Removing the World Bank Blinkers – Income Categories and Foreign Aid

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In one of my very first posts I looked at the recent decision by the UK government to cut foreign aid to India. One of the main justifications used by policy makers was that India had now reached a level of development which enabled it to fight poverty on its own. Arguably the main driving force behind this opinion was India’s graduation to middle income country status (MIC) in 2007. However these average income based measures adopted by the World Bank and OECD have rarely come under close scrutiny. Whilst income has always been highly correlated with many other development indicators, such measures can still mask many important macro level issues.

In a 2011 publication by the ODI, Jonathan Glennie highlights some of the main problems which can evolve from using such measures. Firstly, although low income countries (LICs) tend to have larger proportions of people living in poverty, the bulk of the world’s poor live in MICs. For instance in 1990 94.4% of those living on less than $1 a day were situated in LICs, however by 2008 this number had diminished to just 23.3%. This shift has been mainly attributed to the five major countries known as the PICNIs who recently graduated from LIC to MIC status. The group includes China (which reached MIC status in 1999), Indonesia (1999), India (2007), Nigeria (2008) and Pakistan (2008); all which combined account for 70% of the world’s poorest individuals.

Next Glennie explains that such measures have been criticized for being arbitrarily set with bandwidths that exhibit little rationale. For instance in table 1 we can see that the MIC category has an extremely large bandwidth.

Table 1. World Bank Income Categories

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This means that for at country at one end of the spectrum can be up to 12 times more richer than those at the the lower end. Unfortunately, as highlighted by Glennie, such categorizations can lead to countries receiving less in aid once they cross over into the MIC category. Prominent examples include Japan which has reduced the proportion of its total aid dedicated to MICs from 66% to around 34% over a ten year period. Similarly countries such as Canada and the Netherlands have cut theirs by around a third.

This highlights a worrying trend whereby aid is being shifted away from MICs despite the fact that they contain the highest number of poor individuals. The Economist also stresses this issue by stating that policymakers may soon face a dilemma where global poverty is mostly focused in countries which may be seen as rich enough to not require aid. Naturally, with the current economic difficulties,  policymakers and the media in the west will look to these arbitrary categories to justify cuts in aid.  In contrast, if more multidimensional indicators of development were accounted for such cuts would be more difficult to justify.

For instance former international secretary Andrew Mitchell has recently proposed for aid to be withdrawn from Ghana, Uganda and Zambia by stating,

“The aim of aid is to do itself out of business so it should not be needed any more. Ghana, Uganda and Zambia are countries making significant progress and are candidates.”

Both Ghana and Zambia achieved middle income country status in 2011 and Uganda is expected to reach the threshold by 2017. On this basis alone it would be easy to accept Mr Mitchell’s claim. After all the word ‘middle’ conjures up connotations of faring okay or not doing too bad. Its the center ground, not too poor but still striving for top. However look at a multidimensional indicator of development such as the UN’s Human Development Index, which takes into account statistics such as life expectancy and education, and the picture changes dramatically.

In the latest 2012 rankings all three countries rank outside of the top 100 countries, Ghana ranks 135th, Uganda 161st and Zambia 165th. With a total of 186 countries included in the measure these countries no longer reflect the middle ground. Likewise it is hard to justify that these countries are making ‘significant progress’ in relation to the rest of the world. If you click on the graph below you can also see that the countries also exhibit high levels of poverty (Y Axis),  in Zambia for instance 68.5% of the population live on less than $1.25, and score among the highest for gender inequality (X Axis) – I also added India’s position on the graph to further highlight how misleading the MIC classification can be.

Graph 1. HDI Data showing headcount poverty and gender inequality measures.

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Source: UN HDI Website

After observing these statistics it is extremely hard to accept that these countries are prime candidates for the immediate withdrawal of aid. Although they may be exhibiting high levels of economic growth and a middle income status these countries still have a long way to go when we look at a broader definition of development.

A new focus is therefore needed, policymakers must shrug their dated view that most poor people live in poor countries, this is no longer the case. Aid allocation models should no longer be modeled upon World Bank income categories. Instead they should take into account absolute levels of poverty and other social indicators of deprivation. In this sense aid should be focused on the poorest and most deprived individuals not the poorest sovereign states. After all this is the key principle for giving aid in the first place.

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When Economists Get It Wrong! The Worst Economic Predictions Of All Time

Economics is often described as the ‘dismal science’. Unlike other traditional sciences, economics rarely provides a simple solution to present day issues. Furthermore economists have a poor record of predicting the future. Even notable economists such as Joe Stiglitz agree that economists only get it right at best around 3 or 4 times out of ten. However it should be acknowledged that economic forecasting is a difficult art at best – human behavior is forever changing and the economy is a complex mechanism with many working parts. Nevertheless I thought it would be entertaining to highlight some of the most wildly inaccurate forecasts in recent times. Here are some of the best…

1. The Great Depression

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Almost every economist failed to predict the great crash of 1929. Most famously the economist Irvine Fisher (who Milton Friedman regarded as “the greatest economist the United States has ever produced”) predicted that stock market prices had reached “what looked like a permanently high plateau”. A week later the stock market crashed and didn’t bottom out until 1932, with the Dow Jones recording a 88% total loss in value.

Even the great John Maynard Keynes failed to see the fore-coming shock allegedly stating in 1927 that “We will not have any more crashes in our time.” 

2. The Japanese Automobile Industry

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In 1968 the BusinessWeek magazine stated that, “With over 15 types of foreign cars already on sale here, the Japanese auto industry isn’t likely to carve out a big share of the market for itself.” Fast forward to the present day and Japanese car manufactures now account for around 36% of the total US car market. Add in other Asian car makers and this figure jumps spectacularly to around 49.9%

3. The Soviet Economy

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In 1989 nobel winning economist Paul Samuelson asserted in his best selling textbook Economics that, “The Soviet economy is proof that, contrary to what many skeptics had earlier believed, a socialist command economy can function and even thrive.” Two years later the Soviet economy collapsed.

4. Dot Com Bubble

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Numerous predictions failed to foresee the dot com bubble. For instance in 1999 Smart Money magazine highlighted AOL, Yahoo and MCI WorldCom as some of its top picks for the forthcoming year. By 2001 AOL had lost 70% of its stock value after its merger with Time Warner. Later in 2002, MCI WorldCom became involved in one of the largest bankruptcy cases the US had ever seen.

However no prediction about the Dot Com boom was as profound as that made by James Glassman and Kevin Hassett in 1999. In their book, “Dow 36,000: The New Strategy for Profiting From the Coming Rise in the Stock Market”  Glassman and Hassett argued that the Dow Jones Industrial Average may rise to 36,000 within just a few years.  After reaching an initial high of 1,750.28 in January 2000, the Dow Jones fell to a low of low of 7,286.27 in October 2002. Even today the average remains still below 15,000. Glassman and Hassett’s book can now be found on Amazon for $0.01.

5. The Credit Crunch and Financial Crisis.

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In 2008 the sub prime mortgage crisis led to the collapse of a number of financial institutions and a global economic recession. However before 2008 many economists had an optimistic outlook for oncoming years, growth had been steady and inflation was finally under control. Despite the impending financial crisis many economists and policymakers were contend with the health of the banking sector. 

For instance in 2005 Alan Greenspan declared, “The use of a growing array of derivatives and … more-sophisticated approaches to measuring and managing risk are key factors underpinning the greater resilience of our largest financial institutions … Derivatives have permitted the unbundling of financial risks”.  

Similar optimism was forwarded by individuals such as David Lereah, chief economist for the National Association of Realtors, who in February 2006 published “Why the Real Estate Boom Will Not Bust,” which was essentially a guide for homeowners on how to profit from the expanding real estate market!

However these predictions fall short in comparison to the statement made by Federal Reserve Chairman Ben Bernanke  in 2007 who famously declared that, “The impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained.”

 

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Opening Pandora’s box – the G8 turns to Nestle and Monsanto to combat hunger

So the London Hunger Summit has culminated in a doubling of funds devoted to tackling hunger. The summit has promised to increase annual funding from rich countries to $900 million (currently $418 million) by 2020, equating to a total of $4.15 billion to tackle malnutrition. Eradicating extreme hunger by 2015 is one of the key Millennium Development Goals set out by the developed world. As of present, malnutrition accounts for 3.1 million child deaths per year, furthermore it is a major cause of stunted growth which has been shown to have implications for both a child’s future education and health prospects.

Although this agreement is being hailed as a ‘historic moment’ in the battle against hunger, the new commitment still falls short of the mark whilst creating a smokescreen for more damaging projects which have already been initiated. Firstly, the respected medical journal The Lancet claims that an extra $9.6 billion is needed to effectively reduce the level of malnutrition by 1 million. Clearly again when it comes to aid, we are falling short. For instance, in 1970 rich countries promised to give 0.7% of their total income as aid. However only 5 countries have met this target, known as the G07 these countries include Norway, Sweden, the Netherlands, Denmark and Luxembourg.

Secondly despite this lack of apparent aid there is another more worrying trend at work, governments are turning to the market to solve problems of agricultural underdevelopment. Whilst David Cameron would like us to focus on this new deal, the announcement overshadows other talks which may in fact worsen the problem of hunger in Africa.

In 2012 the G8 launched its new so called alliance for food security and nutrition. This alliance involves new deals between some of the largest multinational companies in the world and African governments. In a nutshell this initiative is designed to loosen up regulatory constraints on international capital flows and thus stimulate investment into African agriculture. The aim is to stimulate a so-called second ‘Green Revolution’ whereby African farmers benefit from improved access to inputs and regional markets.

African agriculture in general is described as inefficient by many economists. The continent has an abundance of fertile land however the sector is mainly dominated by many small farmers who produce for themselves and sell their surpluses mainly at the local markets. Consequently productivity remains stubbornly low due to a lack of capital, and the necessary infrastructure. Many multinational companies therefore see Africa as new frontier to make profits. So far companies such as Monsanto, Syngenta, Yara International, Cargill, DuPont, and PepsiCo have pledged to invest $3.5 billion in the African agriculture sector.

But hang on a second haven’t we been here before. In the past Western governments have dictated the terms of many aid agreements and promoted the freeing up of markets with disastrous results – just observe the results of previous IMF and World Bank led structural adjustment programs. Furthermore such past programs left many African governments cash strapped therefore making them more willing to accept any new influxes of investment. This means that the new alliance has undermined and bypassed democratically agreed initiatives such as Maputo declaration. This is particularly evident from the recent letter  addressed to the African Union by 15 African Farmer Federations against the new initiative. 

Likewise the takeover of thousands of hectares of land by multinational companies could have a significant impact upon farming communities. These commonly named ‘land grabs’ have been criticized for their negative impacts upon small scale farmers. In many African countries there is a lack of enforced private land ownership, a world bank study for instance found that only between 2 and 10% of the land is held under formal land tenure. As a result large land acquisitions by MNCs in the past have tended to displace small local farmers to less fertile lands or destroy their livelihoods completely. A special UN report further argues that large scale land acquisitions can heighten the problem of rural to urban migration forcing many into urban slums in search of work.

For me this new paradigm shift to the private sector represents a serious threat to international development. As argued by Sophia Murphy’s blog, companies are not charities, they are there to make a profit. Furthermore although they are bound by law they are not as Sophia argues bound by public interest. This is most pertinently shown by the one of the cooperation frameworks in Mozambique which requires the Mozambique government to,

1) Systematically cease distribution of free and unimproved seeds except for pre-identified staple crops in emergency situations.

This, as argued by a recent guardian article, condition will no doubt serve to lock farmers into buying expensive seeds from the private sector and corporate monopolies.

The proposals therefore reflect to me the burgeoning influence of large cooperations in every aspect of our policy making today. More importantly it reflects an attempt by the G8 to offload the burden of global food security and mask its failure to meet the targets it set in the past.

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What do all those numbers mean? Stock markets and their importance

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They feature in nearly every news bulletin, paper and website. Their ups and downs, bubbles and crashes are reported on a daily basis. Yesterday for instance saw a dramatic plunge in the values of stock markets across the world. However the reality is that for many people unfamiliar with the world of finance, ‘a one point increase in the NASDAQ’ remains an alien phrase. This post will attempt to provide a basic understanding of what stock markets are and what the indices mean for you and me.

Stock markets fulfill two main roles. Firstly they allow companies to raise extra funds by issuing shares without the need for commercial loans. The stock market brings together companies wishing to expand their operations and potential investors looking to gain a return on their savings. Stock markets are therefore an important source of investment for firms. Historically they have allowed for the expansion of today’s largest corporations such as Coca Cola, Microsoft and ExxonMobil.

Secondly stock markets act as a platform for individuals to buy and sell shares through the use of stock brokers. The ease at which shares can be brought and sold is one of the main attractions of the market. This is in contrast to other less liquid forms of investment such as real estate – which can not always be as rapidly sold without loss of value.

Stock markets therefore have a positive effect on the economy in a number of ways:

  • Firstly they allow companies to expand, creating jobs and new products for the real economy.
  • They mobilize savings by allowing private individuals to invest their idle cash or bank deposits into profitable enterprises.
  • Stock exchanges facilitate improved corporate governance. This is because public limited companies have to meet the demands of a more diverse range of shareholders and the regulations set out by the stock exchanges themselves to remain listed.
  • Stock markets allow for governments to raise capital by issuing government bonds (government loans in the form of an IOU) to fund different economic development programs such as infrastructure building.

An economy with a growing and sophisticated stock market is therefore generally associated with a highly developed industrial and service sector.

So what do those numbers in the news mean?

Generally in the news you will see a list of the differing indices which are used to gauge trends within the stock markets. Instead of looking at the value of just one company, indices attempt capture the value of a number of companies or a sector listed at the stock exchange. It therefore allows us to see any movements in the combined aggregate value of these companies. The value of such companies or sectors is measured in two ways.

The first most common method measures total market capitalization (the total market values  of all the shares of the companies e.g. price of share x number of shares) and then uses a mathematical transformation to bring the number into a more manageable range. This is because many companies have market capitalization values listed in the range of tens of billions of dollars. The impact of the change in a companies share price on the index is therefore proportional the companies overall market value.

The second less common method only takes into account the price of the shares. In this type of index each company makes up a fraction of the index proportional to the price of its stock. This type of measure however ignores the size of each company and has therefore been subject to criticism. The Dow Jones Industrial Average is an example of this type of index.

Now I am not going to become bogged down explaining how these indices are mathematically calculated as many methods exist and all are subject to their different critiques. The main point to take from this is that an index reflects a transformed aggregate value for a number of companies within the stock market with reference to a base year.

A rise in a stock market index therefore reflects a increase in the total market value of the companies in the index. Similarly a fall in the index reflects a decline of a the total market value of the companies in the index.

Indices also differ in their coverage. Some attempt to capture the trends of the global market such as the S & P Global index. Other measures attempt to capture the performance of national stock markets. For example, in the UK the main index used is the FTSE100. This index measures and weights the values of the countries top 100 companies. Inaugurated in 1984 at the base level of 1000, the graph below shows the various progression in the value of the UK’s top 100 companies since the index began.

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 Some indexes go further and attempt to capture the whole market. The Wiltshire 5000 index represents the market value of all publicly traded stocks in the US. Such an index is known as a total market index. Lastly, some indexes measure specific sectors such as biotechnology or real estate.

Interpreting the indices for the wider economy

Generally stock market indices are regarded as a barometer of economic development. When the economy is strong and growing, the stock market is assumed to be flourishing. Similarly when the economy shrinks, it is assumed the stock markets will be struggling.

However although this makes sense logically for many reasons this is not always the case and it should be remembered that the stock market and the economy are not the same thing.

For these reasons it is entirely possible that you may have a booming stock market within a struggling economy. This has been the case recently in the UK where the stock market has seen an upward trend whilst the economy has been sluggish. Consequently we must be very careful when interpreting the stock market and utilizing it as a barometer for the economy.

Instead the stock market indices reflect the views of investors and these views are hard to interpret. As Adam Davison of the NY Times rightly states a stock purchase form does not come with a ‘reason’ field. This problem is further compounded by the existence of ‘herd’ behavior in markets which can lead to market bubbles. Investors may purchase stocks just because they see others doing so thereby increasing the price of the stock. This in turn inflates the index of the market and if investors find they have invested in an bad asset (such as with the sub-prime mortgage crisis) it can lead to crash.

In summary, stock markets are an important mechanism for facilitating investment in the growth of firms. Stock indices commonly reflect the performance of a specific sector, a whole market or a number of influential companies. However due to the nature of trading and the narrow scope of many indices caution must be taken when relating such markets to the wider economy.

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The next financial crisis

An intriguing and thought provoking video showing how we may not have learnt from the lessons of the last financial crisis and how the same tools adopted to fix this crisis were also the tools responsible for its cause.

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We don’t make anything any more…..

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One of the most common complaints which I hear working in a machinery retail outlet is that the UK doesn’t make anything any more. Looking around the store this is an easy argument to accept, indeed most of the machinery I sell including lathes, welders and circular saws all come with a ‘Made in China’ tag. Furthermore most of the media reverts to this constant rhetoric, I have seen numerous articles posted in the media over the years foretelling the final demise of the UK manufacturing sector. So what is happening? Are we in a perpetual decline where we no longer have the ability to make anything? Such statements could be no further from the truth.

To begin with here are some interesting facts from a 2009 Price Waterhouse Coopers report that might surprise you. Firstly as of 2009 the UK was the 6th largest manufacturer in world (Some more recent measures vary between 5th and 10th)this includes large global shares within individual markets – the UK holds a 15% global share in the Aerospace sector. Secondly, UK manufacturing output had reached an all time high just before the 2008 global crisis took hold. Lastly, UK manufacturing achieved a 50% increase in labour productivity over the period 1997-2007. Although struggling due to the global downturn in the recent years, the facts show that the UK manufacturing sector is far from dead.

It can be argued that this idea that the UK manufacturing sector is in terminal decline emanates from a number of relative not absolute comparisons. When the relative figures are observed one could be forgiven for believing the above statement. For instance the graph below shows how manufacturing has contributed less and less to the national economy in recent years relative to other sectors.

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Service sector growth has far outpaced growth in the manufacturing sector in recent times. This has further led to a decline in the relative number of manufacturing jobs. In 1980 manufacturing accounted for 25% of all UK jobs, by 2008 this number had fallen to 10%. Combine these figures with the fact that the UK’s share of global manufacturing has dropped significantly in the last few decades and you are left with a national sense of pessimism regarding the manufacturing sector. Yet as the paper argues the UK has been punching well above its weight for the last century in terms of size and population. It is therefore inevitable that we are to be caught up or overtaken in relative terms by countries with more abundant natural resources and supplies of labour as the Solow growth model predicts (the theory of diminishing returns states that the introduction of one more unit of capital into a capital scarce country will lead to a greater increase in output than in a country which is in comparison capital rich).

Despite the relative decline of the manufacturing sector as a component of total GDP, it is a rather unheralded fact that UK productivity in the sector has grown by 48% over the period 1987-2007.  The gradual decline of manufacturing jobs is arguably attributable to such productivity increases and more broadly our natural progression to a knowledge economy. Better technologies and workplace practices have meant that we can now produce much more per individual worker. In an similar process which was seen in the agricultural revolution, these technologies and processes mean we require less manpower to produce the same amount of output compared to say, 1950. This fact should be celebrated, not frowned upon as it often is due to its impact upon jobs.

The manufacturing jobs of the future will not be based as much upon an assembly line but instead in the R & D departments where companies attempt to find a niche markets and thereby gain competitive advantages. This is where the knowledge economy comes in, although the UK is not gifted with large surpluses of labour as in China, it does retain a high level of human capital (the level of knowledge and know how an individual possesses) and this will be the driving force of growth in the long term as new innovations are made. So in this sense it is we should not be pessimistically stating we don’t make anything any more, we should be looking with optimism at what we will be making in the years to come.

Some additional facts of note.

  • The UK has the 3rd largest automotive industry in Europe.
  • The UK is home to the 2nd largest maker of aircraft engines in the world (Rolls-Royce).
  • The UK has the 3rd largest pharmaceutical company in the world (Glaxo-Smith Kline)
  • The UK has the 4th largest oil refining capacity in Europe.
  • The UK manufacturing sector attracted £30 billion of net foreign direct investment in 2010.

This is quite a short post as I have only just returned after from the Philippines after a 3 week trip to see my girlfriend. I have intentionally omitted some of the more crucial challenges that the sector faces to focus on what it has achieved contrary to popular belief. Furthermore it should be acknowledged that the transition to a knowledge economy requires a strong manufacturing base and the current economic crisis may threaten this.

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The Next Global Crisis – The Carbon Bubble

The Next Global Crisis – The Carbon Bubble

This combined video and graphic provides an clear insight into what could potentially bring about another global economic crisis – the so called carbon bubble. As more and more investors continue to inflate the prices of fossil fuels, trillions of dollars are becoming increasingly at risk as these resources may remain in the ground permanently. If the bubble bursts it could plunge major financial centers such as London and New York into crisis with widespread effects for the global economy.

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Thatcherism – Some hard truths

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In recent news I have been particularly concerned by the vast outpouring of sentiment for Margaret Thatcher over the past day or so. The same rhetoric has been repeated over and over again such as, “She changed the world” and, “the greatest prime minister in modern peace time“. However the most astonishing comment has to be from a fellow named David Cameron who proclaimed, “She saved our country“.

Now I am against the need to follow the standard cultural etiquette of not speaking against someone just because they have passed away. Individuals, particularly influential individuals should be judged on their contribution whether dead or alive. The ability to do this however has non-surprisingly been attacked by many Tory affiliates, for instance former Tory MP Louise Mensch has tweeted, “Pygmies of the left so predictably embarrassing yourselves, know this: not a one of your leaders will ever be globally mourned like her”.

So lets look at the facts, in 1979 when she came to power the country was experiencing double digit inflation, many major industries were in decline and trade unions had brought the country to a standstill in instances such as the winter of discontent. However by a combination of sweeping changes such as privatization, deregulation, industrial relations reform, taxation and deflationary measures the country began to find its feet again. After an initial recession the end result was what has be termed an economic miracle. The graph below shows the change in both inflation and GDP since Thatcher was elected.

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This is what David Cameron was referring to when he proclaimed Thatcher saved the nation, GDP growth averaged 3.09% in the 1980s compared to 2.07% in the 1970s. Meanwhile inflation was reduced significantly to single digit values. However all too often politicians, the media and economists focus on such indicators as a sign of development and prosperity. There is a large debate within economics whether GDP is indicator we should be targeting when considering development and well-being. For instance, economist Richard Easterlin discovered empirically that found differences in income across countries and time did not signify a change in levels of happiness and well being. However he found within countries levels of income did positively correspond with levels of happiness.  The findings which became known as the “Easterlin Paradox” led Easterlin to theorize that changes in income do not affect happiness and well-being, relative income is what really matters. In this sense individuals derive happiness from being more well off than their peers, human beings are therefore constantly trying to “Keep up with the Jones”.

In this sense it could be argued that income inequality would be a better indicator to judge Thatcher’s economic performance. During her time in power the UK’s gini coefficient, a measure of income inequality with 0 representing a situation of perfect equality and 100 a situation of perfect inequality, increased from 27.39 in 1979 to 30.54 in 1980. Now this may not seem a great amount but in comparison from 1963 to 1979 (the furthest back the data goes) income inequality had only increased from 26.3 to 27.39 despite surges in inflation.

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Other measures of income inequality by the IFS estimate the rise in income inequality to be even higher (gini coefficients and inequality measurements are usually dependent on the method used and can vary considerably).

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In the above graph we can see that the level of inequality increased by nearly 8 points from 25.3 in 1979 to 33.9 in 1990. In addition to this the level of poverty also increased substantially during Thatchers reign.

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The graph above shows that the percentage of people living below 60% of the median income increased from 13.4% in 1979 to 22.2% by the end of her reign in 1990. The webpage from which these graphs came paints an even grimmer picture such as a rising gender pay gap and record unemployment.

Thatcher’s policies such as the deregulation of the financial markets; the weakening of the trade unions; income tax cuts and the adjustment of industrial policy have all been highlighted by a number of authors as contributing to a wider gap between rich and poor. Although her policies promoted economic growth, this growth was not inclusive and the majority of the benefits accrued to the top end of the income scale. Furthermore it could be argued that the her legacy of promoting the deregulation of financial markets started a inevitable slide towards the 2008 financial crisis.

The death of Margaret Thatcher therefore leaves us to look at how we judge economic performance and development. If economic growth is all that matters then Thatcher’s reign could be considered a relative success. However if we are more concerned with the wider benefits of such growth issues of income inequality should become more prioritized.  Unfortunately this seems to have bypassed our current leader who unquestioned claimed that Margaret Thatcher saved the country. The reality is however, that in the long term, Thatcher’s policies led to a sustained increase in income inequality, decreases in social cohesion and arguably an inevitable road to economic collapse.

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Combating Deflation – The Japanese Experience

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The recent announcement by Japan’s new central bank governor Haruhiko Kuroda to engage in a new round of quantitative easing and combat deflation has been met with a rather positive response. This round will increase the monetary base by around 60 to 70 trillion yen a year. The monetary base will increase from the current 29 per cent of GDP to 55 per cent by the end of 2014,  but such a policy does not come without risks.

Firstly we must ask why deflation is such a problem. In the scheme of things a falling price level is good for everyone, right? Well unfortunately deflation can lead to a spiral of reduced demand, production and prices, known as an deflationary spiral. If prices are falling one might ask themselves, “why should I buy now when next week or even next year the price of the item will be lower?” This may lead consumers to withhold demand, lower demand in effect leads to lower prices and at lower prices businesses will be willing to produce less. This in turn leads to lower wages and again decreased demand and the process continues…

Policy makers further fear deflation because it typically renders traditional fiscal policy ineffective. To boost the aggregate demand and prices, central banks will lower nominal interest rates to stimulate investment and make saving less attractive. However if deflation is present the real rate of interest, that is the nominal rate minus the level of inflation, may become negative. This is because the central bank can only lower interest rates to a floor of 0% and not beyond. Doing so would mean that banks would be effectively paying borrowers to borrow from them. Consequently traditional methods of monetary policy become ineffective when interest rates reach 0% in the face of deflation.

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Japan’s experience with deflation began in the 1990s after it the collapse of the real estate and stock asset bubble in 1990. During the 1980s the Japanese economy had been booming and this had led to a substantial increase in the amount of available credit. As a result assets such as stocks and real estate inflated well above their intrinsic values whilst banks continued to lend to investors. When the prices collapsed in 1990 triggered by the an interest rate hike, many banks were left with a large proportion of bad loans. The economic slump meant many firms could not repay their loans and furthermore the the banks could not retrieve the full value of their loans because the price of the collateral (real estate) had declined sharply. Instead of accepting these losses and liquidating these malinvestments the banks were propped up by the government in the hope that asset prices would recover. This in effect tied up essential economic resources and led to a marked decrease in domestic investment. This is the beginning of what most commentators have began to call the lost decade.

Since this crisis Japan has been marred by further crises which have hit aggregate demand and thus put deflationary pressure upon prices. Such crises include the Japanese financial crisis and Asian financial crisis in the latter half of the 1990s; the collapse of the US dot com bubble in the early 2000s and most recently the 2008 global financial crisis. All of which have damaged the Japanese financial system and its ability to provide capital.

In addition to this other factors have hurt demand whilst supply has increased. For instance, the rising cost of imports for many Japanese firms has meant that they have been forced to streamline operations and cut costs. This has meant many job losses despite increases in labour productivity. As the graph below shows, taken from Musha research, wages have fallen significant since 1990 despite increased productivity which goes strictly against micro economic theory.

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Japanese firms have realised that they can cut investments in labour because productivity has increased. The result is an excess supply of labour which has driven down wages and ultimately consumption. The above factors have all contributed to the deflationary output gap, meaning aggregate supply is outpacing aggregate demand.

To deal with deflation the Japanese have resorted to a unconventional form of monetary policy named quantitative easing. Quantitative easing works through the central bank purchasing financial assets such as bonds, in an effort to increase the reserves of the banks and hence the money supply. The main difference from traditional open market operations is that the purchases made are long-term rather than short-term bonds and that it has a money supply target rather than an interest rate target in mind.

The Japanese government’s goal here is to stimulate investment and spending in the economy. Furthermore it hopes by increasing the money supply the value of the Yen will decrease thus making Japanese exports more competitive. However as noted earlier the policy has risks both for Japan and the wider global economy.

Firstly if the inflation generated by quantitative easing rises more steeply than wages this could reduce both Japanese living standards and consumption. Devaluing the currency by increasing the money supply could push up the price of Japan’s principle imports – oil and gas. As a result the cost of heating, transportation and lighting would increase thus damaging consumption of other goods. In the worst case scenario the policy of quantitative might  lead to higher than expected inflation or even hyperinflation if too much money is created. Furthermore there little is known about how to stop the process once it does begin to work.

Secondly the such inflationary pressure could increase potentially lead to an increase in interest rates. If this were to happen the cost of servicing Japanese debt could increase considerably making the fiscal position unsustainable. This is extremely relevant for an economy such as Japan with gross national debt sitting at 229.773% of GDP .

However on a more fundamental and global level the policy could lead to a race to the bottom or currency war as other countries rush to devalue their currencies. Japan has now joined both the US and UK in delivering such a policy and other members of the international community have already begun to expressed their concern. Currency wars as seen from history lead to no winners as such crises cause uncertainty and therefore reduce international trade.

In conclusion, it seems that this policy is a short-medium term remedy for Japan’s longer term problems. The country must look at the structural causes of it’s economic stagnation, for instance the “demographic time bomb”, policy mismanagement and issues of accountability and transparency. Japanese business is renown for investing in long term solutions perhaps its time the government took the same approach.

 

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Slovenia and Luxembourg – the next victims of Cyprus contagion?

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Since the debacle in Cyprus one question has been at the back of every commentators mind: who’s next? Naturally those countries with the same characteristics as Cyprus have been main contenders – those with a large financial sector relative to their economy.

Slovenia in particular has been singled out as the next potential recipient of a bail out by the Euro zone  The country has a large financial sector equaling around 130% of GDP. Although at much smaller level than Cyprus at 700%, the IMF estimates that up 20% of the loans in Slovenia’s biggest banks are non-performing or near default. This could put more pressure on the Slovenian government to help bail out the sector. The markets have already reacted to such foreseen events. Ten year bond yields rose to a record 6.8% yesterday, whilst two year yields have tripled in the past week rising from 1.2% to 4.26%. Furthermore the cost of insuring debt against default has significantly increased as shown by the graph below.

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 These movements show that investors are factoring in the higher risk of government default and contagion from Cyprus. Such increases mean higher costs for government borrowing which will in turn make raising any funds to recapitalize banks harder to obtain. To further confound the situation, the IMF has predicted that the economy will decline this year by 2% and the recent political turmoil has done little to reassure investors.

Luxembourg too may become another victim of the Cyprus contagion. As the graph below shows Luxembourg’s banking assets sit above 2,500% of GDP by far the largest of any other Euro zone member.

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As the Cyprus situation unravels investors will look to other euro zone economies which they may consider to have unsustainable large financial sectors. In this sense they are unsustainable because the sectors have become so large that the government would not be able to fund a bailout. Luxembourg however does have one advantage, most of the banks in the country are foreign owned subsidiaries, with domestic banks only accounting for 8% of the sector. This means in the event of a major banking crisis these banks may be aided by their parent banks. Nevertheless, the risk still exists and such support is never guaranteed especially if such parent banks are facing difficulties in their own countries.

One thing has become evidently clear from the crises in both Cyprus and previously Iceland. Promoting yourself as a tax haven for large financial companies and allowing the sector to far outgrow the size of the economy is an unsustainable development strategy. The risks of a banking sector collapse certainly outweigh the benefits as shown by the current situation in Cyprus. Furthermore promoting this strategy in a currency union further confounds the problem, when the ability to ease monetary policy is foregone.

Unfortunately the handling of the Cyprus situation, most importantly the deposit tax, has made investors even more wary of leaving their money in such countries. The Euro zone now finds that although it may have solved one crisis, the length of time and the conditions applied now mean that more crises are bound to appear elsewhere.

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