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!!!

Inflation for January 2012

Inflation fell to 3.6% in January, as forecasters predicted. Read more on the Financial Times. The ease in inflation may give signs that this 'stagflation' that the economy has been experiencing may be shifting away. The coming months will tell how unemployment will change in response (Phillips Curve). Inflation faces downward pressure from the effects of higher unemployment, slow exports markets (due to the Eurozone) and lower energy prices (causing a rise in imports).

A further £50bn Quantitative Easing that the MPC authorised earlier this month shows that there is still deficient demand in the economy and it may continue to stay low. Thus economists are predicting more QE to keep inflation from falling below the government's 2% target.

Government Policies to Reduce Unemployment

For government to use the correct policy to reduce unemployment, they must first recognise the cause of unemployment (see here). Using Keynesian fiscal policy to increase AD may be ineffective if structural unemployment is taking place, for example, since this will simply result in inflation.

Free market view

Government policies should only be aimed at reducing structural, frictional and real wage unemployment. Cyclical and seasonal unemployment can be resolved through the market mechanism. Setting markets free can encourage competition and enterprise culture, creating more jobs. Supply can create its own demand.

Keynesian view

The government should intervene to correct the market failure that causes unemployment. They should try to make markets function better, giving them a greater role that the free market economists believe.

Case Study – Government ‘Work Programme’

·       Aimed at reducing long term unemployment and tackling youth unemployment

·       It is a partnership with private companies

·       More information: http://www.dwp.gov.uk/policy/welfare-reform/the-work-programme/

Unemployment Notes

Full employment is, according to the Beveridge definition, when 3% or less of the work force is unemployed. At current, the unemployment rate is 8.4% of the labour force, indicating that the UK is performing far from full employment and full productive capacity. More detail can be found from notes published on 5th August.

The Natural Rate of Unemployment (NRU) is the rate of unemployment that occurs even when the aggregate labour market is in equilibrium (AD_L = AS_L). Below is a diagram illustrating NRU.

Point X is the equilibrium, AD_L = AS_L, the market going wage rate is W_FE and full employment occurs when E_FE workers are hired. AS_LN shows how many more workers are willing and able to work at different wage rates but cannot due to frictional (geographical immobility) and structural unemployment (lack of skills). The NRU can be calculated by E_FE – E₁.

NRU can also be linked with inflation. NRU is also known as the Non- Accelerating Inflation Rate of Unemployment (NAIRU). This means that it is the only rate of unemployment that does not alter the rate of inflation.

Causes of unemployment

·     Frictional unemployment relates to the time taken to find a new job, the period between switching from one job to another. Frictional unemployment is caused by:

Ø  Occupational immobility of labour: Workers need more time to switch between jobs because they don’t have new skills to offer new employers. Lack of training courses, for example, makes the search period longer. Along with that, the longer the search period, the less employable the worker gets because they are losing their employability skills (work ethics, behaviour…).

Ø  Furthermore, new employment practices such as laws on equality (race, gender, sexual orientation...) can prevent perfectly capable workers from finding a job. This is one case against government intervention in the economy.

Ø  Geographical immobility of labour: The difficulty of moving to another location to find a new job. For example, the North South divide in the UK means house prices are too high in the South where more jobs may be available. Other reasons that cause difficulties are family ties and attitudes towards moving to new and unknown locations.

Ø  Search theory of unemployment: Those who are unemployed will continue to look for the ‘right’ job, comparing their old job with the other jobs available, for example, pay, travelling distance….etc. Because of this, workers may reject job offers, leading to a longer period of unemployment.

·   Structural unemployment means that workers lose their jobs due to changes in the structure of the economy. For example, the UK’s economy moved from an industrial one in the early 1900s to one based on providing financial services now. This led to the loss of jobs in the manufacturing sector (read this article: http://www.guardian.co.uk/business/2011/nov/16/why-britain-doesnt-make-things-manufacturing?newsfeed=true).

·   Seasonal unemployment occurs because of changes in the weather. When the UK’s climate changes, it affects the agricultural and tourism industries, leading to job losses in the winter.

·   Cyclical unemployment is caused by deficient aggregate demand. Also known as Keynesian unemployment or demand deficient unemployment, the diagram below displays a fall in  AD_L after a fall in AD. This causes employment to drop from E_FE to E₂. See a more detailed explanation as posted on 3rd October.

·   Real wage/classical unemployment is caused by wage stickiness. Collective bargaining by trade unions (see here) causes wages to remain high, causing unemployment.

Ø  The diagram shows that point X is the equilibrium point. The real wage rate is W_FE and employment is E_FE. When trade unions cause the real wage rate to rise, wages become W₁. This causes an excess supply of labour because at W₁, E₁ workers are willing and able to work at this wage rate. However, demand for labour is only E₂, more workers are willing to work than firms wish to hire, thus creating unemployment equal to E₁ – E₂. W₁ is known as the disequilibrium wage rate.

Ø  Free market economists believe that labour market competitiveness would drive down wage levels in time, however trade unions cause wage rigidity preventing it from going back to equilibrium.

It is important to note that unemployment is a waste of human capital. The disadvantages of unemployment are shown in the table below.

One positive of unemployment that classical economists believe is that it brings a downward pressure on inflation. But that’s up to you to decide whether you agree and be sure to write your opinion in the exam. See tomorrow’s post on government policies aimed at reducing unemployment.