Eurozone Round-Up

No surprises this morning as the Bundesbank has slashed the German growth forecast to 1%. This has followed the past few months where there has been tangible uncertainty about Germany’s macroeconomic vision. With criticism coming from those suggesting that Germany has regularly failed to provide a level of investment, which would lead any kind of recovery, coupled with bullish behaviour in keeping its high trade surplus.

The interdependence of the Eurozone has become increasingly clear since the crises, and it was well understood that Germany maintaining its surplus had constrained the growth of the weaker Eurozone members. The German hopes were that this would still help drive growth, but shown through interdependence the German economy is slumping.

Continuing with the lack of surprises the European Central Bank informed us that the expected inflation for this year would be 0.5% with a forecast of 0.7% for 2015. The last target of the ECB that I can recall was that of inflation being 2%. Germany is clearly causing a whole host of trouble due to its economic weight on the Eurozone, but shows no insight into the potential change of policy as they are still predicting growth to rally to 1.6%. Jens Weidmann throws some spurious figures and he then claims to be surprised by a lack of performance, although nothing has been out of the ordinary for the past two years.

Moreover, it is clear that the only person in the ECB that needs more support is Mario Draghi. I would go as far as to claim that he is the Eurozone’s only hope, with his desire to pursue quantitative easing in a strategic and defined manner in aiding structural reform is essential. With an overall aim of returning the size of the ECB’s balance sheet to that of 2012. It is fair to state that asset purchases do not have defined results, but it would be an improvement in comparison to Weidman’s insistence on a more passive approach. I am not the biggest advocate of quantitative easing, and more in line with structural reform to European labor law and the ease of businesses, but I believe that Draghi is representing an interventionist mixture that will lead Europe to sustained and reliable growth.

It will be interesting to see how the year closes off and what 2015 has to offer in terms to tangible change in our approach to modern economies which no longer fall in line with some of the traditional approaches still used and insisted upon.

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Must “Quantitative Easing” End in Inflation?

Inflation, Money Supply, & Quantitative Easing

Since the financial crisis of 2007-08 the term “quantitative easing” (QE) has been thrown around by politicians and economists alike. The media have gone as far to label it as “printing money”. Governments have been pursuing monetary policy with the aim of encouraging growth. Conventional policy such as the manipulation of interest rates has been ineffective already reaching record rates between 0.5% and 1%. As a result central banks have turned to QE in an attempt to encourage borrowing and spending. However, it is maintained that while pursuing economic growth there is an inflation target of 2%. Through expansionary monetary policy QE should end in inflation, in regards to the short-term. In the long run there are two central theories that can be taken into consideration Keynesian & Monetarist. In addition, there is the “Quantity Theory of Money” which suggests that there is a directly proportional relationship between inflation and money supply.

It is first imperative to understand what is meant by QE and inflation in order to establish their relationship. QE can be simply defined as the “introduction of new money into the money supply by a central bank”. This is done by purchasing government securities, debt or other securities from the market. The monetary aim of this policy is to encourage borrowing by consumers and businesses in order to create more economic activity to spur on growth. Inflation can be defined as the “sustained increase in the price level of an economy”, and it is measured most commonly by the Consumer Price Index (CPI) which measures the change in prices of a basket of goods. An integral factor in establishing the relationship between QE and inflation is money supply. This was clearly shown during and after the financial crisis through the Troubled Asset Relief Program (TARP) which is the direct injection of liquidity into the market.

Money supply can be manipulated through QE, and this has two effects. The first effect is the weakening of that particular currency on the basis of supply & demand. The second effect is that there is increased liquidity which would promote economic activity. This in theory would make countries’ exports more competitive and drive down the cost of borrowing for consumers. What is unique about QE is the manner in which the money supply is increased. Central banks buy long-term government debt and other asset/mortgage backed securities from commercial banks in order to increase their reserves so they could increase lending. In this is the hope that by increasing their cash reserves there will be a “trickle down” effect to consumers.

In order to establish a sound understanding of QE an example such as Argentina in the 1980s can be employed. The country had experienced various economic difficulties, but the crisis during the 1980s exhibited how direct government control of money supply resulted in chronic inflation. The government attempted to both restrict and increase money supply, at times causing inflation to reach peaks of an annual rate of 1000%. In addition, debts had to be repaid in hard currency, so money created went into buying foreign currency thereby monetizing the debt. This led to the weakening of the Argentinian peso and a sustained high rate of inflation. What should be noted was that the government was printing money and not using QE, which had an immediate inflationary response. In 1983 the government introduced the new peso in an attempt to reset the currency, but the weakness of the Argentinian economy through the illiquidity of the money supply led the country back into inflation.

The Argentinian economic crisis is an example of the inflationary trap that can be caused by government involvement in money supply controls.Japan is an example where QE was first used. The central bank created electric money in order to purchase short and long-term government debt from commercial banks in the hope of creating inflation. The Bank of Japan in 2001 concluded that QE is ineffective in regards to targeting inflation. Japan is a unique example as a result of chronic deflation, but it presents two theoretical approaches. It is unknown whether QE was ineffective because of the initial gradualist approach rather than “shock therapy” or that the manipulation of the money supply in regards to targeting inflation was only artificial. Japan has currently embraced aggressive quantitative easing under Shinzo Abe, but this brings into question whether the creation of negative real interest rates will actually increase the liquidity of the money supply. Furthermore, it raises the issue of crowding out and whether or not this will actually stimulate aggregate demand in order to achieve inflation.

Modern Results of Quantitative Easing & Money Supply Controls

Currently, QE is not abiding by “textbook” theory whether it is Keynesian or Monetarist, but this may be a result of the condition in which it is being implemented. Current estimates for inflation put the United States at 2% and the United Kingdom at 2.8%. Both have been rigorously using QE in order to encourage economic growth. Two things are currently evident – both countries are struggling to create economic growth, and that inflation is not dramatically increasing. Acclaimed economist Joseph Stiglitz said that:

“Stimulus measures carried out by the Federal Reserve, the European Central Bank and other monetary authorities won’t fuel the inflationary pressures that many have feared, but they also won’t bring the desired recovery and growth”

This can be explained by the manner in which QE is carried out. In the case of Argentina the government was manipulating the money supply through the printing of money. Currently central banks are purchasing long-term debt instruments and asset backed securities. Through this the central banks have raised the cash reserves of commercial banks to promote lending. After the financial crisis this was done partly in order to bailout the banks, and to ensure the repeat of the Great Depression does not occur. Nevertheless, the continued QE of this form continued to cover the balance sheet of those banks and fortify their cash reserves. The evidence for this emerges from the bursting of the housing bubble during the financial crisis, where the commercial banks held purely toxic assets as a result of the sub-prime mortgages.

The monetary aim of QE was for banks to make borrowing easier for consumers and businesses in order to create the desired economic activity. Arguably, QE has not achieved its purpose. After the financial crisis banking institutions began to cover the disparity in their balance sheets through the money created. Before the crisis banks offered high leverage on a variety of assets, meaning that the majority of the funding for the assets was through debt rather than equity. To give an example scenario a developer wants to purchase a building. The developer brings partial equity and asks for a greater amount of debt when applying for the financing from the bank. However, the bank is still willing to take the risk and provides the debt for the asset, resulting in a thinly capitalised asset. In essence, the bank is the outright owner of the asset, and when the financial crisis ensued the value of these assets was wiped off. So if the building was worth £1bn and the bank provided £900m of debt, while the post-crisis value of the building was £500m there is a balance sheet disparity of £400m. Banks allocated this as “tranches” which are collateralized mortgage obligations that can be configured for varying levels of exposure, which were dictated by the banks. QE helped the banks cover this disparity by covering the debt of what became toxic assets. This goes to explain why the first round of QE after the financial crisis did not end in inflation, as there was no increase in economic activity but the re-organisation of balance sheets.

Quantitative Easing in the United States

Still today there is a considerable degree of QE that is being implemented, and the banks’ balance sheets have been sorted out. So why is there no rapid increase in inflation? Central banks such as the Federal Reserve are still purchasing long-term government and corporate debt, but the money supply has become inactive within the economy – the “trickle down” is not occurring. The money supply is increasing but banking institutions keep the cash in their reserves, so do large corporations. This is demonstrated by the commercial banks willingly going beyond their reserve requirements (“Reserve Requirement” is the minimum amount of deposits and notes that a commercial bank must hold; this can be employed in the use of monetary policy as it can affect liquidity). Before the crisis financial institutions were too willing to take up high risk assets, but now as a result of the crisis there is a lack of risk being taken and also a lack of investment into long-term assets. Both banks and corporate institutions are favouring short-term tactical assets over long-term strategic assets. The short-term assets tend to not require the same level of capital to be raised, and this clearly demonstrates the lack of confidence in the economy but also a failure to employ comprehensive monetary policy.

The illiquidity of the money supply can be identified as a major factor in why QE is not resulting in inflation. This is demonstrated by considering the velocity of money, which dictates how much of the money supply is active within the economy (The issue with taking the velocity of money into consideration is our inability to establish an empirical value, and it is largely based on speculation. Therefore, we are unable to target market dynamics in the same way we can target inflation or growth). In the United States alone it is estimated that American corporations hold approximately $5Trn in cash reserves. This is a clear example of the lack of economic activity that must be facilitated for QE to result in inflation. The United States is desperately pursuing QE in the hope of boosting inflation to counteract the consistently strong dollar and to make exports more competitive. Krugman identifies that the Federal Reserve is pursuing QE with hope for inflation to occur so that:

“Potential home buyers will be encouraged by the prospect of moderately higher inflation that will make their debt easier to repay; corporations will be encouraged by the prospect of higher future sales”

This shows that QE is failing as a means to an end, as there is no subsequent inflation. The American government must create legislation to encourage corporations to pay out higher dividends or invest in R&D. This will aid in the utilisation of the vast cash reserves back into circulation; achieving the economic activity that QE was meant to ensure.

International Elements

A factor that is preventing QE from causing large rates of inflation is the denomination of foreign currencies. Presently the dollar maintains to be the favoured form of hard currency for central banks around the world. Consequently as more dollars are being produced there is a considerable foreign demand and this leads the money out of the domestic economy. Furthermore, this keeps the dollar strong in exchange rates making American exports less competitive. This culminates in a restriction of aggregate demand as a factor of the net exports component, making it desirable for the Federal Reserve to use QE to achieve a variety of economic goals. Yet, the globalised nature of the world economy is garnering unexpected outcomes from what can be considered as “textbook” economics.
The role of China has been questionable in regards to the relationship between QE and inflation. China is the largest holder of U.S. debt estimated at $1.5Trn, which presents a case that money created through QE, is quite simply leaving the country. Between the two economic superpowers a “too big to fail” relationship has occurred. If the U.S. economy was to default on its debt China would severely suffer. However the U.S. must continue its current monetary policies to encourage its biggest consumer of treasury bills (China). China on the other hand could threaten to begin selling of its American debt, entirely removing confidence there is in the dollar. This could lead up to a “run on the currency” which would result in unsustainable levels of inflation. The relationship between the two has had a considerable impact on money supply within the United States, and is a clear contributing factor in the lack of inflation as a result of QE.

European Economic Crisis

In Europe there is a different scenario. The European powers are arguing that austerity budgets are a must in this economic climate, yet the European Central Bank (ECB) continues to pursue QE. In Europe, however, this QE is simply covering the disparity in government’s balance sheets as a result of the various sovereign debt crises of Greece, Portugal, Spain, etc. So rather than QE encouraging economic activity to spur on growth, the created money is once more sinking into the black hole of covering toxic assets and arguably deficits driven by unsustainable welfare states. While targeting growth out of crisis there can be an inflationary response, and this is what QE is expected to achieve, yet the long-term results remain unknown. The money supply is constantly increasing, and interest rates are at 0.75% (at time of writing) and yet there is no evidence of increased borrowing. The banks are scared to take more risk, and the consumers lack confidence in their economies.

The monetary policy of QE can almost be identified as supply side because it has not created any demand, and this is instrumental in understanding why it is not resulting in inflation. The government has effectively setup what is needed for long-term sustainable economic growth through QE, but it has not created what can be coined as the “black start” ( The term black start can be associated as it is similar to how a car engine starts. Cars have a spark plug which ignites the engine, what can be noted is that the economy has no spark plug the money is there and so is the economic infrastructure but there is not anything to induce the utilisation of these factors). A factor contributing to QE not resulting in inflation is the lack of aggregate demand throughout Western economies. Currently the average unemployment rate across the European Union is at a staggering 12%, this clearly represents this lack of aggregate demand, and without this aggregate demand there is a restriction on economic growth in accordance to the simple aggregate supply and demand model. In order for the QE done to result in inflation it would be necessary to pursue demand side fiscal policy. This can take the form of government spending into structural investments such as road networks, railway lines, airports, and power stations. This would support the Keynesian argument for long run aggregate supply as there is spare capacity in the economy that is not being utilised, and showing that demand side policies do not always end in inflation as suggested by the monetarist model.

The relationship between QE and inflation is clear, through the link of money supply. It is clear that our modern situation where QE is not resulting in dramatic inflation is established through the lack of velocity in money. Bank, corporate and sovereign wealth funds’ cash reserves continue to increase and QE is only increasing the money supply but not making it active within the economy. In consideration to economic theory it should be simple – increase the money supply, cause inflation. But by using both historic and current examples and understanding it is clear that there is no causality. Therefore, it is evident that QE does not always end in inflation, and the modern economic climate is testament to that. Money has never been cheaper to borrow with rock bottom interest rates, and progressively increasing money supply, but there is no considerable rate of inflation. The question now is how long will this form of monetary policy be pursued, and what will be the long-term effects?

The Buzz Around Abenomics

japan

Shinzo Abe over the past couple of months has become the most prominent figure in global economics. He has received praise and criticism from all sides of the economic spectrum. Regardless of his international image, he has vigorously backed his “three-arrow” approach. This is the use of comprehensive monetary, fiscal, and structural policies to pull Japan out of its chronic deflation.

The base of the macroeconomic strategy is simple, but what is incredible is the turnaround seen in Japanese politics and the increase in domestic confidence. Before Abe it had seemed like the Japanese government and cooperating technocrats had called it a day in attempting to solve the countries chronic deflation, and suddenly Abe becomes prime minister and confidence is restored. Coupled with his three arrow approach he has used invigorating nationalism to spur the domestic market, and this may be the true long lasting effect of his spirited endorsement of his macroeconomic policy.

The use of such radical policy such as doubling the money supply has revitalised the economy in a manner that is difficult to quantify. It can be argued that purely the willingness of the government to pursue radical policy has restored confidence and boosted consumer and firm spending rather than the actual effect of the change in money supply. The Yen has already weakened from Y77 to a dollar to now bouncing around Y100 to a dollar. This has had a positive effect on exports and reinvigorating the market. The markets have recapitalised at around $1.5 trillion, the biggest rally in the past decade. Japan is beginning to boom, and it is this galvanisation that had driven market confidence which is proving to be the major factor in taking Japan out of deflation.

For years deflation had increased the real debt burden in the economy, and Japan has suffered. But through his stance and that of Haruhiko Kuroda (Bank of Japan’s Governor) they have increased the velocity of money and re-liquidated the market. But there is also the fiscal aspect; Abe has called for firms to increase wages while introducing straightforward tax breaks. This is simple expansionary fiscal policy in the form of maximising injection and limiting withdrawals. So far the short term effects are following through and it looks like the inflation target may be met, however the question stands on whether or not the economy will overheat and induce an inflationary burden.

Shinzo Abe can be identified as particularly patriotic and holds very strong nationalist sentiments, what he is tapping into is what was once the strength of a country that held an empire. Japan has also had continuing issues with its “favourite” neighbour China which has raised questions about security. There was also the tsunami which created a short term energy crisis, and had brought to the surface issues amongst Japans biggest firms. They felt that they could no longer operate with uncompetitive exports, and high corporation tax. This assimilates Abe to the Japanese term “Fukoku-kyohei” which means “rich country, strong army”. Deflation has proven to be the weakness in the economy, and the bane to Japanese industry, but now with this invigoration of fiscal and monetary policy the economy can move forward.

Japan already has the correct economic infrastructure in place, and is also notable for its well educated labour force, the sustainable increase in efficiency and productivity of workers, and suitable regulation. Joseph Stiglitz is a strong advocate of Abe’s approach; he notes that through continued structural investment and future investment into research and education that the growing confidence will be vindicated by reaching inflation and growth targets.

Japan has always been renowned for its commitment to research and development, as well as leading in structural investment. Now the government is backing it with vigorous policy, but there is still the question of what impact this will have as it failed to bring Japan out of deflation during the “lost decade”.

In the coming years it will be interesting to see if Abe can bring the economy to a state where all the strong elements of infrastructure, workforce, and the introduction of drastic monetary and fiscal policy all work cohesively to achieve the target of a once again sustainably booming Japanese economy, without giving up on its strict environmental and working standards and regulations.

As Stiglitz notes “Japan could become one of the few rays of light in an otherwise gloomy advance-country landscape”.

For more reading look at:

Financial Times:

http://www.ft.com/cms/s/0/717274d0-b687-11e2-93ba-00144feabdc0.html#axzz2TkNQ4I9J

Project Syndicate:

http://www.project-syndicate.org/commentary/shinzo-abe-and-soaring-confidence-in-japan-by-joseph-e–stiglitz

Eurozone Unemployment

As a result of the financial crisis in 2007 countries within the European Union have struggled to maintain low levels of unemployment, this is the outcome of retracting economies and austerity measures. Across the Eurozone the average unemployment rate has reached a peak of 12%. The article identifies the occurrence of this peak as countries such as Greece, Spain, and Portugal all have unemployment rates around 25%. There are also fears that unemployment will further increase during April as a result of the Cypriot crisis.

Unemployment can be defined as “Those out of work, actively seeking work at the current wage rate”. This can be calculated in two ways, the first being through a claimant count (those requiring unemployment benefits) and the second being through a labour force survey. The labour force survey most often releases figures higher than through the claimant count, which is why governments tend to publish the claimant count unemployment rate.

Analysis:

As the current unemployment rate of the Eurozone is at 12% it is understood that there is a clear surplus of people willing to work. This can be clearly shown through the demand and supply relationship for labour.

Picture1

The highlighted triangle represents the unemployment as labour is demanded at LD but supplied at LS. This shows a simple representation of the current unemployment, but it does not display the causes of it.

The causes of this unemployment can be recognised through the article as cyclical and structural. Germany maintains to be the manufacturing powerhouse of the Eurozone helping keep unemployment of the country down, however countries such as Greece and Portugal do not have strong industry. This is the presence of structural unemployment as the economies require people to work jobs that they are not trained for or overqualified. The cyclical unemployment was initially the result of the initial financial crisis recession, but double-dip recession has magnified the impact on unemployment. Countries that struggle to create economic growth tend to struggle creating jobs.

The article identifies that as a result of this continuous unemployment, the Eurozone has fallen back into recession. Manufacturing industries and other business have seen a decline in business activity, thereby showing a lack of aggregate demand throughout the European Union.

Picture2

The graph above shows how unemployment in the region has affected growth prospects for the future, as shown through the movement from Eq to Eq1. The shift in aggregate demand inwards is a result of unemployment, as when people do not have a salary their effective demand is further restricted.

Evaluation:

There are clear limitations to the initial demand and supply of labour model above, this model fails to show where the unemployment is allocated (i.e. agriculture, finance, or manufacturing). Furthermore, it does not accurately represent the actual quantity of those currently unemployed. However, it does help establish the significance of unemployment as it contributes to understanding that there is a fall in aggregate demand, and therefore a dampening on growth prospects for the European Union.

The aggregate demand and supply diagram clearly shows the effect of unemployment on the European economies, and it also shows how the price level has gone down. This is true to an extent as European inflation is estimated to be at 1.8%. This identifies that in the short run disinflation is occurring within the Eurozone. This low level of inflation as a result of the drop in aggregate demand signifies that the European Union economies are struggling to achieve growth and employment. However, in the long run there may be the occurrence of reflation as the economies pursue growth, through creating more jobs and reducing unemployment.

The continuous unemployment and resultant fall in aggregate demand will have a negative effect on European manufacturing. There are already signs that business activity is diminishing (PMI=46.8 Contraction), and further unemployment will only hinder European manufacturers.

Currently across the Eurozone governments are pursuing austerity budgets to attempt to reduce debt, and climb out of recession. However, this is keeping unemployment at high rates. This attributes to a Keynesian solution of spending more to save more. If governments were to create more debt in pursuit of structural investments there may be a spur in economic growth. This can take the form of updating road networks, creating new airports, and building factories. This would help significantly aid in reducing unemployment rates in countries such as Greece, which need an infrastructural upgrade regardless.

Introduction to Macroeconomics

Four Main Economics Goals of an Economy:

  1. Stable Rate of Economic Growth
  2. Low Unemployment
  3. Low & Stable Inflation (standard target of 2%-4%)
  4. Satisfactory Balance of Payments

Other Pursuable Goals of an Economy:

  1. Environmental Sustainability
  2. Economic Equality

Growth:

  • Commonly Measured by Gross Domestic Product (GDP)
  • Measure the Output of the Economy (value)

Unemployment:

  • Commonly Measured by Claimant Count & Labour Force Survey (ILO)
  • “Those out of work, actively seeking work at the current wage rate”
  • Labour Force Survey is thorough and usually reveals higher numbers of unemployment
  • Claimant Count is problematic as not everyone is eligible for unemployment benefits

Inflation:

  • Commonly Measured by the Price of a “Basket of Goods”
    • i.e. Consumer Price Index (CPI) or Retail Price Index (RPI)
    • Inflation: Increase in the Average Price Level of an Economy

Balance of Payments:

  • Referring to the accounts of an economy, national scale balance sheet
  • There are Credits which are considered as Injection (e.g. exports or factor earnings)
  • There are Debits which are considered as Leakage (e.g. imports or factor payments)