UPDATE: The state of the European economy

Recently, Europe’s economy has avoided appearing on many of our news screens what with other international affairs such as Russia/ Ukraine, Syria and Iraq in the headlines for probably my entire summer holidays. But that doesn't mean that the European economy is all hunky-dory and the recession is a thing of the past.

This post is an update of what is actually going on in Europe right now, giving you three key case studies: Italy, France and Germany.

Italy

·      Triple dip recession – GDP fell by 0.2% in the second quarter of 2014

·      12.6% unemployment rate

·      43% youth unemployment

·      Little political will to do anything about it

France

·      Rising budget deficit

·      Last quarter’s GDP growth: 0%!

·      Chance of going back into recession, was also 0% in the quarter before last

Germany

·      GDP fell 0.2% in the last quarter, the first GDP contraction this year

·      Manufacturing sector slow down

·      Geopolitics is affecting growth: Russia’s embargo on European food imports is apparently affecting 9.5m European farmers, and is affecting Germany’s trade

Key points to note about Europe right now:

·      Low inflation.

Average Euro Area: 0.4%

Deflation in 8 Eurozone countries including the PIGS (Portugal, Italy, Greece and Spain)

Country in Eurozone	Inflation rate
France	0.4%
Italy	-0.1%
Germany	0.8%
Spain	-0.5%
Greece	-0.3%
Portugal	0.4%

Why is this a problem?

·           Increases the real value of debt which means that government debt increases making it harder to pay off and increasing the likelihood of needing another bail out

·           Taxes will have to rise eventually to fund the increased debt accumulation which means businesses will have a higher tax burden à leaving some Eurozone countries

·           There is danger of falling into a deflation trap where prices just keep falling. This is called a deflation spiral.

·      High unemployment

·      High government debt

·      Political upheaval

·      Geopolitics with Russia

·      Lack of political union

Different countries in the Eurozone want different things and have different views with how situations should be handled, e.g. with Russia, which makes it hard to manage economic policy and introduce austerity measures where needed.

What can be done?

·           Keep interest rates low – increasing interest rates will just decrease inflation more

·           “Quantitative Easing lite”: the European Central bank buys assets to stimulate the economy and help inflation rise

Anything else?

·           Role of competition in markets:

o   There was a period of very low inflation during the late 19^th century in Germany and the UK

o   Analysis shows there was competition in markets and businesses operated in a competitive environment

o   Competition restricts wage growth because there are many companies in the same industry offering the same job and the same wage. This is happening now!!!

o   A competitive market means that firms are unwilling to increase the price of goods and services – preventing inflation from rising. This is happening now!!!

o   It is therefore hard to increase inflation. This is happening now!!!

China - Case Study I

Key Questions:

·         Is growth increasing incomes on the average Chinese?

·         Is growth lifting people out of poverty?

·         Is minimum wage industrialisation the best way to achieve growth?

QUALITY of growth matters

·         Average income for a Chinese worker is (USD)$8000

·         By 2020, it is estimated that average Chinese wages would have risen to (US) $14,000. This level is considered to be the upper income level that moved countries such as Singapore, South Korea, Greece and Portugal, to ‘rich’ country stats - the level that moved these countries past the boundary

Five year plan

·         China’s growth has been, on average, 9.6% over the past 30 years

·         The five year plan is the government’s 12th five-year plan used to set the future growth agenda for China

·         Renewed in 2011, the priorities for this plan are sustainable growth, industrial upgrading and the promotion of domestic consumption

·         Criticism: there is no implementation plan

See kpmg report:

·         Half of china’s growth comes from adding capital. Bear in mind that growth quality is now becoming the most important thing to think about rather than growth quantity

Total Factor Productivity (TFP) is measured by innovation, allocative efficiency (re-allocation of factors, e.g. rural to urban, state owned to private) and human capital. TFP is the contribution of all factors of production to growth. When TFP increases, the growth rate increases. This means that one or more of the factors of production has been changed.

Innovation - micro level data shows that ⅔ technology comes from imitation, most developing countries imitate first to gain enough wealth to then invest it into R&D for new product development. Imitation leads to innovation - creating an increase in growth.

Human capital - China’s investment in human capital is geographical unevenly distributed. Rural parts of China are under-invested in. If China invests in human capital all round, it has a better chance competing with other economies. Human capital is beneficial because:

·         Skill levels increase. E.g. they will be more qualified to perform tasks and will do so quicker

·         Creates a flexible economy - workers have a greater capacity to adapt to changes in the economy, i.e. seize new opportunities for wealth creation

·         Increases occupational mobility of labour and geographical mobility of labour as because of the previous point

·         High levels of education can increase a worker’s ability to use foreign technology, their ability to absorb new information and acquire technical skills

Middle Income Trap

China needs to avoid the middle income trap. The middle income trap is the trap that developing countries fall into when trying to make their transition from a developing country to a developed country. They are not low income by definition, i.e. they experience high growth rates and make money, but they are not high income countries because they do not have technological advantages. China’s wages are starting to increase, as shown here, demonstrating that what was once the most popular destination for cheap manufacturing, is now losing to countries such as Bangladesh and Singapore.

Key points:

·         Wages are increasing

·         Poverty is slowing decreasing

·         Innovation is creeping up

·         Chinese firms are expanding globally

·         Without the prospect for cheap labour, firms will be deterred from investing in China

·         Only urban members of the workforce are educated, also potentially deterring firms

·         The Chinese economy is still imitating

These points suggest that China is heading for the middle income trap, a limbo between the rich and poor, unable to progress. There are criticisms of the middle income trap, read the Economist article here to gain other perspectives, which will help you build your argument in your exam. Remember that providing alternative views are brownie points. Read the sources at the bottom as well.

The Future

·         Focus on overcoming the middle income trap

·         Increase own market reliance, e.g. US consumers are increasingly buying domestically produced goods

·         Increase domestic demand by lowering exports. E.g. exports are only a fraction in the US - China needs to get to that

·         Privatise. State owned companies are not as productive. They distort the allocation of lending and bank credit. State owned enterprises account for 30% industrial output and ¼ of urban jobs

·         Increase innovation

·         Increase opening - more Chinese firms should go global.

o        We have seen Chinese investment in African natural resources, which is a start. They are building infrastructure in poor African countries and providing jobs (however a negative is that they are competing with local firms and undercutting them, making it difficult for locals to make a living)

o        China should focus on moving up the value chain by producing things that is most competitive

o        The government should push to create Chinese multinationals

o        At the moment, Europe in particular can benefit from the additional investment that Chinese firms can offer

·         Services are important - increase job creation, create a high skilled labour force and help China rebalance

·         Raise consumption as a share of GDP, not rising it in absolute terms

·         Restructure the economy: more services, quality of growth needs to increase

·         Productivity and innovation: compete to produce the best products in the world. Join the ranks of rich countries, e.g. Samsung (South Korea) competing with Apple (US)

·         Political reforms are required to sustain a prosperous middle class