Economic Interests

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Archive for the tag “Europe”

Was the Euro Doomed from the Start? (Essay from my graduation year of university last year)


The European Union (EU), an economic union between 27 member states in Europe, has recently suffered its first serious setback since its creation, termed as the “Euro Crisis”. Various members of the eurozone have been found to have serious debt problems which have affected the rest of the EU as they all share a single currency, the euro. But as Verhofstadt (2011), the former Belgian prime minister said “A state can exist without a currency, but a currency cannot exist without a state”. In this essay, I will discuss whether the euro was in fact doomed from the start from structural and unforeseen problems. First a short history of the euro will fill in any background information for this essay. Then the problems that will be considered are; the monetary policy problems, fiscal policy problems, a lack of preparation for any crisis, the lack of a real political union and a lack of equality throughout the EU. I will also explain reasons why the EU has been beneficial to its members including; the growth experienced before the crisis and the safety net the EU provided for the now failing economies in eurozone. The Mundell Fleming model will also be used to help show the different effects of both fiscal and monetary policies.

The euro first came into existence in 1999, though the physical representation of the money wasn’t fully circulated until 2002. Important institutions for the EU are; the European Commission, the European Council, the Court of Justice of the EU and the European Central Bank which decide important decisions within the EU like legislation, European law and interest rates for the eurozone. Entry into the EU was regulated by the Maastricht treaty which stated any nation that wished to enter must pass certain fiscal criteria; inflation must not be 1.5% higher than the average of the three best performers, the budget deficit must not exceed 3% of GDP, government debt to GDP ratio must not rise above 60%, long term interest rates could not be 2% higher than the three lowest members and the applicant should have mirrored the domestic currency to the euro for two years without devaluating currency. Greece famously did not originally meet these criteria and weren’t allowed to join until later on, while the UK and Denmark decided against adopting the euro currency. In 2004, the eurozone expanded to include smaller nations like Cyprus, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Slovakia, Slovenia and then in 2007 Bulgaria and Romania. Out of these nations only Slovenia, Cyprus, Malta, Slovakia and Estonia adopted the euro currency, while the other nations faced difficulties adjusting. Then in 2007/2008 there was a global financial crisis that pushed the eurozone into its first official recession in the third quarter of 2008, experiencing negative growth in the second, third and fourth quarters of 2008 and then into the first quarter of 2009. Greece suffered a crisis in confidence as international creditors started to doubt their ability to repay the huge debts they had acquired; with the debt to GDP ratio at a staggering 159% of GDP. This meant the eurozone countries along with the IMF had to bail out the country for the first time in May 2010, totalling €110 billion. This was followed by a second bailout this year of another €130 billion to help the country finance itself, while other countries like Ireland have also had to be bailed out. This has lead to a new European Fiscal Compact to be created that enforces nations to adhere to fiscal stability. This states that national budgets must either be in balance or surplus, otherwise punishments of fines of 0.1% of GDP and the loss of some of the countries fiscal sovereignty can be used.

The first fundamental problem with the euro was that it was expected a single monetary policy for all the countries would work. The monetary policy, which controls the supply of money into a country by targeting interest rates, is controlled by the European Central Bank (ECB) in the eurozone. This means every country in the eurozone has to operate under the same interest rates, despite the massive differences between the economies of the central countries (Germany, France) and the periphery countries (Greece, Spain). Andre Szasz, a retired Dutch central banker, supports this argument, suggesting it was a mistake to have “a monetary policy of one size fits all” as interest rates will be “too low” for some countries and “too high” for others.  This makes sense, as a country like Germany which produces a lot would be inclined to target low interest rates while a country like Greece which doesn’t produce enough would have higher interest rates. This led to the periphery states like Spain, Portugal and Greece being able to exploit the low interest rates that would not have been possible without being part of the euro. These low interest rates meant poorer countries could borrow money easily from international investors, not a big problem by itself, but when mixed with low productivity it encouraged nations to spend more money than they were making. This has lead to these nations building up vast amounts of debt that they cannot realistically pay back and with the financial crisis making credit scarce, these countries are finding it hard to obtain the loans they once found easy, with Portugal, Ireland and Greece being given junk credit status by credit rating agencies. This mass borrowing by the periphery nations (and Ireland) was good news for the central countries, especially Germany, as it meant new possible customers for their exports financed using money loaned from the richer nations like Germany: A vicious cycle. Zemanek (2010) supports this stating “Germany has experienced rising trade surpluses against the euro area countries starting from 2002 up to the recent crisis… other countries have large current account deficits, thereby accumulating increasing stocks of international debt”.

Bayumi and Eichengreen (1992) argued that the European monetary union could not be an optimum currency union. An optimum currency union is a region where a single currency would maximise economic efficiency, satisfying the criteria of; labour mobility, capital mobility, price and wage flexibility, fiscal transfers and similar business cycles. It is argued that the eurozone does not have price and wage flexibility, fiscal transfers or labour flexibility. Issing (2000) supported the lack of this last quality, arguing “dangers can be identified relatively easily. The most obvious one is the lack of flexibility in the labour union… this poses an almost lethal threat to monetary union”. A single monetary policy also meant individual countries couldn’t de-value their currency by printing. When the financial crisis hit, countries like the UK and USA were able to devalue their currency by printing more money, this helps boost exports and stop imports and can be an important tool in restructuring a countries economy. But countries like Greece and Portugal within the EU don’t have that option and therefore the only way to restructure their economy is through internal austerity; cutting wages and spending.  The Federal Union (2011) wrote “British government borrowing grew from 29.7% of GDP in 2002 to 36.5% in 2008… Since August 2007, the pound has lost 20 percent of its value against the euro”  showing the UK was fiscally irresponsible as well, but that they had the ability to de-value their currency and boost exports and therefore not have to adhere to severe austerity policies like their EU counterparts.

The second fundamental problem of the euro was the fiscal policy of the EU. In contrast to the monetary policy of the EU, each nation has a separate fiscal policy which leaves a very mixed economic structure for the EU. The fiscal policy refers to the government expenditure (e.g. new roads) and the collection of revenue (taxes) which affects the economy of the country. White (2011) suggested that it was “impossible to completely separate fiscal policy from monetary policy as central banks can prop up government bond prices by monetising debt” meaning the central banks of countries can buy up the debt of the country (though it is illegal to directly buy the debt, it can easily be bypassed) to help increase the supply of money, therefore affecting the monetary policy.

The Mundell-Fleming model (an adaptation on the IS-LM model) helps shows the relationship between a country’s interest rates, output and nominal exchange rates. The model argues that a country cannot simultaneously achieve a fixed exchange rate, free capital movement and an independent monetary policy. The EU for example has flexible exchange rates and instead decides to target interest rates and free capital movement. The model shows; the IS curve: Output = Consumption + Investment + Government Spending + Net Exports, the LM curve: Money supply/Price = Liquidity preference (Interest rates, Output) and the Balance of Payments curve: Current accounts (Net Exports) + Capital accounts (Cash Flow). The EU uses flexible exchange rates, which means the European Central Bank allows exchange rates to be determined by market forces alone. With flexible exchanges rates, the central bank can increase the supply of money to try and boost the economy (Monetary change). This causes the LM curve to shift to the right, thereby increasing output and lowering the domestic interest rate in comparison to the global interest rate. This depreciates the local currency, making local goods more attractive and thereby increasing net exports. Increasing net exports shifts the IS curve to the right as well, up until the point where the balance of payment is equal again and the domestic exchange rate equals the global interest rate. But while this returns to normal, the GDP increases once again, meaning any increase in the money supply doesn’t have an effect on interest rates in the long term, but does increase the GDP of the country and vice versa for a decrease in the supply of money. The European Central Bank increases money supply through Quantitative easing, where it prints more euros for all the countries to help boost the economies that are underperforming. Too much quantitative easing can be bad for the economy, leading to a poorer standard of living, bad reputation with foreign markets and even the risk of hyperinflation, while the ECB has to try and balance out whether quantitative easing would benefit all the countries in the eurozone. Another option with flexible exchange rates is to increase government spending (fiscal change), this causes the IS curve shifts to the right, causing an increase in GDP and in the domestic interest rates compared to global interest rates. This leads to the currency appreciating, making foreign goods more appealing and decreasing net exports. This shifts the IS curve back to its original position where domestic interest rates are equal to global interest rates and has no impact on the LM curve. This means if there is perfect capital mobility, then an increase in government spending has no impact on GDP and vice versa with cuts in spending. This shows that both the fiscal and monetary policy are integrated and cannot just be separated like the EU have tried to do with the euro.

A fiscal change with floating exchange rates graph shows what happens when government spending is increased (or taxes are decreased). A monetary expansion with floating exchange rates shows what happens when the supply of money is increased.

The EU also had to make an assumption that with interest rates fixed and a single currency, each country would be fiscally responsible. That assumption was proven badly wrong, as a lot of countries used low interest rates to borrow irresponsibly without having the output to support such loans and built up uncontrollable amounts of debt. Marian Tupy (Legatum Institute) argued that “Greece’s membership in the eurozone allowed the Greek government to borrow at lower interest rates, and thereby enabled its overspending” showing the allure the EU created for poorer nations to borrow beyond their means.  A new fiscal compact has recently been agreed between the countries in Europe (as described previously), with the UK and Czech Republic notably opting out of the treaty, which has the aim of stopping states running huge debts. This new fiscal compact shows an original problem with the structure of the EU, that regulation of fiscal activity in the eurozone was too relaxed. Dominguez (2006) came to this conclusion in her paper, writing “In 2000, one year after the euro was launched, five of the eleven countries in the eurozone were in violation of the public debt rule”, she then added “In 2005, the three largest eurozone economies – France, Germany and Italy – were out of compliance with both the budget deficit and public debt rules”.

Another fundamental problem with the euro was that it seemed totally unprepared for a crisis. As the Economist captured perfectly “the designers of the good ship euro wanted to create the greatest liner of the age. But as everybody knows, it was fit only for fair-weather sailing, with an anarchic crew and no life boats”. The European central banks main purpose was to keep inflation low, not deal with any potential credit problems which it had neither the financial nor political power to accomplish.  David Cameron (British Prime Minister) argued that successful currency unions have a lender of last resort, fiscal transfers, collective debt, economic integration and flexibility to deal with shocks, suggesting “currently it’s not that the eurozone doesn’t have all of these, it’s that it doesn’t have any of these”. Looking at the EU structure, it is easy to see what he is saying; countries are unable to transfer funds to struggling regions (e.g. Germany couldn’t transfer funds to Greece), debt is split unequally between different countries despite all using the same monetary policy, economies are kept largely separate with trade barriers still existing and there is absolutely no flexibility to deal with shocks as the financial crisis showed. Stelzer (2012) wrote ”Nor does Europe have a seamless method of transferring income from flush to stricken areas. America does: cash flows automatically to troubled states with falling tax receipts and rising welfare costs, from states doing better” which shows the one reason how America have been able to bounce back faster than the eurozone, because they have been able to transfer funds to poorer regions and have spread the debt collectively over all the states. But the most important of these factors is arguably having a lender of last resort, some sort of institution that can bail out the government if they can’t pay its debt. The USA has this in the form of the Federal Reserve, which can provide funds for any of the states if they require it. One of the main problems of the euro crisis was a lack of liquidity; this should have been the role of the European Central Bank as a lender of last resort. Instead the EU had a rule of no bail outs, relying on markets to keep a government from acting fiscally irresponsible, which has now backfired as the EU has hurriedly created a rescue fund to help solve a liquidity time bomb. The rescue fund created has little use however as it is massively underfunded, unable to bail-out a country the size of Italy for example. Without the ability to bail out countries, the EU could break up, a topic politically avoided. Ulrike Guerat of the European Council on foreign relations expresses fear in his paper that rather like the Soviet Union, the EU would go down quickly if the euro started to break up, showing a general worry that if a country like Greece (in the worst condition in the eurozone) defaults on its debt and leaves the euro, it could have a domino effect on the rest of the EU, with Portugal and Ireland very vulnerable to any shocks in the market.

An additional structural problem with the euro was that there wasn’t a political union. George Soros (2011) stated “the euro is a flawed construct “by which he meant the euro needed a stronger political union behind it. He then went on to suggest a single-pan European Union welfare state would allow for the creation of one fiscal and monetary policy for all of Europe. The EU faces constant bickering from different members over different policies, and struggles to achieve a united front at times. One such example was with foreign policy, where the UK and France agreed to intervene in the conflict in Libya, while Germany decided against joining in, showing that a conflict in interests can divide the eurozone. The United States of America is a good body to compare the European Union to as it shows the difference of being united politically. The Economist supports this argument, stating “America created political union followed by a fiscal union. But Europe is doing things backwards, creating the euro in hope of fostering political union”. EU policy has long been seen as being dominated by the central nations, with Germany suggested as having a lot of sway in the decision making process. This has stemmed from EU policy benefitting Germany before the crisis; as a weak currency meant they could export their goods more easily and low inflation was suggested to be focused on strongly because of German fear of hyperinflation, indeed the European Central Bank’s main policy is to control inflation.  This has been resented by the periphery nations which feel they are not represented in EU policies. The EU parliament has long been an institution with little power, with the economist describing it well, suggesting they measure “themselves against America’s congress without having its means” meaning that unlike Congress, they have little sway in uniting different countries inside the eurozone and although it can decide how to spend the EU money, it cannot dictate how it is raised. The EU parliament gained mores powers in 2009 after the Lisbon Treaty to monitor national budgets but any decisions have to be debated between two other bodies; the European Commission and the Council of Ministers while all the major topics like education and health are decided by national governments. This sort of system keeps the different nations separate and makes decision making a long and tedious process. The German Chancellor, Angela Merkel, has spoken of a potential “political union” for the EU with a strong parliament, showing the lack of one originally has been realised as a mistake by the leading figures of the EU.

The final structural problem found with the euro was the lack of equality throughout the EU. There is a vast difference between the economies of the central nations and the economies of the periphery nations. Germany has been a highly competitive saving nation since the euro’s creation whiles the “PIIGS” countries (Portugal, Italy, Ireland, Greece and Spain) were the complete opposite; uncompetitive in production and too reliant on credit to finance themselves. This meant the capital flowing into these countries created a wage boom which saw wage growth rise above productivity growth, while Germany’s wage growth remained moderate meaning they could remain competitive over their rivals. A rigid labour market meant that when the financial crisis hit, real wages couldn’t adjust quickly enough in the periphery states, which coupled with an inability to devalue their currency led to a deep recession for these countries. Rogoff (2012) argued that the lack of labour mobility in the euro was a big problem, suggesting “if intra-eurozone mobility were anything like Mundell’s ideal, today we would not be seeing 25% unemployment in Spain while Germany’s unemployment rate is below 7%” meaning the eurozone is not one of Mundell’s optimal currency areas. Zemanek (2010) produced some facts, saying “while Germany and Austria broadly kept unit labour costs at the level of 1999. In Iceland, Portugal, Spain, Greece, Italy and the Netherlands unit labour costs have increased significantly – by up to 30% compared with 1999” showing how competitive Germany had become compared with most other countries. This inequality throughout the eurozone has destabilised the EU, leading to hugely contrasting current accounts; with Germany having a big surplus and Greece having a large deficit.

We can use the idea of an optimal allocation to show the problems with inequality in the eurozone. An allocation (consumption of an individual in an economy) is only an optimal allocation if it is both efficient and equitable. We can judge efficiency by using the idea of Pareto efficiency: that no-one can be better off without making another individual worse off. A lot of allocations can be pareto efficient but still be unfair however, for example if one person has 7 apples and another 3 this would be considered pareto efficient. To make the allocation equitable, it needs to maximise social welfare (benefit society). A good model to show this is the Utilitarian model, which shows an economy of two individuals, where a UPF curve shows the pareto efficient utilities of both consumers and the social welfare function curve shows the point on the previous curve where the allocation is both pareto efficient and equitable. In the case of the EU, the redistribution of endowments in the market is the responsibility of the EU government and they haven’t done this effectively, as the imbalances between different countries shows. Germany is highly productive, export more than they import and have high employment, this is in contrast with Greece where they import more than they export, have high unemployment and have low productivity. The EU needs to fix these sorts of problems, where jobs are available in some areas of the eurozone and non-existent in others. They could do this by producing more public sector jobs in areas that have low unemployment or improving infrastructure to attract private industry, but this will be hard as countries in the eurozone still have individual governments (not in the EU’s power) and political mistrust between countries will interfere in the sharing of resources e.g. Germany are unlikely to agree with strengthening their rivals in the market. A more unified European Union, as discussed in earlier points, in the shape of a real political union could help different countries become more equal in the EU.

Map showing the different debt to GDP ratios of the countries in the eurozone. This shows the contrasting levels of debt in the eurozone; with Greece, Italy, Portugal and Ireland in much worse positions than France and Germany. This inequality is bad for the EU and a collective measure of the debt would help sort out these issues. (Economist, 2011).

However, it cannot be said that the euro was all bad. Most of the countries that joined the EU experienced big growth in the period up to the crisis. Yannos Papantoniou (2011) found that in the years 1999-2008 compared to 1989-1998, the eurozone countries experienced; 1% lower unemployment, 1.1% lower inflation and GDP growth of at least 5% each year (excluding 2003). The periphery nations like Spain and Greece experienced big economic growth (with Greece growing larger than the eurozone in 2003) which has seen their standard of living for their people improve greatly. During this period life was good for those nations, despite it being financed by debt, and their business sectors and infrastructure were upgraded in the process.  Having the same currency also meant countries could trade with each other much easier without the need for different exchange rates. The euro has benefited businesses in Germany and France (whose main customers were in Europe) and tourism for countries like Greece and Spain (whose economies rely on this sector) as there were no longer any transaction costs for each country and made prices in each country relatively equal and transparent. Also it is comparable to look at Iceland who possesses a single currency and has had troubles with volatile exchange rates due to changes in the market. This shows the problems that each country could still be facing if they hadn’t been part of the euro; highly vulnerable to any changes in the world market like rises in oil prices or commodity prices. Papantoniou (2011) supports this stating “the growth of output seems to have been stabilised in the euro area since the end of the 1990’s. Although the eurozone has not been the only area enjoying this decline in volatility of output growth, the convergence of economic policies of the eurozone countries coupled with a steady monetary policy of the ECB in its response to major events, such as the global economic downturn in the early 2000’s”. By employing data over 1982-2002, De Sousa and Lochard (2005) found that the euro has raised flows of foreign direct investment within the euro area by 62%.

Another benefit of the euro has been the safety net that each nation in the eurozone now possesses. Since the euro crisis, Greece and Ireland have had to be bailed out by the EU and IMF, this wouldn’t have happened had they not been part of this union that they can fall back on. The EU can’t afford to let any nation default as it could trigger a domino effect, so all the countries in the eurozone will continue to help bailout any countries in need to stop another crisis. Also, though countries like the UK do have the option of de-valuing their currency that members of the euro don’t have, it does have negative effects. The Federal Union website supports this stating “devaluation leads to reduced living standards, higher inflation and creditors deprived of full repayments abroad” with the last factor leading to countries losing their credible reputation with foreign investors. White (2011) reiterated this stating “For the citizens of an open economy who want to enjoy cross-border trade and investment, and want to have a trustworthy currency, the option of their central bank to devalue carries a near zero or even negative value, while the benefits of membership in a common currency area are important and positive”. He went on to suggest “The euro has so far held its value better than the drachma or the lira or the peseta used to” meaning the countries in the eurozone could have been much worse off had they not shared a currency and seen their economies lose their value. Tilford (2012) suggests that the EU compares favourably with its rivals, stating “Eurozone members as a whole … have a lower budget deficit than the US and the United Kingdom, and a similar level of public debt. Unlike the US and the UK, the eurozone in aggregate is running a current-account surplus” though the problem is whether to perceive the EU as a single organism or a host of multiple countries. The economist also found that “Prior to the crisis, Italy’s government was running a primary surplus and bringing down its debt-to-GDP ratio. So long as markets were prepared to finance Italy’s old debt at low rates, it was in good shape. Now, of course, markets aren’t prepared to do that” showing not all the nations now in trouble were spending outrageously, it’s just that once markets were spooked it effected some fragile economies in the eurozone like Italy. The European Central Bank also managed to keep its inflation rates at low levels throughout the euro (at around 2%), an important step in making sure a problem of hyperinflation didn’t spread through the eurozone.

In conclusion, the euro has some fundamental problems that need to be solved if it is to survive. The first two problems are interlinked, as the EU cannot have one monetary policy and multiple fiscal policies. The EU will need to either centralise the fiscal policy of the eurozone, giving more power to the EU parliament over taxes/government spending or give up some of its power over monetary policy and allow countries to print their own euros with some sort of maximum limit in place. The first choice seems the most likely as the EU continues along a current path of greater unification (bailing out countries to keep the EU in existence) and this could result in Eurobonds, as a way of reducing borrowing costs for each country and creating a safer asset for the EU. The current structure of the EU has political fractures between different governments, as countries fight for their own interests, this will need to be sorted by giving more power to the EU parliament and getting rid of current trade barriers between nations. The vast inequality will need to be treated too, as contrasting statistics between central and periphery states (budget deficits, current accounts) will continue to split the EU. A solution could be to have a system like that in USA where the richer states can transfer funds to the poorer states; this is basically in use now in the eurozone as countries like Germany and France are being forced to bail-out their neighbours. The last fundamental problem of having no preparation for a crisis is already being resolved, as the recent Euro Crisis has caused countries to stop either living fiscally irresponsibly (Greece) or to stop relying on certain  markets (Spain too reliant on construction market). There is also more regulation over fiscal activity and bank credit, which was badly missing from the original set up and encouraged nations to live beyond their means. The euro did allow growth in poorer regions of Europe, but this was financed by easy debt. While the safety net it now provides relies on the belief that the countries footing the bill will continue to decide the costs of bail outs outweigh the costs of a breakup of the euro. Instead there should already be a lender of last resort set up, the European Central Bank for instance, which can help out any country and already have been financed by years of savings from each country. These points add up to suggest the euro was in fact doomed from the start due to innate problems in its structure and the only way it can survive in its current form will be through reforms in its monetary and fiscal policy and its political unity.

PERFECTLY EFFICIENT MARKET HYPOTHESIS


 

 

 Key Idea:

“To be a “master of the Market” you need to look past the immediate effects of major upheavals and fluctuations, and look at their secondary and tertiary effects.” The efficient market hypothesis says, as accepted, that the price of an asset always perfectly reflects the value of that asset.  The idea is that all the information about an asset–public and private–gets translated into market activity, which is a kind of revelation of the asset’s real value.  It’s an elegant, if contentious, theory, that in some way illustrates the intrinsic value and organic nature of the market. The efficient-market hypothesis was developed by Professor Eugene Farma at the University of Chicago Booth School of Business as an academic concept of study through his published Ph.D. thesis in the early 1960s at the same school.

Examples:

When Lebron James, arguably one of the best basketball players of all times, became a free agent, his next move was one of high anticipation, and one that was obviously reflected in the world markets. It is an amusing story to hear that when it became rumored that Lebron James was going to sign with the New York Knicks, it drove up the stock price of Madison Square Garden (MSG) (New York Knicks stadium) up by 6.4%.

http://mrhonner.files.wordpress.com/2010/07/lebron-stock.jpg

As we can see above it is a clear example of the Efficient Market Hypothesis.When someone finds out a secret (Lebron is signing with the Knicks), realizes the financial consequences (tens, if not hundreds, of millions more in revenue for MSG), realizes MSG stock is under-valued, and buys a bunch; other people see this and jump on the bandwagon.  At some point, the stock price levels off at its true value. As we can see in the graph above the price of MSG skyrocketed. However as Lebron signed for the Miami Heat only 3 days after, again the same principle happened, resulting in a drop in the share price of the New York Knicks Stadium.

However there have been some counter-examples:

Remember Chernobyl? When news broke that the Soviet nuclear reactor had exploded, Alexander called. Only minutes before, confirmation of the disaster had blipped across our Quotron machines, yet Alexander had already bought the equivalent of two supertankers of crude oil. The focus of investor attention was on the New York Stock Exchange, he said. In particular it was on any company involved in nuclear power. The stocks of those companies were plummeting. Never mind that, he said. He had just purchased, on behalf of his clients, oil futures. Instantly in his mind less supply of nuclear power equaled more demand for oil, and he was right. His investors made a large killing. Mine made a small killing. Minutes after I had persuaded a few clients to buy some oil, Alexander called back.

File:Chernobyl Disaster.jpg

“Buy potatoes,” he said. “Gotta hop.” Then he hung up.

Of course. A cloud of fallout would threaten European food and water supplies, including the potato crop, placing a premium on uncontaminated American substitutes. Perhaps a few folks other than potato farmers think of the price of potatoes in America minutes after the explosion of a nuclear reactor in Russia, but I have never met them.

Yet if Alexander believed in perfectly efficient markets, he would not have bothered, instead figuring that the market had beaten him to it.  So almost 50 years after the efficient capital markets hypothesis, it’s still a hypothesis.  We don’t really know what drives securities prices.  But one thing we do know: the markets are very hard to beat and as John Maynard Keynes once commented, “Markets can remain irrational far longer than you or I can remain solvent.

By 

For more http://ibej.blogspot.be/

A Happy New Year?


As we head towards Christmas and the New Year, now is a good time to evaluate which economies are heading for troubling times in 2013. This isn’t so hard, with the world economy not exactly working in top gear, and the likes of even China appearing to slow down. But I have picked three countries that I believe are facing an especially tough and defining 2013.

First up is a struggling EU economy that could define how the rest of Europe solves the Euro crisis. No, it’s not Greece. It’s not even Spain or Italy. The country I believe is in considerable danger is France. One of the leading economies in the euro, its fate has large repercussions on the rest of the European Union. France has a host of problems; High unemployment at over 10% of the population, miserable GDP growth of just 0.1% this year and just 0.8% forecasted in 2013 (which is in itself seen as optimistic) and a budget deficit of 4.5% of GDP that needs to be brought down. Yet already the 2013 budget target of 3% of GDP seems unlikely. But worse than that is the longer running trend of the French economy.  France has over the last decades lost competitiveness to countries like Germany, with their products now either upmarket or non-existent. Even their food production is only surviving due to large subsidies from the French government and EU budget. Alongside this the French government is one of the biggest spenders in Europe, spending the highest proportion of its GDP  in Europe (57%) and racking up billions of public debt (equivalent to  90% of its GDP). But even these problems could be solved with significant reforms and cost cutting. The fact is however, that the French government doesn’t seem ready for such hardship. President Hollande campaigned on making the rich pay (with his famous 75% top income tax rate), not cutting budgets. While the likes of Italy and Britain employ heavy austerity measures and hard labour reforms to help fix their economies, France seems to be satisfied to keep an inflated government and unproductive economy. For now the nation remains under the radar of the markets, but this could quickly change in 2013, just ask Italy or Spain. President Hollande has only just started a 5 year term, if he doesn’t act now with time on his side, when will he?

Graph found at the Economist: http://www.economist.com/news/special-report/21566238-how-regain-competitiveness-doing-so-so. Shows Frances high public spending and low competitiveness. 

Next up on the list is one of the famed BRIC economies that seems to have lost its way. It may seem ridiculous to be picking a country that is set to have grown this year by 5.8% but India are in uncertain times. Inflation has been uncomfortably high for the last few years (currently near 10%) and is hurting the poor population of India. The Indian population relies on high growth of around 6% a year to keep lifting millions out of poverty, so the current slowdown of growth to just under 6% is worrying for the nation. This slowdown has occurred because India’s government is very badly run. It intervenes in the private market far too much, running important industries like the energy sector inefficiently. Corruption is also rife, leading to much of the money meant for those in poverty going into the pockets of local officials. The final nail in the coffin is a complete lack of reform in the last few years, with many markets rigid and inaccessible by foreign firms, leading to poorly run Indian firm producing below average goods and services. India’s growth was started by a series of reforms in the past that lead to greater competition and opportunities for the Indian population. A return to these policies would reignite the economy. But what makes me place India in this list is the complete lack of push for any such policies. Recent movements towards have creating greater competition in the country have lead to large protests and a standstill in the government. Even worse, the election in 2014 isn’t set to change anything, with the opposition just as bad if not worse than the current officials in charge. Change is not wanted, yet is exactly what is needed for the Indian economy to keep progressing forward. Standing still is going backwards.

India has a larger budget deficit and public debt than any other BRIC country in 2012. 

Finally, to complete my list, I end with South Africa. For so long the kings of Africa, their dominance is slowly fading. Growth of just 2.4%, high unemployment at 25% and a current account deficit (imports minus exports) of over 6% shows a leading country underperforming. Its crown is challenged by an oil backed Nigeria and a resurgent Egypt, while the smaller nations like Rwanda and Botswana are showing the larger nations how to successfully run an economy. Even its reputation as one of the most sophisticated nations in Africa is losing its shine, as the recent mining strikes show a deep unrest within the country. South Africa remains highly unequal, with a white South African (accounting for only 9% of the population) on average earning eight times more than a black South African. Its Gini coefficient (measuring inequality) has incredibly risen in the last decades from 0.59 to 0.63 (0=Perfect Equality, 1= Perfect Inequality). Education also remains a tragic failure, where the government has somehow managed to outspend every other African country yet still have one of the worst educational systems. Corruption has infested the current government, and with the next general election not till 2014, it seems unlikely anything will change in the next year for the good. Unemployment and poverty remain the big problem (with half the country still under the poverty line), but the problems are all interlinked. A poor educational systems produces unskilled labour, while high inequality keeps millions in poverty. If South Africa doesn’t start investing wisely into education, job creation and equality it is certainly set for a poor future. Don’t look now but South Africa’s crown may be slipping.

Unemployment in South Africa has been incredibly high for the last decade, one of many problems the country faces in 2013. 

There were a few more obvious candidates; Greece and the USA. But I decided against them for a few key reasons. Greece are forecasted to suffer another year of serious decline, but the IMF and the EU seem set on keeping Greece running, which in my view could help keep the economy progressing towards a better run state (with them already running a primary surplus). The USA could face a sudden recession with the fiscal cliff, but the problems are clear and I just can’t see America letting themselves go over the figurative cliff (even if that means kicking the can down the road).

The warnings of the fiscal cliff have been clear enough for America to avoid it. 

Even with my choices there are signs of progress. In France recently a report on the poor competitiveness of the country seems to have hit home, with President Hollande perhaps realising the true extent of problems he needs to overcome. While a crucial vote was won in the Indian Parliament that will open the retail sector to foreign competition.

Important steps maybe, but more is needed to avoid a year to forget.

Daily chart: The maths behind the madness | The Economist


Daily chart: The maths behind the madness | The Economist.

A great graph by the economist showing the different debt levels of countries and what the IMF is predicting in the next few years.

At the centre of it all


HQ of the EU in Brussels.

The Euro crisis ceases to go away, after protests erupted last week in Spain and Greece over tough austerity measures. This followed a relatively calm period in the storm; as Germany’s constitutional court ratified the ESM bailout fund, Holland elected pro-euro parties and Mario Draghi announced that the ECB would buy unlimited bonds from weak euro economies. But despite this the EU is continuing to do badly, with an estimated decline of 0.5% of GDP across the region and unemployment averaging at 11.3% of the population.

In the middle of all this stands Belgium, at the centre of the EU. The country shares its capital city, Brussels, with the rest of the European Union and is the location to many of Europe’s governing bodies. The country understandably supports the EU strongly, with calls for deeper integration and more centralized power. But is the country setting the right example for the other periphery economies?

Mario Draghi’s promises won’t keep the peace for long. 

This year GDP is only expected to rise by a miniscule 0.1%, hardly an improvement for a country that was expecting to be in the middle of a recovery by now. The country also boasts a budget deficit of 3.4% of GDP, not as high as the likes of Spain or Britain (6.8% and 8.4% respectively) but not quite as low as the likes of Germany (0.3%) or even Italy (2.8%). Alongside this the countries debt to GDP ratio is near 100%, a statistic more representing of the unstable southern economies than the prudent northern economies. For a country that sits in the heart of the EU, it would be expected that they would have better finances than that, especially if they are calling for fiscal decisions to be made by a more centralised EU. The interest rates on the 10-year bond yields of a country are always a good way to measure how confident the international markets are with that nation, Belgium’s are at 2.58%, roughly in between the low rates of Germany and Britain (under 2%) and the high rates of Spain and Italy (above 5%). This paints the picture of an economy that is distinctly average, not in danger of being pulled into the current crisis’s of Spain and Italy, but behind the leading economies like Germany and Poland. More importantly, the volume of exports has decreased this year, with the current account swinging from a surplus into a deficit of 0.2% of GDP. This is a bad sign for an open economy that has famously relied on trade in the recent past, with rising production costs and more of an emphasis towards the service sector helping to lower the exports of the country.

A graph at The Economist shows the forecast current account for Belgium swinging into a deficit. 

But there are mitigating circumstances and Belgium as a whole is not doing too badly. When you consider that Belgium is a country reliant on trade to the rest of Europe, then small growth is to be expected when other euro economies are implementing austerity measures. The budget deficit is also only just above the agreed limit for eurozone economies and the government is clearly implementing austerity measures itself so as not to ensure it loses control of its finances. They approved a €11.3 billion package of cuts at the end of last year, rose the retirement age of its people and have already dropped the deficit from the 3.8% level it was at in 2011. The country boasts a lot of positives as well; an excellent infrastructure, strong trade links and high skilled workers. In fact, Belgium is one of the few countries to have higher economic activity than they did back in 2008 at the height of the crisis.

This graph shows that Belgium were ranked 20th in the world for infrastructure in 2011. 

The real problem lies in the future of Belgium. As long as the eurozone crisis rattles on, Belgium cannot legitimately expect to recover from its deep recession years. Were the likes of Greece to default on their debts, Belgium would be highly susceptible to a possible domino effect as markets got spooked and banks runs started occurring in the weaker economies. The country was already downgraded last year by the much feared credit agencies and the estimated growth in the next few years does not generate much enthusiasm with just 0.8% growth next year and 1.3% the following year, notwithstanding any setbacks in the global economy. The downgrade occurred largely because of the forced bailout of Dexia (a Belgium bank), where the Belgium government had to buy their division of the bank for €4 billion and help secure 60.5% of their state guarantees, this following a previous bailout of the bank back in 2008. This was a drain on the states resources and shone a light on the countries worryingly fragile banking system, where another large bank Fortis (the 20th largest business in the world according to revenues in 2007) fell apart after the financial crisis and was sold off in parts. The weakness in the banking sector is systematic of the rest of Europe, as weak banks now have to be re-capitalised by their governments, in deep contrast to their American counter parts who had to go through strict stress tests to ensure they were strong enough to compete in the market. This could be an expensive problem for Belgium to fix and set back their recovery even more. In fact, a survey carried out by Deloitte found that the percentage of CFO’s that believed the economy would recover by the end of the year fell from 60% in March to 20% in June, while 25% believed it wouldn’t recover until after 2014.

The above table found in the Wall Street Journal shows Dexia’s exposure to the fragile economies of the EU, a worrying trend in Belgium banks. 

So while other struggling euro economies are trying to build back up lost competitiveness or pay back uncontrollable debts, Belgium is waiting for these countries to pick up and consequently for trade to begin flowing again at pre-crisis levels (as three quarters of its trade is with Europe). With its fortunes so closely tied to the rest of Europe, Belgium will hope its calls for tighter integration start to pick up momentum.

Europe’s winners and Losers


The Euro Crisis has created a doomsday atmosphere around the continent, with the threat of the “Grexit” hanging over many heads. So I have decided to create a list of those countries that I believe are doing well economically right now and those countries that are suffering the most from these destabilising times.

Winners:

Germany is currently one of the strongest countries in Europe. Germany experienced growth in the first quarter this year of 0.5%, helping to keep the eurozone out of recession, while low inflation (1.9%) and unemployment (6.7%) are the envy of the continent. They are known as Europe’s equivalent of China because of their high current account surplus, exporting more goods than they import (producing over a quarter of European output), though a slump in European demand has damaged their exporting machine somewhat.  In fact, the one major factor stopping Germany from growing more is the rest of the struggling economies in the EU, with the southern states like Greece requiring expensive bailouts to keep their economy running. But then Germany benefited hugely during the boom years, when these same countries were borrowing money off Germany to buy German goods. This northern and southern split can be seen in the bond prices for Germany and Spain, where the difference between the two is the biggest it has ever been. Germany’s 10 year bond yields have dropped to 1.34%, while Spanish 10 year bond prices have risen to 6.55%, a staggering difference that shows the confidence markets have in Germany’s ability to pay its debts. Germany does face some problems like Greece’s potential exit from the EU (with Germany one of the nation’s most exposed to a Greek default) and the possible domino effect that could result, while cries for “Eurobonds” and Germany to accept higher inflation won’t sit well with Angela Merkel but might be the best way forward. As the leaders of Europe they make it onto my list, but they will have to shoulder more responsibility if they are to ensure future growth.

Showing the Difference in the German and Spanish 10 year bond yields.

Poland is the next country on my winners list, as they are one of the fastest growing countries in Europe. They have benefitted hugely from being neighbours to Germany, where German demand helps boost Polish output.  While the hosting of Euro 2012 this month has focused government concentration on improving the infrastructure of the country, for too long a drag on Poland’s development into a modern economy. The country is currently the sixth largest economy in the EU, was the only country not to fall into recession during 2009 and it predicted to grow by 3% in 2012. Poland still has its own currency as well, meaning the current problems other EU states are facing now of trying to devalue their economy through internal cuts has been avoided by Poland, who externally de-valued when needed to remain competitive (allowing the currency to devalue etc). The country also has impressive internal demand which has helped buffer the external factors currently plaguing other EU nations and its banking sector is a lot more secure than its neighbours. But the country can’t completely ignore the outside world and while growth is strong, it is slowing down. More tightening of its interest rates could help reduce persistently high inflation, while more improvement of its infrastructure could attract more external investment, which has slowed down in recent times.

The hosting of Euro 2012 could help boost Poland’s infrastructure.

Sweden is the last addition to my list. This is because Sweden is a country that ticks most of the boxes for success right now; the third highest GDP per person in Europe, an unemployment rate of 7.7% (one of the lowest in Europe), a public debt to GDP ratio under 40% (extremely rare in Europe) and is one of the few countries expected to grow this year. This builds on a good year last year, where they were only one of three countries to have a budget surplus and had growth of 3.9%. They have achieved these accomplishments through being a successful manufacturing exporter, not having the euro currency (allowing them to externally de-value and avoid harsh spending cuts) and by being fiscally responsible which has left them in a much better position than their neighbours. They still have some hurdles to jump however, with their youth unemployment surprisingly higher than the UK’s (a nation it beats in most other departments) there is need for some reforms to help the transition from education to employment. While Sweden’s forecasted GDP growth this year is a lowly 0.3% that shows a slowdown in their economy from last year and the need for a timely boost.

This graph shows Sweden are one of only 6 countries to have a debt to GDP ratio of under 40%. This can be found at http://www.social-europe.eu/2012/05/francois-hollande-is-right-why-fiscal-stimulus-would-reduce-debt/

Losers:

Greece tops my loser list with its economy crashing before everyone’s eyes. Greece’s unemployment reached a new record last month at 21.7% meaning nearly 1.1 million Greeks were out of work, while youth unemployment has reached an incredible 54% meaning over half of young people are not employed. The Greeks debt is the biggest problem however, at €356 billion and set to peak this year at 172% of GDP – an uncontrollable size – and even in 5 years time it is still predicted to stand at 137% of GDP.  Their economy declined by 6.9% last year, is set to decline again this year by 4.7% and if so will mark the fifth successive year of decline. The country have had to agree to two bailouts from the rest of Europe and the IMF just to keep the economy running with the consequences being harsh austerity measures being placed on the Greek public. Recently this boiled over in the parliamentary elections, as the public voted for anti-austerity parties and the end result was that no governmental majority could be formed. If there is one plus right now for Greece it is that they are at least cutting away their budget deficit, with the deficit lower in the last two months than what was predicted in the initial budget. There is talk of Greece exiting the euro, which would have a extremely negative effect on both countries initially, but could actually be a better long term solution as it would allow Greece to de-value its country externally with a weak currency that could boost exports, while also losing the EU a flagging member, though if a domino effect on other weak economy’s was to happen then it could mark the end of the euro.

Portugal is next up on the list with a weak economy that would be vulnerable to any Greek default. Portugal also had to be bailed out last year to help its struggling economy and is in a similar situation to Greece, if not as severe. They have a public debt to GDP ratio that is set to peak at 115%, an unemployment rate of 15%, a youth unemployment rate of over 35% and a decline in their economy last year of 1.6%. They are predicted to decline further this year by 3% and are highly susceptible to any market shocks. Portugal’s problem is that they are uncompetitive in today’s market and are struggling to turn this issue around whilst still in the euro. They had a current account deficit last year of 6% and do not export enough goods to justify their standard of living. Portugal are working well at reducing their high budget deficit of recent years but still have a tough journey to regain their competitiveness, this is why they make it onto my losers list.

Portugal’s current account deficit over the last few years, showing how they have become noncompetitive and too reliant on imports. 

Spain completes the list with one of the most fragile economies around right now. They are different to the likes of Greece and Portugal in that they didn’t overspend before the recession and actually have relatively low public debt (less than Germany currently). Spain’s major problem was instead that their industry relied on a construction boom, which turned into a bubble and promptly burst when the financial crisis hit. This caused a big rise in unemployment, as construction firms were a key employer in Spain, with the unemployment rate at 23.8% and the youth unemployment rate over 50% (the highest rates in Europe).  The other industry Spain relied on was the banking sector which has declined across Europe and left many of Spain’s banks undercapitalised and unready for external market pressures. Spain are now trying to tackle a high budget deficit (8.9% of GDP last year) with big internal cuts (with external devaluation impossible) but are facing problems trying to get local governments to undertake such cuts while also trying to improve growth with the country forecasted to decline this year by 1.8%. Spain also remain extremely vulnerable to a Greece default, with their high bond prices (already mentioned earlier) showing a lack of confidence from the markets in Spain’s ability to pay their debts. If Greece were to fall it would be damaging but fixable for the EU, Spain on the other hand would cause irreversible damage and undoubtedly bring an end to the euro. Europe will need to help Spain remain steady after the recent destabilizing pressure around the country, Spain will have to reform their economy to help improve their poor employment record and competitiveness.

Showing the rise in Spanish unemployment since the financial crisis hit and burst the construction bubble. 

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