Economics in Action

A house of cards

Unless you have been living in a hole for the last year then you have probably heard that the European financial system is in a bit of a mess. Put simply, the countries of the Euro-zone have borrowed quite a lot of money. Some of the people that governments have borrowed this money off of have become less than convinced that the euro-zone countries pay it back. As a result debt holders have been selling a lot more than buying, which has forced the price/value of these loans down and interest rates up. All-in-all, not too pretty.

The question most people are asking, is how likely is it that the cost of debt gets so high for a country (say Italy), that it will have no choice but to default on its debt. This is a very hard question to answer.

So turning to the other side of the story, what happens if a country defaults? I thought it would be interesting to take a look back at one of the more colourful periods in financial history, the Spanish Bankruptcies.

A little History

In 1492, Rodrigo de Triana became the first European to set sight on the Americas in almost 500 years. Few at the time would have thought that the sighting of land sailor on la Pinta, one of three ships in the expedition led by Christopher Columbus, would transform the shape of Europe. The ships had been sent to discover a trade route around the east of the globe to the orient. The goal was to ship spices, which were extremely valuable is Europe at the time from the east, thus making a fortune. The Portuguese would get the spice route as it later became known but the Spanish got a lot more.

It became apparent, over the next few decades that the Americas were extremely rich. Areas that now include Mexico, Peru and Bolivia had huge reserves of gold and silver. At Potosi, there was a mountain which contained the largest reserve of silver ever found. So large in fact that it is still being mined to this day. The value of gold and silver was particularly important in the 16^th century as it was literally used as currency. The influx of gold and silver made the Spanish exceedingly rich, unfortunately this didn’t last.

What would you buy with all the gold in the world?

By the time the Spanish had begun to realise the extent of their new-found wealth a new family had come to power, the Habsburgs. The Habsburgs were extremely ambitious and used their money to finance a large number of wars in order to consolidate and expand their power. They fought for control of Italy, they fought against France and later they fought against protestants in the form of the Dutch, the English and later still many Germans. They didn’t just fight. They donated huge amounts to the catholic church, building the Vatican in its current form. They even built a brand new city from the ground up, which would become their capital, Madrid.

One of the problems they faced was that while the government had a lot of money to spend, by spending it they increase the supply of money in their own lands and inevitably throughout Europe. The rate at which the money supply grew was like nothing Europe had ever seen. Not only that but it grew far faster than the Spanish economy, causing a huge amount of inflation. This impoverished the lower and middle classes and the domestic economy stagnated.

The well dries up

By 1557 Spain’s finances were extremely overstretched and the Spanish were forced to declare a state bankruptcy. This caused chaos in the European financial system of the day. It bankrupted a large part of the Fugger family which had been the Habsburgs main financiers. At the same time the Spanish crown began to borrow large amounts of money, largely from the Genoese (ironically Columbus was born in Genoa).

Continued borrowing and debt led to more bankruptcies in 1576 and in 1596. They lost the great bulk of their European possessions outside of Spain itself and the financial mismanagement in the 16^th century set the stage for the perennial decline of the Spanish Empire over the next two hundred years.

I am not saying that the west is going to go bankrupt. The two situations are not very comparable. It was fiscal mismanagement, a high growth in the money supply and overspending on foreign wars that caused the Spanish Empire to decline. It’s worth not forgetting just how bad, bad economic policies can be.

I was originally going to write a bit on the crisis in Europe. However, when I started looking for the chart that sparked off the idea, I stumbled upon The Economists Daily Chart section (you can see it here).

Essentially the lovely people over at The Economist publish a chart every day on pretty much everything. Not only are they extremely shiny, they are also usually both topical and interesting. They even have an advent calander!

So apart from all of the eye candy, just why are graphs so awesome? I think they allow you to summarize a huge amount of whats going on in just a small area. Not only that but they can be great tool on which to frame a discussion. Here are some charts that I found particularly interesting:

1. European Borrowing and Lending

This graph shows how much banks have been able to raise in the bond markets. Put simply, how much extra cash they have managed to get invested into their business. Investors in exchange for providing this money now, get a rate of return on what is called a bond. The graph firstly shows that banks are having major issues in getting more cash, which they need to meet the new Basel Rules*. Secondly it shows that investors are unwilling to issue these bonds unless they are covered. A covered bond is a bond which is linked to an asset proportional in value to the bond issued. So if the bank cannot pay the bond interest then the investors can take control of the asset to get there money back. Fundamentally this graph shows just how little liquidity and how much paranoia is driving the behavior of European banks.

*(Basel 3 is the latest set of guidelines issued for global banking. Passed after the financial crisis they required banks to keep a far greater proportion of their assets as cash, the kind of money you carry around in your pocket everyday, as opposed to investments, say mortgages)

2. Bribery and Corruption

This graph shows perceived corruption within the public sector on the Y-axis graphed against a survey-based score for how likely private companies are to engage in bribery on the X-axis. A higher score suggests bribery is less common. It is worth noting that the companies Bribe Payers Index is the likelihood of companies using bribes when doing business in foreign  countries. There are some interesting results here. Italy and Turkey rank as the most corrupt amongst the OECD (developed) countries. Hong Kong has one of the least corrupt administrations in the world, despite being part of the China which ranks quite poorly on this scale. Perhaps unsurprisingly the Russian oligarchy is bringing up the rear amongst the major economies.

3. Dangerous Places

When it comes to crime it is often very difficult to make comparisons between countries, partly because the chance of a crime being reported differs greatly across cultures. One of the better measures to get around thus problem are murder rates, as murders tend to be reported. It seems that less developed countries have higher murder rates. Rather surprisingly while Mexico hasn’t topped the chart, they didn’t even make the top ten. Afghanistan has a lower homicide rate than the USA. Quite whether this makes Afghanistan a safer country would be hard to believe.

http://www.zerohedge.com/news/charting-fundamental-cash-supply-demand-dilemma-europe

http://www.economist.com/blogs/dailychart/2011/11/bribe-payers-index

http://www.economist.com/blogs/dailychart/2011/10/homicide-rates

Disclaimer: All of the charts here are reproductions from the websites linked above.

Here is a personal take on the situation in Iceland and the rest of Europe by our new contributor Harry Simmons:

Iceland has been the world’s whipping boy for the last few years.  The collapse of its banking system uncovered huge international systemic failures leading to the economic crisis.  The snowy nation has had a rough time of it.  But as we begin 2011, I ask the question, are they really still in that much trouble?  Figures released by the International Monetary Fund in December 2010 showed that Iceland’s GDP grew by 1.2% in the third quarter, ending the recession caused by the actions of those in its banking sector.  What about those European countries still in economic strife?

In direct contrast to the actions taken by almost all other western countries and most significantly Ireland, Iceland let its banks fail.  It was able to do so because the international risk of contagion is comparably lower than many of the European countries currently receiving bail-outs.  This forced foreign creditors and the banks themselves to foot the bill of failure, rather than the taxpayer.  Essentially, Iceland stuck to free market principles.  Those institutions that operated in an economically viable manner were able to survive; those that chose to take on too many liabilities in foreign currency must face the consequences.  In a system such as banking where when times are good, the mechanisms of capitalism and free market economics define the actions of agents in market, why should those mechanisms not also define what happens when it goes wrong?  In addition to the economic reasoning, there is also the moral issue of the taxpayer having to pay for the mistakes of a small elite.  The actions of many other governments in bailing out the banks served as an attempt to prop up an already unsustainable bubble.  These actions have exacerbated existing public finance problems further, the implications of which are to be felt by those who have not caused the problem.

During the recession Iceland’s economy shrank 11 – 15% depending on your source, but it did so with inflation peaking at 18%, which devalued its debt.  The soaring inflation was furthermore caused by the Icelandic central bank’s decision to halve the value of its currency, the Kroner.  The difference in terms of inflation between Iceland and those euro-zone countries thought to be in the worst economics position, the PIGS (Portugal, Ireland, Greece and Spain), is quite stark.  Iceland’s inflation soared whilst Ireland, for example, is still going through through a sustained period of deflation

Iceland’s inflation is now down to a respectable 3%, hence interest rates are now at 4.5% from an 18% peak.  These inflation rates are, however, higher than the PIGS.  Iceland’s debt situation is also looking up.  Forecasts for 2011 predict a deficit of 6.3% which will soon turn to surplus approaching the mid-point of the decade.  The IMF said Iceland has turned a corner and that its economic performance “compares favourably against other countries hard hit by the crisis”.

Iceland’s current account balance suffered greatly at the beginning of the crisis with the nation running a 26% of GDP trade deficit with the rest of the world, which is much greater than any of the PIGS.  However, due to the high inflation rates and devaluation of its currency, the trade deficit in 2010 fell to just 0.9% of GDP, with a surplus forecasted in 2011.  Comparably, the PIGS are still running significant deficits approaching and exceeding 10% of GDP.  The long-term effects of these deficits are yet to be seen.  One thing is clear, the PIGS do not have the monetary sovereignty of Iceland and hence cannot devalue their debt, they must in effect, toe the economic line of the European Monetary Union and European Central Bank.

Many have portrayed the path chosen by Iceland and subsequent recovery as a model for other beleaguered economies, such as the PIGS group in the EU.  However, such comparisons must be contextualised.  Iceland’s economy is comparably tiny and would have little chance of bringing the entire world economy down if it walked away from its liabilities compared to the aforementioned PIGS.  Defaulting in one of those economies would risk contagion throughout the euro zone and possibly beyond.

Iceland’s monetary independence from the European Monetary Union has been sighted by many as a possible reason for its recent good performance.  Having experienced the worst financial crisis in memory, the country has emerged ahead of many of its contemporaries having endured less punishment than many EU member states.  Greece and Ireland have already been forced to accept bail-outs, and it appears Portugal will soon follow with an €80bn rescue package mooted.

But how sustainable is this recovery?  Iceland’s public debt has reached in excess of 115% of GDP, over four times what it was in 2007.  Furthermore, Government bonds issued in foreign currency are becoming more and more expensive to repay due to the devaluation of the kroner.  Domestic austerity was aided by this devaluation and the subsequent increase in inflation; however, many commentators have indicated this had little to do with the recent return to positive growth.  The turnaround is attributed to the return to current account surplus from deficit.  Moreover, the aforementioned debt burden is not only applicable to government finance; house prices have plummeted in the crisis leaving many homeowners in negative equity.  By no means is Iceland out of the woods, its current account turnaround from deficit to surplus has been accredited to falling imports rather than a surge in exports.  More tough times are ahead.

The implications of bail-outs on the PIGS are also uncertain.  What is obvious is the political motivation behind their economic choices; the European Union needs the single currency.  It is those with vested interests in the Union that have the most to lose; there is an unnerving air of inevitability in what is happening.  Interest rates are remaining low, aimed at a sluggish Germany, whilst those euro-zone countries experiencing increasing inflation desperately need interest rates to rise.  Where the European project falls down is, in throwing hugely different nation economies under a single monetary policy, it lacked the complete supranational economic governance and social mobility required.

On balance, Iceland has taken a radical path of devaluation which saw violent shifts in economic measures, which all looked terrible whilst it was happening.  It may however appear preferable to the long-term damage that may be seen in those countries which have chosen austerity, debt deflation and bail-outs, but like driving a car using only the rear-view mirror, we will not know until it has happened.

About the author: Harry is a fist year undergraduate studying Politics and Economics (BA) at the University of Leicester.

Recently, the Centre for Economic Performance (CEP) celebrated its 21^st Birthday by holding a series of lectures at the London School of Economics and Political Science (LSE). The chief economist at the International Monetary Fund, Olivier Blanchard, gave the first lecture on the state of the world economy. Last Tuesday, the second lecture of the series was given by Professor John Van Reenen on the topic of restoring economic growth.

The Economics Network received an invitation to attend both lectures, and as a new guy on the job, I was appointed to go. However, being a second year student with a very busy schedule means I could only attend one of the lectures. Since I was doing economic growth as part of my macro course, I decided to go to the latter lecture.

I arrived in London quite late, but managed to quickly find my way to the lecture theatre in the LSE’s Old Building where the talk was held. The CEP has reserved a front row seat for me, so not only did I have the best view; I also managed to take many photos. There was a brief introduction of John Van Reenen by Stuart Corbridge before the lecture started.

John divided the lecture into three sections: the problems we currently face, the sources of growth and the policies we need. He started by saying the beginning of the current recession was a lot worse than the Great Depression; however, the government has not made the same mistakes it did in the 20s. Bank capitalisation, loose monetary policy and stimulus packages instead of spending cuts and tax raises have resulted in a much faster recovery for the UK. He also stressed that accelerated budget cuts proposed by the current coalition government will harm the economy in both short and long terms.

The three main sources of growth identified by John in his lecture were: technological innovation, management practices and microeconomic structural reforms. The main accent was made on the link between productivity and management. John argues that productivity growth is what matters, not absolute growth of GDP. Increases in productivity will drive real wages and consumption up, which in turn can
facilitate distribution. He also made a very interesting point about happiness. Current economic theory focuses on maximising income and consumption, but John thinks that after a certain level, addition to growth will not lead to more happiness. In my opinion, this is definitely something economists could focus more on.

He went on to analyse productivity in the UK. According to the findings, the UK’s relative productivity has improved compared to France and Germany. However, there is still a big gap relative to the US. John argues that this is all down to management practices. His data shows that the US has very few badly managed firms, hence, it has high productivity. On the other hand, in developing countries where there are many family businesses, management is much worse. John thinks that competition in the labour market ultimately leads to better selection of managers, which has a great impact on how firms’ productivity.

So what can we do to restore growth? The lecture concludes that structural reforms and macro policies should do the trick. Things like competition policy, public sector planning and better human capital management at the low end (apprenticeship scheme) are going to improve productivity in the long run. Finally, John argues that the austerity measures proposed by the current government will affect long-term employment as private sector cannot speedily adjust to the fiscal shock.

Here are the links to the webcasts of the two lectures if you want more:

Lecture 1: The State of The World Economy (Olivier Blanchard)

Lecture 2: Restoring Growth (John Van Reenen)

About the CEP

The CEP is an interdisciplinary research centre at the LSE Research Laboratory. It was established by the Economic and Social Research Council (ESRC) in 1990 and is now one of the leading economic research groups in Europe. Its current Director is Professor John Van Reenen.

The CEP studies the determinants of economic performance at the level of the company, the nation and the global economy by focusing on the major links between globalisation, technology and institutions (above all the educational system and the labour market) and their impact on productivity, inequality, employment, stability and wellbeing. Its researches have affected numerous Labour policies, in particular the apprenticeship scheme.

Here is the first article we received from Josh Taylor – our new contributor.

As a student of Economics and a political neutral, the recession has been particularly interesting, with the revelations of how much debt we as a country are in. This is not just governmental overspending revenue incomes, but the public and the culture of buying now paying later on credit. For proof you only have to watch TV for an hour or so and you’ll be amazed at how many advertisements (ok not BBC) there are for quick-money, consolidating your debt etc. The conservatives and now the newly-informed liberal-democrats are for reducing the debt of the nation, by limiting the size of governmental spending i.e. “The Cuts”, I don’t intend to get into any sort of political debate as to whether we need to cut or not, but the nation’s majority have decided democratically that this is the way that we are going to get out of this “crisis”.

But, I can’t but help see the contradiction in raising university fee’s at this moment in time, here it’s not so much a cut but an increase in revenue, which hypothecates the budget reduction. With the clear aim of reducing debt, what the coalition here is effectively doing is lowering governmental debt in the short-term, 5 years let’s say, in exchange for a higher student debt. This is completely counterproductive, and I do realise that there is no debt till graduation or drop-out, but this then has to be paid back which reduces the spending power of those graduates who will be lucky enough to have walked into a job straight after their graduation. This coupled with the aim of 50% of school leavers moving into higher education as well as international intellectuals, equates to a more competitive job market giving lower wages and increased uncertainties over employment, means that we are highly likely to have an even more indebted student population. This in fact, will make our nation’s debt and future less sustainable.

Students can feel more aggrieved depending on what subject they study, those on engineering, chemistry, physics, medicine are actually getting a cut-price deal for their education, which is actually compensated by degrees which cost their respective universities a lot less such as geography, mathematics, languages, politics, media studies, music, history etc. So broadly speaking on the whole students are proportionally paying more than what they are actually receiving from their education anyway. Therefore this increase in fees, like any other increase to those yet to enter the professional job ladder, is most unwelcome.

About the author: Josh Taylor is a first year undergraduate at the University of Manchester studying Economics and Economic & Social History (BAEcon). In the past, he has blogged on the economics of football, faith and religion, music, law amongst others.

The inevitable has finally come!

In his Spending Review yesterday, George Osborne announced a 40% cut in the teaching budget for universities. This is part of the coalition’s plan to tackle the UK’s historical deficit. Universities now have no other option than increase tuition fees in order to fill the new gap in funding. This will be possible if Browne plan is implemented. Essentially, the implementation of this proposal will create a free market for higher education in the UK, very similar to what already exists in the US. However, this also signals the end to a great education system that used to be free and available to everyone. So, what do we take from this?

The cost of teaching a degree is estimated to be around £7,000. Under the current system, universities are allowed to charge students up to £3,290, which most of them do. The remaining cost is then subsidised by the government. If the cap on tuition fees is removed, we can expect most elite universities to raise their fees without facing a decrease in demand for places (demand for places at big universities is indeed very inelastic). This will enable them to invest more in researches and compete with big American universities.

However, there is also a downside to this. Firstly, creating a market place for higher education will benefit only a certain group of universities. As in any other competitive market, smaller and less prestigious universities will struggle to compete and shut down eventually. This will increase unemployment level in the public sector (not every lecturer can go and work for a private company), which in turn will have a wider adverse effect on our newly recovered economy. Furthermore, bright students from poor families will no longer be able to go to places like Oxford or Cambridge simply because they cannot afford them.

In the end, higher education is a public good that will always be under provided in a market system. This is why government provision of education is so vital. However, a market for higher education now means it is money that gets you into the best universities, not your real academic potential.

Please comment below to let us know what you think.

With Greece’s debt rated ‘junk’ what effect will it have on the rest of Europe and the UK?

Stephine Flanders writes that

“Like other governments that are borrowing a lot, ours would be vulnerable if international investors decide, overnight, that sovereign debt isn’t a safe bet after all. We recently won the chance to host the Olympics. But there the similarity ends…

That may change. We may, after all, have some serious political uncertainty coming down the track. But market movements today are a good reflection of the distance between London and Athens.

Investors may worry a lot more about Britain’s public finances than they did a few years ago. But they worry half as much about it as they worry about Greece.”

Its worth a read you can find it here.

Why does this matter? Well think back to the banking crisis two years ago and the knock on effect that one shake can have on a nation. Imagine rather than banks whole nations collapsing.  Economist Jonathan Loynes, of Capital Economics, said that Greece could be a “sovereign equivalent” of Lehman Brothers; the bank which started the collapse.

Will we have to bail out a whole country? Several countries? Time will tell.

We’re not out of the woods yet.

“Fear the Boom and Bust” a Hayek vs. Keynes Rap Battle

Econstories.tv is a place to learn about the economic way of thinking through the eyes of creative director John Papola and creative economist Russ Roberts.

In Fear the Boom and Bust, John Maynard Keynes and F. A. Hayek, two of the great economists of the 20th century, come back to life to attend an economics conference on the economic crisis.

Before the conference begins, and at the insistence of Lord Keynes, they go out for a night on the town and sing about why there’s a “boom and bust” cycle in modern economies (as you do) and good reason to fear it.

Get the full lyrics, story and free download of the song in high quality MP3 and AAC files at www.econstories.tv

Discuss and enjoy guys!

In many ways economics is the study of incentives. An incentive is any factor (financial or non-financial) that enables or motivates a particular course of action, or counts as a reason for preferring one choice to the alternatives.

In English, Incentives make you want to do something you otherwise wouldn’t want to do. Today let’s talk about an incentive which is in the media at the moment, the oft criticised, proposed marriage tax break. (more…)

Karl Marx was an unwitting world changer. Unlike his predecessor Adam Smith, Marx saw and believed in the inequality that capitalism could bring. This inequality would lead to a revolution of the oppressed workers leading to the formation of a Communist state.  However, like the rest of his economist kin, Marx loved to write, his principal works, Das Kapital could make claim to be one of the longest (and most boring) books ever written. However his ideas when teamed up with accomplished writers were haunting.

A leaflet called the ‘Communist Manifesto’, which was distributed to the masses in London contains several passages which to this day remain a part of the canon of political economy.

“A spectre is haunting Europe — the spectre of communism”

“ The Communists disdain to conceal their views and aims. They openly declare that their ends can be attained only by the forcible overthrow of all existing social conditions. Let the ruling classes tremble at a communist revolution. The proletarians have nothing to lose but their chains. They have a world to win.”

Despite the attractions of Marxism, it never really took hold in the US and Western Europe. Economists were just too enamored with the free market orthodoxy of classical economics. Just to remind you, these economists differed little from the original ideas postulated by Adam Smith.

However in the 1930s free market economics was to face an impossible challenge – The Great Depression. With it came mass unemployment, bankruptcies and falling output. Western democracy itself was threatened. The result of this was a new way of thinking about economic problems and the end of blind optimism that economists held that in the Long Run everything would be OK.

Thus it was in the middle of the great depression that J.M.Keynes rose to prominence retorting to orthodox economists that “In the Long Run we are all dead” Keynes saw no point in waiting a couple of decades for the depression to come to an end. Keynes argued for immediate intervention and by that he meant that in particular the government should spend, spend, spend.

We will look more at Keynes next week.