Cure for Economic Slumps Seen in Raising Rates: Cutting Research

Friday, 23 November 2012 10:26 AM

(Cutting Research is a regular roundup of economic research from academia, banking and policy making.)

Nov. 23 (Bloomberg) -- The solution to weak economic growth may be higher interest rates.

That seemingly paradoxical remedy can apply if the cause of the slump is a confidence shock that cheap borrowing costs are failing to reverse, two Columbia University economists said in a report published this week. In such a situation, ultra-easy monetary policy risks making fears of deflation a self- fulfilling prophecy as spenders sit tight.

If low interest rates can’t motivate jittery consumers, then the answer may be the opposite: an increase in borrowing costs. Such a shift “can boost inflationary expectations and therefore foster employment,” said Stephanie Schmitt-Grohe and Martin Uribe in the study published Nov. 19 by the National Bureau of Economic Research in Cambridge, Mass.

“By its effect on real wages, future inflation stimulates employment, thereby lifting the economy out of the slump,” they said.

The academics said sagging confidence among households and companies has played a part in the recent economic slowdown. Evidence from the U.S. as well as Japan during the last two decades “seems to suggest that zero nominal interest rates are not doing much to push inflation higher.”

At the moment, the Federal Reserve pledges to keep its benchmark interest rate near zero through mid-2015.

* * *

Of the euro area’s fiscally soundest nations, Finland would face the smallest economic cost should it quit the euro, a study by JPMorgan Chase & Co. strategists found.

The report, published yesterday, focused on countries’ current account gaps and the potential for currency appreciation and bond yield shifts following an exit. It said the Netherlands would probably incur the highest cost of leaving the single currency.

“Although EMU exit by a core country is highly unlikely, risks around such an event may increase in 2013,” said the strategists, including London-based John Normand.

The report suggested that the higher the current account surplus of a country, the greater the cost of exit as it would probably incur an appreciating currency.

That leaves Finland in a good position because it has a small current account deficit. By contrast, the Netherlands runs a very high surplus, the authors said.

Finnish and German 10-year bond yields would fall about 35 basis points on an exit while those of the Netherlands would rise by a similar amount, they said.

* * *

The November votes to legalize marijuana for recreational use in Washington and Colorado could be a boon to those states’ economies, according to IHS Inc. in Englewood, Colorado.

Both states passed referenda that would de-criminalize the possession and use of the drug. If eventually allowed by federal authorities, the initiatives would provide tax revenue for the states, alleviate stress on law enforcement and transfer jobs out of the underground economy, Steven Frable, IHS’s U.S. regional economist, said in a Nov. 15 report.

For Washington, most of the direct revenue would come from license fees, while Colorado would get more from excise taxes, the report said. Washington has estimated the total revenue impact generated by sales could be as high as $1.9 billion over five fiscal years.

The states could also benefit from “pot tourism,” just as California attracts visitors for its wine industry, Frable said.

On the other side of the equation, more would need to be spent on programs to support the sale and distribution of marijuana, he said. Washington is estimated to spend $63 million over five fiscal years.

“It could take years before any state can legally sell marijuana, if at all,” Frable said.

* * *

Once bitten, twice shy may not be the rule for banking crises.

A study published on the VoxEU website Nov. 21 suggested past turmoil does not affect the probability of future crisis. Instead, economists Joshua Aizenman and Ilan Noy found in a study of 28 high-income countries between 1980 and 2010 that previous periods of financial pain tend to make repeats more probable.

A possible explanation is that regulators lag behind the pace of bank innovation or are focusing on the causes of the last crisis, not the next one, the report said.

“In these circumstances, a possible remedy may call for slowing down the diffusion or financial innovations, treating them as risky until proven otherwise,” said Aizenman, who teaches at the University of California, Santa Cruz, and the University of Hawaii’s Noy.

* * *

Companies worldwide are paying less tax than before the financial crisis, according to a study by the World Bank and PriceWaterhouseCoopers LLP.

The research, carried out in 185 tax regimes and published Nov. 21, found a medium-sized company pays an average 44.7 percent of profits in taxes to all levels of government. The total tax rate has declined one percentage point in each of the last eight years, the report said.

Companies also spent 267 hours complying with tax requirements, a fall of 54 hours in the past eight years.

Economies that took steps to reduce complexity in tax administration -- in terms of the number of payments and time it takes to deal with it -- tend to enjoy higher economic growth, the study said.

“We are seeing tension between the need for governments to raise tax revenue and at the same time provide a system that encourages economic activity and growth,” said Andrew Packman, an Uxbridge, U.K.-based tax partner at PricewaterhouseCoopers LLP, who worked on the project. “Governments seeking to create a more business-friendly tax climate need to focus not only on rates, but on minimizing the time and effort needed to comply.”

* * *

Switzerland is the best place to be born in this year, based upon long-term economic forecasts to 2030.

That’s the conclusion of a study released yesterday by the London-based Economist Intelligence Unit. Australia and Norway rounded out the top three, while the U.S. was tied for 16th with Germany. The table was based on geography, demography and economic factors.

--Editors: Anne Swardson, Paul Badertscher

To contact the reporter on this story: Simon Kennedy in London at skennedy4@bloomberg.net.

To contact the editors responsible for this story: Craig Stirling at cstirling1@bloomberg.net.

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