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Issue 41/ 11 Jan 2011

 

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  1. Happy 2012? by Charles Wyplosz, Professor of International Economics at the Graduate Institute, Geneva; Director of the International Centre for Money and Banking Studies.
  2. Evaluation Techniques for AS by Maziar Homayounnejad, St Paul's School, Barnes

1) Happy 2012? by Charles Wyplosz, Professor of International Economics at the Graduate Institute, Geneva; Director of the International Centre for Money and Banking Studies.

 

This time last year, I wrote a Vox column wishing us all a better year than the previous one. Alas, 2011 was worse than 2010 and things don’t look good for 2012. The new year will see the Eurozone relapse into recession with a probability that approaches 100%. Is there is any reason to be hopeful?

 

Why does the crisis linger, deepen and spread?

The crisis is, first and foremost, the result of policy mistakes. The authorities have never articulated a clear diagnosis. They cite a long list of woes. Some are correct but obvious, for example, the absence of fiscal discipline in the Eurozone and the associated moral hazard inherent to rescues. Others are sideshows, for example, large current-account imbalances. Most are deeply misleading, for example, blaming financial market speculation and rating agencies pessimism or worrying about inflationary risks and about widening budget deficits. To round up this depressing list, some problems are conspicuously ignored or played down, for instance, the sorry state of commercial banks, the need for serious debt defaults, and the absence of growth prospects.

It would have been a miracle if policy decisions drawn up without a clear diagnosis had been adequate. This is why 2011 was a rerun of 2010. And looking forward, heightened austerity in virtually all Eurozone countries is taking us straight into recession. Fanciful proposals for “voluntary” debt reduction – a.k.a. public sector involvement or PSI – have been on and off the table; they block any possibility for an increasing number of Eurozone countries to recover market access.

Because of the focus on moral hazard, comprehensive solutions remain elusive. Proposals to strengthen the Stability and Growth Pact keep piling up, each one aiming at more automaticity and tougher sanctions. Yet it was only at its last meeting in December 2011 that the European Council recognised that the Pact cannot work when nations are sovereign. A new treaty that would allow for a suspension of sovereignty is now being proposed. A safe bet is that this will not happen.

It is not surprising, therefore, that the situation has considerably worsened. By end 2010, three countries (Greece, Ireland, and Portugal) were facing mounting borrowing costs. During 2011, two of the largest Eurozone countries (Italy and Spain) joined the list. And now two more (Belgium and France) are slowly but surely sliding into the same bad equilibrium. Recession will seriously worsen the debt arithmetic.

 

Do governments and the ECB learn?

It is no surprise, either, that virtually every summit – each one presented as “decisive” – produced “comprehensive” solutions that crumbled in a matter of days. The real surprise is that markets started to buy into the official declarations and that it took them a number of days to reach the obvious conclusion that the proposals were neither decisive nor comprehensive. In the end, each summit has made the situation worse because it showed that policymakers were not able or willing to arrest the crisis.

The amazing sight of policymakers apparently overwhelmed by the problems that they face is undoubtedly the most worrisome aspect of the crisis. There is little doubt that financial crises are complex events. They require an understanding of financial markets and of multiple equilibria. No one expects politicians to spontaneously master this kind of knowledge, but we would hope that they are adequately briefed and that their proposals are thoroughly evaluated before they are put forward. Unfortunately, this has not been the case, and the question is why.

One interpretation is that the Commission, which has the technical resources, is kept out of summit preparations. A related interpretation is that the Commission at its highest levels is unwilling to be critical of governments. Either way, this would represent a tragic under-utilisation of resources that are sorely needed if we ever hope to solve the crisis.

Another interpretation is that the French President and the German Chancellor are not seeking out technical support because they are convinced that politics can solve any problem. Both are known to have such an inclination. Yet, they must have been repeatedly surprised that their “comprehensive solutions” promptly fizzled out. One would expect that these sobering experiences eventually lead them to accept that the laws of economics cannot be discarded.

 

Is policymaking captured by special interest groups?

This observation raises another, most disquieting, interpretation. Are the politicians captured by special interests?

A common thread of many decisions is that they aim at protecting banks. Clearly, no one wishes to see a banking collapse but if, as many believe, some deep bank restructuring is unavoidable, forbearance is highly counterproductive. The capture interpretation rests on a web of signals: the initial refusal of contemplating any sovereign debt restructuring, last summer’s row with the IMF Managing Director, pressure on the European Banking Authority to conduct gentle stress tests, and the negotiation of PSI with the world banking lobby leading to solutions that protect banks while providing little debt relief.

The ECB’s actions have been equally disquieting, raising all the same questions (understanding of the phenomenon, access to technical support, capture). The small-scale bond purchases of the SMP have repeatedly failed to quieten markets down. Tactically, the presence of the ECB in the market provides temporary relief. Yet, official statements that the latest intervention was a one-off have systematically undermined any strategic benefit that could be reaped. Most disturbing is continuous insistence on the primacy of the price stability objective, as well as concern with the transmission channels of monetary policy at a time when bond markets are in panic and the interbank market has stopped functioning. As he left the Executive Board, Lorenzo Bini-Smaghi has evoked “quasi-religious discussions” within the Eurosystem. This would confirm the impression that the central bank is not focused on hard-core economic analysis and would explain why it does not seem to learn from past mistakes either.

The only kind interpretation is that the ECB and some politicians shrewdly want to use the crisis to achieve lasting fiscal discipline throughout the Eurozone. One idea is that acute pain will teach a lesson to countries that have always thought little of fiscal discipline. A better one is that we need to go to the brink to make serious changes politically acceptable.

 

Can we agree on a diagnosis?

The crisis is complicated because it combines financial turmoil with governance issues under challenging macroeconomic conditions. The truth is that the economics profession has not converged on a shared diagnosis, which undoubtedly contributes to confusion among policymakers. Here is a proposal, stated as simply as possible.

Markets fear that some countries will not be able to grow out of their public debts. This leads to a vicious circle, with a number of possible outcomes, where either governments lose market access or have to pay unsustainable interest rates on their new borrowing. There is no point in debating about solvency – a government is insolvent when it loses market access.

To make things worse, any sovereign default stands to lead to bank failures because banks hold large amounts of public bonds. This is an additional vicious circle because governments would then have to bail their banking systems out, meaning an increase in their own indebtedness. Government and bank bailouts further raise a moral hazard issue. While banks can be socialised or dismantled, no such solution to moral hazard is available as far as governments are concerned. Yet, moral hazard needs to be dealt with.

 

Necessary conditions for ending the crisis

This diagnosis implies that the crisis will not stop until the following actions are taken:

1. Governments that lose market access must be bailed out in one way or another.

For "effectiveness" and "moral hazard" reasons, the bailout should not be complete; instead it should encourage debt restructuring.

  • "Effectiveness", because countries with large public debts are unlikely to grow and, therefore, unlikely to be able to run down their debt to GDP ratio.
  • "Moral hazard", because defaults simultaneously reduce the debt burden and give incentives to governments to do what it takes to recover market access.

Defaults would also help with another moral hazard, this time borne out of investors’ beliefs that Eurozone governments never default (investors have been receiving large yields since the start of the crisis).

2. The bailout must be carried out by the ECB because the required amounts are unknown and could be very large.

The total value of Eurozone public debts is about €9,000 billion. The European Financial Stability Facility (EFSF) can mobilise, at most, €200 billion, and the IMF can be expected to put up a similar amount. “Friends” such as China will not add that much. Only the ECB can mobilise any amount of money as it becomes needed.

3. Banks must be recapitalised, if possible before some sovereigns default. The amounts needed are not based on the previous crisis – the consequence of the subprime disaster – but on the future crisis once defaults occur. If the banks cannot raise sufficient capital, the EFSF can provide the funds.

4. Addressing moral hazard requires the firm establishment of fiscal discipline throughout the Eurozone – and quickly. The treaty route is unlikely to lead anywhere.

 

Alternative to a new treaty: ‘Fiscal Discipline Board’ and ECB collateral rules

The current proposal for a new treaty that would allow suspension of sovereignty is extraordinarily intrusive. The proposal is for some European authority (the Commission? Or some other body?) to take over fiscal policy in a country that runs afoul of the Stability and Growth Pact. The idea that a country loses fiscal policy sovereignty is inspired by IMF programmes. These programmes, however, are never imposed from outside. Countries apply to the IMF, on their own, and they negotiate conditions. This makes a huge difference.

A much better arrangement is possible without a new treaty. Currently, in its routine refinancing operation, the ECB accepts as collateral a wide range of assets. Most central banks accept only – or mainly – treasury bonds. The unusual arrangement of the Eurozone is an artefact of history – because practices differed considerably among future Eurozone countries, the ECB decided to accept every asset that was previously accepted. The ECB has the authority to decide what collateral it accepts and it could decide to only accept treasury bonds issued by governments that exercise fiscal discipline. It would work as follows.

The ECB would ask an independent body to examine the fiscal policy framework of each member country. The body, call it the Fiscal Discipline Board, would look for arrangements that adequately constrain member governments, for example the German debt brake or the Dutch coalition agreements. The ECB would bind itself to follow the Board’s judgment. A country that has not adopted arrangements deemed adequate, or that does not abide by its own arrangements, would face the consequences: high borrowing costs, possibly loss of market access. The presumption is that the situation would be promptly corrected.

Details need to be worked out: Who would appoint the Fiscal Discipline Board? What means would the board have? Would there be a possibility of appeal? These are fairly simple issues, much simpler that the new treaty proposal. The key point is that this procedure does not call for a treaty, it does not tread upon sovereignty (fiscal discipline arrangements are left to each country, there is no threat of outside intervention or fine) and it should reassure the ECB, which is currently rightly concerned by moral hazard. By relying on an independent Board, the ECB would not have to pass judgement that can be construed as political. It would also reassert its independence, as it can decide on its own to adopt such an arrangement.

Moreover, all this can be done virtually overnight.

 

References

Bini-Smaghi, Lorenzo (2011), Financial Times, 26 December.

Wyplosz, Charles (2011), “Happy 2011?”, VoxEU.org, 5 January.

© VoxEU.org

 




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2) Evaluation Techniques for AS by Maziar Homayounnejad, St Paul's School, Barnes

 

Introduction

Evaluation is an integral part of AS Economics assessment and is even more heavily weighted in the A2 course. Essentially, it requires you to go one step further than mere analysis and to:

  • quantify the importance of your analysis;
  • identify the situations and contexts in which the analysis is or isn’t valid;
  • weigh up evidence and arguments;
  • prioritise them; and
  • make reasoned judgements about them.

 

Important key words to remember

You will always know when the exam question requires you to evaluate, as it will include key command words like ‘evaluate’, ‘examine’, ‘assess’, ‘discuss’ and ‘to what extent?’ Whenever you see these key words you should analyse first then evaluate your answer.

Likewise, you should always tell the examiner when you are about to start evaluating by beginning your evaluative comment with ‘However’ or ‘To evaluate…’ This makes it easier for the examiner to award you the right marks.

 

So what is evaluation and how do you do it?

Evaluation is about developing a certain way of thinking along the lines suggested in the five bullet points, above. It should not, therefore, be seen as a finite list of points to be memorised; effectively, you can develop your own evaluation points in any given exam question by adopting the following eight techniques as a framework for your thinking.

 

1. Magnitude

How large or small are the changes referred to in the question? If possible, put the data in context by working them out as percentage changes. For example, consider a case study on car manufacturing, where steel prices have increased from £200 to £250 per tonne over a two month period.

For your basic analysis, you would say that this represents a rise in the cost of production for car manufacturers, which shifts their supply curve up / left. Then you would say that this raises the price of cars (from P1 to P2), which in turn causes a contraction of demand (from Q1 to Q2) as some potential car consumers are priced out of the market. Remembering also that labour is a derived demand, the fall in car output may result in job losses as factories will probably need to lay off some assembly-line workers.

Then to evaluate the magnitude of the change, you could argue that the £50 rise in steel prices is relatively large, representing a massive 25% increase over a very short time period (i.e. two months). Accordingly, the supply curve will shift quite far upwards / to the left, meaning the rise in car prices, fall in output and the scale of redundancies are all likely to be quite significant.

 

2. Significance

This is where you consider how large an impact the changes described will have, irrespective of their magnitude. So in the example above, you could point out that steel is a major input in the manufacture of cars and is thus likely to represent a large proportion of total cost. Accordingly, any rise in steel prices is likely to have a significant impact on the cost of production – again, the supply curve will shift relatively far upwards / to the left, meaning the rise in car prices, fall in output and the scale of redundancies are all likely to be very significant.

Alternatively, you can evaluate the significance of the rise in steel prices by questioning the elasticity of demand for cars. Namely, if the demand curve is relatively steep / price inelastic, then the upward shift in the supply curve will cause a large rise in car prices and a small contraction of demand. Conversely, if the demand curve for cars is relatively shallow / price elastic, then the opposite is true (small rise in car prices, large contraction of demand). Note that this evaluation point can be helpfully illustrated with a pair of S&D diagrams.

Of course these aren’t the only ways to evaluate the significance of a change. Indeed any consideration of the impact of the changes will get credit. So for example, if there is evidence that car manufacturers are already unprofitable and struggling to survive, you can argue that any rise in any of the production costs – however small or insignificant – will have a disproportionate impact on them, causing large-scale bankruptcies and redundancies.

 

3. Time-lags

Consider the short-run versus the long-run impact of the changes described in the question. Usually, your analysis will relate to the immediate short-run impact while your evaluation will consider how things may be different in the long-run.

For example, in 2008 the Government announced that VAT was to be temporarily cut by 2.5% (to 15%) in order to stimulate the economy. Your basic analysis would be that the VAT cut acts as a decrease in the cost of production for car manufacturers, shifting their supply curve vertically downwards. The price of cars would fall, thus causing an expansion of demand (along with further analysis of who benefits from the tax reduction).

But to evaluate, you could point out that this was a temporary tax cut, so in the long-run (when VAT is brought back to its previous level), the supply curve for cars will probably shift back upwards, thereby offsetting the fall in price and the expansion of demand. In fact, as the Government had to raise VAT to 20% (partly to finance the initial tax cut), it is even possible to say that in the long-run, the supply curve will, overall, shift vertically upwards (not downwards) with an overall rise in car prices and a contraction of demand.

In other cases, your analysis will relate to the long-run impact while your evaluation will consider the short-run. For example, in the case of rising steel prices we saw how car manufacturers will face higher costs of production with a consequent rise in car prices, contraction of demand, etc. But will all this happen immediately or in the long-run only? To evaluate our analysis, we should consider the possibility that some car manufacturers have already bought large stockpiles of steel at the previously lower price of £200 per tonne. For these firms it will be ‘business as usual’ in the short-run, with rising costs of production only materialising in the long-run (i.e. once current steel stocks have run out).

 

4. Relaxing the ceteris paribus assumption

This refers to the reality that other things are rarely equal. Namely, there may be changes in other variables that partially or totally offset the changes referred to in the question.

Again, it is helpful to consider the case of car manufacturers facing a rise in steel prices, hence an increase in their cost of production. To evaluate this scenario, we may question what is happening to the other costs of production in the business. For example, there may have been a fall in wages or a rise in productivity (perhaps due to more advanced robotics), which have all reduced unit labour costs. If so, this will reduce the cost of production, perhaps even offsetting the rise in steel prices.

Alternatively, if car manufacturers are in trouble and on the brink of collapse, it is even reasonable to suggest that the government may offer the industry a subsidy to help it absorb the rising steel prices. If so, then it is again possible to evaluate your analysis of rising steel prices by saying that the supply curve for cars may not shift after all.

 

5. Likelihood

Consider whether your analysis, while plausible in principle, may be unlikely to materialise in practice.

Thus in the analysis of rising steel prices we said that there would eventually be redundancies. But car factory workers may be highly skilled and very expensive to train. If so, then you may evaluate your analysis by saying that redundancies are unlikely because car manufacturers would be reluctant to lose their substantial investment in human capital; especially as they will have to recruit and train new staff at great expense, once demand picks up again in the future. This evaluation point is even stronger in the case of law firms (laying off solicitors) or airlines (laying off pilots), where recruitment and training costs are likely to be very high indeed. In such scenarios it may be more likely that the firm will ‘hoard’ its staff in anticipation of demand picking up fairly soon.

 

6. Considering sub-categories

This involves breaking down a large concept in order to give a more refined and targeted analysis. For example, the question might ask you whether the demand for ‘food’ is price elastic or inelastic. You may analyse this by saying that food is a necessity required for survival so demand is likely to be price inelastic. Your analysis may even be backed up by data from the case study, which shows that when food prices rose supermarket revenues also increased, thus implying that the increase in price led to a proportionately smaller fall in quantity demanded.

But food is a very large category and not all of its sub-categories will exhibit the same price inelastic demand. So to evaluate, you can argue that, while demand for rice and bread may be price inelastic, the demand for more luxurious foods like chocolates may be price elastic; as might the demand for caviar, since it is both a luxury and it takes up a larger proportion of income.

This same approach to evaluation can be taken with ‘cars’. The overall demand for cars may be price inelastic and this may also be true of more functional cars like Ford Focus, which are seen as necessities for a typical family. However, luxury Marques like Ferrari or Aston Martin, which take up a large proportion of income, may be more price elastic in demand.

 

7. Considering different contexts

This is similar to ‘considering sub-categories’ and involves evaluating different scenarios (based on geographical, temporal, income or cultural / taste differences) to provide a more refined and targeted analysis.

For example, your analysis may reveal that the overall demand for cars is price inelastic. But to evaluate, this is more likely to be true in rural areas with little public transport, hence fewer substitutes; or in wealthy areas, where the price of a car is not a very high proportion of income. Conversely, in big cities which are well-served by public transport, the demand for cars is likely to be more price elastic (due to the greater availability of substitutes); this is especially true in inner-city areas where average incomes are also lower, meaning cars are a relatively higher proportion of income.

A similar evaluation may be applied to food. Thus data may suggest that the EU-wide demand for pasta is price inelastic, but this will surely differ from one country and culture to the next. For example, in Italy, where pasta is the national dish, demand is very likely to be price inelastic. But in other EU countries, where people may be more willing to switch to rice or potatoes, the demand for pasta may be more price elastic.

 

8. Prioritisation

Prioritisation is usually reserved for concluding paragraphs and involves putting your analysis points into a rank order of significance. It is quite difficult to do as it requires you to fully justify why one point is more important than another.

For example, in a question that asks you to evaluate why steel prices have risen, you may have analysed the situation by explaining that a) consumer electronics manufacturers in the EU have switched from tin solder to steel solder, b) there is a construction boom in China, which has increased the demand for steel structures and c) speculators have piled into the market to buy up iron ore, thereby raising the price of this main raw material used to make steel.

To evaluate through prioritisation, you might argue that the most significant reason pushing up steel prices is the speculative activity on the commodity markets, since this occurs on a global scale and therefore has the greatest potential to raise the demand for, and the price of, steel. The second most significant factor is the construction boom in China and the least significant factor is the increased use of steel by consumer electronics manufacturers in the EU: while both of these factors relate to just one part of the world (namely, EU or China), the construction industry tends to use a lot of steel to create its grand structures, while the electronics industry uses a much smaller quantity of steel, mainly for soldering.

Whichever way you prioritise the different factors, always be sure to back it up with sound reasoning.

 

Two final notes on evaluation…

Firstly, as mentioned above, evaluation is not about memorising a finite list of points, but is about developing a particular way of thinking that questions and critically assesses the available data and analysis. Developing these thought processes takes plenty of time and practise, so you should constantly go through all potential evaluation points in every question you do – even if you only do this hypothetically (as a ‘thought experiment’), to sharpen your technique.

Secondly, and related to this, is the importance of appropriate and realistic evaluation, which is suitable for the context at hand. Thus if the cost of tobacco leaves has risen for cigarette manufacturers, it would make little sense to evaluate this by saying that the government may offer the industry subsidies to help firms offset their rising costs: cigarettes are a demerit good which the government actively discourages us from consuming so subsidies are not a sensible suggestion, even in principle. On the other hand, raising the possibility that cigarette manufacturers may themselves try to cut costs to offset rising tobacco prices (perhaps by using more efficient machines to increase labour productivity) is more realistic and, therefore, likely to get evaluation marks. In short, you must always pay attention to context and ensure that both your analysis and evaluation points are sensible in the circumstances of the case study.

 

 

 

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