Look out for the 'J curve'

Economic theory tells us that when a countries currency depreciates (falls in value) that export prices fall, import prices rise and that following the law of demand the level of net exports, X - M, (the balance of trade or current account) will grow.

It's not quite as simple as that. Firstly it takes time for the change in export and import volumes to occur. At first they will stay the same. This means at first export values stay the same (valued in the country's currency) and import values rise (values in the country's currency). So the balance of trade, or current account or net exports at first gets worse.

Providing the Marshall-Lerner conditions hold over time exports grow as foreigners realize they are now cheaper and imports fall as domestic customers switch to home produced alternatives. Therefore the reaction of net exports should be to initially worsen, then improve, and when plotted against time this looks like a 'J'.

 

Following the Brexit vote the value of the British pound fell, up to 20%. Therefore we might expect to see a J-curve effect on the British trade balance.

The data does not yet show this clearly. One reason is that the effect from t1 in the diagram above to the point where the current account turns into a surplus is thought to be about a year and a half. As we are six months in to the process we should only have seen a worsening of the trade balance so far.

 

UK Balance of trade December 2015 to November 2016 (latest data available in Jan 17)

The data shows the initial worsening we would expect in the balance of trade after the late June vote and fall in the pounds value. This isn't a smooth J-curve though.

The reason that we don't see a textbook J-curve is because all variables don't stay the same. In 1967 the UK devalued the pound in a fixed exchange rate system from 1:US$2.8 to 1:US$2.4. And that rate remained fixed until 1971. Therefore there was certainty and stability in the exchange rate after 1967. That isn't true of the current situation, where the pound continues to fluctuate in value in a free floating exchange rate system.

 

UK Pound value against US$ Jan 2016 to Jan 2017

As is clear from the path taken by the UK pound against the US$ there remain variations in value. This is partly because of changing business and consumer confidence as more news arises over the likely results of Brexit.

Therefore we should be looking for evidence of a J-curve effect, but remember we don't live in a world where one change is followed by stability of all variables that allow us to see the elegant relationship the textbooks tell us about. But it should be there, just partially obscured.

The Independent covers the latest trade figures here

This topic is of specific interest to IB students for their international economics section of the course. However the effect of the changing value of a currency is equally important to VCE students as the fall in the exchange rate of the A$ since 2012 and especially since 2014 is highly significant.

Australia is not 'half way' to recession.

Yesterday it was revealed that in the September quarter the Australian economy shrank by 0.5%. Some commentators chose to say that Australia was 'half way to recession' on the basis of the semi-technical definition that a recession is two quarters of declining real GDP.

The fact that Australian GDP has fallen is remarkable and looking at the reasons for this is a very important exercise. There are many articles on the fall in. output that might make useful Macro IA's for the IB students.

The article below is from the Guardian Australia and as always has lots of data and opinion. The opinion makes it unsuitable for an IA article itself, but it can help you write a commentary.

What could be the causes of the fall in real GDP?
Falling AD?
AS not growing fast enough?

Certianly plenty to apply in this story to the AD/AS model.

The Guardian article is here

See above - this is classic IA topic stuff. Causes, consequences and policy implications galore. For VCE students an absolute must to read as well.

Exchange rates as a shock absorber

Economies are subject to 'shocks'. Classic ones include the jump in the price of oil in the 1970's, the rise in commodity prices in the 2000's and the Gulf wars. When they occur there is an unexpected 'shock' to Aggregate Supply or Aggregate Demand (AD). This can result in inflation, unemployment or both in the domestic economy.

The diagram below shows the effect of a shock to AD, say the shock of Brexit to the UK economy reducing consumer and business confidence. This would reduce Consumption and Investment expenditure, shifting AD to the left.

One of the benefits that an economy with a floating exchange rate has in this situation is that the currency can depreciate and act as a 'shock absorber'. The shock of Brexit has led many to believe that the UK economy will perform less well in the future and this, they reason, will mean the UK currency, the pound, will be worth less as a result.

This has led to a lower demand to buy pounds and increased selling as people seek to hold their wealth in other currencies that are less likely to loose value. The falling pound (see two posts ago for that) has an important benefit for the UK economy. 

The lower value of the pound means that UK exports now cost less in foreign currency and import prices in the UK will rise. As a  result there will be a rise in the volume of exports and fall in the volume of imports (the law of demand). As long as the Marshall-Lerner conditions hold (and they will) this will mean a rise in the value of Net Exports (X - M) which is a component of Aggregate Demand. This will, at least partially, offset the fall in AD - absorbing part of the shock.

Many argue that this is exactly why the UK was wise not to join the Euro.

The BBC cover this story here

This is very much an IB post, and touches on macroeconomics and international trade. It is particularly useful as an example of the argument around single currency areas where asymmetric shocks are likely.

Monetary Policy ineffective?

As IB students move to looking at macroeconomic policy I will provide some articles that highlight some recent issues and also help give context to the importance of understanding the theory of policy is important to understanding its use in reality.

The article below makes lots of points. It talks about how the Australian Treasurer (Finance Minister) believes that Monetary Policy has become ineffective in boosting economic activity at present. It also talks about how Fiscal and Supply-side policy must work together to achieve macroeconomic goals.

I am going to concentrate on monetary policy here. Morrison asserts that further interest rate cuts (Australian interest rates have fallen from 4.75% to 1.5% since 2012) will do nothing to stimulate the economy. This is suggesting that the transmission mechanism by which lower rates stimulate economic activity and raise the price level has stopped working.

The theory, which you will learn, suggests that lowering interest rates will raise Consumer and Investment spending and probably Net Exports, all components of Aggregate Demand. However when interest rates are very low many believe that the incentives to change behaviour cease to be significant. If coupled with lower consumer and business confidence even negative interest rates cannot help stimulate the economy on their own.

This is very much a current policy debate. Similar arguments are being had in Japan and Europe where the central banks not only set negative rates but are printing money to try to stimulate the economy.

Notice Morrison's use to the phrase 'pushing on a piece of string' - a classic term used to describe how lowering interest rates does nothing to solve a recession. The answer is more government spending and infrastructure investment. Of course that policy will be cheaper to finance when interest rates are low - so maybe low rates still have a role.

The Age covers the story here

Note that there is a lot of politics in this. Morrison, for example, refuses to acknowledge that more government spending is needed because the political priority is to cut spending to 'solve' the budget deficit. 

There are lots of articles on this argument - look for them for your IA.

Monetary policy in the Euro Area

Like many countries around the world the interest rate is at a record low. The European Central Bank (ECB) has kept its rate at 0% this month.

The Euro Area economy is growing slowly and inflation is so low that deflation is a real possibility. The response of the ECB has been to 'print' 1 trillion Euros of money and lower interest rates to encourage spending.

The ECB has been slower than most to act, partly because it has a 25 member committee that finds it difficult to agree. They may have acted far too late, or they may just feel that with rates so low and confidence so weak that monetary policy is ineffective.

There are lots of good stories like this around the world that will make good IA's.

The BBC cover the story here

If you needed proof confidence is important, look no further than the UK

The decision of the UK to leave the European Union (EU) was widely predicted to be an economic disaster. Therefore we shouldn't be surprised that businesses and consumers have reacted to the move based on the uncertainty this situation has created.

A survey recently published survey shows there has been a sharp slowdown in orders, which will work through the economy to mean lower output. The slowdown is the worst since the Global Financial Crisis.

Both Consumption spending and Investment spending, both components of Aggregate Demand (AD) are partly determined by household and firms confidence (sentiment). Put simply if households are worried about future income they will spend less and save more now. Firms will not invest as much if they are uncertain about future prospects. Brexit has handed out one huge dollop of uncertainty and households and firms are reacting exactly as economic theory predicts.

The effect is to reduce both Consumer and Investment spending and AD will fall.

 

The diagram shows the result of a fall in business and consumer confidence. Inflationary pressure is reduced and this may well lead to the Bank of England having to cut interest rates and engage in more quantitative easing as the UK inflation rate is already well below target. Also with lower output UK economic growth will falter and the possibility of recession and higher unemployment will mean the government might have to allow the budget deficit to increase. 

The Bank of England has already indicated that they will take an accommodating stance  and the new British Chancellor (Treasury minister) has said the aim of returning the government budget to balance by 2020 will be abandoned. 

The BBC report on this story here

VCE students can use this to apply their knowledge of budgetary policy and note the link to monetary policy for the 'policy mix'. For IB students this is an excellent example of fiscal and monetary policy operation using the AD/AS model to analyze the consequences and responses. Not that there will be both discretionary and automatic responses from fiscal policy.

Will lower interest rates work?

The Australian central bank, the Reserve Bank of Australia (RBA), reduced interest rates to a record low of 1.75% last week. The financial markets are sure this is not the last cut in interest rates with some forecasting a rate of 1%, but everyone is sure 1.5% will be seen soon.

The cash rate is Australia's 'bank rate' the lowest rate at which commercial banks can obtain cash if they need it. The RBA is cutting their cash rate because inflation is below their 2 - 3% target and without the cut would be well below that. Economic theory tells us there are a number of ways a fall in interest rates help boost Aggregate Demand (AD), the transmission mechanism of monetary policy. Theory also tells us that it takes 18 months to two years to have its full effect.

The question many are asking is 'will it work'? One mechanism by which cutting interest rates work is by discouraging savings and so booting consumption. However interest rates are already so low why would cutting savings rates discourage more saving? Households save for precautionary reasons as well as financial gain and it might be that most current savings fall into that category.

Another reason lower interest rates boost AD is that it is cheaper to borrow, encouraging both firms and households to invest and consume more. But is business and household confidence high enough for them to act on a small rate cut to a very low rate?

Low interest rates will also harm some members of society. Savers. The biggest groups of savers are retirees and those saving for superannuation fund. Retirees will find their income from saving will fall, and indeed the real value of those savings might fall as inflation exceeds interest rates paid. This will discourage consumption by retired households. Those who are saving for retirement might actually save more as they see the need for a bigger 'pension pot' for their future security. Therefore the interest rate cuts may act to reduce current AD.

The article below provides a survey of the situation and has some good short videos embedded. What is clear is that when interest rates are low cutting them further is like "pushing on a piece of string". While one end moves, the other end stays where it is. Lowering interest rates may have no effect on inflation or AD.

The Age article is here

VCE students need to know the transmissions mechanisms of monetary policy the study design identifies by name. Two or three mechanisms usually suffice. They should also know why monetary policy has been implemented as it has been since 2013. IB students need to understand the operation of monetary policy and be prepared to analysis and evaluate its effectiveness under different circumstances.

"Monetary policy is not enough."

The Governor of the Reserve Bank of Australia (RBA) has told a New York conference that monetary policy is not enough to allow faster growth. he suspects that the world has entered a period of much lower 'trend growth'.

Stevens has made a number of points and this is a quick summary of what I think he means:

1. With nine years of low interest rates there is no longer any room to boost Aggregate Demand (AD) with lower rates.
2. Simply 'printing money' ('Quantitative easing' or 'helicopter money) will also be ineffective.

Low confidence among both consumers and firms contribute to these first two points, but simply that the incentive provided by these measures is now too small. He therefore thinks the use of negative interest rates (as in Japan and the EU) will fail to raise economic growth.

3. More than monetary policy is needed to promote growth and that should be provided by increased government infrastructure spending.

He makes the point that this can be funded very cheaply by issuing bonds (government debt) at record low interest rates and that the return on this investment will far exceed the borrowing cost.

Stevens is not calling for a naive Keynesian fiscal boost. However he is calling for an end to 'austerity' and a blind adherence to the idea that any government Budget deficit is bad. (Some are, some are not.) What Stevens is calling for are projects that will assist the private sector to grow through active supply side policies which have the advantage of adding to AD as well.

Finally Stevens talks about the wider implications of monetary policy. He pointed out that the low interest rates are destroying retirement plans. Pension (superannuation) funds rely on investing in safe assets such as bonds. The interest rates earned on these assets are so low many find their retirement plans are being ruined. A short period of low interest rates will not affect pensions too badly, they can catch up, but we are now nearly a decade into low rates and that has serious implications.

Business Insider covers his comments here

This article is applicable to VCE and IB students. Australia has record low interest rates and the 'policy mix' between monetary and budgetary policy in Australia is a crucially important area of study. For IB students the limitations of monetary policy and the interaction between fiscal and monetary policy and the operation of supply side policy in the policy mix is directly relevant to Paper 1.

Business Confidence threatens growth

As we all know by now Business Confidence is a key determinant of Investment spending. 

If Business Confidence falls, then Investment will likely fall and as this is a component of aggregate demand we can expect a fall in real GDP, or at least a slowing of economic growth.

The latest data suggests that Business Confidence is declining as there is greater uncertainty following the Federal Budget. 

Note this fall in confidence is largely to do with uncertainty. It's not that the business community disliked all the Budget measures, rather they are unsure if those measures will get through the Senate. Predictably firms are also worried that the Carbon Tax will not be repealed as its abolition represents a boost to company profits.

The Age reports the story here

Debt levy looks less and less likely

The Commission of Audit and the government have now scared the population half to death with the prospect of expenditure cuts and tax rises. That was probably their point. whatever the Federal Budget delivers next week will be a relief and might actually lead to a rise in government support which has been battered in the last few weeks.

I remain astounded that the government can still claim a budget crisis and base their policy on the need to fix it. There are three important points we need to consider:

1. The deficit forecast is based on low growth forecasts which depress tax revenues.
2. The government continues to lump capital spending in with current spending when reporting the deficit.
3. Governments are not households and don't have to follow the same rules on borrowing.

The first point means that the deficit crisis is political. Using assumptions which suit their economic case is an old political trick.

The second and third points are related. Most governments try to balance their current spending over the economic cycle. Borrow in the bad years and repay in the good. That's a pretty safe fiscal strategy.

However all governments have the responsibility to invest in infrastructure and capital projects that aid the economy to become more productive and provide the public and merit goods needed to maintain and improve the standard of living. Such projects such as railways, the NBN and hospitals are used for years. They should be paid for by loans that are repaid by the future users, not current tax payers. 

When the capital items are taken out of the budget the deficit looks very manageable.

I will deal with the desirability of managing economic activity in a later post, but for now consider that the deficit is a tool to manage the level of activity.

All this talk of taxes and expenditure cuts is dangerous in itself. A key part of Aggregate Demand is Consumption and this relies not only on income levels but also consumer confidence. Scare the households enough and they will react instinctively to the uncertainty and save more. This will reduce consumption, a component of Aggregate Demand, and so lower the level of economic activity.

A similar argument can be made for business confidence and investment, also a component of Aggregate Demand.

Below is a link to a Guardian article where former Liberal Treasurer Peter Costello says a deficit tax won't work and the head of the Commission of Audit says it will do harm.

The Guardian article is here