We're doomed, doomed I tell yer!!

Two pieces of economic news caught by eye recently.

Net Savings increased. Last year, households deposited £24 billion of savings and borrowed £20billion. The first time since records began in 1988 that net savings exceeded net borrowings.

Retail sales fell for the second month in a row. The CBI distributive trades survey showed a balance of -5% of retailers reporting that sales were down year-on-year. That was up from a 14-month low of -18% in May. But, still in negative territory despite a world cup and good summer. July should be better as consumers seek to avoid VAT rise

The rise in savings and gloom over consumer spending is despite record low base rates. Savings increased because of:

fears over unemployment

Expectations over wage cuts / wage freezes

Banks offering saving rates far above the Bank of England base rate

Given fiscal austerity of the government, uncertainty over house prices and lower confidence by consumers, the trend to greater savings than borrowings may continue.

On the one hand, greater savings is beneficial. In the boom period of the early naughties, households were overextending themselves, running down savings and borrowing on credit. The fact householders are paying down debt is good in the sense that when interest rates rise it will be less of a burden, and the economy will be more balanced in the long term.

However, we should not forget the paradox of thrift' - the situation where individual decisions to save lead to lower overall demand in the economy.

If we have a double austerity - saving by households and spending cuts by government, the chance for a double dip recession increases.

Keynesian Budget deficits

A very casual reading of economics may leave you with the impression that Keynesian economics believes in 'budget deficits', whilst conservative economic thought believes in responsibility and the reduction of budget deficits.

There is always a danger of simplifying economics, and this view would be misleading. Keynesian theory advocates government borrowing only in cyclical downturns when there is a rise in private sector saving and period of unemployment. In a cyclical upturn, there should be the reverse of borrowing - governments should take the opportunity to reduce the budget deficit, and if appropriate run a surplus.

For example, it was a mistake for the Labour party to increase borrowing in the period 2003-04 by raising public spending. The rise in debt to GDP seemed innocuous enough at the time ( a rise in debt from 29% to 35% of GDP hardly seemed cause of much concern, and there wasn't much criticism at the time.) However, in retrospect, it was a mistake to run a bigger deficit in a period of economic boom.

It was a similar story in the late 1980s, when the Conservative chancellor responded to an economic boom, by cutting income tax to put even more fuel on the fire of an overheating economy (the infamous Lawson boom)

It is the same story in the US. In 2001, conservatives were deeply worried about the prospect of budget surpluses they had inherited from the Clinton administration. They feared the prospect of the government having too much budget surplus and having to do things like invest to provide for long term pension commitments and other 'socialist' nonsense.

It's hard to believe only a few years ago, American conservatives were worrying about having a budget surplus. But, it was this ideology which justified huge income tax cuts for the middle class, at a time when the housing bubble was just getting underway.

It is of small irony, that Republicans, such as, Senator Ben Nelson, who recently voted to cut unemployment benefits (worth a small $77 billion on grounds economy couldn't afford it) was the same senator instrumental in passing the first Bush tax cut, which cost a cool $1.3 trillion. It is a case of getting everything the wrong way round.

Deflationary Fiscal Policy

It does not seem that long ago that I was trying to explain 'fiscal stimulus' packages to Maral. It now seemes that I will be trying to explain 'fiscal austerity' as well....unbelievable!!!!

With the evangelical fervour of Franciscan friars, the Conservatives are preparing us for a metaphorical fiscal hairshirt - spending cuts and tax rises. Is it me or do they seem to be revelling in this period of inflicting 'austerity' and 'necessary pain' on the economy? There is a seductive ideology that if there is 'pain' there must be some gain. Conservative ideology loves to portray spending cuts as saving us from 'the road to ruin'.

Presumably, that is what the electorate were told in 1931, the establishment pushing through spending cuts, and tax rises as the world teterred on the brink of the Great Depression. Needless to say, the deflationary fiscal policy combined with tariff rises and lack of money supply growth pushed the global economy into the worst recession on record. And we didn't even learn from our mistakes, in 1936-37, deficit hawks pushed the economy back into a double dip recession as fears of growing deficits led to tax rises and spending cuts pushing an economy back into recession.

Deflationary fiscal policy involves higher taxes and lower spending. This will reduce the growth of aggregate demand and could lead to lower growth or even negative economic growth. The impact of deflationary fiscal policy on growth depends on:

The resilience of consumer spending in face of tax rises and wage freezes

Whether exports can take the slack of slowing domestic demand

Whether monetary policy can absorb some of the deflationary pressure on the economy.

Conservatives may point to individual countries which have reduced a budget deficit without too much pain. (e.g. Canada) However, these experiences of reducing deficit are usually accompanied by

falls in exchange rate and growth in exports to other countries
a significant loosening of monetary policy which enables demand to remain strong.

The problem is that at the moment, every major economy seems to be considering deficit reduction as primary macro objective. There is little prospect of exports compensating for fall in domestic demand. We can't have all major currencies depreciating - who is going to depreciate against whom?

Also, with interest rates at close to zero there is little prospect of interest rate cuts. We could pursue further quantitative easing, but, with inflation already above target, this would be complicated.

If UK domestic demand suffers, I can't see exports to Europe compensating. The ECB seem firmly entrenched in fiscal and monetary austerity - whatever the costs to growth or unemployment.

Year 12 - Introduction to Unit 3

Labour market reform: France raises the retirement age.

I was shocked to hear that in France, the public retirement age is 60 (law since 1982). I was shocked, though not surprised, to hear the French are planning a series of protest against plans to raise the retirement age to 62.

France (like the rest of Europe) faces a twin problem:

Too much government debt (France is higher than Spain -80% of GDP in 2009)

Threat of second recession and even higher unemployment.

The problem is that it is very difficult to reduce government debt without adding to the second problem. If Europe is not careful, it could find itself in a situation of mass unemployment, stagnant growth, growing disillusionment and political upheaval.

Raising the retirement age is one of the few policies which can tackle structural budget deficits without causing lower economic growth. Raising the retirement age can increase a countries productivity and enable higher tax revenues. It can help reduce budget deficits without causing lower growth.

People will say it is not fair that if they plan to retire at 60, it later gets changed to 61. But, I don't have too much sympathy for these people, what about those who suffer long term unemployment? - those who have little chance of employment because of stagnant growth?

Why should society, pay pensions for an average of 25- 30 + years of an adult's life? Most retirement ages were set at the turn of the century, when life expectancy were much lower. Why do we have to cripple the economy and set higher tax rates, just so we can enjoy decades of saga holidays, and day time TV?

It is inconvenient to have to work another year, but, it is a disaster to have youth unemployment rates of 40%.

The problem is people protest about the wrong things. Why aren't there mass protests about double digit unemployment rates, and the ECBs fetish with low inflation in the face of recession?

OK, maybe a strike about the mistakes of not pursuing quantitative easing in the face of a liquidity trap may not captivate the average voter. But, we need to keep things in perspective, having to working to 61 is not the end of the world. A second recession in 2011 would be a real disaster for the European Union.

I'm not saying raising the retirement age is a panacea for all problems. Changing the retirement age probably won't really determine next years economic growth rate. But, it does make sense in the long term. If life expectancy increases, we simple can't afford to pay generous public sector pensions for 50% + of a persons adult life.

Jean-Claude Mailly called the legislation "socially unjust and economically inefficient."

I never though I'd say this, but, France could do with its own Margaret Thatcher now. Raise the retirement age to 68. That's what I want.

Mr Bentley (not a Thatcher supporter btw!!!!)

Balls!! The Law of Diminishing Returns......

check out video from Penn State University....good way to show a diffcult concept!

UK Economic Growth - interesting stats

Typically, the UK economy has grown at around 2.5%. In the last budget, trend growth was assumed to be 2.5% from 2010. In the UK, there have been periods of booms and busts; but, short lived recessions generally don't harm the underlying trend rate.










The recent OBR report on the UK economy suggests that the recent financial crisis / recession has led to a decrease in the UK's long run trend rate.

1. They have downgraded growth forecasts to 2.35% until 2013, and then fall back to 2.1%. For similar reasons, the OBR has cut the estimate of the amount of spare capacity in the economy at the end of 2009 - from 4% of GDP to 2% of GDP.
   
   A lower average growth rate (long run trend rate) means the economy will expand at a slower rate. It means tax receipts will grow slower than expected, making it more difficult to reduce budget deficit.
   
   If the data about spare capacity is correct, it means demand pull inflationary pressures may return sooner than expected.
   
   A prolonged recession has the capacity to reduce long run trend rate of growth because:
   
   Rise in unemployment can lead to loss of skills, people becoming demotivated, leaving labour market early (e.g. going on disability benefits)
   


2. The recession highlighted the flimsy nature of a consumer led (asset price) driven growth.
   


3. Financial sector has taken a hit
   


4. Banks become more cautious in lending, making finance more difficult.
   


5. Change in attitude by consumers and firms.

The good news about the OBR report is that borrowing is likely to be £25bn lower than expected. The bad news is that there is still a substantial structural deficit. But, markets are likely to be reassured that the UK doesn't have any budgetary black holes, and there is a reasonable path to fiscal stability.

The bad news about the report is that growth forecasts of 2.25% don't really take into account;

prospect of spending cuts
prospect of European wide slowdown, from Euro austerity packages.
If there is a strong external shock combined with tightening of fiscal policy (and politicians repeating how bad the economy is) growth may fail to materialise and we will struggle to reduce unemployment and tackle deficit.

However,

Growth forecasts for 3-4 years in future are notoriously difficult to predict. Given volatility in the world, a lot can change.

If we are willing to turn a blind eye to inflation, then loose monetary policy may be sufficient to offset the deflationary impact of fiscal policy.

It may also be too early to judge about the long run trend rate of growth. Technological factors may still enable 2.5% growth.

UK fiscal deficit (compare with Canada's solution)

Good article on fiscal policy.....hope you find it interesting!

It seems the whole of Europe has developed a mania for good old austerity, and deficit cutting. (One could almost forget we have 2.5 million unemployed, it seems the only economic objective in Conservative Britain is reducing the budget deficit.)

Mr Cameron has been holding up the example of Canada as a good example of a country who radically cut spending in the 1990s. It is easy to take a historical precedent and give misleading impressions we can apply it in different circumstances.

A few features of Canadian deficit reduction of the 1990s:

Canada debt wasn't at crisis levels, it was half that of Italy and Belgium

The Spending Cuts were offset by a loosening of monetary policy. Canadian interest rates were cut to maintain consumer spending (UK rates cannot be cut, only more quantitative easing.)

The Spending cuts were also offset by a strong depreciation in the Canadian currency and a boom in exports to the US. At the time the US were growing strongly. In 1998, Canadian exports accounted for a staggering 45% of GDP.

An Example of A Fall in Government Borrowing Leading to A Rise In Private Borrowing.




The fall in government borrowing was offset by a rise in private and corporate borrowing.

What people forget is that in a recession government borrowing needs to rise to offset the rise in private sector saving.

Focusing only on government borrowing gives a misleading impression to the indebtedness of a county. See: Principles of Borrowing which offers a similar graph for US.

Government borrowing in a recession should not be seen as 'reckless' or 'irresponsible'. The only irresponsible action is to starve the economy of spending at a time when it needs it most. It's a lesson we've trying to learn ever since the Great depression

Why UK spending Cuts would not Work like in Canada

There is little room for monetary policy easing.

There is little scope for further export led growth. The Pound is depreciating, but many countries are now trying to allow currency to weaken.

Austerity in Europe is creating less growth in the Eurozone - our main trading partner.

Household sector is still fragile, tax rises and spending cuts would lead to a fall in private sector spending.

Lower growth will make it difficult to reduce the deficit.

Deflation...Again!!

Yes I know I have been banging on about deflation in the past, but it is just as bad if not worse than inflation. So take time out to have a read of following....again;

Despite the UK having inflation of 3.7%, deflation is a potential problem around the world. For example, in April of this year:

US core consumer prices rose by a mere 0.9% - lowest rate for many years

In the euro area they rose by 0.7%.

In Japan, which has battled falling prices for more than a decade, they fell by 1.5%. (Japan now has the same Nominal GDP now as in 1992)

It may seem good when prices fall, but generally falling prices is bad for the economy. The only real exception is when falling prices are due to rising productivity and technological innovation. (ie Aggregare Supply shifts)

This is why.

When prices are falling, consumers tend to delay purchasing. Rather than buy a flatscreen today, they wait a year when they will be cheaper. The effect of falling prices is to depress consumer spending leading to lower economic growth.

Increasing real value of debt. When people take on debt like mortgages, they expect the value of the debt to be steadily eroded by inflation. (A mortgage becomes easier to repay as your wage increases). When there is deflation, the real value of debts increases. You owe the same, but, your wage is falling. Therefore, you have to spend a higher % of your income on servicing the debt

Increasing Government Debt to GDP ratio. Deflation also increases the real value of government debt. It makes it much more difficult to reduce the debt to GDP ratio. Thus countries can start spending a higher % of income on debt repayment. Furthermore, as deflation tend to reduce economic growth, the cyclical deficit increases. This lack of nominal GDP growth is a key factor in why markets dislike the Greek situation.

Real Wage Unemployment. Wages are often sticky downwards. (Unions resist nominal wage cuts). Therefore, falling prices are often not met by falling wages, leading to a rise in real wages. This creates real wage unemployment. It also makes a countries exports less competitive (particularly a problem in the Eurozone where countries can't devalue the exchange rate)

Monetary Policy Becomes ineffective. With deflation, zero interest rates may be too high. Even quantitative easing may be insufficient to get people spending. (deflation and monetary policy)

Year 10 - Economics

Market systems.....

Benefits of Globalisation

This was a bit more difficult to find, which suggests to me that perhaps the impact of globalisation is seen as more negative than positive.....

Disadvantages of Globalisation

Advantages to follow.....

Exchange Rates - A Run on the pound??

A run on the pound refers to a situation where international investors become nervous over holding sterling and sterling assets, and so sell as quickly as possible.

A run on the pound may occur when markets feel the Pound is overvalued and likely to fall quickly. If markets expect the pound to fall, they will sell quickly before making a loss.

What May Cause a Run on the Pound?

A run on the pound is more likely in a semi fixed exchange rate. e.g. when the Government is committed to trying to keep the Pound at a certain level.

If markets feel this level is unsustainable they may keep selling Pounds until the government is forced to devalue.

For example, in 1992, the UK tried to maintain value of Sterling in ERM, but, ultimately markets forced the UK out and we had to devalue (black Wednesday!).

We also had a run on the pound in the late 60s, causing the Wilson government to devalue pound. (In 1967, Wilson devalued pound by 15% after selling many foreign currency reserves trying to maintain value of Pound)

http://www.youtube.com/watch?v=TR8Esy-QMdA

In 1976 there was another run on the Pound as markets feared the UK's fiscal position.

High Inflation

High inflation reduces the value of Pound Sterling. Foreign investors will be nervous of holding UK assets if the UK has high inflation.

Is the UK at risk from a Run on the Pound?

At the moment, we aren't. Firstly the Pound is floating i.e. governments are not trying to keep its value high. The Pound has already depreciated by about 20% in past 18 months. - This wouldn't count as a run on the pound but large gradual depreciation. With a floating exchange rate, there is less chance of markets feeling an exchange rate is fundamentally overvalued.

UK's debt is a concern, but, we still retain AAA rating and prospects for growth have improved situation. It certainly looks worse in some other European countries.

Would Membership of Euro protect against A Run on the Pound?

Well, we couldn't have a run on the Pound, but, it doesn't solve the underlying problems like lack of competitiveness, excessive government borrowing, negative growth. Being outside the Euro, would give Greece more flexibility for dealing with their crisis.