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!!!

Quantitative Easing (QE)

QE causes a change in the money supply. Steps:

1. The Bank of England (BoE) purchases assets such as government bonds and corporate bonds
2. Pays for these assets by creating money electronically and crediting the accounts of the companies that it bought assets from
3. These accounts are called reserves. All banks hold reserves at the BoE and the essence of QE is that it builds up these reserves
4. QE is likely to lead to inflation because banks lend more and increases the money supply (see Quantity Theory of Money). Another reason for inflation is, holding everything else equal (ceteris paribus), more people have more money that they supposedly use for consumption, creating demand pull inflation

Explained by Stephanie Flanders

http://www.bbc.co.uk/news/business-16973560

Stephanie Flanders in the BBC’s economics editor, the link above provides a short video RSAnimate of QE. A summary of the video is as follows:

·         The Bank of England creates money and spends it so that there is “extra cash” flowing into the economy. They spend it by buying government bonds or IOU’s (formal definition: documentation confirming that the debt is owed) from financial institutions such as pension funds or insurance companies.

·         This puts more money into the economy (higher money supply) because these financial institutions that sold these bonds have more money to spend on new businesses or on housing for example.

·         Because of this, it is cheaper for the government to borrow as the BoE pushes up demand for the Treasury’s IOUs and supply of bonds has been reduced. Long term interest rates are lower than they should be making it cheaper for everyone else to borrow as well, because higher demand means more spending and this leads to faster growth.

The last point explains the theory WHY the government uses QE even with the risk of inflation, particularly during recessions. If demand rises, consumption may increase and the economy begins to recover. 

Recent inflation figures!

Once again, the new inflation figures have come out for November and the CPI has fallen 0.2% from the previous month. The RPI also fell from 5.4% to 5.2%.
Reasons for the slight fall in inflation include:

• Supermarket food prices (bread and vegetables) - price war
• Transport costs - fuel prices fell

However, the rate at which prices are rising is still twice that of the rate of increase of wages, making society worse off. Wage rises are not keeping up with inflation, thus in real terms, salaries are falling.

Code for Fiscal Stability (1998)

·     Based on the 5 principles of tax

o      Equitable

o      Economical

o      Efficient

o      Convenient

o      Flexible

Includes:

·     The Golden Rule

o      The government should only borrow to fund new social capital (capital spending, i.e. schools, roads…etc) and not current spending (e.g. welfare benefits)

·     The Sustainable Investment Rule

o      Public sector net debt should not rise above 40% of national income at the end of each financial year of the economic cycle

·     If the government stuck to the two rules, the public sector budget should, in theory, balance out over the course of one economic cycle because the government is not increasing current spending. A deficit is run on capital spending instead, thus balancing it out.

·     Aims

o      To limit how much the government borrows and for what purpose

o      Allow automatic stabilisers (see here) to smooth over the economy

o      Support the role of the monetary policy

o      Avoid an unsustainable increase in public sector debt

o      Ensure that tax revenues that are collected finance public spending as far as possible

·     Australia and New Zealand had a similar code

·     The government complied with the rules from the full economic cycle between 1997-1998 to 2006-2007, just before the recessions/economic crisis.

·     In November 2008, it was written in the pre-budget report that the code had been suspended to allow for the government to act appropriately in response to the global recession.

·     It was replaced by a less restrictive ‘temporary operating rule’ where the target was to manage public finances over the medium term. 

Please note, the Fiscal Policy Framework and the Code for Fiscal Stability should be used in the exam for demonstrating your understanding of past and previous fiscal policy used by governments. As it is no longer in use, be careful when mentioning in the exam.

Inflation to be highest rate for 3 years

This article here highlights that inflation CPI is expected, by city forecasters, to hit 4.9% or even as high as 5.1%. Please read the whole article as it contains information about that rate of pensions increases and past inflation, which is very beneficial to know for the exam!

Monetary Policy

Involves the use of interest rates (see Word of the Day) and quantitative easing (changes to the money supply) to achieve the government's policy objectives. Expansionary monetary policy involves decreasing interest rates and increasing the money supply to increase AD and contractionary monetary policy is the opposite; interest rates are increased to deflate the economy and reduce AD.

Monetary policy is set by the Monetary Policy Committe (MPC) who have meetings every first Thursday of each month to set interest rates. The MPC has 9 members, if you want to find out more, click here.