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Issue 26/9 September 2010

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Today’s Issue Includes:


1) The costs of Economic Growth by Maziar Homayounnejad, Queen Elizabeth’s School, Barnet.

As the main driver of higher living standards, economic growth is often seen by the government as the most important of its policy objectives. However, such growth does come at a cost to other parts of the economy, to society and to the environment.

Environmental Problems I: Depletion of Natural Resources

Economic growth means there is a rise in the output of goods and services. However, to achieve higher output implies there must also be a greater use of factor inputs like oil, gas and metals. Yet some of these natural resources are non-renewable and are in limited supply. So if we are to use them in ever greater quantities to produce more goods and services, we will soon find that economic growth is unsustainable. Namely, that there is a depletion of natural resources which may prevent the economy continuing its growth path into the future.

However, it is arguable that such an extreme scenario is unlikely to happen, since the market mechanism ensures that growing scarcity of a resource results in a price rise. This was certainly the case during the period 1998-2008, where rapid economic growth in China and India led to average commodity prices more than tripling, while oil prices went from $10 per barrel to a staggering $147. With such high prices, three things happen.

Firstly, demand and therefore consumption both fall as there is now a financial incentive to conserve these resources. For example, rising gas and electricity prices several years ago led to an increase in household loft insulation. Rising petrol prices led to a switch away from large engines and towards smaller, more fuel-efficient cars.

Secondly, it becomes profitable for firms to explore for new supplies of these resources. Hence oil prices at $147 per barrel in July 2008 led to a massive rise in the number of geological surveys in the Middle East and Russia, in a bid to discover new oil fields.

Thirdly, consumers switch to substitute products, which in turn encourages producers to discover and commercialise new replacement products. Hence the rising interest in hydrogen fuel cell cars to guard against the risk of high petrol prices again in the future.

This leads us to the idea of Sustainable economic growth, which is defined as a rise in the economy’s productive potential today which does not lead to a fall in the economy’s productive potential for future generations. Those who support this sort of growth argue in favour of:

· Wind power and solar power as energy sources

· A switch from private to public transport along with policies to promote hydrogen-powered engines in cars and other motorised devices

· Recycling of materials in old, unwanted products

With sustainable economic growth, society is increasing its standard of living in a way that is both responsible and forward-looking. While the market mechanism does promote this by raising the price of scarce resources, government policies to actively encourage sustainable habits (such as subsidies for the production of renewable sources and high indirect taxes for the use of non-renewables) are also needed to complement this.

Environmental Problems II: Negative Externalities

Related to the above is the fact that carbon emissions and other forms of pollution are likely to increase with economic growth. This leads to problems like smog-filled air in densely populated cities where there is an abundance of cars, or in industrial areas where there is an abundance of factories burning fossil fuels.

As a result, countries pursuing rapid economic growth are likely to harm the cardiovascular health of their citizens. In the long-run this may have negative consequences for the productivity of the workforce as life expectancies may fall and more people may end up in hospital with cardiovascular diseases. The problem seems to be more pronounced in some LDCs and emerging economies, where governments have prioritised economic growth as the main way to pull their citizens out of poverty.

However, the problem may not be as bad as some environmentalists make out. Firstly, high-income governments often use their increased tax revenues from economic growth to clean up the environment, e.g. by subsidising the use of carbon filters in factories. Secondly, there has even been some international effort to safeguard the environment. For example, the Montreal Protocol, signed between 93 countries in 1987, agreed to phase out the use of CFC chemicals, a major contributor to the destruction of the ozone layer. Likewise, the 1997 Kyoto Protocol, which now has 183 signatories, agrees to reduce greenhouse gas emissions by 5% below 1990 levels between 2008 and 2012.

Income Inequality

As the economy grows, firms which are producing a higher output of goods and services will see a rise in their revenues. These revenues are then shared out between the factors of production – that is, labour (wages), land (rent), capital (interest payments) and enterprise (profits).

Inevitably, those who own the means to production (i.e. entrepreneurs) will try to keep more of this higher income for themselves, in the form of higher profits. And since land is a scarce resource, rents also rise in an economic boom, therefore benefitting land owners. On the other hand, as production becomes more automated, unskilled workers find themselves without a job or income (technological unemployment). Those with non-transferable skills may find that their industries have moved out of the UK, also leaving them without a job or income (structural unemployment).

This means that economic growth may create a ‘two-speed economy’ where land owners and entrepreneurs take a disproportionate share of the benefits, while low-skilled and unskilled labour suffer greater hardship. Hence the adage ‘the rich get richer while the poor get poorer’ as a result of economic growth.

Of course this is an extreme scenario which won’t always play out like this, especially as people retrain over time and are able to find higher-income jobs in the new economy. In such a case, we find that the benefits of economic growth do trickle down to lower-income groups as rich people’s incomes rise by, say, 5% while poorer people see a 10% rise in their income. Yet even this is unsatisfactory, as 5% of £200,000 is far more than 10% of £20,000.

It is therefore clear that even when economic growth does reach everyone in society, richer people still take a larger share of the benefits. It may be more accurate to say ‘the poor get richer but the rich get richer at a much faster rate’. Consequently, income inequality rises and this goes against the idea of a fair society.

Balance of Payments Problems on the Current Account

This is especially the case where economic growth is driven by rises in domestic spending by consumers, firms and the government (i.e. increased C, I and G in the AD model). In such a case, the UK will suck in more imports; and there is less incentive for firms to export their goods as they can sell more easily in the domestic market. Consequently, the balance of payments worsens on the current account.

The instability that this causes is fairly predictable. In the short-run, the UK will have to run a financial account surplus, selling off assets and / or borrowing from overseas to fund the CA deficit. In the long-run, there will be a rise in outflows of investment income (IPD) which simply aggravates the CA deficit and necessitates larger debts to be taken out in future through the financial account. On the other hand, if economic growth is export-led, the current account will actually improve. Likewise, if economic growth is driven by rightward shifts of aggregate supply, there will be a rise in productive capacity – more goods and services can be made for export. And there is a downward pressure on the price level so exports remain price-competitive in foreign markets. Again, this should raise export earnings and therefore improve the current account.

Price Instability – High Inflation

If actual economic growth is too fast and driven mainly by rightward shifts of aggregate demand, the economy will soon get near its full employment level of output. The closer we get to this point, the more demand-driven growth will be inflationary. This causes a vast array of problems such as menu costs, shoe-leather costs, business uncertainty leading to a fall in investment, and higher interest rates causing yet more falls in investment and capital stock.

In order for economic growth to be sustainable, AS and AD both need to shift right together. This ensures that real output rises but with controlled increases in the price level.

In the example below, P1 would have risen to P2 if growth were only demand-driven. But due to the rightward shift of AS, the price level only rises to P3, which should represent an annual change of 2% ±1%.

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Since it often takes a long time for AS to increase, this implies that rightward shifts of AD should also be gradual.

The Opportunity Cost of Growth

Finally, it is worth remembering that potential economic growth is often triggered by a rise in investment spending to boost the quantity and quality of capital goods. This inevitably means there is an opportunity cost of fewer consumer goods today. But note that we are only making this sacrifice in order to have more consumer goods in the future, once productive capacity has increased.

In other words, economic growth involves the dilemma of whether we want ‘jam today or more jam tomorrow’. Essentially, the question is whether we are willing to sacrifice our present living standards in order to have higher living standards in the future.


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2) Current Monetary Policy – Nigel Tree interviews Dr.George Buckley, Chief UK Economist, Deutsche Bank.

NT Will the Bank of England continue to keep interest rates at 0.5 per cent or do you see rates going up in the next few months?

GB Our view is that the Bank of England will begin to tighten interest rates at the start of next year and that they will continue to keep the quantitative easing total unchanged at £200bn for the time being. However, by the end of this year we could well see a few members of the monetary policy committee voting for hikes in interest rates.

NT How can they continue to keep interest rates on hold when inflation is exceeding the government's upper limit of 3%?

GB Well, this is all about the offsetting of risks. Yes, there are concerns about the inflation level, but a substantial amount of inflation has been due to taxes, and this has helped push it over target. If taxes were stripped out, inflation would be closer to 1.4 per cent.

We need to keep this in mind although there are also concerns about a repeat of the financial market volatility seen in Europe in the early summer. So it is all about balancing risks.

NT Surely a major risk is from the government's proclaimed austerity package of expenditure cuts and how this will affect growth and employment?

GB
Well, actually, back in the May Inflation Report, the Governor of the Bank of England said that additional fiscal tightening might actually reduce the downside risks to economic growth. This is because you are not seeing a big increase in bond yields which might have been caused by doing nothing on fiscal policy.

However, that said, government spending is worth quite a substantial amount of GDP. It contributes about a quarter of overall GDP. So if you stop spending it will probably have a negative impact on economic growth. However, lower interest rates will do exactly the opposite.

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