Why France & Germany Out Of Recession But Not UK?

The recent miracle showed by France and Germany’s economic recovery is highly likely to reignite the debate about just how robust and flexible the UK economy has turned out to be. Successive government was once so flamboyant and claimed that UK can perform much better without staying inside the Eurozone. This is because of so called flexibility where UK will not lose the power in controlling in monetary destiny. It can influence the level of interest rate which will successively determine private spending and investment. Also, it can manipulate sterling to change the fate of the beleaguered manufacturing industry

On top of that, the UK government is not constrained by Stability and Growth Pact, which states that in any fiscal year members of Eurozone should not incur a budget deficit of more than 3% and a national debt must not exceed 60%. As such, in theory UK suppose to be the first European nation to escape from recession since their ‘hands and legs are not tied’. However, the current situation is very disturbing. A-Levels Economics and related references probably will have to be rewritten and to some extent with lower tone, instead of bragging how great the flexibility was

Source: BBC

Why France and Germany escape recession before UK?

(1) Reliance on France and Germany. UK used to a consumption driven economy where private spending once stood at about 65%-70% of its GDP. Unfortunately, the present Great Recession has turned the British economy into a pessimism state. Certain sectors of the economy almost come to a standstill after consumption and investment spending have both collapsed. In such case, the health of the economy is then very much reliant on the other two components of AD which are public spending and exports. Bear in mind that about 55% of UK’s trade is with the rest of Europe especially France, German and Ireland. Therefore, it is not difficult to see that economies of France and Germany need to pick up before UK does

(2) Legacy of debts. It is also worthy to note that UK’s growth was paddled by credit boom in earlier years. Since interest rate was quite low and credit easily obtainable, British people had engaged in a form ‘luxury’ spending. The property market was the biggest beneficiary fuelling an increase in personal wealth at that time. The vicious cycle repeated itself through the process called mortgage equity withdrawal (MEW). Now, with the collapse of both economy and housing market many went into bankruptcies and some saddled by burden of debt in the midst of losing their job.

It is said that most of the income now goes to servicing the debts upon the loan they took out earlier. Meanwhile in France and Germany, their economy is not driven by property market and the percentage of house ownership is significantly lower. Therefore debt is ‘trivial’ and with great level of household savings in Germany, the people can spend themselves out of recession

(3) Less exposure to financial crisis. Although Germany and France experienced similar problems in their financial sector, it was not to the similar extent as in UK. The Labour government is reported to have spent nearly £1.5 trillion in bailing out the financial sector, an amount which is significant as a percentage of GDP and much bigger than total spending by the rest of G20 put altogether. Clearly, UK’s financial sector still has a long and winding road ahead. Banks are still relying on state financing and until now very much reluctant to lend as can be seen from the high deposits required for any form of lending. One need to understand that banks are the main facilitator of economic activities, which without will be major impediment on road towards recovery

(4) Stimulus plan for auto industry. The German’s car-scrappage scheme has been accredited for turning around the fortunes of its automotive industry. At €5 billion, it was on an entirely different scale to the UK’s £300 million scheme. This scheme has been so successful that it has been extended until the end of year after attracting 1.2 million applicants. The initiative actually offers buyers new and more fuel-efficient car in return for their nine years old car

In fact purchasers benefited twice. First, falling demand leads to lower car price and with further € 2500 subsidy, car price looks even much cheaper. It has great domino effect. A revival of auto industry will have multiplier effect onto other car related industries. More jobs will be created. As people begin to spend, they will eventually jump start every sector of the economy. It is unlikely that British half-baked policy could produce such desirable result

(5) Growing demand from outside. Unlike UK, Germany’s economy is export-driven. As such, with the collapse of global commerce, its economy sank by as much as 6.7%, a bigger figure if compared to contraction in UK by 4.9% in the first three months of 2009. However the revivals of Chinese economy and reported stabilization in US have both fuelled demand for Germany’s exports particularly high end manufactured goods, thus pulling it out of recession earlier than expected. The latest statistic shown that German exports had grown at their fastest pace for nearly three years at 7%. This has positive spillover effect onto France economy as German is its major trading partner. UK’s fate is somewhat different since it has grown to become a service based economy

(6) Relaxation of fiscal rule. The Growth and Stability Pact is believed to have permitted certain flexibility onto France and Germany, therefore allowing them to spend more than usual. No doubt, both run huge budget deficit and have enormous national debt, but if we were to stringently follow the book, situations could have turned for the worse. Pro-long recession will inevitably lead to higher unemployment, deflation and increasing difficulty to finance debts. Besides, these two are the largest economies in Eurozone. Their survival will lead to the survival of the rests of Europe. The recent reported contraction in Eurozone was 0.1% and this figure would have been much larger if not due to the green shoots recovery of 0.3% in France and Germany

In the next posting, I will discuss the potential downside risks towards recovery

Impacts Of Low Oil Price On Oil Exporting Nations

Perhaps the glorious days for Middle East are over-at least for the time being. Once, when oil prices were high, the mighty Saudi Arabia generated a billion dollars a day. Now, it has to contend with earnings around $700 million. That’s a collapse of 30% and considering the state of its economy which is not well-diversified, this is big money. Others like Oman and Bahrain felt the pinch more

We will consider the consequences both micro and macro

Impacts:

(1) Falling revenue. Since oil is a form of necessity with no close substitutes, it has inelastic price elasticity of demand (PED). As such, any fall in market price for oil will brutally hit their total revenue

(2) Lower producer surplus. It’s defined as the difference between the market price and the lower price these oil producers are willing to sell at. Since the market price has deteriorated from its high of $150 last year and now lingering around $70 per barrel, that is an enormous fall in producer surplus. However one could also argue that since the OPEC oil cartel can always cut the oil supply which they recently did, they can always manipulate the level of producer surplus from nose diving

(3) Difficult to increase output. Oil producing nations need to invest heavily on oil exploration, oil production facilities and R&D. Unfortunately, most of the funding is derived from oil revenue. With such a drastic collapse in oil prices, I’m uncertain if this will discourage oil companies from continuing the oil exploration process since the operating costs are very high too. If materialise, it is expected that oil supply in the near future may increase but at slower rate than demand. Given the supply of oil is inelastic, any increase in demand will quickly drive the oil price up and could be hazardous in a fragile economy

(4) Job losses. Governments in the region derive 75% to 95% of their income from oil exports. That shows that their economies are too dependent on oil and very thinly diversified at same time. There is no solid manufacturing or even services sector to back them up. As such, falling oil prices will begin to eat into employment and so oil engineers particularly will be the first to feel it. It has devastating effect considering the negative multiplier effect. In the end, an initial collapse in exports will bring private consumption and investment to its knee. More unemployment will result leading to even greater problems

(5) Shrinking economy. Simple AD-AS analysis. Collapse in oil exports, fall in investment rate and private consumption will mean that AD shifts leftward. As this happens, real GDP will shrink and therefore resulting in recession. Also, recession will usually lead to price deflation, a gruesome enemy. We have seen how the mechanics work on Japanese economy. However, one could also argue that this may not happen especially when the governments’ fiscal stimulus is effective enough to prevent the three components of AD from collapsing too much


(6) Fiscal deficit. Happens when government spending is in excess of what it earns from tax. In the current circumstance, fiscal deficit is almost inevitable since tax revenue from all sources like employment, corporate earnings, stamp duties, oil related etc fall. Simultaneously, the ambitious spending by some like Saudi Arabia and Dubai on construction projects and lucrative development projects aggravates. To balance the book, they definitely prefer oil prices to be higher than the current rate. Saudi Arabia and Kuwait while may face the danger of budget deficit, need not worry since these two have the biggest pile of cash reserves. It is those like Oman and Bahrain with smaller cash reserves and lower oil wealth which may face the spending wrath

High Sugar Price

Source:BBC

The price of sugar settled at 22 cents per pound as on Monday, a level which we have not seen since 1981. Again the fundamental cause can be explained via the interaction of demand and supply. As in this case, demand increases as Brazil intensifies its ethanol production which requires sugar

At the same time, supply decreases as one of the world largest producers, India is facing supply disruption due to unfavourable changes in weather. Its had less rain during the monsoon season. Sugar production from India fell 45% on a year-on-year basis from 2008-2009

Why Do People Earn Different Amounts?

Until now, there is no single dominant factor that is capable of explaining the gulf in pay that persists between occupations or even within the same occupation itself. Some of the relevant factors are explained in detail as below. In reality, however it is much more complicated as is often the combination of two or more factors

Reasons:

(1) Compensating differential. A popular economic term that relates wage rate to unpleasantness, risk and other undesirable attributes of a job. Technically, it is defined as an additional income that must be offered to motivate one to take up the undesirable job. A construction worker is most likely to receive a much higher pay than, say a cleaner or a clerk for the risk undertaken. They assume risk like falling off from building, industrial accident when dealing with machineries etc. Some IT officers especially system support, may have to work nights or other unsociable hours. As such they receive higher pay to compensate for this

(2) Education and qualification. Level of education should be a good discriminator of pay scale. If an individual who studies for degree receives a pay equivalent to a cashier having O-Level, there will be very few pursuing tertiary study. The logic is, there is an opportunity cost in terms of income lost when one spends more time studying regardless of full time or part time. So now they are compensated for it

Also, depends on number of years one has to spend. The longer it is, the higher the pay (ceteris paribus). For instance a lecturer with PhD earns more than an ordinary teacher. Similarly, a heart specialist earns much more than an ordinary doctor given the length of time adopted for training. The supply of labour from these highly skilled professionals are low and highly inelastic while the demand for their service is great. That accounts for the vast difference in pay

(3) Marginal revenue. Some people are able to command high salary as every economic transaction they involve in yields high marginal revenue. Consider professional footballers like C. Ronaldo and Beckham. They are central in every game. They influence the number of tickets and merchandise related to MUFC sold, fans base and probably to some extent shape the English premier league. Whenever Beckham advertises for Pepsi, directly or indirectly he influences people to drink Pepsi. As such the company generates unimaginable supernormal profit (MC = MR) and wouldn’t mind paying him millions for one advertisement

(4) Protection by trade union. There is empirical evidence that unionized workers receive better pay than those who are not represented. Although the number of trade unions has declined steadily both in UK and US due to the shift from manufacturing sector to services sector, the effect of their presence is much felt. Probably you have heard of United Auto Workers (UAW), United Steel Workers (USW) etc. The chief aim is to gather more voice and to have more negotiation power, namely collective bargaining

There are many ways to push up the salary. First, they try to increase the demand for the goods produced by union workers. For instance, USW once in early 2000s pressurised the Congress under Bush administration to impose tariffs on imported steel hoping that American industries will turn to ‘cheaper’ locally processed steel. Also they could decrease supply of labour to push up wage rate. Craft unions such as bricklayers and electricians have often adopted restrictive membership policies such as high initiation fees, long apprenticeship programs and limitations on union’s membership. Professional associations such as American Bar Association and American Medical Association also adopted similar practice

(5) Fringe and benefits. To some extent, it is true that some jobs may offer lower wages than others because they got more to offer to employees such as annual holiday, company cars, free life insurance, monthly gathering etc. These jobs are thought by some people to give lots of satisfaction and hence may be prepared to undertake without expecting high salary

(6) Immobility. Some people may be offered a hard-to-resist deal, but is in another area which could be far away from current residence. However, at the same time they value family, relatives and friends more than the pay. As such they reject they job. Also some people may want to move to a better-paid job but not able to do so since they cannot afford housing in new area. Consider receiving a pay which is just extra several hundred £ in City. Accommodation would be disastrous. Nevertheless high labour mobility does help to reduce differences in unemployment and wage rates in different parts of a country

(7) Imperfect information. Some people settle down for a lower pay because they do not know about better-paid jobs elsewhere. Meanwhile, people like fresh graduates although may not be able to demand for high wages, sometimes could end up doing a job which its pay is much lower than market as they were ‘misinformed’ that that is the pay they deserve being freshies. These two situations are called imperfect information

Why Supply Is Highly Inelastic In Short Run?

Source: economicshelp

Price elasticity of supply (PES) measures the responsiveness of supply for a good to a change in price. It is given by the formula of:

PES = (% of change in quantity supplied) / (% of change in price)

It is meant to determine whether the supply of a good is sensitive to price changes or not. The sign obtained from the calculation must always be positive due to the natural relationship between the decision to supply and market price. The higher the price the more will be supplied and the lower the price the lesser will be supplied. However, not all the time producers can be very responsive to market price. In this case the PES < 1. The interpretation is, a large change in price leads to a smaller than proportionate change in quantity supplied. In other word, say even with large increase in market price, producers will be unable to supply much

In real world, there are several items that fall into this. For instance supply of new housing, fresh vegetables and commodities (this may be arguable). Consider a property developer. Even if he receives the information that the area will be booming in nearest time, he will not be able to suddenly increase the quantity of houses and shop lots due to constraint in factors of production. He needs more time to hire necessary workers, obtain planning permission to enlarge the housing area, order raw materials and getting the right number of construction machines

In some extreme cases, PES could be 0 (perfectly inelastic). How is that possible? Yes it is, if we are considering a very immediate time period. Last week when I was in a hobby shop, I planned to get an item called Fallen from Transformers: Revenge of the Fallen and at that time I am willing to offer much higher market price due to its rarity. However I was told by the shop owner that next wave of stocks will arrive the following two weeks. This means, no matter what price I offer he will be unable to supply me that item. So his PES at that time was zero

In short, PES is largely concern with time frame under consideration. The shorter the time, the more inelastic is the supply and the longer the time, the more elastic it will be

Casino And Recession

The ‘Great Recession’ had claimed another casualty-MGM Mirage. It’s a powerful group of 20 casinos operating in Nevada, Michigan, Illinois, Mississippi and China. In the recent report, its quarterly profit ending June took a sharp dip with the lost of $216.2 million. This whooping figure is tantamount to a fall of 69%

Based on this statistic, gaming industry may be regarded as a form of luxury goods but an ‘extreme’ one, perhaps surpassing the income elasticity of demand (YED) in sports car industry, designers’ clothes, expensive handbags and shoes, foreign holiday etc. Even between these goods some can be ‘more luxury’ than others. Recall the formula of YED which is given by:

YED = (% of change in quantity demanded) / (% of change in income)

Being a luxury good, YED must be greater than 1. The relationship must be positive. This means, as income falls the quantity demanded for gaming will fall but GREATER THAN PROPORTIONATE. Consider a numerical example of (-28%) / (-10%) = + 2.8 and vice-versa

However, some may argue that a fall of 69% profit may not necessary related to the number of gamers and patrons of its premises. It could be due to other factors yet to be considered such as soaring fuel and food prices which increase its operating costs as well as other cost inefficiencies

How China Accumulate So Much Of Foreign Reserves?

Before 1980s, the Chinese economy was rather insignificant due to the establishment of herself as a ‘self-centered’ economy. In other word being a centrally planned economy where there was very little trading that took place, very few private enterprise and much of the economic activities were in the hand of the government. China conducted minimal trade with outside world by exporting just enough raw materials and simple manufactured goods to cover payments for the import of strategic minerals and other necessities not available back home

How it accumulate so much of foreign reserves then?

(1) Massive trade. The Chinese economy took a turn when Deng Xiaoping, the leader of the Communist Party of China became a reformer who transformed China towards market economics. It took place somewhere in late 1970s. This means unleashing the economy from the central grip by allowing private firms to grow, promoting international trade and encouraging the flow of foreign capital.

As at 1978, its foreign reserves stood at $1.6 billion. However by 1984 the figure whooped up to $17.4 billion. What an amount during that time and considering the accumulation within just 6 years. However by 1985 and 1986 the foreign reserves shrank to around $12 billion. Nevertheless it was a healthy indicator as China was importing capital goods like machineries to finance and expand its production capacity (outward shifting PPF) to meet the growing demand from outside. China’s major export destinations are like US, Hong Kong, Japan, South Korea and Germany. Since then, China’s accumulation of foreign reserves continues to mountain ‘abnormally’ especially with her accession into WTO (World Trade Organisation) in 2001. Countries like US being the world’s largest consumer, continues to buy from China due to factors like low production cost, improving quality and innovation but mainly due to the undervalued yuan. Amazingly China is set to topple Germany as the world’s largest exporter this year due to tumbling European economy.

(2) Inflow of foreign capital. The liberalisation of Chinese economy is one but out of many other reasons as to how it becomes the centre of attention. Large number, cheap and yet educated workforce is often cited as the top reason why increasing number of transnational firms are relocating or even outsourcing part of their production process in China. Of course there are other reasons too, such as tax-friendly policy, ease of obtaining certain natural resources and modern infrastructure. When foreign firms set up subsidiaries, factories or outlets in China the process is called inward investment. They will more often than not, raise capital from home country and bring it into China, especially new firms

In the recent, its foreign reserves had surpassed $2.13 trillion for the first time. However, it is not due to excess of exports over imports. This is as a result of foreign investors perceiving China as the world’s ‘safest’ haven in uncertainties like now. Its economy is estimated to grow by around 8% in the second quarter, indicating that the stimulus package seems to be working well unlike in other major economies. As foreign investors continue to pour money into Chinese stock market as well as property market. The Shanghai Composite Index surged has jumped over 74% alone in this year. There is also a fear that this will create a bubble in an already heating commercial property market. Much of these however are hot money. It refers to money controlled by investors who actively seek short term but high-yielding investment opportunities

As such it can flow out of the country anytime too. Therefore it could be highly unlikely for China to sustain its position of foreign reserves at such high level for long term

What Accounts For The Growth In Number Of Self-Employed In UK?

Self-employed people simply refer to those who work for themselves rather than being directly under an employer. The growth in the number of Britons who dumped their rat-race job increased dramatically during the tenure of Conservatives. Although the figure is now growing at a diminishing rate, nevertheless as a proportion of total workforce, it is somewhat significant. It is estimated that around 15% of Britons are now self-employed and more will join the rank soon

Geographically, Brighton, Belfast, Bristol, Southampton and London are the entrepreneurial hotspots

Reasons for growth:

(1) Great satisfaction. Perhaps this is the strongest argument. No matter how hard one works for others, he will never be rewarded proportionately with his effort. Suppose a person stays back everyday after the official working hour, he may be just given a decent allowance. There is no guarantee of increase in annual pay, bonuses and promotion and yet the opportunity cost in terms of quality time lost is much larger. This argument may not be that applicable to a sales person. However, being own-boss one could dictate what his business does and how to do it. If things went well, he will be rewarded handsomely for the value he created. Unlike sticking with a company, he will get small portion of the value he created for the organization. Lastly, he can’t be retrenched

(2) Recession. One of the reasons why self-employment peak in early 1990s was due to recession when UK locked herself into the Exchange Rate Mechanism (ERM). Interest rates were at historical high level, causing every level of economic activities to come to a standstill. Being unemployed for a long time period had forced the jobless to turn into self-employment

(3) Dying manufacturing industry. UK was once known as the ‘workshop of the world’ producing for more than 50% of global output. However, the importance of manufacturing sector to British economy is fast deteriorating. There are few explanations for this. First is the weakening of trade union since several laws that are in favour of employers were passed. Jobs are no longer that secure. Secondly, the rise in the standard of living has caused demand for services to continuously increase since it is income elastic in nature while manufacturing goods generally have lower income elasticity of demand. Lastly, the strength of pound and the emergence of low-cost Asian economies have caused UK to strongly lose its cost-competitiveness. More jobs are outsourced now. Similar with previous explanation, long run structural unemployment forced these people to go into self-employment

(4) Government policy. Various policies were put into action to jumpstart entrepreneurial activities. The government offers advice and gives grants to encourage people to start their own business. For instance in Budget 2008, the Labour government offered Small Firms’ Loan Guarantee Scheme (SFLG). A huge sum of money was also set aside to assist women entrepreneurs. Besides, revamp was made onto capital gains tax where the first £1 million of gains on business assets will be given a relief

Perfectly Inelastic Demand

Price elasticity of demand (PED) measures the responsiveness of demand for a good to a change in its price. It is given by the formula of:

PED = (% of change in quantity demanded) / (% of change in price)

We have 5 types of PED namely elastic in demand (price sensitive), inelastic in demand (less price sensitive) and perfectly inelastic in demand (NOT price sensitive at all)

The other two, unitary elasticity (PED = 1) and perfectly elastic in demand (PED = ∞) are true only in their mathematical property. In reality we don’t really come across goods and services that have similar percentage of change as its price (50% / -50% or -40% / +40%). The same goes for the latter. We will not come across situation where PED = 5000 (+50% / -0.01%)

For the discussion, I’m only concern with PED = 0. Many asked me if there is such good where it is not responsive to price AT ALL? The demand curve is vertical and as such parallel to price axis. The closest example to this will be collectible items or portrait of Mona Lisa. No matter how the prices change, people will only demand for one original portrait of hers because there is only one in the world

Another would be the case for organ transplant. No matter how low or how high is the price, a heart patient will only demand for one heart. So the demand curve stays put

Video Lesson: Production Possibility Frontier

A good reflection on time management. Students whom manage their time efficiently, should be able to produce along the PPF. Point outside the PPF is unattainable given the present state of resources, unless students have more time to prepare before exam, tuition teachers, more past year papers, more reference materials etc

Can A Good Be Both Substitute And Complementary Simultaneously?

A substitute good is a good that can at least partly replace the function of another. Examples desktop and notebook, butter and jam, Starbucks and Coffeebean, Krispy Kreme and Dunkin Donuts etc

A complementary good is a good that must be used in conjunction with another. For instance, whiteboard and marker, car and petrol, sugar and tea etc

Can a good fall into both?

Of course. Consider Alain Anderton and John Sloman economic textbooks. A student can regard both as substitutes. In other word, Alain Anderton texts can be as good as the latter and vice versa. However, to some students both can be considered as complement goods. The argument is that, some information may be available in Anderton but not in Sloman. Likewise the other way is true. As such, both must be used simultaneously to facilitate learning

For a teacher like me and many others who are keen on case studies, one textbook will never be enough. As such we have to make cross-reference. In a nutshell, it’s all about personal preference and to some extent different cultures. Other examples of goods that can fall into both categories are like French fries and burger, tutor2u and economicshelp (major economics reference for students in A-Levels), corn flakes and milk, white board and LCD projector screen during presentation etc

Why Mixed Economy Is Necessary?

Mixed economy is actually the hybrid of free market and command economy. In other word, under this economic system the both the private sector and government will play some significant roles in the economy. Perhaps this mould is the best and that’s the reason most countries practice it. To be truthful, there is actually no pure capitalist or socialist state in the world as dictated in most textbooks. Consider US and the super-scale financial intervention. Look at Cuba. There are various attempts every year by the communist government to crack down small enterprise

From the given example, why both private and public sector need to co-exist? Simple. To overcome the weakness of one another

Why mixed economy is necessary?

(1) Job security. Private firms exist for a reason and that is to maximise profits. They are very responsive to market. In the period of boom, strong demand for their goods and services will lead to rise in employment. In recession like now, companies will not tolerate excess labours as keeping idle workers will simply raise production costs. Therefore, it is said that private workers stand a higher chance to lose employment

Unlike the government, they have to adhere to strict labour acts and laws. For instance, every year a percentage of new employees have to be appointed. Workers with certain years of experience must be promoted. Since the aim is to maximise welfare, therefore chances are slim for anyone to get retrenched. In fact more people will be absorbed during this economic turmoil

(2) Avoid exploitation. Since private enterprise is profit oriented, basic human rights such as education and healthcare may be denied and restricted only to the very few capable. If this were to happen, the gap in the literacy rate and income inequality between the upper and lower social class will widen. To narrow the gap, government sets up various public higher institution and NHS

(3) Regulation of monopoly firms. A monopolist is defined as a single seller of a good or service in the market. Legally, a company is considered as monopoly if the control of market share is greater than 25%. This is a classic example of market failure. Prices are often higher leading to a loss of consumer surplus. Also since monopolists face lesser or no competition, there is lack of incentive to be cost efficient. To overcome this, government can liberalise the product market. It involves breaking down barriers to entry and making them more contestable-to encourage entrance of more firms. This will boost market supply, bringing down prices for consumers and increase competition, investment and productivity. The expansion of European Single Market which seek to promote free movement of goods, services, labour and financial capital help to expedite the process of liberalisation. Also in UK, there are regulators for privatised utilities such as Ofwat, Ofcom, Ofgem and ORR

(4) Economic policy. This is one of the biggest responsibilities for government. Politicians and state economic advisors oversee the economic conditions of a country. In a recession, government will almost inevitably pump more money into the public sector. The money goes to repairing roads and bridges, building schools and hospitals, enlargement of government departments etc. The main aim is to create jobs. Also almost all tax will be lowered to increase spending and buying power. The independent financial institution such as Bank of England will likely reduce interest rates to encourage people to borrow and spend. The private sectors are only keen with profits and not state of the economy such as level of unemployment and inflation (although they contribute to it). Secondly, there is no way they can overtake governments in terms of financial capability

(5) Regulation of water and air pollution. Private enterprise was long known as the environmental villain. In the pursuit of greater profits, factories continuously consume scarce natural resources, and then belching out smoke, pouring out liquid effluents and dumping hazardous solid wastes irresponsibly. As such producers are said to be only concern with their own marginal private benefits (MPB) and marginal private costs (MPC) in decision making. This is why government needs to intervene and perhaps set certain level of compliance. For instance, the UK government is committed to meet the global and European targets of reducing carbon dioxide emissions by 80% in 2050

The EU government also introduced the Emission Carbon Trading (ETS) scheme in 2002. This will help limit the carbon emission in key industries such as energy, steel, cement, glass, brick-making, aircraft etc. The implementation to certain extent has some positive externalities. Other countries have begun to introduce such measures too

(6) Narrowing income inequality. In an almost-pure capitalist state, widening income disparity is a norm with the rich getting richer and the poor gets poorer. With no government intervention, at the end of day, we will have pyramid income distribution. The richest few will control larger proportion of the nation’s wealth or GDP. Again with state interventions, income can be distributed. First is the introduction of progressive tax system. Richer people will pay greater amount of tax than the poor. Also the introduction of national minimum wage which increases every year in UK in line with average earnings, unemployment and sickness benefits can help to mend the situation

(7) Provision of public goods. Public goods have two characteristics. First is non-rivalry. This means the consumption or usage of that public good will not reduce the amount available for other users. Second is non-excludability. Once provided, no one can be excluded from benefiting it. Clearly, private enterprise is not interested due to the problem of free rider. It is a situation where some people clearly ‘free-ride’ on those who pay for it without they themselves contributing anything. In the end, no one will be paying for it. Hence there will be need for government to provide it out of taxpayers’ money. This include street lighting, national defense and roads (quasi public-good)

Opportunity Costs Everywhere

This term I’m teaching Unit 1: Markets-How They Work and Why They Fail as well as Unit 3: Industrial Economics. Both are for Edexcel syllabus. So do expect more posting than usual on these two topics

To begin with, I will briefly discuss about the concept of opportunity cost. It is defined as the value of next best alternative foregone. All economic agents such as consumers like us, companies of all size and government often fall into this. It happens due to scarcity of resources at one point of time. With the finite resources we have at our disposal we must know how to make the best out of it. Unfortunately, human wants are unlimited. As such, we are forced to make wise choice. Once we made our choice, our second best option is considered opportunity cost

Practical examples:

(1) Consumers. I must admit that I’m a great fans of Transformers robot and recently I spent a lot on these collectible items. Last week while I was in the store, I had about RM 250 (£43) with me and I saw two leader class figures which were Optimus Prime and Megatron and they cost RM 220 (£ 38) each. Clearly with the money available, I can only choose one. I picked Megatron. Hence my opportunity cost is said to be Optimus Prime

(2) Companies. At one point of time, a company may consider expansion outside its geographical area. However, with available reserves of profits or considering other factors such as rate of interest rate, it may only be able to choose one from the two. For instance, if Krispy Kreme is considering Malaysia and Indonesia, and ultimately in the end it chose the former, the latter is said to be the opportunity cost

(3) Government. With the worsening of budget deficit for British government, the greater will be its opportunity cost. More development projects such as the upgrade of infrastructure, road building, schools and hospitals in various parts of UK will have to be stopped. In other word, the state government will receive lesser allocation from central government, hence facing opportunity cost at every area. Or it could be a piece of medium sized land. The issue is to build a school or hospital?

Slower Posting

Dear fellow readers,

I will be back in active blogging from next week onwards. I'm extremely busy in these two weeks. College reopens and as usual I have lots of updating to do. However this time I'm revamping whole set of notes for my students

Cheers

Lawrence

Is Strong Dollar Good And A Weak Dollar Bad?

“The Euro has risen to record levels against the dollar”. “The pound sterling has risen to record levels against the dollar”. These are the common quotes that we usually bump into in any economic and financial headlines. What do these headlines mean? Do they matter to us?

Yes, of course. But it has different incentives onto different economic agents which we shall explore shortly. Basically weakening or falling of dollar against other currencies means the same. We need greater quantity of dollar to buy per unit of foreign currencies or a unit of dollar acquires lesser foreign currencies

Very often people are caught up with the idea that strengthening dollar is good and weakening dollar is bad. It is similar with the misperception that people usually have on current account. If deficit is bad but if it’s in surplus, then is good. To be honest there are both advantages and disadvantages to a strong or weak dollar with economic dangers lurking at either extreme

Here I’ll consider only the case of a strong dollar since the argument for weak dollar is just the mirror image

Advantages from a strong dollar:

(1) Lower price of foreign goods and services. With strong dollar, foreign luxury goods such as LCD televisions, handbags, shoes and sport cars from Western European countries which were once perceived expensive now seem to be more affordable. Even household goods such as food item, clothing and other necessities with inelastic demand can be bought in greater quantity. These two lead to rise in standard of living and is a great boost to welfare

(2) Cheaper to import capital goods. Rise of dollar is a good news for companies in secondary sectors. It will provide them an incentive to upgrade or replenish those old capital equipments with falling productivity. From medium to long term perspective, it should be able to increase the productive capacity of US economy. Aggregate supply (AS) will shift rightward. This is important to maintain its productivity ahead of major rivals like Germany, France, UK and Japan. Rise in productivity will lead to many things such as falling price level, increase in national output thus economic growth and lowering unemployment. Second engine of growth is necessary since US depends too much on private consumption to steer its economy forward

(3) Easier to borrow. When the greenback is strong, it is a sign that the US economy is ‘vibrant’. Yes, some may argue that the American economy is in a pathetic state like now, but it is worthy to note that other major economies suffer too. So, generally when all economies are sinking, capital and funds will flock to US which is perceived as safest haven

Sustaining the might of dollar is inevitable. Only by doing so, investors will be keen to continuously hold dollar assets. Dollar run will be minimised. US government will also find it easier to finance their ballooning fiscal deficit by issuing bonds. China and Japan, the two biggest ‘banks’ for US will be very glad to snap up those securities. There are two reasons for this. First both have large dollar reserves and secondly, they are heavily depending on American consumers to buy their goods

(4) Cheaper to travel overseas. Since the dollar is now appreciating against RM we would expect more Americans to visit Malaysia during this summer holiday. More local goods can be bought thus contributing to an increase in economic welfare. Voyagers can also stretch their budgets to include other activities that would have otherwise been foregone. Also more part time jobs will be created in tourism related industries such as airline, hotel, food and beverages and craft industries. It will have multiplier effect although the effectiveness may somehow be slightly muted with recession in US. So, it’s a win-win situation

(5) More affordable foreign stocks. It is not only the consumers that benefit from rising dollar as companies on an acquisition binge do so as well. With stronger buying power, foreign stocks or companies become cheaper in valuation compared to US based firms. This will likely spark a wave of increase in cross border transactions such as vertical, horizontal or even conglomerate integrations. American companies can look forward to expand the scale of their operations or eliminate competitors by buying them out

(6) Reduce inflation. Stronger greenback will reduce the risk of imported inflation. Raw materials and many other intermediate goods will appear cheaper, thus reducing overall production costs. Some of the cost saving may be passed on to end consumers in the form of lower price. Consumer surplus will increase then

Problems:

(1) Uncompetitive exports. This is a bad news for US manufacturing sectors. Stronger dollar against other foreign currencies will mean that importers now need more of their home currencies in order to exchange for the same US $1. American goods therefore become more expensive even when there is no changes in the actual price quoted in dollar. Demand for exports will fall in relative to imports. Current account deficit will worsen. Higher exchange rates will have different impacts onto different parts of the world. Japanese and Chinese government would most probably intervene to devalue their currency if there is an upward movement of yen and yuan against dollar. Meanwhile, for world’s largest manufacturer like German, there is nothing much it can do since the power to manipulate currency and interest rates is at the hand of ECB

(2) Outsourcing. US firms soon find it difficult to compete with local market in overseas due to uncompetitive reasons such as ridiculously high wages and high exchange rate. They will begin to outsource their production, mainly in emerging economies like China, Malaysia, Indonesia or Vietnam since labour costs are far lower and yet the productivity is high. If this happens, average Americans will lose their jobs when factories are shut. It may also lead to severe problems like regional unemployment, hysteresis and negative multiplier effect onto local supply chain

(3) Gloomy tourism sector. On average, US attracts more than 50 million tourists every year and the large influx is during summer. Popular destinations include New York, LA, Miami, San Francisco, Florida and many more. Most of these tourists are from European countries and Latin America. If dollar strengthens, most likely we will witness a fall in tourist arrival during this summer. American stores also expect to see their sales dip further compared to previous years

According to Commerce Department, about 90% of travellers make shopping their first priority and they generally spend more than local visitors. As such, it is not difficult to understand why their presence is important since it may contribute to increase in consumer and business confidence. Probably the US officials are banking on this when they announced that we will likely see a recovery by the 3rd quarter of 2009

(4) Lower overall profits for firms. Weakening home currency against the dollar means that any increase in sales revenue or profits will lead to nothing when repatriate to parent company in US

Krispy Kreme Agressive Expansion Outside US

Krispy Kreme was first founded by Vernon Rudolph in 1937. Since then, it went through a period of blistering expansion albeit facing some financial and operational difficulties in mid 2000s. The first store opened outside North America was in Sydney, Australia in 2003. Besides that, there are also franchise owned stores in UK, South Korea, Hong Kong, Indonesia, Philippines, Japan, Qatar, Saudi Arabia and the most recent one in Malaysia

Possible reasons to expand outside US:

(1) Increase supernormal profits. This is the most fundamental argument and it is also the reason businesses are set up for. Probably the management in North Carolina felt that there is not much space for further growth since most market has been tapped into. The argument sounds since they have been operating close at home for nearly 70 years. Their strongest market is within the Southeast. They even took a bold move to set up stores in Massachusetts, the backyard of its rival, Dunkin Donuts in 2003. Now it will have to choose to go international, since profits usually increase with the size of operation

(2) High income growth. Just before the credit crunch crisis, many countries in East Asia were experiencing a period of economic boom. This led to the creation of many middle income earners with higher appetite to spend outdoor, thus presenting a window of opportunity for Krispy Kreme to capture the market segment. In Japan, between the period of 2006 and 2007, we witnessed a fight-back of Japanese economy, although fragile but still a big market. Last but not least, the bull-run in oil prices have had a significant multiplier effects onto most Gulf Nation’s economy. Rise in income means rise in standard of living. People will want to consume more and desire for variation in goods.

(3) Strong competition in US. Although Krispy Kreme (KK) successfully enlarged its market share in US, still it is no match for Dunkin Donuts (DD). It loses out in many ways. First, its product is not well diversified unlike DD which serves bagels, breakfast sandwiches and now increasingly specialise in coffee. Many claim that its coffee is even better than those served in Starbucks. As such, it gained notorious reputation from industry observers as “coffee shop disguised as doughnut shop”. Besides, one would most likely purchase DD's coffee along with its doughnut (complement goods) though the taste is inferior to KK. It may not be economical to travel to KK to get the doughnut separately

Second, DD invaded the South with a different sort of doughnut which is thicker and cakier than the traditional Southern treat which is lighter and sugar-glazed. The attempt to break KK customers’ loyalty seems to work. Last but not least, DD’s research team had successfully cracked a code in doughnut production. Now it is almost trans-fat free and yet its original taste is preserved, something that Americans desire for in the light of increasing health awareness. Unfortunately, KK made the discovery a little too late

(4) Minimise losses. KK faced a series of financial and operational difficulties earlier. Its share price and profits skyrocketed after listing in 2000 but crashed in 2004 after its shareholders filed a lawsuit. Its reputation also tarnished with investigations alleging it engaged in faulty accounting. Nosediving share performance will make it hard for them to raise sufficient capital for investment in US. With limited capital, therefore it only makes sense it they choose to operate in a low-cost economy. Besides, it can also help KK to offset its financial losses in home country

(5) Create brand awareness. To be honest, I’m not a great fan of doughnut due to health-consciousness. As far as I’m concern, I have seen Dunkin Donuts all over here in Malaysia, from pump station to even hypermarket. But, I just got to know about the existence of Krispy Kreme lately, when its first store was opened in April and I heard that it went well with the locals here. Those who work nearby now frequent it daily after having their first-bite on the original glazed

Between National Debt And The Raise Of Retirement Age In UK

Although there are ‘green shoots of recovery’ in many of the Western OECD economies, rest assured the worst nightmare is far from over. The present credit crunch crisis although has done sufficient damage to world economy, sending prestigious financial institutions six-feet under and denying many people to employment will appear to be nothing more than a blip. The real fiscal headache will be the ‘permanent’ unbalanced equation of national debt and retirement of baby boomers

Think about this. The birth rate in many developed economies has slowed markedly and some had even fallen into negative territory like Italy and Japan, just to name a few. With declining number of young adults entering the job market, tax revenues (income, corporate, VAT, stamp duties etc) will inevitably fall. At the same time, increasing number of people is entering into their twilight years means governments have larger fiscal responsibility of paying out pensions and social benefits. The issue is where to get the needed financial resources?

One thing for sure, governments cannot forever rely on the issuance of bonds to finance these spending. Besides, much had been borrowed in recent months to bail out inefficient banks, assuming responsible of toxic debts etc. These had already caused the national debt to inflate further

Arguably many developed economies are accused of hiding the real level of national debt. Take UK for instance. The reported current level of national debt is quite close to 50% of GDP. But if we were to include all the pension liabilities, the whopping figure is around 103% of GDP

Policymakers address that the most possible solution to this is by extending the working lives of British people, unpopular but the best of a bad lot

Should retirement age be increased?

Yes:

(1) Alleviate shortage of skilled workforce. It is increasingly difficult to substitute a skilled worker who is retiring. Supply of skilled labours is highly inelastic. In other word, even a large increase in wages may bring about a less than proportionate increase in number of people offering themselves into the profession. This is because many years may be needed for the field such as medic, specialist doctor, lecturers, and financial advisors with ACCA or CFA qualifications etc. In short demand outstrip supply which largely explains why they are handsomely paid

(2) High productivity. Generally, skilled employees with seniority are perceived as having higher productivity (output per worker) compared to young ones. This is so, after years of repetition and specialisation. It can come in many forms. They execute decisions efficiently, produce greater number of As or publish more research articles per year, cure more patients, getting more corporate clients etc. Shall these skilled workers go into retirement, the operation and profitability of a company may be jeopardised

(3) Reduce national debt. The beauty of raising retirement age from budget standpoint is that, it raises revenue and at the same time reduces spending. As more Britons are working, there will be a continuous inflow of income tax revenue, at least for now. Having an income, people will continue to spend into the economy. Demand for more goods will hence ensure VAT and profitability of private sectors will contribute to more corporate tax receipts. Government’s commitment on pensions and various social benefits will automatically go down. If this policy is executed immediately, UK may once again get the debt back to the old ceiling of 40% of GDP, set by Gordon Brown

(4) Closing the savings gap. Perhaps this is the strongest argument of all. Over the years, households’ savings ratio in UK had fallen dramatically especially after UK took an exit from the ERM (Exchange Rate Mechanism). There are several reasons for this. First, UK people tend to have high marginal propensity to consume (mpc) by culture. This means, as their disposable income increase, large proportion of it will be devoted to consumption. Secondly, period of low interest rates and high inflation in early 2000s have discouraged savings due to the effect of negative real interest rates (nominal interest rates – inflation rates)

Up to date, many Britons actually do not have sufficient means to have smooth sailing throughout their twilight years, especially when life expectancy have increased. By making them retiring at 70 years of age, actually provides them the ‘second’ opportunity to accumulate more wealth. This policy helps to reduce the gap of what they currently save and what they would actually need to save for a comfortable retirement

Arguments:

(1) No end to increase in retirement age. Institute economists think that UK’s national debt will increase to 100% of GDP by 2015 before gradually coming down to 90% in 2023. However, the forecast may not be reliable as it assumes that this figure is within reach so long as there are no major disruptions to the British economy. What if there are external shocks such as another form of financial crisis, oil price bubble and the debt default explosion originating from Eastern European economies? Are we going to see more bailouts after this?

One thing for sure, UK can no longer tolerates another round of ‘Great Recession’, not at least for few decades (which is quite impossible). Otherwise, the government will again have to spend itself out of recession and entering into an uncharted territory of debt. Probably by that time, retirement age will have to go up to 75 years

(2) Public shouldn’t be held responsible. The late retirement fiasco aggravates once again due to the sudden hike in national debt, after series of effort to bailout RBS, Northern Rock and other inefficient bank. The present Labour and future government hence face greater fiscal constraint, having to pay for pensions and social benefits besides other productive public spending. Hence raising retirement age to 70 years old is one of the methods to ease government finances at the meantime. However, this policy has come under severe attack. Critics argue that government shouldn’t have sacrificed the welfare of millions by denying their rights for earlier retirement. Besides, why must the public be responsible for the wrongdoing of banks?

(3) Graduates unemployment. Setting such high retirement age will also deny fresh graduates from employment opportunities. This often breeds hysteresis, a situation where one finds it increasingly difficult to secure a job after being jobless for a long time period. It eventually leads to many other problems such as social ills, self degradation and lost of confidence, lost of skills and becoming even more unmarketable. Rest assured that UK’s unemployment will probably be as high as in France, Germany or even in Spain if we allow this to happen

(4) Exacerbating recession. Late retirement will exacerbate recession. As the ceiling is set at 70 years, it is expected that many people who retire slightly before the age of 65 years will re-enter the job market, thus creating competition. Increase in the supply of labour will drive down wages, something that employers will always cheer about. They may want to consider expanding their operations since production costs have fallen, leading to an increase in goods and services. However, the demand is not there since there is a fall in purchasing power accruing to lower wages. Nevertheless, there are many arguments for this

(5) Other ways to reduce spending. Again, the retirees must not be victimised. There are in fact many other ways where the government can pursue to reduce its budget deficit. For instance, give priority to development projects that have been identified to be truly beneficial in long run and not ‘pet projects’. Government must also introduce effective mechanism to reduce leakages and corruption or considering an increment freeze in public sector pay for two years

(6) Disproportionate burden on lower income group. Most of the increase in life expectancy made in recent decades has been among higher income workers who can easily gain access to good food, nutritional needs and personalised healthcare. Hence it is an easy say for well-paid elite to contemplate working up to 70 years old or more. For ordinary folk doing manual jobs which strained them physically without rewarding them financially, very often have to enter into early retirement. Hence, making it ineligible to claim for pensions and other benefits before 70 years old will create a vicious cycle of relative poverty

Video Lesson: Obama On National Debt

Obama gave his public speech on the issue of unsustainable national debt. Although the video was made last year, nevertheless the content of the discussion is very much relevant to where we are today

Video Lesson: Reducing National Debt In US

Big Crack In Central & Eastern European Economies

Following the collapse of Soviet Union and Stalinist states, Central and Eastern European Countries (CEEC) provided global capitalism superior access to its cheap labour and raw materials. The recession that plagued many of the Western economies in 1990s had caused influx of capital into the former Soviet states as multinationals seeking to reduce costs by locating in a newly opened up and low tax areas

Giant car companies such as GM and Volkswagen had invested hundreds of millions of dollars into new factories not withstanding the much higher cost of operating in home country due to strong trade unions and legislations favouring employees. In short increasing number of firms around the world is looking at CEEC as a manufacturing hub that have great potential to become the ‘second China’. This together with the European Union (EU) enlargement in 2004 provide rock solid argument for high growth experienced by these economies in the recent few years

Nevertheless, these Central and Eastern European economies had become far too dependent on credit from international market

Problems:

(1) Deepest cut. This round of recession is the first major downturn since the post-communist chaos in 1990s. As mentioned earlier, these emerging economies of Europe have become highly dependent on financial flow especially from richer Western European countries like Germany, France, Austria etc. However, due to unmanageable recession time bomb and credit crisis from those financiers, there is a severe reversal of inward investment, putting an immediate end to its growth. For instance, President Nicolas Sarkozy was under fire lately for his attempt to cut jobs in the car production plants in Czech Republic and ‘bring home’ some of those jobs to kick start local economy

Besides, Czech Republic together with Hungary and Poland are poised to suffer an economy contraction of more than 5% this year. This has something to do with the underlying structure of these economies. More than 50% of their national income is derived from export activities to richer Europe. Their reliance on exports far succeeded Germany, US and China

(2) Rising unemployment. The jobless rate in these emerging economies of Europe increase as fast as they fall. Again, consider countries like Poland and Czech Republic which have become major centres of manufacturing for the EU market. Over the years, the boom comes from the development of car production plants, electrical equipments and household goods for Western Europe. With ailing demand, many of the labours together with those from other related industries are no longer needed. Not to forget, the economic misfortune of large economies like UK, Germany and France have forced many migrants to return home, thus pushing the jobless figure higher. From the positive note, there will be downward pressure on wages which could be good news to employers

(3) Ballooning fiscal deficit. As level of unemployment increase, income tax revenue falls. Marked slowdown in economic activities automatically reduces corporate tax revenue and VAT. Falling number of property transaction reduces stamp duties. However, the governments at the same time have to pump in more money. Schools, hospitals, construction of roads and bridges are expected to kick start soon to offset the fall in exports and private investment. One must also not forget the extraordinary amount money involved in bailing out failed financial system. In near future, commitments towards the baby boomer generation will be an added burden. Together this means unimaginable budget deficit

Many of these Eastern and Central European economies will soon fall into a deficit-trap like UK- big and ‘irreversible’ sudden rise in public spending. Why? Because, it is politically sensitive and unpopular to cut spending even when the economy may have recovered. Given the nature of these fragile economies many would probably face the crisis of confidence and servicing the national debts is utterly painful

Current account deficit in Baltic states

(4) Depreciating currencies. Perhaps, this is the most dreadful ill of all. Under normal circumstance, weakening exchange rate should be able to boost the export market of Eastern and Central European economies. This is because, lesser euro is required to purchase a unit of say, forint. In current situation, their source of demand has dried up. Fiscal deficit and current account deficit are widening, therefore triggering a fall in confidence towards an already fragile economy. Investors no longer keen to hold these currencies, hence began dumping them in foreign exchange market. Simultaneously, massive capital flight and fall in inward investment further belittle all efforts to maintain the currency within a reasonable range

Therefore, debt servicing in these days have become increasingly difficult especially for countries like Hungary and Poland. Going default seems to be imminent when both forint and zloty fell more than 30% against euro. There are contagion worries to Western European countries like Germany, Sweden and Austria which have more than $1.7 trillion of loan exposure to CEEC. A collapse like this will create another version of Asian financial crisis (1997-1998), but three to four times worse

Fall of house prices in Latvia


Fall of house prices in Estonia

(5) Asset price deflation. The housing markets in the Baltic States have many similar traits with those in UK. Due to highly successful economic reform, enlargement of EU in 2004 coupled with the doubling of income per capita, increasing number of people in countries like Latvia and Estonia have shown great interest in storing their wealth in property market. In such a short period, asset prices skyrocketed in Latvia due overwhelming demand and shortage of supply. Between 2004 and 2007, house prices tripled or even quadrupled in Latvia capital city, Riga. This explains why Latvia is the fastest rising economy in Europe

However, the recent housing market crash of Latvia is a painful one and probably not only the worst in Europe but also in the world. One of the main reasons for collapse is due to the pegging of Latvian lat to euro. With series of hike in interest rates by ECB throughout 2006 and 2007, Latvian mortgage rates rose disproportionately as pressure on the peg rose. Latvian variable rate mortgages peaked at 14.7% by end of 2007, creating the highest level of default in history of housing market. Until today, situation seems to be much worse as banks are reluctant to lend or extend credit. Rising unemployment and oversupply of houses are putting more pressure on the price

(6) Currency pegging. The Baltic countries (Estonia, Lithuania and Latvia) which have expressed their interest to adopt euro at later stage, chose to peg their currencies against it. Recently, officials from these three countries have vowed to protect the peg at whatever cause. However, based on previous experience, chances are the costs outweigh the benefits of doing so. The Baltic members are highly likely to go through the same experience as UK which entered into the ERM (Exchange Rate Mechanism). Expected prolong recession is likely to trigger a continuous attack on local currency. This will cause drainage to foreign reserve

Latvia for instance had spent more than $1 billion last year to defend the peg, in which inevitably it turned to IMF to seek further assistance of $9.6 billion. In return, it is allowed to retain the peg but required to cut wages, raise taxes and reduce public investment which will jeopardise the state of its economy in longer term. Probably its other two neighbours are likely to follow suit in near future

That’s not all. In fact CEEC economies have some other distinct problems such as increasing number of ageing population, widespread of relative poverty etc which I’ll cover in some other posts