Thursday, February 25, 2010


It seems pretty clear by now that we are experiencing the worst economic upheaval in global terms since the Great Depression of the 1930's. Indeed I would submit that our present problems are of a more fundamental nature that will require a major change with respect to current economic thinking before they can be solved.

It can perhaps help to provide some perspective on the present situation by briefly reviewing the nature of the changes brought about by the last crisis.

Though it is simplifying somewhat, before the Great Depression, the philosophy of free markets without intervention still held sway. The Government though still necessarily involved in the economy, played a largely passsive role attempting to balance the books with respect to its own incomes and expenditure.

Though the business cycle was well recognised as a regular occurring phenomenon, it was viewed somewhat like weather conditions. Thus when things were especially bad one simply waited for market conditions to eventually improve.

However the Great Depression - which was particularly severe and long protracted - somewhat inevitably led to new thinking with John Maynard Keynes especially questioning the prevailing consensus. One way of expressing this is with reference to the fallacy of composition.

Free market economics is firmly based on the primacy of the individual micro element (with respect to consumption, production and markets). This then led to a somewhat reduced notion of the overall macro economy as simply the aggregate of such micro elements.

However the phenomenon of the Business Cycle - which was a very regular occurence with respect to developed economies - indicated that key assumption on which free markets were based did not actually operate in practice (certainly within a short time frame).

Thursday, February 11, 2010

Greek Problems!

The present economic difficulties in Greece are pointing to serious deficiencies in the overall operation of the Eurozone.

The Eurozone now consists of 16 member countries. Whereas some of these such as Germany, France, and Italy relate to sizable economies, several others such as Greece and Portugal are relatively small (and not as developed as the largest members).

As I have stated before, EMU (Economic and Monetary Union) since its inception has contained a significant weakness. Whereas it is very impressive on the monetary side with a single currency controlled by a strong Central Bank, it is comparatively weak on the equally important fiscal side. Though a European Budget does indeed exist, it is of extremely small magnitude (just over 1% of Community GDP) and not designed in any case for economic management purposes.

Though certain fiscal guidelines (such as maximum level of permitted borrowing) are laid down in the Growth and Stability Pact, no real budgetary coordination takes place as between Eurozone members. So when Germany for example is preparing its annual budget, the focus is primarily on measures to assist the German economy. Consequent effects on other members' performance - if considered at all - are of a very peripheral nature.

While the overall policy of the European Central Bank is geared to consideration of the Eurozone (en bloc), the performance of individual member countries can vary significantly from the norm.

And this scenario is much more likely for a smaller member as its individual performance has little impact on the whole Eurozone.

So for example when Ireland (representing between 1% and 2% of total Eurozone GDP) was experiencing an inflationary boom around 2000 and 2001, the Eurozone area was showing signs of recession. Therefore the consequent action of the Central Bank in reducing interest rates to stimulate overall performance only acted to aggravate the boom in Ireland.

Now in the current economic climate several of the smaller peripheral Eurozone countries such as Ireland, Portugal and Greece have been experiencing especially harsh deflationary problems. However as the rest of the Eurozone returns to economic growth, the ECB could respond by gradually increasing interest rates, which could then make the problems of adjustment of these smaller members much more severe.

It might help to understand the nature of the current problems in Greece (and to a lesser extent in countries such as Portugal, Spain, Italy and Ireland) by referring to the previous exchange rate system that operated in the Community prior to the establishment of EMU in 1999.

In the early 90's, the European Monetary System (EMS) was in place with a key element the Exchange Rate Mechanism (ERM). Countries were still using separate national currencies but attempting to keep them relatively fixed (with only small margins of fluctuation permitted). The ultimate basis for deciding on the central rates given to each currency was with reference to a notional currency called the European Currency Unit (ECU) that was to become the eventual Euro.

From 1987 to 1992 the ERM appeared to be working very well with all member countries staying within the narrow permitted limits of deviation (just over 2%) from the central value of the ECU without resorting to revaluation of national currencies.

Indeed the ability to preserve such discipline was considered at the time as a necessary prerequisite for eventual introduction of a common currency, where effectively no exchange rate deviations would be possible.

However this apparent stability was to prove something of a mirage when in late '92 and early '93 a number of currencies in the system came under speculative attack forcing eventual devaluation.

Then in order to preserve the Exchange Rate Mechanism the permitted deviation in day to day values was - incredibly - widened to 15% (either way of the central value).

So in effect little or no true exchange rate discipline was required in currency behaviour prior to introduction of the Euro.

I was therefore strongly of the view that the new Euro system would prove to be highly inflexible in the wake of any sudden deflationary shock in the system.

And in 2008 we certainly experienced that shock through unprecedented problems in the international financial system.

Now if the old ERM system was in existence it is easy to imagine that a country experiencing special difficulties would find that speculation with respect to its currency would force the required devaluation before then switching to another currency. And in all likelihood this would have led to a major realignment with respect to the currencies of several member countries.

However because of the single currency, such adjustment is not possible. Rather speculation manifests itself in an alternative fashion in an investor unwillingness to accept the bonds issued by the government in question (as it is forced to borrow more to deal with the deflationary problem).

In effect that country then faces a sharply rising interest rate differential to be offered to borrowers to compensate for the perceived uncertainty (and growing possibility of eventual default on such bonds issued).

And for a country such as Greece already facing the prospect of severe and very unpopular cutbacks, such a burden could easily prove intolerable.

What makes the situation worse is that because of the need to protect the Euro experiment as a whole, the "offending" country Greece could easily take the view that it would be better to wait to be "bailed-out" by the other members of the Eurozone rather than implement extremely harsh deflationary measures in its own economy.

So what we are witnessing at the moment is an unconvincing game of bluff. At yesterday's meeting of the European Council it was announced that no aid was requested by Greece but that if the situation persisted through continuing speculation, that a rescue plan was in place to deal with the situation.

In other words the EU Council was hoping that this somewhat vague strategy would be enough to stabilise the bond markets (without having to declare its hand on the precise details of a recovery plan).

If however - as seems increasingly likely - that further assistance will indeed be required for Greece, then the EU could get into deeper water, for any rescue plan is bound to be seen as a "bail-out" irrespective of Council denials.

And once the concept of a "bail-out" is accepted with relation to Greece, why should this not apply next to Portugal, Spain and Italy (who are also suffering considerable financial difficulties)?

And as speculators are very shrewd, they will quickly realise that perhaps the will is not there to mount expensive "bail-out" rescues for every state suffering extreme speculative pressure with respect to the price of its bonds.

So the crisis in Greece is really pointing to the question of the very viability of EMU as presently conceived.

And in its present form it has to be admitted that it is crucially flawed.

I will propose now what I feel is actually necessary for a sustainable EMU and then suggest what I believe is actually feasible in the present circumstances.

When we compare the Eurozone to the US (which represents another EMU region) we can detect a noticeable difference.

In the US a considerable amount of fiscal activity is controlled centrally through the federal budget. This therefore enables stabilisation measures to be taken with a view to influencing economic activity throughout the whole region.

So for example in the past year, President Obama has implemented an expansionary plan with a view to boosting output and expenditure in the US.

However in the Eurozone no similar mechanism exists with the vast bulk of spending controlled at national budget level. Therefore no adequate fiscal means exists for presently attempting to achieve overall recovery in the Eurozone area.

Indeed for such a mechanism to exist we would need a much greater level of political integration whereby member countries would hand over considerable levels of fiscal control to a central budgetary authority. And needless to say such a degree of EU political integration does not actually exist.

In an attempt to influence fiscal policy at a national level, the Eurozone operates a Growth and Stability Pact. This is mainly designed to control the size of budget deficits and the consequent need for borrowing. However it has proved a very flawed mechanism of control.

Though financial penalties are supposed to be imposed for failure to meet guidelines, this has proven quite impractical as adequate means do not exist for collecting fines from offending members.

Also the guidelines are somewhat vague whereby the rules can be broken in - not clearly defined - exceptional circumstances.

Finally they are asymmetrical in that no similar rules are laid down with respect to the size of budget surpluses that governments should aim for during boom economic conditions.

Also there is a crucial problem in the way in which borrowing arrangements are financed for Eurozone countries whereby this remains the responsibility of each individual member.

This is causing a huge difficulty in Greece. Bond investors are clearly uncertain regarding the ability of the Government to take the necessary measures to cut its excessive budget deficit (13% of GDP). Therefore they are demanding a significant additional premium in terms of interest rates before lending money.

And this is not confined to Greece. It proved a significant problem for Ireland last year and with the present uncertainty could quickly spread to other troubled economies such as Portugal and Spain.

It would seem logical however in a true single currency area that euro bonds should be issued with borrowing required by any individual country thereby backed by all Eurozone members. Because of the lower risk of possible default on such loans, the interest rate attaching to such bonds should thereby stay much lower than that presently being paid by several of the weaker members.

Though this proposal has indeed been already suggested it was stoutly resisted. For stronger members, such as Germany and France, this would entail a large commitment, probably entailing higher interest rates on bonds than what they presently pay, without any obvious benefit in national terms.

So once again we have to face the fact that political integration is not yet sufficient to enable a true EMU to operate. Therefore it is not really feasible to maintain it in its present form without endangering the long run economic performance of many of its members.

My own suggestion as to a more viable alternative would run along the present lines!

A small core of economies (largely associated with original EU members) could indeed continue in a workable EMU. However even here, greater fiscal co-ordination and stricter control measures would need to be imposed. Also a common euro bond, guaranteed by all member states to fund borrowing requirements, should be considered.

Then we would have perhaps a larger layer of other economies in an exchange rate arrangement similar to the previous ERM. Basically these economies could use national currencies that closely track the Euro. However a degree of flexibility with respect to day to day movements could be maintained with the possibility of more substantial realignment of currency values in exceptional circumstances.

A degree of movement of switching as between both systems could be facilitated with poorly performing economies in the EMU facing eventual relegation to the 2nd tier and with successful countries in the 2nd tier becoming eligible for promotion to EMU.

Finally a small group of countries remaining especially resistant to further political integration, including perhaps the UK, Sweden and Demmark, might remain outside these systems altogether and maintain freely floating currencies.

It would be a mistake to push the notion of integration (both economic and political) further than is practically possible. Though I broadly supported the Lisbon Treaty, I would accept that political masters in the EU have been more in favour of integration than common citizens in the member countries. Much more therefore needs to be done to foster an authentic European identity before measures, properly dependent on further political integration, are pursued.

Thursday, November 26, 2009

What is the Short Run!

The short-run is a much used concept in Economics. However when one investigates what it is actually supposed to mean it appears so nebulous as to be virtually meaningless.

One context where is it widely used is in relation to costs of production. Here the distinction is made as between the short run and long run based on fixed and variable costs.

Fixed costs relate to financial commitments that occur at certain discrete time intervals and are therefore not related directly to changes in the output level.

For example a retail firm could enter into a leasing agreement on a premises for a period of 3 years. Therefore the rent on the premises would have to be paid for this period of time irrespective of trading conditions.

The implication therefore is that in the case of - say - a sharp downturn in sales that cost adjustments would have to be confined to variable costs e.g. raw material inputs and labour.

However though there is a certain truth to this, in practice it is not so clear cut. Fixed costs may not be entirely fixed. Thus in the present climate of recession many tenants are seeking to renegotiate lower rental terms on lease agreements (with varying degrees of success).

Also there are a whole series of fixed costs which come for renewal at varying periods of time. So there is therefore not just one short run period (which varies from sector to sector) but in fact a number of vaguely defined overlapping short runs occurring as certain payments fall due for payment.

There is also another source of confusion as the short run is sometimes referred to the period in which the overall scale (or size of the business cannot be changed.

For example a retail business might be operating out of a certain sized premises on a lease agreement.

Now if business is good and the owners wish to move to a larger premises they may feel obliged to wait till the present lease agreement expires. However in the meantime other fixed cost payments may come up for renewal e.g. insurance, interest payments to banks, depreciation etc.

So, the long run in this sense i.e. where the scale of a business can be changed does not equate in any exact way with the previous definition (where certain fixed cost commitments occur not directly related to the level of trading).

The short run is also used in another vague sense to refer to somewhat different circumstances.

For example it is accepted that it may make sense for a firm to trade at a loss in the short run (provided that variable costs are covered). So, many hotels in Ireland are in this position at present due to the severity of the current recession. The rationale for doing this is based on the hope that trading conditions will eventually pick up with acceptable profit margins once again attainable.

However the short run here has no clear time scale. Some hotels with deeper financial pockets would be able to ride out the recession for a considerable period of time. For others more deeply in debt, inevitable closure would occur at an earlier stage. Indeed these calculations can be complicated further by the fact that in certain cases the banks may not want hotels to close because of the slump in property prices thereby enabling them to keep operating (without even variable costs being fully covered).

The short run is used yet again in another economics context (which bears no direct relationship to previous meanings).

For example in speaking of perfect competition, economists distinguish as between the short run and long run.

The idea here is that certain firms could steal a march on rival firms e.g. through greater efficiency thereby making supernormal profits. However in a highly competitive sector one would expect other firms to keep catching up thus eliminating excess profit margins. So in the long run only "normal" profits would be made. However clearly this meaning of the "short-term" while again extremely vague in practical terms bears no direct relationship to previous definitions based on the distinction between fixed and variable costs.

Monday, November 16, 2009

The Paradox of Competition

One of the key assumptions of the free market approach to Economics is the benefit of competition in ensuring greater efficiency in the provision of goods and services. And indeed from one valid perspective this has considerable merit. For example look at how the airline industry was revolutionised (for the better) through greater deregulation allowing private operators to compete against the - formerly - state owned airlines!

However there are subtle problems inherent in this approach. Some companies will always for various reasons be "more equal" than others with a strong incentive to use inherent advantages to achieve a more permanent dominance in their sector.

For example we might view Microsoft in this light. Now, one can theoretically argue that any firm is free to enter the software sector and compete with Microsoft. However Microsoft has already built up such a strong position that it would not be able to do so on equal terms. So it is only the possibility of new technological revolution - led by another pioneer firm - such as Google that can really hope to threaten its position.

So if we are to ensure that firms such as Microsoft do not abuse market power we need more rather than less regulation (which goes against free market instincts).

However there is an even bigger potential problem which has received very little attention. Once again the benefit of free markets is based on the preservation of competition. However for the the free market system - as both an economic and political ideology - since the ending of Communism in the early 90's, there has been no such competition.

Indeed one can justifiably argue that the near collapse of the international financial crisis recently has been due to the unhealthy dominance of just one ideological system (devoted to unfettered market competition).

There are inherent weaknesses in the capitalist system that remain continually ignored. Unfortunately despite this latest near miss I expect in the short-term that there will be an attempt to return to business as normal.

If it is justifiably considered unwise to have markets without competition, it is even more unwise in ideological terms to then attempt to maintain a monopoly for the market system!

Monday, November 9, 2009

Who Bears Risk?

Anyone who has been exposed to an introductory course on Economics will be familiar with the four factors of production, land, labour, capital and enterprise.

These - we are told - serve as the basic inputs for all economic output. Thus to produce any economic good or service, some unique combination of the factors of production is required. Likewise associated with each of these factors is a characteristic payment. Indeed all income that is generated relates to payments to these respective factors.

Associated with land we have rent, with labour, wages (salaries and other earnings), with capital, interest and with enterprise, profits.

However the 4th of these i.e. enterprise, is quite problematic especially in light of the recent financial crisis. I am not the first to raise queries regarding the nature of profits!

For Karl Marx "value" attributed to enterprise in capitalist societies properly belonged to the workers who produced the commodities.
And major communist societies such as the Soviet Union and China for many years attempted to organise production without proper recognition of the special contribution of enterprise.

However, while acknowledging the important role of enterprise, it is still valid to raise important issues regarding its interpretation.

The entrepreneur in capitalist society is viewed as the person who, in attempting to initially set up a business, takes a special risk.

In economics the characteristic payment for this risk is referred to as "normal profits". However due to the many uncertainties typically involved actual returns may exceed the normal return (leading to supernormal profits) or fall below (resulting in supernormal losses).

In large publicly quoted businesses e.g. banks, these risks are spread out among a wide number of shareholders. Typically a shareholder might expect a characteristic dividend payment (as measurement of normal profit). However in good times extra rewards might arise through substantial capital gain in share values and/or extra generous dividend pay-outs. However - sticking with banks for the moment - there is a big problem with this view of risk, as taxpayers in countries, such as Ireland, are now financing the massive losses of banks resulting from reckless mismanagement.

The point I am making is that we need to distinguish as between risk (as narrowly defined), applicable to shareholders and a more general risk that is shared by all society. The narrow risk in this context relates to the possible losses that accrue directly to bank shareholders. The more general risk relates to possible misperformance - and perhaps ultimate collapse - of the banking system generally that would cause huge losses for taxpayers.

For example this is very obvious in my own country, where taxpayers are rightly indignant at being asked to provide for the attempted "clean-up" of the major banks while business also suffers other losses due the the continuing lack of liquidity in the system.

Given that this is patently the case i.e. that the losses of the banks are being generally borne by society as a whole, it makes little sense therefore in good times to associate profits exclusively with bank shareholders. It is precisely this lack of symmetry in the way that we view the matter that is leading to such a strong sense of injustice worldwide. It indeed represents a fundamental problem with the capitalist system.

Thus there is a holistic collective irreducible nature to rightful reward in any society that is blatantly ignored in present market economics.

The collective nature of risk also extends to the setting up of new businesses. Now, in the normal course of events many such businesses are doomed to fail (often within a relatively short time frame). The risk here does not merely extend to the prospective owners of such failed businesses but also to unpaid creditors and loss of resources generally to society. Given that this clearly is the case then it makes little sense to identify the profits of successful surviving businesses merely with their owners!

Another strong example of this problem arises from the fact that millions of workers are now losing their jobs in the private sector. Once again there is a narrow and general risk involved in running a business. If a large business fails, the shareholders clearly will suffer (representing narrow risk).

However the workers employed by that business will also suffer. And because in a recession the possibility of obtaining alternative employment is greatly reduced the loss that is thereby suffered by the workers may be much greater that that pertaining to the shareholders.

Once again the logic of this is that in a very real sense as workers are exposed to - perhaps - the greatest risk (in terms of possible job loss) that have a right to participate in the profits of a business when it prospers.

The failure to recognise this fact therefore exposes the lack of any true collective dimension in our treatment of economic society.

I will give just one more example. If we look at a highly successful company e.g. Microsoft we can see that enormous profits have accrued to its owners especially to founding member Bill Gates. However we cannot properly view a successful innovation such as a seminal new software product solely with its producers!

In fact, the success of any product entails a complex relationship involving both producers and consumers. Therefore there is a much more general aspect to risk with respect to any new product or service that involves the wider group of consumers as essential partners. Therefore the attempt to associate all risks narrowly with the producer is strictly invalid.

What we need therefore is a radical change in perspective.

The success or failure of any product pertains ultimately to society as a whole (and not just narrowly to initial producers who are never independent of consumers).

When we recognise this essential collective dimension, profits from economic production accrue ultimately to society as a whole and thereby should be distributed much more equally than in present circumstances.