Is the world heading for a trade war?

President Trump has announced that he is planning to impose long-term tariffs of 25% and 10% on steel and aluminium imports.  His argument is that these two industries have been facing decades of unfair overseas competition, resulting in the loss of American jobs and been one of the causes of the large US balance of payments deficit. He tweeted earlier this week that “We want free, fair and SMART TRADE.” Implicit in his argument is the idea that countries exporting to the USA are unfairly helping their domestic industries rather than being able to export cheaply because they are more efficient than US steel and aluminium producers. However it is not always easy to decide whether an industry is being artificially favoured through some sort of subsidy (cheap energy for Chinese steel makers has been mentioned) which allows it to compete unfairly or whether it is able to sell more cheaply because of lower costs through, for example, cheap labour, more efficient management or economies of scale achieved through its size. He also argues that steel and aluminium imports threaten national security, presumably if the US went to war with its trading partners!

The impact of the proposed tariffs is not. clear-cut. Although US steelworkers will benefit from reduced imports and increased domestic output, any user of steel in the US is likely to have to pay higher prices either because they will buy more expensive domestically-produced steel or because they will continue to buy from overseas and pay the tariff. Thus, US car workers might find that their cars are now more expensive, leading to an increase in foreign cars imported into the US and a fall in domestic production, thereby creating unemployment in the motor industry. Many industries using steel and aluminium, such as construction and the drinks industry (because of the cans they use) would also be adversely affected as would US consumers who will have to pay higher prices because of the tariffs. In economic terms, their consumer surplus (the extra utility they receive in excess of the price paid for the product) will be reduced. Some of this lost consumer surplus – a welfare benefit for the economy – will go to the government via the revenue from the tariff and some will go to US producers whose output has increased. However there will be a net welfare loss since higher prices will discourage consumption, with consumers turning to alternative products which provide less satisfaction. There is also likely to be a negative impact on labour since the number of steel and aluminium workers favourably affected, given that these industries are becoming more capital-intensive, is almost certainly smaller than those in other industries who will suffer from the falling demand caused by rising prices after the tariffs.

The tariffs are likely to provoke retaliation with the EU, Latin America and China talking of counter-measures on US goods such as Levi’s jeans, Harley-Davidson motorbikes and Bourbon whisky, and the WTO warning of the dangers of a trade war which President Trump has tweeted will be easy for the US to win. Following the EU’s talk of retaliation, President Trump has further escalated the issue by talking of imposing tariffs on EU cars exported to the USA.  Fears of a trade war, with countries retaliating and then the US imposing further protection, caused a fall in stock markets in Asia, London and Wall Street.  For the UK steel industry, the situation could be serious since almost 15% of our steel exports go to the USA.

Possibly most importantly to economists is that the tariffs mark a move away from the principle that free trade is beneficial to the world economy, enshrined in the principle of comparative advantage, where countries specialise in the production of goods and services in which they have the greatest comparative advantage (akin to the lowest opportunity cost of production) and import other products. With countries specialising according to the theory, resources are optimally allocated, and consumers benefit from lower prices. Try explaining that to a US steel worker.


Gender pay gap is falling – will new regulation continue the trend?

New regulation means that all UK firms with more than 250 employees need to report the difference in pay between men and women. The new regulation is intended to encourage large firms to focus on reducing gender pay inequality. The idea is that by publishing data, employees, customers, the general public might put pressure on firms to act. ONS data suggests the gap is falling; in 1997 it stood 17.4% (median pay), in 2017 it is now 9.1%. Equal pay has been a legal requirement for decades, but men still dominate top positions and, so, earn more. It is interesting to see the differences between individual firms and sectors. Banking appears to be an industry dominated by men, with a very large gender pay gap – Lloyds having the most marked gap (of the firms to have submitted thus far) with the median pay gap at 42.7% and the bonus gap at 60.7%.

New insights into GDP

A new book “The Growth Delusion” by David Pilling, a Financial Times journalist, provides interesting insights into our obsession with economic growth and how we measure it. This blog highlights only some of his key points which are relevant to A’level and IB economics. The book is definitely worth a read. Modern GDP statistics (“the value of goods and services produced in a given period”)  have their origin in the USA around the 1930s with the work of Kuznets, who produced the first national income data to see the impact of the Great Depression on the US economy. They became more important during the Second World War when the UK government, prompted by Keynes, and the US government needed to be able to manage the war effort to maximum effect while still providing enough resources for consumption.

Pilling points out the many failings of GDP as an economic indicator such as the way it takes no account of what is produced, merely its value. Thus he points out that  wars can be good for GDP if they involve countries producing more tanks, weapons and aircraft. Similarly, two forks are, in GDP terms, as useful as a knife and fork, but less useful in reality when trying to spread jam on toast or cut one’s steak.  He is also scathing about the use of averages and points out that while a rich country might have a high average GDP, and therefore, according to economists, a high standard of living, if this is held by a very small number of people, the standard of living of the majority might be below that of a country with a lower average of GDP.

Measurement of GDP is difficult since it is impossible to measure every transaction and therefore relies on surveys e.g. the Living Costs and Food Survey for about 5,000 households and monthly surveys of approximately 45,000 businesses. The development of technology has made the measurement of GDP more difficult. The UK Government set up an inquiry under Charlie Bean – OB and former Deputy Governor of the Bank of England – who made comments similar to those expressed by David Pilling in terms of activities which are now much harder to measure and value such as using Google Maps rather than buying a paper OS map or streaming films rather than buying or renting DVDs. Another problem is that many things have become cheaper and better – my new recorder is easier to use and records more than a previous DVD recorder  but, in GDP terms, it is less valuable because it is cheaper.

There have been many debates over what should be included in GDP and although these might seem largely irrelevant, they matter when trying to compare countries’ GDP. In the past certain things, such as the sale of cannabis in cafes in Holland were legal and therefore recorded while a similar purchase in Romford would not be counted. However Eurostat wanted consistency among its members and decided that all transactions for goods or services involving money were to be recorded, whether they legal, illegal, good or bad. Therefore, in a purely numerical way, those who argue in favour of increasing GDP as being a key government objective, could argue that encouraging the sale of drugs or prostitution is as valid as increased spending on education or health – something even an economist would find hard to justify! More relevantly sales of guns in the UK  are part of the shadow economy but in the US they are legal, widespread and contribute to their GDP.

Pilling also considers the problems of measuring GDP in developing countries where a significant percentage of production takes place in the shadow economy; for example in Zimbabwe only 6% of the is formally employed. Similarly, my purchase of bottled water from Waitrose  is counted in the UK’s GDP, but the effort of a African villager who spends hours walking to and from a stream or well to collect “free” water has no value according to GDP statistics. He describes the way lights at night are used to indicate economic activity in different areas with increases in intensity over time indicating growth. Such methods indicate that the proportion of economic activity occurring in villages, and not always measured, is more significant than thought and therefore the GDP of many developing countries is, similarly, larger than previously calculated.


Falling Share Prices – Causes and Effects

This week has seen major falls in share prices across the world with $6 trillion being wiped off world share values.  America’s Dow Jones index dropped 5.2%, Japan’s Nikkei index fell 8.1% and the UK’s FTSE index fell 4.7%, the lowest it has been for 15 months, while in Japan and America the falls broke records for the size of their drop since October 2008.

The initial reason for the fall was, paradoxically, good US economic data as their service sector boomed and wage levels grew at the fastest rate since the start of the decade. This good news meant that it is now more likely that US interest rates will rise sooner and by more than had previously been anticipated. Mark Carney reinforced this view when he expressed similar sentiments about the future of UK interest rates.

Although a rise in interest rates has been expected for some time as the world economy’s growth accelerated, the reminder that it might occur soon has come as an unpleasant shock. The scaling back of QE by central banks is expected to reduce the ability to borrow cheaply, some of which has financed recent purchases in shares. Financial investors expect that the forthcoming rise in interest rates will reduce company profits, therefore reducing the demand for shares. Simultaneously existing shareholders might be encouraged to sell quickly before prices fall further, thereby increasing the excess demand. In addition, the economic uncertainty was increased by the fall in the value of bitcoin by approximately 50% since the state of the year.

Economists are trying to decide whether we are currently experiencing a “correction” or  are entering a bear market, where prices fall by more than 20%. The “correction” proponents believe that shares are over-priced in terms of their price compared to their earnings – the price:earnings ratio – and therefore the fall was due. However there is concern that the behaviour of investors, whether in shares, currencies or commodities, sometimes leads to markets over-shooting since falls (increases) in price encourage selling (buying) which further reduces (increases) the price.

According to economic theory, the fall in share prices might lead to a negative wealth effect (the idea that consumption is determined by one’s wealth as well as one’s income). However, given that many shareholders are in the upper income brackets, their marginal propensity to consume will be low and therefore the effect will small. More significant might be the general impact on consumer and business confidence from the media reports about the falling share prices. As Keynes wrote in his General Theory,  “animal spirits” outweigh the  “weighted average of quantitative benefits multiplied by quantitative probabilities.”.


The Recent Rise in Consumption

Household spending has returned to levels not seen since before the financial crisis in the year to March 2017 in real terms, reaching £554 per week. The last time it was at this rate, adjusted for inflation was in 2005/6. Transport is still the largest category but leisure spending overtook housing spending to reach second place. A key driver of the increase was in pensioner spending (with almost 20% of their spending being on foreign holidays and their pets!). However the increase in spending exceeds the increase in income meaning that the rise is being financed either be running down savings or it is being financed by increases in personal debt which might cause problems if interest rates rise over the year, as they are predicted to do.

The data excludes spending on mortgages, rent, house insurance, council tax and house maintenance and were they to be included, this would make housing the largest category, over twice the size of transport.

It is interesting to compare the current figures with those from 2007, the year before the financial crisis affected households in the UK. Although food has slipped slightly in percentage terms as its price has fallen in real terms and communications and recreation have increased their share, the percentages have changed relatively little.

               2007                    2016-17
  Per Cent RANK £ pw Per Cent RANK
Transport 14.6 1 79.70 14.4 1
Recreation 11.1 4 73.50 13.3 2
Housing, fuel and power 13.0 2 72.60 13.1 3
Food and non-alcoholic drinks 11.3 3 58.00 10.5 4
Restaurants and hotels 8.9 5 50.10 9.0 5
Household goods and services 6.7 6 39.30 7.1 6
Clothing and footwear 3.6 7 25.10 4.5 7
Communication 2.7 9 17.20 3.1 8
Alcoholic drinks, tobacco and narcotics 3.1 10 11.90 2.1 9
Health 1.3 11 7.30 1.3 10
Education 2.7 8 5.70 1.0 11
Miscellaneous goods and services 20.9   113.80 20.5  
TOTAL 100.00   554.20 100.0

So how is the economy doing?

This week has seen the publication of considerable economic data and much of it is contradictory, making it hard to tell exactly how well the UK economy is (or is not) doing.

In the year to March 2017, household spending in real terms returned to levels not seen since before the financial crisis, reaching £554 per week. The UK budget deficit has fallen and was £2.6bn in December, compared with £5.1bn in December 2016, and almost half economists’ expectations. This was partly due to higher than expected tax revenues from income tax receipts because of higher employment, higher VAT receipts and a refund on contributions to the EU. The positive news on the budget deficit means that government borrowing is likely to be at its lowest level since the financial crisis. Before celebrating too much, be aware, firstly, that the higher VAT receipts were due to higher inflation as well as to the growth in consumption and, secondly,  the refund from the EU was because the UK share of the EU budget has been revised downwards as a result of slower growth in the UK than the rest of the EU.

Another boost for the UK economy  was news that the employment rate had risen to a record high of 75.3% or 32.2 million, confounding forecasters who had predicted that the employment boom was over, based on the fall in October 2017 which is now being treated as a temporary fluctuation. At the same time as the employment level rose, the unemployment rate remained at 4.3% or 1.4 million, a 42-year record low. Equally encouraging was the shift from part-time work to full-time work which occurred over the period.

Further positive news  was that the economy grew at 0.5% in the last three months of 2017, faster than expected, largely because of the resilient service sector which makes up about 80% of the economy. As a result, growth last year was 1.8%, significantly higher than the 0.5% prediction by some disappointed economists following the Brexit vote. However, it is worth noting that the UK has dropped from being a growth leader to a laggard among the G7 countries, its growth rate is now at its lowest rate for the last five years and, given more rapidly rising incomes among our main trading partners, a slowdown in UK growth is disappointing.

On the downside, wage growth continues to be slow, meaning that real incomes are falling, the number of people starting apprenticeships fell by a quarter in the three months between August and October compared to last year, and sterling rose to its highest level since the Brexit vote. While this is good for importing businesses and holiday makers, it is less good news for exporters who have enjoyed the benefits of a low pound. It has also hit the share prices of companies with significant dollar earnings which are now worth less when converted into sterling.

Finally a word of caution; some of the figures, such as consumption spending, relate to the previous financial year while others, such as the growth in GDP, are subject to significant revision over time. Most recently, the figures for UK productivity have been questioned because the ONS might have significantly over-estimated inflation in the telecommunications industry and therefore underestimated the increases in its output. As a former Governor of the Bank of England pointed out, “trying to control the economy is like steering a car by looking in the rear view mirror”.


The exchange rate and the economy.

The traditional view of a fall in the value of a developed country’s currency was that it would lead to an increase in the value of their exports and a fall in the value of their imports, hence improving the balance of payments and, via the resultant increase in aggregate demand, cause an increase in employment and growth.

However the above analysis needs considerable qualification. Although a fall in the value of a currency will almost always increase the VOLUME of exports and reduce the VOLUME of imports, whether the values change in the same way will depend on the elasticities of demand for exports and imports. For a developing country whose exports are commodities with an inelastic demand, a fall in the value of the currency might worsen its balance of payments. Over time the UK’s exports have moved up-market and therefore it can be argued that they have become less price sensitive since factors such as design and quality become more important.

Secondly, the analysis assumes that firms can increase their production of exports to meet higher demand and this will depend on the state of the domestic economy, the availability of labour, raw materials and components. This is unlikely to be easy in the short term and economists talk of the “J Curve effect” whereby a devaluation initially leads to a worsening balance of payments as quantities of exports and imports do not change much, possibly because of long-term contracts or the difficulties in increasing output of export and import-substitutes and, only over time, will the balance of payments improve. While this might not apply to tourism, where people can switch their holiday destinations relatively quickly, high tech exports and imports of manufactured exports will be much slower to adjust. Firms need to take a view as to the permanence of any change in the exchange rate. In my last post, I wrote that the £:$ exchange rate fluctuated from $1.71 in July 2014, $1.32 after the Brexit vote, then to $1.21 in January, 2017, and was at $1.38 (20th January 2018) but at the time of writing (27th January 2018) it had risen to $1.42. Firms planning long-term contracts will need to take a view as to the likely long-term exchange rate and largely ignore short-term fluctuations.

We should also not forget the downside of a devaluation which is that imports become more expensive and therefore living standards fall. Not only does one’s foreign holiday cost more, but imported finished products and anything using imported components or raw materials becomes more expensive, with the increase in price depending upon how easily the supplier can pass on the increased cost to the buyer. As products become more complex and firms take advantage of globalisation, the supply chain becomes longer and there is a greater likelihood of imports being involved in some in the final product. Thus an increase in UK exports of goods is very likely to require an increase in imports needed to make our exports and some of the increased competitiveness will be lost by the higher cost of imported components and raw materials.

Recent examination of the exchange rate and UK trade in goods might suggest that the exchange rate  has a significant impact. In the last year the volume of UK goods exported rose almost 9% which would imply that the fall in sterling post Brexit has had a positive impact until one reflects that UK imports have increased by 7% during the same period, despite their increase in price. What this shows is that the exchange rate is simply one of many factors affecting the demand for imports and exports and we cannot ignore factors such as quality, income, interest rates or anything else which changes the desire to consume goods and services.