Fiscal policy
In Ausiralia, liscal policy is decided by the government ol the day at the national, state and local level, the most involved being the Commonwealth government located in Canberra. The Treasury is in charge ol all budgetary matters, and the Treasurer usually proposes an annual budget to parliament in May each year. Sometimes, liscal decisions are made outside ol the annual budget cycle.
Figure 1.3 presents the liscal balance ol all levels ol Australian government, Irom 2004 to 2009. Ai the time ol writing (October 2008), the 2008-09 outcome was not known. However, we have made a rough forecast lor that outcome based on statements made by the Rudd government in September and October 2008 in the heat ol the global financial crisis.
Over the last decade, the liscal balance has been in surplus al an average ol just above 1 per cent of CDP. The world and the Australian economy had been growing fairly consistently, apart from a minor slowdown in 2001. World commodity prices had shot up, and Australian exporters of commodities earned large profits, which led to significant tax revenues lor the government. The Australian government wisely used this good fortune to ain liscal surpluses, lirsl eliminating its debt and then building up a Future Lund of government net assets. But these good times seemed to have ceased ai the end of 2008.
The Rudd government made a number ol announcements in October 2008 indicating that it was prepared to change course and reduce the surplus. Given the grave risks from the fallout on the real economy globally from the linanciai crisis, the government was prepared to increase its net spending. First ii declared that it was prepared to guarantee the deposits ol all Australian banks until 2011 (although a lee will be charged lor deposits exceeding $1 million). II no Australian banks become insolvent in that period, the government will make a profit. But there is surely some risk ol some collapses, in which case the fiscal bottom line will suller. Second, the government announced specific new spending plans ol $ 10.4 billion about I per cent ol GDP) that included $4.8 billion for pensioners, $3.9 billion to low- and middle-income families to support childcare, and $1.5 billion for first-time home buyers. As a rough forecast, we show the 2009 fiscal surplus falling by more than I per cent of GDP. However ii could easily be a deficit, il output slows and il commodity prices fall further, since these would hit tax revenues.
After a sequence of large fiscal surpluses, the government changed course in late 2008. and the announcements made make it likely that the surplus will all but disappear. SOURCE-RBA Bulletin,Ell.
This about-face in fiscal policy is a rational response by the government to try and check the potential negative macroeconomic effects ol the crisis. Will it be enough? We can't be sure. We will discuss this issue at length throughout the book.
There is every chance that this linanciai crisis will have an eflect tor a tew years at most. Into the longer term, Australia has to consider issues surrounding its productivity growth and its external accounts.
Is productivity growth high enough for the longer run?
Productivity growth is an essential ingredient in making everyone belter off. We will measure it as the rate of growth of output of the average worker. If workers on average are able to increase how much they produce, the economy is likely to be better oil.
figure 1.4 plots the rate ol growth of output per worker in Australia since 1950. (Output per worker is also called productivity; the rate of growth ol output per worker is called the rate of productivity growth.) We show in the figure a five-year moving average of productivity growth, for example, the 2008 measure ol 0.9 is the average of actual productivity growth in each year from 2004 to 2008. It is therefore a longer-run measure.)
A look at the figure suggests two conclusions:
• Although growth rates vary a lot from year to year, it appears that, starting at 1974, there was a decrease in the average rate of growth ol output per worker (represented by the dashed horizontal lines), tailing irom 2.3 to 1.2 percent. After picking up in the 1990s, productivity growth began a steady descent in the 2000s, averaging 0.9 per cent. Ignoring the 1990—91 recession, it reached its lowest level in 2008 in more than nearly sixty years. This is a worry as we look toward.
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| 3 n. 3 о |
| A TOUR OF THE WORLD chapter I Figure 1.3 Fiscal surpluses in Australia. 2004-09 |
• Maybe we mis-measured productivity growth by subtracting employment growth from output growth. Australia has seen a signilicant increase in the share of part-time workers in jobs. A better measure may be to subtract the growth of the total number of hours worked in Australia. That productivity growth measure is also shown in Figure 1.4, but only from 1985 due lo data availability. The story it tells seems to be very similar, even if its average growth rate was twice as high in the 2000s. Its trend is also definitely downwards in the 2000s.
The underlying average rate of growth of output per worker decreased in the mid-1970s. It fell again in the late 1980s to a low point in 1991 when Australia was in recession, only to recover fast during the 1990s. Since 2001, it has continuously declined to below I per cent Productivity in terms of hours worked was higher per worker in the 2000s due to the increased proportion of part-time workers in Australia (now 15 per cent).
| If the growth rate of ► output per worker had been 0.11 per cent higher from 1974 to 2000 (for 27 years), the level of output per worker would have been (I.OII)27- I =35 per cent higher than it actually was in 2000. In addition, if it had been higher by 0.14 per cent from 2001 to 2008 (for seven years), it would have been (1.014)7-I = 10 per cent higher. Adding these, the level of output per worker would have been 35 + 10 = 45 per cent higher in 2008 than it actually was. |
SOURCES: 1950-60: Paper by Budin (RBA. 1977): 1961-2005: ABS. cat. nos 1364,6291. RBA G10.
A difference in the average growth rate of output per worker of 1.1 per cent per year from before 1974 to after 2000 and by 1.4 per cent from 2001 to 2008 may not seem like much—but it is! Think about it in this way: if the average growth rate of output per worker had remained the same after 1973 as it had been Irom 1950 to 1973 (2.3 per cent), then output per worker in 2008 would have been 45 per cent higher than it turned out to be. Other things being equal, the same would have been true of output per capita, what economists call the standard of living. The Australian standard of living would have been 45 per cent higher—a substantial difference.
By the same argument, if the decline in the rate of growth of output per worker continues, Australia's standard of living in the future will not increase as much as it has. This is a longer-term issue that policymakers in Australia have to address. The government needs to have a strategy to raise the productivity growth ol workers. This is an issue we will look at in Chapters 10 to 14.
Is Australia's current account deficit a problem for the longer run?
A country's trade account measures the difference between export and import revenues Irom goods and services in a particular year. If imports exceed exports, the country runs a trade deficit. If you buy more goods than you sell, then your spending exceeds your income, and you must make up the difference by borrowing. Exactly the same thing is true of a country. To pay for the trade deficit, the country has to increase its borrowings from the rest of the world. This in turn increases its net foreign debt, and in luture years it has to pay interest on that. When you add those interest payments to the trade account, you get the current account.
| ~i---- 1---- 1---- 1---- 1---- 1---- 1---- Г 1950 I9SS I960 1965 1970 1975 1980 1985 1990 1995 2000 2005 |
| Figure 1.4 Rate of growth of labour productivity in Australia from 1950 to 2008 (five-year moving averages) |
Figure 1.5 shows Australia's trade and current account as a proportion of GDP since 1996. Both accounts have been in deficit for most of the period. The current account has been getting worse over time, reaching 6 percent of GDP in 2008. In 2008, Australia had to borrow the equivalent ol 6 percent of its GDP. I his is a large amount. 7 hese numbers worry many economists, who believe that the trade account, the current account and net foreign debt in Australia are likely to worsen.
| Trade account
Current account -7 - |
A TOUR OFTHF WORI.D chapter I
Figure 1.5 Australia's trade and current accounts as a proportion of GDP since 1996
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-8
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| 1996 |
| 1998 |
| 2000 |
| 2004 |
| 2006 |
| 2008 |
2002
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Australia's сurrent account deficit reached 6 per cent of GDP in 2008. SOURCES: ABS. cat. no. 5302; RBA 6u»«.n.Tabic G12.
Why the worry? Think what might happen i( global financial markets go into crisis with a credit Ireeze, as we saw in late 2008. Australia would find it harder and costlier to borrow the necessary 6 per cent of its GDI'. II the sentiment in global markets was that Australia was struggling with raising such large borrowings, foreign investors in Australia would quickly move their funds out of Australia, which would lead to a collapse in the Australian dollar on foreign exchange markets.
Let's see what has happened to the Australian dollar in recent times. Figure 1.6 presents the Australian exchange rate. The figure shows the exchange rate with the US dollar (US$)—how many LIS dollars you could get for one Australian dollar—as well as the exchange rate with regard to all other country currencies weighted by the proportion of trade that Australia conducts with each country. This latter exchange rate is sometimes called the trade-weighted index.
There are two important features of this figure.
• There is very little difference in the recent behaviour of the US$/A$ exchange rate and the trade- weighted index. This doesn't mean that the United States is Australia's main trading partner—it isn't. What it tells us is that many of Australia's trading partners (largely Asian countries) have been keeping their exchange rates more or less constant, or even fixed to the LIS dollar. This is why the performance of the US$/A$ seems to be crucial to the Australian economy. In recent years, whenever the LIS dollar appreciated, the Australian dollar depreciated with regard to all its trading partners.
• In 2001, the Australian dollar was at an historic low relative to other currencies. From 2002, il began to appreciate, and by August 2008 it had reached heights not seen in more than twenty years. In September and October 2008, with the onset ol the global linanciai crisis, it fell a massive 20 per cent in just two months.
Big movements ol exchange rates are surely not good, because they can seriously disrupt peoples plans. But is a high exchange rate or a low exchange rate good for Australia? There is no easy answer to this.
I he very strong Australian dollar in August 2008 was good for importers but bad for exporters. The collapsed exchange rale in October 2008 would have pleased exporters but not importers. It should eventually lead to higher export demand for our goods, and that may indeed help Ausiralia by lessening
| 0.95 |
| 0.85 |
| 0.75 - |
| 0.65 - |
| 0.55 - |
| Trade-weighted index (right scale) |
| ----- 1------- 1------- 1------- 1----- 1— 2000 2001 2002 2003 2004 2005 |
| —i--------- 1— 2006 2007 |
| 45 |
| 2008 |
| 1Л D |
| 0.45 |
Figure 1.6 The Australian dollar since 2000
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From an all-time low in 2001, the Australian dollar appreciated gradually until August 2008, and then collapsed about 20 per cent in two months. SOURCE: R3A 8u//etm.Tab!c FN.
the negative macroeconomic ellects ol the expected global downturn in 2009. On the other hand, what Australia imports will be more expensive. For example, it will raise the A$ price of oil, which will hurt consumers as well as raise firms' costs. So il is not easy to decide what the right exchange rate is. We will look at this issue in more detail in Chapters 19 to 21.
Since the Australian economy is so dependent on what happens in the United States, Europe and China, we now visit these three economic superpowers.
1.2 THE UNITED STATES
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| Figure 1.7 The United States. 2008 |
Output: US$ 14.1 trillion Population: 305 million Output per capita: US$46,300
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SOURCE: CECD Main Economic Indicators. Map printed courtesy of maps.com.
| Trade account
Current account -7 - |
Л TOUR OFTHF WOR1 D chapter I
Figure 1.5 Australia's trade and current accounts as a proportion of
GDP since 1996
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-8
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| 1996 |
| 1998 |
| 2000 |
| 2002 |
| 2004 |
| 2008 |
2006
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Australia's current account deficit reached 6 per cent of GDP in 2008. SOURCES: ABS. cat. no. 5302; RBA Bu/tetm.Tablc GI2.
Why ihe worry? Think what might happen if global financial markets go inlo crisis with a credit freeze, as we saw in late 2008. Australia would find it harder and costlier to borrow the necessary 6 per cent of its GDI' It the sentiment in global markets was that Australia was straggling with raising such large borrowings, foreign investors in Australia would quickly move their lunds out of Australia, which would lead to a collapse in ihe Australian dollar on foreign exchange markets.
Let's see what has happened to the Australian dollar in recent times. Figure 1.6 presents the Australian exchange rate. The figure shows the exchange rate with the US dollar (US$)—how many US dollars you could get for one Australian dollar—as well as the exchange rate with regard to all other country currencies weighted by the proportion of trade that Australia conducts with each country. This latter exchange rate is sometimes called the trade-weighted index.
There are two important features of this figure.
• There is very little difference in the recent behaviour ol the US$/A$ exchange rate and the trade- weighted index. This doesn't mean that the Llnited States is Australia's main trading partner—it isn't. What it tells us is that many of Australia's trading partners (largely Asian countries) have been keeping their exchange rates more or less constant, or even fixed to the LIS dollar. This is why the perlormance of the LJS$/A$ seems to be cmcial to the Australian economy. In recent years, whenever the US dollar appreciated, the Australian dollar depreciated with regard to all its trading partners.
• In 2001, the Australian dollar was at an historic low relative to other currencies. From 2002, it began lo appreciate, and by August 2008 it had reached heights not seen in more than twenty years. In September and October 2008, with the onset of the global linanciai crisis, it fell a massive 20 per cent in just two months.
Big movements of exchange rates are surely not good, because they can seriously disrupt people's plans. But is a high exchange rate or a low exchange rate good for Australia? There is no easy answer to this.
The very strong Australian dollar in August 2008 was good for importers but bad for exporters. The collapsed exchange rate in October 2008 would have pleased exporters but not importers. It should eventually lead to higher export demand (or our goods, and that may indeed help Australia by lessening
A TOLR ОГ THt WORLD chapter I
The United States is the leading economy in the world, with more than US$14 trillion output in 2008. giving an average standard of living of US$46,300 (US$5,000 more than Australia in I'l'l' terms .
The hasic numbers tor the US economy arc given in Table 1.2. The format of the table is the same as Table I.I. As in Australia, from an economic point of view there is no question that the past decade has been one ol the best decades in recent memory. Look at the column giving the numbers lor the period 1996 to 2006:
• The average rate of growth was 3.4 per cent per year, substantially higher than the average growth rate since 1970.
• The average unemployment rate was 5.0 per cent, substantially lower than the average unemployment rate since 1970.
• The average inflation rale was 2.0 percent, substantially lower than the average inflation rate since 1970.
Growth was not high in every single year: in 2001. ihe LIS economy actually went through a short recession—a decrease in output. But lor the period as a whole the LIS economy had an impressive performance.
In the recent past, however, the US economy has slowed down Growth reached only 2.0 per cent in 2007, worsened to 1.5 per cent in 2008, and is projected to be a poor 0.5 per cent in 2009. It may even be worse!
Most believe that the risk ol a recession is extremely high. Back in February 2007 Alan Greenspan, < Alan Greenspan was the previous chairman of the Federal Reserve Board ' the US central bank, known as the 'Fed') and a very chairman of the Fed influential economist, put the probability ol a recession in 2007 at one-third. He was one of those who from 1987 to 2005 He believed that a recession was likely because ol what was happening in the housing sector: housing has Ьее" геР|:1Се^ by construction, which was very strong until 2006, had slowed down sharply. Housing prices were Ben Bernnnl
macroeconomist from
demand: as housing prices fall. consumers will feel poorer and reduce their spending. The Fed believed ^ whe^Greenspari'made that if this happened the decrease in demand, from lower housing construction and lower consumption hjs be||ef known it|ed demand, might lead to a recession. t0 a dccline in nock.
Others were more optimistic. The decline in housing prices had been limited, and consumers had market prices of more not yet cut their spending. Thev thought that even il housing prices led to lower housing construction t^3" 3 per cent in one and lower consumption, the Fed could decrease interest rates to stimulate demand and avoid a recession. This is indeed one of the major responsibilities of the Fed and it is something it has done in the past. But monetary policy is not a magic bullet. In early 2001 feeling that the economy was slowing down, the Fed aggressively decreased interest rates down lo I per cent lo stimulate demand. This was, however, not enough to avoid a (small1 recession,- but the recession would have surely been deeper and longer in the absence of the decrease in interest rates. However, the side-effect of this aggressive action was to set off one of ihe biggest housing and credit bubbles in history.
It turns out thai the pessimists were right. By 2008, the bubble was set to buret and did. The housing sector problem in 2008 had much wider implications than expected. The fall in house prices didn't just
| Table 1.2 Growth, unemployment and inflation in the United States since 1970
|
| SOURCE- OECD Economic Outlook Database. |
reduce the wealth of consumers. It exposed fundamental weaknesses in the architecture and regulation of housing finance. These weaknesses spread from the failing sub-prime mortgages on urban streets to related mortgage assets on Wall Street, with many famous financial institutions descending towards insolvency. Share prices began collapsing, and banks dramatically curtailed their lending to conserve their diminishing capital. The financial panic spread across the world, and the global financial crisis was on lor all money.
The developing crisis to October 2008 is certain to have real eflects on the economy going into 2009. Not only consumption but more importantly real investment expenditures were being allected, reducing demand and therefore output. With output slowing right down, unemployment is expected to soar to 6.5 percent in 2009. It will also mean much lower pressure on prices, and so inllaiion is expected to fall back to 2 per cent.
The Fed and the US Treasury realised the gravity of the situation, and arranged a series of responses. For example, as you saw in Figure 1.2, the lederal lunds rate was pushed down to 1.5 per cent in October. The Houses ol Congress approved a US$700 billion bill to insert public capital into bank balance sheets to help banks recover Irom the crisis. The idea ol these initiatives was to restore confidence in the system, so that normal business could resume. How long it will take to restore normality, nobody knows. Whether we will see an economic slowdown or a recession or even a depression, nobody knows tor sure. Problems involving a loss ol confidence and trust are hard to predict. When you read this, you will have a good idea ol how serious this crisis was in 2008. (We will have a lot more to say about this linanciai crisis in Chapter 22, where we discuss its analytics and provide specific details about its origins in the US sub-prime mortgage fiasco.)
Looking beyond the short mn, however, there are two other issues that macroeconomists worry about in the United States. These are the same issues as we discussed for Ausiralia.
The first concerns productivity. High output growth in the United States in the past decade has come largely from high productivity growth (even more so than in Australia). A crucial issue is whether we can count on productivity growth remaining high in the future.
The second concerns the trade deficit. Since the mid-1990s, the trade deficit ol the United Slates has steadily increased. The trade delicil is now very large as a proportion of output, and a crucial issue- is whether this can go on and for how long.
Let's discuss both of these issues in turn. Has the United States entered a New Economy?
The strong performance ol the US economy in the second hall of the 1990s led many people to argue thai ihe Llnited States had entered a New Economy, in which it could sustain high growth, low unemployment and low inflation forever. Many of the New Economy claims had no basis in tact and have proven empty. Recall, for example, ihe claims ol some ol the dot-com companies whose share prices rose to astronomical heights, only to collapse in the early 2000s. One claim, however—the claim lhat the LIS economy had entered a period ol laster technological progress and therefore that higher growth could be expected in the future than had occurred in the past—is more plausible and worth examining.
The way to examine this claim is to plot the rate of growth of output per hour worked or productivity since 1970 in the United States. This is done in Figure 1.8. A look at the figure suggests that the underlying rate of productivity growth may indeed have increased since the mid-1990s. The average annual growth rate for the period 1996 to 2008 (represented by the horizontal dashed line from 1996 to 2008) was 2.7 per cent, I per cent higher than the average of 1.7 per cent for the period 1970 to 1995 (represented by the horizontal line from 1970 lo 1995).
Can we be confident that productivity growth will continue in the future ai the same higher rate as it has since 1996? Figure 1.8 suggests caution: the rale of productivity growth fluctuates a lot from year lo year. The high growth rates since 1996 might just be a series of 'lucky' years that won't be repeated in the near future. Some economists believe that it is too early to tell. Other economists are more
A TOLR OF THE WORLD chapter I
Figure 1.8
Rate of growth of output per hour in the United
States since 1970
The average rate of growth of output per hour appears to have increased since the mid-1990s. SOURCE: Economic Report of Ihe President. 2008.ТаЫе B49
optimistic. They believe thai the underlying rate ol technological progress has indeed increased in the United States largely as a result ol the development and better use ol information technologies, from computers to faster communication networks. If they are right, it is reasonable lo expect higher productivity growth and a raster increase in the standard ol living lor some time to come.
Should we worry about the US trade deficit?
Since the early 1990s, the United States has consistently bought more goods and services from the rest of the world than it has sold to the resi of the world. Put another way, US imports have consistently exceeded US exports. The trade deficit has steadily increased and is now very large. Figure 1.9 shows the evolution ol the US trade delicit as a proportion of US output since 1990. The deficit, which was equal to about $80 billion, or just over I percent ol US output in 1990, stood at about $700 billion or about 5 per cent ol US output in 2008.
To linance its trade deficit, the United States has been borrowing from the rest ol the world, building its net foreign debt and interest payments and thus its current account deficit. As the trade and current account deficit has increased, so has the amount of borrowing. This should strike you as a bit strange: the richest country in the world, borrowing more than $800 billion per year from the rest of the world. An obvious question is whether this can go on. If not, what is likely to happen?
Fven though the United States has been able to borrow, it may not be wise to do so. Borrowing more means having to repay more and having less to spend in the future.
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I l l l l l l l l l l l l l l l l i l i l l l i i I I l l l l l l l l l l l l l 1970 1974 1978 1982 1986 1990 1994 1998 2002 2006 |
Can the United States continue to borrow such large amounts in the future? So far, foreigners have been quite willing, indeed often eager to finance the US trade deficit. They have been willing, for example, to buy US government bonds or to buy shares in the US stock market. The question is whether thev will be willing to do so in the future. In the late 1990s, foreigners who had been willing to lend to a number of Asian countries suddenly changed their mind, forcing the countries to immediately eliminate their trade delicits, which led to a collapse in their currencies and caused major economic crises in countries from Thailand to South Korea. The United Stales is not Thailand, and iThis crisis is known as there is little chance of a similar sudden change of mind on the part ol foreigners. But some economists the Asian crisis, worry that it may be increasingly difficult for the United States to borrow such large amounts from the rest of the world in the future.
The trade and current account deficits increased from about I per cent of output in 1990 to about S per cent of output in 2008.
| In May 2004. eight ► Eastern European countries plus Malta and Cyprus joined the EU. In January 2007. Romania and Bulgaria joined. A challenge for Europe is how to absorb these twelve countries that are poor and have h;gh unemployment rates. |
SOURCE: Federal Reserve Bank of St Louis (FRED2).
Even if the United States can borrow, shouldn't it try to reduce its trade deficit and therefore its borrowing? To answer this question, one must look more closely at who is borrowing—the government, firms or people. Some economists point to the US government budget deficit, which has increased a lot since 2(100, as one of the main causes, and argue that it should be reduced: budget deficits lead to the accumulation ol government debt and the need for higher taxes in the future. Others point to the low saving rate ol US consumers as another cause. They worry that US consumers may not be saving enough for their retirement and thus argue for an increase in the private saving rate. Should budget deficits be reduced and, if so, how fast? Should private saving be increased and how? How would these changes affect the trade deficit? These are among the most important questions confronting US macroeconomists today.
1.3 THE EUROPEAN UNION
In 1957, six European countries—Belgium, France, Germany, Italy, Luxembourg and the Netherlands— decided to form a common European market, an economic zone where people and goods could move- freely. Over the next few decades nine more countries—Austria, Denmark, Finland, Greece, Ireland, Portugal, Spain, Sweden and the United Kingdom—joined. This union is now known as the European Union, or F.U Until a few years ago, the olficial name was the European Community, or EC. You may encounter either name.) This group of fifteen countries has an acronym, F.U 15.
The data in Figure 1.10 are for the HU15. As the figure shows, their combined output is close to the output ol the United Slates, and many of them have a standard of living—a level ol output per capita— close to that of the United Stales. Not only has the number of members increased in recent years by twelve but the ties among them have tightened. Together, they form a formidable economic power. The new enlarged European Union has the acronym EL127.
| -|—i—i—r 1992 1994 |
| 1998 2000 |
| ~l- 1- 1- 1- г 2002 2004 2006 2008 |
| Figure 1.9 The US trade and current account deficits since 1990 |
Table 1.3 gives the recent economic performance lor the group composed ol the five largest F.U members: Germany, France, Italy, Spain and the United Kingdom. Together, these countries account for 75 per ceni of the total output of the F.L127. The format ol the table is the same format as that used
| A TOUR OF THE WORLD chapter I
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| 2008 | Output (US $ trillions) | Population (millions) | Output per capita (US $) | Output per capita (US $ PPP terms) |
| Germany | 3.63 | 82.2 | 44,100 | 34,200 |
| France | 2.84 | 63.8 | 44,500 | 33,500 |
| Italy | 2.29 | 59.6 | 38.500 | 29.400 |
| Spain | 1.59 | 45.3 | 35,000 | 29.500 |
| United Kingdom | 2.88 | 61.2 | 47.100 | 38.900 |
| SOURCE: OECD Main Economic Indicators. Map printed courtesy of maps.com. |
for Australia and the United States. The first two columns give the average value of the rate of growth of output, the unemployment rate and the inflation rate for the period 1970 to 2006 and for the period 1996 to 2006. T he next three columns give the numbers for 2006 to 2009. The numbers for 2009 are forecasts, as of mid-2008.
The main conclusion to draw from Table 1.3 is that the economic performance of these five countries over the past decade has been far less impressive than that of the other economic superpower, the United States, over the same period:
| Table 1.3 Growth, unemployment and inflation in the five largest European countries since 1970
|
| SOURCE: OECD Economic Outlook Database. |
• Average annual output growth from 1996 to 2006 was only 2.0 per cent. This was 1.4 per cent below the average annual growth rate in the United States over the same period, and it was 0.3 per cent below the average growth rate in the European Union from 1970 to 2006.
• Low output growth was accompanied by persistently high unemployment. The average unemployment rate Irom 1996 to 2006 was 8.7 per cent, 3.7 per cent higher than the average LIS unemployment rate over the same period.
• The only good news was about inflation. Average annual inflation lor these countries was 1.8 per cent, much lower than the 5.4 per cent average over the period 1970 to 2006.
While the numbers lor 2006 and 2007 gave a more positive picture, unlortunately those for 2008 and especially the 2009 lorecast look bad. Output growth for 2009 is forecast to be negative, which means a recession. And unemployment is forecast to return to the high average seen from 1996 to 2006.
There had been a feeling in Europe in 2007 that the future would be brighter than the recent past, following on from the implementation of a number ol reforms. Llnfortunately, the effects ol higher energy prices 'which have since eased) and the onset ol the global financial crisis have dashed those sentiments.
At this time, two issues dominate the agenda ol European macroeconomists. The first is, not surprisingly, high and now rising unemployment. Can il be reduced, perhaps all the way down if> the LIS rate ol unemployment? What reforms and what macroeconomic policies would be needed to achieve this?
The second issue is associated with the introduction, in 2002, ol a common currency, the euro. Many people slill question the usefulness of a common currency. What is the euro doing lor Europe? What macroeconomic changes has it brought? How should macroeconomic policy be conducted in this new environment?
Let's discuss the two issues in turn.
How can European unemployment be reduced?
High unemployment has not always been the norm in Europe, figure I.I I plots the evolution of the unemployment rale since 1970 in the four large continental European countries ( Germany, France. Italy and Spain) taken as a whole, and in the Llnited States. Note how low the unemployment rate was in these European countries in the early 1970s. At that time, the talk in the United States was about the European unemployment miracle. US macroeconomists actually went lo Europe, hoping to discover the secrets of that miracle. By the late 1970s, however, the miracle had vanished.
Since then, unemployment in the lour largest continental European countries has been much higher than in the United States. And despite a decrease since the late 1990s, it slill stood at 8.1 per cent in 2008, nearly 2.4 per cent higher than the unemployment rate in ihe United States.
Despite a large amount ol research, there is no full agreement on the causes of high European unemployment.
Politicians often blame macroeconomic policy. They argue that the monetary policy followed hy the European Central Bank has kept interest rates too high, leading to low demand and high unemployment. According to them, the central bank should decrease interest rates and allow lor an increase in demand, which would lead to a decrease in unemployment.
Most economists believe, however, that the source ol ihe problem is not macroeconomic policy but labour-market institutions. Too tight a monetary policy, they concede, can indeed lead to high unemployment lor some time, but surely not for twenty years. The tact that unemployment has been so high lor so long points lo problems in the labour market. The challenge is then to identify exactly what these problems are.
Some economists believe thai the main problem is that European states protect workers too much. To prevent workers from losing their jobs the laws make it expensive for firms to lay off workers.
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A FOUR OF THfc WORLD chapter I
Figure I.I I Unemployment rates: continental Europe versus the United States since 1970
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The unemployment rote in the four largest continental European countries has gone from being much lower than the US unemployment rate to being much higher. SOURCE: oecd.
One of the results, however, is to deter firms from hiring workers in the first place, and this increases unemployment. To protect workers who become unemployed, the governments provide generous unemployment insurance. Bui by doing so, they decrease the incentives lor the unemployed to look for jobs,- this also increases unemployment. The solution, the economists argue, is to be less protective, to eliminate these labour-market rigidities and adopt US-style labour-market institutions. This is indeed what the United Kingdom has largely done, and its unemployment rate is low.
| Whac to call the group of countries that Have adopted the euro was a problem.'Euro zone' sounds technocratic. 'Euroland' reminds some of Disneyland.'Euro area' has now been |
Other economists are more sceptical. They point to the fact that unemployment is not high everywhere in Europe, h is indeed high in the five large continental European countries focused on in Table 1.3 (which is precisely why they were chosen >. But it is low in a number ol smaller countries, such as the Netherlands and Denmark, where the unemployment rate is now under -1 per cent. Yet these countries arc very different from the United States and provide generous social insurance to workers. This suggests that the problem may lie not so much with the degree of protection but with the way it is implemented. The challenge, these economists argue, is to understand what the Netherlands or Denmark does right. Resolving these questions is one ot ihe major lasks lacing European macro- economists and policy-makers today.
What will the euro do for Europe?
In 1999, the European Union started the process ol replacing national currencies with one common currency, called the 'euro. Only eleven countries, among them France. Germany, Italy and Spain, participated at the start,- since then four more countries have adopted the euro. Some countries, in particular Denmark, Sweden and the United Kingdom, have decidcd not to join the move to abandon the old currencies, but ihey may do so in the lutiire.
The transition took place in steps. On I January 1999, each ot the eleven countries fixed the value ol iis currency lo the euro. For example, I euro was sei equal to 6.56 French irancs, to 166 Spanish pesetas, and so on. From 1999 to 2002, some prices were quoted both in national currency units and in euros, but the euro was not yet used as currency. This step happened in 2002, when euro notes and coins replaced national currencies. The lilteen countries ol the euro area' have now become a common 4 adopted, currency area.
What will the euro do lor Europe? Supporters of the euro point first to its enormous symbolic importance. In light of the many past wars between European countries, what better prool that the page has definitely been turned than the adoption of a common currency? They also point to the economic advantages of having a common currency: European firms no longer have to worn,' about changes in the relative price of currencies, and there is no need to change currencies when travelling between euro countries. Together with the removal of other obstacles to trade between European countries, which has taken place since 1957, the euro will contribute, they argue, to the creation of a large, if not the largest, economic power in the world. There is little question that the move to the euro is indeed one of the main economic events of the start of the twenty-first century.
Others worry that the symbolism ol the euro may come with some economic costs. They point out that a common currency means a common monetary policy, and that means the same interest rate across the euro countries. What if, they argue, one country plunges into recession while another is in the middle of an economic boom? The first country needs lower interest rates to increase spending and output; the second country needs higher interest rates to slow down its economy. Il interest rates have to be the same in both countries, what will happen? Isn't there a risk that one country will remain in recession for a long time or that the other will not be able to slow down its booming economy?
Throughout the 1990s, the question was whether Europe should adopt the euro. That question is now moot: the euro is here, and it is here to stay. So tar, no member country has had to face a severe recession, so the system has not really been tested. The lull costs and benefits of the euro remain to be assessed.
1.4 CHINA
China is in the news every day. It is increasingly seen as one ol the major economic powers in the world. Is the attention justified? A look at the numbers in figure 1.10 suggests that it may not be. True, the population of China is enormous, more than tour limes that of the United Stales. Bui its output, expressed in US dollars by multiplying the number in yuan (the Chinese currency) by the US dollar-yuan exchange rate, is only US$4.2 trillion, roughly the same as that ol Germany, and just under
Figure 1.12 China. 2008
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| Output: US$4.2 trillion (US$7.9 using PPP) Population: 1.33 billion Output per capita: US$3 (US$5,950 using PPP) |
SOURCE: IMF Wo rid Economic Outlook Database. 2008. Map printed courtesy of maps.com.
A TOUR ОГТНЬ WORLD chapter I
a third of that of the United States. Output per person is only US$3,180, roughly one-filtecnth of output per person in the United Stales.
So, why is so much attention paid to China? There are primarily two reasons. First, let's go back to the number for output per person. On our visit to Australia, we introduced the notion of PPP measures. These are especially relevant when comparing rich countries with poor countries. When comparing the outputs per person ol a rich country such as the United States and a relatively poor country such as China, one has to be careful because many goods are much cheaper in poor countries, l or example, the price of an average restaurant meal in New York City is about US$20,- the price of an average restaurant meal in Beijing is about 15 yuan, which at the current exchange rate is about US$2. Put another way, the same income (expressed in LIS dollars) buys you much more in Beijing than in New York City. 11 we want to compare standards of living, we have to correct for these differences; measures that do so arc called PPP (for purchasing power parity) measures. Llsing such a measure, output per person in China is estimated to be about $5,950, roughly one-eighth of output per person in the United Slates. This gives a more accurate picture ol the standard of living in China. It is obviously much lower than that of the United States and other rich countries. But it is much higher than suggested by the numbers in Figure 1.10.
Second, and more importantly, China has been growing very last for more than two decades. This is shown in Table 1.4, which gives the rates ol output growth and inflation for the periods 1980 to 2006, 1996 to 2006 and the years 2006 to 2009. The numbers for 2009 arc forecasts.
Note two things about Iable 1.4. first, the numbers go back only to 1980, not to 1970 as in the previous tables. The reason is that the pre-1980 numbers are unreliable. Second, the table does not give unemployment rates. Llncnplovment in poorer countries is difficult to measure because many workers may decide to stay in agriculture rather than be unemployed. As a result, ollicial unemployment rates are typically not very informative. However, The economist magazine gives an estimate ol unemployment in China in 2007 as 9.5 per cent.
Now, focus on the main feature of the table: the very high growth rate of output since 1980. Since 1980, Chinese output has grown at close to 10 per cent per year, and the forecasts are tor more of the same. This is a truly astonishing number. Compare it with the 3. t per cent number achieved by the US economy over the same period. At that rate, output doubles every seven years.
These numbers raise many obvious questions. Are the numbers for real? Could it be that growth is overstated? After all, China is still a communist country, and government officials may have incentives to overstate the economic performance ot their sector or their province. Economists who have looked at this carefully conclude that this is probably not the case. The quality ot data collection in China has increased signilicantly in recent years. The statistics arc not as reliable as they are in richer countries, but there is no obvious bias. Output growth is indeed very high in China.
So where docs the growth come from? It clearly comes from two sources: • Very high accumulation of capital. The investment rate (the ratio of investment to output) in China is between 40 per cent and 45 per cent of output, a very high number. For comparison, the investment rate in the Linked States is only 17 percent. More capital means higher productivity and higher output. And China has no problem getting low-cost labour to work with this new capital,
| Table 1.4 Growth, unemployment and inflation in China since | 1980 | | | |||
| | 1980-2006 (average) | 1996-2006 (average) | 2006 | 2007 | 2008 | 2009 (forecast) |
| Output growth rate | 9.3 | 8.8 | 1 1.6 | 11.9 | 9.7 | 9.3 |
| Inflation rate | 5.4 | 3.3 | 1.5 | 5.1 | 6.2 | 4.2 |
| I | ||||||
| SOURCE■ IMF World Economic Outlook Database 2008. |
because there is a large population in rural areas keen to move to better-paid jobs. In atral areas, average income per capita is estimated lo be about a quarter of the national average. However, rural incomes are likely to improve due to reforms in 2008 that gave farmers greater rights over their land. • Very fast technological progress. The strategy followed by the Chinese government has been to encourage foreign firms lo come and produce in China. As foreign firms are typically much more productive than Chinese linns ibis has increased productivity and output. Another aspect ol the strategy has been to encourage joint ventures between foreign firms and Chinese firms.- having Chinese firms work with and learn from loreign firms has made them much more productive.
When described in this way, achieving high productivity and high output growth appears easy, with easy recipes that every poor country could and should lollow. In fact, the reality is less clear-cut. China is one of many countries that have made the transition Irom central planning to a market economy. Most ol those countries, among them Russia and Central European countries, have experienced a large decrease in output at the time ol transition. Most still have growth rates lar below that of China. In many of these countries, widespread corruption and poor property rights make firms unwilling to invest. So why has China lared so much better? Economists are not sure. Some believe that it is the result ol a slower transition: the first Chinese reforms took place, in agriculture, in 1980, and even today many lirms are still owned by the state. Others argue that the fact that the Communist I'artv has remained in control has actually helped the economic transition,- tight political control has allowed lor a better protection of property rights, at least for firms, giving them incentives to invest. Getting the answers to why China has done so well, and thus learning what other poor countries can take from the Chinese experience, can clearly make a huge difference—not only tor China but lor the rest ot the world. We will study China further in Chapters 12 and 13.)
This concludes our world tour. A summary ot where we have been is given in Table 1.5, which shows GDP measured in PPP terms, the share ot each country's GDP in world GDP, the population size, and GDP per capita. Using PPP figures which are necessary lor country comparisons), the United Slates is the biggest and richest economy, producing more than 20 per cent ol world GDP. Europe is the next biggest, with almost I1) per cent, but China, despite being much poorer i by a factor of about 71, is the third biggest economy, with more than I I per cent ol world GDP and a population equal to almost 20 per cent ot the world's population.
| Table 1.5 Country comparisons in June | 2008 | | | |
| | GDP @ PPP rate | Share in world | Population | GDP per capita |
| | (US$ trillions) | GDP @ PPP | (millions) | @ PPP |
| Australia | 0.88 | 1.3% | 21 | 41,272 |
| US | 14.1 1 | 20.4% | 305 | 46.266 |
| EU27 | 12.90 | 18.6% | 497 | 31.002 |
| Germany | 2.81 | 4.1% | 82 | 34.219 |
| France | 2.14 | 3.1% | 64 | 33.468 |
| Italy | 1.75 | 2.5% | 60 | 29.359 |
| Spain | 1.33 | 1.9% | 45 | 29,452 |
| UK | 2.38 | 3.4% | 61 | 38,938 |
| China | 7.89 | 11.4% | 1,328 | 5,943 |
| WORLD | 69.23 | 100.0% | 6.700 | 10,333 |
| 1 1 | ||||
| SOURCE.- IMF World Economic Outlook Database 2008. |
a i our ог the woki1) chapter I
There are many other regions oi the world we could have looked at:
• Asia, which is now the fastest-growing economic region in the world. Some countries, such as Singapore, South Korea and Taiwan have already achieved standards ol living close to those of Western Europe. Crowing rapidly is India. India's average output growth rate has been around 6 per cent, but in 2008 it reached 7.7 percent. Like China, though, India is still poor. Despite its large population of 1.1 billion, India's total output remains relatively small. In 2008, India's output (measured in US dollarsi was still only 9 per cent of US output. If it can maintain its high growth rate, however. India will soon become a major economic power. Already its economic weight is being felt in the world economy, as, along with China, it demands more raw materials and energy to supply its economy.
• [apan, whose growth performance lor the lorty years following World War II was so impressive that it was referred to as an economic miracle . But japan is one of the few rich countries that have done- very poorly in the past decade. Since a stock-market crash in the early 1990s, Japan has been in a prolonged slump, with average output growth ol under I per cent per year. (We discuss Japan at length in Chapter 23.)
• Latin America, which went from very high inflation to low inflation in the 1990s. Some countries, such as Chile, appear to be in good economic shape. Some, such as Argentina, have been struggling: a collapse of its exchange rate and a major banking crisis led to a large decline in output in the early 2000s, from which it is now recovering.
• Central and Eastern Europe, where most countries shitted from a centrally planned system to a market system in the early 1990s. Many economists expected this shilt to a market economy to lead to a large increase in output. In most countries, the shift was characterised instead by a sharp decline in output at the start ol the transition. Only later did output growth become positive,- in some countries, output is slill below its pre-transition level. The Russian economy has improved significantly in recent years due to the high world prices ol oil and gas, which it exports. However, the halving ot these prices in 2008 means that Russia is going lo struggle in the expected downturn of 2008-09.
• Africa, which has suffered decades of economic stagnation, but where growth has been high since 2000. Growth is expected to reach 6.9 per cent in 2008, reflecting growth in most of the countries of the continent.
There is a limit, however, to how much you can absorb in this first chapter. Think about the
questions to which you have been exposed already:
• What determines expansions and recessions? Why did Australia (and many other rich countries) experience such a long expansion in the 1990s?
• How are countries responding to the global linanciai crisis that started in 2008? Can monetary and fiscal policy prevent a recession? How will the euro affect monetary policy and fiscal policy in Europe?
• Why was inflation so much lower in the 1990s and 2000s than it was in previous decades?
• Should we be worried about the trade and current account deficits in Australia and the United Slates? Can a weak currency assist an economy in a slowdown?
• Can Europe reduce its unemployment rate?
• Why do growth rates diller so much across countries, even over long periods ol time? Have the rich countries entered a New Economy in which growth will be much higher in the future? Can other countries emulate China and grow at the same last rate?
The purpose ot this book is to give you a way of thinking about these questions. As we develop the
tools you need, we will show you how to use them, by returning to these questions and showing
the answers they suggest.
AIOUROFTHI WORLD chapter I
There are many other regions of the world we could have looked at:
• Asia, which is now the fastest-growing economic region in the world. Some countries, such as Singapore. South Korea and Taiwan, have already achieved standards of living close lo those of Western Europe. Growing rapidly is India. India's average output growth rate has been around 6 per ceni, but in 2008 ii reached 7.7 per cent. Like China, though, India is still poor. Despite its large population of I.I billion. India's total output remains relatively small. In 2008, India's output (measured in US dollars' was still only 9 per cent ol US output. II it can maintain its high growth rate, however, India will soon become a major economic power. Already its economic weight is being lelt in the world economy, as, along with China, it demands more raw materials and energy to supply its economy.
• lapan, whose growth performance lor the forty years following World War II was so impressive that it was referred to as an economic miracle'. But Japan is one of the few rich countries that have done very poorly in the past decade. Since a stock-market crash in the early 1990s, Japan has been in a prolonged slump, with average output growth of under I per cent per year. (We discuss Japan at length in Chapter 23.)
• Latin America, which went from very high inflation lo low inflation in the 1990s. Some countries, such as Chile, appear to be in good economic shape. Some, such as Argentina, have been struggling: a collapse ot its exchange rate and a major banking crisis led to a large decline in output in the early 2000s, from which it is now recovering.
• Central and Eastern Europe, where most countries shitted from a centrally planned system to a market system in the early 1990s. Many economists expected this shift to a market economy to lead to a large increase in output. In most countries, the shilt was characterised instead by a sharp decline in output at the start ol the transition. Only later did output growth become positive,- in some countries, output is still below its pre-transition level. The Russian economy has improved significantly in recent years due to the high world prices ot oil and gas, which it exports. However, the halving ol these prices in 2008 means that Russia is going to struggle in the expected downturn ot 2008-09.
• Alrica. which has suffered decades of economic stagnation, but where growth has been high since 2000. Growth is expected to reach (>.9 per cent in 2008, reflecting growth in most of the countries of the continent.
There is a limit, however, to how much you can absorb in this first chapter. 1 hink about the
questions to which you have been exposed already:
• What determines expansions and recessions? Why did Ausiralia (and many other rich countries) experience such a long expansion in the 1990s?
• How are countries responding lo the global financial crisis that started in 2008? Can monetary and fiscal policy prevent a recession? How will the euro aflect monetary policy and fiscal policy in Europe?
• Why was inllalion so much lower in the 1990s and 2000s than il was in previous decades?
• Should we be worried about the trade and current account deficits in Australia and the United States? Can a weak currency assist an economy in a slowdown?
• Can Europe reduce its unemployment rate?
• Why do growth rales differ so much across countries, even over long periods of time? Have the rich countries entered a New Economy in which growth will he much higher in the future? Can other countries emulate China and grow at the same fast rate?
The purpose of this book is to give you a way ol thinking about these questions. As we develop the
tools you need, we will show you how to use them, by returning to these questions and showing
the answers they suggest.
|
|
Where do the data examined in this chapter come from? Suppose we wanted to find the number for inflation in Germany over the past five years. Forty years ago, the answer would have been to learn German, find a library with German publications, find the page where inflation numbers were given, write them down, and plot them by hand on a clean sheet of paper. Today, improvements in the collection of data, the development of computers and electronic databases, and access to the Internet make the task much easier.
International organisations now collect data for many countries. For the richest countries, the most useful source is the Organization for Economic Cooperation and Development (OECD). based in Paris. You can think of the OECD as an economic club for rich countries. The complete list of member countries is: Australia, Austria, Belgium. Canada, the Czech Republic, Denmark, Finland, France. Germany, Greece, Hungary. Iceland, Italy, Japan. Korea. Luxembourg, Mexico, the Netherlands, New Zealand. Norway. Poland. Portugal, the Slovak Republic, Spain, Sweden, Switzerland,Turkey, the United Kingdom and the United States. Together, these countries account for about 75 per cent of world output.The OECD Economic Outlook, which is published twice-yearly, gives basic data on inflation, unemployment and other major variables for member countries, as well as an assessment of the countries' recent macroeconomic performance. The data, often going back to 1960, are available on CDs; they are on most macroeconomists' hard drives.You can also access much of the data at the OECD's website.The main website is accessible to all and has lots of summary data.
For those countries that are not members of the OECD. information is available from other international organisations.The main world economic organisation is the International Monetary Fund (IMF).The IMF publishes the monthly International Financial Statistics (IFS), which contains basic macroeconomic information for all IMF members.The data are available on a CD, and via the Internet at a charge. (Check whether your library has an Internet subscription.) It also publishes the annual World Economic Outlook, an assessment of macroeconomic developments in various parts of the world. Although their language is sometimes stilted, both the World Economic Outlook and the OECD Economic Outlook (and their databases) are valuable sources of information.
Because these publications sometimes don't contain sufficient details, you may need to turn to specific country publications. Major countries now produce remarkably clear statistical publications, often with an English translation available. In Australia, the main source of data is the Australian Bureau of Statistics (ABS). which is accessible on the Internet. Another is the Reserve Bank of Australia, which has an excellent statistics section on its website that includes all of the data published in its monthly Bulletin. The papers produced for the annual federal budget are a valuable source of data, both historical and forecasts. In the United States, an extremely good resource is the Economic Report of the President, prepared by the Council of Economic Advisers and published annually.This report has two parts.The first is an assessment of current US events and policy and is often a good read.The second is a set of data for nearly all relevant US macroeconomic variables, usually for the entire period after World War II. A longer list of data sources, as well as how to access data sources through the Internet, is given in the appendix to this chapter.
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