Some are similar to light bulbs which means they work until they blow – economists refer to this as the “one hoss shay” case. This is based on a poem where it imagines a horse-drawn cart built so well that it never broke down until it eventually fell apart. victim of a “general flavour of mild decay”. Other assets are more linear in how they depreciate in that they lose the same amount each year. Japan assumes that houses lose 4% in value each year and that is why Japan’s consumption of fixed capital is high – 22% of GDP – see graph from The Economist.

Too often governments, and organisations for that matter, preserves day-to-day spending by cutting maintenance and investment. Finance ministers might invest more in maintenance if the resulting boost to public wealth became more transparent. Furthermore if all government departments had to account for all the capital tied up in their operations, they might feel obliged to be more productive with it. New Zealand seems to be the only country to update its public-sector balance-sheet every month, allowing for timely assessment of public-sector worth. So instead of impressing voters with ideas and glossy projects, being boring might actually do some good. Economists tend to be good at this.

Source: The Economist – October 20th 2018

Economic Consequences of Trump

Very good video from Project Syndicate looking at the recovery of the US economy and if it is sustainable. Also was Trump responsible for the growth or Obama? Maybe Janet Yellen and central bankers with such low interest rates for a long period of time. However if there is another downturn do governments have the tools to grow the economy again? It seems that central banks have run out of ammunition i.e. no room to cut interest rates further. There is agreement that the levels of employment are not sustainable in the future and the focus should be on assisting low wage work and help people prepare for and keep work- ‘reward work’.

  • Features Nobel laureates Angus Deaton and Edmund Phelps, along with Barry Eichengreen,
  • Rana Foroohar author of ‘Makers and Takers’
  • Glenn Hubbard Dean of Columbia Business School

A2 Revision: Keynes 45˚ line

With the Cambridge A2 exam coming up here is a revision note on Keynes 45˚ line. A popular multi-choice question and usually in one part of an essay. Make sure that you are aware of the following;

Common Errors:
1. C and S are NOT parallel
2. The income level at which Y=C is NOT the equilibrium level of Y which occurs where AMD crosses the 45˚ line.
To Remember:
1. OA is autonomous consumption.
2. Any consumption up to C=Y must be financed.
3. At OX1 all income is spent
4. At OB consumption = BQ and saving= PQ
5. Equilibrium level of Y shown in 2 ways
a) where AMD crosses 45˚ line
b) Planned S = Planned I – point D

Remember the following equilibriums:
2 sector – S=I
With Govt – S+T = I+G
With Govt and Trade – S+T+M = I+G+X

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