ocr f585 global economy june 2011 toolkit

8/3/2019 OCR F585 Global Economy June 2011 Toolkit

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OCR A2 Economics Unit F585 -

The Global Economy

June 2011 Revision Toolkit


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OCRF585ToolkitJune2011(tutor2u) Page2

TableofContentsIntroduction ............................................................................................................................................ 3

Extract 1: Recession in the euro area economies 2008 2009 .............................................................. 5

Extract 2: Portugal, Italy, Ireland, Greece and Spain the PIIGS .......................................................... 20

Extract 3: The future of the Spanish economy ..................................................................................... 29

Extract 4: International trade, international trade negotiations and developing economies .............. 39

Suggested exam-style questions ........................................................................................................... 47

Glossary of Key Terms for F585 The Global Economy .......................................................................... 51


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IntroductionThis is the introductory section of the pre-release material we will look at some of the concepts

and issues flagged up by this introduction in the right-hand column below.

Recession in the Euro Area

The euro area economies all experienced

negative economic growth during 2008 2009

as the global economic crisis spread.

However, the reduction in GDP was not uniform.

Some euro area economies entered recession

earlier than others, some experienced moresevere recessions than others and not all

economies had emerged from recession by the

end of 2009.

The lack of convergence of the economic cycles

in the euro area raised questions about the

viability of the monetary union which was just

over 10 years old.

Comments on the introduction

Definition of a recession:

A marked slowdown in economic activity, more

strictly defined (in many countries) as at least two

consecutive quarters of declining real GDP

The economic / business cycles of the seventeen

countries inside the Euro Zone are not fully

convergent. The timing of recession and recovery hasbeen different as has the depth of the downturn and

the strength of the rebound in demand, output and

employment

In macroeconomics, convergence normally refers to

the process by which the per capita income of a

relatively poor country catches up with that of a

richer country. But it is also used in the context of

convergence of inflation rates, interest rates and real

measures such as economic growth, productivity and

trade patterns.

Shifting competitiveness

It was not just the lack of convergence of the

economic cycles which raised concerns about

the future of monetary union in the European

Union (EU). A number of economies appeared to

suffer from a lack of competitiveness both

inside and outside the euro area. Portugal,

Ireland, Italy, Greece and Spain (dubbed the

PIIGS) had grown increasingly uncompetitive

union.

Without implementing measures to tackle this

lack of competitiveness many thought that their

continued membership of the euro area was

unsustainable.

Competitiveness

Competitiveness is a broad term describing whether

or not a business or a country is competitive in

international trade against competitors. We often

make a distinction between price/cost

competitiveness and non-price competitiveness:

Cost competitiveness: Typically measured by thelevel of relative unit labour costs of one country

against another. Competitiveness is affected (over

time) by relative rates of inflation. For example if

inflation in Spain is regularly higher than the Euro

Area average, then Spain will tend to lose

competitiveness in European markets

Non-price competitiveness: This focuses on factors

such as product quality, brand reputation, the ability

to get products to the market on time and the

performance characteristics of a product relative toothers.


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Calls for further trade liberalisation

Whilst fiscal stimulus measures had had an

impact on economic growth in the short term,the World Trade Organisation (WTO) called

upon developed and developing economies to

renew their efforts to further liberalise world

trade.

Pascal Lamy, the Director-General of the WTO,

stated his belief that, in the long term, trade

liberalisation was the key to promotingeconomic growth for developed and developing

economies alike.

Such a view is strongly supported by economic

theory, yet trade liberalisation on its own is not

a guarantee ofhuman development and

poverty reduction.

Trade liberalisation:

Liberalisation means deregulation and other

measures, including the lowering of tradebarriers, aimed at opening up a market or

industry to full competition. In the context of

world trade it is a process whereby countries

sign bilateral or multilateral trade agreements to

reduce import tariffs, quotas and other forms of

protectionism in a bid to stimulate greater trade

in goods and services.

The World Trade Organisation:

The WTO is an organisation that was formed in

1995 to control trade agreements betweencountries and to set rules on international trade.

It replaced GATT (the General Agreement on

Tariffs and Trade). Their website is at

www.wto.org

Human development:

TheHuman Development Index(HDI) is an index

devised by the UN Development Programme to

assess comparative levels of development in

countries, quantified in terms of literacy, life

expectancy and purchasing power (i.e. real GDPmeasured in US dollars and with a purchasing

power parity adjustment).

Is the Euro Area in crisis? This is the main focus on extracts 1, 2 and 3
http://www.wto.org/http://www.wto.org/http://hdr.undp.org/en/statistics/http://hdr.undp.org/en/statistics/http://hdr.undp.org/en/statistics/http://hdr.undp.org/en/statistics/http://www.wto.org/


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Extract1:Recessionintheeuroareaeconomies20082009

The Euro Area in 2011 with Estonia the 17th

country to join in 2011 (Source: ECB website)

The text for Extract 1 is belowwe have highlighted key terms in bold textand after each section

we pick out some of the detail to provide further background, evaluative comment and analysis.

Since its launch in 1999, and the issue of notes and coins in 2002, the euro has established

itself as a major international currency. Fears that the euro would be a have

not been reserve currencyand the

second most popular currency forinternational transactions. The euro area economy is the second

largest in the world, based on comparisons of GDP at purchasing power parity.

Background

The Euro Area is a group of seventeen countries that share the same currency the Euro. Aggregate

statistics on the Euro Area are summarised in the table below

Data is for 2009 Euro Area European Union United States

Population 330.5 500.3 307.5

GDP (PPP) Euros, trillion 9.0 12.6 11.3

GDP per capita (PPP), Euros, thousands 27.1 25.1 36.9

Exports of goods and services (% of GDP) 19.7 13.4 11.1

Labour productivity (PPP), Euro Area = 100 100.0 91.2 128.3

Source: European Central Bank Annual Report, 2010


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Purchasing Power Parity (PPP)

Reference is made in the article to

Purchasing Power Parity is a commonly used method of currency valuation based on the idea that

two identical goods in different countries should eventually cost the same. This is illustrated by theBig Mac index, which takes a Big Mac hamburger and compares its prices in different

countries in order to establish the relative value of their currencies.More here

The external value of the Euro

The external value of the Euro against the US Dollar (source: Timetric)

The Euro has become one of the most heavily traded currencies in the world. Partly this is the

natural consequence of the economic size of the currency bloc. This section makes reference to a

reserve currency:

Reserve currencies:

A reserve currency is a currency that is traditionally held in countries' official reservesbecause of its global importance as a medium of exchange and its inherent stability.

A reserve currency is sometimes called an anchor currency and is a currency that nationalgovernments and other institutions are happy to hold as a key part of their foreign exchange

reserves. It acts as a pricing currency for commodities such as gold, oil, wheat and copper.

For decades the reserve currency of choice has been the US dollar partly because the USA is the

gest economy. For the Americans one of the benefits of this is that the USA can borrow

from the rest of the world at a slightly lower interest rate because there has been a lengthy queue of

foreign investors willing to purchase $ denominated assets such as US Treasury bonds. China for

example has amassed a mountain of foreign exchange reserves arising from their trade surpluses.
http://www.economist.com/markets/bigmac/index.cfmhttp://www.economist.com/markets/bigmac/index.cfmhttp://www.economist.com/markets/bigmac/index.cfmhttp://www.economist.com/markets/bigmac/index.cfm


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In recent years there has been a shift in holdings of foreign exchange there are now more Euros in

circulation than dollars, an

the euro accounted for 27 per cent of official foreign reserves, up from 18 per cent soon after its

same period.

The two requirements for a currency to have reserve status is credibility of a government that it willnot default on its debt or by printing too much of it. Will the

economic difficulties facing several Euro Area countries including the PIIGS that dominate much of

the OCR F585 stimulus cause a loss of investor confidence in the Euro and threaten its reputation

as a reserve currency?

The external value of the Euro against UK sterling (source: Timetric) a rise in the chart shows that the Euro

has appreciated against sterling (e.g. during 2008)

The economies of the euro area were not immune from the effects of the global economic crisis of

2008 2009. Setting interest rates for the euro area as a whole is difficult when there is a lack of

convergence in economic cycles. The European Central Bank (ECB) must make a judgement based

on the performance of the euro area economy as a whole.

The global economic crisis

A2 students will be familiar with the phrase global economic crisis a period of time when the

world economy was subject to a number ofsevere external shocks including the world financial

crisis that followed the collapse of the sub-prime lending boom. And also the fall-out from a surge in

the prices of internationally traded foodstuffs, energy and metals. The financial crisis was a major

demand-side shock for advanced, highly developed nations including member countries of the Euro

Zone and such was the severity of the shock that a deep recession was inevitable in late 2008 and

through 2009 despite attempts by policy-makers in government and in central banks to launch

economic stabilisation / stimulus policies.


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Convergence in economic cycles

Convergence means a coming together of one or more economic data series. The extract refers to a

meaning that countries in the Euro Area were not at the

same stages of their business cycle. Ensure that you understand what these stages are:

Boom Slowdown Recession Recovery

The European Central Bank has the job of setting the nominal policy interest rate for the currency

bloc and it has a clear target for price stability defined as an annual rate of consumer price

inflation of 2%. The rate of inflation in anyone of the Euro countries will depend in part on where it is

in their business cycle because inflation is determined by a mix ofdemand and cost factors. For

example a country experiencing a demand-led boom with rising wage costs and other input costswill have a higher rate of inflation than a country experiencing slower growth and where cost-push

inflationary pressures are lower.

Policy interest rates in the Euro Area

The OCR F585 stimulus document does not provide any data on the policy interest rates set by the

ECB so we have included it below for information:

Official nominal interest rates set by the European Central Bank (source: Timetric)

As the financial crisis enveloped the European Union, the European Central Bank started to cut

interest rates from 4.25% in late 2008 down to just 1% in the spring of 2009 they have stayed at

this historically low rate ever since.


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Inflation in the Euro Area

The OCR F585 stimulus does not provide data on inflation in the Euro Area here it is

Consumer price inflation for the Euro Area the ECB targets price stability (inflation of 2%) source: Timetric

Fig. 1.1 shows the quarterly growth in real GDP for the euro area as a whole and for its individual

economies, except Malta. Despite euro area GDP falling in the second quarter of 2008, only five of

the 16 members had experiencednegative economic growth. This number rose to nine by the third

quarter of 2008 and to 13 by the fourth quarter of the same year. It was not until the first quarter of2009 thatall euro area economies were experiencing falling GDP.

Similarly, the end of recession for the euro area economy as a whole came in the third quarter of

2009, yet three economies (Greece, Spain and Cyprus) remained in recession. They were joined by

Italy in the fourth quarter as the country looked set to enter a double-dip recession.

Not only was the timing and length of the recession different in the various national economies of the

euro area, so too was the severity of the recession. Ireland, Luxembourg, Slovenia, Slovakia and

Finland all experienced a reduction in GDP from peak to trough significantly above that of the

average for the euro area economy as a whole. The fall in GDP in Greece, France and Cyprus was

significantly below this average.


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There is a lot in the preceding paragraph and in the table so let us take it piece by piece!

Fig 1.1 contains a huge amount of data on the quarterly change in the real (inflation-adjusted)

national income (real GDP) for the member nations of the Euro Area. The data deals with the

Timing of the recession The duration of the downturn The severity of the contraction in national output from peak to trough assuming that the

trough of the cycle has been reached (perhaps not so in Italy, Spain and Greece up to the

end of the data provided)

Timing

According to Figure 1.1

1. Slovakia and Ireland were the first countries to see negative growth in Q1 20082. Ireland was the first to officially fall into recession using the conventional definition of a

period of two successive quarters of falling GDP


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3. Five countries were contracting in the 2nd quarter of 2008, nine by the 3rd quarter andthirteen by the 4th quarter

4. All fifteen were contracting in the 1st quarter of 2009 this fell to ten in the 2nd quarter andonly three in the 3rd quarter of 2009

5. Greece was the last Euro Area country into recession (the 4th quarter of 2008) this explainsin part the lower fall in GDP from peak to trough although data for the 4

thquarter of 2009 is

not available and Fig 1.1 does not provide any data for the 1st half of 2010

Duration

Duration refers to the length of time over which real GDP was declining. According to Figure 1.1

1. Germany suffered four quarters of falling GDP (Q2 2008 through to Q1 2009)2. Italy saw five quarters of negative growth3. Spain saw six quarters of contracting GDP (Q3 208 through to Q4 2009) although the severity

of recession was not as steep as for Germany or Italy4. Slovakia avoided a technical recession (output fell in the 1st quarter of 2008 and the same

period in 2009) but the country also saw the highest quarterly decline in real GDP with an

8.1% drop in the 1st quarter of 2009. This highlights the flaw in the official definition of

language!

Severity

The final column in figure 1.1 displays the % fall in real GDP from peak to trough. For the Euro Area

as a whole the decline was 5.1% - by way of contrast the fall in UK real GDP during the recession was

l output

(6.7%) but Germany has recovered strongly during 2010 and into the early months of 2011.

The absolute fall in real GDP is one way of measuring the severity of the downturn.

But there are other approaches not covered in the data one of which is the output gap. The

output gap shows the difference between actual and potential GDP.

During a recession real GDP declines and nearly always takes actual GDP well below the long run

potential level implying a negative output gap.

As a result of the recession, many Euro Area countries have a large amount of spare capacity

measured both by the output gap but also by the rate of unemployment.


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Average output gap for the seventeen countries of the Euro Area

For the Euro Area as a whole in 2009 the level of output was 5% below estimated potential GDP. A

slow recovery in 2010 and another year of growth in 2011 are expected to shrink the output gap

but this will vary from one country to another. When the output gap is negative there is less risk of

demand-pull inflation in the single currency area. This will be a factor considered by the European

Central Bank when setting interest rates.

Unemployment as a % of the labour force average for the Euro Area

The rate of unemployment in the Euro Area climbed from 7.5% in 2008 to nearly 10% in 2010 the

chart above (taken from the OECD World Economic Outlook) shows that unemployment is forecast

to decline gradually but remain above 9% of the labour force. Much of the increase in

unemployment in n2008-2010 was cyclical, caused by a fall in aggregate demand and output.


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Risks of a double-dip recession

Fig 1.1 makes reference to Italy as one of the countries that -dip

.

A double-dip recession happens when an economy goes into recession twice without having

undergone a full recovery in between. In other words there is a second downturn before the

negative output gas has closed and actual GDP has recovered to be in line with potential GDP.

No data is provided in Fig 1.1. about what happened in the first six months of 2010 and whether a

double-dip recession happened? A double dip can occur for a variety of reasons including:

A fresh external economic shock: Industries involved in exporting goods and services areaffected by a downturn in one or more of their major overseas export markets

Consumer confidence: There is a decline in consumer confidence which turns a fragileeconomic recovery into another contraction. Confidence might decline for a variety of

reasons for example a persistent fall in property prices, declining real disposable incomes

or the effects of rising unemployment

Business confidence: There is a fall in business confidence leading to a fresh burst ofproduction cut-backs and a fall in planned capital investment spending. One of the features

of the recent recession in Europe has been the sharp decline in business and investor

confidence Higher exchange rate: Recovery might be halted by an appreciation of the exchange rate

for example an appreciation of the

Euro against the US dollar.

Policy mistakes - e.g. tightening of policy too soon: The withdrawal of a monetary and/orfiscal stimulus (e.g. higher interest rates, higher taxes and cuts in government spending) has

the effect of causing a contraction of demand and production in the circular flow.

You might use an AD-AS analysis diagram to show a double-dip recession illustrating for example

an inward shift of the AD curve or a leftward shift in the short run aggregate supply curve.


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In the end the Italian economy has avoided a double dip recession although real GDP growth rates

remain low and the recovery is fragile. Real GDP in Italy increased by just over 1% in 2010 but is

forecast to be weaker in 2011 so the risk of a double dip is not over for Italy!

The economic cycle for Italy (source: Timetric)

ed concerns that the national economies of the euro area had not

converged. Differences in their economic performance could be only partly explained by differences in

thefiscal response to the downturn. Much more important was that economic performance

appeared to be affected by differences in theiropenness to international trade, the structure of

their economies and in theircompetitiveness.

As it emerged from recession there were concerns that a - was developing,

seriously affecting the viability of the monetary union

Economic convergence

No discussion of the economics of the single currency is

complete without reference to the idea ofconvergence!

Convergence means that the economic variables of

different countries move closer together over time.

How might convergence be measured? As always in

macroeconomics we can take a number of indicators

some of which are said to be nominal (meaning they are

essentially monetary indicators) and others are real or

structural (meaning that they refer to the supply-side or

underlying structure of the economy).


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Nominal convergence:

This refers to monetary indicators such as:

1. Consumer price inflation the annual % change in the consumer price index2.

Short term interest rates

3. The size of the annual Fiscal (Budget) deficit4. The level of gross government debt5. Measures of exchange rate stability

Real convergence

This is referred to in the previous section of the extract real indicators include:

1. The trend (underlying) growth of GDP (i.e. the sustainable long run average growth rate)2. Labour market performance including the rate of structural unemployment and the non-

accelerating inflation rate of unemployment (NAIRU)3. Growth of labour productivity i.e. output per person employed4. Trade balances in goods and services and also differences in the geographical pattern of

trade and share of GDP taken up by trade

5. Capital investment as a share of GDP6. Housing market structures including rates of home ownership and the size of the rented

property sector

7. Indicators of cost and price competitiveness such as an index of relative unit labour costs inmanufacturing industry and annual changes in output prices (referred to in Figure 2.2 on

page 8 of the F585 stimulus document).

Why does the apparent lack of real economic convergence matter and perhaps, as the extract

suggests, the viability of the Euro Area in the years to come?

Part of the answer lies in the concept of an optimal currency area (OCA) developed initially by the

work of the Canadian economist Robert Mundell.

Mundell explored the conditions required for a group of countries to establish and run a successful

single currency. An optimal currency area is a geographical region where it is thought a single

currency would help to maximise economic welfare and enhance macroeconomic performance over

a period of time.

Start from the idea that all participating nations share the same currency and have to live with the

policy interest rate set by the central bank. In our focus for June 2011 this is the policy rate set by

the European Central Bank (ECB).

Can the interest rate decision work for all members of a currency union? Or will structural

differences in their economies be exposed and perhaps made worse by having a monetary union

where there is no option for an exchange rate adjustment to restore lost competitiveness?


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For Mundell an optimal currency area requires:

1. Countries within it are highly integrated with each other, i.e. a high percentage of trade ingoods and services is done with fellow currency union members

2. Where each economy has a sufficiently flexible labour market to cope with an externalshock such as rising oil prices or a major demand-side shock in the world economy. Labour

market flexibility might include:

a. Flexibility in real wages and salaries at different times during an economic cycleb. Workers with flexible and adaptable skills to reduce structural unemploymentc. A high level of labour mobility within and between members of a currency uniond. Flexible employment contracts including lots of shorter term job contracts

3. An OCA is also likely to work well when the impact of interest rate changes have a broadlysimilar effect on businesses and households from country to country.

4. When member nations are willing and able to make fiscal transfers between each other, forexample to help stabilise demand and provide financial support during difficult times

The economic, social and political difficulties in the Euro Area throughout the last few years have

thrown into the spotlight the reality that the Euro Area is not close to be an optimal currency zone.

A currency union works best with a small cluster of highly integrated and similar countries, for

example Germany, the Netherlands and Austria. It was never likely that launching a currency union

with twelve nations rising quickly to seventeen in 2011 would work well.

Crucially the countries joining the Euro have not exercised the same budgetary controls many

countries including the PIIGS referred to specifically in Extract 2 have run up huge fiscal deficits

which ultimately has caused a loss of confidence among investors and speculators in international

bond markets. Little wonder that many heavily indebted countries have seen the interest rates they

pay on their loans rise sharply. We return to this in the section on Extract 2.

Let us pick out three items mentioned on the convergence agenda:

1/ Openness to international trade

An open economy is one that is open to flows of trade in goods and services and inflows and

outflows of direct and portfolio capital investment. In other words, it is an economy where asignificant and rising share of national income is linked directly to trade and investment with other

countries.

As one might expect, countries within the Euro Area have different histories of openness to world

markets and also to the effects that changes in world trade have on their balance of payments and

economic growth.

2/ Structure of their economies

This refers to the structure of output and jobs from economy to economy. Some EU nations have a

relatively high dependence on high volume manufacturing industries such as textiles, footwear, carmanufacturing and household appliances. For others, the size of their construction and tourism


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industries or the value-added from sectors such as business and financial services is particularly

important. These variations come into stronger focus in Extract C when we look at the problems

facing the Spanish economy.

Although Spanish manufacturing industry contributes a similar percentage of GDP as or Germany, a

sizeable percentage of Spanish GDP and employment also comes from the property andconstruction industry, much of it linked to the fortunes of the tourism sector. Greece is a good

example of a country with a relatively smaller share of GDP from the industrial sector.

Country GDP Per

Capita Euros

2009

Industry as

share of GDP

(by valued

added) (%)

Unemployment

% of labour force

(Oct 2010)

Budget Balance 2009 %

of GDP

Germany 29.1 26.5 6.7 -3.0

Ireland 32.2 31.9 14.1 -14.4

Greece 23.4 17.9 11.5 -15.4

Spain 26.2 26.1 20.7 -11.1

France 27.0 18.8 9.8 -7.5

Italy 25.6 25.1 8.6 -5.3

Portugal 19.8 22.8 11.0 -9.3

UK 29.2 21.1 7.7 -11.4

The table above uses data from EuroStat to illustrate differences in the economic make-up of a

selection of Euro Area countries and also the UK (which of course has an opt-out from the Euro).

3/ Competitiveness

We mentioned competitiveness in the introduction to the toolkit. This is a term used to describe

whether an industry or an economy has a competitive advantage or an edge when trading in

international markets. A common measure of competitiveness is to look at relative unit labour costs

in manufacturing industry (i.e. the labour costs per unit of output relative to other countries).

We can also consider data on producer output prices (the prices of products as they leave the

factory gate). And also the actual figures for the value of exports and imports as part of the current

account of the balance of payments. Real world trade data can help to reveal whether or not an

economy has a comparative advantage in a particular good or service.

As it emerged from recession there were concerns that a - was developing,

seriously affecting the viability of the monetary union

-

A two-speed Euro area means that there is a variation in the average growth rates achievedby countries inside the currency union.

Some nations may have to suffer a number of years of slower growth and persistently highunemployment and falling real and relative living standards.


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The governments in these countries are likely to continue to experience difficulties in cuttingtheir fiscal deficits and in limiting the rise in government debt.

Much attention has focused on the PIIGS group in this respect (more of that in our section on Extract

3) but keep in mind that there are seventeen member nations of the Euro and all countries are

vulnerable to difficult macroeconomic conditions and external shocks having a single currency

does not mean a consistent and similar growth rate!

Why might this threaten the viability of the monetary union?

Protests about government spending cuts and other economic reforms in Greece

There are stresses and tensions within the Euro Area and the events of the last two years have

thrust many of these onto the front pages of the newspapers and the TV news bulletins.

A cluster of under-performing Euro Area countries have high and rising unemploymentmuch of which is long-term and employment prospects for the unemployed are bleak

Slow growth and recession has cut the flow of tax revenues to many EU countries bringingabout a huge rise in budget deficits as a share of national income.

In 2010 we saw a sovereign debt crisis engulf several Euro Area nations notably in Greeceand Ireland both of whom were eventually forced into accepting emergency bail-outs from

the International Monetary Fund and from fellow European Union members

Part of the conditions attached to the emergency financial support is deep cuts in state(government) spending and also higher taxes both of which bring about reductions in

living standards for millions of people in these countries.

Little wonder that public support for the Euro has fallen and it is this which may be thebiggest threat for the future health and stability of the single currency system


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Rising government debt

Gross government debt as a share of GDP (source: Timetric)

Our additional chart above tracks what has happened to gross government debt measured as a

share of GDP. The crucial point is that the recession has caused a surge in debt levels Italy has a

huge level of debt but Portugal, Ireland and Greece appear to have reached and perhaps breached

the tolerance levels of the international bond markets in terms of how much debt can be issued.

Now we turn in Extract 2 to the PIIGS countries finding life tough inside the single currency!

Spain is featured in Extract C but this chart is important context for what is to come. Spanish

government debt as a share of national income was falling consistently during the strong growth

years from 2002 onwards. Indeed in some years the Spanish government was running a budget

surplus causing debt to fall.

So Spain went into the recession when her housing bubble burst with a relatively low level of

national debt. This is one reason why long-term bond yields for Spain are fairly low in stark

contrast to Greece, Portugal and Ireland.

Overall

The global financial and economic crisis from 2007-2010 has exposed fault-lines in the currency bloc

and there remains a possibility albeit a remote one that some nations may opt to cut loose from

the Euro, devalue and partially default on their debts and return to their own currency.

Fundamentally the single currency system brought together seventeen countries that are different

from each other in their economic structure and performance and this has made it incredibly hard

to accommodate a single currency and a single official interest rate during times of global economic

distress. The Euro Area is not an optimal currency area and the crisis is prompting calls for further

economic reforms among the countries that have chosen to use the Euro as a medium of exchange.


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Extract2:Portugal,Italy,Ireland,GreeceandSpainthePIIGS

Five countries in the euro area are now singled out as countries sharing common characteristics

likely to make theircontinued membership of the euro area challenging.

These economies Portugal, Italy, Ireland, Greece and Spain (the PIIGS) on the surface look an

unlikely grouping (see Fig. 2.1). Economic performance in Ireland, Greece and Spain was strong

before the recent recession. All three economies had experienced above average rates of economic

growth in the period 2000 to 2007. Over the whole period Greece and Spain had grown twice as

much as the average for the euro area as a whole, where real GDP had increased by 18.5%. In

Ireland, real GDP had grown by almost 56% over the same period. In comparison, economic growth

in Portugal and Italy over the period was about two thirds of the average for the euro area economy.

The PIIGS group of countries are selected for special treatment in this stimulus document partly

this is because they have all to one degree or another been involved in a debt crisis since the

recession hit Europe. And all are regarded as vulnerable within the Euro Area has their economic

performance worsened since joining the single currency?

What unites these five economies is a loss in competitiveness compared to the rest of the euro area

and to economies outside the euro area. The ECB produces two measures of competitiveness. One is

based on increases in output prices (see Fig. 2.2) and the other on increases in relative unit labour

costs (see Fig. 2.3). Both measure changes in the competitiveness of individual economies relative to

their main trading partners over time. Both indices show a decline in the competitiveness of the PIIGS

since 1999, the year of the launch of monetary union in the EU.

We look at the data at competitiveness in the following pages


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Part of this lost competitiveness is due to thefailure of ECB monetary policy to control inflation in

all parts of the euro area. Effectively, for Portugal, Italy,

Ireland, Greece and Spain. Short term economic growth has come at the cost of high inflation .

Part of their decline in competitiveness stems from these economies having a

against other members

With the risk of depreciation eliminated, FDI has poured into these fast-growing economies. But

these are short term influences on economic growth. The real problem for these economies is the

longer term influences on economic growth which come from a poor supply side performance.

Has the ECB failed to control inflation?

No. The European Central Bank sets policy interest rates with the aim of maintaining price stability

within the Euro Area as a whole rather than for any one particular country. The extract above is

misleading because it is ngle economy it could

never do thatshould not be used.

What does this phrase mean?Effectively, for Portugal, Italy,

Ireland, Greece and Spain

The extract is suggesting that higher inflation in the PIIGS group has been in part due to the ECB

setting policy interest rates too low for these economies

rates in countries such as Ireland and Spain were negative and that this contributed to a boom inborrowing much of it linked to a booming housing market which created extra inflationary pressures

in these countries and caused them to be heavily exposed when the Global Financial Crisis took hold

from 2007 onwards.

Short term economic growth has come at the cost of high inflation

This line hints at a worsening trade-offbetween economic growth and price stability. Be prepared

to use an aggregate demand aggregate supply diagram to show how this might come about. The

risk of demand-pull inflation is greatest when an economy is operating with a positive output gap

i.e. there is a shrinking margin of spare capacity, unemployment is falling and there is pressure for

wages and other input costs to rise too.

No data is provided in the extracts on the rates ofconsumer price inflation for the PIIGS countries.

Instead we are given information on producer prices presumably because this is a proxy for

inflation at an earlier stage of the supply chain.


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Consumer price inflation for the PIIGS and the Euro Area (Source: Timetric)

Our additional chart above provides some background on consumer price inflation in the PIIGS

economies. The histogram tracks the inflation rate for the Euro Area as a whole. We can see that for

the PIIGS between 2001 and 2008, in most years, their inflation rates were higher than the Euro Area

average in some cases by 2% or more in any given year.

Key point: Over time, a persistently high relative rate of inflation can lead to a loss of

competitiveness for a country because their export sectors may get priced out of markets. And

imported goods and services will begin to appear cheaper in domestic markets threatening to take arising share of consumer demand.

The PIIGS group did experience higher inflation but they did not lose control of inflation, indeed in

historical context their inflation rates were still below what they had experienced in the 1990s.

Price deflation in 2009-2010: The crucial change is what has happened to consumer price inflation

during the recession year of 2009 and into 2010. Notice in the chart above that Ireland, Portugal and

Spain all slipped into a period of price deflation. And persistent deflation can be as damaging to a

area

This phrase explains a possible connection between inflation and the value of the exchange rate.

Brieflyeir exchange rate may start to depreciate in value

because of a worsening trade balance (growing imports and less competitive exports). Foreign

investors in a country may also take some of their money out (this is known as capital flight) if they

regard the economy as weak on controlling inflation and in the expectation of slower growth and

lower real returns on their investments.


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Key point: Within the Euro Area, a country with a relatively high rate of inflation cannot expect a

depreciation of their exchange rate to restore lost competitiveness they will have to achieve this in

other ways such as a better supply-side of the economy or (more painfully) lower wages.

Figure 2.1: Annual GDP growth rates for the PIIGS and for the Euro Area

The chart shows the annual percentage change in real GDP for the PIIGS and Euro Area average.

The data is not sourced properlyone has to assume that the data comes from an officialsource such as EuroStat and we are not told whether the GDP statistics for 2010 are a

forecast or not. The data for 2011 is clearly a forecast but this is not shown in the chart and

we are not told from where the forecast has come.

1.

Speed of growth: Ireland had the fastest average growth for most of the years from 2000through to 2007, followed by Greece and then Spain.

2. Over the same period Portugal and Italy were growing more slowly than the Euro Areaaverage and from 2001 they failed to achieve an increase in real GDP of more than 2%.

Portugal had a shallow recession in 2003, in the same year Italian growth was close to zero

3. Ireland saw the steepest decline in annual growth rates from 6.1% in 2007 down to -7.5%in 2009 but the forecast for 2011 is that her economy will recover the strongest of those

shown although at a rate of around 3% which is much low2er than her average growth rate

during the 1990s and first seven years of the new century.

4. Greece was the last of the countries shown to fall into recession, had the smallest fall in realGDP during 2009 and is forecast to have the weakest recovery in 2011


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Figure 2.2: ECB Index of competitiveness based on output prices for Portugal, Ireland, Italy, Greece

and Spain 1999-2009 (1999 Q1 = 100)

This is the second of the three data charts in the stimulus material it focuses on producer prices

What data is the chart showing?

The data in Fig 2.2 is for producer output prices. This measures the prices of (typically

manufactured) goods when they leave producers. In the UK this is often referred to as

and what happens to producer prices is frequently shown through later on in

changing retail prices for consumers. Some producers supply direct to the final consumer. Others sell

to wholesalers and from there to retail chains.

What does the data tell us?

Over an eleven year period the index of producer prices for all selected countries shows an increase

but this ought not to surprise anyone! We would expect the prices charged by producers to have

increased over this period; indeed the firm conclusion is that the annual rate of producer price

inflation for all of these countries was low. In Spain there was a 20% rise from 1999-2009, in Ireland

a 15% increase. Greece saw producer prices move higher by 14% and Italy and Portugal saw the

slowest rate of factory gate inflation of 9% and 7% respectively. For all five countries, the average

annual change in producer price inflation over the ten year range was less than 2%.

There was some evidence of producer price deflation from 1999 through to the end of 2000and another phase of mild deflation or gently rising producer prices during the middle of thedecade from 2004 through to 2008.


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The steepest annual rise in producer prices came from the start of 2002 through to the endof 2003. Does this provide some evidence about the impact of the introduction of the Euro

which came into common circulation in January 2002? Some critics of the single currency

claim that the switch to a new currency gives producers the opportunity to exploit confusion

about the value of a new currency by raising their prices and making higher profit margins.

The index of producer prices in Ireland for example climbed from 102 in the 1st quarter of

2002 to 116 at the same stage two years later.

We could do with better data to come to a stronger view on this claim we are not providedwith comprehensive data on consumer / retail prices which would be a better guide to any

likely price gouging by retailers as a new currency the Euro came into circulation as a

means of exchange when buying goods and services.

What causes producer prices to change?

This chart provides an opportunity for some analysis of the possible causes of rises or falls in the

prices of manufactured goods.

Producer price inflation is affected for example by changes in:

1. The exchange rate e.g. depreciation in the exchange rate will cause an increase in theprices of imported components and raw materials, leading to higher variable costs for

manufacturers who may then choose to pass on their higher costs to their own customers.

All five of the countries shown in the chart share the same currency

2. Changes in indirect taxes e.g. a change in value added tax or other excise duties which aretaxes on producers. Whether or not they are passed through in producer prices depends in

part on the price elasticity of demand and price elasticity of supply for their final output3. Changes in international commodity prices e.g. a rise in the world price of oil or natural

gas and also foodstuffs used in the food processing industries.

4. Changes in wage costs e.g. producer prices may rise in industries where wages rise fasterthan productivity (causing an increase in unit wage costs) and where labour costs are a

5. The strength of demand and the economic cycle producers find it easier to make higherprices stick when demand in their markets is strong and rising. Spain and Ireland fit the bill

here as for most of the decade - until their economies were engulfed in the global financial

crisis they enjoyed above average real GDP growth with a fast-expanding aggregate

demand. In contrast during a recession when demand has fallen and producers find that

they have high levels of unsold output, there is pressure for price discounting. Notice in Fig

2.2 that during 2the later months of 2008 and into 2009 we see producer prices falling in

Spain and Ireland and they were fairly flat in other countries.

Be ready to use supply and demand analysis diagrams to explain why produce prices can rise or fall.

Overall Spain and Ireland are two countries where producer prices have risen most quickly but this

is not decisive evidence that they have become less competitive within the single currency area. The

gap with the other PIIGS countries is not huge. And we are not given any information on an index of

producer prices for the Euro Area as


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Figure 2.3: ECB Index of competitiveness based on relative unit labour costs for Ireland, Italy,

Greece and Spain 1999-2009 (1999 Q1 = 100)

Competitiveness figures prominently in the F585 stimulus material for the June 2011 paper and Fig

2.3 is an important part of this.

What data is the chart showing?

The data in Fig 2.3 shows an index ofrelative unit labour costs for Ireland, Italy, Greece and Spain

over a period from 1999 through to the end of 2009.

What are unit labour costs?

Unit labour costs are labour costs per unit of production. Two factors determine changes in this

measure

1. The rate of increase in average wages / earnings in the labour market2. The rate of increase in labour productivity (i.e. output per worker employed)

Say for example that, in a given year, wages rise by 5% and there is also a 2% improvement in

productivity this implies that unit labour costs will rise by 3%.

What are relative unit labour costs?

These are labour costs relative to those of another country (e.g. comparing German labour costs

with those of Ireland) and they are usually expressed in a common currency. This means thatchanges in the exchange rate can bring about a change in relative unit labour costs for example a


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depreciation of the pound (sterling) against the Euro can lead to UK relative labour costs appearing

cheaper than they were.

Inside a single currency area the option of a depreciation / devaluation of the exchange rate are not

open to member nations. A rise in relative unit labour costs is taken as an indicator of a worsening of

cost competitiveness within the Euro Area.

What is the data showing?

The data covers four countries (Portugal not included although it was in Fig 2.2)

Over the eleven years since the launch of the Euro (1999-2009)

Irish relative unit labour costs have increased by 27% - but significantly there was a 32% risefrom 2003 through to the middle of 2008 this was the period when the Irish economy

became notably less competitive (in purely cost terms)

Spanish relative unit labour costs have grown by 13% - there was a 14% rise between 2002and 2008

Greece relative unit labour costs have risen by 15% but since the start of 2002 there hasbeen a 32% growth in this measure

Italy relative unit labour costs have edged higher by 12%Relative unit labour costs were falling for the first two -2000. In

part this was because the external value of the Euro was depreciating against currencies such as the

US dollar and the pound (sterling).

Is this change in the data significant?

Yes! Fig 2.3 reveals an important change in relative costs within the single currency area. The four

countries chosen have seen their unit costs rise and assuming this has been translated into higher

prices this implies that they have lost some cost and price competitiveness. Depending in part on

the price elasticity of demand for different goods and services, a rise in the relative cost / price of

output will lead to a substitution effect away from producers in PIIGS economies and we might see

this in a change in the balance of trade in goods and services. Countries such as Spain and Greece

saw a sizeable increase in the size of their trade deficits in the years before the global financial crisis.

Limitations of the data given in the extract

We are not given any information on what has happened to relative unit labour costs for other

nations within the Euro Area. It would have been preferable to see the path of relative costs for the

leading economy Germany a country that has experienced supply-side reforms (notably in the

former East Germany) with the result that relative unit labour costs have actually fallen.

It would also be helpful to have some data on the trade balances for the PIIGS countries to see if

their above average growth, higher relative inflation and worsening competitiveness has shown

through in a widening of their trade or current account deficits on the balance of payments. I have

provided this data below for Spain and we can see from the next chart how the current account

deficit for Spain measured as a share of GDP grew from 4% in 2002 to more than 10% in 2008.


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Spanish economycurrent account of the balance of payments (source: Timetric)

Has the recession affected relative unit labour costs?

The data in Fig 2.3 takes us up to the end of 2009 and we can see some of the effects of the

recession on unit labour costs. Relative unit labour costs have dipped for Spain and Ireland but not

for Greece whose data appears to show a continuing rise in relative costs the index based to the

start of 1999 actually overtakes Spain and Italy in the 2nd

and 3rd

quarter of 2009.

Relative unit labour costs will fall when:

1. There is a fall in average wages / earnings in the labour market. One feature of therecession has been pressure for hundreds of thousands of workers to accept either a pay

freeze (meaning a real pay cut) or an actual cut in their wages and take home pay

2. An improvement in productivity businesses have been challenged by the recession tostreamline their production and find ways to improve labour efficiency


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Extract3:ThefutureoftheSpanisheconomy

Extract 3 focuses on Spain s biggest economies (until recently it was the 9th largest

in the world but the recession has caused them to drop to 12th

in the global league table). Spain

makes up 8.5% of the EU GDP so developments in Spain have a sizeable bearing on the economic

health of the Euro Area as a whole and also the UK the UK is the second largest foreign investor in

Spain and there are around 700 British companies based in the country. There are around 387,000

British people permanently residing in Spain.

Spain Macro Indicators 2007 2008 2009 2010 2011

Real GDP (% change) 3.6 0.9 -3.7 -0.2 0.9

Consumer spending (% change) 3.7 -0.6 -4.2 1.5 1.7

Capital investment (% change) 4.5 -4.8 -16.0 -6.8 -1.8

Exports (% change) 6.7 -1.1 -11.6 9.2 8.1

Imports (% change) 8.0 -5.3 -17.8 6.4 5.8

Unemployment rate (% of the labour force) 8.3 11.3 18.0 19.8 19.1

Fiscal balance (% of GDP) 1.9 -4.2 -11.1 -9.2 -6.3

Official policy interest rates (per cent) 4.3 4.6 1.2 0.8 1.1

Consumer price inflation (per cent) 2.8 4.1 -0.2 1.5 0.9

Balance of Payments Current Account (% of GDP) -10.0 -9.7 -5.5 -5.5 -5.2

The Future of the Spanish Economy

Up until the end of 2009, the (4.71% from peak to trough) was less than the

average of that in the euro area as a whole (see Fig. 1.1).

Yet RR de Acua & dependence on the

construction industrymight mean that itwould not recover from recession with the rest of the euro

area economies and that, peak to trough, the decline in GDP might be as much as 11%.


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They suggested that an economic recovery

unemployment rate could rise to 25%.

The Spanish economic cycle (source: Timetric)

Unemployment in Spain, measured as a % of the labour force (source: Timetric)

Our supporting charts reinforce the extract in showing the recession in Spain and what appears to be

a shallow and fragile economic recovery. Unemployment rose from 8% of the labour force in 2008 to

peak (for now) at just over 20% - less than the 25% mentioned in the extract. But keep in mind that

official figures for unemployment nearly always understate the true level of unemployment.


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A housing bubble in Spain increased construction from 7.5% to 10.8% of GDP (2000-2006), but the

Spanish building boom has come to a spectacular end - since the market's peak in April 2007, home

prices have tumbled 24 per cent and nearly 750,000 homes remain unsold or not completed.

The importance of Construction

The extract makes clear reference to the dependence of the Spanish economy of the construction

industry. The building industry takes up a large percentage of GDP and millions of jobs depend

directly or indirectly on it from construction firms, building supply industries, estate agents,

architects and other occupations connected to the property sector. On some estimates around 15%

of Spanish GDP is created from the construction industry and more than one worker in ten has a job

in the building industry.

There is no doubt that the Spanish property and construction sector has taken a big hit during the

recession. Many building projects remain half finished either because the supply of finance has

dried up or because property developers suffered a steep loss of confidence as buyer-demand

dropped away. Refinancing loans to finish construction projects became both difficult and expensive.

This section of the extract is an opportunity to bring in a discussion of negative accelerator and

negative multiplier effects:

Negative accelerator effects: This is when there is a collapse in investment demand becauseof a decline in final demand for a product in this case new housing (including off-plan

buildings)

Negative multiplier effects: This happens when a fall in investment spending brings about amultiplied final decrease in equilibrium national income and jobs. The multiplier effects of a

deep recession in the Spanish housing / construction industry have been large. The industry

is labour intensive and so the domestic labour market feels the effect of both of contraction

in employment and cuts in nominal and real wages.


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Dependence on tourism and property highlights the risks of an unbalanced economy and Spain

provides a good example of this. There is much talk of trying to bring about a balanced recovery in

European countries. This is much talk about the need for a balanced recovery one where

consumers and the government sector spend proportionately less (as a share of GDP) and exports

and investment grow in their place.

Quite how Spain will achieve this is open to question! The extract does not say which policies the

Spanish socialist government under Prime Minister Jose Luis Rodriguez Zapatero has introduced (if

at all) to provide economic support for the struggling construction sector.

Spain has one of the mostgenerous welfare systems in the euro area. Typically, a worker made

unemployed in Spain will receive up to 60% of their previous wage for 18 months after losing their

job. Fearing the social consequences ofrising unemployment, the Spanish government introduced

for the long-term unemployed. This alone added 3% of GDP

budget deficit.

This next section is about the possible connection between the generosity of welfare benefits and

the rate of unemployment. The important concept to explain here is that of the replacement ratio

i.e. the ratio of income out of work to income when in a job. The extract mentions that workers can

receive close to two thirds of the wage from their previous job for an extended period (18 months).

What might this do for the incentives to actively search for work? Does this mean that there is a higher level ofvoluntary unemployment in Spain? Does Spain therefore have higher frictional unemployment and a higher natural rate of

unemployment?

What options does the Spanish government have to change this? Will sufficient people votefor a government that plans (voluntarily) to change employment laws including reducing the

scale of out-of-work benefits?

Social consequences of rising unemployment

Unemployment in Spain is high perhaps the highest in the whole of the European Union and

much of it is long-term. Spain in particular has a high level oflong-term youth employment where

people have been out of work for at least one year. It is difficult to achieve a sustained reduction in

long term unemployment rates think about why this is so:

The extract asks us to think about the social consequences of high jobless rates:

1. Unemployment increases relative poverty especially in regions and for families where thereis no one of working age in a job

2. It can lead to social unrest and a loss of social cohesion damaging the fabric of society3. There is a possible rise in unemployment-related crime4. Increased incidence ofstress related health problems and family breakdown5. The social costs of rising level of debt many of the poorest families with poor employment

prospects can fall into a spiral of debt, paying huge annual rates of interest on unsecured

loans


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In other words persistently high unemployment is a failure of the labour market and creates

important and costly negative externalities.

The next section of the extract deals with the fiscal costs of the recession in Spain

Combined with a reduction in tax receipts, the budget deficitin Spain has required big cuts in

discretionary spending and has limited the ability of the Spanish governmentto continue to use

fiscal policy to prevent aggregate demand falling further.

Discretionary spending is that spending that is not determined by the stage of the economic cycle

and which a government has some degree of control. This is different from automatic changes in

government spending that arise as the economy moves from boom to slowdown to recession. In the

case of Spain, the relatively large welfare state and big public sector as a share of total GDP has

meant that the automatic stabilisers have helped to mitigate the impact of the recession on her

GDP. This links back to the top of Extract C which claims that the drop in Spanish GDP has been less

than for the Euro Area as a whole. This has been useful in preventing a depression but it has left

Spain (along with other PIIGS countries) with a huge fiscal deficit to contend with.


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Real house prices i.e. nominal house prices adjusted for inflation (source: Timetric)

The Spanish government has had to introduce a period of fiscal austerity in a bid to reduce the size

of their budget deficit. The official retirement age has risen to 67 from 65 and the government has

cut government spending, including across-the-board public servant wage cuts and frozen welfare

payments from pensions to child support. It is also aiming to introduce labour market reforms that

make it easier to lay off employees and reduce redundancy packages.

Unlike the first decade of its membership of the euro area, Spain cannot expect the ECB interest rate

to boost economic growth. With high inflation for much of the last decade, real interest rates in

years, Spain must turn its attention to improving its long-run growth potentialas emphasised not

only by research groups such as RR de Acua & Asociados but also by the IMF.

As part of its role, the IMF holds discussions with members every year. A team from the IMF visits the

country, collects economic and financial information,

economic developments and policies before preparing a report. Fig. 3.1 summarises key aspects of

the report published by the IMF on the Spanish economy in March 2009.

Key aspects of a report published by the IMF on the Spanish economy in March 2009

Despite the economic slowdown, wage and unit-labour costs are outpacing those in other euro area

countries andinflation remains structurally above the euro area average. This reflects a lack of

competition and contestability in output markets, inefficient labour markets, andrelatively low

productivity. Spain must introducepolicies to improve its international competitiveness. Plans for

product market reforms also need to be implemented.

Some of this extract repeats what has already been said namely that the Spanish economy enjoyed

a period of strong growth during the early years of their membership of the Euro (propelled in part

by strong inward investment and a period of low interest rates) but at a cost of relatively high

inflation and a boom in borrowing and credit that came unstuck in 2008-09.


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This reflects a lack of competition and contestability in output markets, inefficient labour markets,

andrelatively low productivity. Spain must introducepolicies to improve its international

competitiveness. Plans forproduct market reforms also need to be implemented.

Competition and contestability

Make sure you understand some of the features and characteristics of a contestable market:

1. Low entry barriers and exit costs which affects the ease of short-2. High levels of product differentiation between competing businesses and brands3. The ability to price discriminate charging different prices to different consumers for the

same products

4. The cost structure of a market such that the minimum efficient scale is not a largepercentage of market demand allowing many firms to enter and be competitive

5. There is interdependence between firms (similar to a competitive oligopoly)Barriers to market contestability exist when there are sunk costs. These are costs that have been

committed by a business cannot be recovered once a firm has entered the industry

Inefficient labour markets and relatively low productivity

What does this mean? In simple terms a labour

market that fails to match labour demand and

labour supply in ways that achieve desired

economic outcomes. The word inefficiency hints

strongly at a number of causes of labour market

failure some examples might include:

Persistently high rates ofstructuralunemployment caused by occupational

and geographical immobility of labour.

This can show through for example in big

differences in regional unemployment

rates within a country.

Workers in jobs for which they are not best suited for example a generation of graduatestudents who find that many of the available jobs do not make use of their qualifications.

This is an example ofallocative inefficiency in the labour market.

Failures of the labour market to provide sufficient skills and training for people Disincentives to look for and take paid work a classic example of a labour market

inefficiency is the existence of the poverty trap or an unemployment trap where people feel

that there is little economic incentive to work extra hours or take a job


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Employment rates in the Spanish economy (Source: Timetric)

An inefficient labour market finds it difficult to increase the percentage of the population of working

age into a full or a part-time job. Our chart above provides some data on employment rates for Spain

since the Euro was launched in 1999. Spain has made some progress in lifting employment both for

male and female workers but we can see the damage that the construction and tourism recession

has done to male employment rates a decade of increase has been wiped out in two years.

Note in the chart above that the employment rate among older workers has also started to decline

because of the recession.

The importance of labour market flexibility

We think a key word in this section of the extract is that offlexibility! In a rapidly-changing world

there needs to be a high level ofadaptability as patterns of demand change bringing about changes

in the pattern of employment.

The IMF appears to be criticising inflexibilities and immobility in the Spanish labour market and

arguing for labour market reforms to boost the human capital of the workforce and the skills and

incentives of people joining the labour market for the first time.

Relatively low productivity

Productivity is a measure of how much is produced per unit of input. Labour productivity can be

calculated per worker, per hour worked, etc. The IMF claims that labour productivity is relatively low

in Spain. And we have provided some background on this below. Note how for a long time after

1999, the annual improvement in labour productivity in Spain has lagged the average increase

attained by the Euro Area as a whole. Indeed in a few years Spanish labour productivity actually fell!

There was a surge in output per worker employed in 2009 but this can be put down largely to the

savage job losses in construction and tourism which meant that the employed labour force fell by

more than output. There is some evidence here for Spain under-performing on labour productivity.Consider which policies might raise labour efficiency in Spain in the years ahead.


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Productivity growth in Spain and in the Euro Area (source: Timetric)

Spain must introduce policies to improve its international

There is a huge potential policy agenda here! Remember that competitiveness is partly a question of

price and cost but also (and perhaps more importantly in globalised markets), it is down to non-price

factors when battling for sales and market share in world trade.

Plans for product market reforms need to be implemented

Examples might include:


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1. Reforms to competition policy i.e. tougher policies on cartels and collusion andenforcement of competition policy rules

2. Liberalisation of markets to reduce monopoly power (e.g. in retailing and property) andmake markets more contestable

3. Reductions in red tape e.g. fewer rules and regulations for private sector businesses4. Policies to improve incentives for business start-ups - new suppliers may have the

advantage of product innovation or a more competitive business model based on

different pricing strategies

5. Trade i.e. opening up the domestic market to greater international trade and inwardinvestment both to create more competition but also to raise productivity and

increase the productive capacity of the economy. Lower tariffs and quotas also have the

effect of reducing the cost of imported technology and other capital goods.

The IMF agenda

The prescription that the IMF is proposing for Spain is not unusual! The International Monetary Fund

has long preached increased competition allied to fiscal discipline as a recipe for economic reform.


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Extract4:Internationaltrade,internationaltradenegotiationsand

developingeconomies

Trade, Economic Recovery and Development

Having spent the bulk of the stimulus material focusing on the recession in Europe, Extract 4 changes

the focus away from the macroeconomic difficulties facing the PIIGS group of countries towards the

broader issues of how best to sustain a recovery in world trade in goods and services.

The focus of the extract is an edit of a speech given by the Director General of the World Trade

Organisation a body given the task of policing trade around the world economy and promoting

liberalisation of trade between nations and regions. One would expect the Director General to be in

strong support of measures designed to reduce protectionist measures and stimulate trade flows.

This shows through clearly in his comments.

Background: Turbulence in the World Economy 2007-2010

Much of the important background to extract is key developments in the global economy during the

remarkable period from 2007 onwards.

2007 2008 2009 2010

Real GDP (% change)

World 3.6 1.3 -2.2 3.5Emerging Economies 7.9 5.6 1.9 7.2

Latin America 5.0 3.4 -3.4 6.0

USA 1.9 0.0 -2.6 3.7

World Trade (% change) 8.4 3.7 -12.5 12.5

World Capital Investment Spending (% change) 7.1 3.6 -3.2 9.9

Developed (advanced nations) 1.5 -3.1 -14.0 1.9

Emerging Economies 19.5 16.1 13.8 19.5

Source: HSBC Global Economic Outlook

It is rare for global GDP to decline in real terms but it did so in 2009 by over 2 per cent. Crucial to

many of the issues raised in this case study is that world trade also shrank for the first time in nearly

twenty years and it did so spectacularly by over 12 per cent. There was also a collapse in

manufacturing production

capital investment spending among developed economies.

But many emerging economies continued to grow during the Global Financial Crisis and in its

aftermath. These countries are now the biggest drivers of demand growth in the world economy

leading to huge shifts in power and influence in the global economic and financial system.


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Here is the main body of Extract 4 together with our commentary and analysis:

Concerns about the impact of the global economic recession are not confined to members of the

euro area. Pascal Lamy, Director-General of the World Trade Organisation (WTO), emphasised the

importance ofinternational trade in his speech to the European Policy Centre in Brussels on 24

February 2010. The role of the WTO is to promote international trade and ensure that trade flows

smoothly, freely, fairly and predictably. Pascal Lamy concluded his speech by stating that there was

Doha Roundof international trade negotiations.

Fig. 4.1 below reproduces excerpt from his speech.

Further background on the Doha Round can be found here:

http://en.wikipedia.org/wiki/Doha_Development_Round

Fig. 4.1

Excerpts from a speech by Pascal Lamy, European Policy Centre in Brussels on 24 February 2010

These are not easy times. We know that in 2009, growth of real world GDP was negative, estimated

at2.2%. Furthermore, the global unemployment rate reached its highest level ever. The adverse

impact of the recent financial crisis on the world economy in terms of output and employment is

undeniable.

World trade has also been a casualty of this crisis, contracting in volume terms by around 12% in

2009 the sharpest decline since the end of the Second World War. The main explanation for this

freefall in trade has been the simultaneous reduction in aggregate demandacross all major world

economies.

To a lesser degree, trade has been adversely affected bysome instances of increased tariffs and

domestic subsidies, new non-tariff measures and more anti-dumping actions

This section concerns the sharp fall in the real value of world trade (i.e. in volume terms) in the wake

of the global financial crisis and the world recession in 2008-09. A contraction in global output of 2%

was accompanied by a 12% decline in the value of international trade. This is known as de-

globalisation. See the supporting data in the chart below.
http://en.wikipedia.org/wiki/Doha_Development_Roundhttp://en.wikipedia.org/wiki/Doha_Development_Roundhttp://en.wikipedia.org/wiki/Doha_Development_Round


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The steep fall in the value of global trade is also shown below by the drop in the value of

merchandise trade measured as a percentage of global GDP. This was a sudden reversal of a long-

term increase in global exchange of goods and services growing from 20% of world GDP in 1970 to

over 50% in 2007.

Several factors have combined to cause the slump in trade:

a. A freezing of trade credit many export dependent businesses and countries found itdifficult to get the finance necessary to pay for making and then transporting products

to overseas markets

b. The dominance of manufactured products in global exchange: The percentage of worldtrade now accounted for by manufactured durable products has grown over the years

but in the international downturn this is where cancelled orders were concentrated.


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Exporting countries such as Germany and Japan suffered most from the collapse in

demand. There was also a slowdown in the growth of manufactured exports from China

c. Export quotas: Some food-producing countries took steps to limit food exports in theaftermath of rising world foodstuff prices. They wanted to make sure that there was

sufficient to eat at affordable prices for their own population first.

d. The vertical disintegration of global production a slump in demand for consumerdurable products and capital goods (e.g. new machinery and technology) hit supply-

chain industries across the world causing a steep decline in intra-industry trade

e. The rise of protectionism - in 2009 the World Trade Organisation warned of a return toopen and hidden forms of import controls by many countries struggling to cope with the

recession. This is referred to by Pascal Lamy in his speech when he mentions new non-

tariff measures and more anti-dumping actions.

Recap on protectionist policies

Protectionism represents any attempt by a government to impose restrictions on trade in goods and

services. The aim is to cushion domestic businesses and industries from overseas competition.

Tariffs - a tariff is a tax that raises the price of imported products and causes a contraction indomestic demand and an expansion in domestic supply.

Quotas - quantitative limits on the level of imports allowed. Voluntary Export Restraint Arrangements where two countries make an agreement to

limit the volume of their exports to one another over an agreed period of time.

Embargoes - a total ban on imported goods. Intellectual property laws (patents and copyrights). Preferential state procurement policies where a government favours local/domestic

producers when finalising contracts for state spending e.g. infrastructure projects

Export subsidies - a payment to encourage domestic production by lowering their costs.Subsidies in the form of soft-loans can

in overseas markets. Well known subsidies include Common Agricultural Policy in the EU, or

cotton subsidies for US farmers.

Domestic subsidies government financial help for domestic businesses facing financialproblems e.g. subsidies for car manufacturers or loss-making airlines

Import licensing - governments grants importers the license to import goods. Exchange controls - limiting foreign exchange that can move between countries. Financial protectionism for example when a national government instructs its banks to

give priority when making loans to domestic businesses. This form of protectionism seems to

be on the rise in the aftermath of the credit crunch.

Murky or hidden protectionism - e.g. state measures that indirectly discriminate againstforeign workers, investors and traders. A government subsidy that is paid only when

consumers buy locally produced goods and services would count as an example.

Competitive devaluations:Where a government intervenes in currency markets to keep theforeign exchange rate of their currency artificially low. This has become more prominent in

recent years with some countries (notably Brazil) claiming that their economy has suffered

because of currency wars. The WTO is currently investigating this.


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In most developed economies, including the EU, stimulus packages have been instrumental in

preventing further deterioration in output, while preparing the path to recovery. But the positive

impact of national stimulus packages is at best temporaryand worries are mounting over the huge

budget deficits created by many governments. Economies urgently need other sources of growth.

This section links in to the issue of fiscal stimulus policies and the arguments relating to the high size

of fiscal deficits in many countries. For the OCR exam understand well how fiscal stimulus policies

can work in stabilising demand, output and jobs. (Keynesian economists support the active use of

fiscal policy to actively manage demand during a recession). But be prepared to evaluate the

possible effects of high budget deficits and rising levels of government debt.

European countries with a high level of state debt may be constrained in using fiscal policy to

manage demand and activity in their economy during a recession. Some of the risks of a high level of

debt are:

Interest rates on bonds may have to rise to persuade investors to fund further newborrowing. This will increase the cost of servicing debts and put pressure on how much

money is available for other important areas of government spending such as education

Rising debt today may lead to higher taxes in the future and may crowd out consumerspending and business investment. It also means that future generations of taxpayers

may face the largest burden of repaying the debt even though they were not responsible

Possible future balance of payments problems by selling debt to overseas investors theinterest on the loans will leave an economy adding to the current account deficit

When debt levels reach high levels there is an incentive for a government to reduce the real

This can lead to capital flight from a country and a run on the currency.

That said there are many economists who are less worried about the size of government debt. If a

country has access to lines of credit from both domestic and foreign sources, what is wrong with

extra borrowing? Especially if this helps to restore & stabilise aggregate demand at a time of

macroeconomic weakness

An example of a fiscal stimulus would be a social housing investment project


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Why might the impact of a fiscal stimulus be largely temporary?

Much depends on what type of stimulus package is introduced for example:

Temporary scrappage schemes such as for cars, boilers and other consumer durables Temporary cuts in direct or indirect taxation for example a reduction in VAT Temporary increases in state sector spending / financial support for jobs including labour

subsidies (the German government used such a scheme during the recession)

The temporary nature of a stimulus may refer to the weakening of the fiscal multiplier effect arising

from a stimulus from the government. The fiscal multiplier measures the final change in national

income that results from a deliberate change in either government spending and/or taxation.

Several factors affect the likely size of the fiscal multiplier effect:

1. Choice of stimulus: Tax cuts or higher government spending?2. Taxes: Who are the beneficiaries of tax reductions? Tax cuts seem to have a bigger effect on

demand when targeted on lower income families with a high propensity to spending

3. Expectations of taxation in the future consumers may save temporary tax cuts becausethey fear or expect a reversal of taxes later on in the business cycle

4. Availability of credit for businesses affected by fiscal stimulus policies can they raise thenecessary finance to allow them to expand production and take on extra workers?

5. Openness of the economy and the level of the exchange rate to what extent will a fiscalstimulus lead to a rise in import demand with money leaving the circular flow?

6. Monetary policy response to a large rise in government borrowing will policy interestrates rise in response to a higher budget deficit?

7. Amount of spare capacity in the economy (size of the output gap)8. General level of consumer & business confidence / uncertainty sometimes known as the

state of animal spirits.

This is where trade can be an important part of the story, both in the short to medium-term and in

the long run. We must, therefore, ensure that trade remains open. But we must also work to keep

opening trade through the conclusion of the Doha Round. A Doha deal would provide new market

opportunities for developing economies, in particular, through the reduction of tariff barriers and

domestic subsidies.


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When analysing a tariff or a domestic subsidy try to consider the direct and indirect effects on

consumers and producers. And also use economic welfare concepts such as consumer and producer

surplus

Allegations ofdumping have been the most frequent cause of trade disputes in recent years. 88 of

the 104

ocr f585 global economy june 2011 toolkit

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