Falling prices are worse than rising ones!!!!

Deflation

Deflation can be a bigger problem than inflation. This short piece explains why...

In the MPC's last monthly inflation report they forecast that inflation could fall to 1%. They even hinted at the possibility of deflation. What is deflation and why does it strike fear into economists and policy makers?

Deflation is simply a fall in the general price level. If deflation is a result of improved productivity and greater efficiency, it may not be a problem (ie an AS shift to the right). But, usually deflation is caused by falling demand and lower growth.

It is no coincidence that the worst period of deflation was in the great depression of the 1930s.

This kind of deflation is very damaging because:

1.Lower Spending

When prices are falling, there is an incentive to delay purchases. Why buy a TV now, when it will be cheaper in 12 months?

Look at how the housing market is suffering because of falling prices. Nobody wants to buy with falling house prices; this is why property transactions have slumped and of course causes further falls in prices.

In Japan, the decade of deflation created a culture of thrift and saving. Japanese housewives just wouldn't spend. Tax cuts, government spending and interest rate cuts all failed to stimulate growth because all the Japanese wanted to do was save (an example, of the Paradox of thrift - Y13 Ask Me)

2.Liquidity Trap

A liquidity trap occurs when lower interest rates fail to stimulate spending. If prices are falling by 2%, it can be more attractive to save money in cash then spend. Therefore, cutting interest rates to 0% may be ineffective in increasing demand.

3.Increasing Burden of Debt

If you take out a mortgage and make mortgage payments of say £500 a month, inflation will progressively reduce the real value of your mortgage interest payments. High inflation thus makes a mortgage more attractive, over time, it increases the disposable income of mortgage owners.

•However, with deflation, this £500 a month becomes a bigger % of your disposable income. In deflation, debt becomes an increasing burden reducing spending and economic growth.

•The problem is that the UK and US are increasingly indebted, personal savings are very low. Personal debt is very high therefore, deflation would be very damaging for an economy burdened with a legacy of debt.

4. Rising Real Wages

Workers will general seek to prevent a cut in nominal wages. Therefore, with deflation, real wages rise by stealth. This can lead to real wage unemployment. With deflation, it is much more difficult for prices and wages to adjust.

How To Overcome Deflation

Basically, Monetary authorities need to implement bold policies. In particular they need to increase inflationary expectations. The problem is Central banks are so used to trying to reduce inflationary expectations, that they can struggle to implement the opposite.

However, the experience of Japan in the 1990s and 2000s suggests timid policies can lead to several years of economic stagnation.

What the poverty figures show

Poverty is a subject likely to come up in some form in Unit 4 (it may be developing economies, but could also be UK based). You need to be able to define Absolute and relative and understand why poverty is an issue and finally, suggest or evaluate policies aimed at reducing it. (this is usually relative poverty)

What the poverty figures show Society guardian.co.uk

Y13 - Terms of Trade (important for development)

Terms of Trade

The terms of trade measures the rate of exchange of one good or service for another when two countries trade with each other.

For international trade to be mutually beneficial for each country, the terms of trade must lie within the opportunity cost ratios for both country.

We calculate the terms of trade as an index number using the following formula:

Terms of Trade Index = (Average export price index / Average import price index) * 100

If export prices are rising faster than import prices, the terms of trade index will rise. This means that fewer exports have to be given up in exchange for a given volume of imports.

If import prices rise faster than export prices, the terms of trade have deteriorated. A greater volume of exports has to be sold to finance a given amount of imported goods and services.

The terms of trade fluctuate in line with changes in export and import prices. Clearly the exchange rate and the rate of inflation can both influence the direction of any change in the terms of trade.

OIL PRICES AND THE TERMS OF TRADE

Many developing countries are heavily dependent on exporting oil. And volatility in international commodity markets create serious problems with these countries’ terms of trade. In the chart below, notice how closely the annual % change in the terms of trade follows the movement in oil export prices.

When oil values collapsed in 1998, developing countries faced the enormous problem of having to export much more oil to pay for a given volume of imports. The worsening in the terms of trade will have adversely affected living standards in these countries. There has been a sharp rebound in global oil prices this year, helping to boost the terms of trade for oil exporters.

TERMS OF TRADE FOR DEVELOPING NATIONS

Developing countries can be caught in a trap where average price levels for their main exports decline in the long run. This depressed the real value of their exports and worsens the terms of trade. A greater volume of exports have to be given up to finance essential imports of raw materials, components and fixed capital goods.

The problems intensified in 1998 with the collapse in the currencies of many Asian developing countries. A big fall in the terms of trade signifies a reduction in real living standards since imports of goods and services have become relatively more expensive.

TERMS OF TRADE AND COMPETITIVENESS

Consider the effects of a large fall in the value of the exchange rate. The effect should be a fall in export prices and a rise in the cost of imports. This worsen the terms of trade index. But the lower exchange rate restores competitiveness for a country since demand for exports should grow and import demand from domestic consumers should slow down.

Much depends on how producers respond to the lower exchange rate. And for countries without a diversified industrial base, the decline in earnings from each unit of exports has a damaging effect on output, investment and employment.

Taxes...riveting stuff!!!!

Inequality in the distribution of income is an inevitable result of an economic system that rewards the households with the highest skills, best education and most access to capital with higher wages and incomes in the marketplace.
The existence of poverty, both relative and absolute, poses several obstacles to the improvement of well-being for a nation’s people. Social unrest among the poorest members of society can lead to political and economic instability for a nation as a whole. The hardships experienced by society’s poorest members are ultimately felt by the rest of society as the needs of the poor must be met in one way or another, and in extreme circumstances may lead to a violent struggle between economic classes.

The existence of absolute poverty poses the greatest obstacle to national economies and society as those who experience it are unlikely to contribute whatsoever to national output and economic growth given the desperate state of their health and education. Without promoting some degree of equality in the distribution of income, governments run the risk of undermining their accomplishment of other social and economic objectives. So how do governments achieve more equal income distribution? Before we look at the modern mechanisms by which this objective is achieved, it is important to examine the historical ideology that frames modern economic policy.
For centuries the role of government has been debated among economists. The extent to which it is the government’s job to assure equality in the distribution of income has never been fully agreed upon by policymakers, whose opinions differ depending on the school of economic ideology to which they prescribe. On the far left of the economic spectrum is Marxist/socialist ideology, which believes that households’ money incomes should be made obsolete and each household’s level of consumption should instead be based on the “use-value” of the output which it produces. In a pure Marxist or socialist economy, money incomes do not matter since the output of the nation will be shared equally among all those who contribute to its production. Private ownership of resources and the output those resources produce is wholly abolished in a socialist economy and the ownership and allocation of resources, goods and services is in the hands of the state and production and consumption is undertaken based on the principle of equality.

The slogan “from each according to his ability, to each according to his need”, made populate by Karl Marx, summarized the view that a household’s consumption should be based on its level of need. To take this idea to its logical conclusion, all households in a nation have essentially the same basic needs therefore household incomes should be equal across the nation.

On the other extreme of the economic spectrum is the laissez faire, free market model which argues that the only role the government should play in the market economy is in the protection of private property rights, which assures that the private owners of resources, including land, labor and capital, are able to pursue their own self-interest in an unregulated marketplace where their money incomes are determined by the “exchange-value” of the resources they control. In a laissez-faire market economy, the level of income and consumption of households varies greatly across society as the exchange-value of the resources owned by households determines income, rather than the principle of equality underlying socialism. Each individual in society is free to pursue his monetary objectives through the improvement of his human capital and the subsequent increase in its exchange-value in the labor market.

In today’s world, there exists neither a purely socialist economy nor a purely laissez fair free market economy. In reality, all modern national economies are mixed economies in which governments do much more than simply protect property rights, but do not go so far as to own and allocate all factors of production. The role of government in the distribution of income in today’s economies is relegated to the collection of taxes and the provision of public goods and services and transfer payments.

A tax is simply a fee charged by a government on a person’s income, property, or consumption of goods and services. Taxes can be broken into two main categories: direct and indirect.
Direct taxes: These are taxes paid directly to the government by those on whom they are imposed. An income tax is a direct tax because it is taken directly out of a worker’s earned income. Corporate and business taxes are also direct taxes based on the revenues or profits of firms. Direct taxes cannot be legally avoided since they are based on the earned income of each individual. The burden of direct taxes is born entirely by the households or firms paying them.
Indirect taxes: These are the taxes paid by households through an intermediary such as a retail store. The consumer pays the tax at the time of his purchase of a good or service and the amount of the tax is usually calculated by adding a percentage rate to the price of the item being purchased. Indirect taxes include sales taxes, value added taxes (VAT), goods and services tax (GST) as well as ad valorem taxes (or excise taxes) which are placed on specific goods such as cigarettes, alcohol or petrol. Indirect taxes can be avoided simply by not consuming certain products or by consuming less of all products. The burden of indirect taxes is born by both households and firms, the proportion born by each is determined by the price elasticities of demand and supply (as demonstrated in chapter 4).
Taxes can be either progressive, regressive or proportional in nature, meaning that different taxes place different burdens on the rich and the poor.

Proportional tax: A tax for which the percentage of income taxed remains constant as income increases is a proportional tax. The rich will pay more tax than the poor in absolute terms, but the burden of the tax will be no greater on the rich than it is on the poor. A household earning 20,000 euros may pay 10% tax to the government, totaling 2,000 euros. A rich household in the same country pays 10% on its income of 200,000 euros, totaling 20,000 euros in taxes, but the burden is the same on the rich household as it is on the poor household. Proportional taxes are uncommon in advanced economies, although some “payroll taxes”, which are those collected to support social security or welfare programs, are payed by employers based on a percentage of employees’ incomes up to a certain level. For instance, the US social security tax is 6.2% of gross income up to $108,000. Regardless of a person’s income below $108,000, he or she will pay 6.2% to the government to support the country’s social security program.

Regressive tax: A tax that decreases in percentage as income increases is said to be regressive. Such a tax places a larger burden on lower income households than it does higher income earners since a greater percentage of a poor household’s income is used to pay the tax than a rich household’s. You may be wondering what kind of government would levy a tax that harms the poor more than it does the rich, but in fact almost every national government uses regressive taxes to raise a significant portion of its tax revenues. Most indirect taxes are actually regressive, which may not make sense at first, since a sales tax is a percentage of the price of products consumed consumed. The regressiveness is apparent when the amount of the tax is compared to the income of the consumer, however.


To demonstrate how a sales tax is regressive, imagine three different consumers who purchase an identical laptop computer for 1,000€ in a country with a value added tax of 10% added to the price of the computer.
Income of buyer Amount of tax paid % of income taxed
10,000€ 100€ 1%
50,000€ 100€ 0.2%
100,000€ 100€ 0.1%

The higher income consumer pays the same amount of tax as the lower income consumer, but the the tax makes up a lower percentage of her income than it did the lower income consumer’s. Although they appear to be fair since everyone pays the same percentage of the price of the the goods they consume, indirect taxes such as VAT, GST and sales taxes are in fact regressive taxes, placing a larger burden on those whose ability to pay is lower and a smaller burden on the higher income earners whose ability to pay is greater.



Progressive tax: This is a tax for which the percentage of income taxed increases as income increases. The principle underlying a progressive tax is that those with the ability to pay the most tax (the rich) should bear a larger burden of the nation’s total tax receipts than those whose ability to pay is less. Lower income households not only pay less tax, but they pay a smaller percentage of their income in tax as well. Most nation’s income tax systems are progressive, the most progressive being those in the Northern European countries which, not surprisingly, also demonstrate the most equal distributions of income. Of the various types of taxes, a progressive income tax aligns most with the macroeconomic objective of increased income equality.
A progressive income tax typically consists of a marginal tax bracket in which the increasing tax rates apply to marginal income, rather than to total income. In such a system, the average tax a household pays increases less rapidly than the marginal tax, since the higher marginal rate only applies to additional income beyond the upper range of the previous bracket.

United States marginal tax rateshttp://www.moneychimp.com/features/tax_brackets.htm
Income range Marginal tax rate Tax paid by someone
at top of bracket Average tax rate
$0-$8,375 10%
$837.5 10.00%
$8,375-$34,000 15% $4,681.25 13.77%
$34,000-$82,400 25% $16,781.25 20.37%
$82,400-$171,850 28% $41,827.25 24.34%
$171,850-$373,650 33% $108421.25 29.02%
$373,850 -$500,000
(and above) 35% $152,643.75
(on $500,000) 30.53%



Notice in the table above that the total tax paid by Americans at the top of each income bracket is NOT the simply the tax rate times income. Rather, the tax rate for each income bracket only applies to income earned above and beyond the upper boundary of the previous bracket. An American worker earning $8,000, for instance, will pay $800 in income tax. But if his income increases to $10,000 he will NOT pay 15% of the full $10,000, or $1,500. Rather, he will pay 15% on the income earned above $8,375. Such a worker would therefore pay 10% of his first $8,375 ($837.50) plus 15% on the additional $1,625 he earned, which is another $243.75. The marginal rate of taxation (MRT) is the change in tax (t) divided by the change in gross income (yg). His total tax would therefore equal $1,081.25.


The marginal rate of taxation between the first and second income brackets above is found using the equation:


The average rate of taxation (ART) is equal to the tax paid (t) divided by the gross income (yg):


The average rate for workers who fall in the second income bracket above can be found using the equation:


For workers in each of the income brackets above, the average rate of taxation is always lower than the marginal rate of taxation, since tax increases only apply to additional income earned beyond the previous bracket. The graph below shows the marginal (in blue) and the average (in red) rates of taxation for individuals earning between $0 and $500,000 in the United States in 2010.

Inflation Article: A regular topic in Units 2 & 4

Should We Worry About Inflation?

Recently, UK inflation rose to 3.7%. Again the CPI measure of inflation has exceeded the expectations of the MPC, and inflation is well above the governments target of 2%.

The MPC point to temporary factors such as rising petrol prices and rising food prices. Because of these temporary factors they expect (hope) inflation will decrease next year.

However, others are concerned that inflation may not fall and we are in danger of losing the low inflation expectations, we have worked very hard to gain.

Furthermore, the policy of quantitative easing (increasing the money supply) combined with high government debt is often a recipe for inflation. (both are expansionary, or reflationary policies!!!!)

It is true, that the inflation rate has often exceeded expectations, and even stripping out temporary factors, core inflation still rose to 3.1%. However, I still feel that inflation is not the most pressing problem facing the UK.

Just last week, we had news of record unemployment (the highest since 1994) - Strange that record unemployment seems to get much less coverage and analysis than high inflation.

The problems in the Eurozone are likely to lower growth in the Europe and therefore a slow down UK exports. Combined with fiscal tightenening (prepare for tax rises and spending cuts), it is likely the UK recovery will be fragile.

With continued spare capacity (negative output gap) and sluggish recovery, underlying inflation is unlikely to take off. To worry about a boom in this stage of the business cycle, - after the deepest recession since the great Depression, doesn't make sense.

Talk Tough on Inflation

It would be a shame if inflation expectations did rise (Y13 - ask me about this) . The MPC have to tread a careful line of talking tough on inflation and trying to keep expectations low, whilst at the same time not panicking if inflation does go above target.

The problem is that there is only so many times you can explain inflation away as being a 'temporary factor'. If the MPC are saying in 12 months time we are still having 'temporary inflation' people will have lost confidence.

However, we always need to keep things in perspective. If we had a choice between the deflationary potential of the Eurozone, e.g. Greece, Spain and a small exceeding of the inflation target, I would always be choosing a moderate amount of inflation over deflation - especially in the current climate of high unemployment and high debts.

At the same time, it should also be remembered that although inflation has often exceeded expectations, there have also been times when it fell much quicker than expected. For example, the high inflation of 2008, was a misleading indicator given the imminent severe recession. Inflation of 5% soon gave way to inflation of less than 1%

Inflation, Debts and Savings

Although the MPC and government would never want to particularly admit it. A bit of inflation does help in reducing our Debt / GDP ratio. However, it is a tricky balancing act. If the UK gains a reputation for higher inflation, it will lead to depreciation and higher bond yields to compensate for the inflation risk. But, again, it is preferable to trying to reduce Debt combined with deflation. (Year 13 ask me about this also!)

Savers

Technically, we have a very high negative real interest rate - Base rates 0.5%, CPI inflation 3.7%. This means savers are losing in real terms the value of their savings. You could argue the high inflation is hitting savers hardest.

However, given nature of banking liquidity, there are still generous offers for savers. If you shop around, you should be able to maintain the real value of your savings.

Unit 4 revision notes - from examiner so read!

http://www.edexcel.com/migrationdocuments/GCE%20New%20GCE/tsm-gce-economics.pdf

Interesting??? Notes at end

Levels of Public Debt as a % of GDP from 2009

1 Zimbabwe 304.30 %
2 Japan 192.10
3 Saint Kitts and Nevis 185.00
4 Lebanon 160.10
5 Jamaica 131.70
6 Singapore 117.60
7 Italy 115.20
8 Greece 108.10
9 Sudan 104.50
10 Iceland 100.60
11 Belgium 99.00
12 Nicaragua 87.00
13 Israel 83.90
14 Sri Lanka 82.90
15 Egypt 79.80
16 France 79.70
17 Germany 77.20
18 Portugal 75.20
19 Hungary 72.40
20 Canada 72.30
21 Jordan 69.90
22 United Kingdom 68.50
23 Austria 68.20
24 Ghana 67.50
25 Malta 66.20
26 Cote d’Ivoire 63.80
27 Ireland 63.70
28 Netherlands 62.30
29 Philippines 62.30
30 Norway 60.20
31 India 60.10
32 Spain 59.50
33 Uruguay 58.70
34 Mauritius 58.30
35 Malawi 58.00
36 Bhutan 57.80
37 El Salvador 55.40
38 Albania 54.90
39 Kenya 54.10
40 Morocco 54.10
41 Tunisia 53.80
42 World 53.60
43 Cyprus 52.40
44 Vietnam 52.30
45 Panama 49.50
46 Thailand 49.40
47 Costa Rica 49.30
48 Argentina 49.10
49 Turkey 48.50
50 Malaysia 47.80
51 Croatia 47.70
52 Poland 47.50
53 United Arab Emirates 47.20
54 Brazil 46.80
55 Finland 46.60
56 Aruba 46.30
57 Colombia 46.10
58 Pakistan 45.30
59 Bolivia 44.00
60 Seychelles 43.90
61 Switzerland 43.50
62 Sweden 43.20
63 Bosnia and Herzegovina 43.00
64 Mexico 42.60
65 Dominican Republic 41.50
66 United States 39.70
67 Yemen 39.60
68 Bangladesh 38.20
69 Denmark 38.10
70 Montenegro 38.00
71 Serbia 37.00
72 South Africa 35.70
73 Cuba 34.80
74 Gabon 34.70
75 Slovakia 34.60
76 Taiwan 34.60
77 Papua New Guinea 33.70
78 Czech Republic 32.80
79 Guatemala 32.70
80 Latvia 32.50
81 Ecuador 32.30
82 Syria 32.30
83 Ethiopia 31.70
84 Zambia 31.50
85 Slovenia 31.40
86 Lithuania 31.30
87 Moldova 31.30
88 Bahrain 30.10
89 Indonesia 29.80
90 New Zealand 29.30
91 Korea, South 28.00
92 Trinidad and Tobago 26.70
93 Mozambique 26.10
94 Peru 26.10
95 Tanzania 24.80
96 Macedonia 24.50
97 Honduras 24.30
98 Senegal 24.00
99 Paraguay 22.10
100 Bulgaria 21.40
101 Ukraine 20.70
102 Saudi Arabia 20.30
103 Romania 20.00
104 Iran 19.40
105 Venezuela 19.40
106 Uganda 19.30
107 Namibia 19.10
108 Australia 18.60
109 China 18.20
110 Hong Kong 18.10
111 Botswana 17.90
112 Nigeria 17.80
113 Angola 16.80
114 Gibraltar 15.70
115 Luxembourg 14.50
116 Cameroon 14.30
117 Kazakhstan 14.00
118 Uzbekistan 11.70
119 Algeria 10.70
120 Chile 9.00
121 Kuwait 8.20
122 Estonia 7.50
123 Qatar 7.10
124 Russia 6.90
125 Libya 6.50
126 Wallis and Futuna 5.60
127 Azerbaijan 4.60
128 Oman 2.80
129 Equatorial Guinea 1.10

Notes: Japan’s Public sector debt is very high. However, Japan has a high savings rate which makes it easier for the government to finance the debt. 90% of Japanese debt is owned by Japanese individuals. US has a low savings ratio and 25% of US debt is owned by foreigners. Nevertheless the National Debt of Japan is a real burden for the economy

An important factor is not just cumulative national debt, but, the annual budget deficit. This annual deficit determines the rate of deterioration in the public sector debt.

In the above list, the UNited States debt is given at just below 40% of national debt. But, a more commonly used statistics is gross government debt which stands at close to 90% of GDP

Spanish Unemployment - Causes, effects & solutions

With more than four million Spanish people out of work this week, the eighth largest economy in the world finds itself once more in a perilous position. In the last twelve months the number of unemployed people in Spain has doubled. Spain now has as many unemployed people as France and Italy combined, and the unemployment rate is nearing the historic highs of 1993.




The type of unemployment in an economy can be classified in different ways. The main types are cyclical or demand deficient unemployment but other forms exist such as real-wage unemployment and equilibrium unemployment. Some economists also refer to unemployed people as structural, frictional, seasonally or cyclically unemployed.

From the graph below we can see that unemployment in Spain has been high for at least the last 20 years, compared to other countries within the European Union.























The cause of growing Spanish unemployment in 2008 to 2010 is related to the collapse of the domestic building boom and the wider global recession.





In 2006, Spain enjoyed low interest rates and therefore cheap loans, this allowed developers to build new apartment blocks, houses and commercial buildings with a relatively low cost of borrowing. Spanish people could afford mortgages at low interest rates and therefore purchased houses contributing to the building boom.





However, when the flow of “cheap money” ran out in mid 2008 the building stopped and the flow on effects of spending dried up. Falling tourism receipts and less foreign investment have also exacerbated the issue leading to unemployment doubling between 2008 – 2010.

We can classify the form of unemployment, illustrated in the Spanish example as demand-deficient unemployment. It is related to a downturn in the economic cycle. This concept is explained below.










Effects & Solutions

The social and economic impacts of 20.7% unemployment are obvious, but the solutions are less so.

Climbing unemployment creates two evils; falling tax revenue as workers no longer earn wages and the increased burden of paying benefits to the four million unemployed citizens.

In addition, a series of social problems are often intertwined with high unemployment, these include depression; lose of skills, poverty and higher crime rates. Spain therefore has a few problems to solve this summer. Whilst Spanish people may enjoy a summer by the beach, and a glass of sangria, the government will be hitting the books to find a solution to the problem. Here are a few suggests to get the politicians thinking.

1. Use fiscal stimulus to boost consumer and government spending, thereby increasing the demand for jobs.

Spain could plan for a budget deficit (expansionary fiscal policy) and fund spending increases though increased government borrowing. Spain’s current level of public debt is 67% of GDP, which is well below stricken Greece at 124%.

However, Spain now has to borrow money from international bond markets, which are skeptical about Spain’s ability to pay back this debt. This is despite assurances and favourable rates offered from the European Union this week. Increasing government debt in a period of European financial crisis is a risky option.

2. Use loose monetary policy (lowering central bank interest rates) to encourage Spanish people to increase their consumer spending through increased borrowing.

If you understand the complexities of the European Union, you understand that all 21-member countries use the same currency and follow the lead of one central bank. Despite one country wishing to lower interest rates, other countries may think differently.

Europe can be compared to a train rolling along on a set of rails, with 21 separate carriages. Each European country must follow behind the big engine, there is no room to deviate from the central banks interest rates and all of the countries must move together.

Many people have wondered how long the European train would run, before one of the carriages derailed.

3. Force Spanish firms to employ more people.

Firms have no requirement to hire more people. They may choose to employ more people but will logically offer everyone lower wages to maintain profitability.

4. Use supply side policies to bring greater efficiencies to firms though increased on the job training and worker education.

This is a long-term solution, which will require large structural adjustments, how Spain produces goods and services and exactly what is does produce. A startling statistic is that the average Spanish university graduate will find their first job at the age of 27, long after they have graduated.

Discussion Questions:

1.How do economists measure unemployment?
2.Explain how expansionary fiscal policy could reduce the rate of unemployment?
3.What does the concept of the natural rate of unemployment represent?
4.Evaluate the effectiveness and suitability of supply side policies to reduce unemployment in Spain

Domestic policy - what would you do???

As I said in the lesson today, domestic economic policy is just as likely to come up in a Unit 4 paper as global issues, so here are a few thoughts on what should happen in the next parliamentary term.......

Now as you know, I am not a political animal (!!!!!), I don't mind if the new UK government is Red, Blue, Yellow or Brown. I am much more concerned with the policies of a new government than the faces behind them. For what it is worth, I thought in the past few years, Gordon Brown probably did better than if the Conservatives would have been in power. Yes, he didn't regulate the finance sector or housing market in the boom years. Nor did he reign in government spending when the economy was doing well. However, I am convinced that other parties would have done almost exactly the same. (maybe the Tories would have cut taxes rather than increased spending) but, I'm sure the budget deficit would still have been 40% of GDP at start of crisis.

Given the crisis, I thought the response of the government was reasonably bold. A real disaster was averted, though I can understand why you don't get much credit for a situation with 2.5million unemployed and the current state of the government finances.

Anyway looking to the future, these are a few of things I would like to see from a new government.

Stable Growth.

We have just escaped from the longest recession on record. It has left a painful legacy - a rise in borrowing, a rise in unemployment, spare capacity in economy. Stable positive growth, is essential for stabilising government borrowing and bringing down unemployment. (importance of growth)

Fiscal Improvement.

Annual borrowing of over 12% of GDP, is clearly completely unsustainable during peace time. Part of the problem is due to cyclical factors and the financial bailout. But, there is also a medium term structural deficit which needs to be tackled. It is no easy task and a few penny pinching ideas here and there are not going to be enough.

Deficit Reduction should not be so severe, the deflationary impact pushes economy back into recession. On the one hand we need to reassure markets, but, we have to maintain a flexibility depending on state of economic recovery. We need to avoid the hysterical over-reaction of a panic spending cuts. Fortunately,

Monetary policy can remain loose.

The Weakness of the Pound should increasingly help our exports.
The Bank of England's own growth forecasts are cautiously optimistic.
Forecast growth of 3% does give us good room for manoeuvre.
But, it is unfortunately true, we could have several years of depressed growth as we focus on deficit reduction

So what should we cut? (Tanaz, are you still reading this?????)

The Welfare State is the biggest burden for government spending. With an ageing population, moves to increase retirement age are essential to promote long term .

Benefits Trap. There is still an element of poverty trap, which helps explain the huge social security budget.

The temptation is to cut 'easy' targets like transport, defence and local authorities. I don't mind scrapping trident. But, if we cut spending on transport, we could damage the long term productive potential of economy, and it would be self-defeating.

What Taxes To Increase?

As an economist, we want government to make a greater effort to tax goods with negative externalities. Tax unhealthy food to finance spending on NHS and encourage healthier lifestyles. Tax carbon emissions. It is possible to raise revenue, and increase economic efficiency. New taxes are never popular, but, if explained, maybe people will see it is the least bad alternative.

These are just a few thoughts which are obviously open to debate....just remember Alex, I am always right!!!!!

Mr Bentley

More on the Euro...it will come up Y13!!!!

The Euro always had many potential problems, but, the current crisis magnifies the economic disparity between different member countries and the difficulties of dealing with this.

Unfortunately, with this current imbalance between north and South / West, the common monetary policy / exchange rate will continue to create friction between very different economies.

Problems With The Euro:

Different Economies

Generally, Germany has a strong track record of improving competitiveness, productivity and moderating wage inflation. Germany has been able to grow relatively strongly and seeks above all to maintain it's strong commitment to low inflation. This objective has a large bearing over stance of ECB.

Economies on the periphery of the Eurozone, Spain, Ireland, Portugal, Italy and most dramatically, Greece don't have this same economic track record. The Greek economy has struggled under a burden of rising wages, not met by productivity gains. This is reflected in a large current account deficit and double digit unemployment.

The Southern Euro economies desperately need:

* A depreciation in the exchange rate to boost competitiveness.
* Monetary policy aimed at boosting economic activity and avoiding the threat of deflation and continued mass unemployment.

However, with a strong economy like Germany in the EURO, the ECB are unlikely to pursue this strategy of reflationary monetary policy. The ECB are caught between the conflicting threats of deflation in the south and the desire for Germany to maintain its strong anti-inflation stance.

Quite simply, it is too difficult to use monetary policy for economies as divergent as Greece / Italy / Portugal and Germany. They need separate Monetary policies. To keep them in the same monetary and fiscal straight jacket will satisfy neither. It will only raise political tensions as there is a constant struggle between the conflicting demands of the different Euro Areas

The Problem of Debt.

The government debt problem has only exacerbated the tensions in the Euro. Unsustainable debt mountains in the south have put pressure on the Euro. There is no political appetite for German taxpayers to bailout the South - and who can blame them?

With Greece and others having to make drastic spending cuts, it becomes even more important that they have some recourse to an independent monetary policy.

It is important to bear in mind, that the problem of government debt is much worse when there is a threat of deflation to compound the real value of the debt.
Why Can't the Weak Members Just Leave the Euro?

Greece must wish it had never joined the Euro. But, as I explain here - Why Greece can't leave Euro. It is practically impossible for Greece to leave because it would cause an irreversible currency flight.

What Should Germany Do?

Germany could bite the bullet and promise to pursue European fiscal union. It could try hard to get a bailout of Greece, and anyone else who gets in too much debt.

The other option is for Germany to leave the Euro and have the freedom to pursue its own monetary policy and exchange rate. The D-Mark would be likely to appreciate quite significantly as it looks much more attractive than the Euro dominated by weaker southern states. It would give Germany a certain freedom from the debt problems of other countries.
Would This Solve the problems of the Eurozone?

It would be a mistake to blame for Euro and the common monetary policy for all the economic ills of Europe. The problems of Greece are far more widespread than a lack of independence over monetary policy and exchange rate. Greece would still need to tackle its long term uncompetitiveness, its bloated public sector, its addiction to government borrowing. If Germany left the Euro, all these problems would still remain.

However, the present crisis illumines the inherent difficulties of trying to promote a common monetary policy in an area as a geographically and political diverse as the Eurozone area.

The Eurozone simply doesn't have:

* Sufficient geographical mobility. Spain has unemployment of 20%, but, it is difficult for Spanish workers to move to other countries like UK, Germany to find work.
* Sufficient political will to pursue common fiscal budget.

It might be worth cutting the losses of the Euro and the strong countries could leave. If they don't they will just continue to be sucked into crisis in countries elsewhere in the Eurozone.

The ideals of the European Union at promoting harmony amongst nations is admirable. But, the problem is that given the current state of European economies, the Euro will not promote harmony, but only increasing conflict as countries grow exacerbated at the conflicting demands of divergent economies.

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European fiscal crisis - will discuss in tomorrows lesson!

European Fiscal Crisis

After weathering a crisis of subprime mortgages and collapsing banks, fifthteen months on we are facing a different crisis - Government debt default. With a history of default, and little prospect of being able to tackle its debt, Greece has been hammered in the financial markets. It's debt has been downgraded to junk status (meaning default is likely). This has led to record interest rates on Greek bonds. Greece is now having to borrow at a staggering 18% interest rate on two year bond. This cost of repayment is crippling and makes it very difficult to make a dent in the actual debt. (out of interest UK pays approx £35bn on debt interest payments at 4%. If interest rates doubled the cost of debt repayments would be £75bn.)

Why Government Borrowing Has Become Such A Problem?

•Before the Recession, many countries had a large structural deficit. There was an inability to meet responsible fiscal targets. e.g. political pressure against tax increases and spending cuts. In particular, Greece has been hampered by powerful unions which gained large public sector wage increases without corresponding increases in productivity. Greece has also struggled to raise taxes and check government spending (especially on defence and civil service)

•The depth of the recession has worsened the government fiscal position much more quickly than expected. Tax receipts have fallen, spending on unemployment benefits have increased.
•Euro Inflexibility.

Being a member of the Euro, countries face limitations in Monetary policy.

1.Can't devalue to restore Competitiveness. Greece, Portugal and Spain have very large current account deficits - indicative of their uncompetitiveness.

2.Can't pursue a moderate inflation target through quantitative easing, independent monetary policy.

The problem for the likes of Greece and Spain is that they are trying to impose 'austerity' problems against a backdrop of potential deflation. It is this deflation (or at least very low inflation which makes market more suspicious of European debt levels. It is one thing to have high levels of debt, but, this is compounded by the very weak prospect of economic growth.

In the post war period, many countries had much higher debt, but, strong economic growth and moderate inflation enabled a reduction in the debt burden; bond markets had more confidence in the government's strategy to repay.

But, this is much harder to see in the current climate of Euro deflation.

1.The ECB still pursues a false goal of worrying about inflation.

2.Greek debt is financed by short term bonds. This means the debt needs refinancing more quickly and it is then harder to inflate the debt away. - short term investors would require a much higher interest rate to compensate for inflation. With long term debt it is somewhat easier to reduce debt burden through inflation.

3.Greece can't leave Euro, even though everyone now agrees it was a mistake to let them in. (even when they joined their debt was over 100% of GDP)

EU debt as a % of GDP

•Italy - 116%
•EU average - 78.2%
•Portugal - 77%
•Spain - 54%
•UK - 68%
•Greece - 112%
•Ireland - 65%

Annual Deficit

•Ireland - 14.3%
•Greece - 13.6%
•UK - 11.5%
•Spain - 11.2%
•Portugal - 9.4%
•EU - 6.8%
•Italy - 5.3%