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Issue 22/5 May 2010

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Today’s Issue Includes:

1) Crisis in Greece and the euro zone and implications for the UK. Nigel Tree interviews Colin Ellis, European Economist, Daiwa Capital Markets

NT Greece has just had its credit rating reduced to ‘junk’ status, with short term interest rates reaching 18% and the promise of loans not yet materialising. How do you see the prospects for Greece and has the EU been too lax in applying its Stability and Growth Rule and its no bail-out clause?

CE The EU has been too lax - and, ironically, arguably because of Germany (and France). The original Maastricht criteria stated that, to join the euro, countries needed deficits below 3% of GDP, but also debt stocks below 60%. Germany actually failed on that count back in 1998 - but the Commission argued that the reunification costs were acceptable, and that Germany should be allowed in. That opened the door for Italy to be admitted, despite having a debt stock of over 120% of GDP in 1997, and then Greece in 2000.

After this initial watering down, the focus on debt stocks was then largely sidelined - which was a big mistake. Euro area countries should have been trying to get their debt down to 60% of GDP in the good times, but with the likes of France dragging its heels that was never likely to happen. Furthermore, the 3% deficit ceiling was then watered down after France and Germany broke the original conditions in the mid-noughties. Although the Greeks have racked up lots of debt, they were allowed to do so by the EU.

Going forwards, the prospects for Greece are grim. It already faces a painful rebalancing of the economy away from domestic demand towards net exports, but that will be hard given that it needs to regain competitiveness against Germany, which is hardly about to pursue domestic-led growth. The package will basically buy Greece time to try to regain credibility, and let it return to the capital markets that are currently closed to it. I think Greece probably needs around EUR90bn to get it through this year and next - but that may not be enough time. Supporting Greece until the end of 2012 would cost around EUR140bn.

NT According to an article in the Telegraph online, Greece is “merely the canary in the fiscal coalmine.” Do you think the Greek crisis will spread to other countries such as Portugal, Spain, Italy and Ireland and is the euro zone in danger of collapse?

CE This is a clear risk. Financial markets, having now excluded Greece, are now focusing on Portugal, and to a lesser degree the other periphery nations. And the interest rates on Portuguese debt, as I write this on Thursday 29th April, are already above the indicative 5% that the euro area said it would charge Greece. The situation is a bit different - the debt stock is not as high - but the government faces significant challenges to shore up investor confidence, given the small size of the economy. It has made a first step by promising to bring forward measures that were originally slated for 2011 - but more probably needs to be done.

In terms of the other economies on the periphery, Ireland and Spain both have enviable track records of fiscal consolidation. However, while Ireland took early and painful measures to reassure investors that it would do whatever it takes to get the public finances back on a sustainable footing, Spain's deficit reduction plan is far from clear, and the government needs to do far more on that front. Italy is the last domino in the line - and the consequences of Italy getting into trouble are very scary indeed, given its debt stock still being well in excess of 100% of GDP. However, even if we end up with one or more sovereign debt restructurings - essentially, a polite default - that does not necessarily spell the end of the euro area.

NT Is the UK at any risk as a result of the fallout of the current crisis?

CE There are two potential channels the UK should worry about: economic and financial. On the economic front, the fiscal crises in the euro area are likely to weigh on growth both in the euro periphery and in those countries lending others money, as those funds have to be raised. As the euro area is the UK's largest export partner, that means that the much longed-for rebalancing of the UK economy towards exports (and investment) is still unlikely to materialise - I do not expect the UK to start positing persistent positive trade balances any time soon.

The second channel is financial. Potentially, concerns about high deficits and debt in the euro area could transfer to the UK. But there are some fundamental differences: the UK government has plenty of scope to raise taxes and cut spending, given the political will, and we came into the recession with a relatively low debt stock, which is still below that in both Germany and France. Importantly, we also have our own currency, which we can still borrow in (and the BoE is now pretty experienced at hoovering up government debt). And, so far at least, the euro crisis has actually been a net positive for the UK in financial market terms. When investors flee risky prospects like Greece and Portugal, they want to go somewhere safe instead. Germany is the benchmark in the euro area - but the UK has also benefited, as it is still viewed as a safe haven, for now at least. As such, although yields in Portugal, Ireland, Spain and Italy have all risen in the past week as the crisis has intensified, they have actually fallen in the UK, as they have in Germany. And investor demand for UK debt remains solid, particularly index-linked gilts - at one auction in the past week, investors bid so strongly for gilts they were prepared to accept an average real return of just 0.9% over 22 years, which is incredibly low. There is no sign of a buyers' strike just yet - the next government needs to put a credible plan in place, but it has time to do so.


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2) Is comparative advantage dead? Nigel Tree outlines a recent talk by Pascal Lamy, Director-General, World Trade Organisation

In this talk given in Paris last month, Pascal Lamy examines six fallacies concerning international trade.

The first fallacy is: Comparative advantage does not work anymore. Lamy begins by paying tribute to Paul Krugman’s contribution to international trade theory which was developed at the end of the 1970s and is now known as “new trade theory”. In this theory Krugman looked at the presence of increasing returns to scale which had been ignored in traditional theory, and also the variety of products which trade offers. There is a conflict here between economies of scale which will reduce costs and a desire for variety by consumers which will push costs up. Increasing product variety reduces the opportunity for economies of scale by limiting the potential sales which could be achieved by only having a single product. (There is an interesting article by Broda and Weinstein published by the New York Fed in April 2005 which tries to assign a value to growth in variety in US imports. Read the article here.)

Lamy points out that “while the new trade theory reduces the role played by comparative advantage, it identifies new sources of benefits from trade that were not emphasized or recognized by classical economists. More trade benefits all countries because specialization in production reduces average cost and consumers gain access to a wider variety of products. In contrast, traditional theories of trade assume the variety of goods remains constant even after trade-opening.”

Lamy also looks at the doubts surrounding the proposition that specialization based on comparative advantage results in higher total output, with all countries benefiting from the increased production. He cites a recent paper published by Paul Samuelson from 2004 which showed theoretically how technical progress in a developing country like China had the potential to reduce the gains from trade to a developed country like the United States.

However, he also points out that subsequent research by Bhagwati, Panagariya and Srinivasan contradicted this view. Lamy concludes by saying that “what Samuleson has showed is not that trade along lines of comparative advantage no longer produces gains for countries. Instead, what he has shown is that sometimes, a productivity gain abroad can benefit both trading countries; but at other times, a productivity gain in one country only benefits that country, while permanently reducing the gains from trade that are possible between the two countries.”

But, the important conclusion Lamy makes from this is that “the reduction in benefit does not come from too much trade, but from diminishing trade” and that “the principal of comparative advantage, and more generally, the principle that trade is mutually beneficial, remains valid in the 21st century.”

In his talk Lamy goes on to deal with five other supposed fallacies. These are: It is unhealthy for trade to grow faster and faster compared to output; Current account imbalances are a trade problem and ought to be addressed by trade policies; Trade destroys jobs; Trade leads to a race to the bottom in social standards; and, opening up trade equals deregulation.

Read the whole of this interesting talk here


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