Structural Unemployment in Australia

Structural unemployment has many causes; advances in technology can make some jobs redundant, offshoring production to low-cost producers means a lack of domestic demand for certain workers, and a permanent decline in demand can make some industries obsolete.

This article, courtesy of Ryan Z, is an illustration of the 2nd cause mentioned above. Australian’s, obviously, will still buy cars, but all will now be imported as domestic production ends. Car plant workers will find it difficult to find work because their skills are no longer in demand. They either move overseas to find work or retrain. The latter is far more likely but does come at a cost to the individual, through lost earnings, and the government, who are likely to partly fund re-training programmes. Building a flexible workforce can help reduce the level of structural unemployment, but this is far from easy.




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.

Sterling and the UK Economy

The pound has undergone something of a roller-coaster ride over the past three and a half years.  It was $1.71 in July 2014, fell from $1.49 to $1.32 after the Brexit vote and then again to $1.21 in January, 2017 and has recently risen to $1.38 (20th January 2018). However, it is worth noting that while, historically we usually measure sterling against the dollar, the fall against the euro has been greater.  In July 2015, £1 would buy 1.49 euros but by August 2017 the rate had fallen to £1 = 1.08 euros  and it is currently at £1 = 1.33 euros.

This post will consider the factors which might cause the value of a currency to fluctuate. (and the next will discuss the impact fluctuations might have on an economy). Over the last 100 years, the world has moved from a system where currencies were fixed to gold (the Gold Standard), to a time when the dollar was fixed to gold while currencies such as sterling were pegged, with limited flexibility, against the dollar (the Bretton Woods Agreement) to a system of flexible exchange rates where, today, in theory, the demand for and supply of the pound in the foreign exchange market determines its value.

In old economics textbooks, the adjustment process was simple.  The demand for a currency is determined by foreigners wanting to buy UK exports and needing to pay for them in sterling while the supply of sterling came from UK firms and consumers wanting to buy foreign goods and services, such as overseas holidays, and needing to swap pounds for foreign currency to pay for them. If the UK had a balance of payments deficit, the demand for sterling in the foreign exchange market would be less than the supply and so the value would depreciate against other countries, making UK exports cheaper and imports more expensive, restoring international equilibrium.

Today the situation is far more complex; not only do we have to consider the impact of a currency such as the euro which has replaced the individual currencies of the members of the eurozone, making it impossible for them to use depreciation to improve their balance of payments, it is now no longer the sale and purchase of exports and imports of goods and services which determines  the exchange rate, it is the trade in financial assets which is far more important as banks, businesses, governments and individuals buy and sell foreign shares and government securities and move money between countries to gain higher interest rates or profit from speculative movements in currencies. To put this into perspective, the World Trade Organisation estimated that in 2015, total international trade in goods and services amounted to $20 trillion while $5 trillion was traded on the foreign exchange market EACH Day.

Therefore factors which influence speculators’ views of the economy will have a major short-term impact on the value of the currency. Hence, immediately after Brexit, the general view was that leaving the EU would have detrimental effects on the economy (or at least on those dealing in financial assets and currencies) and this reduced the demand for sterling from overseas and increased its supply from UK holders seeking to purchase foreign financial assets. Similarly if the political situation changes and that affects views of the economy, then the value of the currency will change. Other things which will affect the value of the currency will be changes (or expected changes) in our rate of interest or the rate of interest in other major currencies, the economic performance of our economy or other major countries since if, for example, the US economy weakens, then relatively, the UK economy will be stronger and this will encourage a movement of money from the dollar to the pound.

Big pharma, the NHS, and ‘price gouging’.

Over the past couple of years, the news has reported several incidents of sudden and rapid price hikes in medicines bought by the NHS. Drugs are often patent protected, which, put simply, means that firms are legally protected from another firm reproducing their product. Patents are a barrier to entry that helps to increase monopoly power. They do, however, provide benefits, insofar that without legal protection firms are unlikely to conduct the highly expensive research and development process to develop new drugs if another firm can simply come along and copy their idea. Without the high R&D costs, the rival would be able to charge a lower price and so the ‘creator’ stands to make large losses. Consequently, firms would not invest in R&D and we, the consumers, would not benefit from the advances in medicines we have seen.

On the other hand, firms can exploit this legal protection and monopoly power by charging very high prices to earn abnormal profits. These profits can be reinvested to develop new drugs, as Big Pharma will point out, or returned to shareholders in the form of dividends. However, the consequence of high prices, is, of course, lower consumption, and given the nature of the product, this can have a significant impact on consumer’s health.

The NHS is a very large organisation, Britain’s largest employer, with an annual budget of approximately £122bn. This should give it monopsony power when it comes to buying drugs, approximately £15bn of the budget, countering the monopoly power of the large pharmaceutical firms, such as Pfizer. However, reports suggest that the NHS is not getting value for money and is a victim of ‘price gouging’ – the process of suddenly increasing prices to exploit market power and increase profits. Probably the most famous example of price gouging is when Martin Shrkeli bought a patented drug used to treat AIDS and then increased the price by 5500% overnight. The process of extracting a larger ‘slice’ of wealth without creating new wealth is called rent-seeking. He is not a very popular man.

The UK government can take action to deter firms from this practice, which often takes place when a patent expires and the firm can change the name and distribution chain, a process known as ‘debranding’. Recently, Flynn and Pfizer have been fined for their decision to increase the price of an epilepsy drug by 2000%, although this is being contested in the courts. Further regulation is being discussed by the government and may be processed in the near future.

Given the funding issues the NHS currently faces, an increasing medicines bill creates an unwanted opportunity cost and means that cuts in other areas have to be made. Big pharma does need to make a profit to recoup high R&D costs and fund new medicine development, but how much is enough?

Read the original article here.