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Economy

Negative Interest Rates and Deflation

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Authors: Chan Kung and Wei Hongxu*

As the COVID-19 pandemic lingers, major central banks such as the Federal Reserve have to continue to maintain ultra-low policy interest rates in anticipation of being able to help the major economies out of the crisis.  According to the latest Fed decision, interest rates may not be raised until 2023, which means that the zero-interest rate on the dollar may need to be maintained for quite some time to wait for the economy to recover and for inflation levels to pick up again. For now, interest rates in the U.S., U.K., Norway, Australia, New Zealand, Israel, and Canada are all at 0.25% or lower, and of those countries, the U.K., New Zealand, and more central banks are likely to cut rates below zero in response to the economic downturn triggered by the COVID-19 pandemic. Japan and the eurozone have been under the monetary policy of negative interest rates for a long time. With more countries adopting negative interest rates, there are growing concerns about whether this unusual monetary policy will allow the economy to recover.

Recently, according to Reuters, there have been a number of studies by economists that have shown that negative interest rate policy will not bring economic recovery, but will rather cause more troubles. From a behavioral economics perspective, Lior David-Pur, head of Israel’s state debt management unit, said: “If your goal is to motivate people to take on more leverage [debt] and to increase investments in risky assets, then zero interest rates are actually more efficient than negative rates.” David-Pur’s study found that when interest rates fell from 1% to 0%, the positive impact on risk-taking and borrowing behavior was greatest.

The study, a rare look into consumer reactions to negative rates, tracked the investment decisions of 205 university students studying economics who were divided into four groups, each with 10,000 Israeli shekels (USD 2,921) to allocate between risk-free bank deposits and risky assets such as stocks. David-Pur said the group for which rates fell to minus 1%, actually cut leverage by 1.75%. But the willingness to borrow rose by 20% in the group that saw rates fall to 0%.It can be seen from the current stock markets in the United States and Europe that zero-interest rate and massive quantitative easing have indeed brought about a boom in the capital market, whose root is still the change of risk pricing by investors based on the reduction of borrowing costs, which has not effectively improved corporate profits and earnings.

Efforts to boost investment and consumption with a negative interest rate policy may be ineffective, instead households will increase their savings to “survive the winter”. This is because negative rates can suggest “some kind of emergency situation”, said Anatoli Annenkov, a former ECB economist who now with Société Générale. “That per se suggests that you won’t get the impact you want because people might just save more money instead of spending,” Annenkov said. His research shows that the savings rates across the eurozone dipped briefly after 2014, then continued to rise as official rates fell further below 0%. From the 2008 financial crisis to the present, major economies including the United States, have been experiencing low inflation and low growth. In fact, even though the world has unleashed a huge amount of liquidity, the global economy has not been able to change the deflationary situation.

The most worrisome aspect of negative interest rates is what Keynesian economists call a “liquidity trap“, i.e., when nominal interest rates are too low or even negative, further reductions in interest rates do not encourage business investment and only provide little stimulus to the economy. When businesses do not see demand and inflation expectations, they will not increase investment, resulting in fewer jobs and less consumption. In this case, negative interest rates and deflation can be said to be mutually reinforcing, with deflation-induced negative interest rates meaning that both households and businesses hold cash, thus dragging the entire economy into a deflationary black hole of a liquidity shortage.

From the practice of negative interest rate policies in the eurozone and Japan, many scholars also criticized the long-term negative interest rate policy, which does not bring an increase in investment, nor improvementsin inflation and economic growth. In Sweden, the first country to have negative interest rates, Fredrik NG Andersson, associate professor at the Lund School of Economics and Management, said the cost of negative rates for Sweden’s economy likely outweighed the benefits. Andersson said that borrowing did rise when rates were negative, but the money ended up invested mostly in housing, inflating property markets, and household debt.

Judging from past practice and current economic situation, the role of monetary policy in stimulating economic recovery has been greatly weakened. Even if the Fed adjusts its inflation target through technical means, there is less and less room for monetary policy to play in the current macro environment. Because monetary policy, for its part, is about adjusting the cost of capital to prevent liquidity crisis. Yet, the problem now is no longer the liquidity, but a lack of long-term growth momentum. The recovery of economic growth requires not only the increase in money supply, but also an increase in effective demand and supply from the perspective of long-term growth.

Final analysis conclusion:

Major central banks such as the Federal Reserve left interest rate policy unchanged, meaning zero/negative interest rate monetary conditions will remain in place for a long time. This suggests that the global economic downturn is causing deflation to be a longer-term trend.

*Wei Hongxu, graduated from the School of Mathematics of Peking University with a Ph.D. in Economics from the University of Birmingham, UK in 2010 and is a researcher at Anbound Consulting, an independent think tank with headquarters in Beijing.

Founder of Anbound Think Tank in 1993, Chan Kung is now ANBOUND Chief Researcher. Chan Kung is one of China’s renowned experts in information analysis. Most of Chan Kung‘s outstanding academic research activities are in economic information analysis, particularly in the area of public policy.

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US Economic Turmoil: The Paradox of Recovery and Inflation

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The US economy has been a rollercoaster since the pandemic cinched the world last year. As lockdowns turned into routine and the buzz of a bustling life came to a sudden halt, a problem manifested itself to the US regime. The problem of sustaining economic activity while simultaneously fighting the virus. It was the intent of ‘The American Rescue Plan’ to provide aid to the US citizens, expand healthcare, and help buoy the population as the recession was all but imminent. Now as the global economy starts to rebound in apparent post-pandemic reality, the US regime faces a dilemma. Either tighten the screws on the overheating economy and risk putting an early break on recovery or let the economy expand and face a prospect of unrelenting inflation for years to follow.

The Consumer Price Index, the core measure of inflation, has been off the radar over the past few months. The CPI remained largely over the 4% mark in the second quarter, clocking a colossal figure of 5.4% last month. While the inflation is deemed transitionary, heated by supply bottlenecks coinciding with swelling demand, the pandemic-related causes only explain a partial reality of the blooming clout of prices. Bloomberg data shows that transitory factors pushing the prices haywire account for hotel fares, airline costs, and rentals. Industries facing an offshoot surge in prices include the automobile industry and the Real estate market. However, the main factors driving the prices are shortages of core raw materials like computer chips and timber (essential to the efficient supply functions of the respective industries). Despite accounting for the temporal effect of certain factors, however, the inflation seems hardly controlled; perverse to the position opined by Fed Chair Jerome Powell.

The Fed already insinuated earlier that the economy recovered sooner than originally expected, making it worthwhile to ponder over pulling the plug on the doveish leverage that allowed the economy to persevere through the pandemic. The main cause was the rampant inflation – way off the 2% targetted inflation level. However, the alluded remarks were deftly handled to avoid a panic in an already fragile road to recovery. The economic figures shed some light on the true nature of the US economy which baffled the Fed. The consumer expectations, as per Bloomberg’s data, show that prices are to inflate further by 4.8% over the course of the following 12 months. Moreover, the data shows that the investor sentiment gauged from the bond market rally is also up to 2.5% expected inflation over the corresponding period. Furthermore, a survey from the National Federation of Independent Business (NFIB) suggested that net 47 companies have raised their average prices since May by seven percentage points; the largest surge in four decades. It is all too much to overwhelm any reader that the data shows the economy is reeling with inflation – and the Fed is not clear whether it is transitionary or would outlast the pandemic itself.

Economists, however, have shown faith in the tools and nerves of the Federal Reserve. Even the IMF commended the Fed’s response and tactical strategies implemented to trestle the battered economy. However, much averse to the celebration of a win over the pandemic, the fight is still not through the trough. As the Delta variant continues to amass cases in the United States, the championed vaccinations are being questioned. While it is explicable that the surge is almost distinctly in the unvaccinated or low-vaccinated states, the threat is all that is enough to drive fear and speculation throughout the country. The effects are showing as, despite a lucrative economic rebound, over 9 million positions lay vacant for employment. The prices are billowing yet the growth is stagnating as supply is still lukewarm and people are still wary of returning to work. The job market casts a recession-like scenario while the demand is strong which in turn is driving the wages into the competitive territory. This wage-price spiral would fuel inflation, presumably for years as embedded expectations of employees would be hard to nudge lower. Remember prices and wages are always sticky downwards!

Now the paradox stands. As Congress is allegedly embarking on signing a $4 trillion economic plan, presented by president Joe Bidden, the matters are to turn all the more complex and difficult to follow. While the infrastructure bill would not be a hard press on short-term inflation, the iteration of tax credits and social spending programs would most likely fuel the inflation further. It is true that if the virus resurges, there won’t be any other option to keep the economy afloat. However, a bustling inflationary environment would eventually push the Fed to put the brakes on by either raising the interest rates or by gradually ceasing its Asset Purchase Program. Both the tools, however, would risk a premature contraction which could pull the United States into an economic spiral quite similar to that of the deflating Japanese economy. It is, therefore, a tough stance to take whether a whiff of stagflation today is merely provisional or are these some insidious early signs to be heeded in a deliberate fashion and rectified immediately.

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Carbon Market Could Drive Climate Action

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Authors: Martin Raiser, Sebastian Eckardt, Giovanni Ruta*

Trading commenced on China’s national emissions trading system (ETS) on Friday. With a trading volume of about 4 billion tons of carbon dioxide or roughly 12 percent of the total global CO2 emissions, the ETS is now the world’s largest carbon market.

While the traded emission volume is large, the first trading day opened, as expected, with a relatively modest price of 48 yuan ($7.4) per ton of CO2. Though this is higher than the global average, which is about $2 per ton, it is much lower than carbon prices in the European Union market where the cost per ton of CO2 recently exceeded $50.

Large volume but low price

The ETS has the potential to play an important role in achieving, and accelerating China’s long-term climate goals — of peaking emissions before 2030 and achieving carbon neutrality before 2060. Under the plan, about 2,200 of China’s largest coal and gas-fired power plants have been allocated free emission rights based on their historical emissions, power output and carbon intensity.

Facilities that cut emissions quickly will be able to sell excess allowances for a profit, while those that exceed their initial allowance will have to pay to purchase additional emission rights or pay a fine. Putting a price tag on CO2 emissions will promote investment in low-carbon technologies and equipment, while carbon trading will ensure emissions are first cut where it is least costly, minimizing abatement costs. This sounds plain and simple, but it will take time for the market to develop and meaningfully contribute to emission reductions.
The initial phase of market development is focused on building credible emissions disclosure and verification systems — the basic infrastructure of any functioning carbon market — encouraging facilities to accurately monitor and report their emissions rather than constraining them. Consequently, allocations given to power companies have been relatively generous, and are tied to power output rather than being set at absolute levels.

Also, the requirements of each individual facility to obtain additional emission rights are capped at 20 percent above the initial allowance and fines for non-compliance are relatively low. This means carbon prices initially are likely to remain relatively low, mitigating the immediate financial impact on power producers and giving them time to adjust.

For carbon trading to develop into a significant policy tool, total emissions and individual allowances will need to tighten over time. Estimates by Tsinghua University suggest that carbon prices will need to be raised to $300-$350 per ton by 2060 to achieve carbon neutrality. And our research at the World Bank suggest a broadly applied carbon price of $50 could help reduce China’s CO2 emissions by almost 25 percent compared with business as usual over the coming decade, while also significantly contributing to reduced air pollution.

Communicating a predictable path for annual emission cap reductions will allow power producers to factor future carbon price increases into their investment decisions today. In addition, experience from the longest-established EU market shows that there are benefits to smoothing out cyclical fluctuations in demand.

For example, carbon emissions naturally decline during periods of lower economic activity. In order to prevent this from affecting carbon prices, the EU introduced a stability reserve mechanism in 2019 to reduce the surplus of allowances and stabilize prices in the market.

Besides, to facilitate the energy transition away from coal, allowances would eventually need to be set at an absolute, mass-based level, which is applied uniformly to all types of power plants — as is done in the EU and other carbon markets.

The current carbon-intensity based allocation mechanism encourages improving efficiency in existing coal power plants and is intended to safeguard reliable energy supply, but it creates few incentives for power producers to divest away from coal.

The effectiveness of the ETS in creating appropriate price incentives would be further enhanced if combined with deeper structural reforms in power markets to allow competitive renewable energy to gain market share.

As the market develops, carbon pricing should become an economy-wide instrument. The power sector accounts for about 30 percent of carbon emissions, but to meet China’s climate goals, mitigation actions are needed in all sectors of the economy. Indeed, the authorities plan to expand the ETS to petro-chemicals, steel and other heavy industries over time.

In other carbon intensive sectors, such as transport, agriculture and construction, emissions trading will be technically challenging because monitoring and verification of emissions is difficult. Faced with similar challenges, several EU member states have introduced complementary carbon taxes applied to sectors not covered by an ETS. Such carbon excise taxes are a relatively simple and efficient instrument, charged in proportion to the carbon content of fuel and a set carbon price.

Finally, while free allowances are still given to some sectors in the EU and other more mature national carbon markets, the majority of initial annual emission rights are auctioned off. This not only ensures consistent market-based price signals, but generates public revenue that can be recycled back into the economy to subsidize abatement costs, offset negative social impacts or rebalance the tax mix by cutting taxes on labor, general consumption or profits.

So far, China’s carbon reduction efforts have relied largely on regulations and administrative targets. Friday’s launch of the national ETS has laid the foundation for a more market-based policy approach. If deployed effectively, China’s carbon market will create powerful incentives to stimulate investment and innovation, accelerate the retirement of less-efficient coal-fired plants, drive down the cost of emission reduction, while generating resources to finance the transition to a low-carbon economy.

(Martin Raiser is the World Bank country director for China, Sebastian Eckardt is the World Bank’s lead economist for China, and Giovanni Ruta is a lead environmental economist of the World Bank.)

(first published on China Daily via World Bank)

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The EU wants to cut emissions, Bulgaria and Eastern Europe will bear the price

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In the last few years, the European Union has been going above and beyond in dealing with climate change. Clearly, this is far from being a case of disinterested endeavour to safeguard the planet and the environment. On the contrary, the EU’s efforts aim at reinforcing its “normative power”.  In effect, the EU has gained some clout on the international stage, even vis-à-vis faraway countries like Vietnam and China. Yet, in doing so the Union embroiled in the apparent rush for more and more ambitious climate standards and targets. Therefore, Brussels needs to start acting and deliver on its promises to keep staying ahead of the pack. Even more so given US President Biden’s strengthened engagement with friends and foes alike on the climate and human rights.

Last week, the European Commission manifested its acknowledgment of this need by unveiling the Fit for 55 (FF55) growth strategy. Overall, this new, beefed-up Green Deal should reduce greenhouse gas emissions to 55% of their 1990 level by 2030. In some analysts’ view, the FF55 plan is a game changer in the long-term race towards climate neutrality alas. In fact, it could “both deepen and broaden the decarbonisation of Europe’s economy to achieve climate neutrality by 2050.” Moreover, they expect the FF55’s 13 measures to generate a number of positive ripple effects across EU economies.

True, wanting to reduce greenhouse gases significantly by 2030 and reaching net-zero-emission by 2050 goal is commendable under many regards. Still, the FF55 includes a number of measures that could impact ordinary people’s life massively across Europe. Nevertheless, the 27 Member States of the EU are responsible for as little as 8% of global emissions. As such, it is necessary to take a deeper look at how the FF55 will affect different countries and demographics.

The transition’s social cost

The realisation that reduction of capitalism’s dependence on fossil fuels will have serious socio-economic consequences is not at all new. Contrariwise, scholars and politicians have been outspoken about an indisputable “conflict between jobs and the environment”, since the early 1990s. Together, the pandemic-induced recession and the signing of the Paris Accord have brought the notion back on the centre stage.

Factually, pushing the energy transition entails facing mass lay-offs, generalised workforce retraining and taxes hikes on ordinary consumers. For instance, these hardships’ seriousness is evident in the progressive abandonment of coal mining for energy generation in the US. Moreover, the energy transition requires strong popular backing in order to be effective. Yet, measures pursued to achieve environmentally friendly growth tend to generate strong, grassroot opposition. Most recently, France’s gilets jaunes protests shows that environmental policies generate social discontent by disfavouring middle and lower classes disproportionately.

The poorest families and countries will bear the costs

One of the FF55’s main policy innovation regards the creation of a carbon trading market for previously exempt sectors. Namely, companies working int the transport and buildings sectors, be they public or private, will have to follow new rules. As it happened in the energy industry before, each company will have to respect a “carbon allowance”. Basically, it is an ‘authorisation to pollute’ which companies can buy from each other — but the total cannot increase. Despite all claims of just transition, this and other measures will have a gigantic, re-distributional effect within and between countries. And it will be of markedly regressive character, meaning that poorer families and countries will pay more.

Taxing transport emission is regressive

Historically, these sectors were trailing behind most others when it comes to decarbonisation for a variety of reasons. First of all, the previous emission trading system did not include them. Moreover, these are far from being well-functioning markets. As a result, even if the cost of emissions was to rise, enterprises and consumer will not react as expected.

Thus, even as they face higher costs, companies will keep utilising older, traditional vehicle and construction technologies. With taunting reverberations on those poorer consumers, who cannot afford to buy an electric car or stop using public transport. Hence, they “will face a higher carbon price while locked into fossil-fuel-based systems with limited alternatives.” Moreover, the EU could worsen these effects by trying to reduce the emission fees on truck-transported goods. Indeed, the commission is proposing a weight-based emission standard that would collaterally favour SUVs over smaller combustion-engine car and motorbikes. 

In a nutshell, higher taxes and fee will strike lower-class consumers, who spend more of their incomes for transportation. Even assuming these households would like to switch to low-emission cars and buildings, current market prices will make it impossible. In fact, all these technologies ten to have low usage costs, but very high costs of acquisition. For instance, the cheapest Tesla sells at over €95,000, whereas a Dacia Sandero “starts at just under €7,000.”

Eastern Europe may not be willing to pay

At this point, it is clear that the FF55 plan will deal a blow to ongoing efforts to reduce inequalities. In addition, one should not forget that EU Member States are as different amongst them as they are within themselves. Yet, the EU is not simply going to tax carbon in sectors that inevitably expose poorer consumers the most. But in doing so it would impose a single price on 27 very diverse societies and economies. Thus, the paradox of having the poorest countries in the EU (i.e., Central- and South-Eastern Europe) pay the FF55’s bill.

To substantiate this claim, one needs to look no further than at a few publicly available data. First, as Figure 2 shows, there is an inverse relation between a country’s wealth and consumers’ expenditures on transport services. Thus, not only do poorer people across the EU spend more on transport, poorer countries do as well. Hence, under the FF55, Bulgarians, Croatians, Romanians and Poles will pay most of the fees and taxes on carbon emission.

Additionally, one should consider that there is also a strict inverse relation between carbon emissions and the minimum national wage. In fact, looking at Figure 3 one sees that countries with lower minimum wages tend to emit more carbon dioxide. On average, countries with a minimum salary of €1 lower emit almost 4.5mln tonnes of carbon dioxide more. But differences in statutory national wages explain almost 32% of the cross-country variation in emissions. So, 1.5 of those extra tonnes are somehow related to lower minimum salaries and, therefore, lower living standards.

The EU’s quest for a just transition: Redistribution or trickle down?

Hence, the pursual of a ‘just’ transitionhas come to mean ensuring quality jobs emerge from these economic changes. However, many of the FF55’s 13 initiatives may worsen disparities both within countries and, more importantly, between them. Thus, the EU has been trying to pre-empt the social losses that would inevitably come about.

From the Just Transition Fund to the Climate Social Fund

In this regard, the European Union went a step forward most countries by creating the Just Transition Fund in May. That is, the EU decided to finance a mix of grants and public-sector loans which aims to provide support to territories facing serious socio-economic challenges arising from the transition towards climate neutrality [… and] facilitate the implementation of the European Green Deal, which aims to make the EU climate-neutral by 2050.

Along these lines, the FF55 introduces a Climate Social Fund (CSF) that will provide “funding […] to support vulnerable European citizens.” The fund will provide over €70bln to support energy investments, and provide direct income support for vulnerable households. The revenues from the selling of carbon allowances to the transport and building sectors should fund most of the CSF. If necessary, the Member States will provide the missing portion.

The EU Commission may give the impression of having design the CSF to favour poorer households and countries. However, it may actually be a false impression. In fact, it is clear that the entire carbon pricing initiative will impact poorer household and countries more strongly. However, only a fourth of the carbon pricing system’s revenues will go to fund the CSF. The remaining portion will finance other FF55 programmes, most of which have a negative impact on poorer communities. Thus, despite the CSF, the final effect of the entire FF55 will be a net redistribution upwards.

Stopping a redistribution to the top

Nevertheless, there is a way to fix the FF55 so that it can work for poorer households and lower-income countries. Given that the CSF is too small for the challenge it should overcome, its total amount should be increased. In fact, the purpose of higher carbon pricing is in any event not to raise revenue but to direct market behaviour towards low-carbon technologies—there is thus a strong argument for redistributing fully the additional revenues

Hence, the largest, politically sustainable share of carbon-pricing revenues from transportation and housing should ideally go to the CSF. In addition, the Commission should remove all the proposed provision that divert CSF money away from social compensation scheme. In fact, poorer families will not gain enough from subsidies to electric car, charging stations and the decarbonisation of housing. One contrary, “using the fund to support electric vehicles would disproportionally favour rich households.”

Finally, the allocation of CSF money to various member states should follow rather different criteria from the current ones. In fact, the Commission already intends to consider a number of important such as: total population and its non-urban share; per capita, gross, national income; share of vulnerable households; and emissions due to fuel combustion per household. But these efforts to look out for the weakest strata in each country could backfire. In fact, according to some calculations, a Member State with lower average wealth and lower “within-country inequality could end up benefiting less than a rich member state with high inequality.”

Conclusion

A number of well-known, respected economist have been arguing that environmental policies should account for social fallouts attentively. Goals such as emission reduction and net-zero economies require strong popular support in order for the transformation to succeed. Or at least, the acquiescence of a majority of the public. Otherwise, the plans of well-intentioned and opportunistic governments alike will derail. After all, this is the main lesson of the currently widespread protest against the mandating of ‘Covid passes’ and vaccines.

If the FF55 will deal poorer households a devastating blow, social unrest may worsen — fast. But as long as it will also hurt Eastern European countries as a whole, there is a chance. Hopefully, European parliamentarians from riotous Hungary or Poland will oppose the FF55 in its current shape. Perhaps, in a few years everyone will be thankful for these two countries strenuous resistance to EU bureaucracy. Or else, richer countries may force Central- and South-Eastern Europe to swallow a bitter medicine. Even though, whatever happens, Europe alone cannot and will not save the planet.

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