The impact of Covid-19 on countries like China, and other parts of Asia, has meant that firms in the large economies of Germany and France might not be keen to outsource work to Asia. Although the infrastructure and the resources are available in these countries the Covid-19 risks associated with them means some European companies are looking at options closer to home – also referred to as “nearshoring” (moves by China-wary western European manufacturers to bring production closer to home). CEE countries especially Czech Republic, Hungary, Poland, Slovakia and Romania are particularly strong in the manufacturing sector whilst Estonia, Latvia, and Lithuania (Baltic states) have a comparative advantage in services. Although outsourcing will help these economies it will take a bit of time before there is any significant change.
This is an optimistic view but for some Eastern European countries the GDP forecast has been worse than that experienced after the GFC.
With the fall of the Berlin Wall, the transition from command to market systems led to severe recessions within countries – accelerating inflation and very high levels of unemployment – GDP fell by over 40% in the old Soviet-bloc countries. The present recession is proving to be much worse and these Eastern European countries are particularly vulnerable. The Economist came up with three reasons:
These economies are exported dependent – as a % of GDP exports are 96% in Slovakia, 85% in Hungary.
Eastern European countries will find it hard to fund deficits as their credit rating tends to be a lot lower than other countries wishing to borrow money. Bulgaria’s rating is BBB compared to say Austria which is AA+
A lot of these countries rely on tourism as part of GDP therefore with Covid-19 the tourist industry has all but disappeared. For Croatia that is about 25% of GDP.
The outlook looks especially bleak for economies that were in a poor economic condition before Covid-19. Even though there have been radical steps taken to nullify the economic impact of the virus it will take a strong and coordinated response at EU level to steer countries out of their economic hardship.
Source: The Economist – Eastern Europe’s covid-19 recession could match its post-communist one. 28th May 2020
From The Economist – very good explanation on the impact of COVID-19 on the entertainment / service sector. Often it is the low income groups that would be severely affected as they tend to work in the service industry especially – also not being able to work from home. As these groups tend to live from pay check to pay check they will struggle to maintain any quality of life. They are unlikely to have savings to call upon and will depend on handouts form the government in the form of unemployment benefit or the wage subsidy. What happens when government support runs out? The video is well worth watching.
As COVID-19 absorbs most of the headlines worldwide there are other concerns in the UK like Brexit. The farming industry has been impacted by both:
COVID-19 – shutdown of the service that serves the farming industry – 1/3 of the lamb market has gone.
Brexit – a deal needs to be negotiated with the EU.
Brexit and lamb exports to the EU – when the UK was part of the EU it was part of a custom union where there was no tariff between member states but there was a Common External Tariff (CET) which meant that countries outside the EU have to pay the same tariff when they export into any EU member state. For Britain leaving the EU without a deal has serious consequences for the farming sector. Over 90% of lamb exports in the UK have gone to the EU but with no longer being a member state the industry will no have to pay a CET which will undoubtedly make UK exports more expensive in the EU market. The FT visit a farm in Wales to look at the importance of the Brexit negotiations – a lamb is valued around £80 but if the EU charges the going rate of tariff between 40-80% that would bring up the price of lamb to between £112 – £144 in EU countries. This would make it very hard for farmers to remain financially viable. Furthermore it is not just the farming sector as the UK’s overall trade with the the EU is significant:
2018 – 45% of all UK exports go to the EU – $291bn 2018 – 53% of all UK imports from the EU – $357bn
The UK produces approximately 60% of what is required to feed its population with the remainder being imported. The UK’s £110bn-a-year agriculture and food sector is deeply integrated with Europe relying on the bloc for agricultural subsidies of £3.1bn ($4bn) under the CAP – Common Agricultural Policy (explained later in the post). The government has promised to pay the equivalent of the CAP subsidies up to 2022, no one is certain what will happen after that. There lies ahead some major challenges in the UK and not just for the farming sector. The video from the FT below is very useful for explaining the impact of trade barriers and CET.
What is CAP?
At the outset of the EU, one of the main objectives was the system of
intervention in agricultural markets and protection of the farming
sector has been known as the common agricultural policy – CAP. The CAP
was established under Article Thirty Nine of the Treaty of Rome, and its
objectives – the justification for the CAP – are as follows:
1. Raise and maintain farm incomes, through the establishment of high
prices for food. Such prices are often in excess of the free market
equilibrium. This necessarily means support buying of surpluses and
raising tariffs on cheaper imported food to give domestic preference.
2. To reduce the wide flutuations that often occur in the price of agriculutural products due to uncertain supplies.
3. To increase the mobility of resources in farming and to increase the
efficiency of all units. To reduce the number of farms and farmers
especially in monoculturalistic agriculture.
4. To stimulate increased production to achieve European self
sufficiency to satisfy the consumption of food from our own resources.
5. To protect consumers from violent price changes and to guarantee a wide choice in the shop, without shortages.
CAP Intervention Price
An intervention price is the price at which the CAP would be ready to
come into the market and to buy the surpluses, thus preventing the
price from falling below the intervention price. This is illustrated
below in Figure 1. Here the European supply of lamb drives the price
down to the equilibrium 0Pfm – the free market price, where supply and
demand curves intersect and quantity demanded and quantity supplied
equal 0Qm. However, the intervention price (0Pint) is located above the
equilibrium and it has the following effects:
1. It encourages an increase in European production. Consequently, output is raised to 0Qs1.
2. At intervention price, there is a production surplus equal to the
horizontal distance AB which is the excess of supply above demand at the
3. In buying the surplus, the intervention agency incurs costs equal to
the area ABCD. It will then incur the cost of storing the surplus or of
4. There is a contraction in domestic consumption to 0Qd1
Consumers pay a higher price to the extent that the intervention price exceeds the notional free market price.
The increase in farmers’ incomes following intervention is shown also: as has been noted, one of the objectives of price support policy is to raise farmers’ incomes. The shaded area EBCFG indicates the increase in the incomes of the suppliers of lamb.
Throughout most of its four decades of existence, the CAP has had a
very poor public relations image. It is extremely unpopular among
consumers, and on a number of occasions it has all but bankrupted the
Paul Solman on PBS last week interviewed Nobel Prize winner Paul Romer about how the US should go about containing the virus and open up the economy. He is proposing mass testing the population every two weeks.
He states that each additional unit of testing frees up approximately 9 people who can go back to work. So how to does the cost of 1 test compare to 9 people being able to go back to work? He gives the example where the cost of 1 test each day of the year = $3,650 but the income generated by getting people back to work = $450,000 – these figures are approximate.
With this model he suggest that $100bn a year needs to be spent on testing which means 23 million tests per day or test the population every 14 days in the US. Worth a look.
Unemployment around the world is increasing at an alarming rate and one only needs to look at the USA to see the impact of COVID-19 on the rate. Today the number of people claiming benefit is 35 million which equates to 14.7% of the labour force. This is contrast to 3.5% in February this year. More jobs were lost during March than the whole of the GFC in 2008-2009.
Globally it is estimated that 200 million jobs will be lost in 2020 with about 40% of the global workforce in jobs that face a high risk of becoming obsolete – International Labour Organisation. These job losses worldwide will mean mean increasing inequality as the lower income groups more likely to experience unemployment and financial insecurities and therefore more vulnerable to labour market fluctuations resulting from macroeconomic changes. In reality a lot of people on low incomes live from week to week and when their pay suddenly stops the situation becomes desperate. A lot of the jobs that lower incomes do (in the service sector) have now gone with the closure of bars, restaurants, offices etc. Some still work in essential services like hospitals but are now in the front line and exposed to the virus. Research has shown that pandemics lead to a persistent and significant increase in the net Gini Coefficient measure of inequality – see graph below). Government support in a lot of economies has not protected those that are most vulnerable and COVID-19 could end up being a catalyst to increasing inequality more than other previous pandemic episodes.
What is the Gini Coefficient? The Gini Coefficient is derived from the same information used to create a Lorenz Curve. The co-efficient indicates the gap between two percentages: the percentage of population, and the percentage of income received by each percentage of the population. In order to calculate this you divide the area between the Lorenz Curve and the 45° line by the total area below the 45° line eg.
Area between the Lorenz Curve and the 45° line Total area below the 45° line
The resulting number ranges between:
0 = perfect equality where say, 1% of the population = 1% of income, and
1 = maximum inequality where all the income of the economy is acquired by a single recipient.
The straight line (45° line) shows absolute equality of income. That is, 10% of the households earn 10% of income, 50% of households earn 50% of income.
Emerging economies have been affected in numerous ways by Covid-19. The following are just some:
Limited movement of their population
loss of export earnings
drop in foreign direct investment
fall in remittances.
Regarding the last one – the World Bank have estimated that global remittances will decline by 20% in 2020 – more than US$100bn – due to the Covid-19 pandemic and shutdown. There are expected to fall across the regions – see graph below:
In 2019 remittances reached a record US$554 billion but are estimated to be US$445bn in 2020. With the fall in foreign direct investment they have become even more important to low and middle income countries (LMIC). In 2019 remittances were greater than foreign direct investment and were the biggest source of capital in LMIC – 8.9% of GDP. This is especially prevalent when you consider that FDI is expected to plunge by more than 35% to LMIC in 2020.
The importance of remittances is also significant when pooling a poverty figures – it is estimated that a 10% increase in remittances reduces poverty by 3%.
A fall in remittances means:
less spending the economy as a whole
more people below the poverty line
more people unable to afford food, healthcare and basic needs
The World Bank estimate that in 2019 there were 272m international migrants of which 26m were refugees. As well there were in 700m migrants within a country providing financial support elsewhere. However with a downturn in the economy due to Covid-19 it is the foreign workers who are first to lose their job. 2021 might see a slight recovery with remittances set to rise by 5.6% to US$470bn but many things can eventuate over the next year.
Nobel Prize winning economist Paul Krugman defined moral hazard as:
Any situation in which one person makes the decision about how much risk to take, while someone else bears the cost if things go badly.
Companies exploiting moral hazard privatise the reward (they keep the profit) but socialise the risk (government bails them out if everything goes wrong)
Moral Hazard and the GFC During the Great Depression more than 6000 American banks went bankrupt between 1930-33 and caused significant levels of unemployment. Learning from this event authorities believe that in future banks should be bailed out and this eventuated after the GFC in 2008. The main cause of the GFC was the sub-prime mortgage market where lenders faced a situation of moral hazard. Because the banks were taking on the risk the mortgage brokers, who sold the mortgages to the banks, didn’t really check whether the person taking on the mortgage could actually pay it back. Brokers were encourages to lie on the mortgage contracts about the income etc of their clients.
Moral Hazard and Covid-19 With corporate stimulus packages rolling out in most countries one wonders if there have been thorough enough checks on corporate behaviour. Issues like firing employees and bonuses to the top executives of companies have been prevalent in the past especially during the GFC. Then large businesses were favoured over small businesses. Today some of the wealthiest people made their money by borrowing from the banks to buy their own company shares in order to inflate its price. Following this they then sold their shares for a profit on the market. Now some of them are asking for bailouts as their company starts to struggle to survive. As well as government bailouts the central banks around the world have also engaged in the purchase of bonds and risky high-yielding debt. This is to ensure liquidity in the market but this intervention could shape how people perceive risk in the future and reward those institutions that behaved recklessly before the pandemic. Also more generous unemployment by the government might encourage people to be laid off and not seek work. However the time taken to minimise the moral hazard could have meant greater economic harm to the economy as a whole.
Modern Monetary Theory says that you can basically print your own currency by having your own central bank, run large deficits, have full employment, have no inflationary pressure and do this year after year. Nouriel Roubini (see video below) warns that while large deficits and monetary stimulus make some sense during a short deflationary economic contraction, sustaining those policies for years, as he expects will happen, will lead to inflation and economic stagnation – stagflation.
However in a time of crisis like Covid-19 there seems to be a lot more justification for this type of policy over the short-term – when you have a collapse of economic activity, a recession, deflationary concerns and a major reduction in the velocity of circulation of money (MV=PT) – a sort of stag-deflation. At this time a ‘helicopter drop’ makes sense because we have a massive fall in supply as well as demand. But monetising fiscal deficits over a number of years produces a negative supply shock that reduces potential output and increases costs ending up with stagflation like in the 1970’s.
Background to MMT
MMT has its roots in the theory of John Maynard Keynes who during the Great Depression created the field of macroeconomics. He stated that the fact that income must always move to the level where the flows of saving and investment are equal leads to one of the most important paradoxes in economics – the paradox of thrift. Keynes explains how, under certain circumstances, an attempt to increase savings may lead to a fall in total savings. Any attempt to save more which is not matched by an equal willingness to invest more will create a deficiency in demand – leakages (savings) will exceed injections (investment) and income will fall to a new equilibrium. When you get this situation it is the government that can get the economy moving again by putting money in people’s pockets.
MMT states that a government that 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.
How does it differ from more mainstream monetary policy – see table below.
Those against MMT are dubious of the idea that the treasury and central bank should work together and also concerned about the jobs guarantee. They argue that if the government’s wage for guaranteed jobs is too low it won’t do much to help unemployed workers or the economy, while if it’s too high it will undermine private employment. They also say that trying to use fiscal policy to steer the economy is a proven failure because politicians rarely act quickly enough to respond to a downturn. They can’t be relied upon to impose pain on the public through higher taxes or lower spending to quell rising inflation.
The global airline industry has been one of those that has been hardest by Covid-19. In the US passenger volume is down 96 %, whilst globally losses have topped US$314bn worldwide. Based on booking patterns Air New Zealand will lose over NZ$5bn in revenue per year and a loss of 3.500 jobs. What makes it even worse is that the latest Oxford Economics forecast shows that the loss in global output could be double that of the GFC. This has implications on the speed of the recovery in air travel in the second half of 2020. The table shows that Asia-Pacific takes a big hit financially and is second behind Middle East/Africa (51%) with a 50% loss in RPK.
RPK = Revenue Passenger Kilometres is an airline industry metric that shows the number of kilometres traveled by paying passengers
IATA estimate that RPKs will decline by 48% in year-on year terms and passenger revenues will be US$314 billion lower this year compared to 2019- see table below. IATA note that a typical airline has cash to cover around two months of revenue loss.
Below is a short video from PBS Newshour with Paul Solman looking at the airline industry.
ASB bank published some of its forecasting for the Global and New Zealand economies and number of potential routes – read the full article here. They have come up with a central scenario which focuses on what is actually happening at the moment although we know how things can change. They then do an upside and a downside around this central forecast. They also published some graphs that relate to their scenarios – see below.
The ASB also noted that compared to other countries New Zealand is currently in a good position:
The economy is going into a deep but short-lived contraction – the economy will recover.
NZ has more fiscal and monetary ammunition than other countries.
Where the economy actual ends up – how long is a piece of string? Stay safe.