The Economy, Money, & Politics

Three of our favourite things, well at least mine. The election is in full swing here in the United Kingdom, and there is currently the build up to the primaries in the United States.

In the case of the United Kingdom we are facing an election of considerable uncertainty, the outcome of a coalition is highly expected considering current polling. But it will undoubtedly come up to post election day to see who can craft this arrangement.

In the liberal air of university one may find incredible support for the Green party, on the premise that a vote for them is a vote for the beginning of change in parliament, even though they themselves have basically stated it will be near impossible for them to have a serious impact on decisions or push through any of their manifesto ideas. So the disillusionment with the two party system has become ever-clear. The general distaste for austerity based policy is also extremely clear.

The question is should we do a u-turn right now? Krugman says yes, undoubtedly. He was ferociously battling Austerity based policy 5 years ago, and in this last week released an article which is his parade lap of saying he was right and still is right.

http://www.theguardian.com/business/ng-interactive/2015/apr/29/the-austerity-delusion

The only issue is, is that he is not necessarily right. We don’t get the opportunity to test out economic policy in isolated environments, he is basing his success by noting the apparent failure of austerity. Yet we lack an example of any economy which didn’t pursue austerity after the financial crisis. Fiscal based stimulus may have equally failed, but we will never be in the position to know for this occasion.

I am not defending austerity in any manner but I would be cautious to jump onto the other boat, Krugman himself noted while yes a deficit can be managed for a long time there is a point where it is undoubtedly damaging to the health of the economy. Austerian economics is by no means popular or in the post financial crisis economy that effective. However it does highlight a period in which we have explored unconventional policies. The main issue with austerity has been the inequality which it has helped perpetuate, this can be seen in regards to the year on year increase of millionaires and billionaires, but an increasing rate of poverty in developed economies. One may ask who the government is serving, the people as they should be? or the special interests of large corporate institutions? As it is clear that the growth that we have achieved has not been felt by the marginalised factions of society.

I mentioned earlier the upcoming primaries in the United States, I have taken this example specifically due to the data available in regards to where the money that supports candidates comes from. Take the sample below between two democratic primary candidates Hillary Clinton (who has just recently launched her campaign with an advertisement showing how she supports the “regular” American) and Bernie Sanders.

Hillary Clinton has received donations from Citigroup, Goldman Sachs, Morgan Stanley, J.P. Morgan, Credit Suisse, etc. The list goes on. Obviously this does not mean that she will enact policy specifically to disadvantage the people while supporting the financial industry. However, there is a distinct conflict of interest. In comparison to Bernie Sanders he has mostly received contributions from workers unions, and manufacturing related companies. If one was to argue who is more likely to serve the peoples interest, from a financial standpoint it would be Bernie Sanders. But even in this case I believe that campaign contributions to some degree cause a conflict of interest. How can we expect politicians whether they are in the United States or the United Kingdom to make economic policy decisions without an appreciation of the influence that arises from campaign contributions, party contributions, and the coaxing of lobbyists.

The reader will have no doubt that I lean towards the right in regards to political and economic policy. However, I believe that governments have betrayed their ultimate purpose – “serving the people”. With a smaller government I would argue there is less room for financial pressure on elected politicians. As well as the issue of career politicians who get to enjoy the warm cushion of contributions for their entire lives. This is not a comment on the lifestyle or pay of politicians, but how their position is compromised due to the nature of money in politics.

This is critical when we come to assess the type of economic policy whether fiscal or monetary that countries push through. Austerity can seem like a valid decision on the basis that the government would not be crowding out investment, while offering expansionary monetary policy on the side. This has not helped the integral strength of the economy, but specific sectors. While we clearly understand the failures of over-specialisation regardless of how developed the economy.

Exchange Rates: Float or Fixed?

Throughout history countries have adopted both fixed and floating exchange rate systems, usually depending upon the condition of the domestic economy. The value of a currency was traditionally based on a fixed system of gold, which was known as the gold standard. However, due to the limitations incurred by the gold standard such as a restriction on growth through the lack of monetary expansion, free floating systems were adopted. Currently, most developed countries maintain a managed float system which combines aspects of a fixed rate with those of the floating rate.

Free floating exchange rate is where the market forces of supply and demand determine a currency’s value relative to another currency. There are many advantages to the use of this system, as it supports trade and achieves accurate pricing of the currency as the market forces provide price signalling. Nevertheless, the free floating system ensures no government involvement, and this reduces the possibility of market failure. With the absence of government control it is unlikely that the currency will be held at an artificially achieved price which is either over or under valued. Through letting market forces clear the exchange market events such as Black Wednesday can be avoided. Black Wednesday was when the Sterling was pegged to the Deutschmark; there was market speculation that at this exchange rate that the Sterling was being over-valued. This led onto currency traders such as George Soros to undercut the currency by short selling. This had forced the Bank of England to unpeg the currency to allow market forces to clear the market and restore the sterling to a stable value. This exemplifies the danger of fixing the currency, and how this can be easily be avoided by simply letting supply and demand determine the value. This is limited in the fact that speculation can still occur, and developing countries may want to avoid free floating as foreign investors may “bet” either way on the currency and this has national repercussions.

A fixed exchange rate system is where the value of one currency is pegged onto the value of another currency or as mentioned gold; this is done in order to maintain the value of the currency within a given band. Two mechanisms may be used to keep the currency’s value within the band, and these take the form of interest rates and foreign reserves. In a free floating system the interest rate can be varied to any degree in the interest of pursuing monetary policy, whereas in a fixed system the interest rate is only manipulate to ensure the currency’s value stays within its respective band. If the interest rate were to be kept too high, the currency would attract foreign investment leading the currency to strengthen, while the opposite can occur if the interest rate were to be lowered. This means that the government has finite ability in manipulating in the currency for domestic reasons, restricting the pursuit of monetary policies. Furthermore, in order to control the value of a currency a central bank most hold sizeable foreign reserves. The central bank must be able to freely buy and sell the currency in question, and this requires access to foreign reserves. This introduces the possibility of government failure as it is difficult to know how much a foreign currency must be held, and the possible market repercussions of having a preferred reserve currency. In the free floating system these controls are not needed, reducing the possibility of government induced failure, and the free floating system also allows greater monetary flexibility.

The free floating exchange rate system provides an automatic readjustment for an economy’s balance of payments. When a country is running a trade deficit imports are exceeding exports, prompting leakages out of the economy without introducing some kind of injection. Furthermore, as the country maintains a high demand for imports this means that there is a considerable demand for foreign currency, prompting the domestic currency to be supplied. This eventually reaches the point where the domestic currency is supplied to the extent that there is downward pressure on the currency causing it to depreciate in value. This depreciation in value means that the relative price of exports abroad decreases, making them competitive in the foreign markets. It also leads to the relative price increase of imports, as now the domestic currency is less able to purchase foreign currency. This counteracts the trade deficit as now exports will exceed imports closing the trade deficit gap. This is all achieved through the market clearing forces, rather than government intervention which may misallocate resources in an attempt to control the balance of payments. However, this does lead to a cyclical effect where the currency will have stronger and weaker periods. The main limitation in the dependency of the automatic readjustment is that it depends on the type of imports, some developing countries may have staple goods (e.g. gasoline, water, etc.) as their imports, and regardless of currency change their exports may still not be attractive, thus the adjustment does not occur or does not occur to the same extent as it would for a developed country.

Fixed exchange rate systems do promote long run stability, which can be undermined if the market is left to determine the value of the currency. It is beneficial for developing countries to maintain a peg as it helps them plan for the long run, and they need dependable trade flows. As previously mentioned the imports undertaken by developing countries may be basic necessities, so a free floating system may destabilise their ability to import the essentials. With a fixed exchange rate the developing countries can make trade agreements that will be sustainable for a length of time, and ensure some kind of economic stability. Furthermore, there is the removal of administrative costs that are persistent with the free floating system, such as futures contracts, and other types of hedging. Through running a fixed system the currency can be protected from the fluctuations of free floating currencies, which also contributes to the long term planning of developing countries, and a degree of economic stability. One key advantage of the fixed system is that it encourages firms to maintain productive and allocative efficiency so that they can compete in international trade. When a currency is pegged it is difficult to depreciate its value to make exports more competitive, thus producers are driven to allocate their resources wisely and ensure efficiency in order to cut down operational and productive costs.

When comparing the two systems it is clear that a mix of the two is suitable for many developed countries, whereas a fixed rate system has more direct benefits to developing countries who aim for stable growth. In a managed float the two fixing mechanisms can be employed in order to manipulate the value of the currency, but as the currency remains unpegged the overriding market force is that of supply and demand so it is unlikely that the currency will be over or under valued even with the use of fixed system controls. The free floating system has quite considerable benefits, as it not only reduces government intervention but also provides the automatic adjustment of the balance of payments, and monetary flexibility which has become integral in a post financial crisis economic climate.

Monetary Transmission Mechanism

I am going to consider and evaluate the money transmission mechanism in regards to the use of a contractionary monetary policy. This will be in form of a hypothetical increase in the base interest rate set by a central bank, and the no change in money supply. This has a considerable effect on the value of currency, output of the economy, price level, and the factors that establish output.

The increase in the base rate of interest by a central bank does not directly affect the consumer, as it does not lend to individuals. However, the change in base rate does influence the interest rate at which retail banks will lend money, and may vary the cost of long term borrowing such as mortgages.

First there will be a direct effect on consumer spending as a result of the increase in the base rate, due to the influence on retail banks. In a sense the cost of borrowing money has increased, and therefore this will decrease demand for borrowing as people will not be able to afford it. This will considerable effect on households with mortgages, as the consumer will now have more of their income paying off the loan, thereby decreasing their disposable income. This does not only apply to mortgages but also those with short term loans, and even credit cards. The cost of money for the consumer has increased and this restricts their effective demand. In a large scale this would cause a contraction in aggregate demand, as consumer spending will decrease.

This monetary policy will also induce a fiscal effect. Higher interest rates would encourage people to save more of their money rather than to spend it. Fiscally this would be seen as a withdrawal which again would affect the level of aggregate demand. This would “cool-down” the economy and can be noted as part of a policy that would have both monetary and fiscal elements.

Furthermore, the manipulation of interest rates will have a direct consequence on the strength of the currency in regards to foreign exchange. The currency will strengthen as a result of increasing the interest rates, as money will enter the system for the purpose of saving at a lucrative interest rate. An example of this was seen in Australia where interest rates were high and as a result the currency continued to strengthen.

This has adverse effects on the balance of trade, as a result of a strong currency exports will decrease because domestic products are more expensive abroad, and imports will increase because foreign products are “cheaper”. Referring back to the example of Australia the government announced that it wanted to reduce the interest rate as the economy was becoming too dependent on imports and it also sought to increase exports.

In regards to aggregate demand, there would be a considerable contraction if this were to continue for a long period of time. As there is a decrease in consumer spending, and imports would exceed exports. However, the final factor could be seen in a decreasing level of firm investment.

The increase in interest rates will decrease a firm’s ability to borrow money, and so this will decrease the firms’ ability to invest in development, or research. This would mean that firm’s would not seek to increase production, or invest in new technologies to achieve greater productivity or efficiency. It could also possibly involve the freezing of employees wage rates.

 

However as a result of increasing national independence some of these effects may be magnified or reduced by the monetary policy of other countries. The most recent example is that of the United States and China as each is accusing the other of direct currency manipulation it order to ensure economic goals are met by possibly affecting other economies. It is possible that if one central bank in a major economic country such as Britain would raise the base rate, it might signal the European Central Bank to increase their base rate. There is to a degree a large scale of speculation, in regards to what international effect there may be. Australia is a rare example where government announcement was met with direct action as money began to flow out of savings and was reinvested into the stock markets in the U.S. and U.K. identified in the rise of the central indexes of the S&P 500, Dow Jones, and FTSE 100.

Previously mentioned was also the actions of firm, and the question must be raised to what degree would they decrease investment. There is still the entire complex of competition amongst firms, so as a result of this no firm within a given industry may reduce levels of spending as a there is a need to maintain competiveness and market share. It is also a different market in regards to loans for large corporations or small business, the increase in the cost of borrowing for a corporation or conglomerate  may be insignificant, but for a small business it may depend on cheap borrowing to maintain a the entrepreneurial plan for creating a new firm.

In regards to the use of credit cards and other types of short term loans, there may not be such a drastic decline in their use. In many cases consumers are dependent on the use of credit cards to maintain their lifestyle. This brings along the point that even though interest rates are higher so saving is more lucrative, there could be the case that people cannot afford to save. This takes into account the marginal propensity to save. This is the change in savings in regards to a change in income; the change in income would be a result of the increased cost of borrowing. So in a sense marginal propensity to save will decrease as individuals have less income and must use it so live.

The effect on individuals with mortgages may have a time delay, as a result of there being different types of mortgages. Those with variable rate mortgages would suffer immediately as now a greater portion of their income will be taken up with monthly payments, but those that have fixed rate mortgages for a given time period may benefit as their monthly payments have not changed. However, to analyse this it would be necessary to take into account how many people have fixed rate mortgages, and this would establish the aggregate effect on consumer spending.

Finally, there is also the factor of how quick the change in the base rate is. For example in Europe following the financial crisis the central bank quickly dropped the base rate, but in Japan during the 90s the change in the base rate was gradual. In Europe to avert full scale crisis dropping the base rate quickly had arguably aided in ensuring that demand was not completely wiped out as a result of crisis. Although, it is still questionable as times of crisis are unique situations as their causes and consequences differ. This is where there is a greater link between monetary policy and fiscal policy, and the most recent example of this can be seen in European austerity.

Currently in Europe the ECB’s base rate is at 0.5%, simply this means that the cost of borrowing is “cheap” and this falls in line with expansionary monetary policy aimed at achieving economic growth. However, at the same time there is a restriction on government spending and increased taxes to deal with debt, and this can be seen as a reduction in injection and an increase in withdrawals forming contractionary fiscal policy. This forms an obstruction in the money transmission mechanism in regards to trying to pursue growth, but keep inflation down, and reduce government debt.

The money transmission mechanism is a good example of the expected response in changes to monetary policy. However the current economic climate is a fine example of how it may not work as a result of other policies pursued. In the evaluation of the changes it could be noted that it is difficult to consider it on a whole market level as it has different effects for those on high or low incomes, and small or big businesses.

Monetary Policy Basics

Interest Rates:

The interest rate determines the rate of interest at which borrowers pay lenders.  This can be on a consumer level or a business level and may or may not involve the central banks or private banks. When the base interest rate is lowered by the central bank of a country, it can be noted that borrowing is in a sense cheaper. When the base interest rate is increased the cost of borrowing is seen to become more expensive.

Money Supply:

Money supply is the total amount of monetary assets within the economy during a given period of time.  It consists of bonds, investments, other financial instruments, as well as cash. Traditionally an increase in money supply sees the price level of an economy increase, as there is “more money, chasing the same amount of product”. Whereas maintaining a specific money supply or reducing it leads to the price level of an economy decreasing, as there is “less money, chasing the same amount of product” meaning that there is no longer effective demand.

Expansionary Monetary Policy:

This would be pursued in order to achieve increased economic activity in the pursuit of growth. One manner of pursuing expansionary policy is to increase the money supply, while lowering interest rates. This will increase the output of the economy, but consequently an inflationary response.

This would be noted as a shift in aggregate demand outwards as you are increasing factors such as consumer spending, and investing. However, this does not directly affect government spending and the balance of trade may not change.

Contractionary Monetary Policy:

This would be pursued in order to achieve a lower price level in the economy, and to induce a cool-off period for the economy. One manner of pursuing contractionary policy is to decrease or maintain money supply, while increasing interest rates. This will reduce the output of the economy, while reducing the price level. This can be noted as a deflationary response.

This would be noted as shift in aggregate demand inwards as you are reducing factors such as consumer spending, and investing as you are making it more difficult to obtain credit, and establish effective demand.

Monetary Policy:

The most popular type of monetary policy to pursue is currently inflation targeting, whether to induce inflation or reduce it. There are however other factors that come into play in regards to monetary policy, which increase its complexity and its possible results. There is the issue of the velocity of money throughout the economy, and this considers how and where the money is moved and what economic activity it actually participates in.

It was Irving Fisher in 1911 who had established the clear relationship between money supply, velocity of money, and inflation. This can be noted as MV=PQ where M represents money supply, V represents velocity of money; P represents the price level of the economy, and Q the total quantity of goods available.

There is also one key issue that is often debated in regards to monetary policy, and that is the role of the gold standard. Traditionally, the value of a currency had been derived from gold which held actual value and was in existence at any one point. The reset of a currency back to the gold standard has often been used to combat high levels of inflation or hyperinflation as it has a “real value”. However the use of the gold standard restricts our ability to create money in order to manipulate currency, and a common use of monetary policy today has been to decrease/increase the value of a currency to achieve economic goals such as increased exports.

It can be noted that keeping the gold standard is difficult as economies tend to grow faster than the supply of gold, and this results in deflation. This is shown in the case where money supply is reduced, as there is no longer the effective demand at current market prices. The gold standard does to a degree have transparency as it is difficult to manipulate, but it restricts economies when there is a need for higher debt in order to fund war efforts, or revive the economy.

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.

The highlighted triangle represents the unemployment as labour is demanded at L_D but supplied at L_S. 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.

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.