G-20 Fighting a Battle of Relevance

By Grant de Graf

I was always the flea in the chamber, when speakers called for a show of hands, for those in support of Gordon Brown's economic policies. I was always the one that chanted "Aye" amongst the crowd of heads shaking violently, from side to side. Frankly, I am beginning to tire of the Tories' mantra that Labor pushed the country into recession by supporting bankers who robbed innocent folk of their savings. Lest anyone should forget, the whole world went up in flames and anyone standing too close to the fire, was a casualty.

Ironically, I also supported Margaret Thatcher's policies. Britain had been crippled by the unions, and when she slew the serpent with nine heads, the economy breathed with a new sense of life. I admire Ed Miliband for his political conviction, but I think little of his economic perspectives and policies. He is a socialist that would bring Britain to her knees. Similarly, I cannot say that I support the Conservative's austerity. You don't suddenly turn off the Boeing 747's engine, when you are looking for an open field on which to crash land the kite [gently].

The WSJ reports that Gordon Brown's "biggest worry was the G-20′s failure to craft the “global growth pact” that would address the global imbalances of high debts and slow growth in Western economies and high savings rates, undervalued currencies and a lack of consumer demand in Asia and elsewhere."

Point taken, but I wonder what remedy Brown proposes. It's a bit like the rugby prop forward who kept complaining to the referee that his opponent was wedging his head into his chest. "He's boring, Mr. Ref. He's boring," the player protested.

"Well you're not too interesting yourself," quipped the referee. Much to complain about, but nothing much to say.

In defense of Brown, I have not read his latest book "Beyond the Crash" which may offer some gifted pickings or remedies for a troubled economy. Either way, I prefer to push the carrot [the solutions] rather than the stick.

Fool's Trap: Measuring Inflation

By Grant de Graf

Probably one of the most frightening economic phenomena is the restrictive way in which bankers and economists are measuring inflation. These indicators are being used to make game changing decisions that invariably could exacerbate weakness in fragile economies.

Take the Euro-Zone's latest reading for inflation which came in at 2.4% in February, 2011 from 2.3% in January, the highest level since October 2008 and unchanged from the preliminary, or flash, estimate published on March 1, by the European Unions' Eurostat agency.

Let's also look at the report for the rise in consumer prices in the U.K. which "grew at an annualized pace of 4.4% in February to mark the highest reading since October 2008, while the core rate of inflation increased 3.4% from the previous year amid forecasts for a 3.1% expansion."

Typically inflation is measured by changes in the consumer price index [CPI] which provides a very limited perspective on the inflation that central bankers need to address.

The accepted practice for dealing with inflation and an economy which is over-heating, is to spike interest rates. The only problem is that we don't really have an economy that is overheating and that advances in the CPI appear to be a consequence of the demand and supply curve, rather than changes in monetary supply or business activity.

For example, unrest in the Middle East has been the cause for a rise in crude prices, which has caused an increase in fuel prices at the pump and in transport costs. The multiplier impact that this has on an economy is obvious. Secondly, the hike in food prices internationally, partially as a result of shortages, has also effected the CPI.

The fallacy that governments can raise interest rates to reduce inflation, which is essentially a function of demand and supply is misplaced. Most certainly, if trading levels of the Sterling and the Euro are anything to go on, the market believes that central bankers will increase interest rates to combat the recent increases in CPI, which they are calling inflation. Such a move by policymakers, in this instance would be a mistake. Changes in prices within any market mechanism is a natural function that contributes to the equilibrium process and the efficient distribution of goods.

When money supply within an economy increases, or robust growth is the cause for higher prices, then there may be justification for a government to use interest rate policy to curb an overheated economy. That is not the case here.

A more accurate way to measure the harmful effects of inflation that governments seek to constrain, is to track increases in real wages and decreases in unemployment, to access the impact that inflation is having on an economy.

Case in point, WSJ reports:

"Eurostat said wage growth in the euro zone picked up in the final three months of last year [2010] from its record-low pace, although pay still rose less rapidly than prices.

"Employment edged up only modestly over the final three months of last year, so consumer spending appears unlikely to grow rapidly in the months ahead or make a major contribution to growth in the broader economy."

Clearly, the recently reported increases in CPI, both in the United Kingdom and the Euro Zone do not justify for an increase in those region's interest rates. The impact of increasing interest rates would further constrain growth in fragile economies, and would not have an impact on CPI, in the way that governments may desire.

Portugal Victim of EU Poison Pill Policy

By Grant de Graf

Portugal is the latest victim of the difficult standards and expectations that the European Union is imposing on its members, to meet high levels of austerity and government spending cuts. Very often the dogma that is being propagated at central government is one that may be good for the Union in general, but which is inappropriate at a local level.

As predicted, attempts to implement the stringent measures of austerity by central government are bound to impact the electorate. Politicians are being forced to resign or being compelled to become recipient to the wrath of their respective voters, who express dissatisfaction with the manner in which their economy is being managed. This has been true of Ireland where the ruling party was ousted and more recently in Portugal, when Prime Minister José Sócrates was forced to tender his resignation, after Parliament rejected a new austerity plan.

One may argue that Portugal's attempt to implement the austerity measures was voluntary and a course which was inspired to win investor confidence, for its slew of bond issues that it has had to facilitate. However ultimately, investors will be wooed through any action that has a positive long term goal, even if that plan amounts to stimulatory measures, for the economy.

Additionally, Portugal's ratio of GDP to debt remains low relative to Japan, Italy and France.

Austerity vs. Stimulus

By Grant de Graf 
[Sourced  and adapted from an article by Antonios Sangvinatsos, a professor of Finance at Stern School of Business, New York University]

Trying to Understand the Multiplier Effect

Austerity measures are usually combinations of government spending cuts and increased taxes. Stimulating practices, on the other hand, are consisted of combinations of the exact opposite actions, increasing government spending and/or reducing taxation. Therefore, it is clear that perhaps one has to choose one or the other, austerity or stimulation.

The above premise is based on the belief that one can create stimulation in the economy by increasing government spending or reducing taxes, and that one can save money by cutting spending or increasing taxes. But how much of it is true? Are the policies that help the country’s balance sheet hurt the economy’s growth? This article attempts to answer both questions.

It is always the case in economics, that an action generates more than one effect and often times these effects move in opposite directions. This is the case also here. Let us start with the alleged austerity measures and their effects.

Austerity Measures

Spending Cuts
Effect on Output: Output may decline.
Effect on Balance Sheet: Interest rates may decline.

Tax Hikes
Effect on Output: It may decline.
Effect on Revenues: Collected taxes may go up or down.
Spending Effect on Output

In what follows the consequences of spending cuts will be discussed, or increasing spending, on output. The current economic situation is described by anemic growth and high debts. Currently the discussion has focused on whether one, for example the U.S., should engage in tight fiscal policy, and more specifically, in cutting spending. This week FT hosts a debate on the same topic inviting articles from renowned economists.

Whether spending has an effect on output is summarized by the value of the spending multiplier. This is a number that stands for the number of dollars is generated in output by one dollar spent by the government. Advocates of spending policies justify their opinions on spending multiplier greater than 1.0. How much of it is true?

The answer is that, at best, the academic community has been inconclusive about the effectiveness of spending on stimulating output. This means that there is a lot of doubt, in the academic community, that spending works, i.e. that spending has a multiplier value greater than one.

For example, Barro and Redlick (paper link, WSJ article) find that defense spending has a multiplier of 0.6-0.7 at the median unemployment rate – while holding fixed average marginal income-tax rates – and there is some evidence that the spending multiplier rises with the extent of economic slack and reaches 1.0 when the unemployment rate is 12%. Estimating spending multipliers for non-defense spending is problematic as the nondefense government purchases are positively correlated with the business cycle and it is difficult to establish causality. Is it the spending that created growth or the growth that spurred government into spending? Barro and Redlick think the latter.

The same ideas are reiterated also in an FT article by Kenneth Rogoff. He believes that:

“At the same time, the stimulus benefits of massive fiscal deficits are not nearly so certain as proponents of a new surge of spending maintain. The academic evidence on Keynesian growth effects of fiscal deficits is thoroughly inconclusive. Ironically, a lot of the newfound conviction comes from the casual empiricism on the growth effects of the Bush tax cuts, evidence that few academics consider sufficient to outweigh the mass of previous results. Indeed, it will take researchers many years, perhaps decades, to sort out the effects of the massive fiscal stimulus that many countries undertook during the crisis. My guess is that scholars will ultimately decide that fiscal policy was far less important than monetary policy and measures to stabilize the banking system.”

In addition, a rough method I employ gives me a spending multiplier of 0.6, less than 1.0, rendering spending an ineffective policy. Finally, there are people who argue that the multiplier is negative, in which case, spending by the government decreases the output. This is also called crowding out.

There are however economists who argue that the multiplier is greater than one. Christina Romer, head of the President Obama’s Council of Economic Advisers, and Mark Zandi, from Moody’s, claim that the multiplier is 1.6. Note that, Keynes believed that the U.S. multiplier in the 1930s was 2.5.

Policy Implications

It is clear, now, that if the value of the multiplier is what the consensus has it in the academic community, around 0.6 or lower, cutting spending will have a small effect on output, as it is also the case that giving another stimulus package will generate little additional growth in the economy. Clearly, the opposite is true if the multiplier is 1.6 or higher, like some people advocate. However, the benefits of any policy have to be weighed with the benefits or costs of contingency scenarios. A policy creates repercussions that also need to be evaluated. For example, spending cuts may or may not decline the economy’s output, but it also has an effect on the country’s balance sheet, the expectations of both the bond investors and the consumers. A policy decision is an act of balancing the fears of all the groups that are involved in a given situation. (Prof. Antonios Sangvinatsos, elaborates in an article the big number of factors that affect the value of debt.)

One may conclude that the effectiveness of either austerity or stimulus will be largely determined by the economic sectors that are targeted by authorities to invoke their policies. Ultimately, some areas of government cuts or spending will have a greater impact than others.

Ref: http://sangvinatsos.blogspot.com/2010/07/austerity-vs-stimulation-effectiveness.html